Monetary Policy and Financial Stability - Assignment Example

? of the Running Head: Monetary Policy Part A Essay One What are “moral hazard” and “adverse selection”? What are their implications for bank lending? How does the “bank lending channel” of monetary policy transmission operate? Moral hazard occurs when borrowers are actually tempted to engage in activities that are undesirable for the lender while adverse selection takes place before any transaction occurs whereby the borrowers are most likely to produce negative outcome for the lender who is most likely seeking loans and are most likely to be chosen for the loans requested for (Haan & Eijffinger, 2005). The implications of bank lending involve a situation whereby many bank borrowers do not have close substitutes for bank funding. This force the banks undergo challenges especially when they are monitoring their borrowers. Individuals also rely on the banks for credit and many small firms do not access to the capital. Another implication is that contractionary monetary policy reduces the quantity of reserves and deposits in the banking systems (Hammonds, 2006). In addition, banks mend their balance statement by reducing loans and securities holdings therefore, changes in bank lending has got resultant effects on investment spending small firms and debt financed spending. Consequently, the bank lending channel of monetary policy operates in a manner that if the monetary policy contracts, banks cost of refinancing increases hence lending rates also rises. High rates of interest aggravate problems of moral hazard and adverse selection. This is shown below by the following graph: In addition, banks cannot tell honest and dishonest borrowers apart since the mix of honest and dishonest borrowers rely on the interest rate. Therefore, at high interest rates majorly high risk borrowers come forward. In this case, increasing the loan rate may reduce bank expected profit (Haan & Eijffinger, 2005). At interest rate which maximises the lender’s return, there is excess demand for credit resulting into what is known as credit rationing whereby customers obtain less than what they wish to borrow while others receive and the rest miss. Essay Two How are “Taylor Rules” used? According to the Taylor Rule was monetary policy appropriate in the run-up to the international financial crisis? What are the lessons for monetary policy from the experience of the international financial crisis? Taylor’s rules are those instrumental principles that are used to determine and formulate the right model for monetary policy that measures the output gap and measures the rate of inflation in the economy (Keel, 2012). These rules are used to determine whether the monetary policies used by various countries are tight or loose. If the monetary policies are tight then it means that financial institutions such as banks will not under go a financial crisis while when the policies are loose then they are like to cause a financial crisis. Taylor’s rule of inflation Taylor rule concerning federal funds rate since 1980 to 1992 is precisely matched by this rule: it = r* + ?T + ? (yt-y*) + ?(?t- ? T) Where by r* =equilibrium real interest rate of 2% ?T =target inflation rate of 2% (Yt-Y*)=output gap (?t -?T)=inflation gap The power of the two gaps (? and ?) is about 0.5. This model suggests that the central bank can care about output and inflation or it can use the output gap to forecast the future inflation (Jadhav, 2006). It is therefore, noted that Taylor’s rule can be used to make decisions on various economic conditions such as inflation. This model also determines whether a policy has transformed after targeting inflation or not. Open economy Taylor rules are to respond on the role of international spill over while non-linear rules are used to respond to aspects of inflation or deflation. Empirical evidence of Taylor’s rule Taylor’s principles in United States practice, have been used to inform policy decisions and therefore, not a mechanistic rule. Observations of these rules provide a good fit when the policies that were initiated by these rules diverged (Jadhav, 2006). This can be used to as evidence to the economic imbalances such as: the interest rate becoming too low leading to high inflation in 1970 to 1979. This rule can also explain why the interest rate rose highly in 1979 to 1987 which eventually led to inflation fighting at the expense of output growth. Low interest rates causing global financial crisis that took place in 2003 to 2006.Finally, Taylor predicts strongly negative rates, this involves justification of policies which are non conventional. These observations show that Taylor’s rule are informing policy making and are therefore not mechanistic. Conversely, Taylor’s rule monetary policy was not appropriate since; the policies did not match up the financial crisis. Initially, it was realised that most central banks gave credit at very lower rates. The policy here was not appropriate since most of the banks were running out of funds without a back up for future sustainability (Hammonds, 2006). In this case, Taylor noted that the kind of monetary policy applied was a model with lagged interest rates included causing financial institutions to encounter financial crisis. Various lessons from the rules are that the activism of the central bank should be reduced by smoothing the interest rate resulting into partial adjustment to update information. It is also necessary to avoid policy reversals and embrace financial stability this leads to introduction of improved models. Essay Three What are “rational expectations”? What