The Monetary Policy in the U.S.and the UK - Term Paper Example

 Table of Contents I. Introduction ……………………………………………………… 3 II. U.S. Monetary Policy in the Past Ten Years ……………………… 3 a. 1997 Risk of Inflation ...………………………………… 4 b. Effects of the Asian Crisis ……………………………… 5 c. Effects of Globalization ………………………..………. 6 III. UK Monetary Policy in the Past Ten Years …………………….. 7 a. Effects of the Asian Crisis …………..…………………. 7 b. Effects of Globalization ………………………………… 8 c. Improvements in the Financial System of Bank of England ……………………………………….. 9 V. Asian Crisis Effects on US and UK’s Broad Money Growth and Equity Prices ………………………………………………… 9 VI. Conclusion ……………………………………………………….. 10 References ………………………………………………………………... 12 Introduction Monetary policy is used by the governments, central banks, or monetary authorities that manages the supply of money in order to control inflation or deflation, fluctuations in the exchange rate as well as promoting full employment and economic growth. During the past ten years, monetary policy has been widely used by U.S. and UK in order to achieve a constant economic growth despite the external factors that affect these countries’ economic activity. The current major external factor that affects the activity of U.S. and UK is the long-term effects of the Asian crisis and globalization. With the use of monetary policy, U.S. and UK can counter-act inflation and economic recession or depression. In this paper, the historical strategy used in the monetary system of U.S. and UK will be elaborated. Through the historical events associated with the U.S. and UK monetary policy, we will be able to conclude whether monetary policy is boring or not. U.S. Monetary Policy in the Past Ten Years Many people have been praising the work of Fed Chairman Alan Greenspan i for making the U.S. monetary policy in 1990s very successful. (Mankiw, 2001) The Fed was at the center stage during the Asian financial crisis between the years 1997 – 1998 including the failure of hedging the Long-Term Capital Management of funds in 1998 created a worldwide financial crisis and Globalization in the 20th century. The U.S. monetary policy together with the help of fiscal discipline, the U.S. government budget deficit was converted into surplus. Prior to the Mexican crisis in 1994 and the Asian crisis in 1997, the economic performance of U.S. has been very stable. At that time, the real GDP growth of U.S. has increased more than 3% over the fourth quarter of 1996, inflation and the unemployment rate was maintained at a low level. Because of the continuous economic growth in U.S., the nominal wages and salaries of the workers increased faster than the prices of commodities. The increase in salary and wages resulted to increasing the efficiency of production output by investing on new technologies. During the last quarter of 1996, a lot of companies have been laying off employees. This causes the U.S. unemployment rate to increase. Also, consumer debt, credit card delinquencies and personal bankruptcies was very high. 1997 Risk of Inflation In February 1997, the Federal Reserve became very concern about the risk of inflation because of the sudden appreciation of the U.S. dollar. During the height of U.S. economic activities, high inflation should be avoided since it would weaken the long-run economic growth of the country. Inflation would definitely interfere with the efficiency of resources allocation by destabilizing the prices of raw materials. According to the Board members of the Federal Reserve and Bank presidents, the unemployment rate should be kept between 5-1/4 to 5-1/2% and the GDP growth at 2 to 2-1/4% through out the fourth quarter of 1997. (The Federal Reserve Board, 1997a) This figure would make a downshifting movement in the total production output and would cause the demand of the real federal government purchases to decline. The decrease in the production output would result to the decrease in the U.S. net exports and would eventually increase the opportunity to residential constructions for gains. Because of the economic situation in 1997, many banks became very cautious about consumer credit card lending. Instead, banks focused on easing the terms and standards on business loans. Private lenders were still lending out money in exchange with home equity loan market. On the other hand, the Federal Open Market Committee (FOMC) announced that M2 should be between 1 – 5%, M3 at 2 to 6%, and the debt of domestic non-financial sectors at 3 – 7%. According to FOMC, these ranges would aim for long-run price stability. As reported during the third quarter meeting in 