The Relationship between Price and Money Supply - Research Paper Example

?Central banks and monetary policy Table of Contents Objectives of Central Banks 3 Balance Sheet Analysis 4 The monetary base 5 The money supply 5 Role of banks in the money supply process 6 Central Bank’s Control on Money Supply 6 The relationship between price and Money Supply 7 Price Stability and other goals of Central Banks 9 Price Stability 9 Other Goals of Central Banks 10 References 15 Objectives of Central Banks Central banks are government bodies involved in the management of the money supply, the currency and the interest rates of the nations. They regulate all the commercial banks of the respective countries. They also have the duty to print and circulate the national currency in the market. There is one Central Bank in every country. The main objectives of these Central Banks are: 1. The Central Bank is involved in the maintenance of stability in the financial market through printing and circulating the nation's currency. This is done by issuing sufficient monetary instruments when required. The Central banks also help the government in designing the currency of the country, which includes all the unique features. 2. It is involved in regulating and co-coordinating with the government and the stated economic policies of the country. 3. The interest rates are also controlled by the central banks to maintain price stability within the country. It also has to keep a track of the inflation in the market. The Central Banks of all the countries have an effective plan for managing the public debts. They do this through the sales and purchase of government papers such as bonds and securities. 4. The Central Bank is also known as a banker's bank. This means that the commercial banks of the countries are also regulated by the Central banks of the respective country. The Central bank not only regulates them but also provide adequate financial assistance in time of need. 5. The central bank needs to ensure the proper functioning of the financial systems within the county. They regulate the banking system within the country and are answerable to the world market (Downes & Vaez-Radeh, 1991). Balance Sheet Analysis The Balance Sheet of Central Banks has the list of all the liabilities and the assets that the Central Bank possesses. It is important to study the balance sheet of the Central banks in order to understand how they implement the monetary policy because the balance sheet reflects the sales, purchase records of the Central Bank and also states the holding. The Central Bank is the in charge for issuing the country's currency and it also posses the power to eliminate the power of the currency. In short, we can say that the balance sheet shows the true picture of the actions of the Central Bank. The balance sheet of a Central Bank focuses on three main components: bankers to commercial banks, Issuing the nations' currency and banker to the government of the country (Jadhav, 2006, p. 246). The Balance Sheet needs to be analyzed from two viewpoints such as: as an issuer of currency and duty to maintain the price stability and the growth of the economy through attaining the monetary policies of the countries' economy. It is important to know certain important perspectives to understand the balance sheets of the Central banks. Firstly, the central banks are fully government owned. There are very few exceptions, but in that case there are certain restrictions on the share-holding patterns. Secondly, Central banks are the only banker for the government of ever nation. Finally, the Central bank also has to take care of the public debt. It has to always see that the net foreign asset is higher compared to the currency, so as to see that the domestic demand of foreign currency is duly met The monetary base The two components of money supply are monetary base and money multiplier. Monetary base includes the reserves and the outstanding currency of the economy. It comes in the asset side, in the balance sheet, of the central bank. It links the central banks to the other measures of the money supply. So we can say that money supply involves the reserves of the banks with the central banks and the currency circulated in the market It is very important to understand the factors influencing the size of the monetary base of the countries. It simply means the available funds and cash reserves of the central banks. The size of the monetary base usually depends on two factors: The Gold stock and the reserve assets with the bank. Every country has their stock for gold. The money supply also depends on this factor. It also depends on government securities, bonds, and debenture. This helps in creating liquidity in the market (Jain, n. d., p. 217). The money supply Anything that is used to purchase products and services is known as money. In other words, we can say that anything that is valuable enough to be used for trade is termed ad money. Money Supply is nothing but the total money in the economy at a specified time. It is recorded at regular intervals by the Central bank of the country. It is determined by the central bank at a calculated exchange rate. The Central Banks of nations keep changing the money supply to implement a perfect monetary policy. There are