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Monetary Policy and Fiscal Policy: An Overview.

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Monetary Policy and Fiscal Policy: An Overview.

Dr. Muhannad Talib Al-Hamdi
Articles
Dr. Muhannad Talib Al-Hamdi


Monetary policy and fiscal policy are the two tools that are most widely used to influence a nation's economic activity.

Monetary policy is primarily concerned with managing interest rates and the total supply of money in circulation and is generally implemented by central banks, such as the Central Bank of Iraq and the US Federal Reserve Bank.

Fiscal policy is a general term for tax measures (and management of government resources) and government spending.

In Iraq, the country's fiscal policy is determined by the government (the executive branch) and the House of Representatives (the legislative branch).

In this article we will talk about monetary policy and leave the next article about monetary policy.

Monetary policy

Monetary policy is the process of formulating, announcing and implementing a plan of actions taken by the central bank, currency board, or any specialized monetary authority that controls the amount of money in the economy and the channels through which new money is obtained in a country.

Central banks usually use monetary policy to either stimulate the economy or dampen its growth.

By incentivizing individuals and companies to borrow and spend, monetary policy aims to stimulate economic activity.

On the contrary, by restricting spending and stimulating savings, monetary policy can act as a brake on inflation and other issues associated with an overheating economy.

Monetary policy is the most blunt instrument in terms of expanding and contracting the money supply to affect inflation and growth and it has less impact on the real economy.

For example, the Fed was negative during the Great Depression. His actions prevented a complete economic collapse but did not generate significant economic growth to reflect lost output and lost jobs.

An expansionary monetary policy can have limited effects on growth by increasing asset prices and lowering borrowing costs, making companies more profitable.

Monetary policy relates to the demand side of economic policy, and it refers to the measures taken by a country's central bank to control the money supply and achieve macroeconomic goals that promote sustainable economic growth.

This is achieved through measures such as adjusting the interest rate, buying or selling government bonds, regulating foreign exchange rates, and changing the amount of money that banks have to keep as reserves.

Economists, analysts, investors, financial experts and politicians around the world are eagerly awaiting monetary policy reports and results of meetings in which monetary policy decision makers participate.

Such developments have a long-term impact on the overall economy, as well as on specific industrial sectors or markets.

Monetary policy is formulated on the basis of inputs gathered from a variety of sources.

For example, the monetary authority might consider macroeconomic figures such as GDP and inflation, growth rates for different industry sectors and the numbers associated with them, as well as geopolitical developments in international markets, including oil embargoes, tariffs, or trade wars.

Monetary policy-making entities may also consider concerns raised by certain groups such as those representing different industries and companies, survey results by well-known institutions, information from government and other reliable sources.

Monetary policy requirements

Typically, monetary authorities are given political mandates to achieve a steady rise in GDP, keep unemployment rates low, and keep foreign exchange rates and inflation rates within a predictable range.

Simply put, the central bank has a responsibility to balance economic growth and inflation.

In addition, monetary policy aims to keep long-term interest rates relatively low.

The role of the central bank is to be the lender of last resort to commercial banks when they are undergoing a liquidity crisis to prevent financial institutions from failing and spreading financial panic, to provide commercial banks with liquidity, and to be responsible for regulatory auditing of institutions in the financial services sector.

In general, monetary policies can be classified as either:

Expansive monetary policy:

If a country is facing a high unemployment rate during a period of economic slowdown or recession, the monetary authority can choose an expansionary monetary policy aimed at increasing economic growth and expanding economic activity.

As part of the expansionary monetary policy, the monetary authority often cuts interest rates to boost spending and make money relatively favorable.

Central banks are using expansionary monetary policy to reduce unemployment and avoid recession.

This expansionary policy increases cash by giving banks more money through borrowing.

As a result, banks lower interest rates, making loans cheaper.

Firms are borrowing more to purchase equipment, hire employees, and expand their operations.

People borrow more to buy more homes, cars, appliances, and more.

All of this increases demand and stimulates economic growth.

An example of this expansionary approach is the low to zero interest rates that many leading economies around the world have maintained since the 2008 financial crisis.

Contractionary monetary policy

An increase in the money supply can lead to higher inflation, raising the cost of living and the cost of doing business.

Contractionary monetary policy, by increasing interest rates and slowing the growth of the money supply, aims to reduce inflation.

This can slow economic growth and increase unemployment, but it is often necessary to cool down the economy and keep it under control.

