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CENTRAL BANK OF NIGERIA UNDERSTANDING MONETARY POLICY SERIES NO 24 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY POLICY DEPA RY 10 TH T MEN RT MONE TA Stanislaus A. Ukeje Anniversary Commemorative Edition c 2012 Central Bank of Nigeria Central Bank of Nigeria 33 Tafawa Balewa Way Central Business Districts P.M.B. 0187 Garki, Abuja Phone: +234(0)946236011 Fax: +234(0)946236012 Website: www.cbn.gov.ng [email protected] E-mail: ISBN: 978-978-52863-0-4 © Central Bank of Nigeria Central Bank of Nigeria Understanding Monetary Policy Series 24, December 2012 EDITORIAL TEAM EDITOR-IN-CHIEF Moses K. Tule MANAGING EDITOR Ademola Bamidele EDITOR Charles C. Ezema ASSOCIATE EDITORS Victor U. Oboh David E. Omoregie Umar B. Ndako Agwu S. Okoro Adegoke I. Adeleke Oluwafemi I. Ajayi Sunday Oladunni Aims and Scope Understanding Monetary Policy Series are designed to improve monetary policy communication as well as economic literacy. The series attempt to bring the technical aspects of monetary policy closer to the critical stakeholders who may not have had formal training in Monetary Management. The contents of the publication are therefore, intended for general information only. While necessary care was taken to ensure the inclusion of information in the publication to aid proper understanding of the monetary policy process and concepts, the Bank would not be liable for the interpretation or application of any piece of information contained herein. Subscription and Copyright Subscription to Understanding Monetary Policy Series is available to the general public free of charge. The copyright of this publication is vested in the Central Bank of Nigeria. However, contents may be cited, reproduced, stored or transmitted without permission. Nonetheless, due credit must be given to the Central Bank of Nigeria. Correspondence Enquiries concerning this publication should be forwarded to: Director, Monetary Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria, Email:[email protected] iii Central Bank of Nigeria Mandate §Ensure monetary and price stability §Issue legal tender currency in Nigeria §Maintain external reserves to safeguard the international value of the legal tender currency §Promote a sound financial system in Nigeria §Act as banker and provide economic and financial advice to the Federal Government Vision “By 2015, be the model Central Bank delivering Price and Financial System Stability and promoting Sustainable Economic Development” Mission Statement “To be proactive in providing a stable framework for the economic development of Nigeria through the effective, efficient and transparent implementation of monetary and exchange rate policy and management of the financial sector” Core Values §Meritocracy §Leadership §Learning §Customer-Focus iv MONETARY POLICY DEPARTMENT Mandate To Facilitate the Conceptualization and Design of Monetary Policy of the Central Bank of Nigeria Vision To be Efficient and Effective in Promoting the Attainment and Sustenance of Monetary and Price Stability Objective of the Central Bank of Nigeria Mission To Provide a Dynamic Evidence-based Analytical Framework for the Formulation and Implementation of Monetary Policy for Optimal Economic Growth v FOREWORD The understanding monetary policy series is designed to support the communication of monetary policy by the Central Bank of Nigeria (CBN). The series therefore, provides a platform for explaining the basic concepts/operations, required to effectively understand the monetary policy of the Bank. Monetary policy remains a very vague subject area to the vast majority of people; in spite of the abundance of literature available on the subject matter, most of which tend to adopt a formal and rigorous professional approach, typical of macroeconomic analysis. However, most public analysts tend to pontificate on what direction monetary policy should be, and are quick to identify when in their opinion, the Central Bank has taken a wrong turn in its monetary policy, often however, wrongly because they do not have the data for such back of the envelope analysis. In this series, public policy makers, policy analysts, businessmen, politicians, public sector administrators and other professionals, who are keen to learn the basic concepts of monetary policy and some technical aspects of central banking and their applications, would be treated to a menu of key monetary policy subject areas and may also have an opportunity to enrich their knowledge base of the key issues. In order to achieve the primary objective of the series therefore, our target audience include people with little or no knowledge of macroeconomics and the science of central banking and yet are keen to follow the debate on monetary policy issues, and have a vision to extract beneficial information from the process, and the audience for whom decisions of the central bank makes them crucial stakeholders. The series will therefore, be useful not only to policy makers, businessmen, academicians and investors, but to a wide range of people from all walks of life. As a central bank, we hope that this series will help improve the level of literacy in monetary policy as well as demystify the general idea surrounding monetary policy formulation. We welcome insights from the public as we look forward to delivering content that directly address the requirements of our readers and to ensure that the series are constantly updated as well as being widely and readily available to the stakeholders. Moses K. Tule Director, Monetary Policy Department Central Bank of Nigeria CONTENTS Section One: Introduction .. .. .. .. .. .. .. 