1997, a full upswing in the U.S. economy was evident. During the first quarter of 1997, the real GDP increased up to 6% annual rate and the consumers were already enjoying the benefit of a low inflation rate since the CPI increased at less than 2%. Unemployment rate was down to 4-3/4% while the industrial production increased by 5-3/4% as compared to 1996’s output. The consumer price inflation was also reduced from 1-3/4% to 1-1/2% points from the previous year. At the time of economic crisis, FOMC chose to tighten the monetary policy and increased the federal fund rate ¼% to5-1/2%. Because of the appreciation of U.S. dollar, Federal Reserve decided not to increase the federal fund rate during summer and fall despite the problem in the labour market. (The Federal Reserve Board, 1997b) The proper use of monetary policy enables U.S. to remove inflation. This was the key to price stability – the main solution for the turn around of U.S. economy. Effects of the Asian Crisis During the Asian Crisis as well as the appreciation of the U.S. dollar, U.S. export was affected because many Asian economies decided to cut down on importation of goods. During 1998, the Federal Reserve chose not to make any move until they are certain with the long-term effect of the Asian crisis on U.S.’s economy. Monetary policymakers at this point were expecting a higher inflation rates for 1-1/2 years because of the strengthening of the value of U.S. dollar while the Asian economies were experiencing economic crisis. According to Governor Roger W. Ferguson, Jr., the short run effect of the Asian crisis to the U.S. economy is the reduced cost of raw materials. (The Federal Reserve Board, 1997c) However, U.S. will experience difficulty exporting their finished goods and services. He added that during the Asian crisis, the Monetary and Fiscal policy should not be use to distort the markets because it could only complicate private problems. The role of monetary policy at this point is to cushion the slowdown of the U.S. economy. (The Federal Reserve Board, 1997d) As soon as the U.S. economic activities were able to adjust with the effects of the Asian crisis, U.S. monetary policy makers responded to the global economic condition between the year 1998 and early 1999 by cutting down on interest rates. (The Federal Reserve Board, 1997c) Effects of Globalization The weak economic growth all over the world including the world foreign exchange and financial markets as well as the diversified domestic macroeconomic experiences of U.S. is part of the unique challenges the U.S. monetary policymakers are facing since the globalization in year 2000 up to now. In the past few years, the U.S. monetary policy has been very much focused on stabilizing a low and stable inflation better than in 1960s and 1970s. (Romer and Romer, 2002) Since the 1980s, U.S. monetary policy is very successful in maintaining a low inflation. Today, changes in the monetary policy were created because of a much tighter competition in the currency. (Kroszner, 2006) This is entirely the after effects of the increased globalization, deregulation, and financial innovation which resulted from the fluctuation of inflation. (The Federal Reserve Board, 1997f) Globalization is causing more competition to the U.S. local companies and workers. In fact, they have a lesser market power now than in the past. The tight competition with the global market makes U.S. economy less sensitive to inflation caused by domestic resource utilization. Deregulation led to the opening of capital markets which resulted to financial globalization. Lastly, financial innovation such as the electronic payment and trading systems including the use of credit card networks and the promotion of mutual fund movement all over the world. Low inflation would be beneficial for the U.S. economy while a high inflation would cause burden due to declining economic activities. UK Monetary Policy in the Past Ten Years The responsibility of the Bank of England's is to ensure the monetary stability of UK. This can be done by maintaining stable prices, low inflation, and confidence in the currency. Government's inflation target is used to define stable prices. The Monetary Policy Committee controls the interest rates to achieve these goals. 1997 Asian Crisis In 1997, the inflation target was set at 2-1/2% by the Bank of England to ensure price stability and avoid fluctuations to production output and employment in UK. (Bank of England, 1997a) Once the inflation target is set, interest rates can be manipulated to avoid inflation and deflation. Because of the fall of Thai bhat in July 1997, during the third quarter of the same year, the EMI published a ‘General documentation on ESCB monetary policy instruments and procedures.’ (Bank of England, 1997b) This documentation is all about the money-market counterparties of the European System of Central Banks (ESCB) into a monetary union. With the approval of the European Central Bank (ECB), this documentation will be used to allow ECB to steer short-term interest rates in the euro money market. At this time, ECB implemented decentralization on the use of monetary policy among the national central banks. It means that each national central bank will have to deal its own counterparties by fine-tuning the operations between the weekly repos and other smaller group of counterparties. Also, issuance of debt certificates can be used to absorb liquidity or ESCB could simply impose reserve requirements. This strategy was made to ensure the stability in the supply of money. Effects of Globalization Globalization affects many macroeconomic variables which are vital in monetary policy making. It could weaken the short-run trade-off between production activities and inflation. (Bean, 2006) For UK to be able to compete with the global market, the value of Sterling has to depreciate at some point. Depreciation of the Sterling will eventually allow the local producers to penetrate some of the world markets. For some time, the interest rates of Sterling have been increasing. The increase in the purchasing value of Sterling is associated with the increase in the equity prices. It only means that many people are confident with the economic growth of UK. For this reason, the UK Monetary Policy Committee (MPC) did not think twice on increasing the Bank Rate by 25 basis points to 5.25% as of January 2007 and aiming to increase it more up to 5.5% by end of the year. (Bank of England, 1997c) On the other hand, the market interest rates were also increased. As a result, the global equity markets fell sharply while the credit spreads widened especially for those low-rated borrowers. The action of the MPC made the Sterling depreciates against the yen. (See graph on page 9) Chart I – Sterling Exchange Rate Index Source: Bank of England, 2007 The main goal of MPC increasing the interest rates is to influence the sterling asset prices since the GDP growth during the 4th quarter of 2006 was way more than what was expected. MPC had no choice but to increase the interest rates in order to avoid inflation in the long-run. Improvements in the Financial System of Bank of England Over the years, Bank of England continuously search for better ways on how to improve the stability of money and the effectiveness of its financial system. The attack of the World Trade Center in U.S. back in 2001 has led to the development of ‘Value at Risk’ (VaR) models. (Bank of England, 1997e) This model allows banks to calculate the aggregate risks associated with the entire portfolios. Asian Crisis Effects on US and UK’s Broad Money Growth and Equity Prices Since Japan was badly affected by the fall of Thai bhat, its GDP fell sharply. This fact allowed US GDP to grow continuously during the second quarter of 1997. The output of major European countries also strengthened. The demand shock brought by the Asian crisis to US and UK resulted to a continuous increase in the narrow money and a constant growth in broad money. (Bank of England, 1997d) On the other hand, the US and UK equity prices increases sharply between May to July 1997. It started to fall in August of the same year. The same event was seen in the case of UK. Despite the demand shock that occurred in US and UK, inflation rate remains low because of the monetary policy. Conclusion The monetary policy in U.S. and UK is never boring because of the unpredictable economic events that could happen all over the world. Each monetary system is free to choose strategies that could help fight inflation. Over the years, the Federal Reserve as well as the Bank of England would come up with new innovation or programmes to help them achieve their goals. Normally, when a country changes its own monetary policy, there will always be a domino effect as a result of the adverse economic consequences in other nations. Let U.S. consider a situation wherein U.S. is tightening its monetary policy so they could reduce inflation. The monetary policy changes will eventually result to the appreciation of the exchange rate which can affect the inflation rate of other countries since importation of goods and services will become more expensive. International trading is one of the primary factors in the fluctuation of exchange