Creating a stable economy in a country is a parameter that economists use to gouge the performance of every government in a country. In this sense, most governments, through the power that the Central Bank possesses in a country, regulate their economy through the use of monetary policies from the Central Banks. The Central Bank, through its monetary policies, has a critical role in dictating the direction the economy of a country takes in the path of its developments ( Bordo & Levin, 2017). It is worth noting that it is the Central Bank of a country which formulates and implements the monetary policies in a country. In some countries such as India, the Central Bank, or the Reserve Bank, which is the Central Bank of India works on behalf of the Government and acts according to its directions and broad guidelines regulating the economy. There is an argument in the economic field on whether it could be relevant to state that the Central Banks through different monetary policies are relevant in the economy ( Santor & Suchanek, 2016). Precisely, the foundation of the argument is whether the Central Banks and their monetary policies have an impact on the economy. It is a debate that has many arguments, with some sides supporting the idea while others are opposing the idea. In this research study, therefore, the discussion is to assert that the central bank, through different monetary policies, has positive impacts on the economy. In this sense, the debate in this article aims to support the idea that for a sound economy in a country, there is a need to have a central bank that has different monetary policies to regulate the economy.
The central bank and monetary policy
A central bank in a country is a body that conducts monetary policy in addition to regulating banks in a country ( Sims, 2016). It is a body that operates independently to provide financial services to a state that includes conducting economic research ( Bordo & Levin, 2017). The primary goal of a central bank in any country is to stabilize a country's currency, prevent inflation, and also keep employment as low as possible. Central Banks have a reach history in the world. Sweden was the first country to come up with the idea of the central bank in their year 1668 with their establishments of the Riksbank. England was the second country to establish the Central Bank in the year 1694 ( Santor & Suchanek, 2016). France was third before the UnitedStates came up with the Federal Reserve in the year 1913. Since then, the idea of Central Banks spread in Europe and other parts of the world. One of the critical roles of the central bank in any country is to establish the country's economy.
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Economic growth implies the expansion in productive capacity or capital stock in the economy to attain the real national output or income in a country. For any economy in a state, accelerating the rate of savings and investment in the economy are the key factors that can speed up the country’s economy ( Bordo & Levin, 2017). There are three ways to attain such a milestone in a country. The first is to increase the aggregate rate of savings in the country. The second approach is to mobilize the savings so that they are made available for investment and production. The third is to increase the rate of investments, and the last approach is to allocate the investment funds for productive purpose and priority sectors of the economy ( Sims, 2016). Central Banks achieve such control on the economy through the use of different monetary policies ( Sims, 2016).
By definition, monetary policies are the Central Bank's communication and actions that it uses to manage the supply of money in the country ( Sims, 2016). Through the use of monetary policy in a country, the central bank has the power to control and regulate the liquidity in a country, and this increases economic growth. Central Banks use interest rates, bank reserve requirements, and the number of government bonds that banks must hold. All these tools affect how much banks can lend ( Bordo & Levin, 2017). The volume of loans affects the money supply within the economy of a country. Through the Central Bank, the monetary policy has three objectives. The first is to manage the country’s inflation. The second objective is to reduce the unemployment rate in the country, which only comes with strategies that control inflation in a country. The third objective is to moderate the long term interest rate in a country. By doing so, the Central bank has three critical monetary policy tools ( Bordo& Levin, 2017).
The first tool is the open market operation. These are tools that the central bank uses when they want to buy or sell securities. The securities are bought and sold to private banks in the country. By purchasing the securities, the central bank adds cash to the private bank reserves, and by selling the securities, it places cash on the balance sheets and reduces cash holdings on the banks( Santor & Suchanek, 2016). Another tool is the reserve requirement, which is the money the bank must keep overnight. Note that a low reserve requirement allows banks to lend more of their deposits. It is expansionary because it creates credit. A high reserve on the other side is a contradiction as it provides the banks with inadequate cash for lending to the customers. The last tool is the discount rate, which is the amount the Central Banks levy on its members to borrow at its discount window ( Sims, 2016). By using these three tools of the monetary policy, the central bank plays a critical role in developing a strong and sound economic system for a country ( Domanski, Scatigna & Zabai, 2016).