problems arise under discretionary monetary policy regarding achieving socially optimal inflation? In what ways can “credibility” for a low inflation policy be raised? Rational expectations are optimal forecasts using all the available information. A rational expectation is not always accurate but has no systemic errors. This is shown by the following equation ?e = ? t+1 + ?t +1. In rational expectations the mean of the forecast is zero and it has minimal variance thus adaptive expectations are not considered rational. The problems that arise as a result of discretionary policy concerning achieving socially optimal inflation is that a zero inflation target is announced and this will not be friendly to the adjustments of prices of various commodities(Mishkin., 2007). Secondly, rational expectations are the central bank will actually suggest delivering an enlargement resulting into 5% inflation. Thirdly, wage contract will stipulate to a level of 5%inflation thereby posing a serious challenge in the economy in terms of employment. The central bank will also validate this by delivering 5% inflation lower than the expected inflation which would cause output falls and further notes result in loan expansionary monetary policy leading to contractionary effects in this context. The short run response will result to an expansionary policy which will result into a change in the price level of output gains. Nevertheless, a correlated output has no effect on the business cycle (Haan & Eijffinger, 2005). The credibility for an inflation policy that is low can be raised through investigation of the marketing inflation expectation to enable policy makers get the right policy that should be put into action to solve the problem. In addition, various economic surveys are carried out regularly to ensure that competent strategies are made and implemented by the policy makers. The monetary policy frame work can also be used das a method of raising credibility to such a policy (Hammonds, 2006). Part B Essay One What are the costs of disinflation? To what extent do the costs of disinflation depend on the authorities’ “credibility”? In what way can “credibility” be raised? Inflation results to uncertainty in the investments and savings carried in the future. Rent searching takes place only when some resources are merely used to transfer wealth than producing it. For instance, a company tries to measure and battle out the cost of inflation. Inflation redistributes income from those on permanent incomes like pensioners and shifts it to those take a variable income like profits and wages (Haan & Eijffinger, 2005). Those who have debts may be helped by inflation since there is a reduction of the worth of debt. A very good example is where the government is a net debtor and usually this debt reduces when money is distributed to the government (Hooks, 2008). Hence, inflation is at times viewed as hidden tax. A specific kind of inflation as a tax is also called fiscal drag. By encouraging inflation to increase, certain aspects of the tax rules are met by many people(Jadhav, 2006).An example is where the income tax brackets, where the subsequent dollar of income is taxed highly than the previous dollars hence tend to become distorted. Governments that permit inflation to affect people over these rates, are encouraging a tax increase since, the similar real purchasing power is taxed highly. At the time of international trade where permanent rates of exchange are exposed, high inflation that in partners who are trading makes exports more costly and tend toward a weakening trade balance (Haan & Eijffinger, 2005).For instance, shoe leather costs, since the cash value is eroded by inflation, individuals would tend to hold minimum cash at the times of inflation thus imposing real costs. This is seen when there is more visits to the bank. Therefore, this is a reference to the price of getting new shoe leather after the old one has been worn out. Keel (2012) explains that many firms must transform their prices often which impose cost thus restaurants have to reprint their menus. In relative distortions of price, firms do not change their prices. Suppose inflation is very high, firms do not adjust their charges and there will be a lower charge relative to the firms that adjust them. This will create a distortion of the economic policies, since relative charges will not be showing relative scarcity of various goods (Jadhav, 2006). Increasing inflation can make trade unions to demand high wages, to keep up with customer prices hence increasing wages in turn can help stimulate inflation. Hence in this situation of combined bargaining, wages will be considered as a factor of price expectations (Hammonds, 2006). Deflation is referred to as the decline in the general price level that is frequently caused by a reduction in money or credit supply. This condition in the economy results into high levels of real value of debts. When there are a lot of debts in the economy then the indebted firms and households are likely to face bankruptcy and fall in asset prices (Jadhav, 2006). For instance, this is experienced especially when the balance sheets for commercial banks reduce when security loses value and loans turn bad resulting into financial instability in the economy. When there is financial instability then this leads to the increase in the rate of unemployment. Deflation mostly relies on the authorities especially through the formation of various polices that should govern the economy of a particular region. The costs of deflation such increase in prices of commodities can be influenced in the long run