Central Banks and Monetary Policy - Research Paper Example

?Central Banks and Monetary Policy Affiliation with more information about affiliation, research grants, conflict of interest and how to contact Central Banks and Monetary Policy Central banks have a broad variety of responsibilities, from controlling monetary policy to applying definite goals such as financial stability, reduce inflation and income employment. Central banks are also normally concerned with currency, collection, as they are the bank of the government. They control the credit structure, supervise commercial banks, deal with exchange funds and operate as a lender of previous alternative. 1. Discuss briefly the five objectives of central banks. The main purpose of a central bank is, briefly, to supervise a nation's currency. This is attained by setting monetary policy. Following are the five important objectives of central banks; Price Stability: The main objective of a central bank is price stability, or in other words, a stable and low rate of inflation. “Price stability is defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%.The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term” (The Definition of Price Stability n.d para 2). Conversely, the existing view between economists is that in the long run, given that inflation is stable and low, monetary policy only influences nominal aggregates, for instance inflation, the nominal exchange rate and nominal interest rates, and not only their long-term development levels in actual terms. In the long run monetary policy consequently controls its monetary value, which are general prices. Real Stable Growth: In the banking system of urbanized countries there is a stable connection between various interest rates. The lowest price is the one charged to banks by the central bank. “This rate is normally 1-2.5 percent higher than the rate of inflation, depending on the monetary policy stance.” (Trade and Development Report 2008 by United Nations Conference On Trade and Development 2008). In actual terms, all these rates stay close to the actual growth rate of the financial system. One of the most significant circumstances for successful growth is the growth of various sectors including, the financial sector, which cannot deviate enduringly from the growth of price added of the financial system as a whole. Financial Stability: Financial stability illustrates the situation where the financial intermediation method functions easily, and where there is assurance in the operation of important financial organizations and markets within the financial system. Central banks have traditionally played an important role in the management of economic crises, lending to solvent, other than illiquid organizations as a last resort, still if this role has rarely been buttressed or formalized by legal authorities. Central banks consequently have objectives that are reliable with a leading role in a special resolution regime. They can also organize tools that are already in their area (LOLR) to maintain financial stability. They can, additionally, draw on expertise in the study of financial stability, containing the significant ability to measure the crash in markets, payment methods, and the financial communications at large. Interest Rate Stability: Interest rates provide global savers a reason to transfer money from one country to another in search of the safest and the highest yields. The central bank must support interest rate stability in short term and long term maturities. The short term rates are simple enough to understand that a central bank controls the discount rate, and that it can strongly target the federal funds price. Long term rates can be straightly targeted by central banks, other than that the latter typically favor to let financial market participants perform the job and not to affect them directly by credible policies. Exchange rate Stability: An exchange rate states the price of one country's money in relation with the value of a different country's currency. The costs play a significant part in finances, moving the stability of trade among nations and affecting investment policies. The Central Bank steps in to sell or buy foreign exchange such that vast variations in the limited currency are avoided. Typically, in mature markets like the US, Japan or Europe, it is uncommon for a Central Bank to do this process as the currency is frequently stable. Central Banks too can use open market operations as a financial policy instrument. They could sell foreign exchange to decrease money supply in the financial system and vice versa. 2) Examine the balance sheet of the central bank and explain how the following are determined: a) The Monetary Base Monetary base can be explained as the total sum of money that is dispersed in the commercial bank deposits and in the hands of the public held in the central bank's funds. This money supply in general comprises only the liquid currencies. In several countries, the government can preserve a determination of control over the monetary base by purchasing and selling government bonds in the open market. The current global financial disaster has challenged central banks to operate separately the extent of standard financial records in the assumption of monetary policy. Monetary policy is normally measured only in conditions of the choice of an operating target for a temporarily supposed interest rate. However during the recent crisis, the other scope of policy has taken much of the notice of central bankers. Monetary policy examination is concerned with the central bank's balance sheet, and in any case to the scope that one considers in the significance of general-equilibrium examination. Monetary base in the UAE has decreased in 2009, and sustained the same trend till recently with a double growth. This is reliable with estimation by the International Monetary Fund of short inflation, and a low rate of economic growth. All kinds of monetary