allAfrica.com: Ile Maurice: The Transmission Mechanisms of Monetary Policy (Page 1 of 2)

The Bank of Mauritius announced on Friday 2 May, a further cut of the key Repo Rate by 50 basis points from 8.5% to 8%. The current move comes after similar cuts in February and March. The primary motivation of the central bank resides in the potential risks for the economy of a global slowdown and the falling competitiveness of Mauritian exports, following a sustained appreciation of the rupee since the second half of last year.

A higher market value or net worth of assets owned may make the individual feel wealthier and encourage spending.

- Objectives of the central bank

The main objectives of Bank of Mauritius are "to maintain price stability and promote a balanced and orderly economic development". In this context, following the Budget Speech 2007/08, the bank's Monetary Policy Committee (MPC) was given sole responsibility for setting interest rate, in particular the Repo Rate, based on its present and future assessment of both the global and domestic economic environment.

The central bank is able to determine a specific interest rate by virtue of being a monopoly supplier of the monetary base, also known as 'high powered money', which consists of banknotes, coins and bank reserves.

- The Repo Rate

The Repo Rate is the most important instrument of monetary policy. A 'Repo' is in fact a sale and repurchase agreement. Banks can sell assets such as securities, treasury bills and bonds in exchange for cash to the central bank with an agreement to buy them back at a later date. The difference between the sale and repurchase price of the assets is the Repo Rate.

In essence, it determines the rate at which the central bank will lend 'high powered money' to other banking institutions and as such influences the structure of all other interest rates in the financial system. For instance, interest rates on loans, mortgages and overdrafts are adjusted accordingly while banks may also change the savings rate to maintain the margin between the deposit and loan rates.

«Lower interest rates typically mean that

it is easier for households and firms to repay their debts and consequently, it may be less risky for banks to approve loans. This may lead to an increased amount of funds being available for lending.»

A change in the Repo Rate has an impact on the money market and the real economy. It has a bearing on the behaviour of economic agents and is fed through different aspects of the economy via changes in important variables like consumption, savings, investment, output, exchange rate and prices. The processes that link interest rate to real economic variables are known as the monetary policy transmission mechanisms.

- Spending behaviour and investment

Interest rates affect the savings and consumption decisions of households. A fall in interest rates will improve the disposable income of those with significant personal debt, enabling them to spend more on other goods and services whilst, on the other hand, there will be a disincentive to save. Individuals will therefore tend to increase their present consumption and forego future consumption.

Consumer spending is also influenced by the interest rate impact on asset prices. The prices of bonds and other securities such as equities are determined by future income streams discounted by the interest rate. Lower interest rate implies a smaller discounting factor and hence, higher prices. Similarly, there is an inverse relationship between prices of physical assets such as houses and the interest rate.

Low interest rate reduces the cost of financing house purchases, raising demand and prices. A higher market value or net worth of the assets owned may make the individual feel wealthier and encourage spending. Additionally, it may stimulate borrowing to finance consumption as the higher net worth assets can be used as collateral to allow borrowers to get more loans.

A fall in interest rate will in addition reduce the cost of borrowing by businesses. Given that the cost of finance remains a main determinant of investment, a fall in interest rate will encourage investment in plant and equipment and new technology. Increased asset prices, due to lower interest rate not only facilitates access to credit by firms but also contributes to improving the overall net worth of companies. A monetary policy change, such as an interest rate cut, may serve to increase investment, promote the expansion of activity and contribute to job creation.

Lower interest rates typically mean that it is easier for households and firms to repay their debts and consequently, it may be less risky for banks to approve loans. This may lead to an increased amount of funds being available for lending.

When aggregated throughout the economy, the higher consumption and investment levels, caused by a policy induced cut in interest rate, will lead to a rise in total domestic demand and gross domestic product (GDP). Clearly then, changes in interest rate will affect the growth prospects of the economy. Other things remaining constant, rising demand will subsequently result in higher prices as well.

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