Money and Banking – Monetary Economics of Financial System

Dr. Moyi Harry Ruben 

The core functions of the central bank in the global world include managing monetary policy with the aim of achieving price stabilization; to prevent liquidity crisis, situations of money market disorders, financial crisis and to ensure the smooth functioning of the payment system. This article explores these issues and focuses in particular on the conduct of monetary policy, distinguishing between instruments, targets and goals. Furthermore, it will examine some basic concepts as they relate to central banking theory. Especially, the fundamental areas, and question asked normally is what are the monetary policy functions of the central bank. How are we near to these? To answer this question, we need to review the macro-economic policy environment.

Hence, there are five important forms of macroeconomic policies conducted by governments that are of relevance for the economy. These are: Monetary Policy; Fiscal Policy; Exchange Rate Policy, Prices and Income Policy and National Debt Policy. Monetary policy is concerned with the actions taken by central banks to influence the availability and cost of money and credit by controlling some measure (measures) of the money supply and or the level and the structure of interest rates.

Fiscal policy relates to changes in the level and structure of government spending and taxation designed to influence the economy. As all government expenditures must be financed, these decisions also, by definition, determine the extent of public sector borrowing of debt repayment. An expansionary fiscal policy means higher government spending relative to taxation. The effect of these policies would be to encourage more spending and boost the economy. Conversely, a contractionary fiscal means raising taxes and cutting spending.

Exchange rate Policy involves the targeting of a particular value of a country’s currency exchange rate thereby influencing the flows within the balance of payments. In some countries, it may be used in conjunction with other measures such as exchange controls, import tariffs and quotas. -Prices and income Policy is intended to influence the inflation rate by means of either statutory or voluntary restrictions upon increases in wages, dividends and or prices.

National Debt Management Policy is concerned with the manipulation of the outstanding stock of government debt instruments held by domestic private sectors with the objective of influencing the level and structure of interest rates and or the availability of reserve assets to the banking system. As I have stated that my focus is mainly monetarism, however, it must be remembered that any one policy mentioned above will normally form part of a policy package and that the way in which that policy is employed will be dependent upon the other components of the package. Although traditionally the choice of monetary policy over fiscal policy as the main policy tool was viewed as a matter of ideological choice, nowadays it is seen more as a pragmatic solution. As it is widely recognized that high and variable inflation harms long-term growth and employment, policymakers have tended to focus on those policies that appear to be most successful in dampening inflationary pressures.

Price stability, therefore, has become a key element of economic strategy and monetary policy is widely accepted as the most appropriate type of policy to influence prices and price expectations. The preference for using monetary policy over others types of policies relate to two main factors: The role of the monetary authorities (Central Bank) as sole issuers of banknotes and bank reserves (Known as Monetary Base) and the long-run neutrality of money. The central Bank is the monopoly supplier of the monetary base and as a consequence can determine the conditions at which banks borrow from the central banks. The central bank can influence liquidity in the short-term money markets and so can determine the conditions at which banks can buy and sell short-term wholesale funds, (auction sell of Dollars).

By influencing Short-term money market rates, the central bank influences the price of liquidity in the financial system and this ultimately can impact on various economic variables such as output or prices. In the long run, a change in the quantity of money in the economy will be reflected in a change in the general level of prices but it will have no permanent influence of real variables such as the level output and unemployment. This is known as long-run neutrality of money.  The argument goes that real income or the level of employment are in the long run determined solely by real factors such as technology, population growth or the preferences of economic agents. Inflation is therefore solely a monetary phenomenon.

As a consequence, in the long-run: -Central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices. – Economic growth cannot be increased through monetary expansion (increase in money supply) or by keeping short-term interest rates or (exchange rates) at levels inconsistent with price stability. In the past it has been noted that long periods of high inflation are usually related to high monetary growth. while various other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over the short period, overtime these influence can be offset by a change in monetary policy. Monetary policy is one of the main policy tools used to influence interest rates or exchange rates; inflation and credit availability through changes in supply of money or liquidity available in the economy.

