Fiscal Tools of Central Banks - Essay Example

Fiscal Tools of Central Banks Central banks use fiscal tools such as interest rates in order to control money supply in the economy. Monetary policies are widely used by many central banks to regulate money supply by combining output stabilization with inflation. Many economists agree that output is fixed in the long run and any changes in the supply of money result in changes in the price levels. However in the short run, prices and wages do not change immediately because changes in the supply of money can influence the production of goods and services. This has been the chief reason why “central banks consider monetary policies as effective policy tools for attaining growth and inflation objectives laid out by the government” (Dullien, 2004). Since a low stable inflation is mandatory for an optimal economic growth, one of the main roles of the central bank is to control the growth of money by controlling inflation which is attained by using monetary policy tools. According to early classical theories of inflation pertaining mostly to the growth of money, an increase in the supply of money by government forces is primarily responsible for increased inflation levels. However, the growth of money is a necessary prerequisite for the growth of money but it is not adequate on its own (Mankiw & Reis, 2002). Other factors that should be considered include the velocity of money because in the absence of money expenditure, no inflation can occur. A good example of the importance of the velocity of money impact on inflation is when people possess money but instead of spending it, they hide the money in their homes. In such scenarios, there will be no effect on the present inflation levels. Inflation is recorded when suppliers of goods and services increase the prices of their products by responding to the effects of aggregate demand in the economy. “The increase in aggregate demand has the effect of increasing aggregate supply” (total supply of all the services and products in the economy) (Dullien, 2004). Therefore, an increase in inflation levels is as a result of an increase in the demand which is relative to supply. A cycle is created as a result because when people acquire money they proceed to spend the money on a service or product and the money is transferred to the supplier of the good/service and the supplier in turn spends it turn on some else and an endless cycle continues. In this case, the government creates money which is cycled throughout the population endlessly. Velocity of money=Average number of times a dollar is spent to purchase final services and products / Time Therefore, in order for the central bank to assess the impact on inflation levels, money growth changes and the velocity of money has to be contrasted to the growth of services and goods which are provided in the economy measured by the GDP. Graph 1: Graph showing (“Rba.gov.au”, 2014) the relationship between GDP Price Deflator and Real GDP. A reduction in the supply of money shifts the curve on the left hand side as shown below. Graph 2: Graph showing (“Rba.gov.au”, 2014) the relationship between GDP Price Deflator and Real GDP when money supply is reduced. A monetary policy can either be expansionary or contractionary. When the central bank wants to decrease unemployment and increase both inflation and economic growth, it adopts the expansionary monetary policy and if it wants to curtail economic growth and inflation levels coupled with an increase in unemployment, it adopts the contractionary policy. An expansionary policy has been used by central banks over the years to reduce interest rates to entice businesses to obtain the cheaper credit through increasing money supply in the economy. “The policy aims to facilitate growth of aggregate demand” (Deane & Pringle, 1995). The central bank’s decision to increase money supply in the economy has the effect of encouraging private consumption and reducing interest rates that are responsible for encouraging borrowing and investments. Central banks employ monetary policy tools in a variety of ways but the most common tool they use is the open market operations .In this set up, the central bank purchases government bonds from the public resulting in an increase in the supply of money in the economy. Other side effects experienced include lower interest rate levels levied by commercial banks and investment is promoted. Since the “financial institutions and banks which sold the debt to the central bank have greater money supply, they are able to give out loans at favorable interest rate levels. Increase in money supply will however result in higher inflation levels” (Loungani & Sheets, 1997). Other expansionary monetary policies include reducing the cash reserve ratio of commercial banks through the directive of the central bank and increasing the window of lending regarding discount amounts. Through the use of the discount window, eligible financial institutions are permitted to borrow cash from the central bank on a short term basis