by the decision of the government (Keel, 2012). This is because, the government can formulate monetary laws thus controlling the prices of commodities and how money is spent in a particular economy to enhance inflation management. The credibility for an inflation policy that is low can be raised by ways such as investigation of the marketing inflation expectation to enable policy makers get the right policy that should be put into action to solve the problem. In addition, various economic surveys are carried out regularly to ensure that competent strategies made by the policy makers. The monetary policy frame work can also be used das a method of raising credibility to such a policy (Haan & Eijffinger, 2005). Essay Two What are the objectives of monetary policy? Why is price stability often given priority over other objectives? What disadvantages arise with an inflation target of 0%? Price stability which is often the primary goal of monetary policy, defines for a low and a stable inflation. This is based on the awareness of the cost of inflation and avoids zero or negative inflation. The second aim of inflation is the issue of high employment (Jadhav, 2006). In this case, employment goal should be interpreted as zero unemployment. This entails employments such as frictional, structural and wage discipline kinds of employment. The non accelerating rate of unemployment is subject to a lot of debate since it does not appear to be stable overtime. This is due to structural changes and hysteresis. Thirdly, the aim of economic growth is also important in that, it is linked to employment goal a supply side role for monetary policy by aspects such as savings and investment (Hammonds, 2006). Financial stability is a major concern to help the nation avoid bank panics and failures. It is also focuses on the objective of interest rate stability whereby there should be avoidance of lower rate stability for savings and investments together with promoting stability banking in the sector (Haan & Eijffinger, 2005). In consequent to this, the objective of foreign exchange market stability is essential since it targets with issues that might lead to low uncertainty in international trade and investments. A good monetary policy should incorporate objectives like interest rate stability and foreign exchange market stability. Interest rate stability is whereby people are made to trust the policy maker by not altering the interest rates much as this might lead to low uncertainties in investments and saving. This objective is important to the financial institutions since, it promotes stability of finance in banking sector leading to more investments (Haan & Eijffinger, 2005). Foreign exchange market stability entails minimizing uncertainty in global trade and investment. This is because; if it is not stable then it will affect the importation and exportation activities. Price stability is given priority over the rest of the goals since, it tends to define the cost of every commodity service and this is the target point of inflation. Prices of commodities rise highly during inflation and therefore, the price stability should be maintained for available of a smooth running economy (Mishkin. 2007). Since several prices of commodities are low and tend to rise, so efforts aim at a zero rate of inflation which considered as a constant level of the prices. This punishes other sectors with diminishing employment, profits and price (Hooks, 2008).Measures to complete stability in prices can also cause deflation which is commonly viewed by the Keynesians due to the download transformation in wages and output accompanied by it. Essay Three What has the Bank of England done to help avoid a severe depression in the UK economy? Why was it crucial to stabilise the banking system? The bank of England is the country’s lender of the last resort; it therefore, practices the following to help curb depression in the United Kingdom. First, the bank of England hiked the bank’s interest rate thus securing more capital base do that it could lend to the borrowers while still having a reserve for more capital. The bank placed up strategies of controlling the flow of money in the economy (Keel, 2012). The monetary policy in this case was to hike the interests’ rate to develop enough capital that could enhance the liquid capital circulation in the coming years. The bank of England has maintained price stability that seems to be overriding which is considered a long run goal of a monetary policy (Hooks, 2008). The bank has initiated a competent monetary policy that controls the level of inflation by regulating the cash flows in the economy. In addition, the ban of England practices accountability to avoid any cases of illegal acts such as thefts or credit mismanagement in the bank and the country’s economy at large. The central bank also stresses on transparency and communication. In this case, effective communication is preferred since it leads to better performance of the institution. A properly communicated policy will be implemented effectively. The bank of England also has a financial stability goal (Jadhav, 2006). This is very important since it will enable the formation of strategic decisions on how the bank can have a broad financial base thereby supplying the country’s economy with enough capital as some are held in reserves in case of any financial crisis. The bank also ensured and restored credit growth to other banks in the country by strengthening them with public financing. In addition, to avoid additional credit the bank of England offered short term forbearance on capital and liquidity needs to