Monetary Policy Decisions
In our previous article we learnt about how central banks achieve expansionary and contractionary monetary policy objectives. In this article, let’s discuss how central banks decide whether to pursue contractionary or expansionary monetary policy. But before that, we need to understand how central banks control interest rates. Let’s do this using an example.
You can probably recall the typical Zamindar and Lala characters in old Bollywood movies. They used to be among the wealthiest people in the village and anybody in need of money used to go to them for a loan. These villians used to take advantage of the situation and charge very high interest rate on the loan. Suppose there is a very wealthy Zamindar – let’s call him Z, and he lends money to less wealthy Zamindars in nearby villages. He charges 20% interest on loans. Less wealthy Zamindars borrow money from Z at 20% and lend out the same to people in their village at a slightly higher charge of 25%. The differential of 5% is the less wealthier Zamindars profit. Now suppose Z, decides to raise interest rate charged to 23% from 20%. The smaller Zamindars have choice of either raising interest rates and passing on the increased cost to the end borrower or they can decide against raising interest rate thereby making lesser profits.
In our example, Z is the central bank and smaller zamindars are other local banks. We know that local banks borrow money from central bank at repo rate. So if central bank decides to increase the interest rate (repo rate), cost of borrowing funds increases for other banks. They pass this onto the end customer by increasing their lending cost. Similarly, when central bank reduces repo rate, cost of borrowing funds becomes cheap and profitability of banks increases. In such cases, banks might pass on the benefits to their customers by lowering interest rates on funds lent out. This is how interest rate increases everywhere when central bank increases repo and vice versa, and that is how central banks control interest rates.
As we learnt in our article on measuring GDP, GDP increases when investment by firms increase. When interest rates are low, cost of borrowing funds are cheap. When firms can borrow easily at cheaper rates, they increase their investments and this ultimately leads to higher GDP.
When economy is going through a recession and GDP is contracting, Central bank can help by adopting an expansionary monetary policy. As discussed earlier expansionary monetary policy, pursued through either CRR, SLR, open market operations or repo rate route, will result in more funds with banks. If funds are easily made available to banks at lower rates, they will lend out the same to firms at the same lower rate. Lower borrowing cost for firms results into higher investments in the form of new factories and manufacturing units. This results into higher employment, higher incomes and ultimately results in higher GDP.
Now let us look at the different types of deficits that we read about daily.