How an Unstable Demand for Money Creates Problems for Price Stability - Example

How an unstable demand for money creates problems for the central bank’s objective of price stability Name: University: Course: Tutor: Date: The instability in the central bank currency is one of the ever longest, deepest and most persistent events that ever happened in the in the world economy determining countries like the united states of American History (Bade & Michael, 2009, pp.23-45). Financial instability is believed to have lasted from 1929 to 1939 whose effects were severely bad. Financial instability is believed to have started in the United States soon after the New York stock market was hit by financial crisis in the year 1929.According studies by late 1932, the value of the stock had dropped drastically to about 20% as compared to the previous value with 25,000 banks going bankrupt (Bernanke,2000, pp.45-67). These conditions were worsened by the mistakes in the implementation of the monetary policy as well as adherence to the gold standard .This greatly affected the levels of demand and productions which turn resulted to increased levels of unemployment by almost 30%. The financial instability had other effects on other world economies. Germany and Britain were greatly affected by the financial instability so they sought protection through imposing heavy tariffs and quotas on their goods and services which in turn reduced the ultimate value of the international trade by more than half in 1932 (Mankiw,2008,pp.34-60).When this is compared to the 2000, recession it is similar in their effects given that the global market was hit by financial crisis leading to collapse of major investment banks in the United States such as Lehman’s Brother Bank, Bear Stearns an d Merrill Lynch (Rangarajan & Dholakia, 2009,pp.56).The 2000 recession is considered to be similar to the world’s financial instability given the fact that both were caused by the shortages of liquidity in the banking systems which resulted to down fall of major financial institutions as well as government bail outs (Mervyn, 2001,pp.67-70). Moreover, the 2000 recession and the great depression of the United States of America were both caused by fall of stock market prices around the world leading to the collapse of major banks as well as financial institutions. In both events the Gross Domestic Product or real per capita income was greatly affected. Gross Domestic Product is a term which describes the total summation of all goods and services produced in a particular economy, weighted by market prices and adjusted for inflation. Since both the events affected the level of economic activities, the real Gross Domestic Product fell by almost 25%, erasing all the perceived economic growth of the previous years. In addition, the events caused a significant fall of prices in the production sector making the industrial productions to drop by almost 7% in both cases (Rosenof, 2008, pp.77). Among other roles played by the central bank, the central bank is supposed to make sure that the price in any particular state is stable regardless of any underlying factors. But excessive borrowing has led to unstable financial environments which make it hard for the central bank to seriously pursue any financial stability in weak financial states (Rosenof, 2008, pp.77). In addition to this, unstable borrowing from the central bank has led to the increase in opportunities of cost borrowing by the central bank itself. This tends occasionally to reduce the plans of liquidity demand. Most banks in most states do rely on the central bank to facilitate in the states financial liquidity. Therefore this affects the future refinancing efforts of the other financial players in the country. Although there are similarities between the 2000 recession and the Great Depression explicit differences exists between the two events. The differences are exhibited on the impact they have on stock markets and individual economies (Keynes, 2009,pp.45-60).. Many citizens from many countries, both poor and rich were severely affected. There was a witnessed rise in unemployment rates in these countries. Cities which depended heavily on construction industry were virtually affected since its operations were completely paralyzed due to lack of sufficient funds. This emerged from heavy policies which were implemented by the financial institutions regarding borrowing and the high interest rates that were being charged by the financial institutions were very high. Farming was also affected especially in the rural areas since all the crop prices dropped by almost 60%, this contributed to the failure of economic areas which strongly depended on primary sector industries such as cash cropping, mining and logging. When compared to the side effects of the current 2000 recession there are great differences in their impact though in both events the economic activities were highly affected by the events (Keynes, 2009,pp.45-60). Excessive borrowing from the central bank too gives pressure on demand for excess reserves. Unstable borrowing which is associated with failure in the debt repayment leads to shocks in the financial stability of the central bank whereby the size is calibrated to match the increasing recourse to the deposit facility that goes along with certain deterioration of economic conditions thus affecting the central bank’s loans issuance future plans( Keynes, 2009,pp.45-60).Current 2000 recession had great impact since it contributed to the failures of key businesses as well as declines in the consumer wealth. In addition, the current 2000 recession is believed to have severe consequences on the housing industry since it lead to the collapse of global housing financial institutions causing the values of securities which were tied to the real estate pricing to drastically fall (Keynes, 2009,pp.45-60). This greatly led to the liquidity shortages in the financial market which in the end contributed to bank solvency and declines in credit lending. Furthermore, this situation led to the loss of investor confidence in the financial institutions which greatly impacted the global stock markets making the financial securities to suffer huge losses. In both events, the various countries were affected since these periods slowed down the economic activities making it hard for individual borrowers to obtain loans from financial institutions. This was due to the inability of the financial institutions to accurately price the various risk involved in mortgage related financial products since the governments were not in a position to adjust the financial prices. To respond to the situation in both cases the governments as well as the central bank was forced to put in place both monetary policy and fiscal stimulus policy to control the rate of currency supply as well as institutional lending Also, unstable and excessive borrowing from the central bank makes the bank step up assumed counteract measures which are adverse developments in aggressively enforcing immediately a zero policy rate. This in turn generates the