Central Banks and Monetary Policy - Assignment Example

Central Banks and Monetary Policy Name: Institution: Date: Introduction Central banks are the government institutions, established and entrusted with financial responsibilities to perform certain functions within the economy. A part from serving as bankers to the government, a modern central bank provides various services to the commercial banks. It is a banker’s bank, though basically created to ensure effective control of a country’s currency (Brown & Yousefi 2010). This implies that the role of central banks has gone through an evolution. It is evidently pointed out in monetary theory work that the central banks work to minimize the impacts caused by economic fluctuations as well as reduce volatility within the financial system. Therefore, central banks pursue five major objectives so as to ensure that economic and financial stability is achieved. The goals include, price and financial stability, stable real growth, interest rate as well as exchange rate stability. The project examines how the central bank controls the quantity of money supply within the economy in relation to price stability. It also centers on the key roles of the central banks and how they conduct monetary policies with a focus on the United Arab Emirates (UAE) as the case study. Question 1: A brief discussion of the objectives of central banks More functions have been acquired as the central banks evolve into the public policy agencies. However, the main objective of that underlies all the functions of the central bank is geared to the economic interests of a nation which should be consistent with the government economic policy. One of the main objectives of the central bank is monetary policy that focuses on achieving price stability. Monetary policy is a means through which central bank controls a country’s supply of money as well as manipulates interest rates to enhance economic stability and growth. Price stability has been considered as the dominant monetary policy objective clearly specified within the legislation. In this case, stability means the domestic purchasing power of a currency. This objective is singular and more superior than other macro economic objectives stated in the law. For example, laws that require the central bank to support the government with its general economic policy without necessarily prejudicing to the central bank’s key objective of promoting price stability. On the contrary, when price stability is not legally stated as one of the main objectives of a nation’s monetary policy, other objectives that are legally stated are perceived to be too general in nature. This implies that when price stability is not considered as an objective within the law reflects lack of a legally dominant objective, instead provides a broad definition and use of currency value (Olafsson 2006). Achieving financial stability is also another key objective of the central bank. Most banks operate under the assumption that they are obliged to put into practice their policy responsibility to control price stability. Therefore, specifying the country’s financial stability objective means confronting the different issues associated with monetary policy objective. Important questions have been raised as to whether the financial stability objective may be assigned a quantitative representation analogous to the application of inflation targets in relation to the price stability objective. Research indicates that quantification provides a substantially clear framework for monetary policy guidance and accountability (Archer 2008). An objective regarding the payment system supervision has been frequently stated within the central bank law. The payment system is an area of the central bank that increasingly use the extra-statutory statements to provide greater specificity to the objectives as well as their linked policy frameworks. This is more common with the Federal Reserve Policy on the Payment System Risk. Through the payment system area of the central bank, international cooperation plays a greater role in defining the nature of the issues and the widely accepted standards that involve balancing of the robustness as well as efficiency considerations (Pringle & Carver 2003). Question 2: Scrutiny of the balance sheet of the central bank and how the following are determined: The balance sheet of a central bank is similar to that of any other bank. It is composed of the assets that are similar to the ones of common banks, including the government securities and discount loans. The government securities offers the central bank with the required income and liquidity asset that it can cheaply acquire and sell so as to modify its balance sheet. On the other hand, discount loan is the general loans given to the commercial banks. However, the liabilities of a central bank differ from the those in the common banks with its most significant liabilities identified as currency within the circulation and reserve (Kurtzig, Hemus & Goodwin 2003). (a) The monetary base The monetary base is the total amount of cash at the public’s disposal plus the the bank reserves. It is the duty of central banks to determine the monetary base from which the intermediaries generate bank money. An increase in the central bank’s assets means increased reserves of currency, implying that there will be more credit within the banking system. However, the non-monetary liabilities do not necessarily increase while the monetary liability increases create money. A reduction in the monetary