It is important to recognize that monetary policy constitutes only one element of an economic policy package and can be combined with a variety of other types of policy for example fiscal policy as described above to achieve stated economic objectives. Historically, monetary policy has to a certain extent, been subservient to fiscal and other policies involved in managing the   macro economy, but nowadays it can be regarded as the main policy tool used to achieve various stated economic policy objectives or goals.

  1. Stability in Foreign Exchange Markets: Stability in foreign exchange market has become a policy goal of increasing importance especially in the light of greater international trade in goods, services and capital. A rise in the value of a currency makes exports more expensive (an increase in the value of South Sudan Pound relative to the dollar means that consumers in the Uganda have to pay more for goods and services. Extreme adverse movements in a currency can therefore have a severe impact on exporting industries and can also have serious inflationary consequences if the economy is open and relatively dependent on imported goods like South Sudan. Ensuring the stability of foreign exchange market is therefore seen as an appropriate goal of monetary policy.
  2. Financial Market Stability: Financial market is also one of the important objectives of the monetary authorities. A collapse of financial markets can have major adverse effects on an economy. The monetary authorities intervened because they were concerned about the serious consequences for financial markets if they allowed the hedge fund on the brink of failure. Financial market stability is influenced by stability of interest rates (exchanges rates) because increases of bonds and other investments resulting in losses in the holders of such securities.
  3. Interest Rate Stability / Change rates Stability: Interest rate stability is a desirable economic objective because volatility in interest rates creates uncertainty about the future and this can adversely impact on business and consumer investment decisions. Expected higher interest levels deter investment because it reduces the present value of future cash flows to investors and increase the cost of finance for borrowers.
  4. Price Stability: Price Stability is considered an essential objective of monetary policy, given the general wish to avoid the costs associated with inflation. Price stability is viewed as desirable because a rising price level creates uncertainty in the economy and this can adversely affect economic growth. Many economists argued that low inflation is a necessary prerequisite for achieving sustainable economic growth.
  5. Stable economic Growth: Stable economic growth provides for the increases over time in the living standards of the population. The goal of steady economic growth is closely related to that of high employment because firms are more likely to invest when unemployment is low, when unemployment is high and firms have idle production they are unlikely to want to invest in building more plants and factories. The rate of economic growth should be at least comparable to the rates experienced by similar nations.
  6. High Employment: High employment is often cited as a major goal of economic and monetary policy. Having a high level of unemployment results in the economy having idle resources that result in lower levels of production and income, lower growth and possible social unrest. However, this does not necessary mean that zero unemployment is a preferred policy goal. A certain level of unemployment is often felt to be necessary for the efficient operation of a dynamic economy. It will take people a period of time to switch between jobs or to retain for new jobs, and so even near full employment there maybe people switching jobs who are temporarily out of work. This is known as frictional unemployment. In addition, unemployment may be a consequence of mismatch in skills between workers and what employers want, known as structural unemployment. Although structural unemployment is undesirable monetary policy cannot alleviate this type of unemployment, but this can be minimized.
  7. Supervision. This function is not only important to help banks advance with business but important to customers. Yet it has been totally neglected for example, banks propagate that they offer interest on saving deposits (A/C) but none of them have paid any interest on saving deposits, Shareholders funds compensation had ever been considered for dividends. Yet no one questioned “Why”. This is one of the duties of the central bank, to read the balance sheet of these bank and see which of these follow the Memorandum of association filed with the registrar of companies otherwise a breach of obligations may be in question. the corporate governance is completely out ot place. Bank managers claim and record higher profits yet they actual had huge losses. They take advantage of the board of directors who have little knowledge of financial analysis. The complexity of terms i.e. Income, profits, Returns, Earnings, Reserves, capital gains and interest expense. These words have clear definitions if they are used properly -accountants and bankers play with these words and pay themselves huge bonus or claim for bonus and yet no profits have been made who is to blame? (Shareholder).

How the financial system affects the economy of the country, require the understanding of Macroeconomics instruments, that is, How the Financial Institutions, Financial Instruments, and the financial markets affect the national economy. In view of these, understanding of the roles and the functions of Financial Markets, Financial Instruments and financial Institutions become very important in sustainable growth and development.

The author can be reached via mobile number: 211 922 166 557




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