Monetary Policy and International Finance - Assignment Example

Monetary Policy

• If the central bank has an interest rate target, why would an increase in the demand for bank reserves lead to a rise in the money supply?

An increase in the demand for bank reserves means that there is a shift in the reserves demand curve to the right, which in turn would result in the raising of existing interest rates. The central bank, in the aim of stopping the projected increase of interest rates, would purchase enough bonds focusing on increasing its general (non-borrowed) reserves supply volume. This process keeps the central bank’s interest rates from rising. Through the open/ public market purchase procedure, the central bank initiates a rise in money supply (liquidity) and the national monetary base (Woodford, 2001). Figure 1 aptly represents a financial situational context where the federal/ central bank puts a ceiling on its federal funds interest rate.

• The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs?

While the benefits of utilizing rediscount operations to avert bank/ investor panic and subsequent fiscal/ cash flight are evidently important, the accrued costs also significantly affect the economy. A case in pointer is that financial institutions that engage in corporate malpractice, and hence deserve their closure, often survive and thus the root cause of financial crises is often fully tackled. The expected result is an environment where there is inefficiency in the banking system, which would more or less have a variety of mismanagement issues and general corporate malpractice. This is informed by the fact that the general notion presented to banking/ financial sector players is that in the event of a financial crisis (even of their own doing/ cause) they are safe, insured and hence are easily bailed out of their financial situations (Friedman, 1999:322).

• Compare the use of open-market-operations, central bank lending facilities (rediscounting), and changes in reserve requirements to control the money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

Open market operations provide the main avenue through which monetary control is achieved. As Axilrod (1997) explains, these operations enable central banks have greater flexibility in relation to both the volume and timing of monetary operations, within their own convenience/ initiative. In addition, the operations provide an adequate avenue for avoiding the inefficiencies brought about through direct controls, as well as encouraging a businesslike, impersonal interrelation with various marketplace participants/ stakeholders. Through their direct impacts on a national banking system’s reserve base, open market operations affect not only prevailing rates money supply (liquidity) but also other associated monetary measures. Towards controlling the reserves, open market operations are conducted either actively or passively (Axilrod, 1997).

Active conduct means the aim is to reach a given quantity of reserves and thereby enabling free fluctuation of existing interest rates (pricing of existing reserves). Passive conduct, which is the most commonly utilized approach, means central banks aim at a specific/ set interest rate through enabling greater fluctuation of the reserves. Whenever control of inflation is the overriding goal, the active approach is the best option, giving the central bank amply space to clearly define its policy measures. It is also quite useful, theoretically and practically, within developing country contexts, which may often lack efficient inter-banking/ secondary markets critical in the transmission of monetary policy influences to the grassroots (Axilrod, 1997).

If open market operations are to be the primary policy vehicles used by central banks, then there is need for some level of change concerning other financial instruments. This is true in the case of discount window policies (central bank lending), which provides the national banking system with the leeway to obtain reserves through borrowing from the central bank. The effectiveness of open market operations is influenced by limitations placed on the banking system’s access to borrowing during the discount window. By making it less attractive to borrow from the central bank through either restrictive guidelines and/ or high penalty rates, central banks can be able to make portfolio adjustments that are more orderly (Woodford, 2001:297).

Care though should be taken when implementing these guidelines to effectively guard against the central bank’s incapacity to smoothly adjust whenever reserve shortages occur. Another key avenue through which central banks have been able to achieve monetary control is by way of imposing reserve requirements. Reserve requirements provide vital financial information either as alternatives or enhancing factors of open market operations. This is in relation to the minimum binding levels of these reserve requirements which aid in gauging the general impact of initiated open market operations upon existing national interest rates; as well as the overall money supply (liquidity) rate (Axilrod, 1997).

Of note is that whilst considered a crude form of monetary control, reserve requirements are vital in case scenarios where central banks need to give swift, unambiguous, and clear signals concerning either the contraction or expansion of fiscal liquidity. In the U.S., and despite its highly sophisticated monetary market, reserve requirements remain obligatory on existing transaction deposits. They are principally useful to the Federal Reserve in terms of decision-making concerning the size and timing of prevailing open market operations (Friedman, 1999).

