NAME; WILSON CHRISTIANA UWANA

DEPT; BANKING AND FINANCE

LEVEL; ND111
GROUP; C&D
MATRIC NO; 076021368
COURSE; BANKING OPERATION

DISCCUSION ON MONETARY POLICY

The term Monetary policy is the process by which the government, central bank, or monetary
authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of
money or rate of interest, in order to attain a set of objectives oriented towards the growth and
stability of the economy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary

policy, where an expansionary policy increases the total supply of money in the economy, and a
contractionary policy decreases the total money supply. Expansionary policy is traditionally used
to combat unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates to combat inflation. Monetary policy is contrasted with fiscal policy,
which refers to government borrowing, spending and taxation.

HISTORY OF MONETARY POLICY

Monetary policy is primarily associated with interest rate and credit. For many centuries there were
only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper
money to create credit. Interest rates, while now thought of as part of monetary authority, were not
generally coordinated with the other forms of monetary policy during this time. Monetary policy
was seen as an executive decision, and was generally in the hands of the authority with seignior
age, or the power to coin. With the advent of larger trading networks came the ability to set the
price between gold and silver, and the price of the local currency to foreign currencies. This official
price could be enforced by law, even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility to print notes
and back them with gold, the idea of monetary policy as independent of executive action began to
be established. The goal of monetary policy was to maintain the value of the coinage, print notes
which would trade at par to specie, and prevent coins from leaving circulation. The establishment
of central banks by industrializing nations was associated then with the desire to maintain the
nation's peg to the gold standard, and to trade in a narrow band with other gold-backed
currencies. To accomplish this end, central banks as part of the gold standard began setting the
interest rates that they charged, both their own borrowers, and other banks that required liquidity.
The maintenance of a gold standard required almost monthly adjustments of interest rates.

During the 1870-1920 periods, the industrialized nations set up central banking systems, with one
of the last being the Federal Reserve in 1913. By this point the role of the central bank as the
"lender of last resort" was understood. It was also increasingly understood that interest rates had
an effect on the entire economy, in no small part because of the marginal revolution in economics,
which demonstrated how people would change a decision based on a change in the economic
trade-offs.

Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply
at a low, constant rate, as the best way of maintaining low inflation and stable output
growth. Therefore, monetary decisions today take into account a wider range of factors, such as:

 short term interest rates;

 long term interest rates;
 velocity of money through the economy;
 exchange rates;
 credit quality;
 bonds and equities (corporate ownership and debt);
 government versus private sector spending/savings;
 international capital flows of money on large scales;
 Financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination of the
dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically
that monetary policy is fraught with risk and these risks will result in drastic harm to the populace
should monetary policy fail. Others see another problem with our current monetary policy. The
problem for them is not that our money has nothing physical to define its value, but that fractional
reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small
proportion of society (including all governments) to be perpetually in debt.

In fact, many economists disagree with returning to a gold standard. They argue that doing so
would drastically limit the money supply, and throw away 100 years of advancement in monetary
policy. The sometimes complex financial transactions that make big business (especially
international business) easier and safer would be much more difficult if not impossible. Moreover,
shifting risk to different people/companies that specialize in monitoring and using risk can turn any
financial risk into a known dollar amount and therefore make business predictable and more
profitable for everyone involved. Some have claimed that these arguments lost credibility in the
global financial crisis of 2008-2009.

TYPES OF MONETARY POLICIES

The four main types of monetary policies are bank reserve requirements, open market operations,
the federal funds rate and the discount rate.

Bank Reserve Requirements

Through reserve requirements, the central bank requires banks and other depository institutions to
hold a certain amount of funds in reserve to meet outflows of money, such as customer
withdrawals. Banks may hold these reserves as cash in their vaults, as deposits with the central
bank or as a combination of the two. When a central bank's policy-making body, such as the
Federal Reserve Open Market Committee, wants to expand the money supply, it can lower
reserve requirements. This puts more money into circulation by freeing banks to engage in more
lending. Raising reserve requirements, in contrast, lowers the money supply by requiring banks to
hold more money in reserve, making less available for lending.

Open Market Operations

An important type of monetary policy tool, open market operations involve the purchase and sale
of government securities on the open market by central banks. In the United States, the Federal
Reserve Bank of New York conducts open market operations. When the central bank wants to
expand the money supply, it purchases securities from a bank, increasing that bank's reserves as
payment. This gives that bank more reserves than it want, freeing it to lend the funds. To reduce
the money supply, the Federal Reserve sells government securities to banks and receives
reserves as payment, which lowers those banks' supply of reserves.