aggregates, including M1, M2 and M3 have note down much lesser increase over the past years though government deposits sharply weaken in the first months of this year after a huge increase in 2009. M 1 includes total money in flow while M2 include M1 plus money external to banks, time and savings deposits, demand deposits. M3 comprise M2 plus government security. b) The Money Supply The money supply is the whole sum of money available in an economy at a particular period of time. Money supply figures are verified and made available, generally by the government or the central bank of the country. “The central bank helps to determine the money supply by controlling the monetary base (MB), at high-powered money or its monetary liabilities” (Chapter 14 The Money Supply Process n.d pg 2). When a central bank increases its operations, it raises the money supply by acquiring government securities in the open market thereby raising available funds for private banks to credit through reserve banking. In this way the amount of bank funds and the monetary base increase. By purchasing government bonds, this determines their prices, so that rates of interest decrease with the increase in monetary base. c) What is the role of banks in the money supply process? Explain Money supply is equivalent to money plus demand deposits. As money supply comprises demand deposits, banking system plays a significant role in the process. There are four types of banks that are involved in the process of generating deposits, they generates money. They are: Central Bank: The government agency that manages the banking system and is accountable for the accomplishment of monetary policy. The central bank in the US is the Federal Reserve System. Banks: The financial institutions that receive deposits from individuals and corporations and create loans. In the US, these incorporate commercial banks, mutual savings banks, credit merger, savings and loan dealings. Depositors: The individuals and corporations that gives deposits to banks. Borrowers from banks: Individuals and businesses that get money from banks, along with the State, federal, and local governments that deliver bonds that are acquired by banks. Of these four banks, the central bank, the Federal Reserve System is the most significant. The FRS system examines bank reserves and reacts rapidly to alterations in the activities of depositors or banks. They guide money supply close to the stage it needs to guide. d) How does the central bank control the money supply? Identify and discuss the tools of monetary control. The money supply is controlled through organizing short-term interest rates. The interest rates are generally controlled by the country's central bank. Central banks can control money supply in two means: By restraining their distribution of paper currency. By changing existing supplies of bank reserves and thus controlling the worth of the deposit credits that bank are able to maintain. Additionally, those economists who consider the central bank's control over money supply as weak argue that there are two ineffective relations between the increase of the money supply and the inflation rate. Firstly, an increase in the money supply can produce a constant improvement in actual production as an alternative to inflation in times of depression, when many reserves are underutilized. Secondly, if the rate of money, which means the ratio between nominal gross domestic product and money supply varies, a rise in the money supply will have unpredictable outcome on the increase of nominal gross domestic product. When the central bank decides to change the money supply, it must consider how its dealings will perform through the banking system. The following are the tools of monetary control: Open-Market Operations: If the central bank needs to raise the money supply, it can generate money and utilize it to purchase bonds from the public. After the purchase, the additional currency will be in the hands of the public. In this manner, the open market increases money supply. Refinancing Rate: The central bank establishes an interest rate based on which it decides to lend to commercial banks on a temporary basis. If the central bank increases the refinancing rate, commercial banks try to lend and thus money supply reduces. Reserve Requirements: It is the proportion of commercial banks liabilities that are expected to sustain as reserves at central banks. It supports monetary control as a reserve market management tool of the bank and a safeguard of liquidity. 3. Discuss the relationship between money supply and price. In economics, the money stock or money supply is the sum of money available at a specific time. The money supply or money stock data are published and recorded by the central bank or the government of the country. Private sector and public sector have monitored the changes in the supply of money because of its effects on price level, business cycle and inflation. The relationship between price and money is connected with the quantity theory. It is a strong evidence of the straight relationship between the money supply growth and long term price inflation. This is essential for quick increase in the amount of money in the economy. In this context, the central bank of the country controls the money supply. The increasing money supply, unless it is trapped in the system of finance as surplus reserves, it causes the sustained increase the actual production in its place of inflation, and as the consequences of recession, many of the resources are underutilized. If the money velocity: it is the ratio between the money supply and nominal Gross Domestic Product, changes, money supply increases could have no effect, or have unpredictable effect, or an exaggerated effect on the growth of nominal gross domestic product. Money and prices are the most important macro economic variables that play an important role in shaping an economy. The relationship between these economic variables is of