Central Banks and Monetary Policies Are Necessary For A Sound Economy
There are many ways that the central bank, through different monetary policies, ensures that the country's economy is stable. The paper discusses the pros below.
Manage And Avert The Threat Of Economic Recession
First, the central bank and the monetary policies are at the center of curing the recession in the country and thus are critical in keeping the country's economy under check. Recessions have strange histories in a country such as the USA. The 2000s period was one of the worst for the U.S economy because the country was hit by two recessions that were hazardous to the country's economy. When a country is facing a difficult time with the economy, there are high chances that there can be a high rate of unemployment that results from the reduced aggregate demand in the marketplace ( Sims, 2016). In such situations, it is the central bank with its monetary policies that comes in to cure the economy. The central bank in such situations takes steps to expand the money supply in the economy and lower the rate of interest to increase the aggregate demand, which will help in stimulating the economy( Bordo & Levin, 2017). There are different steps that the Central Bank, through its monetary policy, will take to rescue the country from the recession. For instance, there are expansionary monetary policies that the central government can use to cure the state of recession. Through the use of expansionary monetary policy, the central bank can avert the threat of economic recession.
For instance, the central bank through its monetary policy can undertake the open market operations where it will buy the securities in the open market. In this sense, there will be an increase in reserves of the banks or the amount of currency with the general public. When they buy security from the public, there is an increase in the reserves in the private banks. In this sense, there is more cash on the banks, and this will encourage the private bank to reduce loan interest and also encourage the investors and businesses to take loans from the banks ( Santor & Suchanek, 2016). In this sense, there will be more investment in the country, and this will have an impact on the aggregate demand curve that will course it to shift upwards. Buying the securities thus will have an expansionary effect on the economy and will reduce the chances of recession ( Bordo & Levin, 2017).
The Keynesian theory elaborates more on how the monetary expansion theory works better and the rationale that makes it beneficial for the economy when the Central governments take such an approach to control the supply of money in the economy to limit the chances of economic recession. From this theory , the banks determine their rate of interest by the demand for and supply of money ( Adler, Castro & Tovar, 2016) . The theory postulates that when there is an expansion in the supply of money in the economy, the rate of interest will fall, and this will enhance or encourage business people and investors to borrow more investments and spending. Note the falling rate of interest is an opportunity for the investors and the country as it raises the investment expenditure, which is an essential component of aggregate demand. The increase in aggregate demand causes an expansion in aggregate output, national income, and employment. The image below illustrates the Keynesian view on how expansion in money supply can help to cure a recession
In the first figure on the image, it observable that when the central bank uses monetary policy that increases the money supply in the country from m1 to m2, the rate of interest falls from the r1 to r2. In the second figure on the image, it shows that when there is an interest rate fall from r1 to r2, there is an increase in investments in the country from I1 to I 2. The last figure in the image showcases the impact the investment increase from I1 to I2 will have on the demand curve. From the figure, it is evident the increase will shift the “aggregate demand curve (C + I 1 + G) upward so that the new aggregate demand curve C + I 2 + G intersects the 45° line at point E 2 and thus establishes equilibrium at full-employment output level Y F ”( Sims, 2016). From the figure above, what comes out clear is that the central bank and its monetary policies can play a critical role in stimulating the country’s economy.
Encouraging Investment In A Country
There are two ways through which the bank can use manage economically. Firstly, the central bank, through its monetary policy, will do is to lower the bank rate or the discount rate. The bank rate or the discount rate is the interest the Central Banks or a country charges on loan to commercial banks. When there is an inflation threat in the country, reducing the discount rate will encourage more commercial banks to borrow from the Central Banks, and this will have a ripple effect on the economy ( Santor & Suchanek, 2016). The banks will be willing to give out loans to the investors, and this will increase business in the country. Note that, such a strategy is not meant to make the credit from the commercial banks cheaper to the business people and investors, but to make the credit available for such people from the commercial banks( Adler, Castro & Tovar, 2016) The expansion in a credit or money supply will increase the investment demand, which will tend to raise aggregate output and income.
