Central Banks & Monetary Policy - Research Paper Example

? CENTRAL BANKS & MONETARY POLICY Central Banks & Monetary Policy Objectives of central banks Introduction As the new roles of central banks changed into agencies of public policy, there were underlying objectives that were infrequently stated. In the context it is used, an individual can conclude that objective that underlie all functions for the interest of the economy, is consistent with economic policy of the government. If compared to a case where objectives included both dimensions of public policy and commercial, such statement significantly increased the clearness of the direction given to bankers with central banks. There was an identity of logic of purpose. They were mandated with the role of discharging their functions in a way that is related to the interest of the public, considering state agencies’ functions and coordinating them. It is to the degree that the interest of the public could be provided by the addition of functions not assigned to the better (Callaghan, 2009). Hence, most central banks started to assume roles for financial sector’s development; payment system oversight and money operation, foreign exchange, capital market and debt oversight. From the present objective, such an interest objective exposes itself to understanding and provides directions on what is to be done when views or functions as to nation’s interest. It is only in the recent past that attention has been awarded to objectives identification for function of individual and to objectives potential to conflict. Specifying objective trends have emerged, but functions of many banks are not directed by legal objectives. Objectives of Monetary Policy Price stability dominates the objective of monetary policy that is made specific in legislation. The stability of currency purchasing power is dominating legal objective. In most situations, it is always superior to other objectives. In contrary, if stability of price is not specific, the legally specified objectives tend to be general. In fact, if the stability of price is not stated specifically as a goal, then there is no objective that legally dominates, and instead definition of value of currency is used (Cecchetti, 2011). There are conflicts which arise if various actions of monetary policies are driven by various objectives. For instance, objectives that regard stability of price and variables of the real economy are concerned with such conflicts. Secondly, is about rate of exchange regimes- local stability of price and stability in the exchange rate requires adjustment of interest rates in directly opposite positions. The conflicts raise interpretation issues of objectives that are legal where both currency and price stability are specific as objectives of monetary policy. If the stability in price would be equal to stability in currency, then conflict potential would be solved. Other ways of solving potential conflicts are; making sure that precedence orders are among objectives, recognition of lower levels to be in a position to clarify and interpret legislation’s higher level, use of extra-statutory agreement, which provide law interpretation on which the central bank agree, and lastly, taking into accountability the technical feasibility. Objectives Financial Stability Most of central banks presume that financial stability has policy responsibility. In a few situations where the central bank is faced with legal objective that is explicit for stability in finance, objective is of a wide range and the responsibility of central banks far reaching. However, in other situations where there are well set objectives for functions of financial stability, the language’s implication is an extent of results responsibility, with these banks charged with stable, safe or sound system of finance. Making a financial stability specific entails confrontation of issues discussed relating them to objectives of monetary policy. It is not an objective that is absolute- financial stability is always flexible. The extent is what varies. There is no standard way to the measurement of financial stability, and this complicates its intention, and if achievement of appropriate sum is reached (Callaghan, 2009). Tradeoffs are to be taken into account. It entails dynamic and allocative efficiency of intermediation of finance. Secondly, there is another that entails potential incompatibility compared to other objective policy. Separate from being a last resort lender, up to date there are no instruments of monetary policy that is suitable for the role of safeguarding stability in finance. The instruments in charge of this role have got other tasks, which are inclusive of money stability interest rates; regulation of finance for efficiency of the market and micro stability and institutional; and micro soundness or institutional prudential supervision. Diversion of those instruments from the basic purpose entails unintended consequences risk and trade off. Recent events sufficiently illustrate these issues. Ideally objective statements would specify a suitable treatment of trade-offs if they arise. Many a time’s central banks are externally focused to take into account efficiency of the economy in their acts. But the directions to take into account efficiency do not clarify wholly the intended action, in any case, they are challenged by a trade-off. The extent of stability and trade-off remains open. When financial and monetary stability objectives clash, laws of many central banks go silent on the way of balancing arising risks from trade-offs. Partially, the silence stands for inadequate knowledge of involved underlying mechanisms. And partially, may imply trade-offs that have complex directions. Among the mechanisms used in the treatment of trade-offs that are mentioned in monetary policy discussions was found out to be conflicting items (Callaghan, 2009). Objectives of the Payment Systems An objective which relates to oversight function of payment system if frequently found in the law of central banks, particularly