How Monetary Policy Affects Bank Rates

Monetary policy is the process by which the central bank of a country manipulates the supply of money in circulation at a given time for a specific purpose. The process is aimed at targeting the interest rates to achieve the desired goals. The movement of interest rates can be used to promote growth and stability in an economy. Factors that can be stimulated by interest rates changes include investment, savings, employment, inflation and the overall economic growth in the country.

The monetary policy can either be expansionary or contractionary in nature. If a monetary policy is expansionary it means that the Central Bank is increasing the total supply of money in the economy. As with the basic laws of demand and supply an increase of money in the economy will lead to a lowering in the interest rates. This usually the core remedy when an economy is under recession and in need of economic stimulation. The increase of money supply will then lead to a fall in the bank rates.

On the other hand if the monetary policy is contractionary the Central Bank is reducing the supply of money in the economy. A cut in the supply of money will entail that interest rates will rise. Most Central banks embark on such a policy when the economy is “overheating” and the threat of inflation is real. A cut in the supply of money will mean more demand forcing the bank rates to go up.

For a Central Bank to achieve its aim they have to use monetary policy tools to achieve the stated objectives. The following tools are commonly used depending on a particular situation. The use of theses tools have the effect of changing bank rates.

a. Open Market Operations (OMO)

This is the primary tool that is used when managing the quantity of money in an economy. This involves the buying and selling of various financial instruments which includes Treasury bills and bonds on the market. It also happens to be the most flexible tool that can be used. In the United States of America for example the Federal Open market Committee (FOMC) sets up the monetary policy. If the Committee decides that there is a need for an expansionary policy and that more money and credit must be given to people then instructions are issued to the trading desk. The trading desk must then move into the market and buy Treasury bills and bonds. The Federal bank would then pay for the instruments by crediting the Banks with the cash. The end result is that Banks have additional capital which then brings down the interest rates. So if one is going to go to the bank under such conditions the bank rate will fall and you can borrow at a lesser price.

To tighten money and credit in the economy the opposite is done, the trading desk sells various financial instruments .The Federal government will receive payments from the banks by reducing their Reserve accounts. With less money in the economy the interest rates will shoot up and lending becomes costly to the bankers who in turn will increase the bank rates.

b. The discount rate or the repo rate.

This is the rate of interest rates that a Central Bank charges to commercial banks that borrows money on the from the Government. The repo rate varies depending on what the Central bank hopes to achieve. If a central Bank increases the discount rate to the banks, then this would be a restrictive policy which makes money more expensive leading to increases in the bank rates. The opposite is also true a drop in the rate would signal cheaper money and an expansionary policy leads to the lowering of the bank rates.

c. Reserve ratio requirement

In the banking world all the financial institutions must set aside a percentage of their deposits to the central bank as a reserve. The reserve ratio is set by the Central bank for all the commercial banks and other financial institutions to comply. So if a bank is allowed to keep 10 percent of its capital as reserves this must be adhered to, similarly if the ratio is cut down to a figure of 8 percent more money will circulate in the economy leading to a drop in bank rates. If the ratio is increased bank funds in the circulation will be slashed and bank rates will go up.

D. Moral suasion

Another tool that can be used for monetary policy and can affect the bank rate is moral suasion. This is a tactic used by authorities to influence and pressure, but not force banks into adhering to a particular policy. In the United States of America this is referred to as “jawboning” tactics that can be used include holding meetings with bank directors or issue out statements in the public. The moral aspect comes in because the banks should have a moral responsibility to operate within a set work frame. This instrument is effective during short-term predicaments. This includes situations where there is financial instability or shortages.

One can therefore conclude that every time there is a monetary policy announcement made by the monetary authorities, it is bound to affect the bank rates.