The Role of Money in the Macro Economy - Essay Example

The Role of Money in the Macro economy Introduction The concept of money and monetary order in the world has undergone changes in the dynamic economic environment from the simple bartering system to electronic transfers over the period of time. In macro economy the fiscal measures of the governments and the monetary control of the central banks of countries play important roles in determining value of money. The stock of money in an economy is regulated with a view to facilitate economic growth. This paper seeks to study the role of money in national and international monetary systems, the relevance of institutions in this context and its impact on macro economy. Importance of the study Money supply in an economy is closely linked to economic growth of the nation, unemployment, inflation in economy and interest rates prevailing in the banking system of the country. ECB (2011, p. 63) states “The volume of broad money in the economy is the result of the interaction of the banking sector (including the central bank) with the money-holding sector, consisting of households, nonfinancial corporations, the general government other than central government, as well as non-monetary financial intermediaries.” Money supply determines liquidity in the economic system and credit growth. Credit growth depends upon the liquidity in the banking system, ability of the banking system to scale up their exposure in relation to demand, interest rates, internal rate of return expected on investments and the general economic condition. Therefore credit growth is considered an important indicator of economic development in a country. A country needs to overcome the imbalances in the current account through regulations for maintaining the exchange rate parity of its currency in the international markets for sustainable growth and development. The US subprime crisis and the European financial crisis have underlined the importance of financial services sector in macroeconomics. The globalization phenomenon necessitates revisiting of global monetary system with International Monetary Fund at the helm of affairs. Surveillance system of the International Monetary Fund should be able to detect the warning signals of impending economic crisis and support the countries in overcoming their economic imbalances. Money supply Keynesian expansionary policy envisages increasing supply of money and government spending for revival of economy and growth. Central banks control money supply using various tools. For example, the Federal Reserve can regulate money supply and manage liquidity through reserve requirements imposed on the banks. By increasing or decreasing the reserve ratios the Federal Reserve can regulate money supply. Also, the Federal Reserve buys and sells securities in open market with repurchase agreements for this purpose. When the economy is on growth mode, banks can borrow money through Federal Reserve’s discount window or avail facilities through autonomous factors that increase supply of money in the economy. The central bank of a country can use ‘Bank Rate’ as a tool to regulate money supply. The change in bank rates leads to changes in the short term and long term interest rates. The impact of the changes on financial and capital markets need to be carefully reviewed after taking into account several factors. For example, decrease in the interest rates will have impact on the pensioners’ income by way of interest on fixed income securities. The economic indicators such as Consumer Price Index related to inflation, Jobless Claims related to unemployment, GDP relating to economic growth and industrial production statistics are useful in taking decisions by the monetary authorities. Increase in money supply increases aggregate demand which encourages entrepreneurs to establish production facilities for meeting the consumer demand. The additional employment generated in this process increases the consumption level and demand. The multiplier effect caused due to expansionary policies needs to be regulated to avoid overheating in the economy and ensure stability in economy through monetary policies. Economic growth The fiscal policies of a government through public spending and changes in the tax rates have significant impact on the economic development and money supply. Increased allocation to planned expenditure generates employment that increases money supply. Reduction in tax rates increases the real income of the tax payers. This could act as catalyst for fresh investments. The fiscal policies of the government would be effective in achieving the intended objectives if they are supported by appropriate monetary policies. The governments which are not in a position to take effective measures to improve the macroeconomic conditions on account of deteriorating financial status due to poor macroeconomic management in the past are forced to print money. This decision is reached due to lack of other alternatives. It could be impossible for the government to increase the tax rates further or borrow in the national or international markets due to poor ratings and very high debt to GDP ratio. This precarious level of the economy results in confidence crisis and hyper inflation. The real income of the people will come down drastically in economy. During the period of recession, revival of the economic situation would be prolonged, uncertain and unpredictable. Economic growth of a nation is affected by internal factors, external factors due to globalization phenomena, wars, famines and natural disasters which are not in the control of the governments. The common denominator of almost all the factors being money, economists concentrate more on this aspect. Borrowing ingrained in the western culture has made the economic system fragile. Therefore, the austerity measures introduced in Eurozone is met with stiff resistance among the people. The economic indicators are useful in assessing the economic situation in a country for formulating fiscal and monetary policies. Economic cycles The interrelationship between various factors in the economic system is very complex. Therefore, the consequences of the decisions by the government or central bank on many times become unpredictable. When the economy is under recession the governments’ spending for the revival of economy is necessary. Generation of employment opportunities at the time of recession is an important objective for the Government. Increase in unemployment benefits causes additional burden to exchequer. Overall increase in income of the people enhances their consumption level that results into increased demand for the products. A portion of the income is saved by the people. This is very important for capital formation in a country. Availability of credit at reasonable interest rates is also important for establishing production facilities to cater to the increased demand that generates further employment. Government’s spending acts as a catalyst for economic growth. Private entrepreneurs will be confident in making fresh investments based on the investment policies of the government. This is because the government’s spending will be mostly on development of infrastructural facilities which would be very difficult for the private entrepreneurs due to huge investment outlay and a very long gestation period. However, there will be competition among the investors both local and foreign to make use of these facilities for the growth and development of their businesses. The expansion cycle initiated by government spending will continues further through private participation. The economic cycles will have impact on the financial and capital markets. Unless this phase is regulated skilfully, overheating leads to accumulation