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Literature Review
Published date:
November 18, 2023
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Central Banks and The Impact of Monetary Policy & Economic Growth

Mengting Lin

1. Introduction

Central banks are responsible for managing monetary policy, maintaining the value of money and preserving financial stability, while regulating the supply of money, keeping inflation low and GDP growth stable, and ensuring the stability and security of the financial system. Central banks influence interest rates, participate in open market operations, and control the cost of borrowing throughout the economy. Central banks use monetary policy to manage economic volatility and achieve price stability. This means keeping inflation low and stable.

Monetary policy refers to the actions taken by the central bank to manage the supply of money and credit in an economy, and the goal is to promote economic growth while maintaining price stability. Central banks lower interest rates in order to boost demand, thereby reducing the cost of borrowing. Many developed economies have explicit inflation targets and developing countries are increasingly adopting inflation targeting.


2. Historical Perspective on Monetary Policy

The Federal Reserve receives authorization from the U.S. Congress to exercise its responsibility for setting monetary policy and regulating U.S. financial institutions. The U.S. Federal Reserve System or the Fed is the privately owned central bank of the United States. Compared with the central banks of other countries, the Fed as the central bank of the United States was born relatively late. Historically, the United States has made several unsuccessful attempts to establish a central bank like the Federal Reserve because lawmakers and presidents feared that the central bank would have too much power or that a few interest groups would kidnap the central bank. This fear was largely determined by the national form of the United States. At the beginning of the founding of the country, the United States was a loose organization consisting of a number of independent states in the form of a federation, and most of the executive power was concentrated mainly in the state governments rather than in the federal government.

The Federal Reserve is the central bank of the United States, responsible for conducting monetary policy and controlling the money supply. The main tools used by the Fed are interest rates and open market operations (OMOs). Federal Funds Rate (Federal Funds Rate): is the interest rate of short-term interbank lending and borrowing of funds in the United States, is the United States central bank through the adjustment of interest rates to affect the money supply and economic activity of the main tool. Open Market Operations (Open Market Operations): refers to the U.S. central bank through the purchase or sale of government bonds and other securities to regulate the money supply and interest rate levels. The Fed can also change the legal reserve requirements of commercial banks or act as a lender of last resort to bail out failed banks, among other less common tools. When the economy is stumbling, the Fed can use these tools to set expansionary monetary policy. If that fails, it can use unconventional policies, such as quantitative easing.

Central banks adjust the money supply through the action of open market operations (buying or selling securities). These operations affect short-term interest rates, which in turn affect long-term interest rates and economic activity. When a central bank lowers interest rates, it is said to be easing monetary policy. Raising interest rates is seen as tightening monetary policy.


3. Theoretical Framework

3.1 Monetarism and Keynesianism

There are a number of major economic theories related to monetary policy and economic growth, the best known of which are monetarism and Keynesianism.

Keynesianism is also known as "Keynesian economics". In times of recession, the government should stimulate economic growth by increasing spending and decreasing taxes; this intervention creates jobs and promotes economic growth. Keynesian economic theory states that macroeconomic tendencies govern the particular behavior of individuals. There is no strong automatic mechanism for production and employment to move towards full employment in the economy.

Monetarism argues that the money supply is the most important factor affecting economic growth and inflation. The rate of inflation and the rate of economic growth are controlled by controlling the money supply and thus the rate of inflation and the rate of economic growth. Inflation is mostly caused by excessive money supply.


3.2 Transmission mechanisms through which monetary policy affects economic growth

Monetary policy is the macroeconomic policy of the central bank to regulate economic activity by adjusting the money supply, interest rate and exchange rate. The transmission mechanism of monetary policy is how changes in monetary policy affect economic growth. There are three main aspects of the transmission mechanism of monetary policy:

Interest rate transmission mechanism: The central bank influences market interest rates by changing interest rates, which affects investment and consumption behavior and economic growth. Exchange Rate Transmission Mechanism: The central bank influences economic growth by changing the exchange rate to affect imports and exports.

Credit transmission mechanism: the central bank influences the supply of credit to banks by changing the bank reserve ratio and the deposit reserve ratio, thus affecting investment and consumption behavior and economic growth. Their interaction constitutes the impact of monetary policy on economic growth.


4. The Impact of Interest Rates

"The Effects of Interest and Inflation Rates on Consumption Expenditure: Application of Consumer Spending Model"It examines the impact of interest rate and inflation rate on consumer expenditure. According to the study, interest rate and inflation rate and other control variables such as per capita income, indirect taxes and savings are significant determinants of private consumer expenditure in Nigeria. The Granger Causality Ward Test extends the investigation of the causal relationship between consumer expenditure, interest rate and inflation rate to determine whether consumer expenditure predicts future interest rate and inflation rate in the economy.

"The Relationship Between Inflation and Interest Rates: Explained" Explain that lower interest rates mean that people borrow more money and then spend more of it. This behavior leads to higher inflation in the economy. Not only do customers not borrow money, but they also tend to save more money because saving and investing bring more returns.

"MONEY SUPPLY, INFLATION AND ECONOMIC GROWTH: CO-INTEGRATION", uses various econometric procedures. The relationship between the two was examined. The results confirm that there are three structural breaks in the long-run relationship between the variables, but there is no short- and long-run effect of money supply and inflation on economic growth. These results are from the cumulative component rather than the natural series, and all the results support the monetarist view of inflation and that money supply is not without effect on economic growth.