base causes a monetary problem. This implies that decreasing the assets of the central bank without reducing the non-monetary liabilities, there will be a reduction in the monetary base. Different variations within the balance sheet of a central bank affect the monetary base, for instance, a deficit or surplus on the balance of payments cannot be controlled by a central bank. This influences the level of a country’s currency reserves (Hörnle 2008). (b) The money supply Essentially, the money supply is determined by the interaction of the four major groups which include commercial banks as well as other depositories and depositors, borrowers and the central bank. The interaction between the central bank, public and other banks determine an economy’s money supply. Since it is not easy to determine the real amount of money the economy may need at a given time, use of the quantity of monetary aggregates is not the most appropriate way to set an effective monetary policy. Knowing the economy's inflation rate is the ideal way to estimate whether the money supply is enough to meet different needs of the economy as well as to monitor the efficiency of monetary policy. The Consumer Price Index is the commonly used measure of inflation (Olafsson 2006). (c) Explanation of the role of banks in the money supply process Banks are considered as one important set of players within the money supply process. Banks are also referred to as depository institutions or financial institutions which accept deposits from various people, corporations as well as make loans. Since an economy’s money supply includes the demand deposits, its banking system play an integral role. Therefore, banks play a central role within the money supply process because they keep government securities and loans which earn them interest. For example, a person pays interest on car loans while the government pays interest for its loan as the bonds or securities. Furthermore, banks hold cash as reserves, though not earn them interest so banks are expected to pursue a profit so as to struggle and minimize the amount cash holdings. There is a link between the roles of banks holding government securities and cash as reserves. This is because the Fed sets the expected reserve rate for banks where the amount of cash required to be kept in a bank is specified so as to finance the demand deposits (Kurtzig, Hemus & Goodwin 2003). (d) How does the central bank control the money supply? Identify and discuss the tools of monetary control. Central banks use Reserve Ratios as instruments for achieving monetary control. Reserve requirements are imposed on the commercial banks so as to curtail their capability to expand money supply. The reserve requirements limit the commercial banks' capacity to lend commercially, and thus contains their profitability. The discount rate is also a tool or mechanism used by the central bank to modify the monetary base. It is an important tool because it determines the rate at which the central bank can be willing to lend the money to banks. For example, increased the discount rate means that credits which the central bank lends to various banks will be expensive, and thus banks will be forced to demand less. On the contrary, decreased discount rate means that the credits will be relatively cheaper which will motivate banks to demand for more money causing an expansion of the monetary base (Neeley 2000). In the attempt to control the quantity of money in supply, the open market operation could be used when the Fed decides to buy the government securities which in turn increases the bank’s reserves. Through making loans on the excess reserves, banks create money for the economy. However, when the Fed decides to sell the government security, the supply of money is reduced. An increase within the required reserve increases the reserves expected of banks to hold, decreases both their quantity of money and lending ability. On the other hand, an increase in an economy discount rate leads to higher cost of borrowing reserves from its Fed, and thus decreasing the bank’s reserves, lending ability and quantity of money. Most banks make use of the excess reserves from open market operation so as to make loans to enable banks acquire excess reserves from locations where such loans are deposited to continue the loan process (Mayes & Jan 2007). Question 3: The relationship between the money supply and price The link between money supply and price level fundamentally lies in the argument that the amount of money circulated within the economy, directly impacts the aggregate price level. This implies that high supply of money leads to an increase in demand for both goods and services, while a scarcity in the money supply reduces the demand for goods and services. It is quite clear that an economy’s amount of money in supply carry a direct bearing on its price level. It is relevant to argue that consumers can only spend if have money to spend, indicating that when there is a high supply of money within the economy, people will have a lot to spend. Therefore, the increase in demand as well leads to a corresponding increase within the price level. On the other hand, excess liquidity causes a situation where a lot of cash will be spent on the limited supply of commodities. Thus, causing the money to slowly lose its value which leads to an increase in prices. Most economists determine the state of their economies by evaluating the current relationship between money supply and the price level as their key indicator of economic