1 .. Section Two: Conceptual Issues .. 2.1 Price Stability .. .. .. 2.2 Sources of Instability in Prices .. .. .. .. .. .. .. .. .. .. .. .. .. 3 3 4 Section Three: Monetary Policy Frameworks for Achieving Price Stability 3.1 Monetary Targeting .. .. .. .. .. .. 3.2 Exchange Rate Targeting .. .. .. .. .. .. 3.3 Price Level Targeting.. .. .. .. .. .. .. 3.4 Inflation Targeting.. .. .. .. .. .. .. 3.5 Mixed Policy.. .. .. .. .. .. .. .. 7 8 9 9 9 10 Section Four: Monetary Policy Tools and their Effects on Price Stability 4.1 Price-based and Indirect (market) Tools .. .. .. 4.1.1 Policy Rate .. .. .. .. .. .. 4.1.2 Reserve Requirements.. .. .. .. .. 4.1.3 Discount Window.. .. .. .. .. .. 4.1.4 Open Market Operations (OMO) .. .. .. 4.1.5 Central Bank Bills.. .. .. .. .. .. 4.2 Quantity-based and Direct (non-market) instruments .. 4.2.1 Credit Ceiling .. .. .. .. .. .. 4.2.2 Sectoral Allocation of Credit .. .. .. .. 4.2.3 Interest Rate Control .. .. .. .. .. 4.2.4 Moral Suasion .. .. .. .. .. .. 11 11 11 12 13 13 13 14 14 14 14 15 Section Five: Conclusion Bibliography .. .. .. .. .. .. .. .. 17 .. .. .. .. .. .. 19 vii HOW CENTRAL BANKS ACHIEVE PRICE STABILITY HOW CENTRAL BANKS ACHIEVE PRICE STABILITY1 Stanislaus A. Ukeje2 SECTION ONE Introduction Every modern State has a central bank or monetary authority which has a monopoly in the issuance of legal tender currency and responsibility for policies relating to the supply of money and credit. Acceptability of notes and coins issued by central banks as means of exchange, unit of account, store of value and standard for deferred payments depends on public confidence. Prior to the 20th Century, confidence in legal tender currency was derived from their gold value. This monetary regime was called the gold standard but as commerce expanded, the supply of gold could not match the demand for money. The Bank of England had to adopt the „responsibility doctrine‟ as proposed by Walter Bagehot, undertaking to lend to other banks on acceptable collateral, to enable them meet their needs. After the World War I, the gold standard weakened, resulting in widespread macroeconomic instability including; high inflation, reduced economic growth and high unemployment. Global efforts to restore the gold standard revealed that each country needed to maintain internal and external stability to guarantee confidence in the fiat money. The introduction of the Bretton Woods system of fixed exchange rate, backed by gold through the United States‟ dollar reduced concern about inflation and the value of money. When this system failed in 1971, inflation and growth became once again a public issue. To confront high inflation and low growth (stagflation) 1This publication is not a product of vigorous empirical research. It is designed specifically as an educational material for enlightenment on the monetary policy of the Bank. Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the accuracy of the contents of this publication as it does not represent the official views or position of the Bank on the subject matter. 2Stanislaus A. Ukeje is an Assistant Director in the Monetary Policy Department, Central Bank of Nigeria 1 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY of the 1970s, Paul Volcker, Chairman of the United States‟ Federal Reserve (central bank), implemented a policy of reducing the rate of growth of money supply and increased interest rates to levels that exceeded the rate of inflation. Price stability was restored and sustained in the advanced economies for many years until the 2007 global financial crises. This prompted some analyst to aver that business cycle and inflation had ceased to be a major economic problem in the advanced economies. Indeed, there were several proposals to remove banking regulation from central banks to some independent bodies. However, the collapse of Lehman Brothers and the subsequent global economic turmoil that started in 2007 brought to the fore once again, the towering responsibility of central banks for financial sector stability, output growth, and employment. Following this introduction, section II contains conceptual issues, while Section III presents monetary policy framework for achieving price stability. Section IV discusses the tools of monetary policy and their effects on price stability. Section V conclusions the paper. 