5. Exchange Rates and Trade

Exchange rate policies influenced by central banks have a significant impact on international trade and economic growth. The exchange rate represents the value of one currency relative to another and can be affected by a variety of factors such as interest rates, inflation and political stability. Central banks can directly affect inflation and exchange rates by raising or lowering key interest rates, which are tools used to restore bank liquidity. Changes in the exchange rate can have a significant impact on a country's economy. For example, a decrease in exports can lead to a decrease in economic growth and employment, while an increase in imports can lead to a decrease in domestic production and competitiveness. By understanding and recognizing the potential impact of exchange rate fluctuations, individuals, businesses and Governments can make informed decisions about their financial and trade policies, and exchange rate policies influenced by central banks can have a significant impact on international trade and economic growth.


6. Case Studies

Central bank policies can indeed have a significant impact on the economic growth of a particular country or region. The United States central bank, the Federal Reserve, has a long history of influencing economic growth through monetary policy. During the financial crisis of 2007-2008, the Fed implemented unconventional policies, including low-interest rates and quantitative easing, to stimulate economic growth. The European Central Bank (ECB) has played a major role in economic growth in the euro area. In response to the European debt crisis that began in 2009, the ECB implemented a variety of policies, including lowering interest rates and launching a large-scale asset purchase program. For decades, the Bank of Japan (BOJ) has used unconventional monetary policies to fight deflation and stimulate economic growth. Policies such as zero interest rates, quantitative and qualitative monetary easing, and yield curve control have been used to encourage borrowing, investment, and consumption. The People's Bank of China (PBOC) on China's Economic Growth By adjusting interest rates, and reserve requirement ratios, and conducting open market operations, the PBOC can influence credit supply and inflation. In response to economic challenges, the PBOC lowers interest rates and reserve requirement ratios to encourage lending and investment. The Reserve Bank of Australia uses interest rate adjustments to manage inflation and stimulate economic growth. The Reserve Bank of Australia reduced interest rates during the Global Financial Crisis and again during the COVID-19 pandemic to support economic recovery. Central banks around the world use a combination of tools and policies to manage inflation, stabilize financial markets and support economic growth. The effectiveness of these policies varies depending on the unique economic environment of each country and the decision-making of the central bank.


7. Critiques and Challenges

Central banks have lost their clear mission, lost their structural independence, and are expected to fulfill social and quasi-political responsibilities without commensurate legitimacy and power. These three major challenges to central bank governance are likely to trigger a shift in the monetary or currency regime that will transform economies and markets for generations to come. In the past, central banks have had a clear objective. Maintain price stability in order to achieve the 2% inflation target. But in later years, the mandate began to change, evolving into a dual one, such as economic growth and job creation. There is a growing suspicion that mandates can no longer be purely technical, as their side effects are all-encompassing. Social well-being, sustainability and environmental action, and even industrial policy are indirectly influenced by central bank policies and the unelected officials who lead them. Central banks are creating winners and losers in the socio-economic sphere, which makes their mandate increasingly complex and ambiguous. Then there is the erosion of independence. Of the independence of central banks, it guarantees an expert perspective with full responsibility and accountability around a clear, technical and apolitical goal. However, the rise of authoritarianism and the questioning of liberal democracy have put enormous pressure on central bank governors.


8. Contemporary Monetary Policy Challenges

Unconventional monetary policies such as quantitative easing and negative interest rates are measures taken by central banks in response to economic downturns. Quantitative easing is when central banks increase the money supply by purchasing assets such as treasury bonds, thereby lowering interest rates and stimulating economic growth. Negative interest rates are when central banks set deposit rates at negative levels to encourage banks to lend and promote economic growth. The impact of these monetary policies on economic growth is quite complex. These policies can stimulate consumption and investment, thus promoting economic growth. They can also lead to inflation, which reduces the purchasing power of money and thus dampens economic growth, and they can lead to asset price bubbles, which increase financial risks. The impact of these unconventional monetary policies on economic growth is complex and needs to be weighed against the pros and cons.


9. Conclusion

The monetary policy of central banks has a significant impact on economic growth. Central banks use monetary policy to manage economic volatility and to achieve price stability, i.e. low and stable inflation. Central banks in many developed economies have set explicit inflation targets. Many developing countries have also begun to adopt inflation targeting. Central banks implement monetary policy by adjusting the money supply, usually by buying or selling securities on the open market. Open market operations affect short-term interest rates, which in turn affect long-term interest rates and economic activity.


References

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Manasseh, C. O. (2019, April 22). (PDF) International Journal of Economics and Financial Issues The Effects of Interest and Inflation Rates on Consumption Expenditure: Application of Consumer Spending Model. ResearchGate. Retrieved November 18, 2023, from https://www.researchgate.net/publication/332569137_International_Journal_of_Economics_and_Financial_Issues_The_Effects_of_Interest_and_Inflation_Rates_on_Consumption_Expenditure_Application_of_Consumer_Spending_Model

Manasseh, C. O. (2019, April 22). (PDF) International Journal of Economics and Financial Issues The Effects of Interest and Inflation Rates on Consumption Expenditure: Application of Consumer Spending Model. ResearchGate. Retrieved November 18, 2023, from https://www.researchgate.net/publication/332569137_International_Journal_of_Economics_and_Financial_Issues_The_Effects_of_Interest_and_Inflation_Rates_on_Consumption_Expenditure_Application_of_Consumer_Spending_Model

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Monetary Policy and Central Banking. (n.d.). International Monetary Fund. Retrieved November 18, 2023, from https://www.imf.org/en/About/Factsheets/Sheets/2023/monetary-policy-and-central-banking

MONEY SUPPLY, INFLATION AND ECONOMIC GROWTH: CO-INTEGRATION AND CAUSALITY ANALYSIS. (n.d.). Sciendo. Retrieved November 18, 2023, from https://intapi.sciendo.com/pdf/10.2478/subboec-2020-0008

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