The Monetary Authorities of Large Economies in the Modern World - Essay Example

? Macro & Micro economics of the Word Count: 2292 Introduction The s of economic affairs in the global marketplaces have become highly complex over time. The modern countries operate in the market by following the motto of free market principles. After the emergence of privatization associated with the globalization and liberalization of the world economy, the powers of the public and private authorities in the economies have changed down the years. The introduction of the classical dichotomy in the macroeconomic environment was responsible for the segregation of the monetary and the fiscal authorities of different economies (Pirounakis, 2013). The central banks of the economies play a pivotal role in the economic systems for prescribing the monetary policies in the respective nations. The fiscal authorities are in turn checked by the governments of different nations (Gerlach and Wensheng, 2004). In order to efficiently trade in the global economies, the countries in the modern economies use the purchasing power parity conditions to analyze the relative worth of different currencies in an economy. Exchange rate is the modern jargon used by the contemporary economies to judge the terms of trade conditions of nation. This essay will show how the monetary authorities of large economies in the modern world have liberalized or loosened their economies in order to adjust their exchange rates according to the market and sustain a favourable value of their terms of trade in the long run (Keohane, 2013). Situation Analysis Exchange Rate Issues Exchange rates are the rate that defines the value of the currency of a country in terms of the value of the currency of another country. Exchange rates are either measured in nominal or are measured in real terms. In real terms, it is the ratio of the aggregate price level in the foreign economy to the value of the aggregate price level in the home currency. A country always desires for an appreciation or evaluation of its exchange rates and similarly never desires to have a depreciation or devaluation of its exchange thresholds. If the exchange rate of a country falls, then the value of the currency of the country in the foreign market declines. In such a situation, the goods and services available in the country become cheap to the world market. On the other hand, the goods and services available in the foreign markets tend to become expensive to the country. In such situations, the exports of the country become cheaper in terms of value than the imports. The country would demand for less foreign exchange (lesser imports) and possesses an excess supply of the foreign exchange (higher exports). This would thus induce the price of the value of the exchange rate (supply > demand) in the market to fall. A fall in the exchange rate would actually imply the fall in the value of currency of a nation in terms of the currency of another country. Thus in the modern world, monetary authorities constantly try to manipulate and keep the exchange rates suitable to the economic environment of the respective nations (GBM, 2013). Macroeconomic Imbalances The countries in the contemporary world are found to have macroeconomic imbalance conditions. The causes behind the imbalances have been associated with both the internal and external affairs of economies. In some nations like Netherlands, the economy is facing high surplus in the current account but the household debt of the country is increasing at a rapid rate. Moreover, the property bubble (rise in the real estate prices) in the economies of Spain, U.S., Ireland etc have resulted in the heightening of the level of government debt and crisis in the economy. Since 2009, the global financial crisis in the economies of the western world has created a trickledown effect in the less developed economies in the world like India, Brazil etc. As after the emergence of globalization and liberalization, economies in the contemporary world have become entangled with each other. Thus, the macroeconomic imbalances in the form of recession have struck in almost all the economies in the world except of some countries like Australia, Dubai etc. Subjected to the recessionary conditions in these nations, the monetary authorities are trying to ease the supply of money in the economies. It is believed by these authorities that such steps would improve the exchange rates of these nations and rectifies the deficits of the government or in short, the macroeconomic imbalances in these nations. The Figure 1 in the Appendix explains the macroeconomic imbalances in the global market in the current era. It shows how at the time of the global financial crisis the nations had faced a budget deficit. However, losing out on the money supply in the economy over time has helped to reduce the deficits (European Commission, 2013). The monetary authorities of the countries have also lost their supply of money in the economy because they had desired to increase the depressing exchange rates of the countries as shown in the Figure 2 in the Appendix. Federal Reserve Lost Control over the Short Term Interest Rates In order to combat with the growing economic crisis, the Federal Reserve decided to augment the supply of money in the economy of U.S. This was an expansionary monetary policy undertaken by the government. The government