Money Supply Process - Assignment Example

1. Describe the money supply process, and illustrate this process with a numerical example. What role does a central bank play in this process? Ans.There are varying degrees of liquidity or ‘moneyness’, depending on how simply an asset can be changed into other assets. The most liquid assets are considered to be notes and coins which are the “medium of exchange by legal fiat” (The Measurement of Money Supply, n.d., p. 9). Liquidity of other assets counts on how effortlessly they are converted into notes and coins. In addition, as the degree of liquidity reduces, the difference between monetary assets and other financial assets becomes more and more blurred. As a result, in this context, the International Monetary Fund (IMF) has sought to sketch out standards for the calculation of the amount of money in an economy. According to the IMF’s guidebook, money supply is calculated as the joint deposit liabilities of the banking system and the currency liabilities of the central bank. They are held by households, companies, non profit organizations and all public sector entities outside of the central government. In this authorized or standard illustration of money supply, there are 3 monetary aggregates defined; M0, M1 and M2. There are other less liquid financial assets, which suit the store of value condition and their incorporation allows for extensive measurements, for instance, M3 and M4 (The Measurement of Money Supply, n.d., p. 9-11). Table 1: Standard Measurements of Supply of Money Measure Definition Comments M0 Currency held by the public and the reserves held on behalf of the commercial banks Monetary base or reserve money which is controlled by the central bank M1 Notes and coins outside the system of banking. In addition, current account balances held for transactions. Readily approved for the transactions of goods and services. There may be inclusion of foreign currency deposit for household transactions. M2 M1 plus short-term and savings deposits, foreign currency transferable deposits, certificate of deposits and repurchase agreements Nominal cost of conversion to cash. M3 M2 plus traveller’s cheques, short-term bank notes, long term foreign currency deposits and money market mutual funds The components of M3 diversify among the nations M4 M3 plus treasury bills, negotiable bonds and pension funds A measure of fairly liquid assets Source: The Measurement of Money Supply, n.d., p. 12. Figure 1: Supply of Money Supply of Money 0 Time period The Multiplier Model of the money supply was initially developed by Brunner and Meltzer in 1964. This has become the benchmark paradigm in macroeconomics and money and banking textbooks to elucidate how the policy activities of the Federal Reserve or the central bank affect the money stock. It also has been applied in empirical evaluations of money stock control and the impact of monetary policy activities on other economic variables. One important aspect of this model is that it breaks up movements in the money supply into the element that is directly because of Federal Reserve or the central bank policy performance (the adjusted monetary base) and the part that is due to alterations in technology and the tastes and preferences of depository organizations and the public (the money multiplier). In this decomposition, the multiplier is presumed to be independent of the policy performance of the central bank. The independence is implicitly established on the suppositions that the demands for both checkable deposits and currency are established by the same aspects. The individuals can swiftly and without any cost change their holdings of currency and checkable deposits to attain the desired proposal of the 2 alternative forms of money. Open market purchases, for instance, enhance reserves and subsequently checkable deposits; but the public simply moves from checkable deposits to currency until the (unaltered) desired ratio of currency to checkable deposits is once again attained. As policy actions have no effect on the public holdings of currency to checkable deposits, the multiplier does not depend directly on the policy performance of the Federal Reserve or the central bank (Garfinkel and Thornton, n.d., p. 47). A numerical example of money multiplier can be shown as follows: Let m be the money multiplier. M= m * (RR + ER + C), where, RR= required reserves, ER= Excess reserves and C= currency. MB (Monetary base) = RR+ ER+ C = (r + e + c) * D, where D is the level of deposits. Since money supply M equals deposits D plus currency C: M = D + C = [1 / (r + c + e) * MB] + C = [1/ (r + c + e) * MB] + [c * D] = [1/ (r + c + e) * MB] + [c * 1/ (r + c + e) * MB] = [1 + c]/ [r + c + e] * MB Hence, money multiplier is m= [1 + c]/ [r + c + e] Excess reserve ratio= e= E/D r = required reserve ratio = 0:10 C = currency in circulation = $400B D = checkable deposits = $800B ER = excess reserves = $0:8B M = money supply (M1) = C + D = $400B + $800B = $1200B Currency ratio c (C/D) = $400B/ $800B = 0:5 Excess reserves ratio e = $0:8B/ $800B = 0:001 Or, m = (1 + c)/ (r + c + e) = (1 + 0:5)/ (0:10 + 0:001 + 