Central Bank and Monetary Policy - Research Paper Example

? Central Bank and Monetary Policy Introduction Since the time of King William of Orange, central banks around the world have becomeinfluential and important for functioning of the economy and countrywide security and welfare. As importance of the government for the welfare of all citizens increased, so did the central bank’s importance (Cechetti & Schoenholtz, 2011, Chapter 15). Today every central bank around the world creates money, controls monetary policy and provides loans to the commercial system and supervises it (Cechetti & Schoenholtz, 2011, Chapter 15). In times of need, the central bank’s duty is to save the financial system. This paper deals with central bank objectives, instruments and theory behind them. Five objectives of central banks will be described and discussed. Central banks’ objectives are price stability, stable real growth, financial stability, and interest rate and exchange stability. Then, direct and indirect tools of monetary policy will be described and discussed. Direct tools affect directly the economic agents (Alexander et al., 1996, p.14). Indirect tools affect bank reserves (Alexander et al., 1996, p.14). Direct instruments are: interest rate controls, credit ceilings, and directed lending to the authorities (Alexander et al., 1996, p.14). Indirect instruments are open market operations, reserve requirements, and central bank lending facilities (Alexander et al., 1996, p.14). Advantages and disadvantages of both will be discussed. It will be described how the central banks control the economy through money supply and how price stability is related to other objectives of central banks, but only as long as money supply can be controlled by the central bank. Finally, United Arab Emirates (UAE) will be shortly analyzed and the performance of their central bank will be discussed. It will be shown that the central bank of UAE’s focus is on exchange rate and economic stability. Since the UAE dirham is pegged to the US dollar, inflation cannot be controlled by the central bank of UAE as its monetary policy is restrained by the peg. Instead, it depends on the inflation in the USA, since the USA is free to adjust its monetary policy. Question I Early versions of central banks provided financing for governments and expanded their functions as time passed by (Cechetti & Schoenholtz, 2011, Chapter 15). Today, they service both, the governments and the commercial banks (Cechetti & Schoenholtz, 2011, Chapter 15). By 2011, there were around 170 central banks in the world (Cechetti & Schoenholtz, 2011, Chapter 15). Though central banks around the world nowadays do not all have the same objectives, most share certain characteristics. They are in charge of monetary policy as the government’s bank (Cechetti & Schoenholtz, 2011, Chapter 15). In countries where the central bank is largely independent to determine the interest rate on its own, the goals toward which the monetary policy should be used are independent of political events. Central banks’ goals are following: price stability, stable real growth, financial stability, interest rate and exchange stability. Each will be shortly discussed with regard to its importance for the central bank and the wider economy. Stable real growth is an objective of some central banks. A central bank can through independence from political processes and a consistent policy promotes economic stability and decreases uncertainty and fluctuations in economic growth rates (Cechetti & Schoenholtz, 2011, Chapter 15). A central bank may insulate an economy from business cycles through independence by ensuring the long – run growth potential is promoted, so that fluctuations in growth rates do not occur, or are minimized (Cechetti & Schoenholtz, 2011, Chapter 15). The long – run growth potential is determined by factors such as capital stock, the size of the capital stock and labor force size (Cechetti & Schoenholtz, 2011, Chapter 15). However, active monetary policy is no longer favored by most central banks. Since effects of monetary policy are long and varied, output may not respond to central bank’s attempts as first predicted (Mishkin & Posen, 1997, p.2). For example, since there is no long – run tradeoff between inflation and unemployment, an increase in output will only further increase inflation. In the long run, output will return to the previous level, and inflation will be higher (Mishkin & Posen, 1997, p.2). Another problem is time – inconsistency. Since consumers adjust inflation expectations based on the government policy, governments end up imposing more expansionary policies than first announced. Workers and firms will adjust prices since they will expect the government to undertake such an expansionary policy. As a result, inflation will increase, but output will not (Mishkin & Posen, 1997, p.3). Thus, central banks only prefer to promote economic stability, without trying to promote a certain level of economic growth. Price stabilization is preferred to stabilization of any real target by most countries (Mishkin & Posen, 1997, p.2). Prices