Different Concepts Which Affect Money and Banking - Essay Example

MONEY AND BANKING by Money is a medium of exchange and a store of value; it is generally accepted for payment of commodities and services and repayment of debts. A bank is a financial intermediary that makes money by lending money to a borrower therefore creating a deposit on the bank’s balance sheet. An integrated and well-developed money market organization is necessary not only for an effective policy in any country but also for improving the operational efficiency of the banking system and modernizing its working in the context of the long-term objectives of the overall development of the country. The flow of money is not constrained by physical proximity, money flows around the globe through banking institutions and financial markets. This seemingly free flow of money is constrained, however, by rules under which banks and financial markets must operate, as dictated by government policy. This essay will examine different concepts which affect money and banking. Question 1: Monetary Policy I. 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? If the central bank has an interest rate target an increase in the demand for bank reserves will lead to increase in the money supply since the increase in the demand for reserves shifts the reserves demand curve to the right which in turn would increase the interest rates. In order to prevent this, the central will buy bonds to increase the supply of reserves. The open market purchase will then cause the monetary base and the money supply to expand (Bishop 2012). II. The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs? The benefits of the central bank lending money to banks include helping them to maintain at least a fixed ratio of reserves relative to their to their transaction deposits, they help stabilize the total willingness to hold reserves in the overnight inter-bank loan market. A stable demand of reserves in the overnight inter-bank loan market helps to stabilize the overnight inter-bank loan interest rate, given a quantity of reserves supplied by the central bank. Central banks may lend emergence reserves and other funds when banks have liquidity problems or other financial problems such as shortage of capital. But like deposit insurance, the lending increases moral hazard if the central bank guarantees that all institutions can have access to discount loans, even institutions that are poorly managed. Part of the cost of poor management of reserves, is borne by the central bank, and by extension taxpayers and anyone who uses money if the prices rise due to the additional money that is put into circulation through discount loans. This means that banks are no longer fully responsible for the costs of their risky behaviour when they have access to in an emergency, and therefore have a tendency or incentive to take greater risks than they otherwise would. Lending by the central bank also gives depositors and creditors less of an incentive to monitor the investments of banks (Bishop 2012). III. 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. The central bank has three tools that it uses for monetary policy purposes this include Open Market Operations This involves selling and buying of government securities by the central bank in the market. An open market purchase increases the monetary base and money supply, lowering short-term interest rates. The Open Market Operations has a very high flexibility, and this changes the central bank funds by a little or a lot. They have a very high speed and are precise, with immediate impact on the interbank lending market, and it is normally followed quickly by short-term interest rates. They are reversible and very effective (Wallach 2012) Central bank lending facilities Lending by the central bank increases the monetary base and money supply. The central bank affects the volume of discount loans by deciding the discount rate and when to make loans. Loans are sometimes given to banks for a very short-term liquidity problems at the primary discount rate. The lending facilities are not very flexible, but they are not easy to set in the right level because of uncertainties associated with the functioning of financial markets. They are not reversible, but the effects on the money supply are quite unpredictable. Their effectiveness is not easy to assess beforehand, and they are not as easy to administer as Open Market Operations, their speed of implementation is quite high ( Rothbird 2002). Charges on reserve requirement It involves determining of the liquidity in form of deposits that the central bank asks banks to have in proportion of their deposits. The reserve requirement is a bit costly to change: Banks must adjust all types of liquidity and asset management strategies. Regular changes in the reserve requirement would force banks to hold a large cushion of excess reserves to deal with the resulting uncertainty, cutting into profits. Reserve requirement has very low flexibility. The ability to reverse is very low, and it is effective but difficult to control because it affects a vast array of different matters. Its cost of administration is high, and speed of implementation is very low (Thomas 2006). Question 2. International Finance and the Exchange Rate I. How can a large balance of payments surplus contribute to a country’s inflation rate? A large balance of payments may require a country to finance the surplus by selling its currency in the foreign exchange market and this will make a country to gain international reserves this will make the central bank to have supplied more of its currency to the public and the monetary base will rise resulting to increase in money supply. This in turn will make the price levels to increase leading to higher inflation rates. II. 