the other banks in service to the public (Keel, 2012). The central banks provide the government with large scale liquidity to avoid a spike spreads and loss of the market access that would turn illiquidity into insolvency. It is important for the banking system in England to be alleviated to take control of the rest of the banks in the country. This is because; the central bank was to help in monitoring the flow of money in the country’s economy (Hooks, 2008). The system of banking in England was an important tool that helped the country recovers its economic performance through the application of proper monetary policies that could help in driving and controlling the liquid capital. In addition, due to transformed policies by the bank, the management of monetary issues became effective and efficient hence curbing the hostile economic conditions like inflation. Essay Four What are the costs and benefits of inflation? What show inflation bias arises under discretionary monetary policy using a theoretical model? In practice, what determinates the size of the inflation bias? Inflation is a situation whereby there is an increased currency circulation in an economy. It leads to uncertainty in the investments and savings carried in the future. Rent searching takes place only when some resources are merely used to transfer wealth than producing it. For instance, a company tries to measure and battle out the cost of inflation. Inflation redistributes income from those on permanent incomes like pensioners and shifts it to those take a variable income like profits and wages (Haan & Eijffinger, 2005). Those who have debts may be assisted by inflation since there is a reduction of the worth of debt. A very good example is seen where the government is a net debtor and usually this will reduce when money is distributed towards the government (Hooks, 2008). Hence, inflation is at times viewed as hidden tax. A specific kind of inflation as a tax is referred to as fiscal drag. By encouraging inflation to increase, certain aspects of the tax rules are met by many people(Jadhav, 2006).An example is where the income tax brackets, where the subsequent dollar of income is taxed highly than the previous dollars hence tend to become distorted. Governments that permit inflation to affect people over these rates, are encouraging a tax increase since, the similar real purchasing power is taxed highly. At the time of international trade where permanent rates of exchange are exposed, high inflation that in partners who are trading makes exports more costly and tend toward a weakening trade balance (Haan & Eijffinger, 2005).For instance, shoe leather costs, since the cash value is eroded by inflation, individuals would tend to hold minimum cash at the times of inflation thus imposing real costs. This is seen when there is more visits to the bank. Therefore, this is a reference to the price of getting new shoe leather after the old one has been worn out. Suppose there is collective bargaining, wages can be considered as an aspect of price expectations, which will be greater when inflation increases. This results into wage spiral (Hammonds, 2006).Therefore, inflation is seen to beget inflationary prospects however, hyperinflation is realised when the inflation gets out of hand. This interferes with the normal conditions of working in the economy hindering the capability to supply goods and services. Fiscal objectives or a government play an important part in monetary policies of the central bank (Keel, 2012). The sources of revenue for government are Taxes and printing currency to fund the operations. Governments have limited alternatives in LDCs (least developed countries) and their ability to borrow money (central bank’s ability to raise debt) is limited as well, and the tax net is often limited. Mostly inflation of a specific economy results into negative impacts such as lack of employment, abnormal prices however, to some extent inflation is important since, sometimes it is hectic to negotiate prices and wages thus with increase in prices regionally, it is easier for the relative prices to change(Haan & Eijffinger, 2005). Inflation bias rising under discretionary monetary policy can be explained by the Barro Gordon’s model. Discretionary policy is where by the Central Bank has both output and inflation objective and can use its discretion to trade off extra inflation for a reduction in unemployment Optimal inflation involves maximising social welfare and in this model optimal inflation is assumed to be 0.Time-consistent inflation: the level of inflation at which the Central Bank has no further incentive to deviate from the announced target (Hooks, 2008). This is the level of inflation that would be anticipated by agents with “Rational Expectations” that is agents that take all available relevant information into account and make no systematic mistakes in their forecast. Description Central Bank can use discretion to trade off extra inflation for employment above the economy’s full employment level by utilising a short runs Philips curve trade-off (Mishkin, 2007). If the Central Bank can generate an inflation surprise that lowers real wages, firms would employ more labour and produce more output. This would raise the Central Bank’s utility. Rational agents anticipate this temptation, the announced inflation policy is not time consistent! They therefore set their wages not according to the socially optimal inflation level, but the time consistent inflation level. This is derived in the model below, as the level of inflation that maximises the Central Bank’s utility. Barro Gordon model: Utility function: U = ? (y-yn) – ? ?2 y = yn + ? (? – ?e) + ? (a Phillips curve plus a shock) ? = ?m + ? (inflation depends on monetary policy and a shock) Substitute: U = ? (? (?m + ? – ?e) + ?) – ? (?m + ?) 