adopted the policy of Quantitative Easing. In this policy, the central bank had accepted worthy government bonds from the commercial banks and in return, had given loans at less than 1% interest to the commercial banks in the economy. It had been analyzed that this would help to raise the demand for bonds and thereby would help to lower the interest rates. This would in turn increase the money supply in the economy and also improve the employment opportunities associated with the rise in the level of investment. But this monetary easing tool in the economy caused a rise in the inflation rate for a short term (higher supply of money in the economy caused rise in the aggregate demand when production was not high enough). This in the short run, the Federal Reserve could not experience lower interest rates (Davies, 2013). Japan fighting back Recession Japan is the only country is the global economy that is suffering from deflationary stagnation for a long period of time. Consumption, investment and wage level of the country have been sluggish over time. Thus the monetary as well as the fiscal authorities of the nation are adopting expansionary tools to recover then economy. The monetary authorities of the country have decided to adopt qualitative and quantitative easing. The country aims to attain a 2% inflation rate. The economy has also decided to trigger the level of technology in the country (BBC, 2013). The banks of Japan have also decided to augment the purchases of assets in the economy. After facing a prolonged depression in the economy, the country has ultimately decided to trigger its aggregate production and demand by facilitating the desired level of inflation in the economy (Aso, 2013). Asian Recession The initiative of expansionary monetary policies in the economy of Japan has helped to expand the supply of money in its economy by almost $1.4 trillion. The investors of Japan have become highly interested in investing in the equity and bond markets of countries in Asia like Indonesia and Thailand. These investors believe that financing the infrastructure projects in these economies would help them to attain high yields from investments. However, it is found that the countries in the Asian continent are struggling to recover from the low growth rates of the country. Aggregate price levels in these economies have been drastically rising and have further contributed to the recessionary phases in these economies (Noble, 2013). Currency Wars The global financial crisis in the world economy forced the monetary authorities of many countries to artificially devaluate their currencies or exchange rates. This particular step has been taken in order to make their domestically produced goods and services more attractive to the foreign economies. These countries started to better their exports to improve their terms of trade conditions. However, by taking such an action, these create artificial competitive advantages for the domestic manufacturer of the economy (Burgis, 2013). It facilitates a greater production in the domestic economy by increasing the money supply in the economy. The supply of money is increased by the process of deficit financing. In such situations, a currency war happens where any of the trading partners can strike back in order to portray its greater competitive advantage to its producers. In this state, the currency of the initial country depreciates instantly. It is similar to the currency war between Japan and U.S in 2013 when the value of Yen got reduced by almost 13% compared to the value of U.S. dollar. Brazilian Currency War Brazil have declared a currency war over the U.S. and Europe as the country claimed that these nations created unrequited capital control in the developing economies like Brazil by imposing tax on the foreign borrowings. It was claimed by Brazil that the expansionary monetary policies adopted by these developed nations was made at the expense of the high taxes which are imposed on the developing countries. According to Brazil, the appreciation of real exchange rates triggered by loose monetary policies actually created an unfair trading condition for the business world in the nation. Thus the central bank in Brazil has started to sell dollars and its derivatives in the economy directly which in turn have declared a direct currency war against the developed economies (Pearson, 2013). Currency Fears in Latin America The severity of the financial crisis was more in Brazil while considering the case of Latin America (Smyth and McQuinn, 2009). However, the continent started fearing that the constant use of expansionary monetary policies in the prominent economies like Japan, U.S. etc in the form of Quantitative Easing or deficit financing which would increase the economic turmoil in the global marketplaces instead of decreasing it. The high officials in the Latin American countries like Chile, Mexico and Peru commented that such loose monetary policies in the global economy would result in currency wars, create new types of trade protectionism, and generate property price bubble and such. These officials realized that instead of intervening in the market directly, it would be better for the authorities in different nations to take indirect steps like macro-prudential measures to rectify the recessionary phases in these economies (Rathbone, 2013). Quantitative Easing to an End According