• Wednesday, June 12, 2024
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Discretionary or rule-based: X-raying CBN reactions to economic rigidities

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Despite recent advancements in economic science, many individuals remain uneducated in basic economic theory and confused by the vast array of economic statistics reported in the media, particularly in the behaviour of monetary policy and the associative consequences for economic performance.

This ambiguity in assessing current economic performance, relative to past performances, informs myopic and short-sighted monetary policy responses. This article captures and conveys economic trends on monetary policy behavioural management of the Central Bank of Nigeria.

The debate on monetary policy and economic growth theories have evolved rapidly over time, dominated by dissimilarities, obscurities, inconclusiveness, and crosscurrents.

Despite the significance of discretion/non-discretionary monetary policy for improved economic performance, little or no experimental evidence on the structural relationships have been advanced.

While the discretionary monetary policy ineffectiveness proposition is well understood in theory, the practical relevance remains largely unclear. Therefore, there is a burgeoning need on the part of government and stakeholders to explore discretionary monetary policy’s impact amidst heterogenous dimensions on individual financial imperative as well as collective objectives.

There is widespread agreement that monetary policy matters, but there is disagreement about how policy should be conducted. Behind this disagreement lie differences in the theoretical understanding of monetary policy indices and macroeconomic performance indicators.

The convex short-run aggregate supply curve offers contradictory evidence in support of the bilateral movement. In the presence of this type of supply curve, during slowdowns, a shift in aggregate demand stemming from a monetary policy shock would have a more substantial effect on output than on prices since the demand curve would be shifting more in the horizontal part of the supply curve.

However, during expansions, the same shift in aggregate demand would have a more substantial effect on prices than on output since the demand curve would be shifting more in the vertical part of the supply curve. As a result, the impact of monetary policy changes on demand and, therefore, on production would be stronger during slowdowns.

Whether policymakers and the government at large should commit to a specific course of action or have the flexibility to approach each situation as it arises continues to be a central question in the design of monetary policy and the associative consequences for growth and development.

Because monetary policy influences poverty and macroeconomic stability, it is essential for high and sustainable growth rates to be a vital component of any growth and development strategy of West African nations.

Discretionary monetary policy behaviour is when the monetary authorities are allowed to vary monetary policy depending on current circumstances and disregard any past promises.

Discretionary monetary policy is widely used by independent central banks globally. A key advantage of discretionary monetary policy is the flexibility that it offers to policymakers to provide quick responses to emerging developments.

However, this raises concerns about monetary policy direction, which can lead to non-credible and ineffective monetary policy and macroeconomic uncertainty. Because the discretionary planner does not make any binding commitments, discretion offers more flexibility, and it would seem to be preferable to a policy whereby the policymaker must honour past promises.

Non-discretionary monetary policy is the ability to deliver on past promises no matter the current situation. For non-discretionary monetary policy behavioural management, promised behaviour is generally contingent on future events. Promises are not typically blanket commitments to be fulfilled, irrespective of future situations. The critical aspect of commitment is that the policymaker keeps his promise to act in a certain way when a particular future event comes to pass.

There is a long-standing debate on the nature of monetary policy and the significant consequences on economic performance. The discussion of rule-based versus discretionary monetary policy and the influence on economic performance trace back to the 1920s (Hetzel, 1985). The discretion in monetary policy conduct has widely been criticised for creating excessive inflation (inflation bias) in the economy.

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The notion has become increasingly popular after several influential works where advocacy for observing commitment in the conduct of monetary policy, particularly in the commitment-based monetary policy frameworks (inflation targeting), was pronounced.

The essential difference between the two monetary policy setups is that in the latter framework, the monetary policymaker avoids the temptation to exploit existing conditions for temporary gains in real growth.

The proponents of commitment argue against the less efficient performance of discretionary monetary policy in achieving low inflation (price stability) and high real growth. They advocate that real growth can be maintained at the potential level through lower inflation.

This argument implies a long-term negative relationship between inflation and real growth. Nevertheless, there is a dire need for the practical position to be extended to account for the short-run and long relationship in addition to the inadequate evidence, particularly in the wake of the undesirable macroeconomic performance of Nigeria at a time when the West African Monetary Zone plans to introduce a common currency.

The rule-based monetary policy is a principle that specifies how a central bank should respond to changes in variables of interest, such as inflation. The rationale behind applying rules to monetary policy is that it allows the central bank to focus on other functions while providing direction for the economy.

It also means that the rule is followed irrespective and independent of economic conditions. It is widely expected that such a rule-based monetary policy will provide considerable improvements to monetary actions’ transparency and predictability.

For instance, the Taylor rule is commonly regarded in central banking quarters as the primary specification rule to which monetary policy should adhere. Its basic reasoning is that a central bank can, at best, support economic growth by lowering interest rates or, in the worst case, generate excessive growth and demand with consequent inflationary pressures and unemployment.

It further stipulates an increase in the central bank policy rate when inflation breaches the stated target or economic activities become unsustainably intense.

Ibrahim A. Adekunle is a lecturer at the Babcock Business School, Babcock University, Ilishan-Remo, Ogun State, Nigeria