Implications of a Large Country Engaging In Loose Monetary Policy for Exchange Rates - Essay Example

Examine the likely implications of a large country engaging in loose monetary policy for exchange rates Contents Contents 1 Introduction 2 Expansionary monetary policy 2 Empirical Evidence of the effects of the macroeconomic policies on the exchange rates of the economy 4 Quantitative Easing by the Federal Reserve 4 Bank of England’s policy of Quantitative Easing 6 Japanese Monetary Policy Changes 7 Critique of the expansionary monetary policy by the large countries 8 Conclusion 10 Introduction In the context of macroeconomics, the monetary policy has a lot of influence on the exchange rate of an economy. Any change in the variables that control the monetary policy would have an effect on the exchange rate in the economy. In most of the cases of an expansionary monetary policies which are undertaken to infuse liquidity into the market, lead to increase in the inflation in the economy which in turn would have an adverse effect on the exchange rate of the economy. Various instances of such monetary policies clubbed with adverse exchange rate phenomenon can be noticed in many of the big economies of the world. The objective of this report is to find out the various nuances of monetary policies and its effect on the economy of the world. The initial part of the report looks back at the theoretical framework of the monetary policy and the related macroeconomic variables. The second part of the report takes into consideration the different cases of monetary policies in some of the nations of the world and tries to analyse the policy measures in light of the theories. Expansionary monetary policy In any economy the monetary policy is implemented on the decision of the Central Bank of the country. On the other hand the Fiscal policy is implemented by the government of the country. While the implementation of the fiscal policy takes place through the adjustment of the government expenditure, taxes and the subsidies, the monetary policy takes place through the adjustments of the interest rates. The rates of interest are the main policy tools that the central bank uses for the changes in the policy measures. The monetary policy is based on the liquidity preference theory (Mankiw, 2002, pp. 311-315). The people in a particular economy would be adjusting their spending depending on the rate of interest that is prevailing in the markets. When the central bank wants to reduce the liquidity in the economy, it would increase the rate of interests. With the banks paying a higher return on the bonds, people would start parking their money in the banks for the expectation of the higher returns from the bonds. Thus they would spend less in the present period expecting that they would have more money to spend in the later period. This would lead to a cut in the spending. As a result the aggregate demand in the economy would decrease. Along with the reduction in the production of the domestic firms, the country would also start importing less. As a result there would be a favourable condition on the trade balance which in turn would bring more foreign currency in the economy. As a result of this the value of the domestic currency would appreciate (Caglar, Chadha, Meaning, Warren and Waters, 2011, pp. 240–273). Exactly the opposite would happen in case the central bank takes an expansionary monetary policy. In cases of expansionary monetary policies the central bank cuts the rate of interest. This would compel the people to keep their funds to themselves for their spending in the present period. This would lead to increase in the aggregate demand in the economy. As a result of this the firms in the economy would start producing more as well as the imports in the country would increase (Arnold, 2008, pp. 179-186). A large amount of domestic currency would flow out of the economy. This would have an adverse effect on the exchange rate of the economy. Thus from the theoretical point of view in most cases of the expansionary monetary policy would lead to an adverse effect on the exchange rates of the economy with the outflow of the domestic currency to the foreign nations. Now it is important to get idea about the exchange rates of an economy in brief. In any open economy in which trade takes place the currencies of the nations get exchanged. The rate at which one currency is exchanged for another currency is known as the exchange rate. Thus the price of one currency compared to the prices of the other currencies is known as the exchange rate. The exchange rate regime is the intensive mechanism that the countries undertake to manage their domestic currencies with respect to the foreign currencies in the foreign exchange market (Abel and Bernanke, 2005, p. 45). Now exchange rate may be of two types the fixed and the floating exchange rate. In case of the floating exchange rate, there is flexibility in the movement according to the dynamics of the foreign exchange market. On the other hand, a fixed exchange rate is that which remains confined within a definite band that is fixed by the central