2 Maximise expected utility noting that at any time t the expected values of both ? and ? are zero. Need to differentiate with respect to the policy variable ?m and set to 0 0 = ? ? - ?m ?m = ? ? Actual inflation = ?m + ? = ? ? + ? and exceeds optimal inflation by ? ?. At this level of inflation the CB has no incentive to produce a further inflation surprise (it would lower utility). If it produced lower inflation its utility would also suffer, as it would create excess unemployment. According to this model it is therefore clear that the average inflation is therefore ? ? and this has no influence on employment as it is fully anticipated that inflation rise in the capacity central bank puts on the output objective ?.It is also noted that inflation increases in the effect of the monetary policy on out put ?.therefore, under discretion the economy is worse off thus the central bank takes the role to stimulate the output (Keel, 2012). Empirical Evidence Barro Gordon model illustrates actual inflation in the current global economy. This is clearly observed in countries such United States and United Kingdom where there are large number of people who are lacking employment and therefore, cannot contribute to high economic performance. The size of information bias can be determined by the central bank since they are the ones who care about the output as well as inflation itself. In this case, if inflation techniques are low then an inflation surprise provides utility to the central bank of that country (Hooks, 2008).This is rationally expected by agents who expect inflation as a level where the central bank has no incentive for a farther inflation surprise. Essay 5: What is the Taylor rule? Are Taylor rules used as mechanical monetary policy rules? How are they used in policy analysis? What does the Taylor rule evidence tell us about central bank policy mistakes in the run-up to the financial crisis of 2007? Taylor rules are based on instrument rules versus discretion. Taylor rules are applied in modelling monetary policy whereby the output gap is measured together with the rate of inflation. Open economy Taylor rules are used to super see the role of international spill over while non-linear Taylor rules are used to respond to aspects of inflation and deflation responses. Taylor’s model Taylor rule concerning federal funds rate since 1980 to 1992 is precisely matched by this rule: it = r* + ?T + ? (yt-y*) + ?(?t- ? T) Where by r* =equilibrium real interest rate of 2% ?T =target inflation rate of 2% (Yt-Y*)=output gap (?t -?T)=inflation gap The weight of the two gaps (? and ?) is about 0.5. According to this model the central bank can care about output and inflation or it can use the output gap to forecast the future inflation. It is therefore, noted that Taylor’s rule can be used to make decisions on various economic conditions such as inflation. Taylor rules are therefore, used in policy analysis whereby theoretically it is applied in the determination of output at non-accelerating inflation rate of unemployment. Taylor rule are used in the analysis hence involves description rather than prescription (Hammonds, 2006). In this case this rule informs policy decisions hence it is not a mechanistic rule. This forms a good fit between divergence of policy from Taylor’s rules and economic imbalances. Empirical Evidence Taylor’s rules in United States practice, have been used to inform policy decisions and therefore, not a mechanistic rule. Observations of these rules provide a good fit when the policies that were initiated by these rules diverged. This can be used to as evidence to the economic imbalances such as: the interest rate becoming too low leading to high inflation in 1970 to 1979. This rule can also explain why the interest rate rose highly in 1979 to 1987 which eventually led to inflation fighting at the expense of output growth. Low interest rates causing global financial crisis that took place in 2003 to 2006.Finally, Taylor predicts strongly negative rates, this involves justification of policies which are non conventional (Jadhav, 2006). These observations show that Taylor’s rule are informing policy making and are therefore not mechanistic. Taylor rule evidence about the central bank policy mistakes in the financial crisis of 2007 majored on the issue of banks giving out loans at low interest rates therefore, this was causing many banks loosing a lot of liquid capital which could not result into good capital when paid back by the borrowers hence these were very negative rates at which loans could be given out (Mishkin, 2007). This therefore, shows that the central bank policy during this year was not able to help in securing the bank from a financial crisis since it had given out large amounts loans at very low interest rates. This led to the financial crisis of the central bank. Bibliography Haan, J. d., & Eijffinger, S. C., 2005, The European Central Bank: credibility, transparency, and centralization. Cambridge, Mass.: MIT Press. Hammonds, H. 2006. Money: Banking. North Mankato: Smart Apple Media. Hooks, J. A., 2008, Money & banking (6th Ed.). Washington, D.C.: American Bankers Association. Jadhav, N., 2006, Monetary policy, financial stability, and central banking in India New Delhi: Macmillan India. Keel, L., 2012, Inflation New Delhi: World Technologies. Mishkin, F. S., 2007, Monetary policy strategy Cambridge, Mass.: MIT Press. Read More