How Monetary Policy Rules Influences Economic Crises - Case Study Example

How Monetary Policy Rules Influences Economic Crises Name: Course: Professor: Institution: City and State: Date: Introduction Monetary policy rules are those rules that guide central banks on how to adjust the nominal interest rate to influence the level of output, inflation and other macroeconomic conditions. On the other hand, financial crises are associated with business cycles. They are a culmination of a period of economic growth that is usually followed by a downturn. During financial crises economic activities contacts as witnessed by reducing business activities. The aftermath of major world economic crises made economists and central banks acknowledge that the complexity of an economy is more important than earlier fathomed. In this regard, their ability to solve economic problems to avert economic shocks seemed unachievable. This lead to a situation where many economists seemed not to understand their economies in a way monetary policy rules could be applied effectively to prevent economic shocks and main stability. Nevertheless, the sense of misapprehension that resulted went contrary to the confidence people had on their ability to measure and control their economies. In this vein, those who viewed macro economies as too complex confirmed the imperfect understanding of its functioning. However, the recent economic crises reaffirmed the extent to which central banks can stabilize the economy with precision. In this view, economic crises doubled the efforts to enhance the robustness of macroeconomic policy rules. The central bank is charged with the responsibility of maintaining stable and low inflation rates. This should be in line with the definition of stable prices that averts major economic crisis. This study seeks to explore the impact of crises on monetary policy rules. How monetary policy rules influence economic crises There are various models that link monetary policy to financial crises. These models indicate that external shocks may lead to unfavorable changes in foreign exchange rates resulting in loss of reserves. However, if such unfavorable changes remain uncontrolled, it could lead to the credit crunch and financial crises. Smets and Wouters (2003) argue that weak monetary policy rules only serve to weaken financial institutions particularly when a significant portion of their liabilities are denominated in foreign currency. Taylor’s models explain that the financial sector related challenges gives rise to a currency collapse. This model also indicates that when banks decides to bail out troubled banks through increasing the money supply, this could have the potential of causing currency crash due to excessive money creation. Other models indicate that monetary and banking crises have similar causes. These models indicate that inflation converges to international levels resulting to cumulative real exchange rate appreciation. Notably, during the early stages of the economic stabilization plan, a boom in economic activities occurs as the current accounts continue to widen. As such, the stabilization program looks more unsustainable, and therefore, could lead to attacks on the local currency. Since the boom results in a decline in credit, the financial sector has been forced to borrow from foreign markets as local asset market crash and the capital inflows become the outflows. According to Ilbas (2010), such balance of payment crises is resolved through monetary policy rules such as a floatation of exchange rate and devaluation of domestic currencies. Through the application of such monetary policy rules, the central bank can resolve to contract monetary policy rules and intervene in foreign exchange markets in an attempt to overcome speculative attack. This could, on the other hand, lead to increases in domestic interest rates leading to massive loss in foreign exchange reserves. According to Calvo (1983), stable monetary policy rules help to prevent economic shocks by cushioning the economy from economic disturbances hence negating the chances of depression, deflation, hyperinflation and other economic crisis. Adolfson et al. (2011) asserted that the primary objective of monetary policy rules is to cushion an economy against financial risks in order to reduce the chances of the financial crash. Monetary policy rules influences financial stability. According to Clarida, Galí and Gertler (2000), monetary policy rules influence variables such as credit and asset prices making the rules exert amplifying effects if implemented haphazardly. Some economists argue that monetary policy rules play a key role in exacerbating the severity of economic crisis. For instance between 2002 and 2006, the US federal funds rate fell below the rule of thumb of a good economic performance. However, the interest rate provided by Taylor’s rule was more than the federal funds rate implying that such counterfactual policy rate would have controlled rapid rise of the housing market bubble. In addition, Givens (2012) asserted that abandoning such rule based framework influenced the likelihood and the degree of the financial crisis. Salemi (2006) argued that failure to take into consideration the impact of economic crises when estimating monetary policy rules is detrimental to an economy. Notably, banks apply margins in lending rate hence causing economic distortions as a result of inconsistent price setting and equilibrium allocation that is not Pareto efficient. According to Kahn (2012), monetary policy rules ensure stability of a financial system. In this vein, Taylor’s rule shows that high interest rate can reduce the severity of the economic crisis. Jensen (2011) suggested that monetary policy rules adopted by the Federal Reserve together with stringent supervision and regulatory framework could have been more effective in mitigating the effects of 2002-2006 economic crises. According to Taylor (1999), economies adjust their monetary policy rules after regime change. For instance, as Woodford (2001) noted, speculations by US monetary authorities led to the severity of US macroeconomic problems in 2000, but they were hesitant to act due to the presidential election process. In addition, macroeconomic changes such as changes in inflation levels were also found to influence monetary policy rules. Another event that affected the US economy was the 9/11 event where the Federal Reserve tried to restore the stable price environment. The federal funds rates were immediately lowered to ease the US monetary policy. In 2007, initial