Monetary Policy, Open Market Operations - Assignment Example

Monetary Policy Question task I During recession time, the economy has a high spare capa therefore when the money supply increases, the central bank strives to attain the unemployed resources to be used in a country’s economy. An increase in interest rates, however, may cause a liquidity trap, where even though the interest rates fall below 1%, people are not stopped from saving, leading to a fall in circulation velocity, leading to deflation (Gali, 2008). Buying of bonds by central bank causes an increase in the monetary base and the bank reserves, and since banks do not want to have idle money that earns no return, they will loan out the cash, which attracts borrowers. Many borrowers make the banks to lower their interest rates, with the borrowers spending the cash on purchasing goods and services (Eberhardt, 2010). According to Walsh (2003), the expenditure results in incomes that are saved in banks, increasing the money supply in an economy, by a greater margin than the rate offered by central banks on their reserves due to the money multiplier effect. Jones asserts that, it will result into increased investment activity by business firm, increasing the aggregate demand and the GDP growth. When the central bank buys bonds from commercial banks; it results in excessive reserves for the banks. Some banks may want to raise cash on short-term basis if their accounts are below the reserve requirement or require the cash to give a loan to a big corporate client (2003). Question 1 task II Discount loans to the banks results in an increase of the monetary base and supply, every central bank has a discount window, where banks facing financial difficulties can go and get a loan. The central bank determines the volume of discount loans it can provide by setting the discount rate and determining when to open the discount window. Banks take discount loans to solve short term liquidity issues at a fi9xed discount rate set by the central bank (Richards, 2014). According to Mishkin (2012), the loans are also extended to the banks to help regions that have reserve fluctuations like the agricultural sector, or to banks having financial problems, though at a secondary discount rate. Banks are encouraged not to go for discount loans by, to avoid increased scrutiny from the financial regulators that handle liquidity management of the bank. It allows central bank to perform its function of ‘lender of last resort’, to financial institutions having financial troubles, to avoid panic in the banking centre. It also protects the large depositors from losses, as it prevents bankruptcy of the banks. According to Forbes (2014), they are however not ideal money supply tools, because they change the exchange rate and many speculators may view it as an ‘announcement effect’. And yet the central bank may only be interested in maintaining the interest rates. It is this fluctuating spread of central banks and discount rate that will cause a fluctuation in the volume of money supply and discount loans, making it difficult for the central bank to control money supply. It is the case because not all discount loans are controlled by the central banks, because they are also determined by the banks behavior. In addition, the discount rates are not easy to reverse, because it is almost impossible to change the previous loans. Question 1 Task III Open Market Operations Open market operations involve the activity of selling and buying of bonds by the governments. This technique is usually applied to implement monetary policies. The usual objective of open market operations is to maneuver the supply of base money and manipulate the short-term interest rate in an economy, and hence indirectly control the money supply, (Richards, 2014). Flexibility Open market operation is quite flexible as the government can determine the total amount of bonds to be sold or purchased from the public Reversibility It has high reversibility since it involves buying and selling of bonds. The two operations are antagonistic and they reverse each other. Effectiveness Open market operations technique is highly effective and gives instant results. The government can regulate the profit margin on the bonds in order to discourage or encourage individuals from buying or selling. Speed of implementation Relatively, open market operation method is yields instant results as people are more willing to buy the bond at a favorable consideration and again are more willing to sell them at a higher consideration. Thus, its implementation is quite expeditious. Central Bank Lending facility This technique involves the actions of the central bank to increase or decrease its lending interests to commercial banks. This interest change usually trickles down to the consumers and hence affects their borrowing culture. When the interest rate is favorable, many people will borrow while few people will borrow money when interest rate is low, (Richards, 2014). Flexibility This technique has little flexibility compared to the open market operations. This is because the method involves two steps; at the central bank and at the commercial banks. This implies that the technique requires a lot of capacity building before it is implemented. Reversibility It is not easily reversible. This is because when individuals borrow money from the bank, they will keep it for a long period in accordance the credit period. As such, reversing the borrowing will take several months or years. Similarly, lowering the interest rate does not necessarily mean that people will rush to commercial bank to obtain loans Effectiveness Compared to the open market operations, central bank lending technique does not achieve its objectives accordingly. It is imperative to note that there are other factors that are considered when a person is applying for a credit facility. This implies that albeit the interest rate may low, just a few people will be creditworthy. As such, the effectiveness of this technique is diminished. Speed of implementation This technique works by encouraging or discouraging people to obtaining or from abstaining from credit facility. Suppose the central bank lowers its lending rate to the commercial banks by 10%. It may take several weeks before commercial banks reciprocate the reduction on their credit facilities to the customers, (Richards, 