International Finance and the Exchange Rate - Assignment Example

Money and banking assignment Contents Question Monetary Policy 3 Question 2: International finance and the exchange rate 10 References 14 Question1: Monetary Policy I. The central banks around the world set a target interest rate to influence growth and control inflation. The interest rate target i.e. GDP growth rate and inflation rate are incumbent on the money supply of the economy. Central banks across the world such as the US Federal Reserve, European Central Bank, Bank of England, Bank of Japan, Reserve Bank of India, etc use various interest rate measures like the lending rate, deposit rate and reserve ratios to control the money demand and supply of an economy. If the central bank targets growth of an economy, it will reduce the interest rate, i.e. the lending rate or the reserve requirement, which will allow banks to borrow funds at a lower rate from the central bank and also increase their own fund capacity. Banks borrowing at lower rates will pass the benefit to its client, resulting in lower lending rates of bank. If the cash reserve ratio (CRR) falls, the commercial banks will have to keep a lesser amount of reserve in the central bank. Therefore, they will pass the reserve to their customer as loans through a lower lending rate and demand for loan will also be increased, which directly increases the demand for reserve of the commercial banks to their central bank. It implies that there will be a credit growth, i.e. more loans are offered at a low interest rate. The credit expansion will lead to increased borrowing by corporate and retail segments for investment purposes (Mishkin, 2007). Money borrowed by companies will be invested in their business expansion that leads to increased money supply in the economy. The retail segment borrowing also lead to increased money supply as they borrow funds to buy homes, cars, home decor, etc that leverages these sectors to produce more. This results increased growth. Usually interest rate target and money supply are inversely related i.e. if interest rate is lowered, demand for bank reserve will increase and accordingly money supply will rise through lower lending rate of the commercial banks (Gowland, 2013). Figure 1: Relationship between interest rate and money supply (State University of New York, 2014) The above figure represents the effect of interest rate on money supply in an economy. The x axis shows the interest rate and the y axis represents the quantity of money supply. With given level of interest rate of 7% the MS line is the red line which intersects with the money demand line MD. The MD follows the general rule of a demand curve i.e. downward sloping. When the interest rate is reduced to 6%, the MD rises, which pushes the money supply line to a new equilibrium. There is a shift in the MS line from red to green, witnessing increase in the quantity of money. II. Banks run short of funds at times of crisis or during bank runs. Banks nowadays provide various services to their clients apart from banking services and earn brokerage or commission on it. They also discounts short term debt instruments like bill of exchange, commercial papers etc to earn noninterest income from its clients. Owing to high reserve requirements or high call money market rates induce such banks to borrow money from the central bank at the pre set discounting rate i.e. the bank rate. Banks experience a shortfall in their reserves leading them to borrow money from the market. It adds to its detriment if the existing market rate is also high (Hossain, 2009). Reputed banks have failed in the past owing to shortage of funds. In recent reforms the central banks as a practice have bailed out sick banks by providing funds at low cost. Economies become weak owing to a fragile banking system. Profitability of banks is the key to a stable economy and central banks across the world have incentivised banks that are in need to pay off their dues or short term debt obligations. It protects the profitability of banks by offering them lower discounting rate than the market interest rate. Banks enjoy the difference in the central banks rate and the rate at which they discount the short term debt instrument of its client. In this case, the lower discounting rate is the main cost to the central bank for lending to commercial banks. The effects of higher costs are on the commercial banks than the central bank. The re discounting role of central bank creates regulatory and incremental costs for banks. It leads to higher rates for future borrowings or stricter regulations i.e. regulatory costs which will prevent lending institutions to avoid bank runs. Regulations compel banks to undertake activities to meet the requirements. Truth in Savings and Banking Secrecy Acts are examples of a few regulations implemented by central banks. Truth in savings requires banks to furnish critical information about its deposit accounts at different intervals. Though banks earlier used to furnish their account information to government agencies and central banks, but after such regulations, it is mandatorily required to file all relevant information which was earlier not disclosed. Regulatory costs are of two types i.e. opportunity cost and operating costs. Operating costs implies the loss in interest income from profitable lending opportunity owing to stricter reserve requirements. Operating costs include all those incremental costs that are required to meet the regulations like Truth in lending, truth in savings, currency reports, transaction reports, etc to regulatory authorities like central banks and government authorities. In meeting the obligations banks incur additional costs in respect to number of employees, equipment runtime, materials, etc. All these factors add to the overall cost of the banks in meeting the regulatory requirements. For example, Company X discounts a bill of exchange of £1000 with a rate of 10% with Bank Y. Bank Y does not have the required fund to discount company X’s bill. It goes to the central bank that offers to rediscount the bill at a rate of 7% and provides bank X with £9030. Bank X now discounts its client’s bill by paying £9000 and enjoys a gain of £30, equivalent to 3% of the bill