to the Federal Reserve, the tools of Quantitative Easing have proved to be successful in triggering the level of money supply in the economies. The low interest rates on the loans that have been generated from the high price of the bonds in the market have been successful to imbibe about $500 million investments in the U.S. economy. The Federal Reserve have analyzed that the country has now become capable of paying back its debts and recover from the depressed state. Thus, it has been decided to reduce easing of money in the economy by claiming to lower the purchase of bonds by $ 85 billion. However, these have made the other developing economies run under pressure where the investment requirements are still inadequate (Wigglesworth and Wagstyl, 2013). Tobin Tax Plan Tobin was an economist who introduced a special concept of taxing in the phase of international trade. He stated that any type of financial transaction that was involved in the conversion of currency of one country into another was supposed to be taxed. It was believed that applying a tax on all the exchange rate transactions would help cushion the volatility or fluctuations in the exchange rates (Woodford, 2003). However, the other economists and analysts believed that such an initiative would negatively hit the unilateral transactions in the economies. It was also stated that this tax would adversely affect the middle-sized companies as they often traded their derivatives to hedge against the currency and price fluctuations. However, it was stated that the commercial banks would be able to reduce some of the cost associated with such taxing by passing over its incidence to the customers or the Multinational Corporations operating in the international borders. Thus, this tax created a constraint on the extent of foreign investments in a nation. The financial transaction tax or the one widely known as the Tobin’s Tax had proved to negatively affect the traders and the manufacturers who traded with derivatives for the purpose of hedging against currency and price changes in the economies. This tax basically helped in controlling the derivatives market trading across international borders (Masters, Grant and Bryant, 2011). Conclusion It has been historically proved by many economists that direct intervention of the government or any other ruling body in an economy is not good in the long run. It is responsible for the loss in the net social welfare of an economy. After the emergence of globalization, it is true that economic systems in the global phase have become highly complex. An economic disturbance in a nation easily creates a cognitive impact on the economies of other nations. This is the reason for the increased importance which is given to international policy coordination in the modern world. The tool of expansionary monetary policies which were adopted by the large economies to improve exchange rate situations, have seemed to be profitable only for the developed economies like U.S. It has negatively affected the developing economies like Brazil that faces currency wars in such situations. Thus, it is desired that like Japan, economies in the modern world must try to recover from the crisis situation through indirect measures. They should try to improve the productivity of these nations instead of enhancing the exchange rates. Thus in this sense, the tool of Tobin’s Tax is actually an appropriate tool (Nishimura, 2013). Reference List Aso, T., 2013. Japan is fighting back at stagnation. Financial Times, 18 April. BBC, 2013. Japan agrees 2% inflation target and asset purchases. BBC, 22 January. Burgis, T., 2013. Currency wars: the battle lines explained. Financial Times, 13 February. Davies, G., 2013. How the Fed lost control of short term interest rates. Financial Times, 28 June. European Commission, 2013. European economy. [pdf] Available at General for Economic and Financial Affairs Publications. [Assessed 29 October]. GBM, 2013. Global financial update. [pdf] Scotia. Available at . [Assessed 29 October]. Gerlach, S. and Wensheng, P., 2004. Bank lending and property prices in Hong Kong. Journal of Banking and Finance, 29, pp 461–81 Keohane, D., 2013. Markets. [online] Available at [Assessed 29 October 2013]. Masters, B., Grant, J. and Bryant, C., 2011. Warning of unintended outcomes of Tobin tax. Financial Times, 5 October. Nishimura, G. K., 2013. Property bubbles and economic policy. [pdf] BIS Available at < http://www.bis.org/review/r130108b.pdf > [Assessed 29 October]. Noble, J., 2013. Asia cautiously eyes impending wave of Japanese cash. Financial Times, 14 May. Pearson, S., 2013. Brazil declares new ‘currency war’. Financial Times, 1 March. Pirounakis, G. N., 2013. Real Estate Economics: A Point to Point Handbook. London: Routledge. Rathbone, J. P., 2013. Currency fears spread in Latin America. Financial Times, 12 February. Smyth, A. and McQuinn, K., 2009. Modelling credit in the Irish mortgage market. Economic and Social Review, 40(4), pp. 371-392. Wigglesworth R. and Wagstyl, S., 2013. Quantitative easing: End of the line. Financial Times, 23 June. Woodford, M., 2003. Interest and prices: Foundations of a theory of monetary policy. New Jersey: Princeton University Press. Appendix Figure 1: Low Real Exchange Rates at the Time of the Global Financial Crisis (Source: Keohane, 2013) Figure 2 Increased Public Debt in Economies (Source: Nishimura, 2013) Read More