Effectiveness of Monetary Policy for the UK - Essay Example

Effectiveness of Monetary Policy for the UK By monetary policy, we mean those measures which are adopted by the central bank to increase or decrease the supply of money in circulation. It means that the policy of the central bank is known as monetary policy. The direction and speed with which changes in the rate of interest affects demand will be a key determinant on the success of monetary policy. Monetary policy can be either a contractionary policy or an expansionary policy. (Kenen, 1995) Contractionary policy will decrease the total money supply thus raising interest rates a thing that helps in reducing inflation while the expansionary policy increases the total supply of money in a given economy thus commonly used in eradicating unemployment in periods of recession by lowering interest rates. It therefore concerns the relationship between total supply of money and interest rates in a given economy. According to Julio, (2004) the main objectives of monetary policy are as follows: Price stability Increase in the rate of economic growth Exchange stability Higher employment level Increase in capital accumulation The monetary policy is operated by the central bank through the instruments of credit control. These instruments are: Reserve requirements Rationing of credit Bank rate policy Open market operations Consumers selective credit control Margin requirements Direct action , moral persuasion and publicity During inflation, the measures are taken to decrease the supply of money in circulation and during deflation; the supply of money is increased by adopting the above methods. Monetary policy will have the following effects on the economy. It helps in maintaining foreign exchange reserves at a desirable level It creates more employment opportunities since the central bank can encourage the commercial banks to provide more loans to the sectors which will in return employ more people this reducing unemployment. It brings the desirable changes in the price level It can affect the rate of economic growth by facilitating more effective use of resources in any given country. Eurozone came into existence in 1998 after a meeting of eleven European Union members who agreed on the convergence principles. This was followed by the official launch of the euro as a common currency in 1st of January 1999. currently the Eurozone has over three hundred and eight million people and twelve member states which includes Spain, Portugal, Netherlands, Luxembourg, Italy, Ireland, Greece, Germany, France ( with the exception of pacific territories which uses CFP franc), Finland, Belgium and Austria. (ECB, 2001) Being a subset of the member states of the European Union Eurozone has adopted the euro as a common currency thus resulting in the currency union amongst the member states. The European Central Bank (ECB) carries the responsibility of monetary policy within this territory .With the monetary policy that is used by the Euro zone being the inflation targeting. The European Monetary Union (EMU) is very much operational with the UK being ambivalent on whether to join or not. By it being an economic and political issue monetary union has generated divergent views from the professional economists, business opinion and the general public opinion as to whether it would be important for UK to join. It is clear that presently European economic union is not a popular option in the UK. (Angeloni and Mojon, 2003) The Surveys conducted by the British Social Attitudes has regularly indicated that less than a fifth of individuals who have polled since 1993 would buy the idea of replacing the pound with euro a result that has been confirmed in the 1999 release. (Tommaso, 2004) However, it has been argued that most of this public opinion could be influenced in a favourable manner by the It has also been argued that public opinion could be favourably influenced by the pro-EMU business opinion revelations. This paper will look at the economic issue although it will still touch on the political issues emanating from joining the Eurozone. The paper will evaluate whether the UK is placed on a single market risk by failing to participate in the European Monetary Union. This will depend on whether monetary independence and exchange rate flexibility provides some form of insurance from outer shocks or they just provide an opportunity for the destabilizing forces to take change, a thing that may not be so obvious with a country like UK which has managed its financial systems in a proper manner. Before joining the Eurozone, UK should conduct a thorough research so as to establish whether: 1. its participation will impact positively on the UK's financial services industry 2. there will be a continued union between Britain and the market partners who use single currency 3. it will be a good move for creating employment opportunities for the population in Britain 4. it will affect investment in a positive way with its effects being felt by the country's investors 5. there will be adequate flexibility to cope with the economic changes.(David, 1998) The idea of joining the European Monetary Union and adopting a common currency has its own advantages and disadvantages as well. (Young, 1998) The advantages include: 1. Ease of transactions across the European Union a thing that will save both time and money. A single currency will end the currency instability outside them. Having enhanced credibility of being used in a large currency territory, the Euro would be more stable against speculation than the pound at the moment. Exporters will have the gut of planning future markets with greater assurance as a result of an end of the internal currency instability and a general decline in the instability of the external currency. These will set free a greater potential for economic growth in Britain. 