With the help of which instruments an economy can be regulated?
When a country wants to influence an economy, it can use 2 instruments: fiscal and monetary policies. These policies are completely different. Fiscal policy is connected to the budget, it is a decision that the parliament makes about taxes and expenses of the country, subsidies, pensions and other types of social help. Moreover, fiscal policy concerns the distribution of people`s income to achieve some equality for avoiding a big gap in incomes. Monetary policy is about the amount of money in the economy and interest rates.
Overall, the main purpose of any economic policy is increasing the level of welfare of the population. The economy tends to grow and fall. There is a long-term trend that usually increases, but with fluctuations. Economists call these fluctuations as economic cycles. Over the last 50 years, the average duration of an economic cycle has been around 6 years. Cycles are not that good, because people are happier during the stability. That is why the purpose of this policy is to lead an economy on the trend that increases and not declines, but, on the other hand, to smooth the cycles. Consequently, for these purposes fiscal and monetary policies are used. With the help of these policies, the country stimulates the economy in times of economic decline and slowing the economy down when it`s “overheated”.
What causes economic cycles and how the economy can be stimulated or “slowed down”? Accumulated level of production (sales) and, consequently, employment and income of the population are determined by two main factors: demand on the produced goods and their supply. Producers may produce many goods, but if the goods are not demanded, they won`t be realized. Thus, the level of sales and incentive for production growth won`t be high and vice versa.
Historically, most of the economic crises were caused by the decline in the aggregate demand in economies of different countries. Respectively, for economic growth to recover, aggregate demand should be stimulated, which fiscal and monetary policy address. Moreover, economic growth is facilitated by an increase in aggregated supply, and the country should create the right condition for this to happen, but fiscal and monetary policies are more focused on the aggregate demand rather than supply.
How does monetary policy work?
The main mechanism the monetary policy influences aggregate demand is the mechanism of interest rates. Interest rates, or rates on loans and deposits, are the price of money. If interest rates decrease for some reason, money will become cheaper and this will increase customer purchasing power. For example, if an individual can take a loan for purchasing a refrigerator or other home appliances with a low-interest rate, the demand for these goods is likely to increase significantly. This way a decrease of interest rates will facilitate an increase of aggregate demand and vice versa.
This mechanism works even when people don`t take consumer loans for purchasing goods and services. In general, people distribute their income between current consumption and savings (for future consumption). Holding other conditions fixed, an increase in interest rates for deposits (income for savings) will lead to an increase in savings and a decrease in expenditures. If interest rates on deposits decrease, people would rather spend their money on current consumption rather than put the money in a bank with a low-interest rate. Therefore, lower interest rates stimulate consumption and aggregate demand in the economy. And by increasing an aggregate demand, the level of production is increased, which leads to the stimulation of the economy.
So, if the country aims to stimulate economic activity, this may happen by decreasing interest rates. How can the country achieve it? With the help of the market mechanisms.
Rates between bank loans and deposits are very connected. If we consider the bank as a business, how does it earn money? It takes deposits from people and gives loans to enterprises. If a bank takes deposits with a 10% rate, it will give loans with a higher rate – for example, 11% or 12%. In this case the bank won`t give loans with a 5% rate, because it isn`t profitable. To have an opportunity to pay back the deposits (with an interest), the bank will need to earn this interest (plus a margin for covering operational expenses).
The rates for deposits and loans depend on the amount and the price of the resources the bank have. In general, the same as the price of any other good in the economy, interest rates are determined by demand and supply of money resources. If banks have extra cheap money, they will have an opportunity to offer cheaper money to their clients.
So, if the National Bank makes money “cheaper”, by offering to loans with a low rate (this interest rate is called a discount rate) to commercial banks, in particular, other loan and deposit rates will decrease after a while. This will stimulate aggregate demand and economic activity.
Nonetheless, the economy may “overheat” and have “economic bubbles” as it happened in 2008 in the USA. At that moment, lots of loans were given, which over-stimulated consumption and caused some structural distortions and impeded the balanced economic development. Acknowledging it, the state of the USA and the Fed (Federal Reserve System in the USA) were interested in decreasing too high aggregate demand in the economy before the crisis. To achieve this, since 2005 the Fed has started to increase interest rates rapidly. Consequently, loans became more expensive and deposits – more beneficial, that is why people started taking their money to the bank instead of spending them on the current consumption.
Unfortunately, monetary policy can`t rescue the economy from the crisis all by itself. The economy of the USA still was too overheated and, as an outcome of the financial crisis, it has fallen significantly. But without any actions, the economic crisis would be much severe. As a response to the crisis, consumers have decreased their demand for goods and services enormously, which has led to a significant decrease in sales and an increase of unemployment. So, if the economy got overheated and its growth slowed down, interest rates should be increased. If the economy is already in the crisis, it needs to be stimulated and taken out of the crisis. For economic stimulation, interest rates should be decreased. This is the work of the central bank. In Ukraine, it is the National Bank of Ukraine, in the USA – Federal Reserve System, and every country has its agency.
How are the responsibilities distributed between the National Bank and the Ministry of Finance?
Economic policy is divided into two agencies that negotiate two different types of policies: monetary and fiscal. Fiscal policy is implemented by the state (Ministry of Finance in particular) and monetary policy – by National Bank. These agencies should be independent. Why? In general, the task of the state and National Bank is to improve the people`s welfare. Welfare is a very complex and multidimensional concept and its economic component is traditionally preset by three standard macroeconomic indicators: GDP growth, low level of unemployment and low level of inflation. Nonetheless, there is a problem of the political cycle in the state and it often tries to focus on unemployment and social help, which leads to high inflation and a damaged economy in general. Why does the state do it? Because unemployment and sources of income are more important than inflation for the electorate. Low unemployment and inflation are difficult to be achieved at the same time. For example, employment can be increased by increasing the level of inflation.
