The Monetary Policy - Assignment Example

Banking Table of Contents Question Monetary Policy 3 I. 3 II. 4 III. 5 Question 2- Exchange Rate, International Finance 7 I. 7 II. 7 III. 8 1References 10 Question 1- Monetary Policy I. The idea in inflation targeting is that central banks can choose to adopt a monetary policy that is focused on keeping inflation rates at an even keel and makes use of interest rate tweaks to move the inflation towards the target when actual inflation either exceeds or falls below those targets. The general idea is that where interest rates move up, inflation tends to slow down, and where interest rates go down, inflation tends to inch upwards. Therefore, interest rate tweaks either upward or downward can effect monetary policy by nudging the rate of inflation downwards or upwards and towards the desired inflation rate levels (Jahan 2012). With regard to the traditional relationship between the reserve requirements for banks and interest rates on the other hand, the traditional understanding is that the supply and demand forces work for money supply and demand, so that increasing the reserve requirements in effect lowers the supply of money in the general economy, and that tends to have an upward impact on interest rates, which in turn has a downward impact on inflation. The reverse works too, in that where the reserve requirements go down, then the money supply goes up and the interest rates tend to go down, which in turn tends to nudge inflation rates upwards Tying this discussion up to the relationship between inflation targets and the interest rates, increasing the reserve requirements leads to the tightening of money supplies, which can lead to increased interest rates. Where the dampening effect on demand is large, this can lead to a situation where banks actually come to hold more money because of the slowdown in lending, and the end result is a rise in the money supply. This is especially true where the increase in ban reserves leads to increases in transaction and processing fees in banks, where those fees are a function of the reserve requirements imposed by the central bank (Friedman and Kuttner 2010; Federal Reserve Bank of San Francisco 2001; Schwartz 2008). II. As the literature notes, the presence of rediscount and discount windows allows for central banks to supply massive amounts of liquidity in times of distress in the economy, in order to fill in gaps in liquidity in banks in times of unusual activities that require banks to raise more liquidity than they have available, and in order for central banks to fulfill their mandate as the last resort lender to the banks. This has positive implications for the stability of the banking system in general, and in providing a cushion of support to banks and a measure of confidence in the banking system by the general public. There are other benefits that accrue to the economy from this presence of funding from the central bank, including that such access to liquidity prevents banks from liquidating its assets in times of extreme distress, and in so doing water down or devalue the price of those assets because they are being sold at times of distress and therefore at prices that are less than their market prices in normal times. Moreover, such has the impact of destroying vital relationships between banks and their customers and the central bank rediscounting window helps prevent that. On the other hand, there are obvious costs to central bank lending too, and those relate to the way the access to central bank loans can generate a negative signal about the financial health of the bank accessing the window, which has implications for how well a bank is able to do business with other banks in the system. Moreover, the costs of borrowing through the central bank facility are often large, and so this is a costly way to generate liquidity for the borrowing bank too. The other costs relate to moral hazards, or of banks not taking more stringent measures to safeguard their financial health and to keep themselves liquid, knowing that when things fail they can always borrow from the central bank. This is a large cost in terms of keeping the banks healthy and disciplined, and is mitigated by the central bank making it expensive for banks to borrow via the rediscounting window. The high cost of borrowing is a disincentive for banks from borrowing more than they really need, and from borrowing unless they really have serious liquidity problems (Santos and Peristiani 2011; Axilrod 1997). III. Among the three instruments, the open market operations or OMOs are said to be the most flexible in terms of effecting monetary policy. The way these OMOs work is by either expanding or contracting