Money and Banking, Costs of Rediscount Operations - Essay Example

• Introduction

The essay represents an in-depth analysis and discussion on monetary policy, international finance and exchange rate, three important areas of the study, money and banking. Different concepts from empirical researches on these major areas of finance will be discussed in the essay. Influences of central bank on monetary policy, money supply, interest rates are the main issues will be discussed in the essay. Optimal currency area and its relation to monetary unit are very important in controlling the exchange rates of the national currency. Concepts of money and banking are intermediary. There are many bodies like fixed exchange rate, optimum currency area, monetary union, central banks, commercial banks, etc. which are responsible for the circulation of cash within the country and controlling the exchange rates.

• Discussion
  • Part 1 Monetary Policy
    • Reasons for rise in money supply

Supply and demand for money

An increase in the demand for reserves will shift the demand curve of the bank reserves to the right which would raise the interest rates and thereby keeping the cash reserve ratio same. To prevent the situation, central bank will buy bonds to increase the supply of money for reserves or the amount of non-borrowed reserves. Rise of money supply and monetary base are caused by the open market purchase. Commercial banks of any country have to deposit reserves to their central bank as a security by maintaining fixed interest rates. In this case, the interest rate is same and the demand curve is shifting. Policies of central bank are the most important determinant of money supply. The bank reserve affects the money supply by affecting the bank deposits. Central bank requires financial institutions and other commercial banks in holding reserves as a fraction of the deposits. Commercial banks hold the deposits of bank reserves as cash or vaults. Central banks control the reserves of other commercial banks by lending money to them. Change in the interest rates of the central bank on these loans leads to open market operations. Central bank uses this open market operation in order to increase or decrease the bank reserves. The following diagram describes the shift of money supply for a demand curve.

Interest rate and supply of money

An increase in money supply from MS1 to MS2 causes shift in interest rates from i1 to i2. Equilibrium drops from A to B which shows increase in demand of money. When money supply decreases central bank increases the discount rates and raised the requirements of reserves thus interest rate increases which would lead to decrease of demand for money.

• • • Costs of rediscount operations

This part of the paper aims to discuss on the costs of rediscount operations. Rediscount operations are the negotiable short term debt instrument issued by the central bank for a second time to the commercial banks. To assist the movements of the market having high demands for loans, sometimes bank rediscount the short term debt securities. Banks generate cash when there is low liquidity in the market by rediscounting the short-term securities. Rediscounting operations of central banks are known as discount window. Commercial bank deposits reserves to the central bank. When a bank gets bankrupt then the central banks help that bank with its rediscounting operations i.e. discount window to avoid the suspension of work in the bank. In this case, central bank acts as a lender of last resort in order to provide liquidity to commercial banks (Brunetti, Di Filippo & Harris, 2011). In this way, the central bank acts as the lender of the last resort. The commercial banks launch upon the central bank for help and this is the primary cost of rediscount operations. The banks are incapable to cope up with the emergency and they do not feel the urge to do anything else other than call for central bank’s help. It is the duty of the central banks to check the bank panics and provide the bankrupt commercial banks discount window. Bank panics of commercial banks are dealt by the central bank by providing funds to them. It is a temporary process of protecting the commercial banks. However, the effectiveness of discount window depends on the willingness of the commercial banks to borrow reserves from central banks. Sometimes banks are reluctant in borrowing reserves from central banks not only for the expensive source of liquidity but also for the stigma that are related to the discount window of the central banks.

• • • Comparison

In many countries, open market operations are the most important instruments of monetary control. It allows central banks in maintaining great flexibility in the volume of monetary operations and timing at their own risks, providing solutions to avoid inefficiencies regarding direct control and creating business relationships with the partners. Open market operations affect financial related measures and money supply by creating impact on the banking system especially in reserve bases (Judson & Klee, 2010). Open market operations become the principal instrument. If the situation requires, the other instruments should be given less priority, most particularly the discount window of the central bank where the commercial banking system collect reserves by its own by borrowing loan from the central bank.

Effective operations of open market need limitations on the access of loans or discount window of commercial banks from central banks. For controlling all the financial conditions and controlling reserves of bank open market operations could not be used without any limitations on the discount window. Discount window of central banks should be made less attractive by strict guidelines.

Reserve requirements are also used by central banks as a means of monetary control, proportion of assets of the bank for holding the reserves is the only means of controlling money supply. Popularity of open market operations has reduced the use of reserve requirements which is a crude tool. Reserve requirements are alternative to open market operations which would enhance the effectiveness of various purposes of monetary control (Gray, 2011).