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? A flexible exchange rate is one determined purely by supply and demand without any government invention. This concept is more theoretical rather than reality in practice a managed exchange rate system is a mixture of fixed and flexible rates in which governments puts effort to influence their exchange rates directly by buying or selling foreign currencies or indirectly, through monetary policy, by raising or lowering interest rates. Different exchange rate regimes have their characteristics that may be classified in various dimensions including; the responsibility of the government, how the exchange rate is determined, and how a balance of payments imbalance is adjusted. For example, under a purely floating exchange rate system, the central bank does not intervene in the foreign exchange; the exchange rate is determined solely by market forces; the balance of payments and the exchange rates adjust simultaneously to equilibrium. A part from the exchange rate policy, a government may also decide whether to allow free convertibility of its currency to other currencies. The government can use any of the two major balance of payments, convertibility can be applied to either account or both (Khanna 2009). In current account convertibility foreign exchange can be without restraint bought and sold provided its use is associated with international trade in goods and services. On the other hand there are still restrictions when the intended use of the foreign exchange is to purchase foreign financial assets or to make investments free trade in currencies for the latter purpose is called capital account convertibility. If convertibility is approved for business in both the current and the financial accounts, we say there is full convertibility. Full convertibility is equivalent to free capital mobility. Restrictions on convertibility are called foreign exchange control. While the automatic adjustment mechanism under a fixed exchange rate regime keeps a country’s external balance, the balance of payments in balance without government intervention, there is an internal cost associated with it, this might cause a country;s economy to go through a recession that is price level goes down and unemployment goes up. That is, the whole economy is adjusting to an imbalance in the external balance (Marrewijk 2012). III. What are the main benefits and costs of monetary union? What are the main criteria for the optimality of a currency area? Monetary union is a situation whereby national currencies are abolished and replaced by a single currency. This generally happens in two steps. The first step the exchange rates between national currencies are irrevocably fixed while different currency are abolished in the final step. This has different advantages and disadvantages. Advantages It has advantages in that there is no need to change money into foreign currencies. This helps in saving time and money which is of benefit to businesses and tourist. It is also good in that it facilitates easier comparison of prices in different countries; this is because all figures are quoted in the same currency. It also enhances reduced exchange rate uncertainty; this is because exchange rates can not affect prices. Monetary union can also make foreign business to choose setting up in the region having the same currency. Disadvantages The governments involved may not be able to change the interest rates in order to manage their economies. Some businesses may also be forced to change their tills and payment systems. The governments involved may not be able to lower the exchange rate in order to become more competitive. Optimality of a currency area This means a geographic area in which a single in currency would create the greatest economic benefit. Countries which share strong economic ties benefit from common currency the common currency area benefits because this allows closer integration of capital markets and facilitates trade. It has a disadvantage in that a common currency leads in a loss of each country’s ability to direct fiscal and monetary policy inventions to stabilise their economies. Bibliography BISHOP, T. (2012). Money, banking and monetary policy. [S.l.], Lulu Com. CROUSHORE, D. D. (2007). Money and banking: a policy-oriented approach. Boston, MA, Houghton Mifflin Co De Soto, J. H. (2009). Money, bank credit, and economic cycles. Ludwig von Mises Institute. Gouge, W. M., & Dorfman, J. (1968). A short history of paper money and banking in the United States. Kelley. GREEN, D. (2008). From poverty to power: how active citizens and effective states can change the world. Oxford, Oxfam International. KHANNA, P. (2005). Advanced study in money and banking: theory and policy relevance in the Indian economy. New Delhi, Atlantic Publishers & Distributors MACESICH, G. (2000). Issues in money and banking. Westport, Conn. [u.a.], Praeger. MARREWIJK, C. V. (2012). International economics. Oxford, Oxford University Press. Neufeld, E. P. (1964). Money and banking in Canada (Vol. 17). McGill-Queens Press-MQUP. North, G. (1986). Honest Money: The Biblical Blueprint for Money and Banking(Vol. 5). Christian Liberty Press. REINERT, K. A., RAJAN, R. S., GLASS, A. J., & DAVIS, L. S. (2009). The Princeton encyclopedia of the world economy. Princeton, Princeton University Press. Rothbard, M. N. (2002). History of Money and Banking in the United States: The Colonial Era to World War II, A. Ludwig von Mises Institute. THOMAS, L. B. (2006). Money, banking, and financial markets. Mason (OH), South-Western. VASUDEVAN, A. (2003). Money and banking: select research papers by the economists of Reserve Bank of India. New Delhi, Academic Foundation. WALLACH, J. M., & TATTERSALL, C. (2012). Money and banking. New York, Rosen Central. Read More