Tools of Monetary Policy - Assignment Example

Tools of Monetary Policy Cash Reserve Ratio The required reserve ratio is a monetary policy instrument used by the central government to control banks’ lending of money. The ratio specifies the amount banks must reserve against what they lend out. A bank cannot lend all its deposits as this would interfere with unplanned withdrawals. In regard to the article attached, the writer is highlighting about the protection of the public against the banks regarded as too big to fail. His idea is on increasing the initial deposit the banks make to the central bank in essence. If the required reserve ratio was increased for these big banks they would hold more deposits and lend few. This would not hold the problem at hand as these banks are too big to suffer from search changes (The Editorial Board). The increase would lead rather to a decrease in money supply and thus the public would suffer as this would lead to an increase in interest rates Graph 1 The graph above illustrates and demonstrates a decrease in money supply, which leads to the increased interest rates. Open market operations Open market operation is the buying and selling of government securities in the open market through the Central Bank of a given country. If there is excess money in the economy or rather inflation, and the government wants to reduce this amount, it will sell its securities to the public. The money obtained is used to develop other sectors of the economy or to invest in investments with high returns (The Editorial Board). If, on the other hand, there is little money in the economy, the government will buy these securities from the public in order to increase money in the economy. To ensure this, government has ensured that the public have information about these securities and are educated on their importance in the economy at large. Graph 2 According to the graph above increase in money supply (ms) from (Ms0) to (Ms1) the increase in essence leads to a decrease in interest rate (r). Interest rate policy In order for the central bank to control the flow of money in the economy besides bank rate and cash reserve ratio, the central bank can directly influence the economy by increasing or reducing the interest rates. An increase in interest rate causes an increase in money demand, in the economy. This would be the best choice in an economy that wants to favor capital investment. The writer is insisting in a change of laws where as in a free market there are already flexible policies that can aid in protecting the individuals. As illustrated above when the interest rates are low the people are encouraged to borrow from the bank since it is cheap, when they borrow they use the money to buy bonds, and for other capital investments the central bank interferes by increasing the bank interest rate to reduce the demand for bonds in essence the money demand shifts from MD1 to MD2. 2. What role did weak financial regulation and supervision play in causing the 2007-2009 financial crises? Financial regulation refers to the laws and rules that are set by the government of a particular country to govern the financial institutions like the banks and other investment companies. It is majorly done to ensure financial stability in the financial system thus ensuring that funds flow smoothly between investors and savers. This will in turn lead to economic growth. The laws also ensure that there is minimized rate of financial crime by doing away with illegal businesses in the financial system. This has made the public have confidence in the financial system since they are sure that their businesses are legal and whatever the returns the get is transparent. Lastly, financial regulation has helped in increasing information to investors, and this has helped in the reduction of both adverse selection and moral hazard problems. A financial crisis takes place when there is a large interference to the flow of information in the financial markets, and this makes the financial system not to function properly. Financial crisis had various effects on the economies of many countries such as reduction in the level of employment due to poor economic performance which went on for a long period, reduction in the wealth of consumers and poor performance of major business, which made some collapse. These worsen the living standards of the citizens in countries all over the world. The major cause of the financial crisis was increased uncertainties. Many people speculated that their investments will have greater yields in the future, and this was not the case. They incurred losses and this reduced their wealth. Also, the government of the United States had a lot of money and wanted to create self-employment to its citizens. They reduced the interest rates in order to encourage people to borrow these funds and invest. Many people did not return their loans and the country was reported to be bankrupt. Another major cause of the financial crisis was with the banks. They did not have adequate information about its customers especially when giving out loans. The people too did not have trust with their banks and this led to bank runs and bank panics. This reduced the amount of money available in the financial system that could be used to develop other sectors of the economy. This forced the countries affected to borrow a huge sum of money from the World Bank and this increased their debts. The stock prices were also reduced in order for the government to obtain the little funds that were in the economy to finance its operations. Lastly, the poor performance of the financial institutions shown by their balance sheet also contributed to the financial crisis as it reduced the amount of money it lends to the government and public at large. This led to a reduction in investments and increase in government deficits, in its operations. This problem of the financial crisis was overcome by increased innovation and borrowing from other countries. Investments with high returns were made and encouraged in the economy and this helped in resettling their debts. 