2. Members will not be expected to change money when travelling, thus encountering less official formalities when transferring huge sums of monies within the member states. This will put Britain a mile ahead since it will reap the associated benefits. Prior to the use of a single currency (i.e. the euro) it was estimated that a traveller visiting all the twelve member states of the Eurozone would lose a big percentage of his money on transactions alone (approximately forty percent). With the introduction of a single currency all this money is saved. 3. Since all the European countries would be looking into the credibility of the German monetary regime, a single currency will result in reduced interest rates, a thing that will favour the United Kingdom. 4. The 1996 Dublin summit of the European heads of state agreed on the stability deal. This agreement will force those countries in the European Union into a fiscal responsibility which in return will improve international credibility of the euro. The effects will be lowered mortgage, increased investments and more employment opportunities. 5. At the moment business in Britain pays hedging costs in an effort of insuring themselves against the currency fluctuation threats. By joining the Eurozone, business in Britain will not be required to pay the hedging costs, a thing that will add up on their profitability. There will be no administrative costs of accounting associated with changes in currencies and the time spent on the same for those businesses involved in commercial transactions at different states within the Eurozone. 6. The European Monetary Union will be of great importance in creating a stronger European Union. This will advocate for improved and strengthened economic, social and political integration. This will help Britain in its enlargement and growth prospects. 7. A single currency will help Europe in achieving a single market whereas the European economies will remain strong and united competing effectively with the high-wage, large and integrated US economy and the Asian low-wage economies. 8. Participation would ensure that UK is not marginalized by other countries and this will make it attractive for the associated investments from member countries. 9. For a country like UK which has not enjoyed stable low inflation, it will enjoy disinflation benefits. This is because the independent European Central Bank (ECB) will bring low inflation rates for the area within European Monetary Union. Low inflation will mean low rates of interest since the premiums for exchange rate risks and inflation would be eliminated from interest rates. However by joining the Eurozone, Britain will suffer associated disadvantages as observed by Young, (1998), these disadvantages include: 1. It will be hard since different member partners will experience varying internal or external shocks. The implications will be different policy applications in different areas covered by the same currency. Effects of this shock will vary depending on the transmissions effects and multipliers. 2. All the member countries have different growth cycles and stages. UK is undergoing a reasonable growth while countries like Germany are experiencing difficulties. Interest rates are normally set in different countries at their appropriate levels. A single central bank may not set inflation at each member's suitable level. 3. Those nations with low external trade levels will not care much about the effects arising from exchange rates. For example, Netherlands has less manufacturing employment percentage than Germany and will therefore be less concerned. 4. A higher proportion of borrowing at varying rate of interest will translate into bigger effects on the level of aggregate demand. 5. It will be hard to come up with a direct target on inflation. 6. Monetary union will lead to the loss of national sovereignty. This implies that weaker countries with higher inflation rates will co-operate with the economically strong countries. This will be a disadvantage to UK which is doing well economically. 7. Introduction of a single currency will be more expensive since it will involve educating people on the new currency, changing labels, training staff, adjusting tills and changing computer software. 8. It will be difficult for some countries to keep pace with the stability agreement since it will be hard to fight recession periods by loosening their fiscal stance. They won't succeed in boosting exports, cut taxes or borrow more. 9. It will be hard for over twelve countries with different languages and economic performances to form a monetary union. Language will be a major hindrance to the labour force movement across Europe. This will lead to some areas flourishing economically while others languish in economic throes.(Tommaso, 2004) Conclusion Considering the above discussed pros and cons, the monetary policy will be more effective for the UK if it joins the Eurozone. Most of these benefits will be achieved in the long run. Joining Eurozone will foster economic, social and political unity between Britain and the member countries. References Angeloni, I. and Mojon, B. (2003): Monetary policy Transmission in the Euro area. Cambridge university press, Cambridge ECB (2001) A guide to Eurosystem Staff Macroeconomic Projection Exercises, June David, B. (1998): the ECB -Safe at any Speed Centre for Economic Research Julio, R. (2004) the Monetary Policy Strategy of the ECB Reconsidered. Centre for Economic Research Kenen, P. (1995): Economic and Monetary Union in Europe, Cambridge University press, Cambridge Tommaso, P. (2004) The Euro and Its Central Bank, MIT press, London Young, H. (1998): the Blessed Plot. Macmillan, London Read More