International Finance and the Exchange Rate - Assignment Example

ASB 3206 MONEY AND BANKING ASSIGNMENT

Question 1: Monetary Policy

• If the central bank has an interest rate target, why would an increase in the demand for bank reserves lead to a rise in the money supply?

Central bank places interest rate targets for different purposes that are mostly inclined on regulating the money supply in an economy. In addition to this the central bank regulates reserves as part of its monetary policy. Different levels of bank reserves have different impacts on money supply. The bank reserves are expressed as ratios and a higher reserve ratio means that there is little loanable amount thus the money supply in the economy will reduce. A decrease in this ratio causes an increase in the loanable amounts and therefore increased supply of money. A demand for bank reserves by the central bank could result in increased money supply when the central bank has an interest rate target. This interest rate target can be targeted at regulating the rate of inflation. In order to do the central bank sets a higher interest rate that discourages borrowing but increases the attractiveness of investing to external investors. This is because higher interest rates will fetch good returns for the investors. Increased inflow of capital for investment results in increased money supply within an economy in spite of the demand for bank reserves by the central bank.

• The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs?

The central bank is regarded as the lender of the last resort alongside being the government’s banker. A lender of the last resort mean that commercial banks can borrow funds from the central banks. The central bank being the banking industry regulator uses this function of last resort lender to stabilize banks. In instances where commercial banks could be faced with huge withdrawal of cash by depositors, they can borrow from the central bank so as to maintain their cash reserve ratios. The lending to commercial banks by the central bank comes at costs that are borne by the two parties. The commercial bank has to repay back the money borrowed from the central bank at an interest rate. This rate is predetermined by the central bank and it also affects the market interest rates. The cost to the central bank is the opportunity cost that is involved in committing the funds towards lending the bank instead of investing it elsewhere .

• Compare the use of open-market-operations, central bank lending facilities (rediscounting), and changes in reserve requirements to control the money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

Central banks control money supply by use of open market operations, re-discounting and reserve requirements. The flexibility, effectiveness, reversibility and speed of implementation varies depending on the economic situation. In an ideal economic environment, these would still differ greatly. In terms of flexibility, changes in reserve requirements and open market operations are more flexible than rediscounting . This is because their implementation is easier and they can be easily controlled from one point in the economy, which is the central bank. Any changes can also be effected easily through decisions made by the central bank. In terms of reversibility, the open market operations are easier to revere than rediscounting and changes in reserve values. This is central bank can price he government bonds accordingly depending on whether it wants to sell or buy them from the public. Reserve requirements and open markets are more effective than rediscounting owing to the fact that they touch on almost every sector of an economy. It would be quicker to implement reserve requirements than the other two because of less policies that are involved in their implementation.

Question 2. International Finance and the Exchange Rate

• How can a large balance of payments surplus contribute to a country’s inflation rate?

A country’s balance of payment should be balanced such that the export values are equal or almost equal to the import values. This results in balanced balance of payment. However, here are instances when the total export value exceeds the total import value or the total import value exceeds the total export value. These two instances result in ether a positive balance of payment, when export value is greater, or negative balance of payment when import value is greater. A positive balance of payment is called a surplus BoP while a negative balance of payment is called a deficit BoP. Both surplus and deficit BoP have their effects on a country’s inflation rate .

Surplus BoP

When a country is exporting more value than t is importing it means that there is more inflow of currency than the outflow. Considering that other factors such as the interest rates and foreign exchange rates are held constant, a large balance of payment surplus will result in increased inflation rates. This can be explained using a country’s production level. When a country has a favourable balance of payment, it means that it is exporting much of its products. It can also be explained that imports are low because the demand for the same is low in the economy. When much of a country’s products are consumed both locally and internationally, there is increased employment in the economy’s different industries. Increased exports also mean that there is increased currency that is circulating within the economy. This is similar to increased employment as it allows more currency to circulate in the economy. Increased currency in an economy increases population spending and this results in a demand-pull type of inflation. Demand-pull inflation is where there is more currency chasing to purchase proportionately less goods. However, the degree of inflation as an effect of surplus balance of payment is subject to other factors such as foreign exchange rates, lending rates and fiscal and monetary policies prevailing during a particular financial period.