value. The above example is optimistic where the central banks’ discount rate is low, there might be situation where the bank rate and the call money market rate is same i.e. 11%, resulting in loss of 1%. Market rate is another key determinant of banks profitability (Labonte and Makinen, 2006). Figure 2: Bank rate of Bank of England (CB Rates, 2014) Figure 3: Bank rate of Federal Reserve (CB Rates, 2014) Figure 4: Euro zone bank rate (CB Rates, 2014) Figures 2, 3 and 4 represent the discount rates of the Federal Reserve, ECB and Bank of England from 2000 to 2015. The banks rates are 0.25%, 0.05% and 0.50% respectively. The patterns observed in the three economies experienced a down trend in the discounting rate which can be attributed to growth and inflation targeting. III. Central banks across nations target the growth or inflation by expanding or contracting the money supply. The Central Banks employ open market operations like quantitative easing, adjusting the funds rate and reserve requirements of commercial banks. Though the effectiveness of the three monetary policies is different it still affects the money supply in the short run (Kennedy, 2000). Open market operations – Central banks use credit easing or quantitative easing in adjusting the money supply in an economy. Credit easing is done by central banks to increase the liquidity of banking and financial institutions and quantitative easing refers the act of purchasing government bonds or treasury bills to increase the money supply by lowering the interest rate. In terms of flexibility and reversibility open market operations are less flexible, but reversible. It can be used to adjust the money supply either upward or downward, but takes time in implementation. It is effective, but at times it becomes ineffective when the interest rate tends to zero. Very low interest rate fails to stimulate the demand which reduces the growth rate of money supply in an economy (Mayes and Toporowski, 2007). Central lending facility – Central banks as a practice use the lending rate more than other monetary policy tools. Central banks at times adjust its lending rate quarterly, bi annually and annually depending on its growth and inflation target. The central lending facility is not so flexible as compared to the other two discussed above since the contract with the central bank and the commercial banks are mainly for some years and it is not possible to change the terms of contract soon. Accordingly the effectiveness shall also be lower since the changes on the terms of contract takes time to get effective. The speed of implementation is lower than the other methods as well. It is used to adjust the lending interest rate, i.e. increase or decrease. Adjusting the interest rate influences the money supply in an economy (Singleton, 2010). Reserve requirement – Funds rate and reserve requirements are the most effective monetary policies of central banks as it has high flexibility. It is at the discretion of the central bank when it wants to increase or decrease the funds rate and reserve requirements, resulting in lower time in implementation compared to open market operations. These are perhaps the most effective monetary measures as the level of money supply changes and the change results in achieving the target rate, unlike in OMO, where the change takes longer time to take effect (Frenkel, and Johnson, 2013). Question 2: International finance and the exchange rate I. Balance of payment refers to the net income of a country. It is a measure of trade by private and public companies in an economy. It indicates the level of a country’s money i.e. whether a company is a net receiver or giver. Balance of payment is a cumulative measure of current and capital account deficit or surplus. Balance of payment is indicative of the net flow of foreign exchange in a country. A surplus BOP reduces the local interest rate. This results in higher demand of other currencies and instruments as they comparatively offer higher interest rate than the local country. This will depreciate the local currency as against the foreign currency, leading to exchange rate volatility. Depreciating currency of a country makes it import dearer in respect to the exporting country. Current account refers to the inflow and outflow of goods and services of a country. If the inflow is more than the outflow it indicates surplus and vice versa. Capital account refers to the flow of non financial assets of a country. It includes transfer of physical assets like land, machinery, etc. If there are more outflows than inflows then it experiences a deficit and when it receives more than it gives, it is termed as balance of payment surplus. An economy should ideally have net balance of payment as zero as a BOP surplus will impact the money supply in an economy, which will result in inflationary pressure. This balancing practice of payments of a country is practiced through resorting devaluation of currency against the currencies of rest of the world. It is highly related with inflation in the economy as a prime cause as well as effect of inflation. If a countries net payment is positive, it indicates an increased level of money supply in the market through injecting liquidity by the monetary policies of central bank. Again, excess money supply in an economy reduces the interest rate which stimulates the demand of goods and services resulting increase in cost of living in domestic market and creates inflationary situation of the economy (Carbaugh, 2012). II. Exchange rate system is of two types i.e. fixed and flexible. Under a fixed rate system the exchange rate is pre determined between two currencies like US fixes its exchange rate with British pound but under floating rate system, the exchange rate is driven by the market forces of demand and supply. The floating rate system does not directly impact the money supply in an economy rather it is affected by the monetary policy which is incumbent on the exchange rate volatility (Siddaiah, 2010). Let us consider an example where the effect of exchange rate system is shown on the money supply. Figure 5: Impact of exchange rate on money supply (St. Andrews Scots School, 2014) The above figure shows the market adjusted rate of dollar against