provide information needed by firms and consumers to allocate resources efficiently (Cechetti & Schoenholtz, 2011, Chapter 15). Inflation and deflation distort the information (Cechetti & Schoneholtz, 2011, Chapter 15). Price stability is an important long - term goal of central banks. According to Mishkin and Posen (1997), central banks announce medium – term inflation targets (p.1). When inflation in one period is higher than desired, next period it will be below the previous year’s inflation rate in order to hit the wanted price level (Mishkin & Posen, 1997, p.10). Its equivalent is stability in domestic purchasing power of the currency (Archer, 2009, p.21). Whereas this objective might increase the price volatility over the short run, it stabilizes prices in the long run (Mishkin & Posen, 1997, p.10). There are costs to the economy when prices are not stable. In countries where prices are unstable, the economy suffers. One of the costs is the shoe leather cost: smaller value of money demands ever larger amounts of cash to trade on the markets (Mishkin & Posen, 1997, p.3). For inflation rates lower than 10 percent, the cost is 0.10 percent of GDP (Mishkin & Posen, 1997, p.3). With inflation rates above 100 percent, the cost becomes larger than one percent of the GDP (Mishkin & Posen, 1997, p.3). Due to inflation, a number of transactions increases, which leads to overinvestment in the financial sector (Mishkin & Posen, 1997, p.4). Inflation also decreases growth rates. A one percentage point increase in inflation decreases growth rates by 0.1 to 0.5 percentage points (Mishkin & Posen, 1997, p.4). Inflation targeting is another objective preferred by many countries. Such an anchor eliminates time inconsistency (Mishkin & Posen, 1997, p.6). However, it takes a longer time to see the effects of monetary policy on inflation, as inflation depends on expectations of future prices (Mishkin & Posen, 1997, p.7). This objective also ignores output stabilization (Mishkin & Posen, 1997, p.7). The exchange rate regime stability is another objective. When a currency depreciates, exports increase. As a result, GDP increases, especially in a small open economy which is overwhelmingly dependent on exports. When the exchange rate is stable, the entire economy benefits (Cechetti & Schoenholtz, 2011, Chapter 15). For example, companies can export products to another country without having to then withdraw them if the foreign currency depreciates unexpectedly. Cechetti and Schoenholtz (2011) argue that stable exchange rates are especially important for emerging markets (Chapter 15). Emerging markets need sometimes exports in order to increase their development rates. China is an example of a success story. However, if the exchange rate fluctuates, export growth will be affected. Moreover, a fixed exchange rate regime could be imposed to stabilize the currency and decrease its volatility (Mishkin & Posen, 1997, p.6). However, then a country loses ability to control its monetary policy (Mishkin & Posen, 1997, p.6). The central bank cannot let the currency fluctuate in order to protect price stability or any other objective. Financial stability is an objective some central banks attempt to achieve. This objective is very wide and vague. Thus, some central banks focus on banking systems, whereas others focus on the entire financial system (Archer, 2009, p.26). According to Giorgio and Rotondi (2008), financial stability is safeguarded through “controls over financial exchanges, clearing houses, payment and securities settlement systems” (p.3). Central banks make smaller and more predictable interest rate changes in order to lower the risk of bank insolvencies and reduce volatility of commercial banks’ profits (Giorgio & Rotondi, 2008, p.2). Interest rate smoothing is seen by some economists to be a crucial element of monetary policy under commitment (Giorgio & Rotondi, 2008, p.2). Under interest rate smoothing central banks gain a reputation that they are committed to financial stability. Commercial banks, on the other hand, are protected from a need to quickly increase the money in their reserves as they borrow short, but lend long (Giorgio & Rotondi, 2008, p.3). Financial stability is oftentimes achieved through required reserve ratio. The reserve ratio affects economy through several channels. Bank runs cannot be prevented, but reserves can save banks from ruin in case some degree of bank runs occurs. Moreover, external finance premiums increase with risk. External finance premium movements can be alleviated if the reserve requirement is adjusted to economic conditions (Glocker & Towbin, 2012, p.68). The currency depreciates if debt is denominated in foreign currency, which decreases firm equity (Glocker & Towbin, 2012, p.68). The effect of the reserve requirements is, as a result, also amplified through the balance sheet effects (Glocker & Towbin, 2012, p.68). Interest rate is the last of the goals of central banks. Interest rate is a relative price, where the price of money today is compared to the price of money tomorrow and weighed accordingly (Friedman & Kuttner, 2010, p.7). A higher interest rate implies a high price of money today relative to money tomorrow. It means that money today is more valuable. High interest rate volatility brings along a high risk premium (Cechetti & Schoenholtz, 2011, Chapter 15). Thus, interest rates must be held constant. Most set some short – term interest rate in order to influence inflation and growth as these cannot be controlled directly (Friedman & Kuttner, 2010, p.1). The Fed in the US controls three interest rates: the deposit rate, the federal funds rate and the discount rate (Cechetti & Schoenholtz, 2011, Chapter 18). However, objectives are not mutually exclusive. A central bank can have all of the goals above as its own objectives. As shown above, price stability can help promote economic stability. Stable interest rates can in turn increase price stability. Cechetti and Schoenholtz (2011) also argue that interest rate stability and exchange rate stability are means to an end, meaning that they are used to achieve other objectives. Still, sometimes objectives conflict with each other. For example, price stability and exchange rate stability require interest rate movements in opposite directions (Archer, 2009, p.23). Question II Every central bank controls its balance sheet. According to Cechetti and Schoenholtz (2011) a central bank has a balance sheet composed of assets and liabilities (Chapter 17). Liabilities are composed of domestic and foreign currency liabilities, government’s accounts and reserves. Assets are usually loans, securities and foreign exchange reserves (Cechetti & Schoenholtz, 2011, Chapter 17). Securities are its primary asset (Cechetti & Schoenholtz, 2011, Chapter 17). Assets and liabilities can be further divided by the role the central bank plays: as the government’s bank or the banker’s bank (Cechetti & Schoenholtz, 2011, Chapter 17). Through loans the central bank performs its role as the banker’s bank (Cechetti & Schoneholtz, 2011, Chapter 17). Through securities and foreign exchange reserves it performs its role as the government’s bank (Cechetti & Schoenholtz, 2011, Chapter 17). On the liabilities side, currency and government’s account are used to perform the role of the government’s bank, whereas reserves are used for commercial banks (Cechetti & Schoenholtz, 2011, Chapter 17). Monetary base and money supply can be determined from the balance sheet. In the US, the monetary base is defined as the sum of currency and reserves (Cechetti & Schoenholtz, 2011, Chapter 17). It is also known as the high powered money (Cechetti & Schoenholtz, 2011, Chapter 17). The monetary base can be seen on the liabilities side of the balance sheet (Cechetti & Schoenholtz, 2011, Chapter 17). The central banks control the monetary base (Cechetti & Schoenholtz, 2011, Chapter 17). Money supply is defined in terms of monetary aggregates. Money supply is measured and used to affect monetary objectives. M1 and M2 have been used as monetary aggregates. M1 is composed of cash in circulation, traveler’s checks, traveler’s deposits and other checkable deposits (Cechetti & Schoenholtz, 2011, Chapter 2). M2 is defined as M1 plus short – run deposits, savings deposits and money market deposit accounts and money market mutual funds shares (Cechetti & Schoenholtz, 2011, Chapter 2). In the US since the 1980’s, M2 has been used as a measure of money supply since it better follows movements in inflation and GDP (Cechetti & Schoenholtz, 2011, Chapter 2). A decrease in the amount of securities owned by the public increases the money supply (Cechetti & Schoenholtz, 2011, Chapter 20). The central bank prints money, buys securities from the public and so increases the money supply. Commercial banks are crucial for money supply control. As mentioned previously, reserves are central bank’s most important liability (Cechetti & Schoenholtz, 2011, Chapter 17). There are two types of reserves: excess reserves and required reserves (Cechetti & Schoenholtz, 2011, Chapter 17). The central bank controls directly the latter. When a central bank increases the monetary base, commercial bank’s reserves increase too (Cechetti & Schoenholtz, 2011, Chapter 17). Money supply increases once commercial banks issue loans to firms and consumers (Cechetti & Schoenholtz, 2011, Chapter 17). However, due to the money multiplier, the final money supply is larger than the initial amount paid by the central bank to the owner of the bond. When a central bank buys its bond, the owner receives the price of the bond, which it deposits at a commercial bank. However, now a commercial bank has excess reserves. A part of this excess reserve is thus loaned out. Loaning out continues through multiple deposit creation and it is depicted by the money multiplier. The money multiplier is the ratio of money supply and the monetary base (Cechetti & Schoenholtz, 2011, Chapter 17). The formula can be seen below in equation (1): (1) The larger the multiplier, the larger the money supply. However, since the money multiplier is unstable, the Fed prefers interest rate changes for the purposes of short – run policies (Cechetti & Schoenholtz, 2011, Chapter 17). According to Alexander et al. (1996), central bank tools of the monetary control are direct and indirect. Central banks can act directly through its regulatory power or indirectly through its influence on the markets with its monopoly over issuance of reserve money (Alexander et al, 1996, p.14). Direct tools affect directly the economic agents (Alexander et al., 1996, p.14). Indirect tools affect bank reserves (Alexander et al., 1996, p.14). Indirect tools are increasingly preferred to direct, as the former promote market efficiency, which is needed in economies with current account convertibility (Alexander et al., 1996, p.14). Alexander et al. (1996) named most common direct instruments. These are: interest rate controls, credit ceilings, and directed lending to the authorities (Alexander et al., 1996, p.14). They also named most common indirect instruments: open market operations, reserve requirements, and central bank lending facilities (Alexander et al., 1996, p.14). Direct instruments are considered to be ineffective. Direct instruments are preferred by countries with undeveloped institutional frameworks (Alexander et al., 1996): They are perceived to be reliable, at least initially, in controlling credit aggregates or both the distribution and the cost of credit. They are relatively easy to implement and explain, and their direct fiscal costs are relatively low. They are attractive to governments that want to channel credit to meet specific objectives (p.15). However, there are also disadvantages to this type of instruments, such as inefficient resource allocation (Alexander et al., 1996, p.15). Credit limits, for example, limit access to entrance to other banks, and thus limit competition on the market (Alexander et al., 1996, p.15). Indirect instruments are preferred. According to Alexander et al. (1996), indirect instruments are efficient: Indirect instruments encourage intermediation through the formal financial sector. They also permit the authorities to have greater flexibility in policy implementation. Small, frequent changes in instrument settings become feasible, enabling the authorities to respond rapidly to shocks and to correct policy errors quickly (p.15). Central banks can directly determine the supply of reserve money, i.e. money supply, which is useful as it speeds up the implementation of policies. However, in the long run this can be done only in flexible exchange rate regimes (Alexander et al., 1996, p.15). Both types of instruments will be discussed. First, the most common instrument, open market operations will be discussed. Nigeria will be used as an example of a developing country to depict how direct instruments are preferred in a developing economy. US will be used as an example of a developed country. Each of the below mentioned instruments affects the money supply. Objectives are achieved through open market operations. A central bank uses bank reserves, or other central bank liabilities, and either sells or buys them in the open market (Friedman & Kuttner, 2010, p.2). Central bank has monopoly control over its reserves and decision to sell or buy them. When a central bank sells reserves, money supply contracts. In turn, interest rates increase and prices decrease, as does inflation too. However, not all central banks are equally successful in affecting the interest rate by performing open market operations. Economists call this phenomenon the liquidity effect, which will be discussed later on in this paper (Friedman & Kuttner, 2010, p.4). The interest rates are either the federal funds rate or the market short – term interest rates (Friedman & Kuttner, 2010, p.4). Another indirect tool of monetary control, besides open market operations, is reserve requirements. Central banks sometimes require commercial banks to hold a fraction of their liabilities as vault cash (Central Bank, of Nigeria, p.1). This tool decreases bank exposure to bank runs by equipping them with some liquidity. By keeping the required reserve ratio constant or around some value, the central bank does not need to interfere as often through the open market operations. Central banks also lend to commercial banks. Lending to commercial banks is another indirect monetary tool. Money is in some countries, such as Nigeria, lent to deposit money banks, which affects reserves and the monetary base (Central Bank of Nigeria, p.2). In the US, Federal Reserve Banks lend money to commercial banks at the discount window (Federal Reserve Bank of San Francisco, 2011). Board of Directors of the Reserve Banks sets this rate, called the discount rate (Federal Reserve Bank of San Francisco, 2011). Banks can also borrow from each other. In the US this is done through the federal funds market, where banks borrow on a short – term basis from other banks at the federal funds rate (Federal Reserve Bank of San Francisco, 2011). The federal funds rate is usually higher than the discount rate. However, the discount rate acts as a ceiling on the federal funds rate (Federal Reserve Bank of San Francisco, 2011). Foreign currency operations are