Monetary Policy, International Finance and Exchange Rates - Assignment Example

Money and Banking Question Monetary Policy Macesich (2000) explains that central banks employ techniques suchas the interest rates with the aim of controlling money supply in the economy. It assists not only in controlling inflation as well as stabilization output. Central banks seldom set a fix interest rate number. The techniques differ in countries and the strategy to compel market towards a rate target is through lending or borrowing money in quantities that is somehow unlimited. This is usually done up to the level where the set target for the target market is accomplished. They accomplish this by either borrowing from or lending money to financial institution (depository-banks) which are qualified. Besides, they also purchase and sell bonds. Macesich (2000) argues further that money plays a vital role in the economic activities since it virtually makes economic transaction possible. When the supply of cash is higher in the economy, consumers tend to have more money. This in turn encourages spending. On the other hand firms or businesses or ventures respond by increasing either raw materials or production. Because business activities tend to be spread, the demand for labor as well as capital goods increases. Increase in expansion of money supply consequently results into increase in prices more so if the growth of output approaches the limited capacity. At this stage, consumers begin anticipating inflation. However, lenders begin aggravating for higher interest rates to balance the anticipated reduction in the purchasing power while offsetting the loans. The converse is true when money supply subsidizes or the growth rate declines. For instant, Federal Reserve policy plays a crucial role in determining money supply. It does so by influencing its deposits in the bank. They do this by mandating commercial banks to hold part of the deposits that they accept. These institutions comply by either holding cash in the vaults or holding deposits that they make at the Federal Reserve. The Federal Reserve in turn manipulates their reserve by lending cash to banks and changing the discount rate on loans. Therefore, when the supply of money in the economy is high, despite the interest rate target, the central banks tend to device mechanism that are aimed at limiting cash flow in the economy. When this is done, the demand for cash that is apparently at the bank reserves increases. This increase in the demand compels the central banks to stop holding money in the reserves. Question 2 Central banks encounter a challenge of policy enforcement in the domestic banking system when there is liquidity surplus. Liquidity surplus hampers central banks from controlling targets deemed operational and the implication may be reflected in profitability. A number of banks have employed the use of security option effectively and efficiently. These securities allow the banks to minimize other parties from holding excess reserves. Central bank securities enables operations that are not size constrained; tradability of instruments; and it allows equal distribution of liquidity in the system especially if the interbank systems are not proper or developed. These securities by central banks however, have disadvantages such as: if a commercial bank commits funds in form of deposits, they are compelled to borrow unsecured funds if they need funds in the short term cash market. This could be expensive depending on the nature of the market or the commercial bank credit. Moreover, commercial banks can utilize the securities they have received though such operations are hampered with the earlier holdings form the balance sheet of the central bank. Many a times the central banks impose the reserves to be at an arbitrary level which unfortunately presents the challenge of equitability in terms of the distribution of resources. Deferent banks hold or have deferent quantities in the reserves, therefore an implementation that tends to increase reserve increase render some banks to have free surplus cash while others may have shortages of surplus. In addition, the distribution of the funds rely on how deep the interbank market is unsecured the standing of the commercial bank in terms of credit in its quest to borrow. The greatest disadvantage of central bank giving security is the likely impact that emanate from the presence of public sector issuer besides the central government is having liquidity for the entire public sector security. Though it is usually perceived that the property of the central bank securities to be better than other possible solutions, issuance cost coupled with the cost of building the requisite infrastructure tend to be higher than other likely solutions. Consequently, central bank may incur losses and minimizes its capital level thus being compelled the government to recapitalize it. This is likely to present the challenge of the central bank to operate independently. The other disadvantage of the securities by the central government is that its properties that are desired may divert from its sole purpose that it is to address. Question 3 Central banks either increase or decrease the quantity of reserves in the banking system thus controlling money supply in the country. When it sells systems it acquires money from the system and when it buys it injects it to the system. This technique is known as open market operations. The operation leverages the central bank with flexibility in timing as well as the capacity of monetary operations. Reversibility of the open market operations emanate from the refinancing of operations where banks bid for discount rates pegged on the collateral value (Posner, 2010). Part 2: International finance and exchange rates i. Contribution of large balance of payments surplus to a country’s inflation rate Blejer & Skreb (1999) vindicate that balance of payment is the record or documentation of all the concluded transactions between a country and the rest of the world over a certain period of time. The inclusion of all the components or facets of balance of payment should sum up to zero. When it sums up to zero then there is no surplus or deficit. Imbalance of the balance of payment is quite common especially on some components such as current account, and capital account with the exclusion of the reserves of the central bank account. The imbalance due to capital account may lead to surplus in the country thus wealth accumulation. On the other hand, when there is deficit, countries tend to have more debts. Surplus of the balance of payments indicate that the payments made by a country is less than that which is received from other countries. It is usually perceived favorable due to influx of foreign currency into countries economy. Such a flow is likely to increase the money supply in the country and decrease as well the exchange rate in relation to