rates. In fact, it is considered as a very important and sensitive issue today. Regular trading of goods and services between different countries will be very much affected in case of rampant changes in the exchange rates. Major worldwide economic changes such as the Asian crisis in 1997 have resulted to a lot of adverse effects in the U.S. and UK economy. Without the monetary policy to cushion the effects, it would be very hard for these countries to counteract inflation, high unemployment rate, continuously changing exchange rates. These effects could impose a great impact on the economic performance of U.S. and UK. Timing is very important in monetary policy. Changing the interest rates before allowing the effects of a crisis to take place will result to a more serious economic problem for US and UK. On the other hand, failure to increase the interest rates during demand shock would result to inflation. Monetary policymakers are responsible in aggressively increase the interest rates in order to defend the pegged exchange rate. In case of a floating rates, aggressively tightening of the interest rates to prevent overshooting of exchange rates. (The Federal Reserve Board, 1997e) Considering these two scenarios the Federal Reserve and the Bank of England should be able to come up with a monetary policy framework that could control inflation. This type of responsibility should always be taken seriously because the quality of living of many people is dependent on the result of the monetary policy. Monetary policy is never boring because of the regular day-to-day changes in the global economic activities. Therefore, economic changes and challenges in the monetary policy of U.S. and UK will always be present. *** End *** References: 1 Bank of England (1997a) ‘The Inflation Target Five Years On’ Bank of England Quarterly Bulletin: November 1997 Retrieved: April 5, 2007 < http://www.bankofengland.co.uk/ > 2 Bank of England (1997b) ‘Monetary Operations’ Bank of England Quarterly Bulletin: November 1997 Retrieved: April 5, 2007 < http://www.bankofengland.co.uk/ > 3 Bank of England (1997c) ‘Markets and Operations’ Bank of England Quarterly Bulletin: First Quarter 2007 Retrieved: April 5, 2007 < http://www.bankofengland.co.uk/ > 4 Bank of England (1997d) ‘International Environment’ Bank of England Quarterly Bulletin: November 1997 Retrieved: April 5, 2007 < http://www.bankofengland.co.uk/ > 5 Bank of England (1997e) ‘Speech by David Clementi, Deputy Governor’ At the Launch of the Oxford Centre for Computational Finance, University of Oxford: October 10, 2001 Retrieved: April 5, 2007 < http://www.bankofengland.co.uk/ > 6 Bean, C. (2006) ‘Globalisation and Inflation’ Bank of England Quarterly Bulletin, Vol. 46, No. 4, pages 468–75 Retrieved: April 5, 2007 < http://www.bankofengland.co.uk/ > 7 Kroszner, R. (2006) ‘The Conquest of Worldwide Inflation: Currency Competition and Its Implications for Interest Rates and the Yield Curve’ Speech Delivered at the Cato Institute Monetary Policy Conference, Nov. 16, 2006 Retrieved: April 4, 2007 < www.federalreserve.gov/ > 8 Romer, C. and Romer, D. (2002). ‘The Evolution of Economic Understanding and Postwar Stabilization Policy’ in Rethinking Stabilization Policy, symposium sponsored by the Federal Reserve Bank of Kansas City, August 29-31. Kansas City: the Reserve Bank, pp. 11-78. 9 RTE News (2006) ‘Greenspan Retires from U.S. Federal Reserve’ Retrieved: April 4, 2007 < http://www.rte.ie/ > 10 The Federal Reserve Board (1997a) ‘Testimony of Chairman Alan Greenspan: The Federal Reserve’s Semi-annual Monetary Policy Report’ February 26, 1997 Retrieved: April 3, 2007 < http://www.federalreserve.gov/ > 11 The Federal Reserve Board (1997b) ‘Testimony of Chairman Alan Greenspan: The Federal Reserve’s Semi-annual Monetary Policy Report’ July 22, 1997 Retrieved: April 3, 2007 < http://www.federalreserve.gov/ > 12 The Federal Reserve Board (1997c) ‘Remarks by Governor Roger W. Ferguson, Jr.’ March 4, 1998 Retrieved: April 4, 2007 < http://www.federalreserve.gov/ > 13 The Federal Reserve Board (1997d) ‘Remarks by Governor Lawrence H. Meyer’ October 5, 1998 Retrieved: April 4, 2007 < http://www.federalreserve.gov/ > 14 The Federal Reserve Board (1997e) ‘Remarks by Governor Lawrence H. Meyer’ February 25, 1999 Retrieved: April 4, 2007 < http://www.federalreserve.gov/ > 15 The Federal Reserve Board (1997f) ‘Remarks by Governor Randall S. Kroszner’ March 12, 2007 Retrieved: April 4, 2007 < http://www.federalreserve.gov/ > 16 Mankiw, G. (2001) ‘U.S. Monetary Policy During the 1990s’ Retrieved: April 3, 2007 < http://www.economics.harvard.edu/ > Read More