Central banks use deflationary monetary policy to reduce inflation as it reduces the money supply by restricting the amount of money that banks can lend.

Banks charge a higher interest rate, which makes loans more expensive.

Companies and individuals borrow less, which slows down growth.

In the early 1980s, when inflation reached record levels in the United States, reaching nearly 15%, prompting US President Gerald Ford to call inflation "the people's first enemy", the Federal Reserve raised the benchmark interest rate to 20%.

Although high interest rates led to an economic recession, the bank was able to return inflation to the desired range of 3% to 4% within the few years after that.

Monetary policy objectives:

Central banks have three goals by exercising monetary policy.

The most important one is managing inflation.

The secondary goal is to reduce unemployment, but only after controlling inflation.

The third goal is to promote moderate long-term interest rates.

Monetary policy implementation tools.

Central banks use a number of tools to shape and implement monetary policy.

The first is to buy and sell short and long-term government bonds in the open market using the financial reserves they have.

These operations are called open market operations.

Open market operations have traditionally aimed to achieve moderate short-term interest rates by adding or withdrawing funds in the market.

The central bank adds money to the banking system by purchasing financial assets (government bonds) or withdrawing them by selling assets, and commercial banks respond to this by lending money more easily at lower interest rates, or more difficultly with higher interest rates, until they are achieved.

The target of the interest rate that the central bank is aiming for.

Open market operations can also target specific increases in the money supply to get banks to lend money more easily by purchasing a specified amount of assets, in a process known as quantitative easing.

The second option used by the monetary authorities is to change the interest rates that the central bank imposes on commercial banks in order to obtain loans from the monetary authority or the so-called discount rate.

With this role, the monetary authority plays its important role as a lender of last resort when commercial banks seek emergency direct loans to cover their operations.

The imposition of higher interest rates, an example of deflationary monetary policy, means that commercial banks must be more cautious about their lending operations or the risk of failure.

On the contrary, lending to commercial banks at lower rates will enable them to offer loans at lower rates of interest and work with lower reserves.

By raising the discount rate, the monetary authority is trying to dissuade commercial banks from borrowing.

This measure reduces liquidity and slows the growth of the economy.

Conversely, by reducing the discount rate, the monetary authority encourages commercial banks to borrow, and this increases cash liquidity and promotes growth.

The third tool is the mandatory legal reserve requirement.

The monetary authority, through a law enacted by the legislative authority in the country, orders the commercial banks to the proportion of the money they must keep from the deposits made by the bank's clients in order to ensure their ability to fulfill their obligations.

The monetary authority checks that matter every day at the end of the working day.

Banks that do not achieve this percentage are subject to heavy penalties, amounting to closure and liquidation.

It is known that the depositors do not need all of their deposited money every day, so it is better for commercial banks to lend to individuals and companies everything that is above this obligatory percentage.

In this way, commercial banks will have enough cash on hand to fulfill most of customers' daily demands.

When the monetary authority wants to restrict liquidity, it raises the mandatory statutory reserve ratio, giving banks less money to lend.

And when it wants to expand liquidity, it reduces the reserve requirement, giving commercial banks more money to lend.

Central banks rarely change the statutory reserve ratio because that requires a lot of political action and legislation and makes the cost of doing business higher.

Finally, in addition to directly influencing the money supply and the bank lending environment, central banks have a powerful tool in their ability to shape market expectations through their public announcements about future central bank policies.

The monetary authority’s data and policy announcements move the markets, and investors who guess correctly what central banks will do can make big profits.

However, the monetary authority’s policy announcements are effective only within the limits of the credibility of the authority responsible for formulating, announcing and implementing the necessary measures.

In an ideal world, monetary authorities should operate completely independently of government influence, political pressure, or any other powers to make their policies.

If the central bank announces a certain policy to place restrictions on increasing inflation, then inflation may continue to rise if the general public has little or no confidence in the monetary authority.

When making investment decisions based on the monetary authority's stated policies, one must also consider its credibility.

In reality, however, governments around the world may have different levels of interference in the work of the monetary authority.

This could be done by the government, judiciary, or political parties, whose role should be limited to appointing key members of the monetary authority’s board of directors only.

Alternatively, the influence of these actors could extend to forcing members of the Monetary Authority to announce populist measures, for example, to affect the economy when elections approach.

Iraqi Monetary Authority

The Iraqi National Bank was established in 1947 with a capital of five million Iraqi dinars and was the nucleus of the Central Bank of Iraq established under Law No. 72 of 1956.