2 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY SECTION TWO Conceptual Issues 2.1 Price Stability Price stability is a situation where the average change in prices of goods and services is just sufficient to support the growth of the economy. Price stability does not necessarily mean that prices are not changing in the economy, but rather connote a situation where the average increase in the general price level is matched with a corresponding growth in the aggregate economy. It is a situation where there is no deflation or inflation in the economy. It means that prices on average are relatively stable over time. The change in the general price level, also termed inflation, can be stable, variable, and/or unpredictable. The stable form of inflation provides a suitable environment for economic planning and investments, while the variable and unpredictable form of inflation create uncertainties and are not conducive for sound economic decisions. Inflation in a country, region or globally is measured in terms of changes in an index of prices over a period of time, mostly over 12-months. The index may be broad or narrow. A widely used price index is the Consumer Price Index (CPI) based on the market cost of living on a representative basket of consumer goods and services purchased by households. Other indexes include: Producer Price Index (PPI) which is a measure of changes in the price of the final products of domestic producers; Wholesale Price Index (WPI); the Personal Consumption Expenditures Price Index or PCEPI; and the Gross Domestic Product Deflator. There are other indexes based on the price of precious metals such as gold, the average of nominal wages and the average of asset (securities) prices. Annual change in the general level of prices within the range of 1 and 3 per cent is generally regarded as low and stable inflation rate in many countries. Thus price stability does not mean the stability of the average level of prices and does not refer to price changes in the short-term such as a day or a week. As there are different indexes adopted to capture change in the general price levels, there are also different inflation measures, namely; core, headline and food. “Core” or underlying inflation refers to inflation measured by changes in CPI, PCEPI or the GDP Deflator but excluding certain volatile prices, such as food and energy prices. “Headline” inflation is a measure of the total inflation within an 3 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY economy, including food and energy, which may experience sudden price spikes. Households are more concerned about this measure of inflation because it reflects the true cost of living. Central banks are usually concerned about the “Core” inflation rate because it shows the effects of demand and supply on the gross domestic product of a country. It is the measure of persistent inflation, excluding short-term and reversible price movements, which the central bank should resist using monetary policy tools. This is because it is now generally accepted, both in policy and academic spheres that the primary objective of central banks is to achieve price stability. In the evaluation of price developments, most central banks use the CPI because it covers goods and services consumed by most households, the public at large are accustomed to it and it is available regularly. 2.2 Sources of Instability in Prices Price instability manifests as price volatility, where volatility refers to the pace at which prices move higher or lower, and how wildly they swing. It is the frequency and severity with which the general price level rises and falls. In general, price instability is caused by factors including money supply, seasonality, and market sentiment that produce wild swings in demand and supply. The assertion that inflation is always and everywhere a monetary phenomenon (Friedman, 1963) has almost been accepted as a truism, because in every instance that the general price level in a country is high for a sustained period of time, the rate of money supply growth is also high. This is so because price stability is closely associated with money and its functions. As the amount of money in circulation in an economy increases, the pressure for output to increase rises. When this happens, prices rise and the value of money declines because more money will have to be spent to buy the same amount of goods and services. Accommodative monetary policy in the United States by the Federal Reserve from 2001 (Taylor, 2007), contributed to stimulating the demand for housing and asset prices. A lot of capital flowed into the United States about the same time from China and commodity exporters, which supported the credit growth and financial innovations that eventually resulted in the global financial crisis of 2007. In Nigeria, the accommodative monetary policy of the Central Bank of Nigeria from 