Loose Monetary Policy for Exchange Rates - Essay Example

? THE LIKELY IMPLICATIONS OF GERMANY ENGAGING IN LOOSE MONETARY POLICY FOR EXCHANGE RATES By of the of the Name of the School City, State 5 December 2013 Introduction A loose monetary policy in any country is one strategy used by the government to stimulate economic growth in the country. Its main benefit arises from the reduced interest rates and expansion in money supply. In this context, the focus is Germany; a large country with a dynamic system of open market and economy that is both affected and influences the foreign market through international intense competition in the mobile capital, technology and world products in the market. Like any other economy in the world, certain internal and external factors move its exchange rates in the short term and long term. These range from inflation and interests rates, balance of payment, investors and traders confidence in Germany and fiscal health of the government among others. Loose monetary policy generates both positive and negative effects to the economy, where the later can be severe and may require protection interventions to regulate the economic behaviour Monetary policies are controlled by the federal governments through the Central Banks in the nations. Therefore, depending on how the economy is performing, the federal government would provide the guidance on the monetary policy (loose or tight) to adopt. On the other hand, fiscal monetary policy in an economy and the transmission of a shock from the broader economy (e.g. global crisis or US shock affecting the Euro) could affect and action of the government and eventually the monetary policy. Large countries have high population of people and due to their engagement in economic development and high international transactions with the rest of the world; they tend to affect the economic variables of other open foreign markets, more than the small countries. Open economies/ countries are those that participate in international trade or economic activities, facilitating some level of freedom in importation and exportation with other countries. Measuring openness is quite complicated and theoretically determined by the level of protectionism (e.g. tariffs) applied by the country. However it can be estimated through the trade to GDP ratio in a country. Small countries are more open than large countries; they have higher than 70 percent openness premium (shares of imports and exports in GDP) (Damijan et al, 2013, p. 4). The effect of the loose monetary policy in the domestic front of small countries tends to be similar to large countries and perhaps faster and severely. However, in the foreign front, there would be a variance, especially in the international factor flow that is translated in the domestic capital market. This is because of the trade volatility and high degree of openness that make them more vulnerable to external shocks. Similarly, the shocks from the small countries tend to have negligible effect in the broader foreign market, hence on the receivers end. What would happen to the exchange rates in Germany in case of a loose monetary policy? German is the largest economy in Europe with an open but regulated market. It also shares a common currency (Euro) with rest of the nations in the European Union who accepted to the terms of currency union. This in fact reduces the chances of speculative attacks on the Germany currency. According to the Europecafe (2013), German stood at number 5 rank of the largest economies across the globe; the dominating European country in trade and especially in machinery export abroad. If German can opt for an expansionary monetary policy, its real interest rates would decline, forcing Germany’s domestic capital and financial assets to have lower real rates of return. The basic principal here is that monetary policy affects finances through interest rates and ultimately the exchange rates. Domestic investment for Germany would hence reduce after some time, as the previous investors prefer to invest abroad in search of higher rates of return. Foreign assets would tend to be attractive than domestic assets as the demand for Germany’s national currency reduces. There would be a fluctuation on the exchange rates with influence from the cuts on the interest rates. Considering that Germany is an open and integrated with other nation’s economies, decline of its exchange rates would have a substantial effect on the linked economies. Generally, through the interest rate channel, loose monetary policy would lower the exchange rates. How is the broader economy impacted? When ease monetary policies are applied, they are intended to generate positive effects to the economy. But they can also lead to unintended consequences in the long run if poor regulations exist. That is why economies alternate from loose to tight monetary policies. 1. Increase in money supply Three instruments are used to control money supply in an economy; they include the open market operations, reserve ratios and discount windows. In the modern economies, open market operations have been preferred over others; though can be used collaboratively in the economy. Large economies like U.S, China and Germany employ utilize these instruments which all work differently but eventually affect the money supply in the economy. According to Piffanelli and Erturk, Germany’s central bank came to adopt the open market operation instrument in the 1980s, to improve its monetary policies that heavily relied on reserve requirement, discount window and Lombard rates (2001). Since the German central bank system has limited power to influence economies demand for money, it uses indirect mechanism to change the bank rates and affect the liquidity