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Economics of Money and Banking - Essay Example

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Economics of Money and Banking Task 1 Banking and non banking financial institutions play a pivotal role in determining the extent of economic development in a nation. It is a traditional theory that individuals or households save a portion of their income…
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Economics of Money and Banking
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Economics of Money and Banking

Download file to see previous pages... Investments are a boon for the progress of any economy. This does not imply that the commercial banks would charge negative interest rates to the investors in order to boost up investment thresholds in the country. The banking institutions may offer loans at zero interest rates. Zero interest rate policy under taken by the central bank of a country is a situation where they charge a low nominal rate of interest (Woodford, 2001). This is associated with stimulating the economy, when the pace of economic development is low in a nation. Interest rates can never be negative, a negative interest rate charged on loans is a hypothetical state where the bank would offer concessions on loans charged to the investors or borrowers. This will not only involve loss of gross reserve in a bank but also lead to non potential investments in the economy. The commercial banks will land up offering loans on risky and unviable projects and thus may be forced to offer implicit bail outs to many failed projects in the economy. This would make the overall investment market uncertain in the economy. Thus, interest rate charged on loans can never be negative. The Taylors rule is a model used for determining the interest rates in the economy; it was introduced by John Taylor in 1992. This rule explained the different interest rates that the Federal Reserve would probably set in future in United States, based on the theory of rational expectations in macroeconomics. Taylor framed his model assuming that all the economic entities in the market will always have positive expectations about the future economy. The Taylors model cannot consider the long term prospects of an economy (Asso, Kahn and Leeson, 2010). As taken in this essay, the Taylors formula is: r=p+0.75(5.5%-u) + 0.5(p-2) + 2. Where r = Federal funds rate. u= Unemployment rate. p= Rate of inflation. Fig 1: Federal Fund Interest Rates by Taylors Rule Years Federal Fund Rate ® 01/03/10 -1.24 01/06/10 -1.48 01/09/10 -1.48 01/12/10 -1.40 01/03/11 0.02 01/06/11 -1.25 01/09/11 -1.18 01/12/11 -0.80 01/03/12 0.19 01/06/12 -0.58 01/09/12 -0.28 01/12/12 -0.28 (Source: STLOUISFED, 2013a; STLOUISFED, 2013b) The table above shows the different quarterly rates of interest, the Federal Reserve could set in 2010, 2011 and 2012 according to the Taylors Rule. “Yes”, following the above schedule it can be concluded that the Taylors rule suggested keeping the federal funds rate negative in the recent years. This is because the economy is facing recessionary trails in the market in the last few years. A negative interest rate would suggest the Federal Reserve to set expansionary monetary policies and augment the velocity of circulation of money in the U.S. economy. Task 2 In normal market conditions, Taylors rule suggested that the federal funds rate must be such that the inflation and real interest rates in the economy would be 2% and the rate of unemployment naturally existing in the economy would be 6%. However considering the present recessionary trails in the market the Taylors rule have suggested that the federal funds rate must be negative to induce monetary easing in the crisis economy of U.S. The Taylors rule has become an important pivotal support for most of the policies framed by the federal bank. However, the analysis about different economic outcomes made by the Federal Bank is much deeper than the other central banks in the globe. Taylors rule viewed that the U.S. economy was in a crisis in the recent years, it was desirable for the U.S. central bank to simply adopt ...Download file to see next pagesRead More
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