Monetary Policy, International Finance and the Exchange Rate - Assignment Example

The essay is about Banking Contents Question 3 Monetary policy 3 Question 2 6 International Finance and the Exchange Rate 6 References 10 Question 1 Monetary policy I. The central bank is engaged in the management of finances of the government and it is engaged in the creation of money that is related to printing of currency. Central bank performs the function of controlling the availability of credit and money supply through the implementation of the monetary policy that is maintaining of the interest rate. The central bank maintains an interest rate target in order to reduce or decrease the rate of inflation, improving the growth rate, stabilizing the financial market and maintain of the stability that is associated with exchange rate and interest rate (Edwards, 2000). The increase in the demand for the bank reserves results in the increase in the money supply in the economy since the extent of openness in the economy results in the increase in the exchange rate in the economy and it results in the increase in the revenue from exports and maintaining of stability in the exchange rate. The interest rate by the central bank leads to stabilizing the economy for the achievement and attainment of the ultimate goal for stabilizing the economy as a whole (Mishkin, 2007). Decrease in the reserves affects the money supply in the economy and the change in the interest rate mainly affects the consumers and the businesses in changing the aggregate demand and therefore he borrowing activity is directly related to the change in the interest rate which influences or affects the economic activity and the growth rate of the Gross domestic product (Arnold, 2008). The central bank introduces the monetary base through which it can change the money supply and influence the circulation of currency and bank reserves in the economy which is mainly represented by monetary base which is considered as the total of bank reserves and the currency in circulation in the economy (Mankiw, 2002). Figure 1: Monetary policy decreases interest rate From the above diagram it can be explained that as the money supply curve moves towards the right, the rate of interest rate decreases and the quantity of money increases by taking into consideration that he demand curve will not shift with the increase in the money supply from Ms1 to Ms2, the interest rate moves from r1 to r2 which indicates that the increase in the money supply decreases the interest rate in the market (Abel and Ben, 2005). II. Central bank is engaged in the operation and the performance of various activities that is associated with lending to the commercial banks which mainly includes the open market operation that is buying and selling of securities by the central bank, foreign exchange intervention by the central banks, the lending initiative that is undertaken by the commercial banks. The central bank maintains the monetary base that has three uses that includes the required reserves, cash in hand for the non bank public and also maintaining of the various cash reserves (Sexton, 2007). The central bank is required to take necessary option for preventing the panic that is included in the contraction of stock of money in the economy and during the time of crisis, the central bank is required to provide short term loans to various solvent financial institutions at high interest rate (Gottheil, 2013). The primary or the main importance is preventing the short term change in the money supply from economic contraction. The central bank is required to achieve the task for management of the monetary base and measurement of the currency associated with the circulation of the currency reserves of the commercial banks (McEachern, 2008). The benefits are providing money or funds at credit when the funds are not available from any other sources, avoiding the lending to the institutions that are financially not viable or healthy in nature and the central bank lends credit on a regular basis to the various private banks and this facilitates the private banks to access or easily avail the loans and motivating the private banks to take much risks (Levine, 1997). III. The comparison on the use of the open market operation and change in the reserve requirements for controlling the money supply in the economy on the basis of the various criteria such as flexibility, reversibility, effectiveness and also speed of implementation can be explained as the open market operation have been introduced on the initiative of the Fed and it has motivated the banks to lend loans by discounting the rate but not controlling the volume of the discounting of loans and the open market is flexible in operation and it can be used to any extent or limits, the open market operation are easily reversible at the time of any error or mistake by the open market operation , the Fed has the ability to reverse it immediately and the rate of the federal fund is very low as there is existence of large number of open market operations and the functions of the open market operation can be implemented quickly without the delay in the administration. The reserve requirement is maintained by the central bank for stabilizing the demand for reserves and maintaining the market interest rate that is very closely associated with the targets. The reserve requirement for controlling the money supply increases with the increase in the demand for the reserves also results in the increase in the federal fund rate and he decrease in the reserve requirement results in the increase and expansion of the money supply and decrease in the federal fund rate. Continuously fluctuations in the reserve requirement will result in the creation of uncertainty of the banks thus striking there liquidity position and therefore the change in the reserve requirement is rarely used as compared to the open market operation. Question 2 International Finance and the Exchange Rate I.A favourable balance of payment leads to the flow of currency in the country as compared to the flow of currency outside the country. And