3. Income gap for the bank a) Initial Rate-Sensitive assets = $20 million Initial Fixed Rate Assets = $80 million After the sale of $10 million fixed rate assets and replaced with Rate-Sensitive assets: New Rate Sensitive Assets = $30 million New Fixed Rate Assets = $70 million Income gap for the bank= Interest rate sensitive assets- interest rate sensitive liabilities = RSA- RSL 30 -50 = -20 Therefore, income gap for the bank = 20 What will happen to profits next year if interest rates fall by 3 percentage points? Change in income= Gap* change in interest rates = -20* (0.1-0.03) = -1.4 The profits will decline by $ 1.4% b) If the First bank decides to convert $5million of its fixed rate assets into rate sensitive assets: Rate Sensitive Assets = $25 Fixed Rate Assets = $75 Income gap for the bank= Interest rate sensitive assets- interest rate sensitive liabilities = RSA - RSL 25-50 = -25 Therefore, income gap for the bank is 25 This implies that any attempt to raise interest rates will reduce the net interest margin and income. c) What happens to the market value of the bank’s assets if the interest rate increases by 2 percentage points? % change in P = -duration x {change in i/ (1+i)} Where P = market value I = interest rates Change in P= -2 x (0.02/1.1) = -0.364 This tells us that the market value of the assets will decline. 4. Explain using an example the statement that "at the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered. Futures contract refers to an agreement between two parties that involve making payments for a particular commodity at the current market price to be delivered at some point in the future. It is majorly used for speculation purposes in that if the price of a given asset is expected to increase then an investor gets into the contract in order to take advantage of the current market price. On the other hand, if the price of the same asset is expected to decrease then the investor will not get into the contract in order to benefit from the future price which is cheaper. With this, risk of incurring losses is minimized. There are different types of futures available for trade depending on the type of the underlying asset. They include individual stock futures, stock index futures, commodity futures, currency futures and interest rate futures. Currency futures refer to a futures contract whereby one currency is exchanged for another at a given date in the future at the current market price. If, for example, one expects the US dollar to appreciate in the future against sterling pounds, one can get into a contract to exchange his pounds at the current market price to be delivered in the future. This is to take advantage of the current market price but will incur loss if this may not be the case since the US dollar is also in a position to depreciate in value against the pounds. Hence it is advisable to get into such a contract if one has full information about the market and able to predict about the future performance of currencies you are dealing with. Commodity futures contract, on the other hand, refers to an agreement made by two people to buy or sell a given amount of commodity at a given market price to be delivered in the future. This is to take advantage of price fluctuations of the product dealt in and uncertainties about the product. Suppose a company speculates that the price of oil is going to increase in the future, it can sign a deal with the oil company to buy a certain quantity of oil with the current market price for future delivery. Such a contract expires when the terms and conditions signed in the contract are fulfilled. This is a very risky method especially for those who do not have proper knowledge about the market since what they expect may not happen in their favor. They may spend a lot of money in entering into such a contract by buying much oil with the expectation of future price increase, but the price might decrease. Lastly, interest rate futures refer to future contracts involving an asset with an interest bearing instrument, for example, the Eurodollar futures. If one expects the interest rates to rise, he can get into a futures contract in order to escape the expected increase in the interest rates. Borrowers normally enter into such a risky contract in order to make profits in the future if their speculation is right. In conclusion, it is important to engage in any of these futures contract if one has full knowledge about the market and can speculate on the future events. There are also uncertainties that might occur which can have negative results on the investor. It is a risky activity, and one should be ready to accept the outcomes as they occur. Explain why the bank rate is an upper limit for the overnight rate Bank rate refers to the interest rate that the central bank of a given country lends money to the commercial banks of the same country. This rate normally changes depending on the state of the economy. During inflation, the central bank increases bank rates in order to discourage more borrowing by the public. This helps to reduce money circulation in that economy. On the other hand, these rates are reduced if the level of unemployment is high and the government intends to increase the level of investments in the economy. Overnight rate refers to the interest rate imposed by a depository institution when it lends the available funds immediately to another depository institution. This normally takes place overnight i.e. one day. The two institutions must have their deposits with the central bank which influences the interest rate, thus making the short term interest rates predictable. The central bank sets the bank rate higher than the overnight rate as a control to their lending rate. The overnight rate is always lower than the bank rate, an increase in the bank rate leads to an increase in the overnight rate without exceeding the bank rate limit. Changes in the overnight rate have a direct effect on consumer loans and mortgages. This case is evident in the Canadian economy. Explain why the bank rate minus 50 basis points (ib-50) is the lower limit for the overnight rate. As discussed above, bank rate is the rate at which the Central Bank lends money to the commercial banks while overnight rate is that rate imposed by two depository institutions when borrowing or lending money in the financial market for an overnight. This is majorly done through the Central bank. The major aim of the Bank is to keep the overnight rate within a band of 50 basis points. The overnight rate can be at times higher, and this will force the Bank to lend to other banks at the same interest rate thereby putting a ceiling on the overnight rate. The other banks will not see the need to deposit with the Bank due to higher rates. The bank rate minus 50 basis points must be a lower limit for the overnight rate to ensure that all the depositors benefit from each other, and the Bank also make a profit. Works Cited The Editorial Board. "Not Too Big to Fail." 8 July 2013. The New York Times. 28 August 2013 . Read More