2004 (fuelled by high oil prices and stable exchange rate regime) caused banks to grow their loan books rapidly, especially by financing the acquisition of privatized State enterprises (e.g. Nigerian Telecommunications Ltd) and grant margin loans to stock market firms. Bank failures and credit freeze followed in 4 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 2009, and the government enacted the Asset Management Company of Nigeria Act 2010, to rescue the banking system from total collapse. The Euro area has been in recession because of unsustainable sovereign debt, owed mainly to private banks which have had to take enormous losses. All three examples above, show that price instability follows any time money supply grows very rapidly for a considerable time. Another factor that produces price instability is seasonality. During some long festivals, such as Lent, Easter, Ramadan and Eid el kabir for instance, transport and many other prices rise sharply and fall also sharply, after the festivals. In this case, the festive season changes demand. A factor similar to seasonality that causes price instability is weather. Food prices depend on the supply and the supply depends on favorable weather for bountiful harvest. Volatility of food prices is one important source of general price instability, because food is a major component of the standard consumer basket of goods and services in Nigeria. Market sentiment is yet another factor that causes price instability. The price volatility of stocks and commodities, is often aggravated by the anxious expectation of stock brokers and commodities traders. The movements in stock and oil prices in recent times have been fuelled by the speculative behavior of traders, and this is transmitted through the financial channel, resulting in the volatility of the general price level. It should be noted that all the factors discussed above are critical in aggravating price instability, if the money supply responds in support of demand. 5 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 6 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY SECTION THREE Monetary Policy Frameworks for Achieving Price Stability A central bank as an institution must have a clear mandate under the law establishing it. It is important, however, to emphasize that experience and empirical studies have shown that central banks may pursue other auxiliary objectives to facilitate the attainment of the price stability mandate. Central banks conduct monetary policy within a given monetary policy regimes (monetary policy frameworks), which provide structures for making monetary policy decisions. . A monetary policy framework is the setting, within which a central bank modifies its key instruments. Mc Nees (1987) defined it as comprising “the institutional arrangements under which monetary policy decisions are made and executed”. The defining characteristics of a monetary policy framework are; (i) target variables set to be achieved and the set of instruments used by the central bank to achieve its goal and (ii) the central bank‟s long-term objective. In addition to facilitating making monetary policy decision, a monetary policy regime or framework enables monetary policy decisions to be communicated easily to banks, financial markets and the general public. Below are widely known and used monetary policy frameworks and their associated instruments, target variables and long-term objectives (Table 1) Table 1: Typical Monetary Policy Frameworks Monetary Policy Framework Target Market Variable Long-term Objective Monetary Aggregates Rate of growth of money supply Target rate of change in the CPI Fixed Exchange Rate The nominal exchange rate of the domestic currency The nominal exchange rate of the domestic currency Price Level Targeting Overnight rate of interest Given level or range of CPI Inflation Targeting Overnight rate of interest A given rate of change in the CPI Gold Standard The spot price of gold Low inflation as measured by the price of gold Mixed Policy Generally interest rates Generally the rate of unemployment and change in CPI Central bank mandate is realised within its monetary policy framework, which is normally determined by the political authority of the country through legislation. In Nigeria, two principal Acts guide the monetary policy framework today. These are the Banks and Other Financial Institutions Act (1991) and the Central Bank of 7 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY Nigeria Act 2007. In selecting a framework, the monetary authority usually takes into account the structure and depth of the financial sector, the level of fiscal discipline, the extent of trade openness of the economy, the structure of the economy (in particular, the dependence or otherwise of the economy on a particular sector), the ease of transmission of monetary policy to economic activities and inflation and other factors. Besides, it is important that there is a sufficient degree