Business in Ghana

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The Relevance Of The Monetary Policy Rate In The Monetary Transmission Mechanism

Posted by Business in Ghana on August 5, 2012

Source: Center for Policy Analysis.  http://www.cepa.org

In May 2007 the Bank of Ghana formally adopted inflation targeting (IT) as the framework for stabilizing prices within the economy. Since then, significant progress has been made in developing the policy framework as well as the institutions and markets that underpin its implementation _ money and capital markets have been developed, there is a framework for forecasting liquidity, and a broad range of instruments with which to conduct monetary policy is available.

The monetary policy tool of the BOG is the monetary policy rate (MPR) _ the rate at which commercial banks can borrow from the central bank _ and it is set at a level that is consistent with meeting the BOG_s inflation target. The MPR, thus, is expected to communicate the stance of monetary policy and act as a guide for all other market interest rates.

The monetary transmission mechanism – the process by which monetary policy decisions affect the real economy and inflation _ operates through several channels.

When monetary policy tightens, for example, and market interest rates rise, the financial position of firms may weaken _ either because of an increase in their interest payments which reduces their net cash flows or because of a fall in the value of their assets and thus collateral _ causing the terms of credit that they face (the cost of external funds) to rise. This is the _balance sheet channel_.

Monetary policy changes may also affect the supply of credit, particularly by commercial banks. Because banks rely on demand deposits as an important source of funds, monetary policy tightening, by reducing the aggregate volume of bank reserves will also reduce the availability of bank loans. When a significant number of firms and households rely on banks as a major source of financing, then a reduction in loan supply will depress aggregate spending and reduce total output and price. This is the _bank lending channel_.

In conventional macroeconomic models, the primary mechanism believed to be at work in the transmission of monetary policy is the _interest rate channel_. In this case, an increase in the MPR, for example, is expected to directly impact on some short-term wholesale market interest rate (the interbank interest rate _ the rate at which banks borrow from each other _ or Treasury bill interest rates) and then transmitted to retail market interest rates _ bank lending and deposit rates. Assuming that prices remain fixed for some period of time, the increase in the nominal market interest rates would translate into an increase in real (inflation adjusted) market interest rates and, hence, an increase in the real cost of capital. This, in turn, would result in a reduction in overall consumption and investment spending (i.e. a decline in aggregate demand) such that total output and prices would fall.

The effectiveness of the monetary transmission mechanism is important for the credibility of monetary policy _ the relevance of the MPR in determining market interest rates and hence the level of economic activity and prices.

In the present exercise we examine the channels through which changes in the MPR pass through to impact on the lending rates of banks. Specifically, we examine pass through to two intermediate money market variables _ the interbank interest rate and 91-day Treasury bill rate _ and assess their individual and joint impact on the lending rate. We also examine any lags in the transmission mechanism.

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