in order to meet liquidity shortages as a result of internal and external factors (“Bank of England”, 2014). By reducing the rate charged during the discount window, it promotes additional discount window lending and reduces other interest rates thus encouraging investment. The quantity theory assumes that, there is an exogenous supply of money, there exists stable income, velocity of the circulation of money and equilibrium exists. The assumptions are erroneous because velocity of money is not stable since it is subjected to cyclical stocks and in cases where the income rises, price levels remain constant even when faced with rising money supply. Post Keynesians have proved that the central bank determines the endogenous money supply which differs to the previous economists who assumed that money supply was exogenous. This means that money creation is mainly due to policies advocating for credit. A huge amount of money is therefore created by non-public banks and the quantity of money demanded which is determined by its private demand (Brumm, 2000). Simply, endogenous money. A money system that is endogenous usually has a monetary system that is endogenous as well if the central bank is mandated to accommodate its customers’ demand for high powered money in order to avoid banking panics and financial crisis. According to post Keynesians an independent money supply function is nonexistent in an endogenous financial world as a result of its demand therefore supply of money is led by its demand and is not independent of money. Money supply contrasts with the quantity theory because changes in money supply are caused by the effects of credit demand changes, economic activity and production activity. Simply, money is the effect and not the cause. The Bank of England recently asserted that, loans were responsible for the creation of loans; banks created money by not just lending out savings and criticized the money multiplier as erroneous. Critics have argued that the single most leading constraint to lending is monetary policy. “Interest rates accumulated from monies that commercial banks place with the central bank are responsible for influencing the rate by which the banks are able to lend money in markets where the central Bank of England and other commercial banks lend to each other and including other financial institutions” (GarciÌ & Rixtel, 2007). The resultant changes in the interest rates from the banks’ lending to each other trickle down to other interest rates in other markets and which are at different rates. It also affects interest’s rates levied by banks to their customers who have saving accounts and including the borrowers. The monetary policy mechanism is aligned with the post Keynesian theory of endogenous money supply and recent innovations such as the New Keynesian literature where the LM curve is replaced by the Taylor interest rate rule (Artis & Kontolemis, 1998). The supply of money in the economy is solely dependent on credit demand which means that interest rates are responsible for influencing the demand for credit. The recent stagnation in the economy is proof of that. The demand for credit is what really pushes credit creation meaning the price of credit supplied is of secondary importance (Lavoie, 2009). References Artis, M., & Kontolemis, Z. 1998. Inflation targeting and the European Central Bank. Florence: European University Institute. Bank of England 2014. Money in the Modern Economy: An Introduction, Bank of England Quarterly Bulletin 2014-Q1 Bank of England 2014. Money Creation in the Modern Economy, Bank of England Quarterly Bulletin, 2014-Q1 Brumm, H. 2000. Inflation and Central Bank Independence: Conventional Wisdom Redux. Journal of Money, Credit and Banking, 324, 807. Doi: 10.2307/2601184 Deane, M., & Pringle, R. 1995. The central banks. New York, N.Y., U.S.A.: Viking. Docherty, P. 2005. Money and employment. Cheltenham, UK: Edward Elgar Pub. Dullien, S. 2004. The interaction of monetary policy and wage bargaining in the European monetary union; Lessons from the endogenous money approach. Basingstoke: Palgrave Macmillan. Dullien, S. 2004. The interaction of monetary policy and wage bargaining in the European Monetary Union. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan. García, J., & Rixtel, A. 2007. Inflation linked bonds from a central bank perspective. Frankfurt, M.: Europ. Central Bank. Lavoie, M. 2009. Endogenous Money: Accomodationist in P.Arestis and M. Sawyer eds., a Handbook of Alternative Monetary Economics, Edward Elgar, Cheltenham, 2009. Loungani, P., & Sheets, N. 1997. Central Bank Independence, Inflation, and Growth in Transition Economies. Journal of Money, Credit and Banking, 293, 381. Doi: 10.2307/2953701 Mankiw, N., & Reis, R. 2002. What measure of inflation should a central bank target? Cambridge, Mass.: National Bureau of Economic Research. Rba.gov.au, 2014. RBA: Conference 2005-What Caused the Decline in US Business Cycle Volatility? Retrieved 27 November 2014, from http://www.rba.gov.au/publications/confs/2005/gordon.html Read More