THE ROLE OF MONETARY POLICY ON INFLATION IN DEVELOPING COUNTRY

Research Title:
The Role of Monetary policy on Inflation in developing country

Background of the study:

The monetary policy plays an act role in a countrys economic growth as it is

applied effectively to maintain price constancy and to keep inflation rate at
minimum level. These authorized goals are achieved through a process by
which monetary authority of a country controls the supply of money,
accessibility of money supply, and cost of money or interest rate. Interest
rate rest on the relationship between rates of interest in an economy (i.e. the
price of money at which money can be lent) and the total interest rate.
Monetary authority uses a variety of tools to control one or both of these
variables to influence outcomes, such as economic growth, inflation,
exchange rates with other countries and unemployment (Hameed & Amen,
2011).
Monetary Policy Instruments
There are numbers of monetary policy instruments that can be used in order
to control inflation rate of country either developed or developing. i.e.
Interest rate policy:
It shows that central bank increases rate of interest (cost) on borrowing or
lending the funds. The rate that can be enlarged include the overnight borrowing rate. This
option is worthy if the commercial banks found only central bank to secure their funds. This
leads to discourage borrowing which then end up dropping the rate of inflation in an economy.
Minimum liquidity asset ratio:

The liquidity asset ratio is defined as the proportion of total assets being held by a bank. This is
usually in the form of liquid assets and cash. This instrument is effective since it accomplishes to
generally affect all banks. Also, this method directly established and effects of its implementation
can be observed soon after its initiation. The planned purpose of the tool is usually to create a
situation where a banks free cash base is reduced. This reduces a banks ability to give our loans
and advances and creates an overall reduction of availability of money. The reduction of excess
money supply ends up limiting prices and inflation.
Open market operation:
Open market operation refers to exchanging (purchase & sale) of securities, usually undertaken
by open market of central bank. . The major aim of this tool is the achievement of a programmed
level of reserve money. This instrument works in this way, that if there is excess supply of money
in economy so that government issues securities to general public in order to control excess
supply & get money back from public to government. But if government want to increase supply
of money in economy they keep on purchasing securities from public in order to float money in
country.
Selective Credit Control:
These instruments overcomes on the quantitative (numeric) measure of
credit control that attempts at encouraging selective vital sectors of the
economy while at the same time discouraging others. . Usually, this aims at
reducing an incident of excess government expenditure. In case of excess
government spending indicates to a situation of inflationary crisis.
Inflation Targeting:
This is an economic monetary inflation policy aimed at attaining an exact
level of inflation in the country. This involves the setting of a certain level of
inflation by the central bank, and then working towards achieving the given

level of inflation. , This is usually done through the application of interest rate
changes.
With acceptance of above monetary policy instruments, many countries still
find themselves being faced by extreme inflation rates. The rates end up
destroying the value of the definite currency. A devaluation of currency ends
up creating an unfavorable (negative) balance of payment and hence a peak
of debts and deficit budgets (income). In this perspective, third world
countries continue to remain poor despite their severe actions aimed at
escaping the unfavorable economic situation.

Research Aim:

Study aims to outline the nature of effective monetary policies, its

nature in order to gain overall impact on macroeconomic objectives
especially on Inflation.

Objectives of the Research:

Monetary policy in a country acts as a tool by which the government or

central bank, attain a set of objectives oriented towards the growth
and stability of the economy
Its objective circulates around exploring macroeconomic objectives.
The specific objectives of the study are as outlined below:

Establish the relationship between money supply and inflation.

Find effectiveness of monetary policy in the Inflation.
Find out the efficiency of the Central Bank of Pakistan in controlling the

supply and availability of money.

Find out whether Monetary policy is properly maintained to enable the
safeguarding the value of Pakistani currency.

Problem Statement:

Developing countries, most of the time find themselves in a never

ending cycle of Inflation. Ultimate end of Inflation cycle is destroying
counties pride, and to some extent, their sovereignty. This loss is
derived from the fact that the countries find themselves up to their
neck with debts resulting from a weak currency deficiency by Inflation,
however they have appropriate monetary policies

Review of Literature:
Before proceeding towards the review of past literature first I want to
drive that there is a relation between monetary policy and inflation for
that we trying to explain the importance of monetary policy in existing
literature
Government policies have potential to affect capital and productivity
especially monetary policy through its huge impact on interest rate.
Monetary policy have an impact on economic activity and growth due
to its high effect on demand and exchange rate of a country
Although policies are principal to smoothly operate economy, in which
monetary policy is used by independent central bank to focus on
control of inflation & that inflation can be decrease by increasing short
term interest rates.
The classical quantity theory of money:
This theory was introduced by Irving Fisher by 20th century, which is
built on the principles of equation of exchange as this shows that
there is direct relationship between price and quantity demand. The
quantity theory of money can be based on theory of price as they both
are equivalent.
Since MV=PT
or
P=MV/T
Where
M= supply of money
V= velocity of circulation (numbers of times, changes in hands)
P= average price level
T= transaction volume of goods/services