• Why is it true that in a pure flexible exchange rate system, the foreign exchange market has no direct effects on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy?

A pure flexible exchange rate system is one where the foreign exchange rates are determined by the activities at the stock market. The exchange rate is purely pegged on the demand and supply forces of a currency. This means that there is no interference that would influence the exchange rates. In such a regime, there is no supply of money, in the form of Federal Reserve so as to influence the exchange rates. In this regard, a pure flexible exchange rate system does not have direct impact on the supply of money. However, a pure flexible exchange rate system has indirect impact on money supply through the level of activities involved. In instances where there is increased activities that result in increased inflow of foreign currency, the money supply within an economy increases . On the other hand, reduced inflow or increased outflow of currency results in reduced money supply within an economy.

Monetary policy includes activities that are aimed at regulating the supply of money within an economy. The fact that there is no direct impact of foreign exchange rate on money supply n a pure flexible exchange rate system does not necessarily mean that the foreign exchange market has no effect on the monetary policy. The foreign exchange market is one of the monetary policy tools that are used by governments to control the supply of money within an economy.

• What are the main benefits and costs of monetary union? What are the main criteria for the optimality of a currency area?

A monetary union is a currency control regime where several countries in an economic region agree to use a common currency whose supply is regulated by a single entity. It is also called a currency area and it can also take the form of several countries in an economic region using distinct currencies but their supply is controlled by a single entity that is appointed by these countries. An example of this is the European Economic and Monetary Union. Going by its definition, the basic function and objective of such an integration is to use the supply of currency to determine the level of economic activities within the currency area. This is achieved through maintaining a fixed foreign exchange rate. A currency union has some benefits as well as some costs for these benefits. One of the main benefits is that there is currency stability that increases confidence of the member countries as well as investors from other countries. Once a country becomes joins a monetary union, the associated costs of abandoning the union are comparatively higher than those of joining it. There is also stability in exchange rates since they are fixed by one entity and each member country has to adhere to these rates. Fixed interest rates allows investors to invest confidently over wider region as well as have the opportunity to specialize production within the currency area. The other benefit if monetary unions is that they make transactions within the currency area cheaper by eliminating transaction costs. This results in huge savings from the costs that would have been incurred as a result of different exchange rates.

There also exists two main costs that are associated with monetary unions. The first cost is that there will always be uncertainty from the management style of the currency area regime. The management style determines success or failure of the economic monetary union. The second cost is that due to the fixed exchange rates, member countries are not able to use foreign exchange rates to as part of their monetary policy to solve monetary problems within the country. Loss of this sovereignty also includes inability to use interest rates to achieve some of the economic objectives.

There exists a criteria for optimality of a monetary union which refers to guidelines of selecting a currency region that would be the greatest benefits to its members. Robert A. Mundell presents that there exists four criteria for the optimality of a currency area. The first one is focusses on the ease of capital movement and the flexibility of wages and prices. Trade activities will be improved if there is ease of capital movement. The movement of capital will be determined by the law of demand and supply of capital and the effect of prices and wages among the currency region’s population. This will result in distribution of money from where there is adequate supply to where it is demanded so as to maintain an economic balance. The second criteria focusses on risks associated with the currency in use. The existing currency risks should be shared within the member countries through the flow of capital from where there is adequate supply to regions within the union that are experiencing shortage of capital. The third criterion focusses on ease of labour mobility within the currency area. Reduced barriers to mobility of labour allows for improved economic activities in areas that are experiencing low activity and therefore an economic balance is maintained. The fourth criterion focuses on the nature of business operations within the currency area. The businesses in a particular area should have a similar cycle of business so that common actions on the foreign exchange rate in the currency area have similar impacts on the individual businesses in the particular regions .