Federal Funds Rate

The federal funds rate is an interest rate that banks charge each other for short-term loans.
Federal Reserve policy makers adjust this interest rate in response to economic conditions. When
inflationary pressures appear in the economy, the Federal Reserve often increases the federal
funds rate, making it more expensive to borrow reserves and thus reducing the money supply.
Lowering the federal funds rate expands the money supply.

Discount Rate

The discount rate is the interest rate that the Federal Reserve and other countries' central banking
authorities charge banks and other depository institutions for borrowing reserves. The discount
rate is typically higher than the federal funds rate, to discourage banks from turning to this lending
source before other alternatives. Central banks can lower the discount rate, to expand the money
supply, or raise the rate to reduce it.

IMPORTANCE OF MONETARY POLICY

• Monetary policy is a potential cure for economic fluctuations.

• Monetary policy promotes price stability.

WHEN / HOW CAN MONETARY POLICY BE USED

Monetary policy may be used either to reflate the economy or to deflate the economy.

Using monetary policy to reflate the economy: If the Monetary Policy Committee considers
that inflation is falling and they will easily meet their inflation target, then they may consider cutting
interest rates. If there is a danger of the economy suffering a downturn this will help reinforce this
decision. Cutting interest rates will encourage people (and firms) to borrow more money. It will
also give people who have mortgages more money to spend each month as their mortgage
payments fall. The combination of these effects will increase the levels of consumption and
investment. Since consumption and investment are two of the key components of aggregate
demand, cutting interest rates should result in increased economic growth and reduced
unemployment.

The government could also allow the money supply to increase to encourage spending,
but monetarists argue that if this is allowed to happen too much inflation will result. This is
predicted by the Quantity Theory of Money.

Reflationary monetary policies are therefore:

• Cutting interest rates

• Allowing money supply to increase

Using monetary policy to deflate the economy: If the Monetary Policy Committee considers
that inflation is in danger of rising and perhaps going over their inflation target, then they may
consider increasing interest rates. Increasing interest rates will discourage people (and firms) from
borrowing money. It will also give people who have mortgages less money to spend each month
as their mortgage payments rise. The combination of these effects will reduce the levels of
consumption and investment. Since consumption and investment are two of the key components
of aggregate demand, increasing interest rates should result in reduced economic growth and
increased unemployment.

The government could also try to cut the level of money supply growth to cut
inflation. Monetarists argue that this will happen as predicted by the Quantity Theory of Money.

Deflationary monetary policies are therefore:

• Increasing interest rates

 • Reducing money supply

MONETARY POLICY GUIDELINE 2009

In the effort to resolve the effectiveness of Monetary Policy, the CBN, following the meeting of the
Monetary Policy committee on July 07, 2009, resolved to guarantee all inter-bank placements and
placements with banks by Pension Funds Administrators maturing on or before March 31, 2010. In
order to give effect to the decision to guarantee inter-bank placements, banks are advised to be
guided as follows:-

•The pricing of the placements must reflect the credit enhancement provided by the guarantee.
Thus, it is expected that overnight placements shall not be priced higher than MPR + 2%, while a
maximum spread of 300, 400 and 500 basis points above the MPR shall be maintained for tenors
up to 30, 60 and 90 days, respectively. Any placements priced outside these bands shall not be
eligible under this programme.

•The guarantee shall be applicable to only inter-bank transactions by Nigerian banks that are
denominated in the local currency, that is, the Naira.

•All transactions by banks in this regard shall be subject to the single obligor limits of the
participating institutions. In other words, for the guarantee to be effective, the placement(s) by an
institution to another institution shall not exceed its single obligor limit at any point in time.

Placements by Pension Funds Administrators shall continue to be subject to the exposure limits
set by the National Pension Commission (PENCOM), if any. To qualify under this arrangement,
pricing most also be in line with (i) above.

•The guarantee on all inter-bank placements that meet the above requirements shall be applicable
to only those maturing not later than March 31, 2010, and it covers full payment of principal and
accrued interest in the event of a default.

Furthermore, in order to avoid arbitrage in the money market, banks are reminded that access to
the CBN Discount Window for the purpose of placement at the inter-bank market, is not permitted.
Such action shall be regarded as unprofessional conduct and would attract very severe sanctions.

Banks are reminded that the ultimate objective of these measures is to bring down lending rates
and stimulate economic growth. They are therefore urged to pass on the benefits of reduced
funding costs to their borrowing customers.

The CBN will continue to monitor rate movements on a regular basis. This circular takes effect
from July 13, 2009.