Chapter 4


government is not (via taxes or credits from private sources) withdrawn from other uses but
leads to an overall expansion of money supply. In essence, this means nothing else than
printing money and bringing it into circulation. The money supply is further increased by
credit expansion within the banking system. Government borrowings from the domestic
banking sector (central bank and commercial banks) increase the assets of the banks (e.g. in
form of treasury bonds) and provide the basis to expand their lending to others, contributing
to an increase of overall money supply. If the increase of money supply exceeds real GNP
growth, i.e. the growth in production of goods and services, this leads to what has been
called "excess demand" or "excess absorption" which, in turn, is a major cause of inflation.
The process of money creation and credit expansion is explained in Annex 2C.

The main objective of monetary policies under adjustment is to reduce inflation by
restricting the growth of money supply and credit expansion. Typically the following
approaches are applied:

1) Restricting public borrowings from the domestic banking sector;

2) Limiting general credit expansion;

3) Adjusting interest rates.

1) Restricting public borrowings

As government credits are the main source of increased money supply (see Annex 2c). strict
upper limits are usually set for the volume of government borrowings from the domestic
banking sector (Central Bank and commercial banks). Such limits may apply specifically to
the volume of credits of the Central Government or of the public sector as a whole. As
monetary restrictions will reduce the overall volume of credits under adjustment, the limits
set for public sector borrowings should also present private investments from being crowded
out by public borrowings.

2) Limiting credit expansion

In addition to the restrictions on government borrowings which will already have negative
effects on overall credit availability, further measures may be taken to limit money creation
through credit expansion within the commercial banking sector (see Annex 2c). This can be
achieved by imposing limits on the level of bank lending or by imposing a condition to
increase the reserve requirements.

3) Adjustment of interest rates

Low or negative real interest rates, when the nominal interest rate is adjusted for the rate
of inflation, are a common feature in many countries in need of adjustment. Low interest
rates discourage savings, hence capital formation, on the one hand, while they encourage
borrowings for consumption and for productive, as well as unproductive, investment
purposes on the other hand, and hence contribute to excessive credit and demand expansion
and to a misallocation of scarce capital resources. Increasing interest rates, at least to a level


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