The study set out to examine the effect of monetary policy and fiscal policy on the lending rates of commercial banks in Ghana. The study used secondary data acquired from the Central Banks quarterly report spanning starting 2004 – 2018. Time series data analysis was used.
The study found that monetary policy had a significant positive effect on the lending rates of commercial banks. Government expenditure had insignificant effect on the lending rate and lastly inflation also had a positive but insignificant relationship with lending rate.
Based on the findings, the study recommends that, monetary policy should continue to be the major tool to control the cost of borrowing.
Background of study
The study aims at examining how the monetary policy and fiscal policy impact the rate at which commercial banks lend in Ghana. Monetary policies are the major function of the central bank. The principal aim of the central bank is the formulation and implementation policies focused at achieving and maintaining general level price stability and keeping inflation at a lower rate. Monetary policy also achieves and maintains sufficient cash in the system to facilitate greater levels of internal savings and individual investment that boosts national development, real income and improved job opportunities.
Fiscal policy is the use of government’s revenue and expenditures to influence economic growth. Tax collection is the main source of government’s revenue and therefore the adoption of tax structure is effective in the economy mainly through varying interest rate. The link amid a government’s fiscal policy and interest rate is of most important to strategy making in every economy. A government’s budget shortage contends with individual sectors for funds, Blinder & Solow (1973) which pushes up real interest rates which causes a reduction in interest responsive aspect of individual expenses like savings.
An existing government influence both monetary policies and fiscal policies to attain financial targets. Both policies are generally believed to have weight on the borrowing cost set via the commercial banks which in turn has an influence on the general direction of every country’s economy D’Adda & Scorcu (1997).
Lending as a major function of the banks has a vital impact on resource organization and distribution in the country through taking of deposits and turning them into loans and investment. Bank loans takes up a very key responsibility in the long-term financing of many private activities in many economies Freixas & Rochet, (2008).
However, the cost of these borrowed funds has become an issue for most developing countries of which Ghana is not an exception. Interest rate in Ghana is considered high among the other countries with high interest rate in Sub Saharan Africa (Mensah & Abor, 2011).
Monetary policy is a tool used by regulatory authorities that influences the quantity of cash which then turns to influence the interest rate in a country. One major aim of this policy is promote a nations growth. Monetary policy can either be in the form of contractionary which is targeted at decreasing the supply of money or expansionary which is aimed at increasing the stock of funds. Expansionary policy stimulates economic growth in recession via dropping cost of credit to entice businesses have access to cheaper credit to expand. Contractionary policy on the other hand is used with aim of slowing inflation to avoid asset value deterioration. The central bank can use three major tools to execute monetary policy; these are the policy rate, open market operations and the reserve requirement. The policy rate is mechanism of monetary policy used to influence the extent of borrowing within a nation. The policy rate is the rate at which the central bank lends money to the commercial banks against accepted collateral. The policy rate impacts the accessibility and the cost of borrowing. An adjustment in the policy rate causes adjustment of the cost of borrowing accessible by banks. The reserve requirement is a percentage of entire assets of commercial banks keep with bank of Ghana as cash reserve. The bank of Ghana uses this reserve requirement to affect the pumping of money into the economy. This is
kept for the tenacity of preserving easy cash and monitoring credit in the country. The Act 2016 (Act 930) which guides deposit taking institutions mandates them to keep 10% of all deposits received with the bank of Ghana as reserves. The open market operations is also about the buying and selling of short term and long term securities by the Central Bank in the open market. The open market operation can be used to either wipe out excess supply or increase the supply of funds in the economy, which impacts how rate of interest should be and stabilize the market. If the Central Bank wishes to cut the source of funds, it sells securities in the open market for banks and private individuals to purchase. In contrast, when the central bank wishes to upturn the source of funds, it purchases back the instruments from the banks via open market. Monetary policy channels through the influence of cost and accessibility of loans on actual activity, and over this on inflation and thus on the exchange rate Aziza, (2010). This is achieved through the reserve bank of every state. The Central Bank in consultation with the finance ministry set the policy rate and has the authority to regulate the quantity of funds and also cost of borrowing, which is known as the policy rate. The rate therefore increases export which fosters business growth and jobs. However, during a period of low cost of credit, increased sources of funds in the economy can lead to inflation if a country’s output and employment does not rise, and more money chases less merchandises it leads to high prices. Unique purpose of monetary policy is preventing excessive inflation whiles promoting economic growth.
Fiscal policy is another instrument that the government has to stabilize the economy. When there is economic recession, the government can reduce taxes and taxpayers will have extra money to spend, thereby increasing the consumption level. The relationship between the fiscal position of a government and longer period interest rate is of countless significance to policy formulators. A
budget deficit contends with the individual sectors for finance known as crowding out. This in turn increases real interest rate as demand exceeds supply. According to Sola (2011), government’s debt maintains a positive relationship with cost of credit, while amid the universal factors combined monetary and fiscal position a quantitatively considerable responsibility. A fully tax revenue funded government spending and the overall budget consequence has unbiased influence on the country’s activities.
Fiscal policy is used where all other mechanisms have failed including monetary. There are three stances of fiscal policy which neutral, expansionary and contractionary. A neutral stance is a well-adjusted economy which results in large tax revenue. An expansionary policy is about governments spending over tax revenue. Contractionary policy is government spending below tax revenue.
This is the percentage of borrowed fund paid the lender by the debtor for the use of fund over a specific time period. It is a ratio of actual amount borrowed paid multiplied by a specific duration.
Monetary policy is a vital tool in handling activities like investment, inflation and unemployment is interest rate target. When the central bank of a country intends to increase investment and consumption it reduces the cost of borrowing. However, a low interest rate creates tension in the economy which is risky, that is large amount of investment going into housing facilities and stock trading. According to Mckinnon (1973), higher real interest rates of return lead to a higher level of savings, which encourages economic growth.
The Link between Monetary and Fiscal Policies
Though these policies are executed via diverse administrations, they are dependent on each other in that they all have one objective in common that aims at attaining economic growth as well as steady macro economy. When the policy management wants to expand the country, the monetary policy is expanded to accommodate and make sure cost of credit are minimal to promote smooth access to finance for the purpose of investment and consumption. However, if monetary policy remains tight which means high cost of credit, the desired advancement of the country from a fiscal policy perspective on the economy will be restrained by the high borrowing cost.
However, monetary policy will be intentionally set to back fiscal policy in as much as it does not threaten its main aim of warrant minimal inflation and maintaining sufficient external reserve. Thus should the fiscal policy expansion put force on the foreign reserve and inflation, there will be the reason to constrict the monetary policy to protect the aforementioned objective of ensuring macroeconomic stability. This imposes restriction on the government spending as cost of borrowing becomes high and thereby raise taxes to increase its revenue. There is therefore the need for harmonizing monetary and fiscal policies in other to accomplish an equal objective of protecting and supporting sustainability in economic growth.