• International Finance and the Exchange Rate
• How can a large balance of payments surplus contribute to a country’s inflation rate?

Under the ‘perceived’ financial contexts where the demand for payment surplus (reserves) remains static (without fluctuation), it is often expected that a direct impact would be the nation’s central/ federal bank reaching its set interest rate target. Such a situation, as Pettinger (2014) informs, would lead to an increase of interest rates, and therefore higher inflation. Under such unique economic contexts, the central bank would be right in implementing the viable option of: pursuing both an interest-rate target and a non-borrowed reserves target simultaneously. The aim would be to regulate the general national interest rates through ‘capping’ the interest range and thereby ensure that the country’s national inflation rate is adequately ‘contained’ (Pettinger, 2014).

By association is the presence of the often-conflicting goal-objectives of the central/ federal bank: ensuring price stability vis-a-vis high employment and economic growth, and stable interest rates. Economic expansion usually means increased employment and by proxy, a rise in inflation rates. Thus, in order to effectively endeavour towards attaining the goal of price stability, the central bank can pursue a mix of anti-inflationary and contractionary policies. Of note is that such policy measures usually ‘conflict’ with the other goal of high economic growth and employment. Similarly, whenever the central bank wants to contain rising inflation it usually engages measures that aim at raising interest rates, as well as pursuing tight monetary policy measures (Davidmann, 2006).

• Why is it true that in a pure flexible exchange rate system, the foreign exchange market has no direct effects on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy?

Under such circumstances, there are no direct effects experienced in relation to the national money supply (liquidity) based upon the fact that there is no form of central/ federal bank intervention. Accordingly, changes in the international reserves, which would effectively influence the prevailing national monetary base, would be non-existent given the ‘utopian’ financial environment of purely flexible exchange rate systems. However, monetary policy is generally influenced by the existing foreign exchange market. This is because monetary authorities (central banks and global financial institutions such as the IMF and World Bank) may want to engage in some level of exchange rate manipulation (Davidmann, 2006). Such manipulation is achievable by way of changing the existing fiscal liquidity (monetary supply), and subsequently influencing the prevailing interest rates.

• What are the main benefits and costs of monetary union? What are the main criteria for the optimality of a currency area?

An economic monetary union (EMU) is usually envisaged where various nations perceive it beneficial – economically, geo-politically and socio-culturally – to unite; such as is the case with the European Union (EU). Minford expresses that such a union has various benefits that are however also a major influence on initial and subsequent cost-expenditure. In terms of benefits, an EMU enables four core elements. These include the general decrease of exchange risk (vital in enhancing greater foreign investment and trade, whilst lowering risk-premium as embodied in the cost/ expense of raising required capital) and the reduction in overall transactional costs concerning currency exchange. The other two include enhanced transparency in relation to currency price comparison and overarching geo-political gains achieved through closer cooperation and union between various state economies (Minford, n.d.).

While benefits to be gained remain the core focus of many proponents, there should also be consideration of the costs incurred. The expenses incurred are in terms of transaction costs such as the hand-to-hand currency exchange procedures which various populations engage in, and where variations are also included in the eventual currency exchange rates. However, on the banking front, there is no cost as the extra computer input required in the conversion of one currency to the other has not actual cost (McCallum, 1995:615). In addition, whenever a state wishes to join an EMU, it is subjected to a massive ‘one-off’ transaction, principally in the process of changing/ converting its currency to the dominant EMU currency. This is quite a cost given that it also entails the changing over of existing accounting systems and vending machines amongst other pertinent financial instruments (McCallum, 1995:615).