the currencies belonging to other nations. Berg & International Monetary Fund (1999) explain that the consequences are inflation, production, and unemployment among others. However, on inflation, the contribution of the BOP is in such a way that its surplus optimizes or increases circulation of currency into the economy. Increase in the circulation leads to increase in prices of commodities which in time have the potential of getting to the level of inflation. II. Pure flexible exchange rate system, effects of the foreign exchange market on the money supply and on monetary policy Floyd (2010) elaborates that a flexible exchange rate system is a monetary system where the modalities of the exchange rate depend on supply and demand. Countries make decisions on the type of exchange rate system to employ. Floating exchange rates appear to be economically effective and efficient as well as volatile on some currency. It may undergo either currency appreciation or depreciation which relies on fluctuations in the market. Monetary policies (expansionary) are policies that elevate demand in the economy and involve lower rates of interest or increasing money supply through quantitative easing (QE). It is prudent to comprehend that changes in the affects both the prices and income. For instant, if monetary authorities employ monetary policies that are expansionary then the real interest rate reduces thus both the domestic and capital assets are rendered unattractive due to the low return on real rates. Foreigners minimize their stands on stocks, real estate, and bonds which are domestic among other assets (Welfens, 2001). As a result financial accounts deteriorate since the foreigners hold little domestic assets. When the foreigners domestic investments drop, it sub optimizes the demand for a country’s currency while increasing foreign currency demand hence the country’s currency declines. Importantly, the implications of the expansionary monetary policy are that it lowers the exchange rate; current accounts are strengthened while the financial account weakens. The converse is true for a restricted account. Expansionary monetary policy is likely to the following can be anticipated in terms of effects on income: increase in the GDP; purchases that are imported increase tend to increase the conversion of the local currency to the foreign currency (Welfens, 2001). III. Benefits and costs of monetary union and the main criteria for the optimality of a currency area Grauwe (2014) illuminates that monetary unions involve countries sharing a single currency. One of the advantages is on the transaction cost since changing currencies into a homogeneous currency eliminates the need to change the currency thus saving individuals from the likely costs that would have been incurred. Secondly, it promotes investments especially the cross border one because transactions are low as well as making the market for the money to be not only deeper but also integrated. Third, there is stability in the exchange rate on common currency as it enables individuals to notice the existence of price difference and the equalization of prices across borders. The other leverage of common currency is that it enhances free labor mobility as workers are free to move across borders hence preventing a shock of the level of inflation that may be present in a country. Members (countries) are also protected form factors such as competitive currency devaluation which may entail theft of business to other. In addition, the other disadvantages are that the countries are able to access large market which results into an increase the income of the country. Moreover, it minimizes shock effects from external instability to a country. Grauwe (2014) asserts that monetary union is ideal for countries with the lack of internal control as goods and services move freely between borders without obstacles. Finally, it encourages tourism as there is no such thing as changing of currency. However, there are certain limitations that accompany the concept of monetary union. One of the disadvantages is that a country tends to loose sovereignty. Thomas (2006) indicates that a country embracing the concept has to do away with its monetary policies and adopt those policies that are directed by the union’s controlling body. For instant, all the member of the European Union abandoned their monetary policies and incorporated those policies that were issued by the union. The adaptation costs that accompany the implementation cost impacts hugely to the economy. Such costs emanate from the need to educate individuals and customers; training of staff; and change of labels on the currency among other costs. Thirdly, Grauwe (2014) points out that fiscal negative policies across borders are likely to spillover to the member countries of the union. The other disadvantage is that difference in language minimizes mobility of labor as well as they lose the ability to acknowledge and synthesis external shocks. James (2012) extrapolates that the optimality of the currency area or optimum currency area refers to region where the economic efficiency is maximized with the aim of having the region to adopt the use of one currency. The theory on this concept is used to evaluate if a certain region is ready to incorporate currency union as the last steps of economic integration. There are criteria that have often been cited for the success of monetary union. One of the criteria is the mobility of labor across the region that intends to homogenous its currency. It attempts to solve movement barriers such as physical and cultural. The second criterion is the need for the openness with the mobility of capital, wages, and prices which should be flexible across the regions. The third involves sharing a risk system and finally the involved countries or members having similar cycles in terms of business. Reference List: Berg, A., & International Monetary Fund. (1999). Anticipating balance of payments crises: The role of early warning systems. Washington, DC: International Monetary Fund. Blejer, M. I., & Skreb, M. (1999). Balance of payments, exchange rates, and competitiveness in transition economies. Boston: Kluwer Academic Publishers. Floyd, J. E. (2010). Interest rates, exchange rates and world monetary policy. Berlin: Springer. Grauwe, P. . (2014). Economics of monetary union. Oxford: Oxford University Press James, H. (2012). Making the European Monetary Union. Cambridge, Mass: Harvard University Press. Macesich, G. (2000). Issues in money and banking. Westport, Conn. [u.a.: Praeger. Posner, R. A. (2010). The crisis of capitalist democracy. Cambridge, Mass: Harvard University Pres Thomas, L. B. (2006). Money, banking, and financial markets. Mason (OH: South-Western. Welfens, P. J. J. (2001). European Monetary Union and exchange rate dynamics: New approaches and application to the Euro : with 12 tables. Berlin [u.a.: Springer. Read More