A nation’s Gross Domestic Product (GDP) shows the citizens’ economic stability and their living standards. The GDP of a nation can be affected by various factors like the change in interest rates, inflation and adjustment in the demand and supply of goods and services. The government’s fiscal and monetary policies can either increase or decrease the GDP. The focus of the paper is to analyze the importance of monetary policy and its impact on the rise and fall of the GDP. In the analysis section, the paper delves deeper into the meaning and goals of the monetary policy while the importance of the monetary is discussed using the contractionary and expansionary financial instruments.
Analysis of monetary policy
According to Borio et al. (2017, p. 50), a country’s financial body like the central bank has many financial instruments that it uses to achieve four goals. The first aim of using monetary policy is to attain full employment by enhancing more investment. The other goals of the monetary policy in a nation are to achieve price stability, attain economic growth and maintain equilibrium in the Balance of Payment (BOP).
The implementation of the financial instruments determines if the GDP of a country rises or falls. However, according to Praptiningsih et al. (2018, p. 13), the objectives of the monetary policy normally conflict. For instance, it is impossible to have price stability and economic growth at the same time since growth comes with a considerable rise in the price of goods and services. Besides, achieving full employment in the country results in a Balance of Payment (BOP) deficit(Hammoudeh et al. 2015, p. 71). The primary elements of the Gross Domestic Product that are affected by the monetary policy include investment and savings.
Monetary policy’s importance in the fall of GDP
Contractionary monetary intervention measures can be used by the Federal Reserve Bank to reduce the money supply in the economy which would have a significant effect of reducing the Gross Domestic Product. There are six monetary instruments which can result into a decline of the GDP. According to Sun (2018), the first monetary policy of increasing the bank rate contributes to the decline in money available for investment by the commercial banks hence resulting into a decline in the GDP. For example, if the Federal Reserve Bank raises the discount rate from 12% to 24%, the cost of borrowing from the commercial banks will increase thus discouraging the public from taking loans (Gertler, 2015, p. 61). The consequence of having a reduction in the money supply would be a decline in the amount of funds that can be used for investment.
Sale of marketable securities through the Open Market Operations is the second monetary instrument which can result into a decline in the GDP. When the Federal Reserve Bank decides to issue exchange money for the paper tenders, money supply in the economy declines leaving the public with little to invest. Consequently, the prices of goods shoot up because there is little money chasing al the goods in the market. The price increase results into inflation which consequently causes the fall in the GDP.
Selective Credit control is the third monetary policy instrument which the Federal Bank can use to reduce investment in certain sectors of the economy which results into the fall in GDP. For example, if the Federal Bank directs the commercial banks to reduce loans in certain sectors like agriculture, then these sectors would have a reduction in investment which results into a decline in the output and GDP.
The interest rate policy can also result into a fall in the Gross Domestic Product. The policy dictates the amount of interest which borrowers of the bank loans have to pay. A significant rise in the interest rates would translate into reduced borrowing by the public. Consequently, the industries which depend on these loans like the entrepreneurial sector would experience a decline resulting into a fall in the GDP.
The use of exchange rate as monetary policy can result into the fall of the country’s GDP. If the government devalues the currency on a random basis, the exchange rate fluctuations increase resulting into the fall in investors’ faith in Foreign Direct Investment (FDI). Consequently, production would decrease causing the fall in the GDP.
Finally, the minimum liquidity ratio can be used by the Federal Reserve Bank to regulate lending which would impact the GDP. The ratio indicates the amount of monetary value in terms of cash and other liquid assets which the commercial banks have to keep with the Federal Reserve Bank (Zdzienicka et al.2015). For instance, a ratio of 0.05 means that the commercial banks must save 5% of their earnings with the Federal Reserve Bank. Increasing the ratio takes away money from the commercial banks which implies that the amount available for lending is reduced. Consequently, the reduction in loans reduces investment opportunities which lowers the Gross Domestic Product.
Monetary Policy’s importance in the rise of GDP
The Federal Reserve Bank’s expansionary monetary interventions can increase the Gross Domestic Product in various ways. First, the policy of buying marketable securities through the Open Market Operation (OMO) increases the money supply in the economy which provides the public with the opportunity to invest hence spurring economic growth. Besides, the rise in money supply decreases the cost-push inflation. The fall in inflation levels can result into an increase in the level of employment which consequently raises the production levels responsible for a high GDP (Aikman et al. 2015, p.1074).
The minimum liquidity asset ratio as a monetary policy can also be used by the reserve bank to increase GDP. The ratio is used to indicate the amount of liquid assets and cash that the commercial banks have to give the federal bank for reservation. For instance, a ratio of 10% indicates that the commercial banks must keep the percentage of all the cash and liquid assets with the federal bank. A reduction in the ratio increases the commercial banks’ lending ability which increases investment which results into an increase in the GDP.
The government can also use selective credit control as a monetary policy to increase the GDP. For example, directing credit to the most productive sectors of the economy increases the level of employment in the affected industries which results into the rise in the Gross Domestic Product (Sims, 2016).
The Federal Bank can also stabilize the exchange rate as an instrument of monetary policy to increase the GDP. For example, a stable exchange rate lowers inflation and increases the Foreign Direct Investments (FDI) in a country which results into a rise in production. Accoding to Galí (2015), bank rate policy is yet another monetary instrument which can be used by the Federal Reserve Bank to regulate money supply and increase the country’s GDP. If the Federal Bank sets a low discount rate, then the amount of interest payable on the loans decreases making it possible for the public to borrow money and invest in the various sectors of the economy. Consequently, the investments increase the production of various industries which raises the GDP.
Overall, according to Adrian "Liang (2016), the monetary policy plays four important roles concerning the economic growth. These roles are; raising the aggregate rate of savings culture in the economy and investment, mobilizing the savings to help in the purpose of investment so as to increase production and allocating funds in a prioritized manner to the sectors of the economy which have the most significant impact in the country’s Gross Domestic Product (GDP).
Conclusion
There are various monetary policy instruments which the government, through a central bank or a federal reserve bank, can use to either raise or decrease money supply in the economy. These intervention measures can either increase or decrease the Gross Domestic Product of a country. The essay has analyzed the meaning and goals of the monetary policy like the attainment of full employment, price stability, and economic growth. Besides, the analysis has shown how the expansionary and contractionary policies can impact the Gross Domestic Product.
References
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Borio, C., Gambacorta, L. and Hofmann, B., 2017. The influence of monetary policy on bank profitability. International Finance, 20(1), pp.48-63.
Galí, J., 2015. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.
Gertler, M. and Karadi, P., 2015. Monetary policy surprises, credit costs, and economic activity. American Economic Journal: Macroeconomics, 7(1), pp.44-76.
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