The nexus between mpr and corporate performance

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.