if the law had been written again ten years ago. Nevertheless, objective statements are always general. Their supervision on operation of payment system and clearing and satisfaction that is sound and efficient. In this area of policy, there are tradeoffs, efficiency versus robust. Hence, much foregone discussions that relate to objectives of financial stability also apply here. The statutory statements increase in use to provide extended specificity to policy frameworks and their related objectives. The reserve policy of the federal on risk of payment system is a situation in point. To add to that, in the area of payment system, an important role has been played by the international cooperation in the definition of issues’ nature. Their standards are also widely accepted inclusive of balancing efficiency and robustness considerations. Economic growth rate The growth rate of an economy can be improved by investing capital. An interest rate that is low suggests that companies can loan out money for investment in their stock of capital and pay an interest that is less. Decreasing the interest is hence considered to boost the rate of economic growth and is always applied in alleviation times when the economic growth is low. Besides, increase of interest rate is always applied when the rate of economic growth is high like a device of contra- cyclical to protect the economy’s overheating and market bubbles. Interest rate stability The obvious and most visible strength of central banks is influencing the interest rate markets. As much as the mechanism if different in countries, most conform to the same mechanism. The effort by the central banks to stabilize interest rates is generally controlled by borrowing and lending money until the market rate that is targeted is adequately close to targeted one. Central banks thrive in maintaining of stability by borrowing and lending money to a specified quantity of banks that are qualified or by selling and purchasing of bonds. Exchange rate Another major objective of the central bank is to oversee the control of exchange rate of the economy. The objective is reached by an increase of money supply via foreign currency purchase by the central banks. This is done by selling or issuing local currency. The central bank subsequently may reduce the supply of money through various means, inclusive of selling bonds. Determination of Money Base In economics, base money relates to supply of money or economy’s quantity of money. The money base is money that is very liquid which comprises of paper money, coins and reserves of the commercial banks that are kept in the central banks. Money measures are always categorized as M levels. This is where money base is lowest and smallest in level M. Money base can be given a description of most liquid or acceptable form of ultimate payment. Money supply in broader measures also is inclusive of money which is not base money like demand deposits and other accounts of deposit (Cecchetti, 2011). Operations of open markets are part of tools of monetary policy, which affect monetary base directly. The money base contracts or expands by use of contractionary policy or expansionary policy but with risk. The money base is generally controlled by a country’s institution which runs monetary policy. The central banks or finance ministry carry out this function. The central bank in particular is vested with the responsibility of printing currency and releasing the currency to the economy or withdrawal of the currency from the economy via transactions of the open market. Central banks are capable of manipulating activities of the bank by changing rates of interest and changing reserve bank requirements. Money base is referred to as high powered as it increases results into bank money increase in a larger degree. This effect is called money multiplier. Money Supply and Bank Roles in Money Supply Money is a value store, value standard and exchange medium. Barter trade emerges where there is no money. In barter trade, there is always the wants ‘double coincidence which is inefficient. Monetary and money economy enable efficient transactions. In the process of supply of money, the main players are depositors, the Fed and banks. A bank can be defined as an institution which accepts individuals’ or firms’ deposits and then make investment of the takings in loans and securities. It must then hold part of the deposits as reserves. The other remaining part that is not reserved is channeled to investment. This move always leads to the expansion of the sum of money supply (Friedman, 2006). There is a simple model that shows an expansion of multiple deposits. It involves the following assumptions: existence of only a bank, required reserves are held by the bank, no currency is held by the public and central bank commences by increment of reserves by 100 dollars. The requirement of the reserve is the deposit percentage which is separated aside for liquidity or regulatory purposes. Excess funds from the reserves required are excess reserves, which do not have returns and, therefore, are not lent out. The excess reserves are always calculated and the process that results to many deposits from one is called expansion of multiple deposits. R-=R-(0.10) D. This is the formula for working out excess reserves where Re is excess reserves, R is total reserves, Rr is required reserves and D is deposits. Formula of deposit expansion Deposits equilibrium level requires working out reserve multiplier D= where r is the total reserve, r is the reserve ratio and D is the deposits. Reserve level change leads to deposit change This model can be extended to include depository categories. Reserves R plus currency C is the money base B=C+R In case currency is held by the public and deposits of two types and excess reserves held by the bank, the deposits of two types are deposits that are checkable Dc and deposits related to time Dt D=Dc+Dt The required reserves are Rr=rcDc + rtDt, it’s then added to the reserves that are excess B= rcDc + rtDt +Re+ C. This