certain set of components on which the money supply of the economy depends upon. It acts as a link between the commercial banks and the central banks. The Central bank always has a monopoly position when it comes to creation of a monetary base in the economy. The central banks are involved in determining the monetary base, the interest rates, the reserves and they also set the discount rates for lending money to the commercial banks. The commercial banks has to determine their reserves against their liabilities at a given reserve ratio. The People determine their money holdings in comparison to their demand deposits. These are the three participants that help to determine the supply of money in the economy. Role of banks in the money supply process The commercial banks always borrow from the central banks during their needs. They often take loan to take to meet the reserve requirements. So if one bank borrows from the other than it does not create any change in the monetary base, so this is not taken into consideration which determining the supply of money (Beale, 2011). The commercial banks have big contribution in creating the supply of money in the economy. Banks lend money to the people thus increasing or decreasing the deposit component of money supply. The lending facility of bank is really important for business in the nation. They help people to encourage saving and facilitate mobilizing money through effective set of rules and regulations. Banks offer loan facilities to retail clients, thus increasing liquidity in the market (Bhole, 2009, p. 244-246). Central Bank’s Control on Money Supply The balance sheet of the central bank gives us a true picture of the money supply. The asset side of the balance sheet consists of government securities and loans. The government securities help in income and it’s a form of quick asset or liquid asset which can be easily converted into cash. Loans are generally offered to the other commercial banks or to the government. The liabilities of the central bank are the currency issued and the gold and money reserves. This is also called the money base of the economy. So the Central Bank has the power to increase or decrease the supply of money in the economy by regulating the bank rates or discount rates (Saylor, 2011, p. 9-11). The relationship between price and Money Supply Money supply plays a major role in determining the price level in the economy. The changes in the level of price can bring about several problems in the economy. This may also in turn influence the cost structures of different companies. Money supply is carefully balanced in order to avoid or minimize inflation in the economy. So if the money supply is not increased then there would a tendency of price increase, while might lead to inflation (Khanna, 2005). In this context we can consider inflation (increase in price) to be a monetary phenomenon. There is always an interval between the time of changes made in the monetary policy and the final result of the change starts showing up in the economy. Now, the length of this time interval is determined by the capacity of the people to adjust with the change in that situation. So we can say that it might take a months or longer time to express and give the real picture. It is really difficult for Central banks to maintain price stability. Price stability means the duty of the Central banks to maintain the price levels in the economy and see that the changes are low. Price instability often leads to creation of hurdles in important economic decision, and inflation, whereas; fall in the price level leads to depression (IMF, 2006, p. 24). When there is too much liquidity in the market, that is, the purchasing power of the people become high and the value of the goods and services falls, then there is a depression. On the other hand, when the supply of money is low, people really have to pay more than deserved price for the available goods or service in the market, then there is inflation. In both of the cases the economy is harmed. So proper flow of money or money supply is very important to maintain the price, that is, stabilize the price in the economy. The price and money supply is directly proportional to each other. As we see that whenever the money supply increases, there is an increase in demand through increase in price. If we consider the cash balance ratio, then we will understand that during a particular time, the money supply being constant, the changing demand will have more affect on the price level. It also states that the demand of money is not only to purchase but also to store, that is, money is not only important for transaction but also for value or storage for future. So if the money supply remains constant, it might also happen that people would try to save more, thus the demand for goods and service would fall. The relationship can be stated in another way by saying that when the price level tends to increase then the demand of money also increases. This means that that the value of money actually decreases. So, we can conclude that the price stability of a nation is largely depended on the monetary policy of the nation. The price volatility can lead to confusions in decision making. It can also adversely affect the savings (Jain, & Khanna, 2007, p. 