Monetary Policy and Increasing or Decreasing the Interest Rates - Essay Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Course : xxxxxxxxxxx Title : Economic policies Tutor : xxxxxxxxxxx @2009 Economic policies Introduction The main point of using monetary policy by increasing or decreasing the interest rates is to affect the individual’s and organization’s demand for goods and services. Originally, monetary policy was introduced in an economy where if change was implemented in the policy, output would be affected. Actually, there is no connection between monetary policy and real variables. This means any change within the policy have no effect on the total level of output since the total level of output is established by the factors of production but not monetary by monetary unevenness (Davidson 2006). When monetary policy is used by the government, the economy is greatly affected. By using the output equation; Y = C(Y - T) + I + G + NX, where Y is fixed by production factors, a change in G or T which is monetary policy produces a change in another variable to sustain a constant Y. The change in Y functions directly through the rate of interest. Every variable within output equation is dependant on interest rate (Geoff 2007). Assume the original economy is as equilibrium, point F. the original GNP point is Y1 and exchange E$/£1. Assume the supply of money is expanded, curve AA shifts. In particular, increase in money supply causes the AA to move upwards. This shift is shown by the shift from red AA to Blue AA line. Rise in AA leads to a shift in the equilibrium from F to H. while changing to the new equilibrium at H, GNP increases from Y1 to Y2 and the exchange rate rises from E$/£1 to E$/£2. The rise in exchange rate demonstrates a decrease in the value of US dollar and increase in the value of foreign currency. So, US expansionary monetary policy leads to a rise in GNP, a depreciation of the US dollar and a rise in the existing account balance in a floating exchange rate structure from the AA-DD model. Fig.1. Illustration of expansionary monetary policy For example, say the Fed uses expansionary monetary policy such as purchasing government bonds, decreasing the reserve requirement, or decreasing the federal funds interest rate. This causes the interest rate to fall, which then causes consumption to rise and investment to rise. But, in order for the total level of output to remain fixed, net exports must fall the same amount that consumption and investment rise. In this way, total output does not change from monetary policy, but the division of total output is affected. For example if contractionary monetary policy like sale of government bonds, raising the reserve requirement or raising of the federal funds rate is used, it leads to the rising of the interest rate which reduces both consumption and investments. However, for the total level of output to stay fixed, net exports should increase by the same quantity that consumption and investment decreases. This way, the sum output is not affected form the monetary policy but the division of output sum gets affected (Davidson 2006). Apparently, changes in interest rate affect the people’s demand for both goods and services largely by changing the borrowing charges, households’ financial status, accessibility of bank loans and foreign exchange rates. For instance, when the interest rate decreases, the borrowing charges reduces and this results into businesses investing more and thus increased spending, makes families to purchase durable and expensive goods like new home and this increases spending. Moreover, decreased interest rates and a vigorous economy raise bank’s readiness to lend loans to people and businesses and this can rise the spending more so by smaller borrowers who have got less credit sources save for banks (Hayes 2006). Decreased interest rates also tend to make it easier to buy stocks and investments like bonds and other debt appliances. Consequently, the prices of stocks increase and the individuals with stocks in their portfolios discover that the worth of their holdings is higher and this rise in riches makes them more eager to spend. Increased price of the stocks also makes it more enticing for business investments in plant and equipment through issuing stock (Maynard 2007). In the short run, decreased interest rates in the United States also decreases the dollar’s foreign exchange value and this decreases the prices of the goods produced in U.S that are sold out of the country and increases the prices that U.S pays for goods imported from foreign countries. This results into higher cumulative spending on goods and services produced within U.S. The rise in cumulative demand for the economy’s output via these various channels makes firms to increase production and employment which then raises business expenditure on capital goods even more by creating bigger demand on present firm capacity. It also increases the level of consumption more due to the income increases that come from the increased point of economic output. This automatically leads to inflation. Earnings and prices starts rising at quicker rates if monetary policy fuels aggregate demand sufficiently to push labor and capital markets further than their long run abilities. Actually, monetary policy that continuously tries to lower the interest rates will finally result into increased inflation and increased nominal interest rates without lasting increases in the output increase or increased employment. Sadly, output and employment cannot be laid down through monetary policy and therefore while trade-off in increased inflation and increased employment is present, trade-off vanishes with time. Monetary policy also has an effect on inflation directly by people’s future expectations regarding the inflation. For