MONETARY POLICY AND DOMESTIC INVESTMENT NEXUS 1986-2020
- Project Research
- 1-5 Chapters
- Quantitative
- Regression
- Abstract : Available
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- Recommended for : Student Researchers
- NGN 3000
Background of the study
Monetary policy interventions such as an increase in money supply indirectly affect aggregate demand and subsequently output and prices through their impact on investment spending. This indirect effect reveals that a change in money supply may have a more direct effect on investment. Furthermore, such monetary policy intervention leads to changes in bank deposits which ultimately alter the pool of loanable funds for investment. This effect is grounded in the Bernanke and Blinder (2018) model. Monetary policy thus affects credit availability as well as investment spending in the economy (Mishkin, 2015).
There is acknowledgement, OECD (2016), Hare and Fofie (2019) that high growth countries invest in excess of 25 percent of GDP. Investment fuelled by the private sector is recognised as the catalyst for attaining the twin goals of broad based sustainable economic development and poverty alleviation as investment allows for entrepreneurship and employment creation opportunities that increase incomes for the poor and rich alike. Investment is created through internally generated funds such as profits, retained earnings, and financing from shareholders, or externally generated finances through private placement, public offerings of shares on the stock market (IPO’s). Other sources of investment include short term financial sector credit (overdrafts, trade finance, debentures, mortgages, loans), long term capital raising from the secondary markets through corporate debt (preference shares, corporate and infrastructure bonds) and finally foreign direct investment.
According to Rima (2016) quoted in Boopen and Khadaroo (2018), the two critical factors impacting domestic investment in industrialized countries are changes in aggregate demand giving rise to the income accelerator and secondly the effect of relative prices of capital and labour and therefore profitability. However in developing countries they allege domestic investment is determined broadly by growth of GDP, (consequently money supply), the level of foreign direct investment (FDI), real exchange rates, public investment, government fiscal deficits, real interest rates and uncertainty. These instrumental factors are complemented by the levels of residual income that private citizens accrue and the liquidity obtaining in the economy. More often then not domestic investment is determined by Government economic priorities established in the short term by the government budget (monetary and fiscal policy) and executed in the long term through a development plan.
Monetary policy is one of the principal economic management tools that governments use to shape economic performance. Measured against fiscal policy, monetary policy is said to be quicker at resolving economic shocks. Discussing the impact of monetary policy on domestic investment Kahn (2015), observes that monetary policy objectives are concerned with the management of multiple monetary targets among them price stability, promotion of growth, achieving full employment, smoothing the business cycle, preventing financial crises, stabilizing long-term interest rates and the real exchange rate. That these objectives are all not consistent with each other is obvious, as the preference of monetary policy objectives is anchored upon the weights assigned by monetary authorities or country priorities. Experience shows that emphasis is usually placed on maintaining price stability or ensuring low inflation rates.
The effectiveness of monetary policy on the real economy is still an issue under intense debate particularly related to the efficacy of the transmission mechanism. Traditionally monetary policy is seen as influencing domestic investment via three routes; namely the interest rate channel, the demand for money and the credit channel. In less developed countries Kahn (2015) avers that underdeveloped financial systems and weak interest rate responsiveness inhibit the use of the interest rate and demand for money channels due to limited applicability, while he argues that monetary policy is effective on the asset side of financial intermediary balance sheet (the credit channel view) where it tends to have greater impact. Bernanke and Gertler (2015) classify three channels of monetary policy as the balance sheet channel, the bank-lending channel and the credit channel. The balance sheet channel focuses on monetary policy effects on the liability side of the borrowers' balance sheets and income statements, including variables such as borrowers' net worth, cash flow and liquid assets whilst the bank lending channel centers on the possible effect of monetary policy actions on the supply of loans by depository institutions.
Through the control of monetary policy targets such as the price of money (interest rate - both short term and long term), the quantity of money and reserve money amongst others; monetary authorities directly and indirectly control the demand for money, money supply, or the availability of money (overall liquidity), and hence affect output and domestic investment. This view is supported by Kahn (2015) who imputes that monetary policy objectives can affect the real sector through the injection and absorption of liquidity, or by affecting the level of reserve money, or through the money multiplier, which is used to manipulate the overall stock of money. For instance the Bank of England on its website explains that aside from the bank rate another tool that may be used to achieve the same ends is to inject money directly into the economy in a process known as quantitative easing.
From the perspective of the firm, monetary policy effects on private sector can be observed through the balance sheet, the cost of capital, its effect on investment decisions and the internal rate of return aver Gaiotti and Generale (2001). Thus monetary policy that facilitates credit to domestic investment encourages the growth of private investment whilst tight monetary policy that restricts credit to businesses discourages private sector growth.
Hare and Fofie (2019) posit that countries who only invest 5- 10 percent of their GDP are unlikely to grow very rapidly as the more successful economies of recent decades have usually achieved investment rates of at least 25 percent of GDP sometimes considerably higher. Evidence that investment is positively correlated with enabling monetary policy can be adduced from countries like India, where Mohan (2018) attributes the turning point of low growth to the current high growth, as the consistent increase in gross domestic savings. Another case in point is Bangladesh that maintained low public debt whilst financing development expenditures from tax revenues. Therefore monetary policy is a prime anchor for the growth of domestic investment in an enabling environment.
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