2.

1 Theoretical Framework

2.1.1 Monetary Policy and Inflation

Both inflation and monetary policy are subjects of great importance and interest,

therefore evaluating them and their effect on various macroeconomic variables is of pivotal

concern to the society at large. According to Keynes (2018), monetary policy may impact the

level of aggregate demand, via modification of money supply. They assert that this may result

in full employment without the generation of inflation. Later, during the advent of the

eighties, the Keynesian theorists lost credibility while the monetarist theories, proposed by

economists such as Alton Melter, Karl Brunner, and Milton Friedman. These economists are

of the view that monetary regulation constitutes the capacity to stabilize the economy. This

way, Cerna (2012, p. 59) posits that the neoclassic school of economic thought introduces a

rational expectations theory.

Gherman & Adam (2010) observed that the objective of monetary policy is to

guarantee a high rate of employment besides price stability. This double goal, which is

renowned and reviewed within literature as the monetary policy’s dual mandate, may resent

the declared aim of several central banks that primarily focus on price stability (Gherman,

2010, p.90). Moreover, Gherman & Adam (2010) opine that the current few businessmen and

market investors, economists or otherwise, focused on economic evolution besides business

opportunities, still have the conviction that central bank actions impose to impact on GDP’s

evolution besides other essential macro-economic variables that are of interest to the public.

The ideology that monetary policy fails to ascertain natural employment growth or to match

the correspondent GDP level is not considered a reason for the absence of effort towards the

optimal sustenance of the macro-variables during economic disturbances.

 In the dependency situation between high uncertainty and global finances, the ideal

monetary policies must by aptly comprehensive, consistent, responsible, dynamic, and

transparent while striving to avoid excessive flexibility and fluctuation (Brash, 2000). The

recent reduced levels of inflation is attributed to an economic policy mix, championing

disinflation, coupled with restrictive fiscal and monetary policies besides rather neutral

budgetary policies. Such monetary policies were substantively characterized by currency

depreciation, mandatory reserves, and a high rate of interest (Pop, 2011). Based on economic

literature, in the current economies, reaching a steady and low inflation results in new

economic climates, which need stringent reconsiderations of a country’s financial stability

and price stability dependency.

The neo-classical quantity theorists perceive inflation in the context of a monetary

phenomenon which is as a result of increased expansion in money quantity relative to the

value of total output (Friedman, 1971). According to Friedman (1963), previous efforts to

implement a counter-cyclical monetary policy were so futile that the most appropriate

approach to adopt a stabilizing policy encompasses the overall prevention and simply

maintaining money stock at a constant level. Korhonen & Nuutilainen, (2016) assert that

Friedman also proposed that the money stock must be allowed to expand exclusively at a

constant rate (k ), which corresponds to the economy’s rate of growth. This measure was

adopted by the CBN during its 2008 monetary-aggregate targeting regime.

Literature on contemporary monetary policy points out that the involvement of

monetary authority is essential during the implementation of counter-cyclical strategies to

offset the prevailing economic fluctuations. Overall, Roberts (2004) opines that inflation is

presumed to be founded on an increased level of demand for services and goods as outlined

in the fact that individuals strive to utilize cash balances. Conclusively, the authors assert that

inflation is consistently a monetary aspect which is associated with Fisher’s equation

(MV=PQ), where;M- money supply, V- Velocity, P- Price, Q- Real output level. Q and V are

assumed to beconstants; while the level of price (P), varies in proportion with the level of

money supply (M).

Jhingan (2011) noted that both the monetarists and the Keynesian economists are

convinced that inflation is a result of increased aggregate demand attributed to several factors

including increased money supply, increased level of disposable income, increased public

expenditure, increased consumer spending, cheap currency, deficit financing, private sector

expansion, black money, public debt repayment, and increased exports. On the other hand,

the factors that affect supply include shortage of production factors, natural calamities,

international factors, law of diminishing returns, increased exports, lop-sided production,

artificial scarcities, and industrial disputes.

Recent research is consistent with the recommendation proposed by McCallum

(1988). For instance, it assesses the significance of the aspects of alternative rules of

monetary policy via utilizing various economic models. However, the distinction between

policy objectives and economic structure could be ineffective. To begin with, the quadratic

loss function of the central bank may be perceived as the representative agents’ welfare

approximation (Woodford, 1999). Secondly, loss functions are endogenously related to

model framework; for instance, an increase in price rigidity increases the inflation objective’s

relative weight in the function of optimal loss that a central bank which adopt inflation

targeting should employ (Walsh, 2009). Generally, researchers are in consult that inflation-

targeting has resulted in substantive progress in the context of monetary policy practice

(Woodford, 2004). Bernanke et al., (1999) describe inflation-targeting as a constrained

restriction regime and highlight its benefit of providing the platform for ample discretion

based on a rule-based framework which is consistent with Kydland & Prescott (1977).
 2.1.2 Monetary Policy and Exchange Rate

Countries within the BRICS organization constitute a similar impact in the

development of the rate of exchange framework. Fundamentally, each of the countries has

experienced a shift from the fixed rate of exchange to a managed floating system of exchange

rate. This scenario is attributed to several reasons. To begin with, the regime is a necessity for

a country in itself. As the most rapidly developing countries under the emerging economies

category, the BRICS states should have more market-compliant and flexible rates of

exchange to balance the scenario. The export and import businesses of the national foreign-

exchange project of reserve management or the enterprises need to adopt a more similar

model to the marketized system of exchange rate in the management of the country’s

exchange rate adjustments. Thus, the open rate of exchange framework may serve an

appropriate role in bridging one currency’s single system of exchange rate with the

advancement of a flexible floating system of the rate of exchange (Jiang et al., 2019). A shift

of either the LM or the IS curve may result in the fluctuation of a country’s business cycle.