example if customers and businesses fathom increased inflation in future, they will request for larger increases in payments and prices. This alone is bound to raise inflation devoid of major changes in employment and output (Michael 2006). Another reason as to why monetary policy is currently impractical is that it can take a long period for a monetary policy action to have an effect on economy as well as inflation. Still, lags differ a lot as well. For instance, the main effects on output take 3 months to 2 years while the effects on inflation engage longer lags, like 1 to 3 years. The inflation lead to negative effects to the economy and eliminating it is difficult. In most cases, the only single way to eliminate inflation is tighten a lot of funds for a long time that there is major employment and output losses (Michael 2006). If an easier policy was adopted where there is a flexible exchange rate, it increases the supply of U.S dollars in the market. Eventually, this is likely to bring down the dollar’s value in relation to other countries as U.S customers and some businesses made use of the increased supply of money to purchase foreign goods and foreigners eliminated the extra U.S money they did not want. Therefore, the price of foreign goods in terms of U.S dollars would increase, even if the price of foreign goods would not rise with reference to foreign currency. The elevated prices of the good that are imported would then increase the price of U.S. goods (Gerhard 2007). In response, the central bank can intercede in the FOREX market. If the dollars in U.S. FED are sold in exchange of foreign currency in the private FOREX, the transaction entails foreign currency in exchange for US money. Because the FED is the final supply of dollar currency, the dollars utilized in the transaction will get into circulation in the economy in a similar manner as new dollars get into when the FED purchases a treasury bill on the open market. Thus, when the FED purchases foreign currency, and trades dollars, a rise in the US money supply will occur on the FOREX. The increased US money supply will lessen US interest rates; decrease the rate of return on US assets thus the dollar will depreciate. Conversely, if the FED purchased the dollars, and sold the foreign currency, on the FOREX there will be a decline in the US money supply. The decreased US money supply will lift US interest rates, raise the rate of return on US assets and hence the dollar will appreciate (Hayes 2006). Another response could be using the sterilized foreign exchange interventions. This changes the exchange rate and leaves the money supply and thus interest rates are not affected. This happens when the central bank counteracts direct intervention in the FOREX with a concurrent balancing transaction within the domestic bond market. For instance, if U.S. monetary policy chooses to interfere to decrease the U.S dollar value, it would need the FED to trade dollars and purchase foreign currency on the FOREX. Sterilization here entails a FED open market operation where is trades Treasury bonds same period and at similar value as the dollar being sold in the FOREX market. If FED intervenes and trades $20 million on the FOREX, sterilization indicates it will also trade $20 million of Treasury bonds on home open market at the same period (Gerhard 2003). Effects of a sterilized FOREX Fig. 2 If the economy was originally at equilibrium point F with GDP, Y1, and exchange rate, E$/£1 and FED intervenes within the FOREX trading dollars and purchasing foreign currency, the effect will be the rise in the money supply which moves AA curve upwards to A’A’. Sterilization implies that the FED will concurrently perform an offsetting open market operation, by trading Treasury bonds equivalent in value to the FOREX sales. T-bonds sale will decrease the US money supply resulting into an instant shift of the AA curve back from A’A’ to AA. In reality, since both actions occur at the same time, there is no shifting of the AA curve. Alternatively, a sterilized intervention retains the supply of U.S currency and hence accomplishes FED’s aim of retaining interest rates (Geoff 2007). Conclusion On using of the monetary policy, the interest rate is affected. Expansionary of the monetary policy directly lessens the interest rate through making it simpler and cheaper to get money while contractionary monetary policy directly increases the rate of interest through making it more difficult and more costly to get money. Therefore, monetary policy has a direct effect on consumption, investment and net export via the interest rate. Consumption decreases when the interest rate increases since the incentive for saving rises and investment decreases as the interest rate increases since the cost of borrowing money rises. Interest rate has no effect on the government spending while the net exports increases with increase in the interest rate owing to the fact that investment is comparatively more attractive to the domestic as well as foreign investors. Therefore, this will in the long run lead to increased money in the economy and consequently inflation which has negative effects trying to counteract including increased massive unemployment. Bibliography Gerhard, M., 2007, Keynes, Pigou and Cambridge Keynesians, Palgrave Macmillan. Davidson, P., 2006, Financial markets, money and the real world, Edward Elgar, Cheltenham UK and Northampton US. Hayes, M., 2006, The economics of Keynes: a New Guide to The General Theory, Edward Elgar Cheltenham UK and Northampton US. Maynard, K., (2007) The General Theory of Employment, Interest and Money, London: Macmillan. Michael, L., 2006, The economics of monetary policy, Palgrave Macmillan, London. Geoff, T., 2007, The Rate of Interest and Economics, Palgrave Macmillan, London. Read More