development (Hörnle 2008). Question 4: The link between price stability and the other goals of the central bank Maintaining price stability has been considered of the key objectives of the monetary policy authorities. It is also universally accepted that price stability results into more economic well-being a nation by enhancing the efficiency of its own monetary system as well as riding the uncertainty about the nation’s future economic performance. The main reason to pursue the long-run price stability as argued by various central bankers is to control the costs associated with inflation. Monetary policy as a means through which the central banks control their money supply as well as manipulates interest rates so as to encourage economic stability and development. This targets specific objectives, for instance, achieving stability in prices and low unemployment. Promoting and maintaining a country’s financial stability is one of the major objectives of the central bank. This requires a keen focus on the financial remittance in regard to the financial crisis that has exposed many of the global’s largest economies into an era of unprecedented turbulence (Kiley 2000). Price stability is linked to the central bank’s objective of monetary policy because it plays a dual a dual role within the modern central banking system. It acts as an end and the means through which the monetary policy is implemented. Basically, the aim of price stability is to preserve the integrity as well as the purchasing power of a nation’s money. This implies that when prices are identified to be stable, individuals can easily keep money for transactions and to use for other reasons without necessarily worrying about the effects of inflation on the actual value of their respective money balances. Question 5: A description of the behavior of monetary aggregates, inflation and output in the UAE In order to determine the amount of money already in circulation, it is important to determine the exact meaning of money because money is more than a currency. This is simply because the concept money has evolved ultimately as the new services offered by banks can effectively provide the services of money. Money is quantified into different forms in accordance with their type, where the quantified total quantities are referred to as the monetary aggregates. Today, the money supply has been componentized into two main monetary aggregates namely, M1 and M2 which are commonly used by the Federal Reserve. M1 comprises of all the assets which can be utilized immediately as a direct means of payment, while M2 includes the M1 and all the assets kept in the accounts at financial institutions which can enable the withdrawal of cash whether immediately or after an agreed period of time (Hummel 2006). Based on the UAE Annual Monetary Growth: 2000-2011 table1, it can be argued that the major expansionary factor such as credit to the private sector could be grouped under the control of UAE monetary authority. Probably, this may account for the existence of this stable relationship between the monetary base and the key monetary aggregates (M1 and M2). From the cointegration analysis point of view, the table indicates a long-run relationship between monetary aggregates M1, M2 and monetary base in a period between the year 2000 and 2011. However, there has been a drastic increase in the monetary aggregates (M1 and M2) between the year 2005 and 2011. Considering the M1 and M2 as the nonseasonal monetary multiplier models, the two are adequately indicators of economic development. It is quite clear that the UAE monetary authority can potentially utilize the two models for a short-term forecast of their major monetary aggregates, the M1 and M2. The general level of prices within the UAE economy adjusts accordingly so as bring the supply of money as well as money demand into balance as indicated, G1 and G2 respectively. This implies that when the central bank of UAE increases its supply of money, it greatly influences the price level to increase as well. Therefore, persistent growth or decrease within the quantity of money supplied may lead to continued inflation or deflation respectively. The United Arab Emirates report by Zawya (2009) indicates that the monetary aggregates within the country slowed in that particular year. The central bank through its monthly monetary survey showed that the monetary aggregates within the UAE decreased markedly in 2009. This trend continued into the year 2010 where the larger money supply aggregate, M2 slowed down by 1.6% during the month of November, increasing by 5.9% in the first 11 months of the same year and at the annualized rate of about 6.5%. This provides a consistent data with IMF estimates of GDP growth. Conversely, the larger money supply, M3 decreased by 1.2% in the month of November, though with an increase in the government deposits by 0.5%. It has been reported that in a period of 11 months of the same month, M3 recorded a slower increase than the M2 by 4.1%. This was as a result of the decrease in the government deposits by 2.3 percent as per the central bank survey. The money multiplier was recorded to be equal to 4.1 by the end of November 2010 within the UAE. The recent variations in the UAE monetary aggregates seems to be largely influenced by changes in the documentations of deposits purchased by banks. Similarly, the money multiplier shows the amount of money supply, M2 that will rise as a result of the increase by the AED1 billion within the monetary base, or possibly the currency in