Towards achieving the optimum currency area critical towards availing the greatest, economic benefits possible. As Swoboda (1999) alludes, Mundell’s theory of optimum currency areas states, as set out in his 1961 – A Theory of Optimum Currency Areas article, tries to present this in relation to two or more currencies interacting within a given geographical placement. He relates this theory to a cost-benefit analysis of a proposed monetary union, especially when perceived from the gains to be made. Of importance under this consideration are the two interlinked elements of the role-play of foreign currency exchange rates and asymmetric shock, when related to projected impacts in terms of capital and labour costs and/ or movement (Swoboda, 1999).

Accordingly, the main criteria for the optimality of a currency area that need to be met include the need for limiting any recurrent, wide-scale asymmetric shocks as well as mobility within the existing factors of production. In addition to the two core criteria, there is need for diversification of existing export product ranges and a specific degree of ‘market openness’ in the case of states wishing to join an existing economic monetary union. Export diversification enables nations to reduce overall impacts of shocks affecting specific export product categories. Economic openness it should be noted portends to greater levels of sensitivity to shocks and hence less monetary liquidity and stability against other currencies (Swoboda, 1999).

Reference list

Axilrod, S H 1997. Transformations to Open Market Operations. International Monetary Fund: Publications – Economic Issues, No. 5. Retrieved (April 6, 2016) from: http://www.imf.org/external/pubs/ft/issues5/

Davidmann, M 2006. Inflation, Balance of Payments and Currency Exchange Rates; Quality of Government (national and local); Standard of Living and Worldwide Inequality; The Struggle for a Bigger share. Solhaam.org: Articles. Retrieved (April 6, 2016) from: http://www.solhaam.org/articles/inflation.html

Friedman, B 1999. The Future of Monetary Policy: The Central Bank as an Army with Only a Signal Corps? International Finance, 2: 321–338.

McCallum, J 1995. National borders matter: Canada - US regional trade patterns. American Economic Review, 85: 615-623.

Minford, P n.d. The Cost and Benefits of Economic and Monetary Union to the UK Economy – the Fifth (Overview) Test.’ Cardiff University, Cardiff Business School. Retrieved (April 6, 2016) from: https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0ahUKEwiCxIXF-fnLAhXJWRQKHaAAA9QQFggjMAE&url=http%3A%2F%2Fwww.euro-know.org%2Feuropages%2FbforsEMUTEST5r8.pdf&usg=AFQjCNHA1FzlswWpxFG5ry_eegAaLulfjA&sig2=RN85MTyamL2WO7Zh83BC0Q

Pettinger, T 2014. The Effect of a Current Account Surplus. Economicshelp.org. Retrieved (April 6, 2016) from: http://www.economicshelp.org/blog/9996/trade/effect-current-account-surplus/

Swoboda, A 1999. Robert Mundell and the Theoretical Foundation for the European Monetary Union. International Monetary Fund: News. Retrieved (April 6, 2016) from: https://www.imf.org/external/np/vc/1999/121399.htm

Woodford, M 2001. Monetary Policy in the Information Economy. In Symposium on Economic Policy for the Information Economy, (pp. 297–370), Kansas: Federal Reserve Bank of Kansas City.

• Appendix

Figure 1: How the Primary Credit Facility Puts a Ceiling on the Federal Funds Rate. Online. Retrieved (April 6, 2016) from: http://home.cerge-ei.cz/pstankov/Teaching/VSE/Reading/Mishkin10.1.pdf

Figure 2: Response to a Change in Required Reserves – When the Fed raises reserve requirements, required reserves increase, which in turn increases the demand for reserves. Online. Retrieved (April 6, 2016) from: http://home.cerge-ei.cz/pstankov/Teaching/VSE/Reading/Mishkin10.1.pdf

Figure 3: Equilibrium in the Market for Reserves. Online. Retrieved (April 6, 2016) from: http://home.cerge-ei.cz/pstankov/Teaching/VSE/Reading/Mishkin10.1.pdf

Figure 4: Response to an Open Market Operation. Online. Retrieved (April 6, 2016) from: http://home.cerge-ei.cz/pstankov/Teaching/VSE/Reading/Mishkin10.1.pdf