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The impact of monetary policy on consumer price index (CPI): 1985-2010

par Sylvie NIBEZA
Kigali Independent University (ULK) - Master Degree 2014

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2.1.3 Instruments of monetary policy

The instruments or tools of monetary policy are of two types Qualitative and Quantitative in nature.

Qualitative control includes change in margin requirements, regulation of consumer credit, moral persuasion, publicity, direct action.

Quantitative control includes open market operations, the reserve ratio, the discount rate, Foreign Exchange Interventions.

Monetary policy guides the Central bank's supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income.

The instruments of monetary policy used by the Central bank depend on the level of development of the economy, especially its financial sector (Federal Reserve System and Monetary Policy, 1979).

The commonly used instruments are:

1. Reserve Requirement

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans.

By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loan able funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.

2. Open Market Operations

The Central bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market).

One such security is Treasury Bills. When the Central bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money.

3. Lending by the Central bank

The Central bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base.

4. Interest Rate

The Central bank lends to financially sound Deposit Money Banks at a most favorable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP).

5. Direct Credit Control

The Central bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions.

6. Moral Suasion

The Central bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment.

7. Prudential Guidelines

The Central bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized.

Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making.

8. Exchange Rate

The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real.

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