Let`s consider the events in Ukraine after the collapse of the Soviet Union in the 90s. Ukraine didn`t have its institutions and the state didn`t have any money, in return, Ukraine had a huge ineffective public sector, which has been the main employer in the country. People needed to be paid, but there was no money. How was it resolved by the state? The state pushed the central bank that could print the money to cover the budget deficit by monetization. As a result, hyperinflation happened. If the central bank is independent of the state, the state will always try to fund its deficits by monetization, because it is the simplest way of getting money. And usually, it results in inflation or even hyperinflation. That is why the independence of the central bank is crucial.
The state has its instruments for achieving goals of economic growth with a low level of unemployment and these instruments are the instruments of fiscal policy. If the central bank is independent, the state can`t require from the bank to print the money for covering the budget deficit. If the state is in deficit, it needs to increase taxes, decrease expenses or take loans from internal and external capital markets. Printing the money is too far from being the best and only solution. Of course, the state won`t be happy, because printing money is easy, but we are aware of the consequences. That is why the National Bank and Ministry of Finance should be separate agencies and they are not connected with monetary policy in any way.
What are the responsibilities of the National Bank of Ukraine?
The task of the National Bank is to keep the prices stable. Now it is especially relevant as the National Bank pursues the policy of inflation targeting. This directly indicates that the National Bank is trying to achieve some particular level of inflation in the country. This level is sufficiently low, and the target is 5%; for now, an actual level is much higher and NBU (National Bank of Ukraine) tries to achieve this target ultimately. This level of inflation is supposed to be optimal for the country and economic agents to be certain about the future.
The first thing to understand is that the influence of the central bank on inflation is indirect. NBU and the state don`t set the prices (except for some socially important goods). The prices are set by the market (by the power of demand and supply) and NBU only can give some incentives to influence demand and supply and, consequently, change the prices. Let`s imagine a traditional model of demand and supply: if an aggregate demand increases, prices increase as well, and vice versa. So, if inflation needs to be suppressed, a growth of aggregate demand should be suppressed as well. Aggregate demand has four components: demand of household, producers (investment demand), country and the external sector. How can it be decreased? It can be done by increasing interest rates and then consumption and investment demand will decrease.
What instruments does National Bank use?
NBU doesn`t give direct instructions to commercial banks. Commercial banks set rates for loans and deposits by themselves. Nevertheless, NBU can make money more “expensive” or “cheaper”. Commercial banks have few sources of income: investors, loans on the external markets and loans from the NBU. A discount rate is a rate at which commercial banks can take loans from the National Bank. If this rate decreases, commercial banks start to make money from the NBU. For this money to “work”, banks issue loans with lower rates. Also, commercial banks are interested in offering the deposits with lower rates, because now they have “cheap” loans from NBU as an alternative source of income. That is how a discount rate influences the loan and deposit rates of commercial banks. This process takes some time, but the changes in discount rates affect deposit and loan rates through the market mechanism, not direct instructions.
There are other instruments. NBU can interfere with the market with the help of operations at the open market. For example, when NBU makes purchases of euros or dollars at the interbank market, it “takes” dollars from commercial banks and gives hryvnias in return. As a result, banks have a big amount of hryvnia and they need to do something about it, i.e. give loans. If they have a lot of hryvnias, they give loans at a lower rate. Consequently, the number of money increases in the economy and its price decreases.
The third instrument is the reserve requirement rate. This instrument almost isn`t used in Ukraine and the world, and this rate is very low. For a long time, this rate was equal to zero, but a few years ago it was increased to 1-2% in Ukraine.
How does the National Bank decide on the amount of money to be printed?
The important question is not how much money should the economy have, but which interest rates will help to achieve the targeted level of inflation. For now, the current level of inflation is significantly higher than a targeted one in Ukraine. For the inflation to decrease, an aggregate demand (economy-wide) on the goods and services needs to be decreased. For achieving it, NBU has one main mechanism, which is an increase in interest rates, its discount rate, in particular. This level of interest rate, which is, in fact, a price of money, determined the necessary amount of money in the economy (for the price (interest rate) to increase, the quantity of goods (money) needs to decrease, and vice versa).
But it is important to remember that there are economic policy lags, namely the difference between usage of instrument and an answer to the inflation can take from 6 months to 2 years. Moreover, there are lots of factors that affect the economy and prices that are difficult to control, or even forecast. For example, natural disasters, or so-called “animal instincts” (optimism or pessimism of consumers).
To achieve the targeted level of inflation, demand and supply should be nicely forecasted in one- or two-year advance. The movement of external and internal factors should be foreseen, especially the condition of the external markets because Ukraine has a large volume of exports and imports a lot. At first, the level of inflation is forecasted at the basic scenario (without changes in the monetary policy). Then, a received number, for example, 10 percent, is compared with the targeted one – 5 percent. What should be done in this case? An aggregate demand should be decreased by increasing interest rates. A recent increase in interest rates in Ukraine has been a response to having the goal, forecast and reality. How much they should be raised? It is an art to a certain extent. Some particular rules help to form an understanding of the vector of movement, but the exact number is extremely difficult to determine. And this is what the National Bank of Ukraine does.
Translated by KSE student Yana Tkachenko.