0:5) ~= 2.5 The money multiplier and the supply of money are negatively associated to r, c and e. The excess reserves ratio e is negatively connected to the market interest rate. Reserves do not shell out any interest, so R is the opportunity cost of holding reserves. The excess reserves ratio ‘e’ is positively associated with expected deposit outflows. Reserves present insurance against losses owing to deposit outflows (Determinants of Money Supply, n.d.) The behaviour of monetary aggregates is significant to the protection of economic stability. Whereas a development in the money supply eases economic growth, excessive enhancements in the rate of growth of money supply have an unfavourable effect on the price level and the income level in an economy. This requires close monitoring of the progress in supply of money by the monetary authorities. In order for central banks to manage the money supply, they have to initially, determine its constituents and then calculate these monetary aggregates at regular intervals. Economists have suggested a functional approach of defining money, that is, any object that is usually acceptable in assisting the trade of goods and services. The emphasis here is on liquidity or the simplicity with which an asset can be utilized for payment or converted into an acknowledged form for payment. Central bankers around the globe have employed calculations that are exceptional to their institutions and sketched to provide more estimates applicable to their nation’s circumstances. Despite differences in the measurement of money supply, it is significant that consistency be upheld. Nations with moderately developed financial and money markets tend to incorporate an extensive range of less liquid securities in their computations, while others restrict their measurement to a more contracted range of highly liquid assets. This underlines the point that only items that are considered to have a comparatively strong actual or potential impact on individual’s spending should be incorporated in a nation’s money supply calculation (The Measurement of Money Supply, n.d., p. 19). 2. Explain the theory behind a counter-cyclical fiscal policy indicating the likely difficulties that a government would face in its efforts to implement such policies. Ans. The current economic slowdown has emphasized attention on how far fiscal and monetary polices can sustain demand in a recession. Certainly, since 2001, several emerging economies have used a variety of combinations of both policies to reduce the external demand shock. Whilst fiscal policy has not been countercyclical in all nations, monetary policy has been comparatively more elastic in responding to the growth deceleration. These developments raise numerous important questions: what issues explain the comparative dependence on fiscal and monetary policies for economic stabilization in recent years? How far has the behaviour of monetary policy been assisted or limited by the latest behaviour of fiscal policy? The sharp retardation in external demand in 2001 has intensified policy challenges in emerging economies. To help revitalize growth, many nations turned to fiscal and monetary polices to motivate household demand. There is as yet no agreement about what should be the suitable role of fiscal policy over the business cycle. In the short run, the probable role that fiscal policy could play in alleviating output may take place through the process of automatic stabilizers or discretionary fiscal policy. The suitability and viability of either may differ according to the circumstances of an individual nation. Furthermore, measuring fiscal policy has always caused a difficult confrontation. There has characteristically been a lack of conformity about the measures of fiscal balance that should be applied to judge the fiscal policy standpoint. In the emerging economies backdrop, the confrontations of selecting a suitable measure of fiscal balance could appear from various sources, including the comparatively greater significance of state and local governments and quasi-fiscal performance in the fiscal system as well as a high level of off-budget spending. Where budget balances are regulated for cyclical effects, the modification is mainly applied to the revenue side, provided the comparatively unimportant role of unemployment advantages and social security associated expenditures in total outlays. One question is whether insufficient modification of budget balances for economic cycles could influence the central bank’s approximations of the impacts of fiscal policy. For example, if fiscal decline is due to a provisional revenue loss resulting from an escalation slowdown it may not have key implications for debt sustainability and interest rate anticipations. Therefore, information about the cyclical adjusted budget balance (CAB) may offer vital information regarding the behaviour of monetary policy. Nevertheless, whilst useful in theory, it may be difficult to calculate a satisfactory measure of CAB in emerging economies. For instance, estimates of probable output are generally considered to be less accurate than in