of expertise on monetary policy issues both inside and outside the central bank, especially in the Ministry of Finance and the Statistical Agency. Some of the distinguishing features of monetary policy frameworks are discussed below: 3.1 Monetary Targeting In this framework, monetary policy aims to control various monetary aggregates in order to keep inflation down, and requires a level of stability in the velocity of money, that is, the speed with which money circulates in the economy. The framework focuses on the growth rate of a chosen monetary aggregate such as RM (reserve money); M0 or narrow money (consisting of coins and currency notes, whether in circulation or in the vaults of banks); MB or monetary base (made up of M0 and mandatory (i.e. minimum) and excess reserves held by banks); M1, the most liquid measure of money supply (consisting of notes and coins in circulation and assets that can be readily converted to cash); M2 or broad money (consisting of M1 and assets that can be converted to cash but not immediately such as savings and fixed deposits, money market funds and overnight repos); M3 a broad money aggregate (made up of M2 and large time deposits and liquid assets, large money market funds and short-term repos usually held by institutional investors); and an aggregate of the liquidity in an economy, money with zero maturity (MZM), which is composed of M2 plus all money market funds less fixed deposits because they are not redeemable at par on demand). A central bank using this framework must choose the appropriate monetary aggregate to target. Monetary targeting framework is based on the assumption that there exist a long-run positive relationship between price growth and money supply growth. The aggregate target becomes the nominal anchor or intermediate target of monetary policy. But financial liberalization and innovation have made it more difficult to monitor aggregate measures of money supply and have also affected the stability of the velocity of money. The relationship between monetary aggregates and the price level has weakened because of the changing nature of financial sector due to financial innovations. It is also the case that the monetary aggregate selected by a central bank may not be amenable to precise management and control. 8 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 3.2 Exchange Rate Targeting This is a monetary policy regime in which interest rates are set, with a view to achieving a target exchange rate, between the currency of a country and the currency of another country or a basket of currencies. The currency against which the domestic currency is benchmarked is termed the nominal anchor, and is usually a stable currency. Otherwise, currencies targeting it will experience volatility, which will negatively affect output and inflation in such countries. In open economies, international trade is very important and the stability of the exchange rate determines the performance of the economy. In the period following the end of the Bretton Woods system of fixed exchange rate, many developed countries adopted exchange rate targeting as a means of stabilizing their economies. A common danger to the integrity of this framework is large international capital flows and speculation, which could weaken the resolve of the monetary authorities to maintain the exchange rate target indefinitely. The Monetary Authority of Singapore (MAS) has successfully used this framework to maintain price stability as a sound basis for sustainable economic growth. A majority of IMF member countries, mainly small open economies, use exchange rate targeting frameworks and adopt the United States dollar as the anchor currency. 3.3 Price Level Targeting This is a monetary policy regime under which the overall goal is to keep the price level stable or at a pre-determined level. The Central Bank or Monetary Authority, alters the policy interest rate in order to keep the consumer price index (CPI) at a specific level over a period. Thus, if the CPI reads 8 per cent at the end of a given year, whereas the central bank‟s price target was 4 per cent, interest rate will be altered to ensure that CPI will be 4 per cent at year-end. Price targeting, therefore considers previous periods‟ inflation to determine future course of policy actions. In this case, price level targeting would reduce uncertainty in inflation outlook. If economic agents accept the price level target set by the central bank, the potential outcome would be reduced variability of output and inflation. However, only Sweden in the 1930s ever adopted price level targeting as a monetary policy regime. The Bank of Canada is currently undertaking research on the feasibility of adopting it. 3.4 Inflation Targeting In inflation targeting, unlike price level targeting, a central bank publicly preannounces official quantitative targets (or a succession of targets) for the inflation rate that it is to achieve over one or more time