another tool. Financial markets as well as the exchange rate can be controlled by selling and buying domestic and foreign currency (Federal Reserve Bank of San Francisco, 2011). Domestic money supply can be affected through this policy as well (Central Bank of Nigeria, p.2 – 3). Through exchange rates exports can be influenced, which influences the real economy. Some central banks also use limits on loans and moral suasion as direct tools. The Central Bank of Nigeria uses direct credit control, through which Deposit Money Banks are given loan quotas on certain industries or activities (p.2). The Central Bank of Nigeria “issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system” (p.2). Through this policy the central bank can persuade commercial banks to abide by its credit expansions or restraints (Central Bank of Nigeria, p.2). Prudential guidelines eliminate some decision making on behalf of commercial banks as the central bank guidelines need to be followed. This in turn reduces risk with regard to commercial bank policies in the eyes of customers and investors (Central Bank of Nigeria, p.2). The central bank is seen as a co – owner of risk. As described previously, these two policies are used in developing countries. They allow central banks to directly control the markets. The Taylor rule is sometimes used to determine how to react. According to the Taylor rule, a nominal interest rate is set in response to changes in inflation and economic activity, usually GDP (Cechetti & Schoenholtz, 2011, Chapter 18). The nominal interest rate in case of the USA is the federal funds rate (Cechetti & Schoenholtz, 2011, Chapter 18). Elements of the formula are the target federal funds rate, real interest rate, inflation and output. The long term interest rate is 2 percent. The inflation gap is the current inflation minus the inflation target, and the output gap is the current output minus the potential output level if employment were at its natural level (Cechetti & Schoenholtz, 2011, Chapter 18). The formula can be seen below in equation (2): (2) When inflation rises above its target level, the policy response must be to increase the federal funds rate. If the economy suffers from deflation, then the interest rate must be lowered. And when inflation is on target and there is no output gap, the best policy will be to set the federal funds rate at two plus the inflation rate (Cechetti & Schoenholtz, 2011, Chapter 18). For each percentage point increase in inflation, the real interest rate goes up by half a percentage point (Cechetti & Schoenholtz, 2011, Chapter 18). The real interest rate will be explained later in this paper. Question III Money supply affects prices through multiple channels. Money supply announcements and interest rates are related through three different channels. Through interest rates, prices are also affected. The first channel is the standard Keynesian theory: monetary expansion leads to lower interest rates through the liquidity effect. The second channel is expectations: interest rates respond to expectations regarding future policy. The third channel is expected inflation: nominal interest rates increase because of expected inflation. Moreover, classical economists argued that money supply directly affects prices, which will also be discussed. The relationship between the money supply and the price level can be described through the liquidity effect. is the nominal stock of money, is the price level, is the level of real income and is the short – term interest rate (Cornell, 1983, p.2). The equation describing the relationship between the three variables is the equation (3) below: (3) A liquidity effect shows how the price level responds to money supply indirectly. First, the interest rate must adjust to clear the market (Cornell, 1983, p.2). The assumption is that prices are sluggish. Thus, as money supply increases, in the short run real money balances increase. The interest rate decreases, as loans are now cheap. Slowly, prices increase as workers demand a higher wage and companies demand higher output prices. In the long run, prices are higher, and interest rates return to previous levels, as does output. The second part of the explanation is the future policy expectations. Interest rates are altered only when the money supply change is announced, which happens a week after the supply is changed in the US. Thus, there are theories that the money supply change affects expectations about future policy changes. The price level is not directly affected by the money supply change. When an interest rate is lowered, money supply has increased. Now, agents expect scarcity in funds and so accumulate them aggressively through loans or stock sales, which increase the interest rate and prices, as demand increases (Cornell, 1983, p.3). This is the policy anticipation effect. However, this effect increases the interest rate in response to an increase in money supply. As the money supply increases, the markets are aware of the fact that the central bank will need to contract the supply in the future. Thus, they increase their demand for