of the banking system. Through open market operations, it can purchase the government bonds or the treasury securities from commercial banks to make increments of money supply in the central bank over time. Basically, the exchange of the short government debt with the banks allows reserves to increase. This is because central bank appends more cash to the accounts (reserve) expanding the money supply that can circulate in the Economy. Increase in money supply through open market can happen into ways; “either allow prices of reserves to fluctuate freely while aiming for a specific quantity of reserves or allowing the amount of reserve to fluctuate while targeting a particular interest rate” (Axilrod, 1997). The volatility of German’s government deposits is quite low; however, the reserve ratio is lowered to facilitate expansion of money supply. This would reduce the vault cash in the banks and allow the larger share to be consumed in money circulation. 2. Interest rates Increases in money supply in the economy imply to the reduced interest rates. In a way central banks of federal governments target the interest rates to set the loose monetary policy. By lowering the interest rates they can implement the expansionary monetary policy and other subsequent economic factors. In an economy where the borrowers and lenders can interact, the supply and demand of funds by both parties acts as a determinant of the interest rates been charged on the loans to the economic society (rohan.sdsu.edu, n.d). Through discount window instrument of monetary policy, low interest rates can be achieved in the event of loose monetary policy. If Germany’s central bank reduced the discount rate it charges on the loans it makes to germanise commercial banks, it encourages them to acquire additional reserves from which consumers and investors can borrow the loans at a less expensive rate. The high demand for money in the short run is inversely related to the interest rates. See diagram 1 3. Chances of higher Inflation Due to the stimulated aggregate demand in the larger economy, the capital markets can exceed their capacities very fast. As the supply of money increases, the nominal interest rates generally decline in the economy, while promoting investment and consumption. The main target for the governments is usually to stimulate growth especially in recession periods. When the money supply in the economy supports the economic growth at a much similar rate, and prices are stabilized, then inflation cannot be the outcomes in the situation. However, in the case where economic growth is not at the same rate of increment in money supply, prices level increases and inflation sets in. The consumer behaviour adjusts to the changes in the economy; they can access loans at a cheaper rate from the banking institutions due to low interest rates, their purchasing power increases and enables them to consume and spend a lot (Muler, n.d). The citizens’ expectation over the future inflation on the other hand, is influenced by the monetary policy chosen by the government. Easy monetary policy is often interpreted as a higher inflation in future and would hence demand for higher prices to cater for the future effect in prices. For example, the loose monetary policy and low interest rates in U.S large economy triggered high commodity prices (Anzuini, 2013). The effect of such expansionary policy with poor regulation was experienced in Germany in the 1920s. The more money people have would be of low economic value and will therefore try to convert the cash at hands into bonds. 4. Increase employment and wages With the increase in credit supply, citizens and investors can be able to affect the output of the economy in the short run through increased production. As the aggregate demand increases, the workforce has to be available to produce the quantity/quality of goods and services needed in the market. Therefore, more people will use the loans from banks to expand their business and production; these means the business cycle expansion will accommodate more human resources in the public and most especially in the private sectors. Germany’s lowered long and short term interest rates would enable firms across the different states to borrow funds (especially when the inflation rate is quite high so that they can repay back the loan at a lower value than when borrowed) and purchase property and equipments to expand their business, hire more workers and enhance production in response to firms’ increases in total expenditure (federalreserve.gov, 2013). In same way people have high prices set through public expectation of future inflation, the labour force will demand a higher wage when aggregate demand increases with increase in money supply. Basically, loose monetary policy aims at increasing employment, whose effect is enhancing real output in the economy (academic.evergreen.edu, 2007). The aggregate economy of Germany can end up realizing a positive GDP gap. However, there is a trade off experienced between higher employment rate and higher inflation rate could exist in the short run. When the prices and wages increases and central banks take no measures to adjust them, an inflationary gap will occur. See diagram 2. Though employment and wages increases, it does not imply benefit to every citizen in the economy. For example, Weidmann warned that low interest rate environment would benefit the certain domestic consumers (like employees and borrowers), but inconvenience the Germans and other nations’ savers, especially where the interest rates reached below inflation rate level (2013). 