Difficulties Faced by Central Banks in Operating Monetary Policy - Coursework Example

Difficulties Faced by Central Banks in Operating Monetary Policy INTRODUCTION Monetary policy is the management of the supply of money, cost of moneyand availability of money in an economy. Central bank is the authority, which is responsibly in establishing and conducting monetary policy. It is very important to analyse the problems faced by the central banks in operating monetary policy because it does not only influence the supply of money and interest rates in an economy, but it also affects the level of economic activity. There are two steps, which the central bank takes to operate a monetary policy. In the first step, the policymakers decide the policy objectives that they want to attain and in the second step, the policymakers decide the process of manipulation of the tools of monetary policy. There are primarily three tools of monetary policy, which are used by the central bank including open market operations, discount policy and reserve requirements. The most commonly used tool of monetary policy is open market operation whereas; the discount loans only make up two to three percent of it. The reserves requirement ratio is not frequently used because it can destabilize the economy. Therefore, the central bank usually relies on open market operations. In the recent years, the importance of monetary policy has increased because of the diminishing role of fiscal policy in the stabilisation efforts made for economy. During the period from 1960s to 1980s, the governments of various countries were facing problems in handling inflation and unemployment through fiscal policy. Therefore, monetary policy appeared as an effective way to fight against unemployment and inflation. However, various limitations to monetary policy have been always creating problems for the central banks in operating monetary policy. During the period of 1930s, when the U.S economy was facing an economic downturn, FED encountered very serious problems in operating monetary policy. In order to combat the economic downturn, the monetary policy of the FED was aimed to increase the amount of money in circulation to cut off the interest rates. After implementing the policy, the interest rates reached to zero and FED did not have any other option. This situation is also known as liquidity trap and Japan also encountered such as situation during the late 1990s. It means, the central banks have been always facing problems while dealing with monetary policy. Actually, there are different reasons because of which the central banks face difficulties in operating monetary policy. For example, in a more liberal environment, where the capital moves freely, the operation of monetary policy becomes very complicated. Another reason is that sometimes the theoretical concepts of the monetary policy totally differ from the practical nature of monetary policy. It is evident from the fact that during 1997 and 1998, the Asian financial crisis was a result of ineffective monetary policy. Actually, at that time it was considered by the analysts that the tight monetary policy was the only solution for the stability of the exchange rate and reduction of the economic slump. However, the policy failure further worsened the financial crisis. Therefore, this essay analyses the difficulties that a central bank faces when operating the monetary policy. MAIN BODY Following are some of the difficulties that a central bank usually faces when operating monetary policy. Difficulties raised by tools of monetary policy These are the problems, which are raised when a central bank attempts to achieve the objectives of monetary policy by using its tools. Suppose, if the central bank aims to expand the monetary base and money supply, it encourages the discount lending. However, the central bank can only act to encourage or discourage the other banks and cannot control the total volume of discount loans directly. Second, if the central bank desires to bring a considerable change in reserves or monetary base, the two tools of monetary policy including discount loans and reserve requirements cannot be used. Third, if the central bank conducts the open market operation, it can easily reverse the process, in the case of any mistake however, the reverse process is not very much possible in the case of discount loans and reserve requirements. If the central bank changes the reserve requirements to achieve the objectives of the monetary policy, then it may face many difficulties. For example, if the central bank raises the reserve requirements, the other banks in the economy face immediate liquidity requirement. Moreover, the continuous fluctuations in the reserve requirements also create uncertainty for the other banks in liquidity management, which create the conflicts between the central bank and other banks. As a result, the central bank has to face various conflicts and disagreements while operating monetary policy. Therefore, although there are three tools of monetary policy available to the central banks however, it is mainly dependent on open market operations to achieve monetary policy objectives. Velocity of money The central bank cannot exactly predict the velocity of money in an economy. The velocity of money gives an estimation of the number of times the average dollar is spent annually. Therefore, if the central bank pursues a tight monetary policy, the velocity of the money increases and people spend faster. Since the total expenses in an economy are usually equal to velocity of money multiplied by money supply therefore, the more the velocity is the more is the money supply. That is why the inability of the central banks to predict the velocity of the money, may create problems during the operation of monetary policy. Conflicting goals: Mishkin and Eakins have mentioned six objectives of monetary policy including economic growth, financial markets stability, foreign exchange market stability, high employment, interest rate stability and price stability.1 Although many of these goals are closely related such as the aim of high employment is linked with economic growth because for increasing productivity the businesses make capital investments thereby, increasing the employment rate and steady economic growth. However, central bank faces various problems in meeting these goals for example, if the objective of monetary policy is to attain price stability, then it conflicts with the aim of interest rate stability and high employment. In other words, if the central bank encourages high