euro, when there is excess liquidity of dollars. Let us assume that the current exchange rate of $1= €1.6 and there is excess liquidity in country X compared to US. Owing to high liquidity in country, the interest rate is low, implying that the return on assets in country X is low compared to US. On the other hand US offers high interest rate which attracts country X’s investment. The excess liquidity is dissolved by excess demand of financial assets in US. The rising demand for US’s financial instrument triggers the dollar euro exchange rate as shown in the figure. $1=€1.7. Euro depreciates owing to high demand for US$. Rising dollar will make country X’s import bill to raise, leading to inflationary pressure. This will induce the central bank of country X to introduce contradictory monetary policy. The monetary policy adopted by country X is targeted to control the inflation owing to the exchange rate volatility. The monetary policy will affect the money supply in country X to rise, thus it shows how the pure floating exchange rate has no direct impact on money supply, but is affected as a result of monetary policies. There exists an indirect relationship between money supply and exchange rate system, but the latter has strong influence on the monetary policy which in turn affects the money supply. A country which has high inflation rate because of depreciating exchange rate will use monetary policies like open market operations, lending rate and reserve requirements to target the inflationary pressure. The rising lending rate will result in credit contraction for banks, resulting in reduced demand. The cost of borrowing for retail and wholesale customers will rise, leading to low demand for loans and other credit facilities. Using such monetary policies will allow the central bank to adjust the money supply in the country. This will result in achieving the target inflation or economic growth rate (Rochon and Rossi, 2006). III. Monetary union or currency union refers to the practice of countries to peg exchange rates at a desired level to mobilise each other’s resources and facilitate trade across national borders. Examples – The European Monetary System formed in 1979 with eight European countries aimed at a fixed exchange rate system. The European Monetary Union was formed in 2012 with twelve member countries that had the same currency and agreed to a mutually fixed exchange rate. Countries come together to form a monetary union to enjoy lower transactional cost, no exchange rate risk, reduced risk of foreign investment, better transparency and comparability of goods and services, increased trade, job creation and uniform monetary policy (Bertola, 2000). Though there are benefits associated with forming monetary union it is still subject to various constraints that affect trade of member countries. There are certain costs associated with currency union like high requirement of foreign exchange reserves, stabilization effect of exchange rate volatility and dominance of strong countries in adjusting monetary policies. Examples – Federal Reserve frames monetary policy considering the major countries and ignores the impact on smaller countries like Ecuador. EU does not pay attention to countries like Africa, Bosnia, Macedonia, etc. Currency area refers to the region where countries share a common currency that is fixed at a mutual level. Optimal currency area is larger than a country and the theory of currency area was introduced by Bretton Woods in the year 1960. Critical factors that affect the optimality of currency area are stated below. i) Fiscal harmony – The fallout of forming unions can affect small countries adversely by exogenous shocks, which can be better managed by redistributing funds to those member countries. ii) Controlling inflation – Current and capital account deficit is reduced as a result of fixed exchange rate system (Baldwin, Skudelny and Taglioni, 2005). Price and wage adjustment- External shocks faced by one member country will not affect the overall employment, as they may find suitable jobs in other member countries at similar wage rate. iii) Capital mobility – machinery, labour and other factors of production enjoy greater mobility across the currency region. Owing to pegged exchange system, members enjoy low marginal rate of substitution of the factors of production (Baldwin, Bertola and Seabright, 2003). References Baldwin, R., Bertola, G. and Seabright, P., 2003. EMU: Assessing the Impact of the Euro. Baldwin, R., Skudelny, F. and Taglioni, D., 2005. Trade Effects of the Euro: Evidence from Sectoral Data. ECB Working paper Series. Bertola, G., 2000. “Labor Markets in the European Union,” Ifo-Studien; 46(1), pp. 99-122. Blackwell Publishing. Carbaugh, R., 2012. International Economics. Ohio: Cengage Learning. CB Rates, 2014. Worldwide Central Bank Rates. [online] Available at: < http://www.cbrates.com/ > [Accessed 4 April 2015]. Frenkel, A. J., and Johnson, G., H., 2013. The Monetary Approach to the Balance of Payments. UK: Routledge. Gowland, H. D., 2013. Controlling the Money Supply. New York: Routledge. Hossain, A. A., 2009. Central Banking and Monetary Policy in the Asia-Pacific. UK: Edward Elgar Publishing. Kennedy, P., 2000. Macroeconomic Essentials: Understanding Economics in the News. US: MIT Press. Labonte, M. and Makinen, E. G., 2006. Monetary Policy and Price Stability. New York: Nova Publishers. Mayes, D. and Toporowski, J., 2007. Open Market Operations and Financial Markets. New York: Routledge. Mishkin, S. F., 2007. Monetary Policy Strategy. US: MIT Press. Rochon, P. L., and Rossi, S., 2006. Monetary and Exchange Rate Systems: A Global View of Financial Crises. USA: Edward Elgar Publishing. Siddaiah, T., 2010. International Financial Management. India: Pearson Education India. Singleton, J., 2010. Central Banking in the Twentieth Century. UK: Cambridge University Press. St. Andrews Scots School, 2014. Factors which affect exchange rates. [online] Available at: < http://www.sanandres.esc.edu.ar/secondary/economics%20packs/international_economics/page_59.htm > [Accessed 4 April 2015]. State University of New York, 2014. Monetary Policy. [online] Available at: < http://www.oswego.edu/~edunne/200ch15.html > [Accessed 4 April 2015]. Read More