industrial nations, given a large manipulation of supply side aspects and recent structural alterations in many nations. Another problem may come from the inexact information about tax and expenditure elasticities (Mohanty and Scatigna, n.d., p. 38-40). Emerging economies react during recessions with fiscal stimulus only fifty percent as frequently as highly developed economies: 22 percent versus 41 percent. When emerging economies do implement fiscal stimulus, the reaction is slightly higher, as calculated by alterations in the cyclically adjusted primary balance as a percent of probable GDP. However, this is because recessions are larger. The pie charts (Fig. 1) show the kinds of fiscal policy response—stimulus, neutral, or tightening—during events of downturns for highly developed economies and emerging economies (Scott, et al, n.d., p. 173-174). Figure 1: Source: Scott, et al, n.d., p. 174. There is little agreement about the effect of fiscal policy on the economy. One typical view has been that administration should vigorously use a countercyclical fiscal policy to counterbalance demand shocks to the economy. According to this point, the role for a discretionary fiscal policy is superior when the economy is stroked by a large demand shock and automatic stabilizers cannot offer an adequate extent of stabilization to the economy. Others have debated that, while a discretionary fiscal policy should usually be evaded, the requirement for such a policy may come up under special circumstances: for example, monetary policy is controlled because of a fixed exchange rate or by the zero lower bound on the supposed interest rate. A contrary view proclaims the comparative ineffectiveness of fiscal policy. According to this point, provisional augmentations in the fiscal deficit have little influence on demand since they entail future tax increases. Permanent alterations to fiscal policy to enhance the economy, despite their demand impact, induce the problems of unrelenting deficits and high actual interest rates. Others debate that fiscal policy may even have a downbeat multiplier impact in the presence of a high public debt. According to this view, plausible fiscal adjustments aimed at undyingly reducing public debt can produce growth by reducing the future tax burden, real interest rates and the credit risk premium on worldwide bonds. This view has achieved ground from the experience of booming fiscal adjustments that seem to have led to a steep rise in investment and growth. An important forecast of this view has also been that fiscal policy may have major non-linear impacts. At low levels of public debt, fiscal policy produces the usual Keynesian consequences. However, it has been observed that when the levels of debt increase to some crucial limit, fiscal policy has exceptional contraction effects. Notwithstanding the challenging views, a number of practical considerations may restrict the application of discretionary fiscal policy in growing economies. Particularly, when the historical relation between the fiscal deficit and inflation is strong, nations may be constrained in applying the fiscal policy option. The concern is that an expansionary fiscal policy may intimidate long-run debt sustainability and increase inflation anticipations that could unfavourably influence the central bank’s capability to control inflation. In addition, in comparatively open economies fiscal multipliers may be undersized due to a high level of external leakage. In such situations, fiscal enhancement to improve demand is likely to deteriorate the existing account balance, with adverse insinuations for external sustainability. External limits on running countercyclical policies may be mainly severe in nations with a history of noticeable exchange rate instability if fiscal expansion deteriorates investors’ confidence and activates speculative currency pressures. In Colombia, fiscal growth adversely influenced the exchange rate since markets sometimes doubted the government’s capability to retain long-term fiscal sustainability, thereby increasing credit risk premia and anticipations of devaluation (Mohanty and Scatigna, n.d., p. 44-45). References: 1. “Determinants of Money Supply”, n.d. Available at: http://courses.cit.cornell.edu/econ331/CHAPTER%2014.pdf (Accessed on Nov. 29, 2009). 2. Garfinkel, M.R, Thornton, D.L. n.d. “The Multiplier Approach to the Money Supply Process: A Precautionary Note”. Available at: http://research.stlouisfed.org/publications/review/91/07/Multiplier_Jul_Aug1991.pdf (Accessed on Nov. 29, 2009). 3. Mohanty, M.S, Scatigna, M, n.d. “Countercyclical Fiscal Policy and Central Banks”. Banks for International Settlement. Paper No. 20. Available at: http://www.bis.org/publ/bppdf/bispap20c.pdf (Accessed on Nov. 29, 2009). 4. Scott, A, et al, n.d. “Fiscal Policy as a Countercyclical tool”. Available at: http://imf.org/external/pubs/ft/weo/2008/02/pdf/c5.pdf (Accessed on Nov. 29, 2009). 5. “The Measurement of Money Supply”, n.d. Available at: http://www.boj.org.jm/uploads/pdf/papers_pamphlets/papers_pamphlets_The_Measurement_of_Money_Supply_.pdf (Accessed on Nov. 29, 2009). Read More