horizons. Inflation targeting is 9 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY forward-looking, and involves active and direct shaping of inflation expectations. Central banks that adopt this regime of monetary policy, set the inflation target on the basis of a vast array of information on the rate of employment, nominal and real exchange rates, output gap, producer prices, import prices, nominal and real interest rates, the total fiscal deficits, the primary deficits and other variables. The data from these various sources helps the central bank to forecast the likely path of inflation. In an inflation targeting regime, the fiscal authorities undertake to coordinate policies in ways that would support the achievement of the target inflation. In practice, inflation targeting has enabled central bank to control inflation expectation, and in a number of cases successfully lower inflation outcome. Typically, inflation-targeting central banks assign monetary policy making to the Monetary Policy Committee (MPC), made up of central bank officials and external members; the Committee is given policy independence and required to operate transparently and be accountable. 3.5 Mixed Policy Whereas price stability is almost universally accepted as the primary goal of central banks, in many jurisdictions, monetary policy regimes continue to pay attention to monetary aggregates, exchange rate and interest rate. The Bank of England has adopted inflation targeting as its monetary policy framework, but it continues to intervene in the foreign exchange market, conduct open market operations and engage in asset purchase programmes. In practice, most countries adopt an admixture of policy regime. 10 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY SECTION FOUR Monetary Policy Tools and their Effects on Price Stability Monetary policy tools are used to control interest rates, inflation, exchange rate and other macroeconomic indicators, in order to achieve price stability. There are broadly two classes of monetary policy tools used by central banks to achieve price stability. Meyer (1980) classified the control tools into two, general or selective. The monetary base and the money multiplier are two variables that have unrestricted impact on money supply. Thus general control tools impact on monetary aggregates through either the monetary base or the money multiplier. The general controls are price-based, and include ratios such as reserve requirements; instruments with interest rates, (central bank rates); open market operations (OMOs); and central bank bills. These instruments are indirect and are market based. The selective controls are quantity-based instruments, which are almost all non-market based and direct instruments. Selective controls are able to alter the choice among alternative uses in the allocation of credit. Credit can be allocated to loans for acquiring securities through margin or down-payment transactions or to hedge on interest rate (floors and or ceilings) received by bank depositors on their savings or paid by borrowers to banks on loans. 4.1 Price-Based and Indirect (Market) Tools Indirect monetary policies are according to Gidlow (1998), monetary policy decisions of central banks or Monetary Authorities aimed at achieving monetary policy objectives by influencing financial market behaviour with regard to lending and borrowing. The behaviour of financial market participants in response to central bank policy actions are directed at taking advantage of incentives or avoiding disincentives embedded in price and interest rate changes. Examples of price-based policy tools are: 4.1.1 Policy Rate Central banks‟ policy rate is an indicator of the monetary policy stance; raising it indicates monetary tightening while lowering it indicates monetary easing. It influences market interest rates towards „targets‟ set by the Bank through lending to DMBs or purchasing and selling bonds to the banks. Usually, a central bank will not lend money to a DMB below the policy rate (MPR) nor will it take deposits from a DMB at a rate above the policy rate. In market economies, bond prices move in an opposite direction to money market rates; and money market rates move in response to the policy rate. Thus by changing the monetary policy rate, central banks are able to influence the demand for money and inflation expectation and outcome. 11 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY There are jurisdictions in which the policy rate is the interest rate charged on repurchase agreements („repos‟ or „RPs‟) with Deposit Money Banks/Discount Houses and Primary Dealers in the financial market by the central banks. A repo is an agreement to sell a financial asset (such as a bond, stock or bank deposit receipt) and repurchase the same asset at a slightly higher rate overnight or such agreed short period. The repo is terminated in a „reverse repo‟. By adjusting their official/target repo and reverse repo rates, central banks influence decision of economic agents to borrow or lend, depending on the attendant costs and benefits. 