Is policy There were very little empirical studies

Is the Bank of Mauritius effective in controlling money
supply to compress inflation?

Overview

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Inflation
occurs in all countries, and Mauritius is not an exception. In Mauritius, the
rate of inflation keeps on fluctuating. The Bank of Mauritius Act 2004, sets
forth that the primary aim is to maintain price stability which is one of the
macroeconomic aim of the government. In order to compress inflation, the Bank
of Mauritius has to make use of a contractionary policy. The Bank of Mauritius
is commanded to adopt the monetary policy and to engage in the management of
the exchange rate of the rupee, to achieve the macroeconomic aims.  

Previous
studies on Mauritius’ monetary policy

There
were very little empirical studies published, while most studies in working
papers were conducted by the International Monetary Fund about the monetary
policy in Mauritius. Porter and Yao (2005) conducted a study about Mauritius
experiencing “inflation targeting lite”. The latter was defined by Stone
(2003), “An inflation targeting lite regime is essentially one where a central
bank which may face low credibility announces a broad inflation target but is
not able to maintain inflation as its principal policy objective”. The
establishment of trustworthiness with “inflation targeting lite” had enabled
the Bank of Mauritius to have a gradual shift from the Exchange rate to
inflation targeting. Sacerdoti et al (2005) argued that this regime had
prompted the Central Bank to lower its overall inflation. However this regime
had moved towards “some more formal form of inflation targeting in the future”
Stoner (2003). The Central Bank of Mauritius shifted from the Lombard Rate to
the Key Repo Rate as an essential monetary policy tool for a more formal targeting
framework. Tsangarides (2010), “the Bank moved from the Lombard Rate towards
the Key Repo Rate as a key monetary policy signaling tool after the setup of a
Monetary Policy Committee”. The Lombard facility was introduced by the Central
Bank in December 1999, which referred to the offer of funds to banks in the
short term against pledged securities. However as from December 2006, the Repo
rate replaced the Lombard Rate. The Repo Rate, also known as the short term
market rate of interest, is the rate at which commercial banks borrow from the
Central Bank, set at 8.50% in December 2006. The inflation rate in December
2006, was at 8.9%, a moderate type. This rate was not a serious economic
problem, but had to be compressed before it became hyper rate.

 

 

 

 

 

Consumer Price Index
and Inflation Rate: January 1998 – December 2006

                                                                                                                                             
Figure 1

It
is seen that in December 2006, the inflation rate was higher compared to the
other years. Hence, this could be the cause that the implementation of the Repo
Rate was initially set at 8.50%. By so doing, commercial banks would borrow
funds from the Central Bank at higher cost. They in turn would raise their
lending rates to the public, abstaining borrowing, simultaneously decrease
money supply, and consequently inflation would be compressed.

The
common monetary policy tools are the open market operations and the reserve
requirements used by the Bank of Mauritius are as follow:

Ø Open Market
Operations (OMOs)

This
entails the management of the quantity of money in circulation through the
purchase and sale of government securities. The Bank of Mauritius would adopt
the open market sale, which would act as a contractionary measure in order to
lower money supply in the economy. In other words, the Central Bank would sell
government securities, squeezing money from the economy. By so doing, the
Central Bank would accumulate liquidity within the banking system, which would
in turn help to compress inflation, instead of engaging in an open market
purchase of government securities, raising money supply, heightening inflation.
Simultaneously, by selling securities, money supply would be curbed, and hence
raising interest rate. A rise in interest rate would lower borrowings by
commercial banks. As the commercial banks, would pay high interests, they would
raise the lending rates to members of the public. This would discourage
public’s borrowings, decreasing aggregate demand for goods and services. The
prices of products and services would eventually fall, compressing inflation in
Mauritius. This is the most used tool to interact with the public for
controlling money supply effectively.

 

Ø Reserve
requirements (RR)

More
than 90% Central Banks compel commercial banks to keep reserves in terms of
cash. Reserve requirements are essential for both monetary control and
liquidity management.  The reserve ratio
is decided by the Central Bank, and is calculated as follows:

Required
Reserves = Ratio for required reserve * Demand deposits

In
order to compress inflation, the Bank of Mauritius increase the cash reserve
ratio on demand deposits. By so doing commercial banks’ reserves would
simultaneously rise, with lending to the public fall. Consequently, money
supply would be negatively affected. “In view of the persistent excess
liquidity in the system, the Bank has decided, in terms of section 49(1) of the
Bank of Mauritius Act 2004, to raise the Cash Reserve Ratio (CRR) on rupee
deposits”.  During any particular
two-week period, starting on 2nd May 2014, the average CRR, has
raised from 8% to 9%, whereas, the daily minimum CRR has increased from 5.5% to
6.5%. However, for foreign currency deposits, the average and daily CRR, has
remained constant at 6% and 4.5% respectively.

 

                                                                                                                                              Figure 2

                                                                                                                          
Source: World Bank            

 

The figure depicts data, in which from 1986 to 2007,
there were fluctuations in reserves. As from 2008, the Mauritian Reserves has
persistently risen, with the peak in 2016. This implies that during these 9
years, there was an influx of money supply. By raising CRR, money supply would
be controlled effectively, and hence, inflation would be compressed.

 

                                                                                                                     
                        Figure 3

The diagram proves that inflation surely compresses,
when money supply is controlled through reserve requirements. We can see that
from 2008 to 2016, inflation rate has a downward sloping trend.

 

The
above monetary policy tools implemented by the Bank of Mauritius help to
control money supply effectively, which in turns compress inflation.