bank of the country. Thus a basket of currencies are tied together in order to keep a control over the exchange rate. In case of a floating exchange rate the determination of the value of one currency compared to the values of the other currencies are take place under the market forces of demand and supply (Beneish and Whaley, 1996, pp. 1911–1929). Thus in case of the free floating currencies the fluctuations in the financial markets would affect the value of the currencies. Empirical Evidence of the effects of the macroeconomic policies on the exchange rates of the economy Quantitative Easing by the Federal Reserve Most of the developing countries like the US, UK and the entire Euro zone were inclined towards an expansionary monetary policy as response to the policy to combat the recession which took place in the aftermath of the financial crisis of 2008-09. The most popular policy that was common to all these nations were the policy of quantitative easing. The Federal Reserve by this policy tried to provide a monetary stimulus to the country which was undergoing a phase of currency crisis. In this type of monetary policy the government starts purchasing assets from the market (Ahmad and Steeley, 2008, pp. 692–699). The government bonds are the most common types of assets that the government spends money into. The Federal Reserve took resort to this kind of policy tool mainly because of the fact that changing the interest rate can no longer effective in making the financial condition of the country a stable one. When the Federal Reserve starts buying the assets from the bond markets the liquidity that would be available in the economy would get increased. The bank had put an amount of $ 2.2 trillion for buying assets from the market and has been planning to put an additional amount of $40 billion for the quantitative easing in the economy of the United States. This would give rise to an increase in the aggregate demand in the economy which otherwise was slowed down in the scenario of financial crisis. The reduction in the rates of interest is not possible in such a scenario because the rates are already at a very low rate (Bernanke, Reinhart and Sack, 2004, pp. 15-49). Thus the United States experienced depreciation in the value of dollars compared to the currencies of the developing nations like Brazil, China and India. The fluctuation of the value of US dollar compared to the Brazilian real has been shown in the following diagram. It can be seen that the value of dollar fell drastically after 2008. Although US$ stabilised slowly with time, just at time when the quantitative easing was introduced the value again depreciated. This means that the new implementation of the monetary policy had an effect on the economy of the US as well as the value of the currency (Pearson, 2012, p. 1). The reasons that the chairman of Federal Reserve put forward for implementing quantitative easing is that it would help in the boosting up of the economy which in turn would lead to decrease in the level of unemployment and bringing about stability in the price levels of the country. The chairman also mentioned that the policy of quantitative easing would help in the renewal of the exports of the other countries which are dependent on the US economy for their international trade. Bank of England’s policy of Quantitative Easing The central bank of the United Kingdom, the Bank of England also adopted the quantitative easing policy in order to tame the various currency crisis pressures that UK had been facing. In the post March 2009 period, the bank had cut the bank interest rate to 0.5 %. Any reduction in the Bank rate was not possible beyond this level (Hancock and Passmore, 2011, pp 1–62). This forced the central bank of UK to take resort to the quantitative easing policy because no other measure was possible to take at this time to fight the liquidity problem in the economy. This decision of the central bank was executed with the purchase of bond worth £ 200 billion and at the second stage of amount £ 75 billion. This purchase of assets took place in subsequent phases which then resulted in the total purchase of amount £ 375 billion. The main motive behind this policy is to the injection of liquidity in to the economy which in turn would act as a factor that would boost the aggregate demand (Afonso and Martins, 2010, pp. 1–29). In this kind of monetary policy neither new bank notes are printed nor does the bank make any alterations in the benchmark rates. This policy had an adverse effect on the currency of the UK and pound faced depreciation. Japanese Monetary Policy Changes The monetary policy of Japan has an effect on Japanese Yen. The recent change that was witnessed in this economy was to combat the inflationary pressures that the country had been experiencing. This problem had been persisting in the economy since a long period of time. The new policies consisted of several parts like the introduction of the expansionary monetary policy, the injection of a fiscal stimulus in the economy as well as the incorporation of the necessary structural reforms (Davies, 2013, p. 1). For