circulation as well as reserves in banks at central bank and records of deposits (Zawya 2009). From the United Arab Emirates National currency table2 on GDP and Implicit Price Deflators, it can be noted that the GDP Index at current prices between 1995 and 2010 registered a consistent increase, though with a drastic increase from the year 2003 to 2010. There is consistent increase in the UAE GDP Index at 2005 prices, though with fluctuations in the Implicit Price Deflator. It is quite clear that an increase in the GDP Index at current price resulted in a consistent increase in the GDP Index at constant 2005 prices. This indicates that the central bank of the UAE has successfully managed to control inflation in the UAE by providing careful regulations on the supply of its Dirham, creating a stable monetary performance in the economy. The pegging of Dirham to the U.S. dollar forces the UAE Central Bank to adhere to monetary policy developed by the US FederaL Reserve so as to maintain a considerable value of Dirham. Currently, the UAE is adjusting itself to the changes in the global financial turmoil, and thus it maintains its currency steady against the U.S. dollar. It is a state of affairs required to continue for more years, despite the increasing diversification of the country’s economy. This is more specific to the financial business that increasingly warrant the need to shift to more flexible exchange rates (Bleaney & Francisco 2005). Question 6: A review of the performance of the UAE central bank. How are the interest rate and exchange rate stability in the UAE The existence of the stable relationship between the monetary base and the key monetary aggregates (M1 and M2), or the long-run relationship between monetary aggregates M1, M2 and monetary base in a period between the year 2000 and 2011. It can be argued that the central bank of the UAE has been to regulate the amount of money supplied in the country. This suggests that the interest rates have been controlled, making it affordable for more banks and individuals to acquire loans. Since the central bank has successfully managed to control inflation in the UAE by providing careful regulations on the supply of its Dirham, there has been considerable regulation of the money supply in the UAE. This indicates that the UAE has had a stable exchange between the year 2000 and 2011. The Dirham exchange rate system is currently fixed and more pegged to the U.S. Dollar. The Dirham’s fixed exchange rate could be as a result of the three main factors that provide the features of the UAE economy. These include the small economy, openness as well as nominal domestic stocks which exists as a result of large monetary expansion account for the fixed exchange rate system for Dirham. However, the inflation factor could support either fixed or the flexible nature of the system. Other four factors could be the great external imbalances, capital mobility, real domestic, external nominal as well as external shocks. This implies that the main objective of UAE considering such policy maker’s factors in their exchange rate regime is to ensure an inflation reduction (Zawya 2009). The emergent pertinent issues include, to determine how the modality of flexibility can be suitable for the UAE Dirham and to evaluate whether if the UAE economy has the required infrastructure to shift from its fixed exchange rate system that has served the economy for a long period of time to a modality of a more flexible exchange system. Studies indicate that the recent inflationary trend within the UAE raised questions concerning the pegging of Dirham with U.S . dollar. In relation to this, the UAE Central Bank Governor has over and over again argued that the register amount of inflation within the country was as a result of the non-exchange rate associated factors (Bleaney & Francisco 2005). Bibliography Archer, D., (2008), Roles and objectives of modern central banks, Issues in the Governance of Central Banks. Bleaney, M.F. & Francisco, M., (2005), Exchange rate regimes and inflation: only hard pegs make a difference, Canadian Journal of Economics 38, 1453-71. Brown, K.H & Yousefi, M., (2010), Deficits, inflation and central banks' independence: evidence from developing nations, Applied Economics Letter, 3(8), 505-509. Hörnle, D., (2008),The Relationship Between the Money Supply and the Inflation Rate and the Role of the European Central Bank in Changing the Money Supply, GRIN Verlag. Hummel, W., (2006), Money: What It Is, How It Works 2nd ed. Bloomington, IN: iUniverse. Kiley, M.T., (2000), Price Level Targeting, Inflation Targeting, and Variability: Does Price Stickiness Matter? Federal Reserve Board , mimeo. Kurtzig, J, C Hemus & Goodwin, I., (2003), Accounting for reserves, in R Pringle and N Carver (eds), How Countries Manage Reserve Assets, Central Banking Publications, London, pp 249-69. Mayes, D & Jan, T., (2007), Open Market Operations and Financial Markets. New York: Routledge. Neeley, C., (2000),The practice of central bank intervention: looking under the hood, Central Banking, 83(2), 1-10. Reprinted in Federal Reserve Bank of St Louis Review. Olafsson, T., (2006), Developments in Monetary economics and central bank practice, Central Bank of Iceland Working paper number 31. Pringle, R, & Carver, N., (2003), How countries manage reserve assets, in R Pringle and N Carver (eds), How Countries Manage Reserve Assets, Central Banking Publications, London, pp 3-31. Zawya, D.J., (2011), UAE monetary aggregates slow down. Appendix Appendix 1: Appendix 2: Read More