expectations that the same level of policy may prevail for a period of time after a macroeconomic recovery. The effects of the unstable borrowing from the central bank have too led to the fact that the central bank has been tempted to rethink on its policies especially the lending policies which seem to be compromised which affects its laid strategies for the future (Keynes, 2009,pp.45-60). Another difference pointed out is the mere fact that over the last 79 years since the occurrence of great depression from the year 1929 and 2008, enormous changes have occurred in the economic procedures which actually differentiate the two events. Secondly the stock prices in the recent 2000, recession were not greatly affected as the way it was during the Great Depression period since the 10- year price to earnings ratio of stocks in the market did not no actually go down to the extreme levels as in the period of Great Depression. The other important difference is the mere fact that during the 2000, recession the inflation rates were adjusted accordingly in the United States which contributed to the raising of housing prices which was not the case during the Great depression period where inflation was considered to be a major problem by several economies immediately after the depression period had occurred (Rothermund, 2006,p.23-40). In addition, the recession of early 30’s is believed to have lasted for over three years’ where the rate of money supply especially the currency plus demand deposits drastically fell by 30% which was not the case in the 2008 and 2009 recession periods as most of the credit control was done by the Federal reserve1. The other major difference between the two events is the mere fact that in the current 2000 recession period, the levels of unemployment rate were not high as during the Great Depression which is believed to have increased by almost 25%. The current 2000 recession was caused by the failures on the demand side of the economy which was caused by the shadow banking systems. This mostly affected the institutions which were regulated due to risk taking. When compared to the Great Depression there is a great difference since the recession was mostly caused by poor monetary and fiscal policies that were implemented to curb the situation. Furthermore, unlike the Great Depression the current 2000 recession was marked by global market integration and synchronization which are believed to have lesser effects on the financial institutions and it is easier for the financial institutions to recover from the economic down turns. Despite the independence that the central bank is supposed to enjoy, sources claim that it is still subject to political manipulation. In most occasions, the so called the political masters of the world has manipulated its operation like the replacement of the central Bank boss from the masters like the Latin American countries. To affirm this, it is seen that when the inflation is going higher, the chances of the current central banks boss remaining in the office are very minimal. Because of this fact, the central Bank has been unable to play its legal mandate which is reflected in its future plans to elevation of the price stability (Rothermund, 2006, pp.23-40). In addition to this, most of the political bigwigs that are said to manipulate the central Bank have occasionally broken the limits on the borrowing from the central Bank to its public sector which affects the future objectives of the central Bank stability. The political manipulation has led to the borrowing from the World Bank and at the end of the day they yield to low turn-over to the central Bank which does not reflect the independencies of the central Bank (Keynes, 2009,pp.45-60). In the affirmation of this, most of the governors have stayed in the office longer because they aren’t the executive bosses. In countries with low turn-over, they hardly relate it to independence. Where the turn-over is higher, the tenure of the governor is termed short due to suspicion of influence from the executive branch. As a result of this, most of the future great plans that the governors that the governors have had have been deeply shelved instead of implementing them and this decision is reached by many office bearers in such position to avoid termination of the tenures (Kennedy, 2000,pp.56-60). According to section 89 of the Monetary law Act, the world bank permits the central bank which are state banks to only grant provisional advances of upto10% from the revenue estimated, but the political control of the governors has led to the manipulation of the control act and therefore releasing money more than the expected thus leading to over lending the amount that will not be raised by the borrower hence affecting the control and the future plans of the central bank (Doyle,2007,pp.20-34).Political intrigues in the operations of the World Bank has led to compromise selection of the governors who at the end of the day they don’t make decisions based o their management policies but are used by other beneficiaries who in turn poorly compromise with future operational plans of the World Bank. This has also led the central Bank into the debts. The control of the governor has also in turn led to the poor control of the money supply in the money market. Conclusion In conclusion most governments have resorted to Keynesian policies to actively control demand and supply of money. Although most countries are subject to recovery using this policies but the other effect is that it will cause other long term challenges which are associated with high budget deficits and high debt levels (Croushore, 2006,pp.40-45). Using the case study of Japan when it was in the liquidity trap in the year 1990, it resorted to the fiscal stimulus that was aimed at reviving the economy but later on resulted in the budget deficits References Bade, R & Michael P (2009). Central bank laws and monetary policy, department of economics. Publisher: university of western Ontario, pp.23-45 Bernanke, B., S (2000). Essays on the great depression. Princeton, N.J.: Princeton University,pp.45-67 Croushore, D (2006). Money and banking: a policy-oriented approach. London: Cengage Learning, pp.40-45 Doyle, E (2007).The Economic System.Publisher: John Wiley and Sons, pp.20-34 Kennedy, P (2000). Macroeconomic essentials: understanding economics in the news.2nd ed.Chicago: MIT Press, pp.56-60 Keynes, J., M (2009). The general theory of employment, interest, and money. New York: St. Martin's Press, pp.45-65 Mankiw, G., N (2008). Principles of economics.5th ed. Publisher: Cengage Learning, pp.12-20 McGraw-Hill Education, pp.34-60 Mervyn, K (2001). The role of money in economics. Publisher: Wiley and Sons, pp. 111-132 Press, pp.67-70 Rangarajan, C & Dholakia, B., H (2009). Principles of macroeconomics. Publisher: Tata, pp.56 Rosenof, T (2008). Economics in the long run: New deal theorists and their legacies. North Carolina: University of North Carolina Press,pp.77 Rothermund, D (2006).The global impact of the great depression, 1929–1939. London: Routledge, pp.23-40     Read More