Five Objectives of Central Bank - Assignment Example

RUNNING HEAD: Central Bank and Monetary Policy Central Bank and Monetary Policy Client Inserts His/her Name Client Inserts Name of Institution Question One; Five Objectives of Central Bank The central bank is the main agency for monetary policy. It also performs significant functions in maintaining the financial stability in the country, and these become more evident during financial turmoil. The structure of roles and responsibilities and the range of functions of the central banks vary in various countries. However the main functions are (Touffut, 2009); Price stability; the central bank regulates a country’s inflation. By definition inflation refers to the persistent increase in price levels relative to goods and services, or the devaluation of the currency. The central bank regulates the inflation level by controlling the supply of money in the economy by the use of monetary policy tools. It uses the open market operations which either injects liquidity in the economy or absorbs the extra monies, thus affecting the inflation level directly. Interest rates stability; the central banks sets the general interest rates that determine whether people would prefer to hold liquid cash or deposit the money in to the banks. The central bank gives commercial banks instructions on which interest rates they should impose to their customers. High interest rates discourage investors taking loans while low interest rates encourage investors to borrow money in terms of loans. When rates are low people may borrow more and this gives another role of the central bank as being the lender of last resort. Commercial banks lend money to customers on the basis of first come first serve. The fact that commercial banks do no hold reserves to meet the needs of the entire market demand and so it may run short of liquidity. In this case the commercial bank is forced to borrow money from the central bank. This bin turn enhances system stability because the central bank cannot favor any particular commercial bank at the expense of others. It also provides funds to the government in times of difficulty. Financial stability; Central banks are the sole authority for establishing the economy’s financial stability as it has comprehensive information on aspects posing a threat to the financial stability through the surveillance and research functions. It acts as the overseer of the infrastructure of the financial markets, mostly having the responsibility of overseeing those private companies that might be having significant effect on the economy of the country like the stock exchange. Through conducting research, the central bank develops macro- prudential indicators and tools which are very vital in detecting vulnerabilities in the financial sector. Economic growth and development; The central bank is the only entity with the authority to print money and at the same time is responsible for the effective and efficient administration of the banking, monetary and credit system of any given country for the achievement of monetary stability and creation of a favorable environment for economic development. This means that it perceives people’s confidence on money as something of value and significant institution of economic system. If this trust is broken then money fails to function as it is supposed to; a pillar of the price system and a tool for economic activities. Exchange rates stability; this is a key function of a central bank though its open market operations. The central bank steps in to sell or buy foreign exchange so that large fluctuations in the domestic currencies are avoided. They can also use this tool to reduce the supply of money in the economy and vice versa. The central bank also manages a country’s reserves whereby it holds different currencies in its coffers so that they can act as buffer in case there issues of currency fluctuations arise. Question Two a) The central bank’s balance sheet consists of assets and liabilities just like any other balance sheet. Monetary liabilities include currency outstanding and reserves. When the treasury monetary liabilities that comprise of the treasury currency in circulation and coins are added to the monetary liabilities they form the monetary base. The monetary base is equals to all the reserves held by the bank and all the currency in circulation which is also called high powered money. Monetary Base = Currency in Circulation + Reserves. b) The money supply on the other hand refers to the total amount of money in circulation in the economy at a specified time. The money supply is given by the monetary base multiplied by the money multiplier. Ms = m × MB. This implies that an increase in monetary base will lead to a proportionate increase in the money supply. c) The banks are financial institutions that allow the deposition of money from individual households and corporations and make loans. This means that banks can play a very vital role in the supply of money in the economy by deciding whether to lend or not. Mostly the use of interest rate is significant, set by the central bank. When banks increase the lending rates, most people will prefer to deposit their money instead of borrowing because of the high interest rates. On the other hand, people tend to borrow more when the interest rates are lowered and thereby increasing the amount of money in circulation. Therefore the banks play a vital role in determining the amount of money in circulation by the use of interest rate regulations. d) Changes in the money supply can influence the economy through its effects on the interest rates, through its effects on the exchange rate as well as through its impact on the prices. The central bank uses three primary tools of monetary policy (Goodhart, 2005). The Reserve Requirement Ratio This is the minimum ratio of reserves to deposit that a commercial bank is legally required to set aside by the central bank. This amount partly depends on the central bank’s requirements and how the banks have planned their operations. These reserves earn no interest and so the banks hold as little as possible in their reserves. By changing the reserve requirement, the central bank can increase or decrease the supply of money. If it increases the reserve requirement, the central bank contracts the money supply since commercial banks have to keep more reserves which reduces the money they have to lend out. If the reserve requirement is decreased, it expands the money supply and banks have more money to lend out and through the money multiplier the stock