signals for the financial crisis were evident. This is after the economic growth started to weaken as the recession took root. Notably, the nominal interest rates were lowered close to zero and the financial markets were not responding favorably. Nevertheless, after significant moderation, the monetary committee found that the monetary policy making did not match with updates of the inflation target. This was due to the fact that the monetary policies implemented were hinged on short-run inflation targets that fell far below the long-term targets. According to Smets and Wouters (2007) this path of flexible inflation rate target was found to be inconsistent with any monetary policy rule formulated by the Federal Reserve. Evidently, economic activities were seriously affected by the 9/11 events. This event was also found to dampen the economic recovery following the moderate economic recession. Dennis (2004) argued that the discrepancy between current and long-term inflationary revels did not pose a serious challenge in the short-run to federal open market operations. Taylor (2012) pointed out that the difference between values estimated by the Taylor’s rule and actual federal funds rates proved that the existing monetary policy rules were unable to prevent further bubbles in the financial markets. This implied that the Federal Reserve should have taken into consideration the effects of potential crisis when estimating the monetary policy rules. In this vein, the Federal Reserve would have found it quite easy to counter the problems of unemployment and increased inflationary rates. This would have helped mitigate inflationary pressures found to negate US economic growth. Nevertheless, the US monetary policy rules were in future estimated based on macro economic conditions that followed the great depression. According to Salemi (2006), a well estimated monetary policy rules help to enhance cyclical fluctuations in employment and prices hence improving investor confidence and economic stability. Calvo (1983) noted that when economic growth dampens, lenient monetary policy rules could help stimulate aggregate demand to encourage employment. Similarly, when inflationary pressures rise due to intensive economic growth or economic crisis, a restrictive monetary policy rules are implemented to restore the ability of central bank achieve the most favorable macroeconomic environment. Jensen (2011) argued that, monetary policy is not an end to itself. The author further suggested that monetary policies must be useful to the extent of supporting the development efforts of respective nations. In this vein, focus on monetary policy rules should not be on inflation alone, but also explicitly consider growth and financial stability of an economy in order to lessen the impact of economic crisis. This was echoed by Ilbas (2010) who pointed out that one of the ways to accomplish this is to amend the existing mandates of central banks to accommodate financial stability and growth. The past economic crises showed the importance of considering the impact of economic crises when estimating monetary policy rules. This is because robust monetary policy rules were found to be critical in responding to adverse shocks. Active monetary policy rules are paramount in cushioning the effects of shocks on the economy’s output. In this vein, there is increased need to reform the present international financial architecture and primarily the approach within which international financial institutions respond to economies faced with balance of payment problem and economic crises. Putting this into consideration, the international financial institutions should consider relaxing policy conditions so as to enable economies to respond to economic shocks. This will enhance world economies to respond appropriately to economic shocks. As pointed out by Taylor (2012), there is increased need for economies to embrace prudence in the management of revenues during the period of booms in order to create a room for countercyclical trends in future. In addition, they should be resilient to counter external shocks and also attain a productive capacity. The world economies are not immune to both financial crisis and other imperfections of the market economy. According to Jensen (2011), this brings the need of taking into consideration the impact of economic crises when estimating monetary policy rules. It would help eliminate systemic risk when developing monetary policy rules. Therefore, international financial institutions such as the International Monetary Fund (IMF) should exercise an oversight responsibility effectively. Indeed, monetary policy rules are critical in the liberalization of capital accounts. However, the degree and pace within which different economies undertake liberalization depends on the level of financial market development as well as the quality and strength of regulatory institutions. Conclusion Global financial crisis experience ignited key reforms in the operation of monetary policy rules by many world economies. According to various measures employed by different economies after the economic crisis, increases in interest rates were found to affect the aggregate demand. Further, the exchange rate was also one of the monetary policy rules found to have been employed by many economies in response to the global economic crisis. As pointed out by Taylor (2012), when monetary policy rules are not robust, economic shocks could affect the output and asset prices could shoot upwards. In addition, credit markets and banks become unable to advance further credit. The global economic crisis encountered in the past years indicated the need to have a comprehensive, timely and coordinated response, besides a robust monetary policy rule. In this vein, many world economies increasingly coordinated their monetary policy rules. Moreover, such experience has enlightened policy makers to desist from merely formulating policies, but also estimating how such policies can respond to varying economic shocks. Therefore, policymakers must adopt a pragmatic approach to macroeconomic policy rules that take into account strengths and limitations of markets, as well as the state of economic development. References Adolfson, M et al. 2011. Optimal Monetary Policy in an Operational Medium-Sized DSGE Model. Journal of Money, Credit and Banking 43 (15),1287-1331. Calvo G. 1983. Staggered Prices in a Utility-Maximizing Framework. Journal of Monetary Economics, 12 (8), 383-398. Clarida R, Galí J., Gertler M. 2000. 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