The Sustainability of Expansionary Monetary Policy

Abstract:

The global financial crisis sent many economies around the world into recession. By analyzing how South Africa plans to combat the recession, namely by implementing an expansionary monetary policy, one can deduce that in the short run South Africa will combat the recession by stimulating the economy. This expansionary monetary policy will however not be sustainable in the long run because of rising inflation.

The impact of the world financial crisis for most countries came in the form of an economic recession. Many countries such as South Africa responded by instituting an expansionary monetary policy. While this approach may stimulate the economy in the short run, in the long run it may be unsustainable because of political economic institutions such as trade unions.

The reason why these countries entered a recession is because of an inadequate level of aggregate demand in the economy. This occurred because of a decrease in demand of the components of real GDP such as consumption goods and services, investment spending, the government’s expenditure and net exports. A decrease in aggregate demand means a decrease in aggregate expenditure, which slows economic growth.

This can clearly be seen when one examines the GDP growth rates of South Africa before, during and after the financial crisis. According to Organization for Economic Co-operation and development, in 2007 before the economic crisis began the GDP growth rates of South Africa was 5.5 percent. In 2008 the financial crisis began as the GDP growth rate of South Africa diminish to 3.7 percent. In 2009 South Africa experienced a negative GDP growth rate of -1.75. In 2010 one can see a recovery in the economy with a GDP growth rate of 2.37 percent (2010:1).

In order to stimulate the economy of South Africa and allow for recessionary recovery, an expansionary monetary policy must be adopted. The repo rate is the interest rate which financial intermediaries pay on loans made from the South African Reserve Bank. SARB has total control over the repo rate and uses it to regulate the economy. The cost savings of loans made between SARB and commercial banks are passed on to the public in the form of real interest rate decreases. If the repo rate rises then the real interest rate on private loans rises too. If the repo rate falls then the real interest rate paid on private loans falls too. In an expansionary monetary policy, the Monetary Policy Committee would undertake to reduce the repo rate.

This transmission mechanism first begins with SARB decreasing the repo rate. The effect of this is that financial intermediaries such as commercial banks pay a lower interest rate on money borrowed from SARB. This means that more money is demanded from SARB, as the marginal cost to commercial banks is lower. SARB has a policy to supply however much money is demanded from it. As a result of this SARB increases the money supply. This can be seen in the diagram above. The supply of money shifts from MS0 to MS1 and the quantity demanded of money increases.

SARB lowered the repo rate, which means that financial intermediaries can pass on this reduction of costs to consumers of loanable funds. The result of this is that the real interest rate paid on money borrowed from financial intermediaries decreases too. The cost to consumers of loanable funds decreases and as a result of this the quantity demanded of loanable funds increases. Financial intermediaries have more money on hand because SARB increases the supply of money and can respond by increasing the supply of loanable funds to consumers. The supply of loanable funds shifts from SLF0 to SLF1 and the quantity demanded of loanable funds increases.

When more loans have been taken out, people and businesses have more money on hand and are now more willing to spend it. As a result of this aggregate expenditure increases. Aggregate demand increases as demand for consumption goods and services, demand investments, government’s demand for goods and services and demands of net exports increase. The money multiplier effect of people making income from the initial increase in aggregate expenditure and then injecting it back into the economy increases aggregate demand from AD0 to AD1. At AD1 real GDP equals potential GDP. As a result of this increase in aggregate demand, inflation increases and prices rise. A trade-off is made between an increase in economic growth and a rise in inflation.

DATES OF CHANGE IN THE REPURCHASE RATE
DATE	%
2008-06-13	12.00
2008-12-12	11.50
2009-02-06	10.50
2009-03-25	9.50
2009-05-04	8.50
2009-05-29	7.50
2009-08-14	7.00
2010-03-26	6.50
2010-09-10	6.00

(SARB, 2010:1)

In conclusion, by looking at the above table one can clearly see that SARB has indeed decreased the repo rate in accordance with an expansionary monetary policy. By reducing the repo rate more money has been supplied in the money market. As a result of this financial intermediaries have increased the supply of loanable funds in the loanable fund market. This has in turn increased aggregate demand, which has brought real GDP closer to potential GDP. This expansionary monetary policy is however not sustainable in the long run.

This is because it brings an increase in inflation with every decrease in the repo rate. Prices will go up but wages will not. In South Africa this means long strikes by the trade unions, which counters economic growth. Even if trade unions achieve the wage increases they are looking for, the increases in wages means that the demand for labour in the labour market will decrease and the unemployment rate will grow which once again counters economic growth.

List of References:

OECD, 2010. Real GDP Growth Rates, 2001-20011. [Online]. Available: http://stats.oecd.org/Index.aspx?DataSetCode=AEO_REAL_GDP_GROWTH_RATES. [Accessed 14 September 2010].

PARKIN, M, KOHLER, M, LAKAY, L, RHODES, B, SAAYMAN, A, SCHOER, V, SCHOLTZ, F and THOMPSON, K, 2010. Economics: Global and Southern African Perspectives. Cape Town: Pearson.

SARB, 2010. Dates of change in the Purchase Rate. [Online]. Available: http://www.reservebank.co.za/internet/Historicdata.nsf/Mainpage?OpenPage&Click=42256DA4002CFF0E.29d44b91ee5b4df442256d860053d613/$Body/0.AFC. [Accessed 14 September 2010].