Monetary Policy & International Finance and the Exchange Rate - Essay Example

MONETARY POLICY AND INTERNATIONAL FINANCE al Affiliation MONETARY POLICY AND INTERNATIONAL FINANCE Monetary Policy I. If the central bank has an interest rate target, why would an increase in the demand for bank reserves lead to a rise in the money supply? If the central bank has a fixed interest rates, an increase is the demand for researves often results into a consequential increase in the money in circulation. At any given time, an increase in demand for reserves translates into an increase in the governemnt budgets target. The federal budget refers to the amount that the government is willing to spend at a particular period of time. However, the government has mechanisms to prevent the increase in government funds budget. One way that may be engage is purchasing bonds to boost the amount of non-borrowed reserves through open market operations (Taylor, 2001). The supply curve analysis indicates that an increase in the amount of nonborrowed reserves implies there will be right shift in the supply curve. The implication is that the governemnt funds rate will not rise any further and a constant value may be achieved. As a result, the open market purchase will result into a rise in the monetary base and hence the monetary supply. II. The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs? The central bank uses rediscount operations which allows the banks to borrow from the central as part of its checks and measures on economic stability. While this approach is crucial for ensuring that there is no economic recession, there is evidence that there is danger when the central banks lends to other banks. One problem with this operation is that it prevents banks that would have failed from failing. While the failure of bank may be a sign of economic instability, there are many other causes for the collapse of banks. For instance, poor management strategies within a bank may result to its failure (Kashyap & Stein, 2004). While there is need to support banks and to prevent them from collapsing, there are times when lending to such banks does not solve the problem. Banks that have weak management should be streamline their operation rather than lend them, an approach that may not its problems. Therefore lending to banks that are in the verge of collapsing poses danger to the public as they feel that such a bank is stable while it dependent on borrowing. III. Compare the use of open-market-operations, central bank lending facilities (rediscounting), and changes in reserve requirements to control the money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of implementation. The open-market operations are one of the most flexible approaches of controlling the money supply. Since this method is under the control of the government, it is possible to use it to fine tune the market and to achieve equilibrium (Carpenter & Demiralp, 2006). This is quite different for both discounting rate method and the bank reserves approach. The reserves approach cannot be used to make fine adjustments due to the expenses that would result, while the discounting rate is under no direct control of the governemnt. In terms of reversibility, open market operations and Federal Reserve’s methods are easier to reverse. The open market operations depend on the government’s purchases and sales, and hence the government can move either way when there is need. For instance, if the government realises that the economy may suffer as a result of high purchases, it is possible to conduct sales and restore the balance (Carpenter & Demiralp, 2006). On the other hands, the government can move either direction by either increasing the minimum bank reserves or increasing the same. Reversibility helps to restore economic balance through correction strategies. The open market operations are the most effective approach in fiscal control. The open market control induces a nature balance and the government uses this principle as the primary economic control tool (Taylor, 2001). To restore a balance, the government needs to either make a purchase or sale when there is need. However, the discounting widow is an effective way to control the economic balance. The government uses this strategy to ensure to allow banks that wish to borrow from the central bank to do so. However, the government does not control the amount that the bank can borrow or even whether the bank should borrow at all. Therefore, this process is dependent on the banks and hence an ineffective way to control supply. On the other hand, the bank reserves are fairly effective since they are compelling and each bank must have the minimum required reserves when such an order is released by the central bank. Therefore, this approach is fairly effective and comes after the open market operations in this respect. Compare to reserve requirements, the open-market approach is quick and adjust money supply as soon as it is implemented. Immediately the government makes a purchase, the money supply is bound to rise and reduce when a sale is made. On the other hand, the market adjusts slowly to government reserves control, making this a rather slow process (Carpenter & Demiralp, 2006). On the other hand, the discounting method is crucial but is the slowest of the three methods. This is because the approach largely depends on the decisions of the banks either to borrow or not, which may vary with their stability. Besides, this approach serves to check the balance and prevent excess researves within the central bank. 2. International Finance and the Exchange Rate I. How can a large balance of payments surplus contribute to a country’s inflation rate? Balance of payments, also referred to as international balance of payments refers to the economy’s transaction that a country holds with the international world. A large balance of payment means that a country has huge surplus