equation can be used in the derivation of reserve multiplier Dc= (B-rtDt-Re-C) For a long time, there have been debates by macroeconomists on the relationship between economy behavior and the money quantity. They also believe money supply increase will result in increased output and inflation. Therefore, it is vital for determination of money quantity. There have been debates on the instruments that are supposed to in the money supply definition. The two common definitions from Fed are; M1 is inclusive of checkable deposits, travelers, currency and demand deposits M1= Dc + C and M2 consists of repurchase agreements, time deposits, accounts of money markets and saving deposits plus M1. M2= M1 + Dt Assuming that excess reserves, currency, and time deposits all increase uniformly with deposits, then when these deposits change, other classes will change uniformly. The parts are given by C=  t=  e=  where c is currency relative to checkable deposits t is time deposits relative to checkable deposits e is excess reserves relative to checkable deposits For money base, substitution is done in the equation B= rcDc + rctDc +eDc+ cDc Dc=  Recalling M1= Dc + C then M1 = = m1B Similarly to M2=  From the above multipliers, it is shown that if the ratio of the required reserve increases, decreases m2 and m1. If c increases, there will be decreases m2 and m1. If e increases, there will be decreases m2 and m1 and if t increases, m1 increases but m2 decreases. The major functions of banks in the supply of money is to control the reserve ratio of deposits. If the reserve ratio deposits are lowered, the loan given by banks increase and the money multiplier increases and if the deposit ratio of currency is low, the money base that is held by the public will be low, and consequently the money multiplier will be low. Monetary Control Tools Monetary Base Monetary policy implementation can be done by change of the monetary base size. The Fed makes use of open operations of the market for monetary base change. The Fed sells or buys asset reserves in exchange for deposit money at the Fed. The deposits can be converted to the currency. Both the deposits and currency add up to the monetary base that is a liability to Fed in its monetary unit. Often, some banks put base money into use as a partial reserve and extend money supply circulation with a big amount. Reserve Requirement Bank control on monetary control is done by authorities. Implementation of monetary policy can be done by change of proportions of the assets commercial banks should hold as reserves with the Fed. A small portion is maintained of the assets in the form of cash that is liquid. The other portion is not liquid. By total asset proportion change in cash to be held, the reserves create changes in available funds that can be loaned. This changes money supply. The central banks do not affect reserve requirement. This is because there are volatile changes that are volatile in supply of money because of lending multiplier. Window Lending Window lending in discounts is where banks, institution of depositories, have the ability for reserve borrowing from the central bank at a rate of discount. Usually, this rate is set below T bills. This allows variation of credit conditions by institutions; hence affect the supply of money. This is the only instrument that the central banks do not have control over. As the supply of money is affected, it is concluded that there can be the establishment of unemployment, inflation, economic growth and interest rates ranges by monetary policy. An environment that is financially stable is created where by investments and savings occur, hence for allowing economic growth wholly. Interest Rates Monetary supply contraction can be indirectly achieved by an increase in interest rates. There are different levels of interest rates controlled by monetary authorities. An individual cannot set targets on both interest rates and monetary base as they are adjusted by one tool. Under the control of the monetary authority, if interest rates are increased, money supply can be contracted as higher rates of interest discourage borrowing and encourage savings. Both effects minimize the size of supply of money. Currency Board This is a board of currency that pins the bases of money of countries. It operates essentially as a hard exchange rate that is fixed in which the local currency that circulates is supported by fixed rate foreign currency from the nation that is anchoring. Hence, in order to develop the monetary base locally, the same amount of the foreign currency should be in reserves with the board of currency. This limits inflation of other objectives by the monetary authority locally. Currency board work on three principles namely; importation of the anchoring nation’s credibility, maintaining exchange rate that is fixed with the nation that is anchored and establishment of exchange rate credibility. Theoretically, there is a possibility of a nation pegging the local currency to many foreign currencies though, it is not practical. There is a special situation where by instead of the local currency be linked with the foreign currency, it is linked by gold value. This case is known as a gold standard. The excesses in BOP of that economy are shown via the local deposits that are held at the Fed by other banks. Growth in supply of money domestically is tied to the central bank’s additional deposits which equals hard reserves of foreign exchange additions in the custody of central banks. The disadvantages are that the economy has lost the ability to establish policy of money in accordance to local consideration and exchange rate that is fixed to some extent set the trade terms, regardless of the differences in the economy between trading partners and it. The boards of currency have advantages for open and small economies which find a policy of money to be difficult to endure. Unconventional Monetary Policy The other ways that are employed when the rate of interest is at zero percent in monetary policy and concerns on deflation