Money and Banking - Assignment Example

Money and Banking Answer 1 Central bank places a high value on stable interest rates. It believes that money demand instability takes place within a relative narrow range. As a result, the central bank target interest rates instead of the quantity of money. The combination of procyclical behaviour of money demand combined with interest rate targeting creates a procyclical money supply. For example, in a typical economic expansion, the nominal GDP rises prompting a rise in money demand and credit. This increase in demand causes a rightward shift in the demand for bank reserves, and this prompts the central bank to create additional bank reserves so as to maintain the stable interest rate. Creation of additional bank reserves causes the supply of money and credit rises. The increase in nominal income causes the demand for money to rise even further and the central bank is prompted to create more bank reserves, and this process continues. The result is that the central bank raises the supply of money during an economic expansion causing economy to produce above capacity thus raising the rate of inflation. According to Lavoie and Seccareccia (2004, p. 147), in economic expansion, the central bank agrees to supply reserves to the banks on demand due to the rise in economic activities and bank lending in form of credit. The banks need to have reserves, and they can only borrow these reserves from the central bank. As the demand for reserves increases, the central bank supplies them by purchasing government securities on the open market. Central banks also enter into repo or reserve repo agreements with commercial banks. Failure by the central bank to adjust to commercial banks’ needs may jeopardise the liquidity of this system. The Central Banks role is to maintain the liquidity of this system. Post-Keynesians emphasised the role of the central bank in maintaining this system (Godley and Lavoie 2004, p. 2). Answer 1.2 There is a great probability for a bank panic to increase. The fear of banks falling into bankruptcy makes depositors rush to banks to withdraw their deposits. This makes banks raise their rates of excess reserves so that they can protect themselves from the disastrous outflows of deposits. Low supply brought about by outflow of deposits prompts banks to borrow more from the central banks. However, there are costs of holding excess reserves from the central bank. Commercial banks derive a lot of benefits from reserves from the central banks. However, the commercial banks exhibit several behaviours. There are benefits as well as costs of holding excess reserves. If the cost of holding excess reserves increases, then the bank decreases how much reserve it holds. On the other hand, if the benefit of holding excess reserve goes up, then the bank responds by increasing the amount of excess reserve it holds (Forrest 2014, p. 106). The cost of holding excess reserve of the bank is the opportunity cost. That is, holding excess reserve means giving up the returns that could be potentially made through lending out the money or investing the money in securities. Commercial banks hold excess reserves in order to reduce the loss caused by outflows of deposits, where the reduced loss is a gain of the banks. When banks expect the outflow of deposits to increase, they will expect an increase in the consequent loss caused by the outflow of deposits so that they would increase the expected return on the excess reserve. The costs of banks borrowing from the central banks are the discount rate and the market interest rate. These are the factors that affect the return. A higher discount rate encourages commercial banks to borrow more from the central banks. A lower discount rate discourages commercial banks from borrowing from the central banks. The discount rate is the cost that commercial banks pay for the reserves supplied to them by the central bank. Chadha and Corrado (2012) state that, the central bank sets the interest rate on the reserves supplied to commercial banks. This is the cost that commercial banks pay for holding reserves from the central bank. Answer 1.3 Through buying and selling financial instruments in an open market, the central bank influences the country’s money supply. This method is the most used method of controlling the money supply. It allows central banks to have great flexibility in the timing of monetary operations compared to other methods. The major effect of open market operations is on the reserves of banks. It would be reasonable to assume that open market operations are likely to impact the availability of funds in the market. Mayes and Toporowski (2009, p. 198) state that open market operations affect the funds rate. They cause banks to buy or sell funds when the supply of reserves is decreased or increased respectively, through open market operations. Open market operation are the preferred monetary instrument because it allows flexibility in timing and amount of the central bank operations, and for the management of interest rates. When capital moves freely, the central bank manages to affect the conditions of both the domestic and external markets in its local currency through open market operations. Central bank lending facilities are usually used to support open market operations. Rediscounting tend to diminish as the main tool for controlling the supply of money. Increased volatility of the money supply due to external actors prompts the central bank to be very flexible in its refinancing operations (IMF 1999, p. 59). Reserve requirements are used to reduce capital inflows or change their composition. Central bank limits the access of banks to borrowing at a discount in order to make the open market operations more effective. Its effectiveness is determined by the level of limitations. In terms of flexibility and effectiveness, reserve requirements are used as an alternative to open market operations. Reserve requirements are used as enhancement tools for open market operations. IMF considers reserve requirements to be a crude tool of controlling the supply of money. In many countries, central banks have lowered the usage of reserve requirements. For example, in the United Kingdom, reserve requirements are considered unnecessary (IMF 1997). However, in terms of speed of implementation, reserve requirements are the most ideal tools because they are useful where bank liquidity needs to be adjusted rapidly and where the central bank needs to give clear and unambiguous signals to the need to expand or contract the money supply. Answer 2.1 Lai et al. (2006, p. 443) states that a balance-of-payments surplus can cause serious problems to the economy of a country. There are three reasons for this proposition. First, the surplus in one country means a deficit in another country. As a result of one country holding a surplus in balance-of-payments prompts the deficit countries to resort to protectionism