funds and drive up the interest rate (Cornell, 1983, p.3). Overshooting has an even larger effect. Unexpected increases will affect the interest rates more than expected increases (Cornell, 1983, p.3). In countries where the central bank has an upper and lower target, once the money supply is unexpectedly increased above the upper target, the effect will be even larger (Cornell, 1983, p.3). Expected inflation affects interest rates as well. This explanation is also related to expectations. As money supply increases, markets start believing that the central bank stopped committing to fighting inflation, especially if overshooting occurs. As a result, prices increase. In efficient markets, expectations adjust immediately. In imperfect markets, where information is not accessible to everyone, expectations adjust slowly and this theory fails (Cornell, 1983, p.4). Classical economists argued that prices increase as money supply increases. They developed the quantity theory of money, which is based on the exchange equation. The equation of exchange determines the relationship between money supply and prices. stands for nominal money supply, is the price level, is the velocity of money and is real GDP (Cechetti & Schoenholtz, 2011, Chapter 20). Velocity is an average number of times a dollar is spent to buy goods and services in a year or a given time period (Cechetti & Schoenholtz, 2011, Chapter 20). This relationship can be seen in equation (4) below: (4) The classical theorists made an assumption that velocity and real GDP are constant in the short run (Cechetti & Schoenholtz, Chapter 20). Thus, an increase in money supply creates a proportional increase in prices. This relationship can be seen in equation (5): (5) What equation (5) depicts is the proportional relationship between money supply increases (decreases) and proportional responses of prices to this increase (decrease). However, in the long run GDP will adjust too and so equation (5) will not hold. Cechetti and Schoenholtz found evidence that in the US, velocity of M2 is constant over time (2011, Chapter 20). M1 velocity has been, on the other hand, increasing. Since velocity is constant for M2, inflation can be controlled through the growth of M2 (Cechetti & Schoenholtz, 2011, Chapter 20). Cechetti and Schoenholtz argue that velocity of money movements in high inflation environments are insignificant and that the central bank can focus on money growth (2011, Chapter 20). However, in a low inflation environment, velocity matters and it must be stable (Cechett & Schoenholtz, 2011, Chapter 20). Question IV As mentioned in Question I, central banks’ goals are price stability, stable real growth, financial stability, interest rate and exchange stability. The relationship between the objectives of a central bank can be described through different theories. Neoclassical models assume only correlations between prices, exchange rates and interest rates. Financial stability is affected through uncertainty. Real variables are unaffected by the money supply, and thus prices. Classical, as described above, assume real variables are constant in the short run, which is similar to the assumptions of the neoclassical economists. It will be depicted how prices affect other objectives of central banks. However, without co - movements in monetary base and money supply, the arguments below will not hold. Prices affect interest rates through inflation. Neoclassical theorists argued through the Fisher hypothesis. According to the Fisher hypothesis, a nominal interest rate is affected by a real interest rate and the expected inflation rate (Cechetti & Schoenholtz, 2011, Chapter 18). When inflation is positive, the nominal interest rate must compensate depositors for the loss in value of their money. This relationship can be seen in equation (6): (6) The real interest rate is determined through marginal productivity, where is the real interest rate and is the productivity of capital in the aggregate production function. This relationship can be seen in equation (7) below: (7) Basically, the more productive is a unit of capital, the higher the real interest rate. Nominal interest rates are affected through two channels. Money supply increase increases investment and production, decreases the marginal productivity of capital and in turn reduces the real interest rate. This is the liquidity effect from the Keynesian theory mentioned previously. Money supply also increases expected inflation. This is the Fisher effect. In order to see a decrease in nominal interest rates, the liquidity effect must outweigh the Fisher effect. However, in neoclassical models money has no effect on output, and thus also none on the real interest rate (Ellison, 2003, p.352).Thus, there is only an effect of future prices on the nominal interest rate. Only when non – neutralities are present is the liquidity effect present as well (Ellison, 2003, p.352). Ellison (2003) designed a model in which the liquidity effect is produced through incomplete markets. He adjusted a basic cash – in – advance model where prices cannot adjust. Banks have more cash