which the government needs to intervene to prevent further growth. To do this, the government may need to finance the surplus by selling part of it currency within the international market. This helps the government acquire or gain international reserves and hence of off-set the balance-of-payment. The consequence of this move is that the central bank will have supplied more currency within the market and the public will have more currency available (Bussière, 2013). The implication is that monetary base, defines as the sum of currency in circulation and reserve balances, will rise. Economic analysts associate inflation or currency depreciates with an increase in the monetary base. This explains why the central bank is keen to ensure that the supply of currency within the market remains stable. However, a large balance of payment makes currency supply control difficult and hence may lead to inflation within the country as the central bank strives to intervene in the international trade. II. Why is it true that in a pure flexible exchange rate system, the foreign exchange market has no direct effects on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy? In a pure exchange rate system, it is apparent that the foreign exchange market has no direct effects on the monetary base and money supply. The only body that has a direct impact on the monetary base and money supply is the central bank. The central bank regulates currency supply by intervening either through open market operations, setting minimum currency reserves, and opening a money lending window (Woodford and Walsh, 2005). However, since there is no central bank within a pure flexible exchange rate system, it follows that the foreign exchange market cannot directly affect the monetary of the currency supply within the public domain. However, this does not imply that the foreign exchange market does not have effect on the monetary policies. At some point, the monetary authorizes may intend to manipulate the exchange rates to suit the market conditions. During such instances, the monetary authorities may change the money supply and interest rates, in an effort to control the exchange rates. III. What are the main benefits and costs of monetary union? What are the main criteria for the optimality of a currency area? In international trade, the choice of joining monetary unions has become important since the approach has both cost and benefits. One benefit of joining a union is that the exchange no longer exists and it no longer inhibits trade. As result countries can engage in more trade and the prices are bound to decrease. As trade intensifies, the countries within the union are bound to experience an upward economic growth. Secondly, a monetary union is trustworthy in trade than the central bank in terms of stabilizing the prices. Therefore investors will enjoy fairly stable prices. Economic unification is also a huge benefit as countries can share infrastructure and other economic development (Fasano, 2003). Hence, there is mutual benefit between the countries within the union, and hence the ability to accelerate trade. However, there are a number of costs that are associated with entering into a monetary union. First, this interaction may lead to high economic fluctuations, which may frustrate economic stability. The economy will only be stable when there is intensive trade within the country. Besides, it may result to exposure to budget deficits and monetary policies that are not suited to a county’s needs. In addition, there may be a moral hazard in the legislation and execution of government budgets, which often violates a member’s economic development strategies (Grauwe, 2014). Lastly non-economic benefits include the loss of a country’s identity and culture. For instance, it would be impossible to use the pictures of the president on the currency (Fasano, 2003). Therefore, a country must weigh the benefits and costs before indulging in a monetary union. An optimal currency area refers to a situation that the benefits of a monetary union far much outweigh the costs. Therefore, such countries will gain maximum value after entering such a union. One of the criteria for becoming an optimal currency is exhibition of high labor and capital mobility. This implies that there is free movement of workers as well as capital within the region in question. Secondly, the price and wages must be extremely flexible within the region. The implication here is that the wages can change in response to economic fluctuations as one way of adjusting to economic changes. Lastly, the government must be able to adjust the taxation rates and transfer funds easily within the area (Fasano, 2003). The three factors ensure that an optimal currency area can easily respond to asymmetric shock without depending on its exchange system. For a country to join a monetary union, it is crucial that it considers the possibility of being an optimal currency area to avoid economic shock. Bibliography Bussière, M. 2013, Balance of payment crises in emerging markets: how early were the ‘early’warning signals?. Applied Economics, 45(12), 1601-1623. Carpenter, S., & Demiralp, S. 2006, The liquidity effect in the federal funds market: evidence from daily open market operations. Journal of Money, Credit and Banking, 901-920. Fasano, U. 2003, Monetary union among member countries of the Gulf Cooperation Council. Washington, DC: Internat. Monetary Fund. Grauwe, P, 2014, Economics of monetary union. Oxford: Oxford University Press. Kashyap, A. K., & Stein, J. C. 2004, Monetary policy and bank lending. In Monetary policy (pp. 221-261). The University of Chicago Press. Taylor, J. B. 2001, Expectations, open market operations, and changes in the federal funds rate. Federal reserve Bank of st. louis review, 83(July/August 2001). Woodford, M., & Walsh, C. E. 2005, Interest and prices: Foundations of a theory of monetary policy. Read More