292). Price Stability and other goals of Central Banks Price Stability One of the main objectives of Central bank is to control price and stabilize its movements in the economy. Several countries are really concerned about making solid framework for risk free monetary policy and a stable price structure. It is the primary function of the Central bank to circulate the currency in the country. So it is the duty of the government and the Central Banks to use the monetary instruments to lower the rate of interest stabilize the price and see that there is a stable price fluctuation in the country's economy. Price stability is a very simple concept. It means that the price will remain constant without much of fluctuations in the country. It also means that the country's economy is not facing inflation, depression or any form of recession. It helps to makes the monetary policies of the central bank along with the government precis and transparent to the people. It also acts a mirror reflecting the future price situations in the country. It is the foremost duty of the government to ensure that the products and services are made available to the people at a reasonable price. When the Central bank increases the supply of money in the market by floating bonds and government securities, or it may lower the rate of interest on loans, the value of money decreases increasing the liquidity in the market. The demand will increase due to increase in money supply. So seeing the increasing demand the producer and manufacturers might increase the price gradually and it may again finally lead to inflation. So this denotes that to avoid inflation excessive liquidly is also harmful. The Central bank should stick a proper balance between liquidity and inflation (Herrmann, 2011, p. 23). Other Goals of Central Banks There is one Central Bank in every country. This signifies that it performs lot of activities that none of the commercial banks can do alone. The goals of Central Banks are many apart from price stability, but a few of them are stated below: High Employment: If the rate of unemployment is high in a country then it would increases the society cost. So, Central banks along with the government come up with several plans and policies to provide employment to maximum unemployed people in the country, especially people staying in rural areas. Stability of the exchange rates: The exchange rates are nothing but the value of the currency in the world market. It is duty of the Central bank to maintain as much possible foreign currency reserve, so as to maintain the value of the currency in the world market. The fall in the value of current is a negative single for the economy. The overall economic growth of the country: It is the responsibility of the government to make economic policies and act upon them. But this task is not achievable without the help of the Central banks. It promotes economic growth by finding out means or policies to revive the economy. The stability of the financial Market: The financial market consists of the stock market and the other commodity markets. The economy of the country is highly depended on the financial market. So the regulation of the policies and liquidity of the market needs to be ensured. This is also a primary goal of the Central bank. Regulating of bank rate or discount rates: The central Bank controls the interest rates and the discount rates at which loans are lend to the commercial banks. This has a major effect on the price stability. Question 1: Describe the behavior of monetary aggregates, inflation and output in the UAE (see in table) The United Arab Emirates (UAE) is the collection of seven small Gulf emirates. The economies of these countries were mainly depended on fishing and pearling, before the discovery of oil in these areas. About 70 % of the people were involved in these professions. The rest 30 % were involved in agriculture and in other works. The oil transformed the country’s economy totally. It helped the country to really compete with the developed countries. This change has come overdue to four main factors: Firstly, the decision of the government to invest on development of amazing infrastructure was a great boost to the economy of UAE. Secondly, they have always tried to maintain a low inflation rates and a stable economy. Thirdly, there is high flexibility in foreign trade. All tax free income and products available, makes the country attractive to the tourist. Lastly, accumulation of labor at a low cost from neighboring countries for making the city a paradise to the shoppers and the tourists. Monetary Aggregates The term Monetary Aggregates involves calculating the supply of money in the economy of the country. There is a standard to calculate the monetary aggregates. These include M0, M1 and M2. M0 denotes the supply of money. M1 denotes all the physical currency in circulation and also the demand deposits or traveler’s checks. While, M2 includes the quasi- monetary deposit sand M1. There is also M3, which signifies the total of M2 and the deposits of the government of the country. So, from the table we can conclude that the M1, that is, currency and other deposits have increased at a considerable pace from year to year. On 2011 it’s the highest, that is, 260 billions of