2014). After the reduction of interest rate by commercial banks, it will take several weeks before the bank gets customer to take the credit facility. However, for very short term financial crisis, the technique is very applicable since it will prevent the collapsing of financial institutions that are facing financial crisis. Changes in reserve requirement Reserve requirement is the minimum amount of money that commercial banks are required to retain with the central banks. If the reserve requirement is small, commercial banks will have more money to give to customers hence increasing money supply. When the reserve is increased the money available for lending is small. Just like the central bank lending facility, reserve requirement technique determines individuals’ borrowing culture. The method is , therefore, not speedy to implement as it will take time to for the effect to reach the customer’s level. Its effectiveness is dependent on other factors that affect borrowing rate at commercial banks level. Flexibility and reversibility have been discussed in the previous topic and as such, the technique is less flexible with less speedy reversibility as compare to the open market operations. Question2 task I Balance of payment surplus is the amount by which the money flowing into a country is more than the money flowing out in a particular period of time. This is mainly caused by very high exportation when matched with importation, high inflow of foreign capital when matched with capital outflow and foreign loans and grants received by a country among others. All the three scenarios mentioned have the effect of increasing the amount of money that is circulating in the economy. when the money supply is huge, the demand of goods and services will go up. In this case, the market forces will come into play leading to increased prices of commodities. This will lead to inflation when the prices of all goods and services are affected, (Gali, 2008). Question 2 task II According to Santomero (2002), a foreign exchange market automatically affects the monetary policy. Flexible exchange rate changes depending on the private market that controls the supply and demand. If a currency’s demand is low, it decreases in value, increasing prices of imported goods and increasing demand for locally produced goods. Turk believes that, Central bank of a country can change its fiscal policy that relies on government spending to expand or reduce a country’s economy. Fiscal policies have an effect on exchange rates when the income, price and interest rates changes (2002). According to Richards (2002), when central bank reduces taxes, money will increase, increasing the demand for goods and services including imported goods, causing foreign countries such as America to sell more dollars in order to buy foreign currencies that ate used tom pay for the imported goods. The procedure ultimately reduces the ‘dollar exchange rate’, making products more expensive. The government can also use the expansionary policy to stimulate the country’s economy. The government can either reduce taxes or increase its expenditure to reduce the tax bill, increasing demand that pushes the prices of goods upward. Increase in prices increases makes it expensive for people to export goods to under countries but the imports become cheaper. It increases the appetite for foreign currency in order to purchase the imports, while reducing the demand for dollars to purchase local goods. The exchange rate is lowered, with the contractionary policy, where government spends less resulting in an opposite effect (Richards, 2012). Expansionary fiscal process to increase spending by government means that it has to get the cash from somewhere. The government raises cash through sell of bonds, which in turn raises the interest rates, which in turn attracts foreign currencies through foreign investors that want to take advantage of the high interest rates and have a higher return. The process will lead tom a rise in the exchange rate, with contractionary policy having a contrary effect (Forbes, 2014). Question 2 task III Benefits There is no exchange rate among the participating members. This will lead to greater competition, more investment and trade and hence lower prices for quality goods and services It increases the credibility of the country’s monetary system. This is because the international financial transactions are conducted by by credible institutions such as the European central bank, (Gali, 2008). It encourage greater heights of economic unification It increases a country’s global status Costs Joining a monetary union can lead to budget deficit as a result of asymmetric shock Can lead to economic fluctuations especially when the country is too small economically compared to other big nations The monetary policy may not be suitable to some countries due to incompatibility. Other non-economic costs include loss of culture and identity, pushed legislation and political dictatorship from bigger countries. Bibliography Eberhardt, D. (2010). ‘Buy Gold and Silver Safely: The only Book You Need to Learn How to Buy or Sell Gold’, 1st edition. California: California University Press. Gali, J (2008), ‘Monetary Policy in the Euro Area: Strategy and Decision Making at the European Central Bank’, 4th edition, New York: Princeton University Press. Forbes, S. (2014). ‘Money: How the Destruction of the Dollar threatens the Global Economy- and what we can do about it’, 2nd edition, Michigan: Michigan University Press. Jones, D, (2002). ‘Unlocking the Secrets of the Fed: How Monetary Policy Affects the Economy and Your Wealth-Creation Potential’ 3rd edition, New York: Wiley Publishers. Mishkin, F, (2012). ‘Monetary Policy Strategy’, 4th edition, New York: MIT press. Richards, J. (2014). ‘Currency wars: The making of the next Global Crisis, 2nd edition, New York: Harvard University Press. Richards, J. (2012). ‘The death of Money: The coming Collapse of the International Monetary System’, 3rd edition, New York: Harvard University Press. Santomero, A. (2002). ‘What Monetary Policy can and cannot do: It can do a Lot but it is important to know its limit’. Business Economics’, Vol 37 (1). Pp, 179- 198. Turk, J. (2012). ‘Money Bubbles’, 3rd edition, New York: Wiley publishers. Walsh, C. (2003). ‘The Monetary Theory and Policy, 5th edition, New Jersey: MIT Press. Read More