National Economic Policy - Example

National economic policy Name Course Institution Date National economic policy Effects of the currency-deposit ratio and reserve-deposit ratio increase in money supply of a closed economy. Currency-deposit ratio rely on households preferences, therefore, in a closed economy it cannot be directly controlled by the government, whereas the reserve-deposit ratio rely on bank policies and regulations. In this case, an increase in both currency-deposit ratio and reserve-deposit ratio will have a negative impact on money supply. Reserve-deposit ratio increase due to banks low reserve will lead to a lower money multiplier hence a decline in money supply. In addition, the currency-deposit ratio also increases due to households preference to hold liquid cash, as s result money multiplier will be lowered hence a decline in money supply. The increase in the currency-deposit ratio implies that money is being withdrawn from the banking system reducing the amount of money available to banks to lend out. The populace view bank deposits in sub crisis situation to be risky. This is because banks are likely to fall during such crisis. Therefore, money creation by banks through money multiplier is limited, hence a fall in money supply. An increase in the reserve-deposit ratio is negatively related to money multiplier and money supply. The reason is that it will lead to reduction of money available to banks to lend. The banks in times of sub crisis view money lending as a risky adventure. This is because a considerable number of the borrowers are likely to default their debt. During such times, banks prefer holding high reserve-deposit ratio since they believe it is much safer. The main effect of the two changes will be on the monetary base (MB), this is because MB= Currency (Money held by the households) plus Reserves (money held by banks). The increase in currency-deposit and reserve-deposit ratio will mean a decline in the monetary base. Money supply is, thus, given by monetary base multiplied with the money multiplier. How would economy’s output and interest rate be affected in the short-run? The sub-prime crisis will lead to a reduction in money supply in the economy. Therefore, a reduction in money supply will result in a decline in output and a rise in interest rate. The effect of a decline in money supply on interest rate and output is best explained using the IS/LM model. During a sub-prime crisis, the banking sector is much affected. With a decrease in money supply, the LM curve shifts from LM0 to LM1. The shift in the LM curve from LM0 to LM1 will result in a rise in interest rate from i0 to i1 and decline in output from Y0 to Y1. Initially, the economy is in equilibrium at a point where i0 and Y0 are at the intersection. The economy facing a crisis due to the behavior of banks and households is likely to witness a fall in money supply. A fall in money supply will have the LM curve to shift from LM0 to LM1. This will have a different effect on the economy’s interest rate and output. The interest rate will experience an increase in interest rate from i0 to i1, and a decrease in output from Y0 to Y1. Change in interest rate is as a result of an increase in inflation rates. The economy through the central bank changes the amount of money in circulation in the economy. When the amount of money supply is shifted the economy’s equilibrium interest is changed. In this case, a contraction in money supply will create a left shift of the LM curve, hence a rise in the interest rate. The effect of the increase in interest rate is witnessed from the declining investment rates by the private sector. The end result of a sub-prime crisis is declining rate of capital formation. The private investors look at bank loan as risky and expensive, therefore, as a result, they cannot borrow huge sum of money due to high interest. The economy’s Gross Domestic Product will decline due to declining investment and low pace of government spending. The central bank is controlling the amount of money available for banks to lend out. The economy will have minimal net export which results in reduced output. The above diagram explains the situation in a crisis. During a sub-prime crisis, the banking sector is much affected. With a decrease in money supply, the LM curve shifts from LM0 to LM1. The shift in the LM curve from LM0 to LM1 will result in a rise in interest rate from i0 to i1 and decline in output from Y0 to Y1. In general, a reduction in money supply results in a decline in output and an increase in interest rate and vice versa. Explain how a monetary policy can be used effectively in such a situation The economy faces the problem of low money supply during a sub-prime crisis. The problem of low money supply is associated with low growth rate due to reduced investment as a result of high interest rates. The impact of high inflation is also experienced during such as situation. The resulting effects of a crisis can be solved by putting in place a monetary policy. The resulting effect of reduced money supply can be tackled by the monetary policy. Tools of