5. Tradable vs. non tradable The behaviour of these two sectors in large and open economies tend to differ in the manner they respond to the monetary policy shocks. Germany is a large economy and together with other several large European economies holds a large percentage of European Output in the global market. Tradable sector is more sensitive to lose monetary policy and essentially to interest and exchange rates than nontrade able sector in any open economy. According to a research on the effect of monetary policy shocks of tradable and non tradable sectors conducted on 15 OECD countries (Germany inclusive), results confirmed that contraction monetary policy appreciated the interest and exchange rates, hence resulting in a decline of price competitiveness of the domestic tradable goods than the non tradable sectors (Liaudes, 2007). Loose monetary policy would lower exchange rates and increase the price competitiveness of both sectors though much profound in tradable sector. Though Germany as part of the European system may be influenced by the union’s policies, the application of a loose monetary policy would lessen interest rates and consequently the value of Euro in Germany, but increase the net exports. 6. Deficit in trade balance and long term competitiveness Expansionary monetary policy affects trade balances trough three mechanism; the income, exchange rates and prices whose effect on the competitiveness may vary in the short and long term. All the mechanism has a substantial effect on the exports and imports of large open economies than small ones. Germany is one of the few large economies that have maintained a positive trade balance all along. However, the previous mechanisms can be used to explain the counter cyclical trade balances of Germany and any other large economies. When income increases as a result of eased monetary policy, household and firms consumption tend to demand more. Therefore, demand for imports in Germany would increase while the exports either remain unaffected or slightly increases at a lower rate due to influence outside Germany’s economy or various companies of interest. Based on the high national income at the time of expansion, the generated high import rate would lead to high imports that may not correspond to the rise or unchanged exports to foreign nations; hence the value of the difference of imports and exports would worsen as the trade balance shifts towards a deficit in the short run (suu.edu, 2003). However, in case of unanticipated eased monetary policy the trade balance may fluctuate in the long term especially when prices and exchange rates become take the lead in controlling trade across the economy. Higher prices also generate higher trade deficits due decreased competitiveness of the exports from a nation. Products produced at a higher cost within a large economy may force the nation to exports/sell it in the international market at a higher price to recover the cost of production, which may result in reduced competitiveness slow movement of products in the market. Although there are few exception (such as Germany’s lack of visible collateral consequences between the rising energy prices that affected aluminium industry and the high car sector exports in the same period of 2001-2008), domestic high prices tend to translate to loss competitiveness f its products in the larger global economy (Zachmann and Cipollone, 2013). Similarly, imported goods tend to be more competitive than domestic products, which make the domestic consumer to substitute imports for domestic products. Suppose exchange rate of Germany’s currency fall, the long term benefit would be its increased competitiveness that would promote an increase in exports and a shift of the trade balance towards the surplus. 7. Investment and Portfolio Flows They are very sensitive to economic shocks and have been the most affected and transmittable across interlinked economies in the world. Over the past decade, the global and Euro zone crisis not only exposed advanced countries’ balance sheet vulnerabilities, but “triggered a gradual shift in portfolio allocation of institutional investors towards emerging markets” (World Bank, 2011, p. 58).Germany and other advanced and emerging economies have increasingly opened their borders to financial flows, which pose both threats and opportunity to the economies. Expansionary monetary policy would generate an increase in stock market indices. Although regulation from the broad EU, Germany would be expected to have net inflows in foreign direct investment and debt securities, and experience net outflows in portfolio equities from Germany. The initial capital outflow would make demand for foreign exchange to increase and the supply of loanable funds to decrease interest rate (wps.prenhall.com, n.d). With the lower interest rates in Germany economy, the foreign capital will tend to leave the economy. Consumers and investors would convert the euro other denominated currencies with a higher value in return. Diagram 1: Interest rates and money supply (Aramco, n.d., p. 2) Diagram 2: Inflationary gap set by higher price level at potential output (Krugman, 2009, p. 3) Reference List Academic.evergreen.edu, 2007. Monetary Policy. [online] Available at: [Accessed 5 December 2013]. Anzuini, A., Lombardi, M. J. and Pagano, P., 2013. The Impact of Monetary Policy shocks on Commodity Prices. International Journal of central Banking [e-Journal] 9(3): published September 2013. Available at: [Accessed 4 December 2013]. Aramco, S., n.d. How do Changes in the Money Supply Affect Aggregate Demand. [online] Available at: [Accessed 4 December 2013]. Axilrod, S.H., 1997. Transformation to Open Market Operations. [online] Available at: [Accessed 4 December 2013]. Damijan, J.P., Damijan, S. and Parcero, O. J., 2013. Is There a Premium in the Size of Nations? 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