the available reserves in the banking system by dealing with repos that have accounts with the banks. In purchase transactions the Fed swells the reserves through the repos, and in sale transactions the Fed contracts the reserves in the banks. Such in turn impact the federal funds rate, or the rate at which banks borrow fund to cover their reserve requirements from other banks. Fluctuations in the federal funds rates also impact other vital interest rates that are short-term. The Fed purchasing Treasuries from the open market for inclusion in what is called the SOMA portfolio has the impact of swelling reserves in a permanent fashion, because Treasuries in this portfolio are held until they mature, rather than traded. Then there are short-term and overnight repos that can tweak reserves balances on a daily and time frames that are shorter than two weeks. Reverse repos on the other hand is about the Fed borrowing funds from dealers in order to shrink the reserves levels. This affords the Fed with the most flexible means of effecting monetary policy, because of the flexibility and the range of tools that can be used to influence rates on daily, weekly, and long-term bases. OMOs also rate highly in terms of reversibility, through the reverse repos that can be short or long term, and can be enacted within the day, affording very fast speeds of implementation, and is highly effective (Federal Reserve Bank of New York 2007). On the other hand, changes in the reserve requirements also is very flexible in terms of controlling money supply and the amount of borrowings that occur among banks to meet reserve requirements and at what cost, thereby also influencing interest rates and the supply of money with speed. It is also highly reversible, because the central bank can change the reserve requirements with ease, and high levels of effectiveness. Rediscounting works too, with some flexibility, in terms of being able to tweak the rediscount rates for lending to banks in order to either stimulate or suppress bank borrowing to swell or shrink the money supply. It is arguably the least effective, and the least reversible and flexible, and also the least reversible in terms of taming the money supply among the three (Friedman and Kuttner 2010; Santos and Peristiani 2011). Question 2- Exchange Rate, International Finance I. Sometimes balance of payments surpluses, can result from a country, such as China, deliberately pursuing to keep the currency in a state of undervaluation, so that exports are cheap and competitive, while import costs soar. This of course can result in a greater amount of export activities overpowering the level of imports, allowing the country to amass foreign reserves and to enjoy perennially high levels of surpluses in the balance of payments. The other consequence of undervaluation of the currency, on the other hand, is high inflation, from the economy overheating from all that influx of foreign currency and too much growth too soon. The inflation is a function of an overheating economy, that the literature says can result from too much growth, and the result of letting currencies appreciate in these regimes of high balance of payment surpluses due to currency undervaluation is of the inflation being tamed eventually (Yao 2011; Nesvisky 2015). II. In a purely flexible exchange rate regime, market forces totally determine the exchange rate for a currency versus other currencies, in forex markets that are totally ruled by supply and demand. In this regime, there are mechanisms to ease large fluctuations in exchange rates true, but those are not meant to control and peg the exchange rates, but merely to ease the transitions and large bumps. The IMF notes that contrary to notions that this will cripple monetary policy, flexible regimes for exchange rates actually enable the conduct of a monetary policy that is marked by a greater degree of autonomy for central banks, because they no longer have to intervene to artificially prop up the currency or to tame any appreciations or depreciations, but are free to tweak interest rates and to control money supply independent of the exchange rate. It is in this sense that the exchange rate can be decoupled from the money supply factors, removing the direct links between the two. On the other hand, obviously the exchange rate impacts money supply, especially for money used to transact in foreign currencies, such as for importing activities and for paying off loans denominated in foreign currencies for instance. The exchange rate influences the demand for money used for these purposes, and therefore impacts money supply (Duttagupta, Fernandez and Karacadag 2005; Stockman 1999). III. Monetary unions or currency areas