considerable importance, especially the policy makers ensuring the stability of effective macro –economic policies can be designed and implement. The quantity theory of money relationship necessitates the comparative relationships between the price level and growth rate of money supply, the money must be in neutrality, and it results in the stationary rate of money and the unaffected output level of money in the long run. It also causes permanent changes in the money supply growth rate. 4. Explain the link between price stability and the other goals of the central bank. The main goals of central bank include price stability, stable real growth, financial stability, interest rate stability and exchange rate stability. Price stability is described as a state in which the common price level is accurately stable, or that the rate of inflation is sufficiently stable and low, such that considerations regarding the nominal element of dealings cease to be a relevant factor for financial decisions. Regarding the descriptions of financial stability, there is less clarity and agreement. One helpful method of describing financial stability is by considering it as a form in which the economic system involves financial mediators, markets and market communications. This is capable of withstanding shocks and the separating of financial disproportions, and is possible to do so for the probable future. The advantages of cost stability propose that stable and low inflation can raise the level of resources efficiently utilized in the financial system, and may even help raise the rate of financial growth. An increased interest rate indicates that it will price more to borrow cash, and people will have less money left to use. The financial system will slow down and the cost will increase. On the other hand, as it can take several months for a rate vary to work its method through varied costs; the cause is not always clearly visible. Central banks that are mainly concerned with the performance of prices will utilize monetary policy while trying insulate costs from changes of exchange rate. Prices then emerge unresponsive to transforms in the exchange rate. The observed relations linking the exchange rate and prices will reflect central bank measures instead of the fundamental relationship between exchange rates and prices. 5. Describe the behavior of monetary aggregates, inflation and output in the UAE One of the important objectives of monetary policy in developing countries and developed countries is to maintain the stability of prices. Generally the accepted stability of prices contributes to the well being of the economy of the nation by improving the effectiveness of is monetary system and subsequently reducing the uncertainty about the future. UAE monetary policy makes are likely to analyze continuously the pressure of inflation that emerges over time as the economy grows. The key components are concerned with the output gap of the country. This model plays an important role in assessing the inflation pressures and the position of the economy. If the output gap is positive it indicates surplus aggregate demand, it has a tendency to put rising pressure on the prices which can potentially increases inflation, and this is also the indication of growing economy. The negative behavior in output gap indicates the exert and capacity persistent in the downward pressure of the price, and it results in decreasing the level of inflation accordingly. Both these behavior calls for the dissimilarity of macroeconomic policy comes from the policy makers. When the positive output gap increases the rate of inflation, the Central Banks can adopt certain financial policies. The policies are designed to meet the cumulative demand, in order to sustain the stability of prices. “Money supply aggregate, M3 (M2 plus government deposits at bank operating in the UAE as well as at the Central Bank) decreased by 0.8 per cent, from Dh 1,009.8 billion at the end of November to Dh 1,001.4 billion at the end of December 2011” (UAE Central Bank Issues Statement on Money Supply 2012 para 6) money aggregates are closely watched by the investors and economists; and it gives them the clear picture of money supply working. Monetary aggregates raise quickly it trigger inflationary fears that is more money is needed to purchase of goods and services, it leads to increase in prices. It causes the Central bank of the country raise the rate of interest or otherwise stops the progress of the growth of money supply. “DUBAI - Inflation in the UAE fell by 0.44 per cent in February, compared to January this year while it increased by 0.56 per cent on year-on-year basis, mainly because food inflation, according to National Bureau of Statistics data”(Inflation In UAE Down by 0.44% in February 2012 para 1). The inflation rate of the country is expected in 2012 remain under 2 percent. “I hope we will be able to control it. It was hovering around 1.5 per cent and it should not get past two per cent,” the minister said last week in Dubai (Inflation in UAE Down by 0.44% in February 2012 para 2). The UAE government has manipulated the effective monetary policy; it reduces the rate of inflation. The output of the country depends mainly on crude oil products. The GDP of UAE expanded to 3.3 percent in 2011. 