Monetary policy refers to the combination of measures designed to control the supply of money and credits conditions in an economy for the purpose of achieving macroeconomic goals.
In other words, it is the regulation of money supply, interest, and exchange rate through the monetary authorities with the view of achieving macroeconomic objectives.
- Price stability (domestic prices)
- Economic growth and development
- Firms employment
- Equitable distribution of economic income and wealth
- Favorable balance of payment equilibrium
Tools of Monetary Policy
- Open Market Operation (OMO): This involves the power of Central Bank of Nigeria (CBN) to purchase or sell securities in the financial markets in order to influence the rate of money supply. It is the injection and withdrawal of money in circulation by the CBN through the sales and purchase of the government securities and treasury bills to or from the commercial bank and the general public e.g. when supply of money is too high the CBN sell securities in order to reduce the money in circulation, excess reserves (liquidity) and vice versa.
- Reserve Requirement: In a nutshell, it is the amount that commercial bank must have in reserve with the CBN. It also refers to the proportion of total deposit liabilities which the commercial and merchant banks are expected to keep as cash against unforeseen development in their operations. Reserve requirements are of two types:
Cash Reserve Ratio: This is the certain proportion of commercial and merchant bank deposit kept with the central bank in form of cash balances. They are not for lending.
Liquidity Ratio: This is the proportion of a deposit to be kept in short-term investment (liquid assets) e.g. shares
- The Discount Rate or Bank Rate: This is the interest rate charged by the Central Bank on its loan to commercial or merchant bank. It is also called a Minimum Rediscount Rate (MRR).
- Special Deposits: These are separate account opened and maintained by the CBN on behalf of the banks. It is used to influence bank deposit.
- Selective Credit Control/Special Directives: This implies that the CBN controls commercial and merchant bank to give credit to a particular sector of the economy with a certain percent of agricultural, and manufacturing sector etc., here the CBN gives directives on the size composition of their credits. It could be done through threat.
- Moral Suasion: This is a means of appealing by the CBN (monetary authority) to the bank that adheres to its monetary policy guidelines e.g. to lend money to a particular sector e.g. Industrial Agricultural Sector this is usually done by CBN governors.
- Credit Ceiling (Direct Credit Control): This involves the fixation or stabilization of bank credit to domestic economy by the CBN to either increase/decrease money supply. It is used to mop up an excess fund and stabilize credit operation. Raising the ceilings is to increase supply while lowering the credit ceiling will reduce the money supply.
- Exchange Route Rate: This is the rate at which a countries currency is exchanged for another country’s currency. It controls foreign exchange earnings and deficit in the balance of payment includes:
Free or Floating Exchange Rate: This is the exchange rate that is determined by the foreign demand and supply i.e. it is not influenced by the government policy of any country.
Pegged Exchange Rate: This is an exchange rate that is determined by the government.
It should be noted that amongst the instrument tools of monetary policy are:
- Tools to influence the volume of credit e.g. open market operation and reserve requirement
- Tools to influence the cost of credit (borrowing) e.g. discount/bank rate
- Tools design to influence the directions of credit e.g. special deposit, selective credit control, suasion, credit ceiling and exchange rate.