Question

Question one

For this question, refer to the Bank of Ghana’s Monetary Policy Committee Press Release of March 18, 2020.

e) Based on the information in the Press Release, in the thinking of the MPC did the risk to growth outweighed the risk to inflation or vice versa? Refer to specific points from the press release to back up your argument.

f) Using the money market diagram, explain the effect of this policy measure on the real interest rate and real money holdings.

g) In ordinary language, explain how the reduction in the Monetary Policy Rate will help the relative risk identified in part (e) above.

h) In addition to the reduction in MPR, the MPC also reduced the Primary reserve requirement from 10% to 8%. Explain how this additional measure will affect the economy, carefully explain the channel.

Answer 1

*Answer:

(e)

UK growth has slowed steadily since 2014 from more than 3% to 1.2% in the most recent four quarters, but the unemployment rate has continued to fall, suggesting growth has nevertheless been stronger than potential growth, so that economic slack has continued to be eroded. I will discuss the major risks to the UK economy as they relate to (a) the future pace of demand growth (b) the future pace of supply growth (c) the extent to which reduced slack in the economy is leading to upward pressure on medium-term inflation.

(a) Future demand growth: the pace of growth in the world economy has generally strengthened from mid-2016 to late 2017, which has provided a tailwind for UK demand growth via improved net trade and investment. The pace of global growth has slowed in Q1 2018. Some of that was likely due to erratic factors such as weather (Eurozone, UK) and timing of tax payments (US). If global growth weakens more persistently, that would present a downside risk to UK growth. Sources of downside risk are a tightening of global financial conditions, an escalation of trade conflicts, a sharper than expected slowing in China. However, still loose financial conditions combined with a less fiscal drag (on average, across advanced economies) presents an upside risk to the MPC’s forecast of a gradual slowing in global growth, such that the overall risks to that global outlook are broadly balanced.

(b) Supply growth: UK productivity growth has been unusually weak over the past decade. Productivity growth has fallen across advanced economies, and has fallen a little more in the UK. No precise estimates are possible, but around half of the slowdown appears to be due to firms operating with too little capital, relative to the labour they employ. This could reflect either or both the persistently weak business investment or the strong employment recovery. Deleveraging in the financial sector has also contributed to weakness in measured productivity directly . Improved business investment growth, and the end of financial sector deleveraging, should lay the foundation for some improvement in productivity growth in the coming years, and that is what the MPC expects.

(f)

A larger money supply lowers market interest rates, making it less expensive for consumers to borrow. Conversely, smaller money supplies tend to raise market interest rates, making it pricier for consumers to take out a loan. The current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates. In a market economy, all prices, even prices for present money, are coordinated by supply and demand. The money supply in the United States fluctuates based on the actions of the Federal Reserve and commercial banks. By the law of supply, the interest rates charged to borrow money tend to be lower when there is more of it.

The demand for money is generally equated with cash or bank demand deposits. Generally, the nominal demand for money increases with the level of nominal output and decreases with the nominal interest rate. The equation for the demand for money is: Md = P * L(R,Y). This is the equivalent of stating that the nominal amount of money demanded (Md) equals the price level (P) times the liquidity preference function L(R,Y)–the amount of money held in easily convertible sources (cash, bank demand deposits). Specific to the liquidity function, L(R,Y), R is the nominal interest rate and Y is the real output. Money is necessary in order to carry out transactions. However inherent to the holding of money is the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. When the demand for money is stable, monetary policy can help to stabilize an economy. However, when the demand for money is not stable, real and nominal interest rates will change and there will be economic fluctuations.

Interest rates aren't only the result of the interaction between the supply and demand for money; they also reflect the level of risk investors and lenders are willing to accept. This is the risk premium. The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). It is viewed as a cost of borrowing money. Interest-rate targets are a tool of monetary policy. The quantity of money demanded varies inversely with the interest rate. Central banks in countries tend to reduce the interest rate when they want to increase investment and consumption in the economy. However, low interest rates can create an economic bubble where large amounts of investments are made, but result in large unpaid debts and economic crisis. The interest rate is adjusted to keep inflation, the demand for money, and the health of the economy in a certain range. Capping or adjusting the interest rate parallel with economic growth protects the momentum of the economy.

(g)

The first is through their impact on valuations, incomes, and cash flows that are typically used as an input in the risk-management models employed by most financial institutions.4 A reduction in the monetary policy rate boosts the prices and collateral values of the assets on banks’ balance sheets, which in turn can modify banks’ estimates of probabilities of default, loss given default, and volatilities. That is, the increase in the price of financial assets coupled with the decline in their volatility translate into more benign estimations of expected risks. A second way in which monetary policy can influence bank risk is through increased search for yield. Low interest rates may increase incentives for financial institutions to take on more risks for a number of additional reasons. Some are psychological or behavioral in nature such as the so-called money illusion: investors may ignore the fact that nominal interest rates may decline to compensate for lower inflation. Others may reflect institutional constraints. Finally, bank risk may also be influenced by the communication policies of a central bank and ex ante perceptions of possible future policymakers’ reaction functions.

(h)

A severe rate cut would not help when the demand in the economy is deficient, instead a fiscal stimulus package from the tax side would help revive the economy, Ghate indicated in the minutes of the March meetings of the monetary policy committee, released by the Reserve Bank on Monday. In a demand deficient economy, a large rate cut, however, will be akin to pushing on a string. I have been raising this concern in several previous policy reviews justifying the need for more structural reforms. It may be better to conserve some policy space for later, when the economy will require a further boost to recover from the pandemic. The erosion of consumer confidence and investment sentiment can operate in an adverse feedback loop to worsen the growth outlook even further. In this emerging scenario, monetary policy needs to proactively arrest any deterioration in aggregate demand, and thereby create enabling conditions for businesses to normalise production and supply chains.

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