Money & Banking - Assignment Example

Money & Banking Response Money Trap” Situation The Central Bank or the Federal Reserve has a duty of maintaining inflation rates close to 0 % and nominal interest rates at or near 0 % (Krugman 1). However, during global economic recessions and fundamental economic growth, the Central Bank or the Federal Reserve struggles to maintain these rates. During this period, both the consumers and commercial banks are afraid of the future and consumers opt for precautionary savings instead of spending while commercial banks lose the interest to lend money.

This leads to a “Money Trap” situation where nominal interest rates do not stimulate consumers and lowering the interest rates to 0% do not translate to reduced commercial bank lending rates (Krugman 1). In this case, the demand for money remains perfectly elastic as monetary policies by the central bank fail to arrest the situation. In this situation, reducing the inflation rate too close to 0 % leads to deflation (Krugman 1). Even if the central bank maintains the nominal interest rates are zero, the eminent deflation will raise the real interest rates to significant levels.

Increasing money supply in this case derives no economic effect since interest rates cannot fall further. Indeed, in a “Money Trap” situation monetary injections into the economy by the central bank do not reduce the interest rates depicting the ineffectiveness of monetary policies. A “Money Trap” situation relates to a condition where any monetary policy to reduce the interest rates during economic recession is futile and creates a recurring crisis that involves consumers, commercial banks, and the central bank.

The “Money Trap” situation manifests in Europe where efforts to rescue the euro from the economic crush led to looming deflation and reduced economic growth (Krugman 1).Response 2- “Quantitative Easing”Central banks regulate money supply by buying or selling government bonds. The buying of government bonds by the central bank reduces short-term interest rates and enhances money supply by enabling commercial banks to access additional capital that increases lending and liquidity. Quantitative easing refers to unconventional monetary policies initiated by the central bank to buy government bonds and other relevant securities with the intention of lowering interest rates and enhancing money supply in the economy (BBC 1).

Quantitative easing does not entail printing more money and is only applicable when short-term interest rates are at or approaching 0 %. The US Federal Reserve initiated a $4.5tn bond-buying Programme in December 2008 to drive the American economy through the economic crisis (Monaghan 1). The program enhanced economic growth and restored confidence in the global financial markets. The Bank of England also initiated a £375bn QE policy that increased Britain’s annual economic output by between 1.

5% and 2% (BBC 1).Response 3- Effective and Ineffective PolicyIn this context, an effective policy may relate to a monetary policy that steers a nation through an economic crisis by lowering interest rates, enhancing money supply, increasing lending, encouraging spending, and improving the economic output of a nation after an economic crisis. For example, the quantitative easing policy adopted in England and U.S after the 2008 financial crisis was effective since it enhanced economic growth, increased spending, and reduced interest rates in the two nations after the economic crisis (Monaghan 1).

The graph below explains the effectiveness.On the contrary, an ineffective policy refer to a monetary policy that leads to low nominal interest rates, high real interest rates, and low spending rates, and high real interest rates. For example, in a “Money Trap” situation, monetary injections into the economy by the central bank lead to deflation and fail to reduce the interest rates since interest rates cannot fall further (Krugman 1). The graph below depicts the ineffectiveness of the monetary injections in UK where interest rate cuts derived little economic recovery.

Works CitedBBC. What is quantitative easing? 7 March 2013. Web. 17 November 2014.Krugman, Paul. The Money Trap. The New York Times Company, November 14, 2013. Web. 17 November 2014.Monaghan, Angela. US Federal Reserve to end quantitative easing programme. The Guardian, Wednesday 29 October 2014. Web. 17 November 2014.