Introduction to Monetary Economics - Essay Example

Monetary economics Contents Contents 2 Introduction 3 Discussion 4 Analysis 8 Conclusion 11 References 13 Introduction Floating exchange rates are better able to deal with the problems that are associated with the inflow and outflow of capital. This statement can be better explained with the help of the fact that during the situation of the international crisis in the economy, the central banks of each of the developed countries has formulated and implemented the monetary policies that has affected and influenced the capital inflow and outflow of the capital across the countries all over the world. The role of the floating exchange rate in controlling the inflow and outflow of capital can be supported with the example of Argentina which has experienced the floating exchange rate in the economy and the volatility and the evolution of the exchange rate which was not affected severely due to the international crisis in spite of the rise or the increase in the exchange rate. The arguments in favour and against the topic can be highlighted with the help of the statement that emphasizes that floating exchange rate is effective in implementing the monetary policy and ineffective or inefficient in implementing the fiscal policy whereas in case of the fixed exchange rate it is effective in implementing the fiscal policy and it is unable or incapable for formulating the monetary policy. In order to derive at the conclusion in ascertaining whether the floating rate has been able to control the inflow and outflow of cash it is required to consider various factors which includes the inflation rate, the credibility of the policy makers, the flexibility in the labour market, the size and the openness in the economy, maintaining of capital mobility and the extent of financial development. The key concept that is required to be considered in explaining the role and function of the floating exchange rate includes the currency peg, currency union and currency board. Discussion The main aim or the objective of floating exchange rate in controlling the inflow and the outflow of capital is reducing the volatility in the exchange rate and also maintaining the monetary stability in the economy (Arnold, 2008). The floating exchange rate generally considers the economic and financial structure and policies in the economy and the intervention of the central bank in the foreign exchange market either dealing in the spot market or dealing in the forward market for developing the regulation and reserves of the capital inflow and capital outflow. The floating exchange rate focuses on increasing the capital inflow and mitigating the excessive capital outflow. The balance of payment is considered as an important instrument for controlling and dealing with the related inflow and outflow of capital in the economy. Figure 1: Capital account balance Balance of payment is represented as capital account which deals with both long and short term transactions in relation to the financial assets and it is determined by calculating the difference between the capital inflow and capital outflow. The balance of payment mainly deals with the net portfolio investment, net foreign direct investment and also other financial items (Mankiw, 2002). Figure 2: Floating exchange rate The exchange rate can be determined or explained with the help of the following equation iϵ - i$ = e$ / ϵ - eE$ / ϵ / e$ / ϵ This represents that iϵ indicates the interest rate in the home country e$ / ϵ - eE$ / ϵ / e$ / ϵ signifies the exchange rate that is expected from depreciation. i$, indicates the interest rate that is prevailing in the world. The floating exchange rate in relation to the inflow and outflow of capital can be explained with the help of the aggregate demand and supply of the products. The aggregate demand curve of the products establishes the relationship between the aggregate demand for the goods and services and the aggregate price charged for the goods and services. The aggregate demand comprises of the government purchases, net exports and investments (Abel and Ben, 2005). Figure 3: Aggregate demand The aggregate supply curve defines or explains the output that the producer is expected to produce for each price level. Money supply plays an important role in determining the floating exchange rate. The floating exchange rate determines the value of currency of each country and it adjusts and establishes the relationship with the money supply. The money supply determines and adjusts the export, import and the capacity of borrowing for receiving the remittances. The money supply reduces the volatility of the exchange price in the economy and also minimizes the problem of inconsistency. The crawling peg system that is included in the floating exchange rate combines the stability and flexibility in the price for altering the par value of the currency and it provides less option for the movement in the exchange rate thus facilitates in maintain stability in the price of the products and goods which will help the economy in maintain a balance between the outflow and inflow of capital (Sexton, 2007). The countries that are subjected or are affected frequently by inflation generally prefer floating exchange rate in order to avoid or eliminate the appreciation in the value of the currency. And the countries that are affected severely by high inflation generally approach to the countries with low interest rate for avoiding the problem arising out of appreciation in the value of the currency. The manage exchange float rate that is determined and assumed in the foreign exchange market introduces the target inflation rate which is established or developed for stabilizing the economy. The target inflation rate reduces the barrier in formulating the monetary and the fiscal policy. The main reason behind the central bank interfering in the foreign exchange market is stabilizing the fluctuation in the exchange rate and the rate imposed by the central bank is referred to as the bank rate. The bank rate is also known as the discount rate. This rate is introduced by the central bank for charging the interest for the loans and advances provided by the central bank from the commercial banks. This will facilitate the central bank in maintain a standard exchange rate and controlling or monitoring the excess inflow and outflow of capital. The crawling peg and the managed float system has assisted or facilitated the floating exchange rate to control the inflow and outflow of capital. The main reason for adopting the floating exchange rate and supporting the statement can be explained with the example of Australia. The Australian dollar was subjected to high fluctuation in the exchange rate therefore it switched to the adoption of the crawling and fixed peg system for adjusting and stabilizing its exchange rate. And therefore in order to stabilize the currency rate it has adopted the concept of monetary targeting for the growth in the money supply. Therefore the floating exchange rate has determined the supply of the Australian dollar in relation to the demand for