of inventories and over capacity which could in turn lead to contraction of economy. After slow down the economy reaches an equilibrium and revival starts again. This is called as business or economic cycle which may last for few years or longer. Lane (2003, p. 15) stated that “institutional reforms in the conduct of monetary and fiscal policies that can do much to improve the capacity to stabilize cyclical fluctuations. Although the case for inflation targeting is by now widely accepted and it is being adopted by an increasing number of countries, relatively less progress has been made in designing and implementing new fiscal procedures.” Money in international finance “The exchange rate—the price of one nations currency in terms of another nations—is a central concept in international finance” (Pearson Education, 2013). Gold Standard System was adopted in Bretton Woods Conference in 1914 by the participating countries for determining the exchange rates of the currencies. However, due to series of devaluations of currencies initiated simultaneously by almost all the countries as well as trade restrictions imposed by them to protect their economy to make their countries’ products competitive in the world markets the world could not maintain the intended international monetary order after World War-I. The International Monetary Fund came into existence in Bretton Woods Conference in 1944 with the purpose of establishing monetary order in the international economy. The fixed exchange rate system as envisaged by the international community could not succeed because it was difficult for many countries to maintain the fixed exchange rates due to mounting imbalances in balance of payment positions. Now most of the countries are adopting floating exchange rate system where the exchange rates of various currencies are determined based on supply and demand factors relating to the currencies. Krugman (2002) stated “Under the "floating" exchange rates we have had since 1973, exchange rates are determined by people buying and selling currencies in the foreign-exchange markets... concern over the instability of floating exchange rates was replaced by an appreciation of the greater flexibility that floating rates would give to macroeconomic policy.”  Purchasing power parity When value of a currency appreciates, the countries products in the world markets denominated in local currency become costlier. This will negatively affects the export performance of the local exporters. On the flip side, the imports become cheaper. Due to competitive prices of the imported products, the demand for the local products comes down. Therefore, decrease in demand for the local currency on account of decrease in exports and increase in demand for the foreign currencies on account of increase in imports will affect the exchange rates negatively. Also, there is speculation involved in currency trading. However, stability in foreign exchange of a currency is very important for the economic growth. The central banks intervene in the markets through open market purchase or sale of currencies to ensure stability at the targeted level of exchange rates. Also, interest rates and inflation are the important determinants of exchange rates. This will also influence the currency flow into the country. For example, increase in interest rates would attract foreign investments. On the other hand, inflationary situation in a country may negate the benefits of increase in interest rates in the country, because inflation is linked to interest rate. In the recent years, foreign direct investments in the developing countries like China and India are on rise. Availability of cheap labour in these countries and the big market with huge population are the important attractions for FDIs. These FDIs can render stability in exchange values of the currencies of these countries in the long run. These countries could act as export hubs of the multinational companies and the export earnings would improve these countries’ balance of payments position. In view of these several factors that influence the exchange value of the currencies, comparing the strengths of the economies of various countries based on exchange rates is fraught with risks and not reliable. Gross Domestic Product (GDP) of a country in terms of common currency can be used for comparison of purchasing power parity with other countries. Current account deficit The imbalances in the current accounts of the countries affect the international trade. External borrowings by the governments and the local private organizations over years to meet their foreign exchange requirements and the interest on these borrowings result into increased strains in balance of payments position which could lead to sovereign debt crisis. Deutsche Bundesbank (2012, p. 14) observed “Balance of payments deficits that change the public external position by reducing foreign reserves or increasing liabilities to foreign government or supranational institutions can only be sustained for a time.” Increasing tempo of globalization and the influence of world trade organization in global trade liberalization have been responsible for the growth in international trade. At the same time this has also increased the trade imbalances or current account deficits in various countries. The Economist (2013) observed “the fundamental source of strain on the multilateral system is the shifting economic balance of power. Emerging markets came into their own early in the Doha round rejecting unappealing rich-world offers. They will play a still larger role in future talks.”  There are criticisms against WTO alleging that its policies are only helpful in promotion of multinational corporations at the cost of infringement of national sovereignty of the developing countries. However, integration of national economy into the world economy is considered important for economic development of the countries. Summary Macroeconomic policies are influenced by several factors and the regulatory mechanisms could yield conflicting results. For example, increase in tax rates in an expansionary phase to avoid overheating could stifle economic growth and lead to slow down. Similarly, a central bank increasing the bank rate to keep inflation under control could affect credit off-take which would affect economic growth. On the other hand, decreasing interest rates for encouraging growth could lead to inflation thereby reducing the real income that could affect aggregate demand essential for economic growth. Coordination between the central bank with independent authority in formulating monetary policies and the government is essential in management of macroeconomic fundamentals. References Deutsche Bundesbank, 2012. The financial crisis and balance of payments developments within the euro area, Deutsche Bundesbank Monthly Report, October 2012, [online] Available at: [Accessed 10 April 2013]. ECB, 2011. The supply of money – Bank behaviour and the implications for Monetary Analysis, ECB Monthly Bulletin, October, 2011, [online] Available at: [Accessed 11 April 2013]. Krugman, P., 2002. Exchange Rates, Library of Economics Liberty, [online] Available at: [Accessed 11 April 2013]. Lane, P. R., 2003. Business Cycles and Macroeconomic Policy in Emerging Market Economies, Prepared for the Council on Foreign Relations / International Finance conference on “Stabilizing the Economy: What Roles for Fiscal and Monetary Policy?” July 11 2002, IIIS and Economics Department, Trinity College Dublin and CEPR, [online] Available at: [Accessed 10 April 2013]. Pearson Education, 2013. International Finance, [online] Available at: [Accessed 11 April 2013]. The Economist, 2013. The Other Conclave, March 16, 2013, [online] Available at: [Accessed 10 April 2013]. Read More