Advertisement
Features

Policy rate reduction unbundled

Advertisement

The Monetary Policy Committee (MPC) of the Reserve Bank of Malawi (RBM) has recently reduced its policy rate— which is the indicative cost of money or, simply put, the interest it charges commercial banks upon lending them money as a lender of last resort— from 22 percent to 18 percent.

The development, which has attracted applause from members of the general public, has come at a time when Malawi has registered its lowest inflation rate in five years.

Normally, the move by the MPC is regarded as an expansionary monetary policy because the reduction in the policy rate means that banks can borrow from the RBM at a lower cost, which may, in turn, make them reduce their base lending rates.

Advertisement

In principle, the implication of this is that loans can be accessed at a lower cost— from commercial banks, that is— by individuals, firms and even government departments than would, otherwise, be the case.

Therefore, this eventually acts as a motivation for investors to borrow more money than they normally would and invest it.

Not only does this move increase money supply in the economy, but also increases its growth through increased investment, production and the ability of the people to demand and purchase commodities.

Advertisement

This increased production —emanating from increased investment resulting from low cost of capital, ignited by policy rate reduction— meets the needs of increased demand. We are referring to the demand which resulted from declining inflation, which is also a motivation for policy rate reduction in the first place.

In the long run, with increased demand, increased investment and increased production, the economy grows. The reduction in policy rate —as it entails a high money supply— also leads to an increase in demand for foreign currency since the people have easy and cheap access to the local currency with which to demand foreign currency.

But the question is, will this be the case for Malawi? After all, is this not more theoretical than practical? To answer these questions, a critical analysis of the economy of Malawi has to be done.

Once that is done, it would be possible to, in the end, determine whether the reduction in policy rate can and will indeed yield its desirable results as theory postulates.

First, we are in a period when inflation continues to decelerate and it is now at 12.3 percent, a desirable state for the economy, considering that we are moving towards a single-digit inflation rate.

Economic growth prospects look promising as the MPC projects it to rebound to 4.5 percent this year, from 2.7 percent in 2016.

And the Liquidity Reserve Ratio (LRR) has been maintained at 7.5 percent since the year 2015. The maintained lower LRR means that banks can still allocate more money to productive use —such as giving it out in loans and mortgages— rather than just holding it idle as reserves.

In addition, Malawi is predominantly an importing country, which means that there is always need for enough muscle of local currency to purchase foreign currency for importing goods.

With this kind of economy, it can be said that the effects of the reduction in the policy rate by the MPC will be economic growth-stimulating as it will not be rendered redundant by other macroeconomic indicators.

The analysis done shows stability and improvement in several things that will aid the expansionary policy adopted by the MPC. As such, it is likely going to be the case that, with this reduced policy rate and commercial banks are likely to follow suit) will come increased borrowing and, with the borrowed money, investment through the purchase of machinery, industrial materials and business is therefore, likely to increase.

The increase will, in turn, accelerate growth, create more employment, increase purchasing power and increase productivity, all remain constant, thus economic growth stimulating.

One may, however, be tempted to argue that this reduction will bring about inflation as it is expected that with lower interest rates followed by increased borrowing comes increased money supply in the economy. The consequence may be inflationary.

But the practicality of things is that increased money supply is not always inflationary, what matters is the use the borrowed money has been put to. If the money borrowed will be used for the purchase of commodities for consumption, then it will indeed be inflationary as it will lead to increased demand for food commodities.

However, if the money is invested through the purchase of machinery, industrial materials, or is used to boost various businesses —which is in the benevolent interest of lenders— it will, in turn, accelerate growth, create more employment, increase purchasing power and increase productivity and, everything else remaining constant, be economic growth-stimulating.

Furthermore, while it is true that some would also borrow to buy consumables, spurred by the low rate— in which case, this only adds up to increased demand, which resulted from the inflation drop— one important thing should not be ignored here, and that is that this increased demand will meet increased production as a result of increased investment.

That means high demand will meet high supply. As a result, the two eventually cancel each other without creating further inflation.

Further to this, it must also be pointed out that it is the abundance of food commodities that has contributed to the continuous deceleration of inflation. As a matter of fact, the theme for this year’s Independence Day celebrations was ‘Thanking God for a Season of Plenty’, (which is mostly food commodities).

This being the case, it is illogical to expect that a rational being will be borrowing money for the purpose of purchase of food commodities. It has to be emphasised, again, that loans are always expected to be repaid and that they are attached to collateral.

As such, it is not expected of rational beings to borrow money for buying consumables but, rather, a rational being borrows money for investment, which, for its purposes, is economic-growth stimulating.

Therefore, it is safe to conclude that, everything being constant, this reduction in policy rate will be economic growth stimulating.

Note: The authors studied Economics at Chancellor College. They work for The Malawi Confederation of Chambers of Commerce and industry but are writing in their personal capacity.

Facebook Notice for EU! You need to login to view and post FB Comments!
Advertisement
Show More
Advertisement

Related Articles

Back to top button
Close

Adblock Detected

Please consider supporting us by disabling your ad blocker