This theory assumes that in the short run V (velocity of circulation) and
T(transaction volume of goods/services) are constant and as change in
money supply is ends up with change in price/ change in supply of
goods/ services and number of transactions is determine by labor ,
capital.
It elaborates that value of money is broadly depends on amount of
money available in an economy. As the availability increases this
causes decreases in value of money as more money are supplied to
get a commodity, this increase in money supply leads to inflation.
As due to inflation, purchasing power, value of money decreases as a
result more of quantity should be offered to get something as money is
losing its worth.
Another notable feature in this theory is that monetary policy should
also recover some growth in money supply that if an economy is
growing that money supply is not increasing as per demand in
economy so that this will for this reason matching in growth and
money supply is needed to avoid deflation.
The monetarist theory:
Monetary schools of economic thought defines that money supply is
the main element of level of production in short run and inflation rate
in long run. Money is best /direct alternative for any assets, as if there
is an increase in money supply so that stable velocity in circulation can
be caused, which have direct influence on other assets demand as
there is huge money available for spending on those assets. This could
ultimately cause increase in prices if the output for economy is fixed.
For reducing uncertainty, this model tells that money supply should be
maintained at constant demanded growth rate.
However monetary policy and quantity theory of money runs in similar
pathway and concluded the same as rise in money supply chain will
directly cause increase in prices and income, real output and as a
result in employment in short run.

Keynesian theory:
Keynesian economics was established by the British economist John
Maynard Keynes in the 1930s,
It argued that if money supply increases of decreased this will have
limited effect on the demand for goods and services and hence level of
income is affected by the change in rate of interest thus lets take a
situation as if there is an increase in money supply this leads to a
decrease in interest rate which will cause fall in personal investment,
which ultimately cause fall in the national income. Impact of increase
in money supply in an economy is measured by the impact it creates
on rate of interest. According to Keynesian view, both investment
demand and consumer demand are relatively insensitive to interest
rate changes. Because he argued that investment volume is greatly
depends technological advancement (innovative ways of doing
business), business confidence & its return expectations. While supply
of money have limited effect on aggregate demand of a country &
which cause consequently negative or limited effect on the output &
rate of employment.
Keynesian argue that monetary policy will have inadequate result on
the economy and national income ,because rise in money supply
would be neutralized by the decreases in the velocity of circulation
leaving PT natural .According to Keynes increase in money supply
cannot lead to a proportional increase in the price level.
Specific literature:
Kenya
Many other developing countries are depending on monetary policy in order to achieve,
positive balance of payments, economic growth, price stability, and economic
development and full employment .lets take a review of how the instruments of
monetary policy have been used to attain stability in the economy of Kenya.
In 1973 in Kenya, inflation rate show a sudden rise in 15 percent reflecting a sharp
increase in money supply partially due to two serial surpluses on BOP and the increase in
private sector borrowing. In response to this the Central Bank Of Kenya (CBK)
introduced a bounded growth of private sector credit to a maximum of 12 percent per
annum and extended the 15 percent liquidity ratio requirement together with a constraint
of local borrowing by foreign companies to maximum of 60 percent of the amount of
their foreign borrowing to avoid potential BOP problems following the 1973 oil crisis.

Government borrowing was limited to 400 million for the year 1973 and the interest rates
were upstretched in both saving deposits and advances but all these efforts did not the
BOP deficit from reaching 434 million and inflation rate from rising to 16 percent
accompanied by a slowdown in output growth of 4 percent. The brown boom which
lasted 1976 to 1977 obvious another stage of Kenyas monetary policy. Foreign exchange
reserves held by CBK increased by 2800 million attended by a surplus in BOP by 787
million to 2176 million .To escape from inflation the CBK raised the liquidity ratio of
commercial banks to 18 percent and increased the lending rate to 10 percent.
Overview of other countries:
Moreover theoretical evaluation stated above, many empirical studies
have been conducted in order to study the relationship between
monetary policy instruments and inflation rate of developing countries.
As in Sudan, a study was conducted to inspect the long-run
relationships between real Gross Domestic Product (inflation rate of
developing countries), interest rate (MS) and price level (CPI) using
yearly data from 1960 to 2005. In this study, Granger Causality test
was used to examine the short-run direction of interconnection
between inflation rate of developing countries, MS and CPI, and cointegration analysis was applied in order to investigate the existence of
long-run relationship. Based on the results of Granger Causality test,
there was no causality between real inflation rate of developing
countries and interest rate of Sudan between 1960 and 2005.
However, the result from co-integration analysis showed that there was
an existence of long-run relationship (Ahmed & Suleiman, 2011).
Similar revision was directed in order to examine the relationship
between interest rate and inflation rate of developing countries in
Nepal; Shrestha (2010) examined the impact of money supply on GDP
growth and price or ultimately on inflation rate in Nepal.

