THE NEXUS BETWEEN MPR AND CORPORATE PERFORMANCE
PUBLISHED BY:RASHEED OTTUN
WHAT IS MPR ?
• MPR is the Monetary Policy Rate.
• It is the official interest rate that is set by the Monetary Policy
Committee (MPC)
• It is also called the bench mark interest rate or baseline interest rate.
• The Monetary Policy Committee (MPC) is the committee that is
inaugurated to set the interest rate independence of the department
of finance.
• The inauguration of the MPC is a way to ensure central bank’s
independence from government in control (use) monetary policy.
WHAT IS THE ROLE OF THE MPC
• The role of the Monetary Policy committee is to:
i. Review economic and financial conditions in the economy
ii. Determine appropriate stance of policy in the short to medium
term
iii. Review regularly, the CBN monetary policy framework and adopt
changes when necessary.
WHY SET AN OFFICIAL INTEREST RATE
• The Central Bank is responsible for the conduct of monetary
policy.ate The conduct of which is focused on the management of
money supply and interest rate.
• The central Bank sets interest rates in order to achieve:
i. Price stability
ii. maintain overall economic growth f
iii. Full employment
iv. Balance of payment equilibrium
DEMAND FOR MONEY
• The demand for money refers to the desire to hold money .i.e. to
keep your wealth in the form of money, rather than spending it on
goods and services or using it to purchase financial assets such as
bonds or shares. It is usual to distinguish three reasons why people
want to hold their assets in the form of money.
HOW IS THE MPR SET ?• The central bank sets interest rate though its conduct of monetary
policy. The conduct of monetary policy lies on the management of
money supply and interest rate.
• The MPR is set through the interplay of money demand and money
supply.
• Money Demand is the desire to hold money.
• Money supply is the stock of money in the economy.
• The central Bank is solely in control of money supply. When the Central
Bank targets a level of MPR, it either adopts an expansionary or
contractionary monetary policy (.i.e. either increase or decrease the
supply of money) as required in order to achieve the targeted MPR.
KEYNESSIAN LIQUIDITY PREFREFENCE FRAMEORK OF MONEY DEMAND
• It is a model developed by JOHN MAYNARD KEYNES that predicts
equilibrium interest rate on the basis of supply of and the demand
for money.
• Keynes assumes that there are two main categories of assets that
people use to store their wealth: money and bonds.
• There is an opportunity cost for holding any of the two assets. The
opportunity cost for money demand is the interest (return ) on
bonds .
MOTIVE FOR HOLDING MONEY• According to the Keynes’s analysis, there are three main motives behind the
demand for money.
THE TRANSACTIONS MOTIVE:
• Money being a medium of exchange, is required for conducting daily
transactions.
THE PRECAUTIONARY MOTIVE:
• The desire to hold money in order to meet unforeseen or unexpected
circumstances.
THE SPECULATIVE OR ASSETS MOTIVE:
• The desire to hold money in order to purchase financial assets such as bonds,
shares etc and other speculations. This motive explains how speculation about
interest rates would affect money demand.
The Transactions And PrecautionaryDemand For Money: L1
• The transaction Demand for money is determined primarily by the
level of transaction. And the level of transaction is proportional to
income.
• The precautionary demand for money is primarily determined by
the level of transaction people expect that they will carry out in
future and that transactions are proportional to income.
• The transaction and the precautionary motive for holding money
are called ACTIVE BALANCE (L1 ). i.e. the money held for transaction
and precautionary purpose.
DETERMINANTS OF L1
LEVEL OF TRANSACTION :
• As the economy expands and income rises, people will want to carry out
more transactions using money and as a result their desire to hold more
money rises. Thus, The bigger people’s money income, the greater their
expenditure and the bigger their demand for active balances.
• Liquidity preference is the desire to hold asset in the form of cash
(money)
• L1 = F(Y)
Where:
L1 = liquidity Preference, which is the sum of transactions and precautionary
demand for money
Y = Level of transaction
SPECULATIVE DEMAND FOR MONEYL2
• The speculative demand for money balances is termed L2.Money
balances held for this purpose are called idle balances.
• The speculative demand for money (L2) depends on the rate of
return on assets and on anticipations about future movements in
security prices (and hence their rate of return) and future
movements in exchange rates.
• There is an inverse relationship between the interest rate and L2 .
DETERMINANT OF THE L2
THE RATE OF INTEREST (OR RATE OF RETURN) ON ASSETS:
• The higher the rate of return on assets, such as shares and bonds, the
greater the opportunity cost of holding money and therefore the lower
the speculative demand for money.
THE FUTURE MOVEMENT IN EXCHANGE RATE:
• Expectations about changes in the exchange rate are a major
determinant of the speculative demand for money. The more quickly is
the exchange rate expected to rise in favour of a currency, the more will
people want to hold that currency.
• L2 = F(i) where i = Nominal interest rate
MONEY SUPPLY•
• The Central Bank directly controls the monetary base. That
is, it is exogenously determined.
• The other measures of the money stock are determined by
the interaction of the monetary base with the banking
sector:
regulatory requirements
the incentive of financial institutions to have enough
funds on hand to satisfy depositors’ demands
• Besides the monetary base (H), there are other definitions of
the money stock such as
M1 (currency, current accounts, travelers checks)
M2 (M1 plus savings accounts, small term deposits, money
held in money market accounts)
M3 (M2 plus large term deposits and institutional money
market balances)
EQUILIBRIM INTEREST RATE
MONETARY POLICY
• These are deliberate efforts made by monetary authorities to
control the volume, cost and the availability of money and credit in
the economy .