the purchasing and selling the Australian dollars. The Reserve bank has played a major role in stabilizing the exchange rate and this process is known as sterilization. Figure 4: Floating exchange rate of Australia Analysis The importance of the floating exchange rate can be explained in relation to the banking crisis and the situation of recession in the economy and the assets were devalued and it had negative reversal in the capital flows. The bank has to face crisis and it faced problems in recovering the assets and it took more than two years in recovering its assets and it lead to the situation of recession in the economy affecting the growth rate of the economy. The main reason for the situation of banking crisis prevailing in the economy is due to the collapse in the asset price of the bank, the negative effect on the wealth of the banks, reduction in the consumer spending and it lead to the situation of credit crunch in the economy and as a result the investment in the banking sector has contracted (Gottheil, 2013). The flexible exchange rate has lead to the increase in GDP in relation to the increase in the foreign interest rate and the output also increases. The rule of the monetary policy ensures that the exchange rate is required to be adjusted in the nominal exchange rate and the changes in the foreign interest rate in case of the floating exchange rate. The capital flow of the floating exchange rate can be explained as it leads to the increase in the GDP of the country and stabilizing the movement of the currency that will reflect the correlation in terms of its trade that is carried out. It determines the factors of the exchange rate. The appreciation in the exchange rate along with the increase in the domestic interest rate will influence and contribute towards maintaining macroeconomic stability. Figure 5: Capital flow in terms of GDP The argument in favour and against the floating exchange rate system can be observed and analyzed as in case of the emerging market the fixed exchange rate system keeps the exchange rate fixed at the time of heavy inflow of the capital and this is argued with the reason that the authorities responsible for maintaining the stability in the exchange rate generally prevents the appreciation in the real exchange rate. In the situation of emerging market economy that is related to the opening of capital market in the outside world and if the interest rate in the rest part of the world is lower as compared to the domestic rate of return then the country is subjected to receive capital inflow and the adjustment process is mainly characterized or featured with the rigidity in the price in case of the non traded goods and product sectors which indicates that the concerned authorities generally prefer to keep or maintain the fixed exchange rate in spite of floating exchange rate for generating capital inflow. Therefore by the process of fixation in the exchange rate the authorities can prevent the appreciation in the real exchange rate in the economy that would have prevailed in case of the floating exchange rate. The situation can be revere in case of liberalization in the capital market that results in the outflow of capital. The country can allow its exchange rate to float in the economy. The floating exchange rate will facilitate the depreciation in the real exchange rate that will result in the situation of capital outflow which will increase its welfare and on the contrary the fixed exchange rate will prevent the depreciation in the real exchange rate but it will reduce the welfare. In case of the floating exchange rate there is the monopolistic price distortion Therefore the exchange rate that will suitable and preferable for the economy is that will eliminate the distortion in the price and the application of monetary rule and the combination of the optimal fiscal and monetary rule will provide subsidy for the non tradable producers and the monetary rule. The main difference between the floating exchange rate and the fixed exchange rate are floating exchange rate is less costly as compared to the fixed exchange rate in terms of the reaction to the shocks and it requires the domestic price to fall or reduce instantly and the fixed exchange rate leads to the fall in the nominal price. The floating exchange rate is less destructible as compared to the fixed exchange rate. In case of the floating exchange rate it is required to maintain stability for avoiding and preventing the situation of inflation in the economy whereas in case of the fixed exchange rate the central bank is forced to devalue or revalue the rate which is considered as the unofficial rate. In case of the fixed exchange rate system the central bank establishes and maintains the official exchange rate in the economy whereas in case of the floating exchange rate the exchange rate is mainly determined by the private market with the existence of demand and supply (McEachern, 2008). Conclusion The above study has focused on the analysis that is welfare based in terms of the policy tradeoffs between the stability in the exchange rate, mobility in capital and independent monetary policy. There are appropriate policies for overcoming the constraint in the exchange rate. The above study focuses and advises that the model for implementing the appropriate change in the exchange rate in case of the capital inflow will vary or differ from that of the capital outflow. The floating exchange rate plays an important role in reducing the financial risk and crisis by modifying the structure of debt in the economy. Therefore it has the ability and capability in determining the exchange rate for gaining independence in the macroeconomic policy. It has been observed that the financial crisis in the emerging markets during the second phase of the period of 1990’s there has been a change in the exchange rate policies There were arguments that concluded that capital inflow is the most effective way or measure for the control of inflation and reducing or preventing financial crisis. Therefore it can be concluded that the floating exchange rate system is determined by the demand and supply forces in the market without the intervention of the government or public. It can adjust accordingly with the shocks during the movement in the exchange rate and it reduces the requirement of holding huge reserves. Therefore it does not impose any restriction on the fiscal and monetary policy in the economy and the floating exchange rate is influenced by the crawling peg system, exchange rate system and the managed float system. References Arnold, R.A., 2008. Macroeconomics. Mason: South Western Cengage Learning. Mankiw, N. G., 2002. Macroeconomics. New York: Worth Publication. Abel, A. and Ben B., 2005. Macroeconomics. London: Pearson Education. Sexton, R.L., 2007. Exploring Economics. Mason, OH: South Western Cengage Learning. Gottheil, F. M., 2013. Principles of Microeconomic. Mason, OH: South Western Cengage Learning. McEachern, W.A., 2008. Macroeconomics: A Contemporary Introduction: A Contemporary Introduction. Mason, OH: South Western Cengage Learning. Read More