than needed when money supply increases, but consumers will not be willing to borrow that money. Thus, to attract investors, banks will need to lower the nominal interest rate (Ellison, 2003, p.54). The reasoning behind the effect of money supply on output can be seen by obtaining the real wage rate , which equals the ratio of marginal productivity of labor, and nominal interest rate, (1+). This relationship can be seen in equation (8) below: (8) Details on how exactly to derive this equation can be seen in the paper by Ellison (2003). When the nominal interest rate decreases, hiring costs decrease, labor demand shifts out and more workers are hired. In turn, this reduces marginal productivity of capital too. Thus, real interest rates are decreased. Because this is a rational expectations model, only unexpected increases in money supply produce this effect. Effects are short lived as economy returns to the production before the increase in the money supply (Ellison, 2003, p.55). The exchange rate is also affected by prices. As interest rates decrease due to a money supply increase, investors now get a lower return on their investment. Thus, investors will start selling the currency. Demand will decrease and supply will increase. As a result, the exchange rate will decrease. Similarly, when interest rates increase, exchange rate will appreciate. These movements are only observable in flexible exchange systems. In such systems it is important to retain price stability, as high volatility of exchange rates leads to withdrawals of funds out of the country, as well as flows in. Such movements can create instability in investment. Financial stability is another objective which is affected by the price stability. Most recent and most important example of this phenomenon is the current 2008 financial crisis. Any price instability in the sector in which financial institutions are active, reduces their portfolio value and leads to their instability. Moreover, as mentioned above, exchange rate depreciation leads to withdrawal of funds from a country, which might create additional burden on financial institutions if they do not have a high enough level of liquidity. However, an important part of the puzzle is understanding the money supply. The central bank only supplies the monetary base. Commercial banks and the banking system supply the money supply (Cechetti & Schoenholtz, 2011, Chapter 17). They can decrease the money supply, even though the central bank expanded the monetary base. For example, in 2008, money supply decreased due to a decrease in the deposit expansion multiplier (Cechetti & Schoenholtz, 2011, Chapter 17). Banks refused to lend as they hoarded liquidity. Thus, if money supply does not follow the changes in monetary base, none of the statements above will hold as prices will not be affected by an expansion in monetary base. Question V Behavior of monetary aggregates, inflation and output in the United Arab Emirates (UAE) has been generally upward. M1 and M2 growth rates were volatile overr the period 2000 - 2010. GDP grew too, with an exception in 2009. However, inflation and deflation were both present. Inflation reached the double digit, as did deflation. Money supply increased constantly from 2000 till 2010 (see tables 1 and 2). Growth rates of M1 were positive from 2000 till 2010, with the highest growth rates being in 2003, at 23.8 percent, and in 2004, at 38.7 percent (see table 1). After 2004, the growth rates of M1 have been decreasing. M2 was more volatile than M1. As mentioned previously, M2 is the monetary aggregate composed of M1 plus assets with check-writing features (Cechetti & Schoenholtz, 2011, Chapter 2). As a result, it should move somewhat similarly to M1. M2 growth rates too spiked in 2004 at 23.2 percent, but they again spiked in 2006, again at 23.2 percent (see table 2). Between 2000 and 2003, the growth rates of M2 were mostly stable and changed by a margin (see table 2). Overall, growth rates of M2 were higher than growth rates of M1. Inflation can be calculated using the implicit price deflator, also called the GDP deflator. GDP deflator is a measure of prices (Cecchetti & Schoenholtz, 2011, p.17). It is calculated by using a ratio of nominal GDP to real GDP. Real GDP is calculated at prices of some base year, in this case 2005. Nominal prices are calculated at prices for each year (Cecchetti & Schoenholtz, 2011, p.17). GDP deflator in year i is GDP in year i is The formula for the GDP deflator can be seen in equation (9) below: (9) In 2005, GDP deflator is thus 100 (UN Stats, 2011a). Inflation rate for a year x is calculated by subtracting the previous year’s GDP deflator value from the GDP deflator for the year x, dividing everything by year x value and multiplying by 100 (Cecchetti & Schoenholtz, 2011, p.18). The formula can be seen below in equation (10): (10) Applying the equation (10), it can be seen that inflation and deflation were both present in the economy of UAE (see table 1). In 2000, inflation stood at 10 percent (see table 1). Though in 2001 the economy experienced a deflation at 3 percent, the general