4.1.2 Reserve Requirements Central banks impose reserve requirements on depository institutions for system liquidity management and for prudential regulation. Reserve requirements limit the amount of funds that DMBs can give as loans to their customers. There are two types of reserve requirements: cash and liquidity reserves. The cash reserve requirement is generally called the Cash Reserve Ratio or CRR while the liquidity requirement is termed Liquidity Ratio or LR because they are measured relative to the total deposit liability of a financial market (bank) entity. CRR, also called primary reserve requirements, is that proportion of the total deposit liabilities (i.e. the sum of demand, savings and time deposit liabilities) of a DMB that the Monetary Authority shall drain and hold as reserves for the entity concerned over a maintenance period. LR on the other hand is the proportion of the liquid assets which a DMB shall hold relative to its total deposit liabilities. It (LR) is composed of assets that should be freely and readily convertible to cash without a significant loss, and free from any charge, lien or encumbrance. The other name for reserve held under Liquidity Ratio is secondary reserve requirement. Over and above the CRR, DMBs also hold voluntary reserves with the central bank to meet clearing balance requirements or as flight to safety. The level of the reserves affects the interbank rate (i.e. the overnight interest rate in the interbank market in which banks lends and borrows from one another without collateral). CRR is a particularly blunt instrument, which impacts on the interbank rate without a lag. Central banks alter reserve requirements in response to price developments; a rise in reserve requirements generally will lead to increase in interbank rates, thereby increasing short-term and long-term interest rates, which can cause a reduction in credit and growth of money supply. A reduction in reserve requirements would have the opposite effects. 12 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 4.1.3 Discount Window This is a monetary policy instrument by which a central bank provides accommodation (lends short-term) to eligible institutions to enable them meet liquidity shortage. Repurchase (repos) and reverse repurchase (reverse repos or RRPs) take place at the Discount Window. The interest rate at the Discount Window is called discount rate, base rate or repo rate charged on such loans is called the discount rate, repo rate or base rate. It is an important tool for maintaining financial and banking system stability. In some jurisdictions, the discount window mechanism is referred to as Standing Facility. In Nigeria, there is the Standing Lending Facility (SLF) through which the Central Bank the Central Bank lends to banks and the Standing Deposit Facility (SDF) through which the DMBs place funds with the Central Bank. Increase in lending through the Discount Window increases money supply through enlarging the monetary base while decrease contracts money supply by contracting the monetary base (Mishkin, 1997). 4.1.4 Open Market Operations (OMO) This is a tool used by central banks to change the level of money supply. It is purchase or sale of government securities by a central bank to the banking and non-banking public for liquidity management purposes. When a central bank notices there is excess liquidity in the system, it sells securities to reduce DMBs‟ reserves (monetary base). But to increase money supply in the economy, a central bank buys securities from DMBs and by doing so injects liquidity into the system. By injecting or withdrawing liquidity from the banking system, central bank affects money market and other interest rates in its desired direction. Interest rate is a key macroeconomic price which has impact on asset prices, the exchange rate and the general price level. Thus OMO can be used to ensure price stability. 4.1.5 Central Bank Bills These are short-term securities (unlike Treasury bills) issued by the central bank for periods not exceeding 12 months. Banks holding the bills do not add them in the determination of liquidity reserve requirements. In that way, the bills affect liquidity and interest rate in the money market. Also, central bank bills cannot be discounted for cash at the central bank or accepted by the central bank as collateral in a repo transaction. Therefore, unlike treasury bills, issue of central bank bills reduces DMBs‟ reserves by the amount of the issue for the duration of its tenure. OMO transactions using central bank bills are sterilisation operations in local currency and can be used to prevent depreciation of the domestic currency. 