Monetary Economics - Assignment Example

Monetary Economics Monetary Economics In a closed economy with fully flexible wages and prices, what is the effect on the rate of interest, output and price level of an increase in averaged desire to consume, doubling quantity of money and a fall in the desire to work? 3 Can central banks control real interest rates? If not, what is the point of interest rate setting by central banks? 5 Should there be an independent fiscal authority? 7 Reference 9 In a closed economy with fully flexible wages and prices, what is the effect on the rate of interest, output and price level of an increase in averaged desire to consume, doubling quantity of money and a fall in the desire to work? Consider a closed economy consisting of output market and money market. The output market of the economy can be represented as Y= c(y)+i(r)+ g Where Y is the aggregate demand of the output, c is the consumption, i is the investment level which is depended on the interest rate r and g is the government expenditure. The market is in equilibrium when the aggregate demand is equal to the aggregate supply. If the aggregate demand is lower than the aggregate supply of goods, then there will be an accumulation of inventories. However, here we have an increase in the aggregate demand implying an increase in y. The product market can be represented by the IS curve. The IS curve is the locus of the income and interest rate that brings the market equilibrium. The IS Curve is steeper if a large change is required in the interest rate in order to offset the impact of the small change in income. This takes place when investment is sensitive to interest changes. On the other hand real money supply can be have three source of demands, speculative, transactions and precautionary. The transaction demand for money is proportional to the movement of income and can be expressed as k(Y). The speculative demand and precautionary demands have negative relation to interest rate. Thus the component can be expressed as L(r). The classical economists advocate that prices and wages are flexible and the economy is at the full employment levels. If the money supply increases, the LM curve shifts to the right (Keynesian Model of a Closed Economy, n.d). Here we have three changes, increase in the desire to consume, doubling quantity of money and a fall in the desire to work. With the rise in the desire to consume there will be an increase in the demand for goods. Since the price is flexible, this will increase the price of the goods. This is also supported by the fact there is an increase in the supply of money in the market, so the consumer will have more money to spend. With an increase in the purchasing power, the consumers will further increase their demand for goods. It is also known that with the increase in the money supply LM Curve shifts to the right. So from the above diagram it is seen that the rate of interest decreases. Now since there is a fall in the desire to work, there will be a decrease in the work force. As the wage is flexible, the wages will increase with the reduction in the labor force. With the increase in wages the cost of production will also increase as such, there will be a hike in the price of the goods. With the shift in both the IS and LM curve, there will be an increase in the output. Can central banks control real interest rates? If not, what is the point of interest rate setting by central banks? Central Bank of any nation is the apex institution responsible for the monetary policy of an economy. The monetary policies are the policies which impact the economy by the changes in the supply of money and rate of interest. By definition, interest rates are the price of borrowing money. Interest rates can be Nominal and real interest rates. The nominal interest rate is the amount of interest to be paid in terms of money. Say, a person taking loan of $100 has to pay an interest amount of $10. Here this $10 is the nominal interest and 10% is the nominal interest rate. The real interest rate is the true value of the interest amount. It is the purchasing power of the interest amount. The real interest rate is calculated by adjusting nominal interest rate with the inflation. The real interest rate is given as, - p Here p is the actual inflation rate over the year, ir is the real interest rate and the in is the nominal interest rate. Thus here the relationship between the real interest and the inflation is very apparent. If the inflation has to be controlled the central bank can control the real interest rate. According to the Poole (1970), a central bank can improve price level if it changed the nominal interest rates instead of monetary parameters. However, it has been noted that this may result in higher real interest rates and unstable prices (Canzoneri, Matthew B & Dellas, Harris, n.d). Central bank operates the monetary policies in order to control the economy. The monetary policy can be expansionary or contractionary. By expansionary policy the bank increases the total supply of money in the economy. This extra money supply increases the purchasing power of the people. This will also lower the interest rates. As a contractionary policy, the bank may also restrict the money supply in order to curtail the purchasing power of the people. This reduction in the money supply raises the interest rates, which help to lower the inflation rates. The money supply can be restricted indirectly by increasing the nominal interest rates. The change in the interest rate affects the other market interest rates. If the interest rates are high, then the people will tend