Different economic factors result in the shifting of the IS-LM curves, hence they shift

independently. A variation in the level of aggregate demand shifts only the IS curve rather

than the LM curve.

For a flexible economy such as that of the BRICS, the condition of the equilibrium in

the goods market provides that production (Y) equals the demand level for goods. The latter

points to the sum of net exports, public spending, investment, and consumption. This

relationship is reflected in the IS curve. Suppose the definition of consumption is provided as:

C = C(Y-t), in which t is representative of the tax rate, the equilibrium level would be

defined as:
 Y = G + NX+ C(Y-t) + I

This case holds that the level of investment is unstable, and Young, Warren & Darity,

William (2004) observe that it is mainly dependent on two aspects: the interest rates and sales

level. Suppose a firm’s sales increase, it must opt investing new plants to increase the

production level, hence a positive link. In line with rates of interest, the higher the latter; the

costlier the investments, such that the relationship between investments and rates of interest is

negative. Besides the provisions of the IS-LM framework, since net exports exist, the rates of

exchange must also be brought into consideration, hence a direct impact on the net exports.

Assuming that e represents a foreign currency’s domestic price, or alternatively, the number

of units of a home currency that have to be foregone to obtain a unit of a foreign currency.

This new relationship is defined as:

Y = G + NX(e)+C (Y- t) + I (Y, i)

i= Rate of Interest

If we keep in mind the equivalence between production and demand, which

determines the equilibrium in the market for goods, and observe the effect of interest rates,
we obtain the IS curve. This curve represents the value of equilibrium for any interest rate. A

rising rate of interest would result in reduced production via its impact on the level of

investment. Ultimately, the slope of the curve is negative (Meyer, 1983). The LM curve

reflects the relationship which defines money and liquidity (Boianovsky, 2004). In a floating

economy, the rate of interest is established in the money demand and money supply

equilibrium: M/P=L(i,Y); where;

M-money supply quantity

Y-Real Income

i-Rate of interest

L-Money demand (Function of Y and i).

Also, the analysis of the rate of exchange is essential since it impacts money demand,

such that investors would opt to sell or buy bonds based on the rate of exchange.

The money market equilibrium implies that, based on the money quantity, the rate of

interest is positively related to the level of output. With an increase in output, money demand

increases, however, as pointed out, the supply of money is given. This way, the rate of
interest should increase such that the opposite impacts influencing the money demand are

offset (Friedman, 1966), hence individuals will raise their demand for money attributed to

increased income and reduce the demand due to increasing rates of interest.

Moreover, in the monetary policy and exchange rate of the BRICS countries, a

balance of payment curve indicates the specific points at which the BP curve achieves

equilibrium. Conversely, it reflects the combination of the rates of interest and production

rates that ascertain that the BP is appropriately financed, implying that the net export volume

which influences total output should exhibit consistency with the net-capital outflows’

volume. Often, the curve slopes upwards because increased production means more imports

that will cause disturbances to the BP equilibrium, unless the rates of interest rise (which may

result in a consistent equilibrium based on capital inflows). However, in line with the

greatness of capital mobility, it would have a smaller or greater slope (Mundell, 1963) such

that a higher mobility implies that the curve gets flatter. Upon the derivation of the BP curve,

it is essential for the monetary authorities to appropriately employ it. On the one hand, any

points situated above this curve implies a surplus in the balance of payments. On the other

hand, any points situated below the balance of payments curve will represent a deficit in the

balance of payments. This is significant since base on the country’s economic state of the

world, different economic factors may impact the rates of interest.

In a scenario where the capital is perfectly mobile for these countries, expansionary

monetary policies tend to shift the LM curve (LM’), hence the equilibrium moves from e0 to

e1.
 On the contrary, Maradiaga (2014) postulates that since the BRICS countries operate

on a flexible rate of exchange, the scenario is different. Consequently, the IS curve shifts to

the upper right (IS’). The ultimate equilibrium is established at E2. Given the same rate of

interest, the level of production has substantively increased, hence revealing the effectiveness

of monetary policy under such circumstances.

2.1.3 Monetary Policy and Economic Growth

The classical theory of monetary economics is the first most established monetary

policy theory based on Irving Fisher’s QTM, which sets the basis for the connection between

economic variables and monetary policy. This theory postulates that both output and money

velocity are held constant, therefore any increase in money quantity will ultimately result in a

proportional increase in prices based on the theory of money quantity. Moreover, growth over

the long term was only impacted by real factor aspects, and that money supply comprises

both long run and short run neutrality (Mankiw & Taylor, 2007; Galí, 2015).