employment for steady economic growth, the inflation and interest rate also increase. No doubt, these conflicting aims usually occur in the short run and they may not be significant in the end, however, central bank really faces the difficulty because if it desires to increase cost of money to reduce inflation, the rate of unemployment in the country increases. Therefore, the conflicting goals give hard choices to the central bank. Influencing the goals: Although the aim of central bank to operate monetary policy is to achieve any of the objectives mentioned above however, the problem is that the central bank cannot directly influence the goal. In any case, central bank has to employ the three tools of monetary policy to affect the goals. Moreover, the goals are indirectly influenced at least after a period of one year. It means that the central bank has to wait for at least one year to analyse the impact of its decision, which was made one year ago. If after one year the central bank decides to make a correction in the policy, it gets too late thereby, making the correction impossible. Problems in developing countries: The central banks in the developing economies face various problems while conducting a monetary policy. One of the major problems is that many of the developing countries have deep markets in government debt. Lags in monetary policy Lag in monetary policy is the difference between the time when the need to change the policy is felt and when the action is taken. Sometimes the lag gets so long that it becomes uncertain for the central bank to decide when to implement and operate the policy. Although the lags can be reduced, if central bank uses complex questionnaires and econometric models however, they cannot be completely reduced. Conflicts in Balance of Payments The concerns related to the balance of payments may also cause difficulties for the central bank. During the economic boom, the balance of payments concern may arise because of the tendency for import to increase and exports to decrease. This situation is further worsened when the buyers and sellers of foreign exchange make short-term capital movements and expect devaluation in currency. The challenge for the central bank is to take the restrictive actions related to monetary policy, which increases the unemployment and slows down the economy, thereby, making it difficult for the central bank to take the right action. The problems of balance of payments were faced by the central banks of Britain and Denmark during the periods of boom. Fixed exchange rate: Many countries of the world have been trying to target a low level of inflation by pegging the value of their currencies with the currency of the other country that has stable inflation record. This strategy creates problem for the central bank because in this case, the central bank cannot use the monetary policy for responding to domestic stocks and exercising the control for operating monetary policy. Nature of monetary control framework The nature of monetary control framework may also cause problems for the central bank as it happened in mid-1970s with Central bank of Nigeria. The Central bank of Nigeria faced the failure in attaining the monetary targets because the monetary control framework was relying on credit ceilings and selective credit controls. Sensitivity of market interest rates Another reason, which is causing difficulties for the central bank in operating monetary policy, is the focus of the world economy towards the common approach of monetary policy. This approach makes the policymakers to target the short-term interest rates. Once the interest rate is announced, the central bank has the variety of tools to affect the behaviour of fed fund rates. However, the major issue which central bank faces in operating the monetary policy is the sensitivity of the market interest rate to the changes in the supply and demand that are not anticipated. Actually, the small estimation errors expose the central bank to various problems during operating monetary policy. Political Involvement Apart from the problems mentioned above, another problem that is usually faced by central banks of various countries in operating monetary policy is the political desires and government involvement. Since, after the failures of governments in managing inflation and unemployment through fiscal policies, the interest of governments has been increasing in monetary policy. Since the aim of the central bank is to increase its power and prestige and to preserve its autonomy therefore, central bank may undergo conflicts with power groups. Such political desires create problems for the central banks in the implementation of the monetary policy. Cyclical Asymmetry: The central bank pursues either an expansionary monetary policy or tight monetary policy. If the level of inflation in an economy is high, the central bank implements a tight monetary policy however, although it will work to manage high levels of inflation but it will not encourage help the economy to stop a recession. It is also known as cyclical asymmetry. Foreign Investors: The central bank has less power because of the growing global nature of finance. In other words, the central bank cannot affect the decisions of the foreign investors related to buying securities of the country. Therefore, when operating the monetary policies, various uncertainties are faced by the central bank. CONCLUSION From the above discussion, it is concluded that apart from the various shortcomings of monetary policy, there are various other factors, which are also contributing to the difficulties faced by the central banks in operating monetary policy. The lags in monetary policy, velocity of money, cyclical asymmetry and inflation targeting are the some shortcomings of the monetary policy that usually create problems of the central banks. However, the reasons like political influences, market interest rates and exchange rates are external causes that create problems for the central bank. The primary reason that is contributing to these difficulties is the conflicting goals or objectives of the monetary policy. Moreover, among the three tools of the monetary policy, the only tool that is under the control of the central bank is the open market operations. Therefore, to reduce such problems, the central bank should be very careful and free from political influences, throughout the process of formulation, operation and implementation of monetary policy. BIBLIOGRAPHY Mishkin, F. S., & Eakins, S. G. (2006). Financial Markets + Institutions . Pearson Education . Read More