Manage The Threat Of Economic Depression
Through the use of expansionary monetary policies, central bank and its monetary policies can avert the threat of severe or extreme recession called economic depression ina country. When faced with a threat of economic depression, can reduce the Cash Reserve Ratio that the commercial banks keep. Such are strategies that a country like India uses more to control credit expansion and increase the supply of money in the economy ( Bordo & Levin, 2017). When there is a low rate of the reserve requirement, there is a large amount of money that the banks will release in terms of loans to different investors, and this will increase not only the supply of money to the economy but also the employment rate in the country.
Manage And Avert Inflation Threat In The Country
The central bank and its monetary policies are also better for a country because, through its tight monetary policy, the central bank can control inflation in the country. Inflation is one of the most undesirable situations in the country's economy. It usually occurs in a situation where there is an excess government expenditure that is more than the total income the government collects from its citizens. In such a case, there is always a massive deficit in the budget, and this results in demand-pull inflation in the country ( Bordo & Levin, 2017). On the other side, an increase in the creation of money that also occurs due to different government activities in the country also generates inflationary pressure in the country's economy. With such economic pressure, there is a need for the government to reduce the pressure on the economy. It is due to such issues that the central bank will call into action the monetary policy, which is sometimes called tight monetary policy to reduce the threat of inflation in the country. The following will be the actions that the central bank will take, which are part of the tight monetary policy.
The first alternative to reduce the threat of inflation is to sell government securities to the banks and the general public. The central bank does that by opening an open market for selling the securities to the public and other commercial banks in the country. Such action reduces the liquid cash in public and also the amount of reserve in the commercial banks in the country. With such a move, there will be a reduced rate of reserves in the bank and reduce liquidity in public ( Santor & Suchanek, 2016). Therefore, they will have to reduce their demand deposits by refraining from giving new loans as old loans are paid back. As a result, the money supply in the economy will shrink. The second alternative is to trigger the high rate of bank rates to discourage commercial banks from giving out loans to the investors because they will be having difficulties with borrowing from the central bank. Thus will reduce the liquidity in the economy resulting in low credit availability in the country( Adler, Castro & Tovar, 2016) Such a move will have an impact on the inflationary pressure in the country by reducing the rate of spending and thus balancing them economy.
The last alternative is to use the anti-inflationary measures such as raising the statutory Cash Reserve Ratio. Such a move will also compel the commercial banks to reduce the rate of money supply in the economy leading to less supply of money in the country. The last alternative is to use qualitative credit control. Qualitative credit control means raising the minimum margin for obtaining the loans from the banks against the stocks of sensitive commodities such as food-grains, oilseeds, cotton, sugar, vegetable oil ( Santor & Suchanek, 2016). Note that the tight monetary policy by the central bank is meant to reduce the supply of money in the market and thus balance the economy by reducing the liquidity in the public and reserves in the commercial bank, therefore adjusts the economy to reduce any threat of inflation in the economy. It implies that Central Banks and its monetary policy are critical for a sound economy as it offers the country a chance to balance its economy to reduce inflation in the country.
Keynesian's theory gives an economic insight on how the Central Banks use tight monetary policy and how they work best to control inflation and prevent its threat to a country's economy ( Jawadi, Mallick & Sousa, 2016). Keynesian also hold a similar view as many economists that when the central bank uses this approach of monetary control, the aim is to cut the money supply in the economy by contracting the the3 credit in the marketplace and also raising the cost of the credit to chock lending rate and inters in the country. The interest rate will thus increase to reduce the rate of investment spending. Such will lower the aggregate demand curve (C + I + G). The decrease in aggregate demand tends to restrain demand-pull inflation. The image below is an illustration of how the central bank uses its tight monetary policy to restrain the pull inflation in the country, according to the Keynesian theory.
Beginning from the panel c in the image above, assume that the full-employment level of a country’s income stands at Yf. Due to the increase in money flow in the economy that comes due to a large deficit in the budget, the demand curve shifts to position C + I 2 + G 2. It implies that there will be an inflationary gap that will be E 1 H at the full-time income level in the country. “That is, the sum of consumption expenditure, private investment spending, and Government expenditure exceeds the full-employment level of output by E 1 H.” such will create demand-pull inflation that will result in a rise in the product prices. "Though with aggregate demand curve C + I 2 + G 2 equilibrium reaches at point E 2 and as a result national income increases but only in money terms; real income or output level remaining constant at OY F ”( Sims, 2016).