Keynes critiqued this theory, both as an applied policy tool and theoretically,

suggesting that money velocity is not constant and is unstable. Also, QTM was built on the

assumption of the lack of a trade-off between output and inflation (Keynes, 2018). The

Keynesian economists insisted on price rigidity besides that money quantity rapidly adjusted.
The demand for money was rather more endogenous but exogenous and depends on interest

rates and income as outlined in the theory of liquidity preference. Also, the theory assumes

that the rate of interest and output are positively related, drawing from the LM curve

(Relationship between liquidity Preference and money supply). The basic IS-LM version

framework assumes that the price level is fixed; hence cannot be employed in the analysis of

inflation except for the short run output (Boianovsky, 2004). The theory of liquidity

preference combines the demand for money with the central bank’s money supply quantity to

establish the level of money equilibrium. This equilibrium is an indicator that interest rate is a

phenomenon of monetary economics. The supply of money is considered exogenous hence

any rise in money supply results in reduced rate of interest at which the money demand

quantity is equal to the level of money supply. Lower rates of interest constitute a positive

result on the marginal efficiency of investment and capital. This results in the expansion of

output. The Hicksian IS/LM framework’s perspective of the Keynesian overall theory,

however, was empirically contested (Backhouse & Bateman, 2011). Keynes questioned the

monetary policy’s effectiveness when an economy plunges into a liquidity trap besides due to

financial market uncertainties. Rather, he advocated for a more effective fiscal policy role.

The assumption that the supply of money is considered exogenous in both the Keynesian and

classical theories had been similarly critiqued and abandoned in modern theories (Romer,

2006). The lengthened periods of low rates of interest in the Keynesian perspective are also

considered to constitute distortions in the context of asset price-bubbles that are unsustainable

(Schwartz, 2009). However, monetarism has been challenged based on the money demand

function’s instability and technological developments (White, 2013). Also, monetarism

assumes exogenous supply of money which is both empirically and theoretically contested

(Romer, 2000). The constant money velocity assumption has also been subjected to criticism

(Mishkin, 2007). Tang (2016) observes that neutrality over the long term has also been
empirically challenged. More succinctly, the author finds that over the long run, money’s

neutrality over the long run is absent, suppose the same holds as true for the short run,

particularly, suppose economic growth is considerably endogenous. Thus, suppose economic

growth is classified as exogenous, it results in the establishment of long-term neutrality.

Considering that the five BRICS countries share similar aspects in the nature of their business

cycles, Kutu & Ngalawa (2017) sought to determine the probability of any of these states

shifting to expansionary regime from the contractionary regime. The study finds that the

region-wide monetary policy has substantively large impacts on the level of industrial

output in both the recession and boom periods of the economic business cycle.

Practically, monetary policy may constitute a sustained positive impact on the growth

of the economy via avoiding negative outcomes of an ineffective monetary policy. This needs

a stable and low rate of inflation. However, this does not reflect the perspectives of various

individuals when they seek to establish the relationship between growth and monetary policy.

Rather, individuals envisage monetary policy as enhancing growth via the stimulation of

aggregate demand based on low rates of interest. This evidence suggests that the influence of

monetary policy is substantively limited when in itself, it does not result in instability (Borio

& Disyatat, 2010). Unprecedented changes in monetary policy stance such as monetary

disturbances and shocks, may enhance the level of economic activity, however, this has a

temporary effect. Efforts to persistently and systematically stimulate growth in this manner

results in increased inflation, hence compelling the central bank to raise the rates of interest

and cause recession to maintain their operations during inflation. The events of the late

seventies and early eighties demonstrate the undesirability of such an ineffective strategy of

monetary policy.

However, the central bank may still employ another approach in impacting real

economic operations. For instance, central banks may employ their balance sheets in altering
credit allocation within the economy. Through buying or lending the securities owned by

entities in the private sector, allocation of central bank credit may result in the flow of more

resources to specific economic segments. This limits the flow of resources to other sectors,

however, and can interfere with distorting economic activity in an unproductive manner.

However, this section considers the allocation of central bank credit as fiscal policy rather

than monetary policy. Consequently, it is appropriate that such actions are exclusively

undertaken by government branches, instead of the central banks.

Monetary policy constitutes a unique capacity in influencing the long run price level.

The mechanism upon which monetary policy exerts its eventual impact on the level of price

is via the money creation process, implying the process by which the actions of the central

banks impact distinct money forms, including bank deposits, used by individuals in

transactions for services and goods. In the contemporary, it is more often to imagine the

scenario of monetary policy as a tool of interest rate targeting, rather than the supply of

money, partly due to the fact that the demand for money appears to fluctuate substantively

(Cornand & Heinemann, 2014). Nevertheless, before two thousand and eight, the Fed was

successful with the achievement of the federal funds rate target via the manipulation of the

bank reserves’ supply. Declines in the rate of interest target by the Fed compelled an increase

in bank reserves’ supply. The resultant money creation process and the private system of

banking consequently influences the determination of price.

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