Money and Banking - Assignment Example

Money and Banking I. Money and Banking Question One: Monetary Policy I. The reason for an increase in demand for bank reserves increasing money supply when central bank has target interest rate When the central bank has a target interest rate, it is fixed at a certain point and cannot be used to influence the changes in money supply in the economy (Friedman & Kuttner, 2010, 12). A high demand for bank reserves will result in banks having excess reserves that they will use in the creation of demand deposits through the multiplier effect resulting in the increased level of money supplier in the economy (Lipsey & Harbury, 1992, 381). The banks must allow for money supply in the economy to increase to avoid the rising of interest rates to counter the high demand for bank reserves. II. Costs of Central Banks lending to banks (rediscount operations) Central bank lending has many benefits but it also comes at a cost mainly being the cost of funding that is achieved through public borrowing through issuing of government bonds and payment of interest rates (Beau, et Al., 2014, 4). The interest rates payment for the funding is the main costs that central banks face. The other cost is in writing off debts that could by be paid back by commercial banks that are affected by losses or financial crisis and fail to repay back loans from the central bank. Another cost to the Central banks is the payment of interest rates on deposits borrowed from commercial banks when it aims at achieving a target interest rate. Central banks at times have to borrow money from qualified banks through accepting deposits and have to pay for these deposits interest resulting in costs to the central bank. Purchase and sale of bonds from the public in an effort to influence the monetary policy in a country of reducing or increasing money supply involve other costs to the central bank. Central banks pay interest on the bonds to the subscribers and full payment if often required at the end or as the central banks dims fit. The full payment of the bonds before maturity involves the payment of compensation to the holders forming the other cost of the central bank. III. Comparison of using Open-market-operations, Central bank lending facilities, and changing reserve requirements in money supply control a. Flexibility Open market operations are the most flexible monetary policy tools available to the central bank owing to the ability of purchase or sale of security bonds to influence the money supply in the economy. Changing lending facilities of central banks are moderately flexible but have different impacts on the different commercial banks owing to their different reserve amounts affecting the overall impact on the interest level in the economy and the money supply. Changing reserve requirements is less flexible as a method of influencing the money supply in the economy. b. Reversibility Open market operations are easily reversible owing to the possibility of the central bank selling securities on the market easily ion finding out that it has bought more securities than were required to implement a contraction monetary policy. Changes in the central bank’s lending facilities are not easily reversible as is the case in open market operations because of the inability of making changes on previous loans. The reserve requirement ratio may have dramatic and unpredictable effects on the money supply, changes that may be impossible to reverse making it the least used monetary policy instrument owing to its high irreversibility (Cechetti & O’Sullivan, 2003, 37). c. Effectiveness The most effective monetary policy instrument is open market operations because it is not dependent on the banks and it is carried out at the sole discretion of the central bank/monetary authority. Changes in central bank lending facilities are moderately effective owing to the control it provides to commercial banks operations and provides a benchmark for setting up of interest rates in the economy (DSouza, 2009, 403). The reserve requirement is least effective in meeting the needs of monetary policy owing to the unexpected effects it has on the market. d. Speed of implementation Open market operations have the fastest speed of implementation owing to the easy manner in which they can be effected through the participation of the monetary authority in the open market. Changing the central bank lending facilities frequently result in the fluctuation of discount volumes and money supply resulting in difficulty in controlling money supply in the economy taking more time to enforce, hence has a low implementation speed. Changes in the reserve requirement has a slower implementation period because of the need for the adherence to the directive by the central banks that may fail to comply or even result in changes in the interest rates owing to having excess reserves. Question 2: International Finance and Exchange Rate I. Contribution of large balance of payments to a country’s inflation rate Having a large balance of payment necessitates the sale of a country’s currency in the foreign exchange market for the payment of the large balance of payment receiving international currency. Since the international currency is bought from the public, the local currency will increase in the hands of the public depicting high money supply in the economy. High money supply in the economy results in price increase augmenting the inflation rate in the economy (Strano, nd). II. Explanation for the lack of direct effects of foreign exchange markets on the money supply in a pure flexible exchange rate system. Implication of the role of the foreign exchange market on monetary policy The reason for the lack of direct effects on the money supply in a pure flexible exchange rate system is the lack of a direct central bank intervention resulting in the lack of changes in the country’s international reserves affecting the monetary base. This does not imply the lack of an impact of the foreign exchange market on monetary policy because of the possibility of monetary authorities in a country using interest rates and money supply changes to affect the exchange rates. III. Benefits and costs of monetary union Joining a Monetary Union Benefits Smaller transaction costs in close border trade (Minford, 2002). Lack of an exchange rate and the associated uncertainty between member states Unification of economies High political integration and economic influence internationally and even globally Reduced risk premium in capital creation (Latter, (1996, 18). Costs Economic fluctuations when the monetary union is not optimal (Minford, 2002) Inability to set economic policy suitable for a specific country through the exchange rate and interest rates (Labonte, & Makinen, December, 2008, 6). Loss of culture of a specific country and identity Criteria for the optimality of a currency union The optimality of a currency union according to Robert Mundell (1961) include the need for the currency to meet certain criteria including: 1. Labour mobility in the region and this is illustrated using the European Union that has made it possible for movement of labour in the region through availability of physical travel for all the member states citizens within the region (Swoboda, December 13, 1999). Institutional arrangements have been instituted and cultural barriers including language have been minimized to ensure labour mobility within the EU meeting the first criteria. 2. The openness of capability mobility, prices, and flexibility of wages is the second criteria for optimal currency union (Swoboda, December 13, 1999). Letting the forces of demand and supply to determine the demand and supply of goods and services is the main emphasis of the criteria. The EU has demonstrated this through augmented trade among the member states in recent years and the lack of barriers to capital movement in the region evidenced by the use of a single monetary authority. 3. The presence of a risk sharing system including fiscal transfer to allow for support to disadvantaged countries in the region is the other optimality currency criteria. 4. The similarity of business cycles in the member states is the other criteria and this is clearly evident in the Eurozone that had a depressed economy since the start of the economic recession 5. Other criteria include diversification of production, having a common destiny or goals to be achieved, and following the same set of preferences to avoid infighting and competition among member states. References Beau, E., Hill, J., Hussain, T., & Nixon, D. (2014). Bank funding costs: what are they, what determines them and why do they matter?. Bank of England Quarterly Bulletin, Q4. Cecchetti, S. G., & OSullivan, R. (2003). The European Central Bank and the Federal Reserve. Oxford Review of Economic Policy, 19(1), 30-43. DSouza, E. (2009). Macroeconomics. New Delhi: earson Education India. Friedman, B. M., & Kuttner, K. N. (2010). Implementation of monetary policy: How do central banks set interest rates? (No. w16165). National Bureau of Economic Research. Labonte, M., & Makinen, G. E. (December, 2008). Monetary policy and the Federal Reserve: current policy and conditions. Congressional Research Service, Library of Congress. Latter, T. (1996). The choice of exchange rate regime. Bank of England. LIPSEY, R. G., & HARBURY, C. D. (1992). First principles of economics. New York, Oxford University Press. Minford, P. (2002). The costs and benefits of Economic and Monetary Union to the UK economy-the ‘fifth (overview) test’. Cardiff Business School. Strano, A. How and how much can the Money Supply affect the Inflation Rate?. Swoboda, A. (December 13, 1999). R Robert Mundell and the Theoretical Foundation for the European Monetary Union. Retrieved on April 15 from https://www.imf.org/external/np/vc/1999/121399.htm Read More