The Central Bank of Iraq was reconfigured on March 6, 2004, as an independent monetary authority for the country.

Its formation was necessary due to the events that led to the US invasion of Iraq and its consequences, as well as the downfall of the former regime.

The bank was established with a capital of 100 billion dinars provided by the state in exchange for 100% of the bank’s capital, meaning that the federal government is the sole owner of these non-transferable shares.

The first governor of the Central Bank of Iraq after the regime change was the well-known economist Dr. Sinan Al-Shabibi, and Mr. Mustafa Ghaleb was finally appointed as governor of the Central Bank by Prime Minister Mustafa Al-Kazemi in September 2020.

The bank manages domestic monetary policy and oversees the country's financial system.

It is headquartered in Baghdad and has four branches in Basra, Mosul, Sulaymaniyah, and Erbil.

The new Law No. 56 of 2004 granted the Central Bank independence as it should not receive instructions from the government.

In the past five decades, monetary policy has been constrained by two factors, the rentier nature of the Iraqi economy

The effect of fiscal policy, and thus the money supply was linked to government expenditures, but coordination between monetary and fiscal policy remained weak.

In 1964, the Iraqi authorities reduced the role of the private sector, commercial, industrial, and banking services, through nationalizations that included commercial banks.

Until the 1980s, commercial banking transactions were concentrated in a single state bank, the Rafidain Bank.

Later another state bank, Rasheed Bank, was established.

In 1991 licenses were granted to establish private banks.

The main objectives of the Central Bank of Iraq are to ensure domestic price stability and to develop a stable and competitive financial system based on a market economy, which is a system consisting of commercial banks, financial companies, stock exchanges and insurance companies.

To achieve these goals, the CBI aims to support sustainable growth and employment in the country.

In order for the Iraqi banking sector to perform its functions, the Central Bank of Iraq undertakes the following tasks:

Implementation of the exchange rate policy. The Central Bank of Iraq manages the exchange rate policy of the Iraqi dinar, which is pegged to the US dollar.

The International Monetary Fund describes the peg to the dollar as a fundamental pillar of the economy, which has led to the persistence of low and stable inflation in Iraq, with an average of approximately 2% for several years.

Managing Iraq's gold and foreign exchange reserves. The Central Bank of Iraq has built a respectable level of reserves of $54 billion by September 2020.

Issuing and managing the Iraqi national currency, the Iraqi dinar, as a new currency was put into circulation at the end of 2003.

Supervising the payment system and regulating and supervising the banking sector.

Liberalizing the financial sector, especially the interest rate.

6. Allowing foreign banks to operate in Iraq.
7. Reschedule the local debts owed by the Ministry of Finance.

The Central Bank of Iraq used the following rules to manage monetary policy to generate stability in the financial market.

1. Controlling liquidity in two ways: primary and secondary lending and acting as a last resort for lending.

2. The compulsory legal reserve ratio: 25% for private sector deposits and 75% for the government sector since July 2007, but it was modified after that.

3. Audit surplus bank reserves to monitor and control liquidity.

4. Buying and selling treasury bills for a period of 91 days, 63 days and 28 days.

5. Management of lending between commercial banks.

The Central Bank of Iraq faces a number of challenges, including managing monetary policy.

One of the main issues of concern stems from the insurgency by ISIS gangs in parts of the country that are believed to be responsible for a number of severe financial turmoil.

The Central Bank of Iraq says ISIS looted nearly $800 million worth of the country's banks between 2014 and 2017, most of which was denominated in Iraqi dinars.

Another major issue for the central bank stems from fluctuations in oil prices.

Oil exports are the main source of foreign currency for Iraq, and thus the most important for the country's economy.

According to the Organization of the Petroleum Exporting Countries (OPEC), Iraq's crude oil exports reached nearly 4 million barrels per day in 2019.

The decline in oil prices was the driving force behind the decline in Iraq's foreign reserves, from $54 billion at the end of 2015 to 45 A billion dollars at the end of 2016.

Global oil prices collapsed in early 2020, amid a global economic slowdown due to the Coronavirus pandemic, putting economic and social conditions in the war-torn country under severe pressure.

Total Iraqi oil revenues nearly halved, from $5.05 billion in February 2020 to $2.99 billion in March of the same year.


Professor of Economics and Political Science, Kansas State University, USA.
Number of observations 276 Date of addendum 01/31/2021

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