Gupta and Goldfajin defined a tight monetary as “a case in which real interest rates in the aftermath of the crises are higher than the average real interest rate during the 24 months preceding the crises”(Goldfajn and Gupta, 1999, p.4). The primary objective of ensuring that the monetary policy is tightened is to make sure that the supply of money in the economy is reduced and also to ensure a conducive environment for businesses. For a commercial bank to lend money, there are a lot of factors that it considers. Some of the factors include the volume of deposits, prevailing level of interest, the liquidity ratio of the bank and domestic and foreign investments. The monetary authorities adopt the policy to ensure that all the economic activities are controlled so as to prevent cases of inflation and to secure the country’s currency. Although the tight monetary policies are made to control the economic situation in a country, there must be a proper management. Good management would ensure that other money lending institutions (such as the commercial bank) are affected in a positive manner.
A tight monetary policy involves the use of interest rates, which is one of the monetary policy tools. Ordinarily, the Central Bank increases its base rate (Roussakis, 1997, p.254). If a Central Bank of a particular country raises its base interest (the amount of interest that it charges to the commercial banks), then the net effect would be an increase of interest rates of commercial banks. Sometimes, for commercial banks to lend money to their clients, they obtain loans from the Central Bank. If the Central Bank offers loans to commercial banks at low interest, then the commercial bank would also provide their loans at low interest. The effect of the high interest is the reduction of the aggregate demand in the society.
The second tool of monetary policy is reserve requirement. The reserves are held by the commercial banks so that they may have enough money to cover the money that is withdrawn by the consumers. The Central Bank encourages the commercial banks to have reserves so that they can control the supply of money in the economy. To reduce borrowing, the reserve requirement is increased by the Central Bank (Welch and Welch, 2010, p.242).
The other tool of the monetary policy is known as Open Market Operation (OMO). This tool is used by the Central Bank to restrict the amount of money in circulation. To succeed in restricting that supply of money, the bank can engage in the printing of less money. Besides printing of less money, the bank may also engage in the selling of government bonds that are long-dated to the existing banking sectors (Welch and Welch, 2010, p.244). The OMOs are also used in stabilizing the prices of government securities, an objective that conflicts most of the time. When the Central Bank purchases securities in the open market, then several consequences take place; first, the reserves of commercial banks are increased; secondly, the price of government securities is also increased; lastly, the interest rates are reduced which later leads to increased business investment. The open market operations (OMOs) are classified into two; they are temporary and permanent OMOs.
The first advantage of the Open Market Operation is that they are precise and flexible (Powers, 2008, p.51). This, therefore, means that they can be applied in enacting of both the large and small changes in monitories base. The second advantage of the OMO is that they can be easily reversed; this means that correction of errors can be tackled fast, which is impossible when discount lending or reserve requirements are used. Thirdly, the OMOs can be quickly implemented, meaning that administrative delays are excluded when open market operations are conducted (Powers, 2008, p.51). Lastly, the Central Bank fully controls open market operations; this means that it cannot be compared to other tools such as discount lending where the Central Bank sets borrowing prices, but there is no direct control of the amount that is borrowed by commercial banks.
The aggregate demand is regulated through several ways. First, as borrowing money becomes more difficult, both the consumers and the firms are discouraged from spending and investment (Samuelson and Nordhaus, 2010, p.480). The other way through which the total demand is reduced is by the increasing number of savings. As more people are discouraged from spending money, they are encouraged to save more in the banks. The other means of reducing total demand is through decreasing disposable income. The consumers with variable mortgage have less income to spend due to the increase in interest payments on mortgage. For the production firms, they are also prone to the fluctuations in interest rates. If the firms are the net debtors of the banking system, then this is an indication that the high interest rates induced by the banks would increase the production cost.
The increase interest rates would also affect the exchange rates. For example, there would be a direct effect on inflation, which is associated with the cost of the imported goods. An appreciation of exchange rates would lead to the reduction of the price of domestic imports and a high price for the competing import products. Moreover, the immediate effect of the domestic change in the interest rates is that the exchange rate would appreciate, and there would be an inflow of the capital in the country (Agénor, 2004, p. 136). Some scholars have criticized the issue of reducing interest rates with an aim of reducing the rate of inflation. The reduction of interest rates is believed to have a slow impact in terms of correcting issues related to businesses in the economy.
The demand and supply for loans can be affected by the tightening of monetary policies. Some commercial banks are in recession-prone areas, and this is a big risk as they would lose capital; they may also decide to reduce the loan channel and liquidity risks (Huang, 2008, p. 3). The United States is a good example of a country that uses tight monetary policies. It is important to note that this strategy has both positive and negative impacts on the society. One of the positive impacts of a tight monetary policy is that it attracts a lot of foreign investors in the country. For the U.S, The investors introduced foreign capital, which was used in the development and growth of the country’s economy. As the economy of the nation continued to grow, then this was an indication that there was a lot of money for the commercial banks, which could be borrowed for investment.
However, for a tight monetary policy to have a positive impact on the commercial bank, it should be properly managed. For example, the Central Bank can reduce the amount of credit to its lenders. In developing countries, it is difficult for the businesspeople and investors to survive without the loans; consequently, even if tight monetary policies are used to provide loans at a high interest rates, then people would still get the loans. The key thing to investors and businesspeople is to see that the monetary system maintains the growth of their businesses. A tight monetary policy that is managed effectively assists the commercial banks to lower their liquidity ratio to avoid any shocks related to liquidity (Ewijk and Klant, 1985, P.121). Other commercial banks can hoard liquid assets and securities as a means of safeguarding them.
The main drawback of a tight monetary policy is the reduction of the credit offered by the commercial banks. Credit is the loan given to the people and their organizations. The tight monetary policy reduces the credit issued by the commercial banks. This challenge later makes the sectors that are very sensitive to interest (such as consumers of the durable goods and housing) to reduce their spending habits.
The tight monetary policy should be carefully managed; this is because if the Central Bank reduces money demand, it also limits the pace of economic expansion. When the monetary policy is tightened, interest rates will also be increased (Sharma, 2003, p.104). The higher the interest rates, the higher the borrowing cost to the commercial banks. This later forces the commercial banks to charge high-interest rates on the customers who come to borrow money. Due to the high rates, the customers are discouraged from investing, and this also makes them lower their spending habits. The monetary policy should, therefore, be tightened during the time when the economic growth is positive and also during the periods when inflation is very high.
The other reason as to why the tight monetary policy should be managed is so that it can be applied in the reduction of inflation (Carbaugh, 2015, p.359). When lending institutions give more money to their customers, then there is a lot of money in the economy and at the same time, there are only a few goods. This problem can only be eradicated by ensuring that monetary policy is tightened. Tightening should be carefully done by the Central Bank to reduce the amount of money in circulation and to ensure that economy is stabilized. Failure to do so may lead to deflation which comes about if the markets are severely tightened.
In conclusion, a tight monetary policy has three tools. They include the reserve requirement, interest rates, and Open Market Operations (OMOs). Among the three, Open Market Operation is the most important to the Central Bank when it comes to controlling the supply of money in the economy. When the Central bank wants the money demanded in the economy to reduce, the tight monetary policy, which is also referred to as the deflationary policy, is applied. The deflationary policy mainly involves raising the Central Bank interest rates. However, the deflationary policy should be carefully managed so that the commercial banks may have enough money to lend to their customers and organizations.
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