to correct their balance-of-payments deficits. This makes both the surplus countries and deficit countries to suffer from a reduction of trade. In the worst case scenario, the world trade may collapse. Secondly, the surplus may cause a rise in the exchange rate thus reducing the competitiveness of country’s exports and increase in imports competitiveness. As a result of this, most of balance-of-payments surplus ends up being used in financing imports. The surplus also generates a demand-pull inflation. According to Keynesian model, a surplus is an injection of demand into the economy. Therefore, surplus in the balance-of-payments makes the country suffer the ill-effects of inflation. An injection of demand into the economy brings inflation. However, this may be only a natural, temporary phenomenon until supply rises. Inflation occurs when there is extra demand and there no increased supply to match the demand. It can be concluded that without an injection into the supply side to meet the surplus in the balance-of-payments there will be inflationary pressure. Answer 2.2 In a pure flexible exchange rate regime, only the market forces have the power to determine the foreign exchange value of the currency. Under flexible rate regime, the foreign exchange market does not have direct effect on money supply. In a flexible rate system, the exchange rate is determined by the market forces. Therefore, the money supply is not affected by the foreign exchange market. Money supply does not get affected by the exchange rate consideration. Therefore, money supply can be decided on exchange rate policy. According to Pailwar (2012, p. 441), central banks pursue independent monetary policies regarding the money supply. Shifts in the supply curve of the domestic currency take place when there are changes in the domestic or world economy other than the foreign exchange rate. Under the flexible exchange rate system, exchange rates are determined by the forces of demand and supply of currencies. The official reserves of a country do not change because the country’s monetary authority does not interfere with the foreign exchange market to influence rates. However, this does not mean that the foreign exchange market has no effect on monetary policy. Foreign exchange market intervention has effects on the money supply. For example, if the U.S. Federal reserve intends to increase the dollar price of the Euro, it can create dollars to purchase euros. In such a case, it can be said that domestic currency has been used to buy foreign currency. Such a move serves to increase the domestic money supply. Answer 2.3 In 1999, the euro became the common currency for 11 of the 15 European Union countries. This monetary union arose from the ratification of the Maastricht treaty in 1993 (Leblond 2004, p. 554). This move brought both positive and negative consequences for the member countries. However, the advantages outweigh the disadvantages. If the advantages did not outweigh the costs, the European Union would not have adopted the euro. The greatest benefit that is derived from the adoption of monetary union is the elimination of the need to exchange currencies between the member countries. Some countries in the monetary union with low trade shares usually find it advantageous to be in a monetary union. For example, some countries in the European Union such as Italy and Greece found it advantageous to be in the Union because their shares in relation to other countries were low. Therefore, Italy and Greece did not consider the loss of their national monetary policy instruments costly. Another benefit is that the labour market becomes more flexible in terms of wage and labour. However, countries that experience different demand and supply shocks find it more costly to enter into a monetary union. Countries that form a monetary union prevent competitive devaluations and speculation. Countries in a monetary union will not devaluate their currencies with an aim of increasing their exports. If one country tries to do this, the other countries in the union will do the same and this will result in a downward spiral as well as increase inflation domestically (Eudey 1998, p. 14). The monetary union also eliminates the problems that arise due to the exchange rate volatility between the member countries. For example, the only fluctuation that remained in the EU monetary union is the fluctuations between the euro, the yen, the dollar, and other currencies. There are fluctuation costs that are associated with the monetary union such as the business between trading firms from different countries becoming riskier. For example, if the manufacturer from one country decides to sell his products to an importer in another country, and one currency falls in value in relation to the other, the manufacturer will end up getting far less for his products. Another disadvantage of monetary union is that if one country is in a recession, it will have to look for other means to end the recession because of the complexity of changing the monetary policy of the union. Changing the policies of the monetary union would hurt many countries in the union. Nevertheless, such a country can still change its fiscal policy even if it does not have the power to change the monetary policy. Countries in the monetary union can also raise taxes to increase the purchasing power. The extra money raised by these members can be used to bail out the country that is having problems. References Axilrod, S. 1997. Transformations to Open Market Operations, International Monetary Fund. Economic Issues, No. 5. Available http://www.imf.org/external/pubs/ft/issues5/issue5.pdf Chadha, J. and Corrado, L. 2012. Macro-Prudential Policy on Liquidity: What Does a DSGE Model Tell Us? Journal of Economics and Business, 64 (1), pp37-62. IMF. 1999. Sequencing Financial Sector Reforms. Washington: International Monetary Fund. Forrest, J. 2014. A Systems Perspective on Financial Systems. London: Taylor & Francis Group. Godley, W. and Lavoie, M. 2004. Features of a Realistic Banking System within a Post-Keynesian Stock-Flow Consistent Model. Working Paper No. 12. Available http://www-cfap.jbs.cam.ac.uk/publications/downloads/wp12.pdf Lai, K., Lim, E., Koh, E., Chan, S. and Lim, K. 2006. College Economics. Singapore: EPB Pan Pacific. Lavoie, M. and Seccareccia, S. 2004. Central Banking in the Modern World: Alternative Perspectives. Cheltenham: Edward Elgar Publishing. Leblond, P. 2004. Completing the Maastricht Contract: Institutional Handicraft and the Transition to European Monetary Union. Journal of Common Market Studies, 42(3), pp. 553-572. Mayes, D. and Toporowski, J. 2007. Open Market Operations and Financial Markets. Oxon: Routledge. Pailwar, V. 2012. Economic Environment of Business. New Delhi: PHI Learning Private Limited. Eudey, G. 1998. Why Is Europe Forming A Monetary Union. Federal Reserve Bank of Philadelphia Business Review, pp. 13-21 Read More