Monetary Economics in Developing Countries - Essay Example

of the Introduction Exchange rate refers to the rate at which one country’s currency is exchanged for another country’s currency. Exchange rates can both be fixed or flexible and as such, differ from one country to another. An exchange rate is said to be fixed when the countries involved retain one fixed rate for their import and export use, whereas it is flexible when the countries let the prevailing international market forces of supply and demand determine the exchange rate. A flexible exchange rate system depends on a country’s exports and imports while a fixed exchange rate system is usually determined by a country’s monetary policy. The two exchange rate systems have their advantages and disadvantages in their application in a country’s economy. The advantages of the fixed exchange rate system include stimulating international trade as they offer much more stability for both importers and exporters and as such, they do not have to worry about the effects of currency appreciation and depreciation. Fixed exchange rate systems are also said to have a bit of control over the speculative nature of importers and exporters and thus reduce to a certain extent speculative activity in trade practices. This regime disadvantage can be depicted in the inefficiency of a country’s economy. This happens as a result of the government’s artificial support of the exchange rate which means it does not change accordingly with changes in the prevailing economic conditions and thus may loose out from the benefits that would be felt in the economy if the rate was adjusted according to the existing conditions. Furthermore, the dependence of interest rates on the exchange rate can lead to reduced economic growth of a country in cases where they differ greatly with those being experienced in the market. In cases where one of the countries involved in the fixed exchange rate system agreement has a weaker economy, it may be dominated by the country with a stronger economy and at the same time undermine the prevailing market situation in the country with the weaker economy. Similarly, the flexible exchange rate regime has its advantages and disadvantages. The major advantage of this regime is its flexibility as it allows a country’s economy to adjust quickly to prevailing market conditions. This system also determines the interest rate in a country allowing for effective control of the economy in order to create balance. Despite its advantages, the flexible exchange rate system may lead to volatility in the market as it does not encourage the improvement of production and trade. The flexible exchange rates may also lead to a destabilized economy and thus lead to an economic crisis in the countries involved. Most developing countries are found in Africa and Latin America. Exchange rate systems in various developing countries underwent various changes in the 1980s due to the tough economic conditions that were being experienced at the time and thus most decided to adopt fairly flexible exchange rate policies. During this time, most of them experienced problems such as deteriorating terms of trade, declining growth rates especially in industrial countries and changes in the cost and accessibility of financing from foreign countries. This necessitated the adoption of a floating exchange rate policy as well as monetary and fiscal policies to prevent increase in foreign debt services and losses resulting from international competitiveness. It is important for developing countries to adopt both flexible and fixed exchange rate systems as both have features that would work well in these economies because most of them depend on the importation and exportation of primary products. For these to work effectively, there should be good political systems which mostly lack in these countries. Monetary Policy Options for Developing Countries Monetary Policy refers to those measures that are used by governments to control a country’s economic activity with specific reference to the manipulation of interest rates and money supply. The monetary policy of a country is usually determined by its Central Bank. Money Supply as a tool of Monetary Policy in Developing Countries Money supply refers to the amount of money in supply in a particular country at a specific period of time. The supply of money in a country can be used by the government as a tool of controlling the economy of a country in order to bring about economic and price stability, low levels of unemployment and a growth in the Gross Domestic product. In order for this to happen, the government should be able to adequately regulate the amount of money in the country in order to avoid inflation, which is where there is too much money in the economy, or deflation, where there is a less than adequate supply amount of money in the economy. (Ghatak, 2007) The following are ways which governments of developing countries can use to control the supply of money in the economy. Open Market Operation Many developing countries such as Kenya, Egypt, and Argentina use Open Market Operation as a tool of reducing money supply in the economy. This is where the government sells or buys treasury bonds in the open market. Where a country is experiencing inflation, the government sells the treasury bonds to the people in order to reduce the money supply in the economy whereas when a country is experiencing deflation, the government buys back the treasury bills and bonds from the people and in effect increases the amount of money supply in the economy by increasing the amount of cash people hold. Open Market operation has a direct effect on the amount of money in the economy and it also affects the interest rate in the market because when the government buys bills and