the unequal or the disequilibrium results in the expansion of the supply of money in the economy and consequently decreases the exchange rate that is relative to the currencies of other countries or nation. This has affected the rate of unemployment, production and inflation in the economy. The balance of the trade surplus is considered as the main source for the surplus in the balance of payment whereas the other payments have lead to the surplus in the balance of payment. The balance of payment has affected the rate of inflation in the economy and it indicates that the relative increase in the inflation rate of the country will result in the decrease of the current account resulting from the decrease in the export and increase in the import The increase in the inflation rate of one country is relative to the inflation rate of another country and therefore it creates a pressure in the exchange rate that exist between the two nations where there is a tendency of depreciation in the currencies of the countries with high rate of inflation. II. In case of the floating exchange rate system, the exchange rate is determined or defined as the rate that is required for equalizing the demand for the currency in the market in the private market with the private supply in the market (Obstfeld, Shambaugh and Taylor, 2004). The central bank does not play any major or vital role in the determination of the flexible exchange rate and the central bank does make necessary intervention then the process or the system is considered as the dirty float (Mishkin, 2000). The foreign exchange market can intervene in the exchange rate and affect the money supply only through the buying and selling of the domestic currency. Figure 2: Foreign exchange market: USD vs. Euro The central bank has the authority for selling the currency (dollar) in exchange of other currency (pound) in the foreign market and this transaction will result in the increase in the money supply in the economy, which will increase the value of dollar and reduce or decrease the value of pound in the economy and it has resulted in the depreciation in the value of dollar. In this case the Central bank has the authority of directly intervening in the foreign exchange market whereas if the Central bank wishes to increase the value of dollar it has to reverse the process of transaction. But the capacity of the Central bank to increase or decrease the value of the currency through the direct intervention in the foreign exchange is limited (Fischer, 2001) III. The benefits of the monetary Union can be explained as the decrease or the reduction in the cost of the currency will be relatively small and will reduce the cost of the conversion of the currency. The monetary Union will provide various benefit or advantages in the process of elimination of the exchange risk that is associated with the domestic currency and will increase the volatility in the market. The monetary union will provide potential advantages from the increase in the transparency of the price. The cost associated with the monetary union mainly includes the loss of the monetary policy which will be more than as compared instability in the economic cycle. The result of the harmonization agenda that is influenced by a common aim may result in serious consequences on the employment and decreasing the competitiveness of the labour. The cost is associated with the increase in the risk of the emerging crisis in the nation. The main criteria for optimality in the currency area are associated with the geographical area in which the single currency will provide more economic benefit and the countries that share more economic ties receives greater benefit from the use of the common currency which will facilitate in the establishment and maintenance of integration in the market and promotes trade. Therefore the use of common currency results in the loss of the ability of the country towards the intervention of the monetary and the fiscal policy for stabilizing the economy (Campello, Graham and Harvey, 2010). The six main criteria of the optimality in the currency deals with the correlation in the business cycle, the volatility in the real exchange rate, correlation in the real interest rate, convergence of inflation in the economy, the openness to carry out trade and commerce and the flexibility in the labour market. References Abel, A. and Ben, B., 2005. Macroeconomics. London: Pearson Education. Arnold, R.A., 2008. Macroeconomics. Mason: South Western Cengage Learning. Campello, M., Graham, J. and Harvey, C., 2010. The real effects of financial constraints: evidence from a financial crisis, Journal of Financial Economics, 97(1), pp.470-487. Cecchetti, S., 2008. Monetary Policy and the Financial Crisis of 2007-2008, CEPR Policy Insight 21, April Edwards, S., 2000. How effective are capital controls? Journal of Economic Perspectives, 13(2), pp.65-84. Fischer, S. (2001) Exchange rate regimes: is the bipolar view correct? Journal of Economic Perspectives, 15(3), pp.3-24. Gottheil, F. M., 2013. Principles of Microeconomic. Mason, OH: South Western Cengage Learning. Levine, R., 1997. Financial development and economic development: Views and agenda. Journal of economic literature, 35(4), pp.688-726 Mankiw, N. G., 2002. Macroeconomics. New York: Worth Publication. McEachern, W.A., 2008. Macroeconomics: A Contemporary Introduction: A Contemporary Introduction. Mason, OH: South Western Cengage Learning. Mishkin, F., 2000. Prudential supervision: Why is it important and what are the issues. NBER Working Paper 7926. Mishkin, F., 2007. Everything You Wanted to Know about Monetary Policy Strategy, but Were Afraid to Ask. Massachusetts: MIT Press. Obstfeld, M., Shambaugh, J.C. and Taylor, A.M., 2004. Monetary Sovereignty, Exchange Rates, and Capital Controls: The Tri-lemma in the Interwar Period. International Monetary Fund Staff Papers, 51, pp.75-108. Sexton, R.L., 2007. Exploring Economics. Mason, OH: South Western Cengage Learning. Taylor, A.M., Taylor, M.P., (2004) The Purchasing Power Parity Debate. Journal of Economic Perspectives, 18(1), pp.134-158. Read More