Question

In the midst of COVID-19, it is reported that over 195 million people will lose their jobs and many small businesses have already closed around the world as a result. Central Banks across the world have been advised to institute policies to help stabilize their economies. Discuss whether central banks should implement expansionary or contractionary monetary policies to achieve stabilization Discuss arguments for and against each policy direction. Discuss tools that can be used.

Answer 1

I think Central banks should follow expansionary monetary policy as to boost demand in the economy.

Arguments in favour of expansionary monetary policy:

• Covid-19 has created massive fall in aggregate demand of the economy where income levels have dropped to a historical low. In this situation, expansionary monetary policy would help in reducing interest rates as to incentivize private investment.
• Private investment is one of the fluctuating component of aggregate demand and a significant one too. Considering the the uncertain situations that the crisis has created, investors need a stable policy environment and for that they need more funds in the pipeline.
• Decreasing interest rate would enhance credit creation in the economy thereby boosting aggregate demand.
• Expansionary monetary policy would be helpful also in stabilizing exchange rates which may have fluctuated due to the crisis. Currency arbitrage given a stable accommodative stance of Central Bank would prevent negative impacts of capital flows.
• This period is also witnessing an interesting feature of the falling prices which may be stabilized by increasing the money supply in the economy which is possible through expansionary or quantitative easing by the central banks.

However, this may help only for a short period of time and has to be complemented with robust fiscal stimulation in terms of government expenditure or reduced direct income taxes.

Arguments against expansion:

• It has been found through various studies that monetary transmission takes time and therefore short run results may not be visible.
• It is generally observe that investment demand becomes highly inelastic during the time of uncertainty like war, epidemics, disasters etc. So, expansion may not help as per this argument.
• Expansionary monetary policy may also lead to outflow of capital due to fall in domestic interest rates which might hurt on the capital account side of balance of payments.

Overall a policy mix is required in which, monetary expansion is complemented with strong fiscal stimulus as to boost aggregate demand in the economy and reviving growth.

There can be various tools that can be used for expansion of money in the economy such as:

1. Lowering Bank rate that is the rate at which customers borrow from Bank.
2. Buyback of government securities by the central bank also known as open market operations.
3. Easing on the requirements of reserves to be maintained by banks with the central bank.
4. Reducing the minimum reserves that are to be kept by banks with themselves for future uncertainty as to boost credit creation.