to save more and borrow less. Thus money supply can be affected by the interest rates. (Freixas. Xavier & Jorge, José, n.d ). Thus central bank can change nominal interest rates and affect the inflation through the change in money supply; these changes will eventually affect the real interest rates. UK based mortgage lender Northern Rock requested the Bank of England for emergency funding when it had trouble raising finance. Here Bank of England is acting as the source of the last resort to the bank. Northern Rock raises its finance mainly from the capital markets instead of customer deposits. The banking sector is facing liquidity crunch as the lenders refuses to provide short term credit to the sector. The rate of interest has increased, the three month interest rates on loans between banks is more than 1% above the base rate of Bank of England (5.75%), (Kennedy, Simon, 14 September 2007 ) Should there be an independent fiscal authority? There should be an independent fiscal authority in every economy. Central Bank is the institution controlling the monetary policy of an economy. It acts a guiding force. It primarily maintains stability of the national currency and money supply. It can lend money to the other banks as such all the other banks are answerable to the central bank and thus called bankers’ bank. The central banks controls subsidized loan interest rates and applies other policy tools to ensure that banks and other financial institutions do not undertake any recklessly actions. Central banks perform several functions like issuing currency, controlling the money market by the monetary policy. The central banks controls the market by interest rate interventions, open market operations etc. The central bank holds liabilities and assets like foreign exchange, gold and other financial assets along with maintenance foreign currency reserve. The major liabilities of the central bank are the currency outstanding which are backed by the assets owned by the bank. By the interest rate intervention the central bank can influence the stock, bond and mortgage markets thus avoiding undesirable movement of funds in the markets. The central bank also adopts several policies which avoid situations like flight of Hot Money out of the country. If the economy is left to the market forces, the economy may lose its stability. Central bank ensures that the market moves in the interest of the people. Central bank acts as the Government’s banker and the banker’s banker. As such it acts as a guarantee to the people of the economy. Through the central banks the government can allot funds in the profitless constructive sectors of the economy where are the private concerns are least interested to invest in. The central bank also ensures that no banks default. Central bank may have all the power to control the market forces; in fact too much restriction is not beneficial for the economy. However, some kind of restrictions can avoid toxic assets and undesirable fund flows. On the same way need for an independent fiscal authority exists, which will has the power to control the fiscal policy as per the economic scenario. This independent authority will carryout surveys collect crucial information on those matters which directly impact government spending and taxation and then setting the policies. The whole world is facing economic slowdown, so to boost economy, government is giving huge stimulus in form of government spending, tax holidays to those sectors which play vital role in economical growth and have a major contribution in GDP, reduction in the indirect taxation to enhance the disposable income and to increase demand. Thus the fiscal policy plays a vital role in every country, but in absence of an independent authority, it suffers from political influence. For example when the inflation rates goes too high or to low, when the number of unemployed individuals increases or when fiscal deficit goes up, then strict fiscal measures have to be taken which in the short run may not get appreciated by public. In such a state political influences become active on fiscal policy and it creates pressure, but these political influences can be avoided in presence of independent fiscal authority. In the same way fiscal policy has to under take restriction imposed by Central Bank regarding foreign borrowings and investment. Thus it can be concluded that fiscal authority should be independent but it should work in collaboration with other authorities like Central Bank and Finance ministry (Ter-Minassian, Teresa, January 2002). Reference Canzoneri, Matthew B & Dellas, Harris, no date. Abstract. Real Interest Rates and Central Bank Operating Procedures. [online]. Available at: http://ideas.repec.org/p/cpr/ceprdp/1099.html [Accessed 25th June 2009] Freixas. Xavier & Jorge, José, no date. A Model with Rationing [online]. Available at: www.econ.upf.edu/docs/papers/downloads/1027.pdf [Accessed 25th June 2009] Kennedy, Simon, September 14th 2007. Northern Rock tossed Bank of England lifeline. Market watch. [online]. Available at: http://www.marketwatch.com/story/northern-rock-gets-central-bank-lifeline-as-credit-squeezed?pagenumber=1 [Accessed 25th June 2009] Keynesian Model of a Closed Economy, no date. Macroeconomic Policies in an Open Economy. [online]. Available at: http://www.econ.iastate.edu/classes/econ355/choi/mac.htm [Accessed 25th June 2009] Ter-Minassian, Teresa, January 2002. Institutional Reform For Fiscal Reform Sustainability With Special Reform To Latin America. [online]. Available at: http://www.eclac.org/de/noticias/paginas/0/9200/InaugTer.pdf [Accessed 25th June 2009] Read More