dirhams.Similarly, M2 has also shown a consistent increase in the consecutive years. Inflation The inflation in UAE was 0.7 percent in January 2012. The rate of inflation increased from 6.75 to 11 percent from the year 2002-2007. So, within this span of time the lowest rate of inflation was 2.90 percent in the month of December 2002 and the highest was 11.0 percent in December 2007. To measure the inflation in the economy special financial instruments are used, such as CPI and GDP deflator. CPI is used for measuring the prices of the consumers while GDP deflator is used to calculate the whole economy's inflation. Output in UAE The difference between inflation and the economic condition or position of the country is denoted as output. It needs to be estimated. The output gap is also explained as the difference between the actual outputs to the potential output. So, it the output is balance is positive then it denotes that the aggregate demand is in excess and this may also lead to increase in the price leading to inflation. On the other hand, the output gap is negative then the price may decrease leading to fall in the rate of inflation. So when the result of the output gap is positive then the Central Banks apply a monetary policy to put restrictions on the demand aggregates, so as to stabilize the price. So we can say that the output gap is very essential to predict and indicate the future price (Elhiraika & Hamed, 2002, p. 1). Question 2: Review the performance of the UAE central bank based on the above data. What can you say about interest rate and exchange rate stability in the UAE? UAE has a very well organized monetary policy due to which they are always capable of controlling the price factor and keeping a low rate of inflation in their economy. The currency of UAE is known as dirham. They usually follow the standard of dollar in the market. In the world market, price of currency of a country is when compared to the relative price of the other country's currency, and then it is known as the exchange rate. These measures are taken by the world market for the smooth functioning of the world trade without any hurdle. It creates a standardized medium for trade that is export or import. The buying and the selling prices of currency may always differ. The UAE Dirham always follows the US Dollar. So the value of both does not differ much mostly. Last 12month, the exchange rate of dollar and Dirham was equal. Actually the world market usually considers the US dollar to be a standard currency. To the dollar all the other currencies are relatively compared to ascertain the exchange rate of currencies. The recent crunch in the real estate Industry has created an unpredictable situation in Dubai. This was mainly due to the increase in the non-performing loans, the rate of mortgage loans were fixed the people whose properties were ready, were not accepting the ownership due to the fear of losses in their investments. But in next years to come they have recovered from this situation. So in order to encourage people from other countries to invest in Dubai, all the banks that are operating in these countries have slashed their interest rates on the home loans or mortgages. So, as the loan rates have lowered, so banks are also able to provide lower interest rates loans to individuals. Decrease in interest rates in a significant step in attracting more buyers from the world to invest in the country, especially in real estate. We have seen that almost all the Gulf countries have always tried to follow the dollar prices. It has always strongly competed the US dollar. But due to the real estate and mortgage loan issues have come up, it would be helpful for the UAE economy if exchange price of dirham lowers. This can happen by the reduction of interest rates by the Central bank. It will attach foreign investors. Thus, it would lead to the stabilization, which was interrupted due to Dubai crisis. References Beale, L. (2011). How Banks Create Money. Retrieved from http://ecedweb.unomaha.edu/ve/library/hbcm.pdf. Bhole. (2009). Financial Institutions & Markets 5E. India: Tata McGraw-Hill Education. Downes, P., & Vaez-Radeh, R. (1991). The Evolving Role of Central Banks. New York: International Monetary Fund. Elhiraika, A. B., & Hamed, A. H. (2002). Explaining Growth in an Oil-Dependent Economy: The case of the United Arab Emirates. Retrieved from http://depot.gdnet.org/gdnshare/pdf2/gdn_library/global_research_projects/explaining_growth/UAE_final.pdf. Herrmann, C. (2011). European Yearbook of International Economic Law 2011. Germany: Springer. IMF. (2006). The move to inflation targeting- back to basic. Retrived from http://www.imf.org/external/pubs/ft/fandd/2003/06/pdf/basics.pdf. Jadhav, N. (2006). Monetary Policy, Financial Stability, and Central Banking in India.UK: Macmillan. Jain, T. R., & Khanna, O. P. (2007). Economic Concepts and Methods. India: FK Publications. Jain, T.R. (no date). Macroeconomics and Elementary Statistics. India: FK Publication. Khanna, P. (2005). Advanced Study In Money And Banking Theory And Policy Relevance In The Indian Economy, Vol. 2. India: Atlantic Publishers. Saylor. (2011). Chapter 14. The Money Supply Process. Retrieved from http://www.saylor.org/site/wp-content/uploads/2011/07/ECON302-4.2.pdf. Read More