introducing a monetary policy with the backing of a fiscal stimulus the central bank intended to increase the monetary base of the economy by 100%. This in turn would increase the amount of cash in the economy of Japan. Alternatively the increment in the holding of the government bonds would also be a form of quantitative easing and monetary policy expansion in the country of Japan (BBC News, 2013, p. 1). The chief motive of the Japanese central bank in these set of activities was to increase the amount of money supply in the economy of Japan. Though the effect of the monetary expansion would act as a blessing for the country in terms of the increase in the growth rate of the economy, this would also result in the decline in the value of Japanese Yen. The drastic fall in the value of the Japanese Yen was a result of this and the percentage of decline in the value was as high as 25%. The figure below depicts the changes in the levels of depreciation of the Japanese Yen compared to the US dollars. This drastic drop is noticeable in the post 2012 period. The scenario was quite unlikely give given that the Japanese Yen was in no way linked with the other international currencies of the world. Thus Japan being quite a large country would have an adverse impact on the smaller countries like North and South Korea which are to a large extent dependent on Japan for the various trade relations. Critique of the expansionary monetary policy by the large countries Most of the large countries are engaged in the process of quantitative easing have been able to create a surge in the economies as a result of the increase in the money supply in these economies. The currencies of the developed countries have experienced a depreciation compared to that of the developing nations. The exports of the developed countries have experienced a boost due to this process (Joyce, Lasaosa, Stevens, and Tong, 2010, pp. 7–34). This is considered to be not a fair way to maintain a superior position in the scenario of international trade (Krishnamurthy and Vissing-Jorgensen, 2011, pp 18–45). In the opinion of the economists the monetary policy that most of the large countries as well as the European Union has taken would be a successful measure that would help in the stimulation of these economies (Anderson and Sleath, 1999, pp. 1–14). The economists predict that this condition would help the countries to move toward a way of increase in the price levels in the stable manner in the medium term. Hence the net effect on the real exchange rate would be less in this case for the medium term despite decline in the nominal rates of exchange. One point to be noted in this regard is that the rates of inflation in most of these countries are very low and hence the reason for this lack of effect (Wigglesworth and Wagstyl, 2013, p. 18). Another branch of economists are of the opinion that the expansionary monetary policy helps in the stimulation of the commodity market which would result in the increase in the imports from the other countries of the world to the large countries that are involved in international trade with the emerging nations (Hau, Massa and Peress, 2010, pp. 1681–1717). Various set of surveys conducted by the International Monetary Fund stated that the US policy of quantitative easing was useful for the international economic environment by increasing the output for the other countries of the world. It is often stated that the expansionary monetary policy is not fair enough for the countries to pursue because it adversely affects the other countries that are linked to the policy making countries. It was posited by a group of economists that it was quite likely for a country to adopt such policies in order drive the economy out of financial crisis. Conclusion From the above analysis it is clear that the implementation of these policies would be affecting the large economies and thereby affects the emerging economies that are dependent on these economies. These policies taken by the respective central banks of the countries have resulted in the currency wars among these nations. The main objective behind the adoption of these unconventional policies was to make the working of the financial markets stable and to make an accommodating monetary policy when there was no scope for the countries to implement the policies in the conventional ways. Most of these aims have been achieved with the obvious presence of various loopholes. The effectiveness of the policies has been proved by the growth and export import statistics of most of the countries. However, they had an adverse effect on the currencies of most of these large nations and is said to be leading to further bubbles that may burst in the near future. It is therefore a duty on part of the countries to mitigate the various types of risks that may crop up in the process. References Ahmad, F. and Steeley, J., 2008. “Secondary market pricing behaviour around UK bond auctions”. Applied Financial Economics, Vol. 18, pp. 692–699. Arnold, R. A., 2008. Macroeconomics. Mason: South Western Cengage Learning. 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