Depending on the economic growth or stagnation of the nation, monetary policy can be broadly categorized as either expansionary or contractionary.
The purpose of a contractionary economic policy is to increase interest rates in order to reduce the money supply in the economy, thereby slowing investment. This contributes to economic growth, and as a result, it enables a reduction in the rate of inflation, which raises the cost of goods and services and erodes the purchasing power of currency.
In times of recession or sluggish economic growth, expansionary policies will be implemented. In this case, the government reduces the interest rate to lower the desirability of saving and increase consumer spending by increasing bank lending activity.
Inflation, unemployment, and the exchange rate are thus managed through monetary policy.
In order to increase the money supply in the economy, contractionary monetary policy discourages inflation, whereas expansionary monetary policy encourages inflation. It reduces unemployment by increasing the economy’s money circulation. Using an expansionary monetary policy, as money circulation in the economy is raised, the local currency’s exchange rate versus the foreign currency becomes substantial. This means that a large amount of money can only purchase a small amount of foreign currency.
Since underdeveloped nations have weak financial markets, institutional issues, and an inflexible system, the central bank is viewed as having difficulty implementing monetary policies. Commercial banking activity is currently dominating the developing financial market. The government, not the market forces of demand and supply, determines interest rates.
When interest rates fall, savers will receive less interest on their deposits. This suggests that savers prefer to consume more now and less in the future. As a result of this monetary policy’s inability to promote a rapid economic recovery, future demand to participate in the economic recovery is diminished.
The efficacy of monetary policy in developing nations has been a topic of debate for some time. There are fundamental reasons why monetary policy is not always effective in developing nations, despite the absence of a definitive answer.
One is the degree to which the central bank is independent from political influence. A central bank with a high degree of independence from political influence is more likely to implement monetary policy effectively and make decisions based on economic considerations than one that is influenced by politics.
The second factor is the transmission mechanism, which is the process by which monetary policy changes influence the economy. While the process is well understood and efficient in developed nations, the transmission mechanism in developing nations is poorly understood, resulting in ineffective monetary policy.
The third factor is an underdeveloped financial system, which makes monetary policy implementation extremely difficult. In addition, developing nations are susceptible to external shocks, such as fluctuations in global commodity prices and exchange rates, which can hinder the effectiveness of monetary policy.
In order to overcome these obstacles, the central bank can enhance the efficacy of monetary policy by instituting transparency and effective communication in order to comprehend the objective of monetary policy and the factors that influence decisions. As a result, the central bank can enhance the credibility and trustworthiness of its policies.
The alternative strategy is to enhance the monetary policy transmission mechanism. This can be accomplished by establishing a robust and sophisticated financial system and enhancing the central bank’s capacity to manage interest and exchange rates. To better manage external shocks, developing countries may need to adopt more flexible exchange rate regimes.
Devaluation is one of the elements of monetary policy. Devaluation is the deliberate adjustment of a country’s currency value relative to other countries’ currencies with the expectation that it will increase exports, reduce trade deficits, and reduce the cost of a country’s debt. The government should be aware, however, that devaluation has its own limitations and negative effects.
One of the primary drawbacks of devaluation is that it can result in inflation due to higher import prices for goods and services. Additionally, it can have negative effects on domestic industries. The increase in import prices has a negative impact on domestic industries, rendering them inefficient.
Notably, devaluation can also lead to currency wars, which occur when countries intentionally devalue their currencies to gain a competitive advantage on the global trade market. This can result in a vicious cycle of devaluation and retaliation, with negative repercussions for all countries involved.
Foreign exchange liberalization is yet another aspect of monetary policy. When liberalizing foreign exchange in developing nations, a number of restrictions must be taken into account.
Currency volatility, which can be detrimental to the economy, can result in cycles of currency appreciation and depreciation, which can contribute to economic instability. This can make future business planning difficult and make borrowing money from other countries more expensive.
Consideration should be given to the loss of control over monetary policy and the domestic financial system as domestic financial institutions become more exposed to global financial markets. After opening their economies to foreign investors, developing nations may find it difficult to maintain control over their monetary policies. If a country has a fixed exchange rate, for instance, it may be compelled to raise interest rates to defend the rate, even if doing so is not in the best interest of the economy. This can cause inflation to rise and economic growth to slow. It also complicates government efforts to regulate the financial system and protect consumers.
There are potential benefits to liberalizing foreign exchange in developing countries despite these limitations. Attracting foreign investment, which can result in increased economic growth and job creation, and increasing competition on the domestic market are two advantages that can result in lower prices for consumers.
As countries increase their domestic interest rates, developing nations face a variety of constraints due to the risk of currency, banking, and debt crises that deter local investment. Hence, before implementing monetary policy, incorporating the aforementioned drawbacks will result in effective monetary policy.
Ameha Tefera (DBL) is a financial expert with many years of experience in the finance industry.
Contributed by Ameha Tefera (DBL)