bonds from people, market prices are pushed up and as such, interest rates decrease. If the government sells its bills and bonds to the public, prices decrease and the interest rates increase. (Petroff, 2009) Reserve Requirement This is where a government establishes the amount of money a bank or any other depository institution must have in its possession at a given period of time and should not be used for lending purposes or invested. By altering this reserve ratio, the government is able to control the amount of money these institutions can lend out as loans or invest. The rate is in most cases is expressed as a percentage. During inflation, the government increases this rate which in effect reduces the amount of money lending institution has in its disposal and as such the institutions are left with little money to give out in terms of loans and therefore cannot increase the amount of money supply in the economy. In a deflation situation, the government reduces this rate, leaving banks and other depository institutions with more money to lend to its customers and as such increases the amount of money supply in the economy through lending. Interest Rate Manipulation This refers to the adjustment of interest rates by governments in the short term. The governments can either raise or lower the interest rate depending on the prevailing economic situation to combat inflation or deflation. To control deflation, the government lowers interest rates making borrowing cheaper to the public and other investors as compared to saving. Thus, more people borrow money and spend it thereby increasing the amount of money supply in the economy. When a country is experiencing inflation, then the interest rate is raised making borrowing more expensive and saving more beneficial to the public and therefore they reduce their borrowing and increase their savings thereby reducing the amount of money in the economy. In order for the Manipulation of interest rates to work as a money supply control tool, the government should be very careful on how it determines the rates as at times lowering the interest rates may result to increase inflation. (Petroff, 2009): retrieved from http://www.investopedia.com on 28th December 2009. Causes of the Financial Crisis in the 1990s The 1990s saw the emergence of an international financial crisis, which led to the decline in confidence in the value of several countries’ currencies. This led to financial panic among people and institutions alike, the threat of bankruptcy in several institutions including banks and other firms as well as large-scale recession. This mostly affected Eastern Asia with Indonesia, South Korea and Thailand bearing most of the brunt. Many governments and international organisations were left with the task of repairing the destruction that was left in these countries’ economies. Before the crisis, the affected were said to be some of the most successful countries due to their rapid growth and gains experienced by their citizens as reflected in the improvement of their living standards. Due to increased foreign investments and financial inflows into these countries, the institutions charged with the responsibility of safeguarding the financial sector failed to do so as their policies proved inadequate. This led to some of the causes associated with the crisis. They include exaggerated property and stock market values and huge external deficits. Long-standing exchange rates even when their levels were not sustainable which greatly affected the effect of monetary policy in these economies, insufficient management of financial systems together with increased direct lending by the government which affected bank lending rates, political uncertainties which led to the reluctance by foreign investors to increase the period within which loans were to be repaid and the ignorance by foreign investors of the risks involved as they sought soaring returns. (Maxwell, 1995) To counter this damage, the countries affected together with the International Monetary Fund carried out corrective measures. The IMF offered Korea, Thailand and Indonesia, which were the worst affected countries, financial support to help in the countries reform programs. This was met by resistance from the government especially in Indonesia thus worsening the condition. To avoid the same problem, there was increased commitment from the other governments in carrying out the necessary reforms. The IMF sponsored programs sought to bring changes in areas related to monetary policy reforms, weaknesses in the financial sector, governance and reforms in fiscal policies of the countries involved. (International Monetary Fund, 1998): Retrieved from http://www.imf.org/ on 28th December 2009. Money Demand as an element of Monetary Policy in Developing Countries Money demand refers to the amount of money individuals desire to hold during a specific period of time either in cash or in form of bank deposits. People hold money as a result of speculative, transaction or precautionary motives. Money demand is important in monetary policy making as it determines how people will react to the policy suggestions. It is therefore important for governments to study the economy in relation to peoples demand for money before making its policies. This is especially important when the government intends to use moral persuasion as a monetary policy tool. References Ghatak, Subrata, and Sanchez-Fun, Jose. R. Monetary economics in developing countries, 3rd ed. Palgrave Macmillan Publishers: New York, 2007. Maxwell, Fry. Money, interest, and banking in economic development, 2nd ed. Johns Hopkins University Press: Baltimore, 1982. International Monetary Fund. The Asian crisis: Causes and Cures. Finance and Development. June 1998 http://www.imf.org/ Read More