• The essence of the conduct of monetary policy is to control the
quantity of money in circulation in the economy so that the Central
Bank can achieve price stability, economic growth and reduce
unemployment.
• The central bank enjoys the autonomy in the conducts of the
monetary policy. Depending on the goal it intends to achieve, it can
either control money supply or the interest rate but cannot use
both at the same time.
MONETARY INSTURMENTS/TECHNIQUES
• The various monetary instruments (techniques) are:
Market Based (indirect) Techniques/ Traditional Monetary Instruments– Open Market Operation
– Discount rate Policy
– Reserve Requirement.
Non-Market base Technique:– Supplementary Reserve Requirement
– Variable Cash Ratio
– Variable Liquidity Ratio
– Credit ceiling
– Selective Control
– Moral Suasion
– Directives
EXPANSIONARY MONETARY POLICY
• Expansionary Policy are the deliberate
attempt taken by the central Bank to
reduce the interest rate by increasing
the quantity of money in circulation.
• In this case the central bank fixed MPR
(interest rate) by increasing the money
stock .
• By changing the interest rate , the
Central bank tries to achieve maximum
employment, stable prices and a good
level growth
CONTRACTIONARY MONETARY POLICY
• Expansionary Policy are the
deliberate attempt taken by the
central Bank to increase the
interest rate by decreasing the
quantity of money in circulation.
• In this case the central bank fixed
the MPR (interest rate) by raising
the money stock using any of the
monetary instruments at its
disposal.
MPR AND BUSINESS BORROWING• MPR directly influences business borrowing. Businesses often need to
take out short term loans to make up for shortfalls in payroll or other
expenses. When the central bank raises the MPR, all other short-term
interest rates rises and as a result, higher interest rates make such
shortfalls more costly, since the businesses will have to pay more
interest back to lenders. Companies also frequently take out longer
term debt for improvements and infrastructure. A raise in MPR also
causes the long-term rates to rise. The higher the prevailing interest
rates, the more costly it is to take debt and therefore the less likely
businesses will be able to commit the funds to such projects.
MPR AND BUSINESS STRATEGY
• The ultimate goal of businesses is to make profit. Therefore, it is very important that
before businesses consider another venture, thorough analyses of the ultimate prospects
of profit generation of the venture must be considered. The venture’s prospects must
also be compared to other possible (alternative) sources of revenue. Saving the capital to
be ventured at current interest rate is another possible (alternative) source of revenue,
there is the tendency that a higher interest rate can make ventures less attractive. For
instance, if a cost benefit analysis shows that a new program within a company is likely to
yield a profit of 4% per year for all money put into the program, but the prevailing
interest rates are 6%, the company is better off putting their money in the bank. In this
way, interest rates dictate what a business will consider a strong return on investment.
THE MPR AND STOCK PRICES• It affects the ability of businesses to raise capital through stock and the
value of stock prices. When a company goes public, it sells shares of the
company in the form of stock to raise capital. Subsequently, the implied
value of the business is tied to the share price of the stock, and share
price is tied to demand for the company's stock. When interest rates are
higher, the demand for investment tends to be lower, so higher interest
rates are generally detrimental for company's stocks, and their ability to
raise money through a stock offering. The reason higher interest rates are
bad for stocks is that higher interest rates make traditional saving more
attractive; if someone can earn a 5% guaranteed return by saving at a
bank, they will be less likely to risk money investing, than if they could
only earn 1 or 2% in a savings account.
MPR AND PROFITABILTY
• As the Central Bank lowers or raises the MPR, banks need to adjust
the rates that they charge their customers when they
lend funds or pay their customers on deposits.
• The rates charged and the rates paid can certainly have an affect on
the profitability of a business.
• As the MPR changes the interest rate on variable rate ( adjustable
rate ) loan changes.
• For a business with variable-rate loan, a rise in MPR, raises the
interest rate on such loan and the business will pay more interest rate
charges on the loan as a result. Consequently, the profitability of the
business declines. It becomes very worrisome, when the earnings
from the investment cannot cover the interest rate charges on the
loan. On the other hand, if the Central Bank decides to loosen up i.e.
reduce MPR, the interest rate charged on such loan will fall and the
interest rate payment on such loans will reduce and the profit of the
business will rise, all things being equal.
• Also, when Central Bank cuts the official interest rate, companies
get loans at lower interest rates. When official interest rate goes up,
it costs them more to borrow money. This affects overhead costs.
And it means that companies' profits are affected. So if interest
rates go down, the thought is that companies will spend less money
and therefore have higher profits. This invites investors to put their
money in the stock market, and it raises the market values. Interest
rate hikes, on the other hand, can have an opposite effect in some
cases.
MPR AND CORPORATE PERFORMANCE NEXUS
• Whenever the central Bank sets monetary policy rate by adjusting
short-term interest rates, which changes other short-term and long-
term rates, such as bank loan. Interest rate changes affect
businesses directly through interest costs and indirectly .
• MPR directly affects the cost of borrowing of corporations which in
turn affect their spending i.e. investment.
• MPR affects the business strategy of businesses as a result changes
in the cost of borrowing and possible returns that could be derived
from the alternative sources that funds can be put to.
• MPR affects the ability of businesses to raise capital in the loanable
funds market and the value of the stocks of businesses as a result of
changes in profitability of the companies.
• The price of stock must also reflect the market interest rate. As a
result, for any change in the interest rate the price of stocks change.