occur are called unconventional monetary policy. They are inclusive of quantitative easing, credit easing and signaling. Taking the case of credit easing, assets of the private sector is purchased by the central bank for improvement of credit access and liquidity ability. The signaling measure can be applied in lowering of expectations of the market for interest rates in the future. For instance, in the time of credit crisis in 2008, the central bank of US showed that there would be low rates for a long period, and Canadian bank made a commitment that was conditional to maintain the rates at 0.25% up to the start of the third quarter. Money Supply and Price The relationship between price and money is directly proportional. In the classical theory, change in money is through demand effect channeled by price levels. The main link is how the expected real balances relate with the actual ones. Classical economists believe that the main reason for holding money is for transaction reasons. Therefore, assuming the economy operates at full employment, the household would have preferred constant amount of the real balance. As the supply of money is assumed to be external, at price levels that exist, the supply of money dictates actual real balances. The velocity with which people spend creates the differences on money held. Assuming that the economy operates at its full capacity if spending increases, an upward pressure is exerted on prices. This will continue to increase till the holders of cash reaches satisfaction of holding the existing money. The equilibrium is stabilized immediately there is adequate rise of rice that results to real balances of cash. Price Stability and Other Goals Price stability dominates the objective of monetary policy that is made specific in legislation. The stability of currency purchasing power is dominating legal objective. In most situations, it is always superior to other objectives. In contrary, if stability of price is not specific, the legally specified objectives tend to be general. In fact, if the stability of price is not stated specifically as a goal, then there is no objective that legally dominates, and instead definition of value of currency is used. There are conflicts which arise if various actions of monetary policies are driven by various objectives. For instance, objectives that regard stability of price and variables of the real economy are concerned with such conflicts. Secondly, is about rate of exchange regimes- local stability of price and stability in the exchange rate requires adjustment of interest rates in directly opposite positions. The conflicts raises interpretation issues of objectives that are legal where both currency and price stability are specific as objectives of monetary policy. If the stability in price would be equal to stability in currency, then conflict potential would be solved. Other ways of solving potential conflicts are; making sure that precedence orders are among objectives, recognition of lower levels to be in a position to clarify and interpret legislation’s higher level, use of extra-statutory agreement, which provide law interpretation on which the central bank agree, and lastly, taking into accountability the technical feasibility. Behavior of inflation, monetary aggregates, and output in UAE From the table, an assumption can be made that money growth is external to prices. This means that growth of money causes inflation. Moreover, as conventional wisdom states that money supply that is high money supply leads to the rise in prices, it can also be argued that rise in prices leads to money supply that is high. Having focused on M1 rather than M2, as it shows the transaction balances. Form the table, there is extended lag on the impact of money supply on inflation. Performance of the UAE central bank The exchange rates that are fixed in UAE led to inflationary pressures since the year 2004. Excess money fueled boom that was ultimately followed by UAE bust in 2009. An exchange rate that is floating targeting inflation policy moderated price bubbles and stabilizes output and the rising inflation of UAE. The UAE seems not to be aware of their negative rates of real interest and the disaster that might be approaching it (Taylor, 1999). Reference Athanasios, O., & Williams, J. C. (2002). Robust Monetary Policy Rules with Unknown Natural Rates. Brookings Papers on Economic Activity, 63-118. Brillembourg, A., & Khan, M. (1979). The relationship between money, income and prices: has money mattered historically. Journal of Money,credit and Banking,, 358-365. Callaghan, M. (2009). Reform of the International Financial Institutions. Workshop on the Global Economy ? Causes of the Crisis: Key Lessons, (pp. 120?128). Mumbai. Cecchetti, S. (2011). Money, Banking and Financial Markets - Global edition. London: McGraw Hill Publishers. Edwin, T. (2009, January 22). The IMF and the Global Crisis: Role and Reform. Speech to the Tulsa Committee on Foreign Relations and to the Dallas Committee on Foreign Relations. Friedman, M. (2006). The Quantity theory of Money. (M. Friedman, Ed.) Chicago: University of Chicago Press. Jehle, G. A., & Reny, P. J. (2001). Advanced Microeconomic Theory (2 ed.). Amsterdam: Addison-Wesley. Plosser, C. (2008). The Benefits of Systematic Monetary Policy: Speech to the National Association for Business Economics. Washington Economic Policy Conference. Schadler, S. (2009, February 11). Returning to rules: Reform of the International Monetary System. Financial Times. Truman, E. (2009). The Global Financial Crisis: Lessons Learned and Challenges for Developing Countries. Eighteenth Cycle of Economic Lectures, Banco de Guatemala, Guatemala. Visco, I. (2009). The Global Crisis: The Role of Policies and the International Monetary System. Workshop on the Global Economy: Causes of the Crisis: Key Lessons, (pp. 57-79). Mumbai. Taylor, J. B., 1999, A Historical Analysis of Monetary Policy Rules, in John B. Taylor ed., Monetary Policy Rules, Chicago: University of Chicago Press for NBER, 319-40. Read More