• • Part 2 International Finance and Exchange rate
    • Contribution of balance of payment

A large amount surplus in balance of payments surplus or trade surplus has immense contribution to the inflation rate of a country. In this situation, a country requires financing the excess or surplus. It can be done by selling the currency of the country in the foreign exchange market. Hence, international reserves can be gained. As a result of it, the central bank of that country will be able to supply more currency to the general public of the country. In this way, the monetary base of the country will rise. Thus, the rise of money supply will cause rise in the price level of commodities which will lead to higher inflation rate. The money supply can be expanded due to large balance of payment surplus in order to facilitate the country’s purchase of assets and foreign exchange (Frenkel & Johnson, 2013). Balance of payments imbalance of a nation is referred to as payments which are made by the country in the market is less than the payments the country is receiving. It is also known as favourable balance of payment. It is considered as favourable balance of payment because amount of currency flowing in the country is more than that of currency flowing out. Unequal flow of currency will lead to expand in the money supply within the country. Subsequently it will cause decrease in the exchange rates. It has implications on unemployment, inflation rate, production capacity and other aspects of the domestic economy which is relative to the currencies of other countries. Sometimes balance of trade surplus is the source of a balance of payment surplus.

• • • Effect of foreign exchange market on monetary policy

There is no direct effect of foreign exchange market on the monetary base and money supply. It is because there is no intervention of central bank in the pure volatile rate system regime. As a result of it, changes in the international reserves which will affect the money supply and the monetary base does not occur. In some other cases, foreign exchange market can affect the monetary policy because authorities of monetary policy want manipulation of exchange rates by making change in interest rates and money supply (Odell, 2014). Monetary policy is the process in which monetary authority of a particular country controls over the supply of money in the country. It is done by targeting interest rate or inflation rate in ensuring the general trust in the currency and price stability. Monetary policy has many goals such as maintaining predictable exchange rates in comparison to other countries, contribution in stability and economic growth, lowering the rate of unemployment, etc. Currency intervention or foreign exchange market intervention is the monetary tool which is applied by central banks (Carpenter & Demiralp, 2012). Usually, central banks intervene in the foreign exchange markets but not in the pure flexible rate regime. Intervention of central bank in foreign exchange markets lead to inflation control, financial stability maintains and maintaining competitiveness. Sometimes foreign exchange market may manipulate exchange rates which depend on number of factors such as degree of integration and development of financial market, stages of country’s development, etc. Thus it is proved that foreign exchange market has some effect on monetary policy in certain circumstances.

• • • Benefits and costs of monetary union

Monetary union is also known as common currency area or currency union which controls the activities of multiple countries in controlling the money supply to a common authority. Power of a country’s central government is the ability in issuing money that is usable for transactions. The power is used on the benefit of nation’s sovereignty. In many ways, a monetary union resembles a fixed exchange rate regime. Countries sometimes retain identical national currencies, but it also agrees tin maintaining a desired exchange rate by making adjustments in the relative supply of the national currencies. Monetary union is the extreme form of fixed exchange rate regime (De Grauwe, 2014). There are two differences in the perspective of this. First distinction is the switching of a country to a new currency gives the people confidence that the new system will have immense benefit. In this case, the cost of abandoning new system is more than that of the usual fixed rate regime. Second difference is elimination costs transaction costs of people in performing the international transactions.

Monetary union formation carries costs and benefits. An important benefit is that traders are free from the unexpected movements in the exchange rate. Optimum currency area is the region where the economic efficiency is maximised in sharing a single currency throughout the area. Optimal currency area is larger than a country. The concept of optimum currency area is related to the benefits and costs of monetary union. It discusses the optimal characteristics regarding formation of new currencies or merger of two or more currencies. The theory of optimal currency area is used to make argument on the readiness of a particular region while becoming a currency union or economic integration (Johnson & Swoboda, 2013).

• Conclusion

The essay covers the role of central bank in maintaining monetary control, money supply and recovering the panics of the commercial banks by providing discount window or rediscounting operations to them. In the first part of the essay, various parts of monetary policy are discussed such as reserve requirements, open market operations, discounted window, circulation of money within the country, etc. and in second part, various concepts of international finance and exchange rate are explained clearly. It is concluded that money and banking are interrelated with each other which are regulated by several financial bodies in every country with an aim of overall economic development of nation.