monetary policy such as open market operations, reduced discount rates and reduced reserve requirements will lower the rate of interest of the economy. The government through open market operations will sell securities such as treasury bonds and bills to the populace. This implies that the money held by the public can be reduced. As a result, banks will have money to advance to banks at a lower rate so that investment options can be taken. As a result, high investment rate will boost economic growth. The expansionary monetary policy has a positive effect on the challenges that an economy is going through in a sub-prime crisis. The challenges include low growth rate and skyrocketing interest rates. The policy will reduce the interest rate which a recipe for increased capital investment, hence an improvement in economic growth. The use of discretionary monetary policy is suitable for the reserve bank in control of the prevailing economic crisis. The result of a sub-prime crisis is ballooning inflation rates; the households find it difficult to meet their daily needs. To reduce the high inflation rates which are closely related with the deficiencies within the financial sector is to adopt monetary policies that are geared towards reducing the interest rates and stability of commodity prices. Open economy with fixed exchange rate and perfect capital mobility In an open economy with fixed exchange rates, money supply is endogenous. This means that money supply cannot be influenced by the government. Therefore, it implies that money supply is solely used in the economy to ensure a stable exchange rate. In addition, the hands of the monetary authority are held tied. The central bank can control the high powered money implying that it can control the money supply using tools such as foreign exchange market intervention and open market operations (Roubini & Backus, 1998). The central bank is obligated with the responsibility of maintaining stable exchange rates in an open economy through passive exchange intervention. This is established by purchase or sell of international reserves so that it can attain stabilization of nominal exchange. This implies that International reserve cannot be controlled whereas Domestic Deposits can be controlled in an open economy with fixed exchange rates. As show in the diagram below, when there is no capital mobility BOP is equated to trade balance plus intervention, and since real exchange rate is fixed the BOP line is established when T=0 and is symbolized by the perpendicular line. The right side of this line represents a deficit total balance, therefore, the central bank is forced sell dollars, and M and IR will decline. An open economy with perfect mobility will have i=i*, therefore, the BOP is represented by the horizontal line. On the upper side of this line there is a huge capital inflow and below it is a huge capital outflow. However, the central bank in an open economy with fixed exchange rate can still control the amount of money in circulation in an economy using open market operation so as to counter the effects resulting from a passive foreign exchange intervention. The move to control the money supply is hampered in situations where there is perfect mobility of capital. This is true any central bank attempt to increase domestic credit is offset by an equal loss in interventional reserves, hence sterilization process is hampered. In an open economy with perfect capital mobility and fixed exchange rate, under the equilibrium condition there is the interest rate equalization as opposed to a trade balance. Precisely, monetary policy will be ineffective, for instance, consider any expansionary monetary policy to increase domestic credits through open market operations such as purchase of government securities including bonds. The initially effect will a down-right shift of the LM curve but the move is offset immediately by a loss of International reserves and a massive capital outflow, at the insignificant reduction in an economy’s interest rate. Therefore, the high powered money (H) given as domestic credit plus international reserves remains constant. Hence, the LM curve cannot shift as shown below In the current sub-prime situation under review, the economy is experiencing a reduction in money supply. The situation will force the central bank to purchase bonds so as to sterilize the effects of reduced money supply. As a result the central bank will run short of foreign currency reserves (Roubini & Backus, 1998). This means that it will be impossible for the bank to maintain a fixed nominal exchange rate. In addition, it leads to an overall conversion of the central bank’s assets into bonds. Therefore, sterilization is not the best option but devaluation is pursued. References Krugman, P., & Wells, R., 2009, Macroeconomics, London: Worth Publishers. Roubini, N., & Backus, D., 1998, Output and Real Interest Rates. Retrieved from http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP5.HTM Roubini, N., & Backus, D., 1998, The IS/LM Model. Retrieved from http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP9.HTM Read More