■ <B>Objectives of the central bank</B>

The main objectives of Bank of Mauritius are ?to maintain price stability and promote a balanced and orderly economic development?. In this context, following the Budget Speech 2007/08, the bank?s Monetary Policy Committee (MPC) was given sole responsibility for setting interest rate, in particular the Repo Rate, based on its present and future assessment of both the global and domestic economic environment.

The central bank is able to determine a specific interest rate by virtue of being a monopoly supplier of the monetary base, also known as ?high powered money?, which consists of banknotes, coins and bank reserves.

■ <B> The Repo Rate</B>

The Repo Rate is the most important instrument of monetary policy. A ?Repo? is in fact a sale and repurchase agreement. Banks can sell assets such as securities, treasury bills and bonds in exchange for cash to the central bank with an agreement to buy them back at a later date. The difference between the sale and repurchase price of the assets is the Repo Rate. In essence, it determines the rate at which the central bank will lend ?high powered money? to other banking institutions and as such influences the structure of all other interest rates in the financial system. For instance, interest rates on loans, mortgages and overdrafts are adjusted accordingly while banks may also change the savings rate to maintain the margin between the deposit and loan rates.

<I>«Lower interest rates typically mean that it is easier for households and firms to repay their debts and consequently, it may be less risky for banks to approve loans. This may lead to an increased amount of funds being available for lending.»</I>

A change in the Repo Rate has an impact on the money market and the real economy. It has a bearing on the behaviour of economic agents and is fed through different aspects of the economy via changes in important variables like consumption, savings, investment, output, exchange rate and prices. The processes that link interest rate to real economic variables are known as the monetary policy transmission mechanisms.

■ <B> Spending behaviour and investment </B>

Interest rates affect the savings and consumption decisions of households. A fall in interest rates will improve the disposable income of those with significant personal debt, enabling them to spend more on other goods and services whilst, on the other hand, there will be a disincentive to save. Individuals will therefore tend to increase their present consumption and forego future consumption.

Consumer spending is also influenced by the interest rate impact on asset prices. The prices of bonds and other securities such as equities are determined by future income streams discounted by the interest rate. Lower interest rate implies a smaller discounting factor and hence, higher prices. Similarly, there is an inverse relationship between prices of physical assets such as houses and the interest rate. Low interest rate reduces the cost of financing house purchases, raising demand and prices. A higher market value or net worth of the assets owned may make the individual feel wealthier and encourage spending. Additionally, it may stimulate borrowing to finance consumption as the higher net worth assets can be used as collateral to allow borrowers to get more loans.

A fall in interest rate will in addition reduce the cost of borrowing by businesses. Given that the cost of finance remains a main determinant of investment, a fall in interest rate will encourage investment in plant and equipment and new technology. Increased asset prices, due to lower interest rate not only facilitates access to credit by firms but also contributes to improving the overall net worth of companies. A monetary policy change, such as an interest rate cut, may serve to increase investment, promote the expansion of activity and contribute to job creation.

Lower interest rates typically mean that it is easier for households and firms to repay their debts and consequently, it may be less risky for banks to approve loans. This may lead to an increased amount of funds being available for lending.

When aggregated throughout the economy, the higher consumption and investment levels, caused by a policy induced cut in interest rate, will lead to a rise in total domestic demand and gross domestic product (GDP). Clearly then, changes in interest rate will affect the growth prospects of the economy. Other things remaining constant, rising demand will subsequently result in higher prices as well.

■ <B> The exchange rate</B>

The exchange rate is also affected by changes in the rate of interest rate. A lower interest rate relative to interest rates on foreign assets will diminish the attractiveness of rupee denominated assets and thereby induce a depreciation of the currency.

The exchange rate has an effect on the relative prices of imports and exports. A strong currency means that imports are relatively cheaper and may help to ease the impact of imported inflation on purchasing power. However, exported goods and services would become more expensive. This has negative implications for the competitiveness of domestic producers of import competing goods and more significantly of exporting industries such as Textiles and Clothing and Tourism. Given the contribution of these sectors to the Mauritian economy, a worsening of their competitive positions could compromise employment creation and the overall economic growth.

■ <B> Expectations</B>

Changes in monetary policy will affect expectations about the future course of economic activity and in turn influence the behaviour of economic agents. Positive perceptions of the economy can breed high confidence amongst households and businesses leading to more spending and investment and higher aggregate demand and economic growth. Although, the rise in aggregate demand would in turn generate inflationary pressure on the economy.

It is difficult to predict the exact impact of changes in interest rate on expectations and confidence. For instance, an interest rate cut can signal that the economy may slow down in the future and therefore serves to lower confidence in general or it may be interpreted that the central bank perceives the need to give a boost to economic activity which may help to raise expectations of future growth and as a consequence, consumer and business confidence may improve.

■ <B> Time lags and quantitative impact</B>

The impact of a change in interest rate will take time to be fully absorbed by the economy. It may be several months before the interest rate cut is translated into higher demand and growth. Adjustments in the spending behaviour of households and investment by firms are typically slow and can only occur over a period of time. Existing empirical evidence in more advanced economies show that a change in the rate of interest can impact upon economic activity after one year and that the full impact on inflation can take up to another year. Moreover, the magnitude of the interest rate effects is also uncertain and subject to considerable variations. Both the time lags involved and the quantitative impact of monetary policy changes will depend on a diverse set of factors including business and consumer confidence, the stage of the business cycle, the state of the world economy, the fiscal policy stance and the credibility of the monetary policy regime itself.

■ <B> Influencing GDP growth in the long term</B>

As reiterated by the Bank of Mauritius, monetary policy is but one amongst other policy measures available to influence economic activity. In particular, monetary policy generally cannot raise GDP growth in the long run. This is best achieved by supply-side factors such as capital accumulation, technical progress and the size and quality of the labour force which are facilitated through policies that promote a flexible labour market, reduce bureaucracy and impediments to free market, tax reforms that encourage people to work, create incentives and entrepreneurial spirit, reforms to the education system and improved access to training and education as well as incentives to innovate and develop new technology.

<B>Dr Vishal Ragoobur</B> <I>Economist Mauritius Employers? Federation</I>