6. Central Bank of UAE; The Central Bank of UAE was established in 1980. The bank is considered as the chief supervisory body as well as the chief regulatory agency in the banking industry of the emirates. The UAE Central Bank has the main authority to implement banking policies concerned with money credits taking into account the UAE’s general policy. In recent years the UAE’s banking and monetary system has made significant progress due to the Central Bank’s strict control of financial institutions. In fact, there was an impressive growth in 1998 in the banking sector. In the last ten years, the Central Bank of UAE has played an important role in the supervision of the banking industry in UAE and it has improved the performance and quality of service of a number of banks. The Central Bank assures to create a stable economic structure, so with the aim of providing prosperity of all the residents in the country. At present the country is served 20 national banks with 301 branch and 26 foreign banks with a total of 83 branches spread throughout the country. This extensive network of banking services indicates a high degree of financial deepening” (Elhiraika & Hamed 2002 pg 19). The main responsibility of the Central Bank of UAE lies in its formulation and implementation of banking, credit and monetary policies and plans to ensure the growth of UAE’s national economy in a stable manner. The bank plays a vital role in maintain a fixed exchange rate of dirham against the U.S. dollar and it also ensure the free convertibility of the national currency into foreign currencies. In addition to this, the bank acts as a "Bank of Banks”. The main objectives of Central Bank of UAE are, direct monitory plans, credit and banking policy and supervise the implementation of these policies in accordance with the state’s general policies. Through this ways it helps support the national economy and maintain the stability of the currency. Exchange Rate; Exchange is an important factor in the economy of a country. An exchange rate responds to the laws of supply and demand. The significance and behavior of exchange rate can be understood only by paying attention to the factors that affect it elsewhere in that system. Exchange rate (ER) can be defined as the comparative price of two currencies. It is the price of one currency expressed in terms of another currency. Fixed (pegged exchange rate) refers it is a system in which a monetary authority declares the buying or selling rates for its currency in terms of a another country’s currency and promises to trade in unlimited amounts on that rate. The rate of buying and selling could be same, but in most systems buying and selling rate may differ. The different types of exchange rates are; Fixed Exchange Rate Floating Exchange Rate Fixed Vs. Floating The term exchange rate means, the policy made by the governments in order to determine the value of their country’s currency, related to that of foreign currencies. In the case of UAE, most of its trade is conducted in US dollars, so UAE’s currency is pegged to the US dollar. It helps foreign investors to eliminate currency risk in their operations, and allow them long-term planning and more accurate business forecasting. UAE central bank maintains stable and strong exchange rates. It has stably developed its foreign currency to a strong stand. UAE exchange rate mostly shows an upward trend instead of a downward one. The national currency of United Arab Emirates is dirham.  The six powerful kingdoms of Dubai, Sharjah, Ajman, Abu Dhabi, Fujairah, and Umm-al-Qaiwain, have accepted dirham as their common currency. It gives greater monetary benefits to the emirates. The dirham substituted the Riyal of Qatar and Dubai, in all forms. It is abbreviated AED or Arab Emirates Dirham. The economic survey 2000 shows that the exchange rate of UAE Dirham was considerably stable until January 2012. Interest Rate: The Central bank of UAE maintains a stable interest rate .The latest reported benchmark interest rate in the United Arab Emirates is 1 percent. In UAE the decisions regarding interest rate are taken by the Central Bank of United Arab Emirates. “The official interest rate since November 2007 is overnight repurchasing rate. From 2006 until 2010 the United Arab Emirates' average interest rate was 3.11 percent reaching an historical high of 5.53 percent in December of 2006 and a record low of 1.46 percent in November of 2009” (United Arab Emirates Interest Rate 2012 para 1). Conclusion: Central banks are concerned with currency, collection, as they are the bank of the government. They control the monetary of the nation as a whole. Its main objectives include price stability, financial stability, exchange rate stability and interest rate stability. The Monetary policy is concerned with the central bank's balance sheet, and the money supply figures are verified and made available, generally by the government or the central bank of the country. The central Bank manages the banking system and is accountable for the accomplishment of monetary policy in the country. These are controlled through open market operations, refinancing rate and reserve requirements. The straight relationship between the money supply growth and long term price inflation helps in increasing the amount of money in the economy. UAE monetary policy makers are likely to analyze continuously the pressure of inflation that emerges over time as the economy grows. The Central Bank of UAE has played a significant role in the supervision of the banking industry in UAE and it has enhanced the performance and quality of service of a number of banks. Overall, with a stable economic growth, many of the banks will have a permanent future and thereby provides financial assistance to the public at large. Reference List Chapter 14. The Money Supply Process (n.d). Retrieved from Elhiraika, B, Adam & H, Annas (2002). Explaining Growth in an Oil – Dependent Economy: The Case of the United Arab Emirates. Retrieved from < http://depot.gdnet.org/newkb/fulltext/elhiraika.pdf> Inflation in UAE Down by 0.44% in February (2012). Khaleej Times. Retrieved from < http://www.khaleejtimes.com/kt-article-display-1.asp?xfile=data/uaebusiness/2012/March/uaebusiness_March38.xml§ion=uaebusiness> The Definition of Price Stability (n.d). European Central Bank. Retrieved from Trade and Development Report 2008 by United Nations Conference on Trade and Development (2008). United Nations Publications. Retrieved from UAE Central Bank Issues Statement on Money Supply (2012). The Free Library. Retrieved from United Arab Emirates Interest Rate (2012). 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