trend until 2008 was upward, and then in 2009 there was again a deep deflation of 13 percent (see table 1). Similarly to M2, inflation too had two spikes. One occurred in 2005, and another one in 2008. In general, inflation followed increases in growth rates of money supply, but with lags. GDP grew from 2002 till 2006, but in an unstable manner. Since 2007, GDP has been lower than it was in the 2000 – 2006 period (see table 2). The highest level of growth of GDP was reached in 2006, at 10 percent (see table 2). Growth rates were also high in 2002 and 2003, reaching 9 percent in each case (see table 2). In 2009, just as in case of inflation, GDP growth rates became negative and amounted to negative 2 percent (see table 2). The movements of GDP growth rates followed more closely the movements of M2 than M1. In short, the UAE economy suffered from inflation, as well as deflation. M2, inflation and GDP moved more closely together than M1 and the other two aggregates. Each time there was an increase in the growth rate of M2, inflation increased with a lag. As M2 started decreasing after 2006 (with a steeper decrease after 2008), GDP and inflation reached negative values. Question VI UAE is an example of a country where the exchange rate is pegged against another currency, in this case the US dollar (Ishfaq, 2010, p.1). UAE dirham is traded at a certain rate in an unlimited amount (Ishfaq, 2010, p.1). The central bank of UAE managed to keep exchange rates constant. Since 1995, the exchange rates have been between 3.6711 and 3.6725 (UN Stats, 2011b). The range is small, indicating that volatility was relatively contained. Thus, the money supply changes were directed at exchange rate stability instead of inflation. Preference for exchange rate stability can be seen from the objectives of the central bank of the UAE. According to the Union Law No. (10) of 1980, the central bank’s objectives are direction of monetary, credit and banking policy, as well as supervision of its implementation, while ensuring exchange rate stability, and stability of the national economy (Central Bank of UAE, 2012). To attain the objectives, the central bank has monopoly over currency issuance, it directs credit policy in order to achieve growth in the national economy, it supports currency and maintains its stability, maintains reserves of gold and foreign currencies and ensures a flexible exchange rate regime of dirham (Central Bank of UAE, 2012). There are benefits to pegging against the US dollar. Domestic inflation is lower if the currency is pegged against a foreign currency whose domestic inflation is low (Ishfaq, 2010, p.15). The government cannot change its macroeconomic policy at its own will, as it depends on the foreign government’s macroeconomic policies. As a result, though inflation was unstable in UAE, it might have been even more volatile were it not for the peg. On the other hand, the central bank of UAE could not control inflation due to the peg. GDP growth was positive during the 2000 – 2010 period, but it was susceptible to changes in inflation. Conclusion The United Arab Emirates are an example of the dilemma many central banks face: the tradeoff between price and exchange stability. However, in spite of the lack of price stability, GDP grew quite steadily. It seems that the central bank managed to fight off the adverse effects of inflation (Mishkin & Posen, 1997, p.4). Though price stability implies exchange rate stability, in case of the United Arab Emirates, the opposite does not hold. However, a relationship between an increase in money supply and an increase in economic activity went hand in hand. M1 and M2 increased over the years as did the GDP. An increase in M2 enabled an increase in economic activity. However, UAE did not manage to solve the problem of inflation control. Dependent on the inflation in the USA, exchange rate stability was favored over domestic inflation. As a result, GDP suffered too, though its growth rates remained positive and high at times, until 2009. References Alexander et al. (1996). Adopting Indirect Instruments of Monetary Policy. Finance and Development, p. 14 – 17. Archer, D. (2009). Chapter 2: Roles and objectives of modern central banks. Retrieved from: http://www.bis.org/publ/othp04_2.pdf Central Bank of Nigeria. What are the instruments of monetary policy? 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Retrieved from the Federal Reserve Bank of Cleveland: clevelandfed.org/research/workpaper/1995/wp9514.pdf The Federal Reserve Bank of San Francisco (2011). About the Fed: What are the tools of the U.S. monetary policy? Retrieved from: http://www.frbsf.org/publications/federalreserve/monetary/tools.html UN Stats. (2011a). United Arab Emirates: National Accounts [Data file]. Retrieved from: http://unstats.un.org/unsd/snaama/GraphsC.asp UN Stats. (2011b). United Arab Emirates: Exchange Rates. Retrieved from: http://unstats.un.org/unsd/snaama/resQuery.asp Table 1 Growth Rates of M1, Real GDP and Inflation for the Period 2000 – 2010 Table 2 Growth Rates of M2, Real GDP and Inflation for the Period 2000 – 2010 Read More