of money in the economy is expanded further. The Discount Rate This is also called the bank rate or window rate. It refers to the rate of interest the central bank charges commercial banks when they approach it as a measure of last resort. An increase in the discount rate makes it more expensive for commercial banks to borrow from it and vice versa. Therefore changing the discount rate is the second way through which the central bank can contract or expand the money supply. A discount rate decrease lowers the bank’s costs allowing it to borrow more from the central bank. More reserves (IOUs) of the central bank are in the system, so money supply increases and the interest rates commercial banks charge their customers is expected to fall. An increase in the discount rate works in the opposite direction. The central bank uses this tool as a signal to the commercial banks. An increase in the discount rate signals that the central bank desires money tightening whereas a decrease in the discount rate signals that the central bank desires for money supply to be expanded. Commercial banks are expected to respond appropriately. Open Market Operations This is the central bank’s mostly used tool in controlling the supply of money in the economy. Open market operations refer to the act of selling and buying of government securities (the only type of asset that the central bank is allowed to by the law to hold in any amount). Changes in the discount rate and reserve requirements are not daily monetary policies but are used for major monetary changes. The open market operations are the primary tool for monetary policy. When the central bank buys a treasury bill or bond, it pays for it with its IOUs. Since the IOUs are reserved to the banking system, the simple act of buying a treasury bond can increase the money supply since it creates reserves for the bank. When the central bank sells treasury bonds, it collects some of its IOUs reducing the banking system reserve and decreasing the supply of money. Thus, to expand the money supply, the central bank buys bonds whereas to contract the money supply it sells the bonds to the public. Question Three The relationship between the supply of money and prices can be explained by the quantity theory of money developed by Fisher. In the monetarist economy, there is a direct relationship between money supply and price levels as identified in the Fisher’s equation also known as equation of exchange. It states that; M V = P Y; where M is the money supply V is the velocity of circulation of money P is the general price level Y is the real value of national output (i.e. real GDP). The velocity of money in this case refers to the average number of times per year ach unit of currency is used to purchase final goods and services. In this equation, it is assumed that the economy is at full employment which implies that all the existing resources in the economy are in use at the existing technology. Therefore real output cannot change. This means that Y is constant. The velocity is predictable and therefore assumed to be constant also. According to the above assumptions, if V and Y are constant, then the equation of exchange; M V = P Y means that M = (Y/V) P M = α P; where α is a constant This implies that any increase in M results into a proportionate change in P. For example, if M increases by 6%, price grows by 6% (Mankiw, 2011). Question Four Price stability is consistent with the other monetary policy goals in the long run. Firstly, as regards to employment, price stability makes it easier for people to identify the changes in the prices of goods and services. This means that consumers and firms do not risk in misinterpreting the changes in the general price levels as relative to the price changes and so they can make informed decisions on their consumption and investment. According to Say’s law, supply creates its own demand. This implies that every increase in production made possible by the increase in the productivity capacity will be sold in the market and there will be no problem of lack of demand. There is also no possibility of overproduction when there is price stability. Greater production automatically leads to greater money income which creates the market for the greater flow of goods produced. Deficiency in demand being no problem, the process of capital accumulation and extension of productive capacity will continue until all the people in the economy are employed and there is no reason why the productive capacity created remains unutilized or underutilized. Lasting price stability therefore enhances the economy’s efficiency and in turn therefore, the welfare of households through employment (Abdul, 2007). As regards to interest rates, if creditors are sure that the prices are going to remain stable in the future, they will not be in a position to demand extra returns (inflation risk premium) for their compensation regarding the inflation risk associated with the holding of assets over a given period of time. By effecting a reduction in the risk premium, thus decreasing the nominal interest rate, the stability in prices enhances the efficiency with which the allocation of resources is handled by the capital markets and therefore increasing investment incentives. This in turn enhances the creation of jobs which generally leads to improved economic welfare (Brealey, 2007). Through price stability, financial stability is also enhanced. The soundness of a bank’s balance sheet can be undermined through sudden revaluation of its assets due to unexpected changes in the inflation levels. A fall in the real value of assets will be experience if a bank gives out a long term loan to be financed by short term sources of deposits when there is unexpected shift to high levels of inflation. As a result, banks would face solvency problems causing chain effects. These inflationary or deflationary shocks are avoided if the central banks maintain stability in prices thus enhancing financial stability (Ahmed, 1993). Price stability also enhances the stability in the exchange rates. Exchange rate is the rice of domestic currency in terms of other foreign currencies. The changes in the money supply affect the domestic currency value relative to other foreign currencies through the avenue of price. Expansionary monetary policy pushes up domestic prices relative to foreign prices. This causes imports to become expensive and thereby losing international competitiveness. The imports will tend to become cheaper and the result is that there would be an increase in the demand for foreign