From the penal (a) in the above diagram, there will be some changes in case the central bank’s tight monetary policy succeeds in reducing the supply of money from M2 to M1. For instance, such an increase in the money supply will cause the rate of interest to rise from r1 to r2, as shown in the above image in the panel (a). From the panel b in the image above, it is evident that a high-interest rate at r2 will trigger investments to fall from I1 to I2. The reduction of investment, as shown, will have a reducing impact on the demand curve. In this sense, the demand curve C + I 2 + G 2 will thus push downwards to point C + I 1 + G 2 . In this sense, therefore, the inflationary gap is closed, pushing the equilibrium at the full-employment output level to Y F . Though the theory has many assumptions that, to some extent, cannot be guaranteed in the real world situation, it implicates the role of the central bank in controlling inflation. Through the use of tight monetary policies in the country as shown, the central bank is thus necessary for the country as it has policies that help in balancing the economy and reducing any sense of inflation in the country ( Santor & Suchanek, 2016).
The opposition's viewpoint
The opposition refutes the idea that the central bank and its monetary policies are critical for a sound economy and demand that fiscal policies in the country could work better than the central bank and its monetary policy in regulating the country's economy. These individuals point at issues such as the elasticity demand or the liquidity preference ( Bordo& Levin, 2017). They claim that, to some extent, the increase in money supply by the central bank may not have an impact on the rate of interest and the expansion of investments in the country as well as the aggregate demand mostly in a situation where there is high elasticity. Besides, these individuals claim that “even if the money demand curve is elastic and, therefore, expansion of money supply lowers the rate of interest significantly, the investment may not rise much”( Sims, 2016).
Such situations occur in some cases because there are situations where the investments demand curve is inelastic or steep. In such cases, the investments may not be sensitive to changes that lead to a high rate of interest as they will fail to course any significant increase in the country's investment( Adler, Castro & Tovar, 2016). In such a case, there will be no effect of the expansionary strategies since there will be no change in the aggregate demand curve. They also claim that the size of the multipliers is a critical factor that has an impact on employment and output. In this sense, if there are any leakages in the multiplier process, an increase in the investment process may have insignificant on the employments ( Santor&Suchanek, 2016). In this manner, the government shall not have succeeded in controlling the country's economy. In the review also, they advocate for the monetary policies to reduce issues such as inflation and threats of recession in the country.
The opposition’s view is critical because some of the issues that they mention concerning this idea are critical, and there have been numerous evident in the literature and research field that have also backed such ideas. However, it is also evident from the discussion that the countries cannot underestimate the role of the Central Bank and its monetary policies ( Adler, Castro & Tovar, 2016). Despite such weaknesses, there is evidence that suggests that through monetary policies that Central Banks possess, they can regulate the economy in a manner that balances the money flow, thus reducing the chances of inflation and threats that come from economic recession depression in the country. In that sense, it would be wrong to go to the conclusion that the central bank and its economic policies have less significance to a country’s economy.
In conclusion, the central bank and its monetary policies are critical to a country’s economy. Thus, they are necessary for a country to have a sound economy. From the discussion, the central bank, through its monetary policy, has power to reduce the threat that comes due to economic recession in a country by balancing the economy. Through the monetary policies that increase the flow of money in the economy, the central bank plays a key role in encouraging investment to avert depression, inflation, and recession. Such vital roles make it necessary for a country to encourage the use of monetary policies for a sound economy.
References
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Bordo, M. D., & Levin, A. T. (2017). Central bank digital currency and the future of monetary policy (No. w23711). National Bureau of Economic Research.
Domanski, D., Scatigna, M., &Zabai, A. (2016). Wealth inequality and monetary policy. BIS Quarterly Review March .
Jawadi, F., Mallick, S. K., & Sousa, R. M. (2016). Fiscal and monetary policies in the BRICS: A panel VAR approach. Economic Modelling , 58 , 535-542.
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