13 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 4.2 Quantity-Based and Direct (Non-Market) Instruments Direct monetary policy instruments are tools used central banks to achieve monetary policy objectives by setting aggregate monetary, credit and interest rate targets for DMBs and other financial institutions. Through regulations, direct instruments operate by setting or limiting either quantities (e.g. amounts of credit outstanding) or prices (e.g. interest rates). By the term “direct”, it means that there is a one-to-one correspondence between the tool and the policy goal objective (Alexander, Baliño, and Enoch, 1996). Direct instruments are commonly used in countries where the financial market is not highly developed, even though it exists to different degrees in all jurisdictions. 4.2.1 Credit Ceiling A central bank may direct DMBs to limit the amount of credit to the private sector within a period, issuing the directive well before the beginning of the period. Accordingly, both credit institutions and credit customers would be aware of the directive. The goal is to control the expansion of bank credit. Recent experience with public sector debt sustainability has resulted in some central banks similarly capping credit to the government from time to time. By directly limiting credit expansion, the central bank controls the contribution of money supply growth to inflation. 4.2.2 Sectoral Allocation of Credit Where a government (the fiscal authority) has preferred economic sectors in her growth and development agenda, central banks would issue directives to the DMBs, requiring them to allocate either specified percentages or amount of credit to the preferred sectors. Considerations about equity and social justice sometimes make governments and monetary authorities to identify economic and geographical regions, social groups and gender for priority allocation of credit. Apart from controlling the expansion of credit and money supply, sectoral allocation of credit influences the use of credit and its impact on inflationary development and aggregate demand. 4.2.3 Interest Rate Control Interest rate represents the price of capital; it influences savings mobilisation and financial intermediation. Free market interest rate in an uncompetitive market situation may discourage financial intermediation, and encourage financial repression. Where this is the case, experience shows that much of the currency issued by the central bank is outside the banking system, thus limiting the velocity of money. To counter this, central banks in some jurisdictions set interest rate floors for savings and ceilings for credit. By controlling interest rate, a key component of macroeconomic prices that feeds into inflation is controlled 14 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 4.2.4 Moral Suasion Regulatory powers of central banks over financial institutions, especially deposit money banks, provide opportunity for persuading them to pursue suggested strategies and policies such as intensifying savings mobilisation, reducing charges, increasing or restricting credit and others. The DMBs yield to the persuasion of the Monetary Authorities in order to maintain harmonious relations. In this way, strategies and policies that moderate inflation can be implemented by DMBs contrary to their profit-maximising behaviour. 15 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 16 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY SECTION FIVE Conclusion Price stability is a situation where the average change in prices of goods and services is just sufficient to support the growth of the economy. Price stability does not necessarily mean that prices are not changing in the economy, but rather connote a situation where the average increase in the general price level is within a narrow range. Consumer Price Index (CPI) is the most widely used price index, based on the cost of living on a fixed basket of goods and services. It was discussed that there are different indices of change in the general level of prices as there are also different inflation measures, namely headline, core, and food. In general, price instability is caused by factors (such as money supply, seasonality, market sentiment, among others) that produce wild swings in demand and supply. Several monetary policy frameworks such as monetary aggregates, fixed exchange rate, price level targeting, inflation targeting, and mixed policy were extensively discussed. Two major categories of monetary tools, namely; price-based and indirect (market) and quantity-based direct instruments are deployed in the monetary policy management. 17 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY 18 HOW CENTRAL BANKS ACHIEVE PRICE STABILITY Bibliography Alexander W., T. J. T. Baliño, and C. Enoch (1996). Adopting Indirect Instruments of Monetary Policy Finance & Development / March Bagehot W. (1873). 1969, Lombard Street. Reprint of the 1915 edition. New York: Arno Press. In Bordo, Michael D. (1984). The Gold Standard: The Traditional Approach Bofinger, Peter Reischle, Julian, and Schächter, Andrea (2001). 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