Research Methodology
Introduction:
The research project covers how monetary policy is used to control inflation rate in developing
countries. In a sense how these variables of monetary policy create an impact on inflation rate.
Research Design:
This study has been performed using quantitative data collection technique. As the data assemled
from Pakistan Bureau of Statistics(PBS),Kenya National Bureau of Statistics(KNBS) Journals
,economic reviews, Central Bank of Kenya, Pakistan proposals and journals ,World Bank
economic reviews. This data has been helpful to analyze the impact of money supply, exchange
rate & interest rate of commercial banks on inflation rate of different struggling (developing)
countries. The data analyze a ten year period from 2005 to 2014 of the respective average annual
variables listed above.
Study Area
The study area in the research was the whole country. Thus, data utilized for the research was the
countrys national data.
Ethical Consideration
Data collected was secondary and thus slight ethic issues arose. However, where data was of a
confidential nature, it was gathered after seeking authorization from the national registration
agencies or respective organizations. This was after guaranteeing extreme confidentiality and
promising that the data would be utilized only for research purposes only. After verification of
the data, which formed the population for this research, any confidential information was
deleted. The data collected was solely be used for this research purpose and a lot of care was
taken to ensure that any sensitive information did not leak out to unauthorized individuals.

Target Population:
In this study the target population are the persons involved in making business, their decisions
and economic policies of this country. This also include those individuals who are researchers
and students doing any business or economic related courses.
Data type and source
This research mainly relied on secondary data obtained from written materials which included
publications from National statistics bureau of countries publications from the Central banks,
world Bank and from the internet; amongst others.
Data collection:
In this research the data utilized was collected through studies, observations and from published
materials.
Data analysis:
The entered data was then presented in the form of tables, graphs and pie charts .This provides
for an easier analysis and interpretation of the data inputted.

DATA ANALYSIS AND PRESENTATION

Descriptive Statistics
This chapter gives data analysis and presentation in graphs enabling interpretation of the results.
The results of the analysis were used in the making of conclusions and recommendations. The
graphs below represent the collected data.

YEAR

2009

INFLATION
RATE
EX RATE

2010

2011

2012

2013

2014

9.2

14

9.4

5.7

6.9

77.3
5

79.2
3

88.8
1

84.5
3

86.1
2

87.9
2

16.4
6

22.3
6

19.1
5

14.3
9

12.8
4

17.0
5

Kenya:

MONEY
SUPPLY

kenya
90
80
70
60
50
40
30
20
10
0

inflation rate
2009

ex rate
2010

2011

2012

money supply
2013

2014

The following table

shows the average annual rates of inflation in Kenya from 2009-2014

This graph of Kenya shows numerical data of inflation rate, exchange rate & money
supply, which represents that Kenyas currency is less preferred comparative to USA
dollar, as it is shilling. The foreign exchange rate is continuously increasing which means
that Kenyan currency shilling is depreciating with respect to Dollar, as a result cause
inflation. Due to its positive relationship between inflation & exchange rate. When the
foreign exchange rate grows (domestic currency depreciates) the rate of inflation also
rises and when it falls the rate of inflation also drops.
Beside this, there is also a positive relationship between money supply & rate of inflation.
As supply of money increases & decreases as a result rate of inflation also rise or fall.
However, other non-economic factors such as political instability, tribal violence and the
contagion of world economic crisis do not seem to follow this trend they can be attributed
to.

Pakistan
Pak

2009

2010

2011

2012

2013

2014

The following

INFLATION

13.6
5

13.8
8

11.9
2

9.69

7.69

7.19

table shows the

81.7
1

85.1
9

86.3
4

93.4

101.
63

101.
1

14.7
6

15.0
5

12.0
4

17.0
4

14.7
3

10.5
9

RATE
EX RATE
MONEY
SUPPLY

Pakistan from 2009-2014

Graphical Representation Of Data:

average annual
rates of inflation,
money supply&
exchange rate in

Pakistan
120
100
80
60
40
20
0

inflation rate
2009

exchange rate
2010

2011

2012

money supply
2013

2014

As per above mentioned data of 2009-2014 in the table, shows that due to
the direct relationship of money supply & exchange rate with rate of
inflation,
Increasing foreign exchange rate means that Pakistani currency is losing its
worth against foreign Dollar, it means they are favoring export & restrict
import by making it expensive.
As above graph also shows positive relation between money supply and
inflation rate that as money supply in economy rises this cause gradually
increment too in inflation rate can be seen in 2009 till 2012 but in 2013
money supply start decline so cause fall in inflation rate.

INFLATION
RATE
EX RATE

2009

2010

2011

7.1

8.9

106.
01

115.
93

2012

2013

2014

18.7

9.1

6.6

4.1

135.
54

155.
82

171.
82

186.
2

MONEY
peruSUPPLY
INFLATION
RATE
EX RATE
MONEY
SUPPLY

26.2 29.7 11.9 24.5 21.4 19.7

2009 3 2010 1 2011 4 2012 4 2013
2014 4
2.9

1.5

3.4

3.7

2.8

3.2

3.01

2.83

2.75

2.64

2.7

2.84

2.66

21.6
6

9.56

13.8
2

18.7
5

5.2

Peru
25

20

15

10

inflation rate
2009

exchange rate
2010

2011

2012

money supply
2013

2014

Vietnam: