Monetary Policy Strategy in Rwanda
par Serge Musana Mukunzi
University of Kwazulu Natal - Maitrise 2004
After selecting monetary policy objectives, Central Banks make use of various monetary policy instruments at their disposal. Fundamentally these instruments allow the Central Bank to stimulate or slow down the economy by influencing the quantity of money and credit the banks can provide to their customers through loans. Two types of monetary instruments are generally classified, namely indirect and direct policy.
According Gidlow (1998), the indirect policies are considered to be actions taken by the Central Bank whereby it achieves its monetary policy aims by encouraging market participants to take particular actions in terms of their lending and borrowing behavior. These actions may be the result of price and interest rate incentives or disincentives brought about in the financial market. The direct policy instruments on the other hand refer to the measures taken by Central Bank that seek to attain the aims of monetary policy by means of certain rules prescribing the behavior pattern of banks and possibly other financial institutions. The indirect instrument is also considered as market-oriented whereas the direct instrument is a non-market-oriented. Meyer (1980) agreed that monetary policy instruments are generally classified as either general or selective controls. General controls have their primary effect on either the net monetary base or the size of the money multiplier. These include open market operations, changes in reserve requirements, and changes in the discount rate. Selective controls on the other hand, have their primary influence on the allocation of credit among alternative uses. The examples of selective controls include margin (or down payment) requirements for loans to acquire securities and interest rate ceilings on rates paid by banks on savings accounts or charged by banks on loans. Gidlow (1998) provided as an example of direct policy instruments, the case of instructions sent to banks under which the latter are requested not to exceed a certain amount of lending to domestic private sector borrowers as specified period, and instructions that banks must not quote interest rates above or below a certain maximum or minimum level on their various credit and deposit facilities made available to customers. Alexander et al (1995:14) also provided an interesting explanation about direct and indirect policy instruments. They showed that the term «direct» refers to the one- to one correspondence between the instrument (such as credit ceiling) and the policy objective (such as a specific amount of domestic credit outstanding). Direct instruments operate by setting or limiting either prices (interest rates) or quantities (amounts of credit outstanding) through regulations, while indirect instruments act on the market by, in the first instance, adjusting the underlying demand for, and supply of bank reserves. Based on these descriptions, it can be noted that both types of policy instruments play an important role in economic activities. However, direct and indirect instruments do not have the same effectiveness in improving market efficiency in the same economic environment. As has been specified previously, the most common direct instruments are interest rate controls, credit ceilings and directed lending. Alexander et al (1995: 15) argued that «direct instruments are perceived to be reliable, at least initially in controlling credit aggregates or both the distribution and the cost of credit. They are relatively easy to implement and explain and their direct fiscal costs are relatively low. They are attractive to governments that want to channel credit to meet specific objectives». In countries with very rudimentary and noncompetive financial systems, direct controls may be the only option until the institutional framework for indirect instruments has been developed. The same authors also showed the disadvantages of direct instruments. These consist of the fact that credit ceilings are based on amounts extended by particular institutions and therefore they tend to ossify the distribution of credit and limit competition, including the entry of new banks. All those advantages lead to the conclusion that direct instruments often lose their effectiveness because economic agents find means to circumvent them.
Three main types of indirect instrument are mentioned:
-Open market operations
-Central Bank lending facilities
The open market operations are often seen as the most important monetary policy tool because they are the primary determinants of changes in interest rates and the monetary base and are the main source of fluctuations in the money supply (Mishkin, 1997).
The way this instrument influences the economy can be seen from purchase or sale of financial instruments by the Central Bank. Open market purchases expand the monetary base, thereby raising the money supply and lowering the short-term interest rates. Conversely, open market sales reduce the reserves of the banking system, reducing the ability of banks to lend and invest, and limiting the amount of funds available for the economy to use (Federal Reserve System and Monetary Policy, 1979).
Open market operations are also based upon dynamic defensive operations; dynamic operations are those taken to increase or decrease the volume of reserves in order to ease or tighten credit. Defensive operations, on the other hand, are those taken to offset the effects of other factors influencing reserves and the monetary base.
Another interesting indirect monetary policy tool concerns the changes in the reserve requirements. This consists of obliging banks to hold a specified part of their portfolios in reserves at the Central Bank (Alexander et al, 1995). This instrument affects the money supply by causing the money multiplier to change.
Lastly, the Central Bank's lending facilities it is an indirect instrument, which is often well known as discount policy. The discount policy involves changes in the discount rate which affects the money supply by affecting the volume of discount loans and the monetary base. A rise in discount loans adds to the monetary base and expands the money supply whereas a fall in discount loans reduces the monetary base and shrinks the money supply (Mishkin, 1997).
Once all the instruments mentioned above are well applied, the results easily seen in the level of economic activity since those instruments influence the growth of the money supply as well as other financial variables.
However, it is also worth noting that by using indirect instruments, the Central Bank can determine the supply of reserve money in the long term only under a fully flexible exchange rate regime. Even under a pegged or managed exchange rate regime, however, Central Bank transactions affect reserve money, at least in the short term. These transactions affect bank's liquidity position, which results in adjustments to interbank, money market, and bank loan and deposit interest rates to re-equilibrate the demand for, and the supply of, reserve balances (Alexander et al, 1995).