currency and a decrease in demand for domestic currency. Thus the relative price of domestic currency declines, this is, currency depreciates. By maintain stability in prices, the central banks regulates maintaining a stable exchange rate system that minimizes the chances of currency depreciation (Bernanke & Mihov, 1998). The stability in economic growth is enhanced by the role of the central bank of maintaining price stability. Price stability means low levels of inflation such that they do not influence the economic decisions of savings and investing by firms and households. When the prices are stable, people do not waste resources in pursuit of protecting themselves from inflation. They have the confidence to save and invest believing that the value of money would stabilize over time. In a given economy, consumers and firms base their consumption, savings and investments on information they get about prices. The price determines how efficient the resources will be allocated in an economy. If the prices are unstable, it becomes difficult for the firms and households to determine whether price changes will affect the supply and demand or they would just affect the general level of inflation. By the central banking ensuring that there is price stability, the potential drag in the resource allocation is eliminated and thereby a drag in economic growth is also eliminated (Parker, 2007). Question Five The behavior of monetary aggregates, inflation and output in the UAE does not seem to be proportionate or constant. The table suggests that the monetary aggregate M1 has a leading relationship with the output and inflation. The coefficient M2 does not seem to be having a leading relationship with the nominal growth and inflation in the short run but can be seen to have an effect on the growth in the long run. Generally, output and price levels are positively correlated which implies that inflation and growth are negatively correlated as shown in the table. There is a negative correlation in the long run whereby as the money supply, M1 and M2 increases from the year 2000 to 2011, the growth G1 and G2 decreases. However, in the early years, increase in money supply which was increasing in small margins led to a slight increase in growth. This means that increase in money supply, which in turn translates to an increase in the level of inflation, leads to slight growth. After 2005, there was a massive increase in the money supply which led to high inflations which in turn led to a downturn in growth (Barnett & Serletis, 1992). This means that, mild inflation can be essential for growth of an economy but as inflation increases, investor’s confidence would be killed which means they would not invest thus leading to a decline in growth (Tobin & Okun, 2003). Question Six From the table, the price deflator implies that there has been persistent increase in the price levels from 2001 to2010. Generally, there was a price increase from 1995 to 2006 apart from the years 1998, 2001 and 2009. In general terms it can be deduced that there has been increase in price levels with the worst being in the year 2008 where the price increased from 143 to 174 which translated to a price increase of 31 and a percentage increase in deflator price of 18%. This means that there have been fluctuations in prices and investors are not sure of when to invest because of the uncertainties in the stability of prices. High price inflation is not ideal for the bond market. The bond investors in this case cannot receive the change in the deflator prices favorably. This causes the central bank to intervene and raise the interest rates. In terms of the exchange rates, high inflation usually has uncertain effects. It would lead to currency depreciation as high prices mean low competitiveness. On the other hand, high inflation leads to high interest rate and therefore a tighter monetary policy is essential to counter the depreciation (Barnett & Serletis, 1992). From the data, the interest rates and exchange rates are not stable and it is the responsibility of the central bank to intervene and bring about price stability in the economy (Tobin & Okun, 2003). Conclusion Central banks play a vital role in any given economy. Financial stability is of significant interest to central banks and is the primary objective of central banks. However, central banks cannot work alone, it needs to share information with other financial institutions, the government about measure to prevent crisis, and recognize a common interest that will be beneficial to the whole economy at large. Money supply in the economy needs to be regulated so as to maintain a balanced economy in terms of price, exchange and interest rate stability. The central bank uses its monetary policy tools to do this. These tools include; the discount rate, open market operations and reserve requirement ratio. As a result, economic growth and development will be enhanced that translates to improvement in people’s living standards, employment and general improvement in all sectors of the economy. It has been observed that there is a direct relationship between money supply and prices through the quantity theory of money equation. To attain other central bank objectives, it is important that price stability objective is met first. When there is price instability, all the other objectives like interest rates, exchange rates, financial stability and economic growth would be uncertain. References Abdul, Z. (2007) .Causality link between Money, Output and Prices in Malaysia; An Empirical Re-examination. Applied Econometrics and International Development, Vol.7-1. Ahmed, S. (1993). Does Money Affect Output? Business Review, Federal Reserve Bank of Philadelphia, 13-28. Barnett, A., Fisher, D. and Serletis, A. (1992). Consumer Theory and the Demand for Money. Journal of Economic Literature. Bernanke, S. and Mihov, I. (1998). Measuring Monetary Policy, Quarterly Journal of Economics, 13, 869-902 Brealey, R. (2007). Financial stability and central banks: a global perspective. New York: Routledge. Goodhart, C. (2005). The central bank and the financial system. New York: MIT Press. Mankiw, N. (2011). Principles of macro economics. New york: Cengage learning. Parker, E. (2007). The Economics of the Great Depression: A Twenty-first Century Look Back at the Economics of the Interwar Era. Cheltenham: Edward Elgar. Tobin, J., and Okun, A. (2003). Macroeconomics, prices and quantities. New york: brookings institution press. Touffut, J. (2009). Central banks as economic institutions. London: Edward Edgar Publishing Read More