generate several benefits, including increasing the level of trade among member countries in the union, and eliminating currency-related transaction costs among trading entities within the currency area. Those costs relate to making conversions from one currency to another, which simply disappear when there is just one currency for trade, and the overall impact of this is to enable an explosion of trade among the member states in the currency union. Tied to these are benefits of removing the risks associated with fluctuations in the exchange rates among trading countries, which further give impetus for trade to flow among the countries with a common currency versus among those who are not part of the currency union. The costs on the other hand relate to loss of monetary policy control for member states in the currency union, because that is surrendered to a central authority. Here the loss of control impacts the way a country is able to chart its own destiny in terms of controlling vital aspects of the economy, including the use of controls such as interest rates and the control of money supplies to tweak inflation and to set economic targets in that sense. Moreover, the common currency disallows for different states in the union getting the brunt of economic shocks in an asymmetric fashion, according to the internal states of their economies (Bergin 2008; Swoboda 1999). The criteria for optimal currency areas on the other hand include the lack of those shocks to the area that are non-symmetric, or if they occur, not with great frequency; that production factors are mobile; that exports are diversified; that new countries wanting to join the currency area must have open economies. These criteria are culled from the theories of Robert Mundell (Swoboda 1999). 1 References Axilrod, S. (1997). Transformations to Open Market Operations. International Monetary Fund. [online]. Available at: http://www.imf.org/external/pubs/ft/issues5/ [accessed 4/12/2015]. Bergin, P. (2008). Monetary Union. The Concise Encyclopedia of Economics. [online]. Available at: http://www.econlib.org/library/Enc/MonetaryUnion.html [accessed 4/12/2015]. Duttagupta, R., Fernandez, G. and Karacadag, C. (2005). Moving to a Flexible Exchange Rate. International Monetary Fund. [online]. Available at: https://www.imf.org/external/pubs/ft/issues/issues38/ei38.pdf[accessed 4/12/2015]. Federal Reserve Bank of New York (2007). Open Market Operations. NewYorkFed.org. [online]. Available at: http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html [accessed 4/12/2015]. Federal Reserve Bank of San Francisco (2001). What effect does a change in the reserve requirement ratio have on the money supply? Federal Reserve Bank of San Francisco. [online]. Available at: http://www.frbsf.org/education/publications/doctor-econ/2001/august/reserve-requirements-ratio [accessed 4/12/2015]. Friedman, B. and Kuttner, K. (2010). Implementation of Monetary Policy: How Do Central Banks Set Interest Rates? NBER Working Paper 16165. [online]. Available at: http://isites.harvard.edu/fs/docs/icb.topic808193.files/PAPERS%20Fall%202010/Friedman-Kuttner%20Handbook%20chapter%20--%20NBER%20WP%20No%20%2016165.pdf [accessed 4/12/2015]. Jahan, S. (2012). Inflation Targeting: Holding the Line International Monetary Fund. [online]. Available at: http://www.imf.org/external/pubs/ft/fandd/basics/target.htm [accessed 4/12/2015]. Nesvisky, M. (2015). Current Account Surpluses and The Correction of Global Imbalances. The National Bureau of Economic Research. [online]. Available at: http://www.nber.org/digest/septoct07/w12904.html [accessed 4/12/2015]. Santos, J. and Peristiani, S. (2011). Why Do Central Banks Have Discount Windows? Liberty Economics, Federal Reserve Bank of New York. [online]. Available at: http://libertystreeteconomics.newyorkfed.org/2011/03/why-do-central-banks-have-discount-windows.html#.VSyrtEAe4wo [accessed 4/12/2015]. Schwartz, A. (2008). What is the Money Supply? The Concise Encyclopedia of Economics. [online]. Available at: http://www.econlib.org/library/Enc/MoneySupply.html [accessed 4/12/2015]. Stockman, A. (1999). Choosing an exchange-rate system. Journal of Banking & Finance 23. [online]. Available at: http://www.bates.edu/Prebuilt/Stockman.pdf [accessed 4/12/2015]. Swoboda, A. (1999). Robert Mundell and the Theoretical Foundation for the European Monetary Union. International Monetary Fund. [online]. Available at: https://www.imf.org/external/np/vc/1999/121399.htm [accessed 4/12/2015]. Yao, Y. (2011). China’s current account surplus and inflation. East Asia Forum. [online]. Available at: http://www.eastasiaforum.org/2011/03/27/china-current-account-surplus-and-inflation/ [accessed 4/12/2015]. Read More