What comes to mind when you hear the words monetary policy? Most probably Central Bank, interest rates and inflation. If one is better informed they’ll probably think about the central bank rates, treasury bills and bonds and the interbank rate. All these are associated to monetary policy but none of them are descriptions or explanations of what is meant by monetary policy.
So, what is monetary policy?
Monetary policy refers to policies that the government implements to control money supply. These policies are carried out through state organs such as the Central Bank. By controlling money supply in the economy the Central Bank is able to control interest rates and guard against inflation and ensures stability of prices and exchange rates.
Therefore monetary policy is the vehicle by which the government attempts to control the economy and promote economic growth. Through monetary policy, the Central Bank creates a suitable economic environment for increased output of goods and services in the economy.
In Kenya the Monetary Policy Committee (MPC), a committee of the CBK, is responsible for formulating monetary policy.
How is this monetary policy actually carried out?
The Central Bank conducts monetary policy using the following methods:
- Reserve Requirement: commercial banks are required by law to deposit a proportion of the customer deposits with the CBK. In this way the CBK attempts to influence the amount of loans commercial banks can advance the public and this affects the supply of money. An increase in this proportion reduces the amount of money available for commercial banks to lend and reduces money supply further while a reduction has the opposite effect.
- Open Market Operations: The CBK buys and sells Government securities (Treasury Bills and Bonds) in the money market in order to achieve a desired level of money in circulation. When the Central Bank sells securities, it reduces the supply of money in the economy as investors give the CBK money in exchange for the securities and when it buys securities it increases the supply of money in the market.
- Lending by the Central Bank: The CBK lends money to commercial banks overnight when they fall short of funds thus affecting the amount of money in circulation and the amount deposited by banks at the CBK. The interest rate the CBK charges the commercial banks is known as the Central Bank Rate (CBR) and in turn the level of the CBR influences the interest rate commercial banks charge on loans to the public
- Persuasion: The Central Bank persuades commercial banks to make decisions or follow certain paths to achieve a desired result like changes in the level of credit to specific sectors of the economy. It does this by suggesting the interest rate at which banks should lend money to the public.
Now that you know hopefully you clearly understand why the Central Bank is one of the most important organs of the government. Their actions have an effect on whether the ordinary Kenyan can access credit from commercial banks and by controlling inflation the CBK influence whether Kenyans can afford to buy goods and services at acceptable prices.