Monetary policy basics Summary

Question1: Explain critically what monetary tools are used by central banks, such as the Bank of England, the European Central Bank and the US Federal Reserve to control the money supply. Explain why central banks cannot fully control the money supply. Central Bank was given to their formulation and implementation of monetary policy by government; it is special financial institutions to manage macro-economic control and management of the national economy. From the operational objectives, Central Banks are not for profit-making purposes.

It responsible to regulate financial in orders to stabilize the currency and promoting economic development. Do so in the operational activities of the Central Bank also made a profit, but profit is not a goal. From the service object, Central Bank only movement fund between commercial banks and other financial institutions. And through the business relationship with such institutions, carrying out and implementing the Government’s economic policies, and fulfill their duty of managing the financial.

From the operational content, Central Bank exclusives the right of issue currency. Through the development and implementation of monetary policy and controlling the money supply so that currency aggregate supply and aggregate demand tend to balance. The Central Bank most belongs to the authority of State and Government. For example, United States Federal Reserve system is directly responsible to Congress; it is a Department of the National Assembly.

(The role of central banks, 2007) This shows Central Bank is the country’s Supreme management institution of the finance industry; Central Bank represents State to develop and implement a unified monetary policy, monitoring of national financial institution’s business activities; Central Bank represents the State to participate in international financial organizations and international financial activities. Monetary policy tool is a mean of regulation to achieve the goal of economic macro-control.

Because of balance of aggregate supply and aggregate demand in the community and the total amount of the money supply and money demand balance of the total complement each other. So as to realize such as stable currencies, increasing employment, balance of payments, develop economic, etc. Monetary policy is related to global macro-economic policies, and close ties fiscal policy. Comprehensive measures must be implemented in order to maintain currency stability.

After the Central Bank’s monetary policy objectives have been identified, you also need a set of effective monetary policy tools to ensure the implementation of monetary policy objectives. Tools of monetary policy is directly controlled by the Central Bank, it have a direct or indirect effects on money supply, interest rates, and financial institution credit activities, and it in favors of the Central Bank’s monetary policy objectives are met. The Central Bank’s monetary policy tool, there are three main ways: 1. Changing the reserve requirement; 2. Changing the discount rate; 3. Open market operations. (The tool of monetary policy of central bank, 2007) Changing the reserve requirement:

Reserve requirement refers to the Central Bank by adjusting reserve ratio of commercial banks to change the money multiplier, ability to control the financial institutions credit expansion and indirectly control the society money supply. Thus affects national economic activity. Reserves concentrated in the Central Bank, initially began in the United Kingdom. But in the form of law requires commercial banks must be deposited with the Central Bank reserve, this requirement began implement in 1913 United States Federal Reserve Act. At begin, reserves no scalability.

In 1935, Fed first time got rights to change the statutory deposit reserve ratio, deposited reserve system really become an important tool of the Central Bank’s monetary policy. So far, all country which has central banking system, represent they implement the reserve system. In times of economic recession, the Central Bank reduced reserve requirements ratios, enables banks to create more money that is commercial bank credit expansion, increasing the money supply, lower interest rates to stimulate the expansion of investment demand, finally achieve elimination of economic recession.

Conversely, in times of inflation, if increase the statutory required reserve ratio, the remaining reserves of commercial banks will be reduced, even shortages of reserve requirement so that have to reduce the loan or investment. Thus necessary recover the loans or sells securities to compensate for the lack of required reserves. In this case, commercial banks can only create a little bit deposits, and even cause deposit currency double reduction. The advantages of reserve requirement are its equal impact on all commercial banks, and have strong influence on the currency aggregate supply.

Have obvious effective on inflation and easy to operate. If changing reserve requirements that cause the Central Bank can often quickly achieve the desired ultimate goal. However, as a monetary policy tool has some limitations. Main problems: reserve policies lack of flexibility. Since the huge of bank deposits, little changing statutory reserve requirements will cause great changes in excess reserve requirement, and through the money multiplier effect to have a huge impact on money aggregate supply and may even bring strong economic shocks. The policy has larger impact on the economy.

Therefore, statutory reserve requirements should not be adjusted at any time, lack of flexibility. (Explain on reserve requirement, 2007) Changing the discount rate: Discount rate is the interest rate of commercial banks to the Central Bank when borrowing. Central Bank increased or decreased interest rate for commercial bank loans to limit or encourage bank borrowing, thus impact the reserve requirements of the banking system and interest rates, which in turn decides the money stock and interest rates in order to achieve the goal of macro-control.

In times of economic recession, the Central Bank reduced the discount rate, expand discount number in order to increase the reserves requirement of commercial banks and encourage commercial banks to loans, and increase the money supply through the multiplier effect of money, lower interest rates to stimulate investment demand, expanding aggregate demand, and finally the elimination of the economic recession and unemployment.

Conversely, in times of economic inflation, Central Bank to raise the discount rate, commercial banks is needed at a higher price to get the loans from the Central Bank, which will raise discount rates to customers or increase loan rates, the result will make the credit volume shrink, reduction in money supply in the market, and finally the elimination of inflation.

The advantages of discount rate are: Central banks can be used to perform the functions of the lender, and certain extent reflect the policy intention of Central Banks, which can adjust the amount of money, and can adjust the credit structure, impacts on a country’s economy is relatively moderate. It is in favors of a country’s economy stable. Discount rate policy limitations include: first, if the discount rate is too high, commercial banks would not go to the Central Bank to rediscount, and via another channels to funds.

The Central Bank cannot compel commercial banks must to discount from the Central Bank, so the Central Bank in a passive position; Second, such as in times of high economic growth rate, there are very difficult to curb commercial banks to discount or borrowing from the Central Bank’s no matter how high of discount rate; Third, the rediscount policy of Central Bank lack flexible, because it will cause fluctuations in market interest rates if often adjust the discount rate, so that enterprises and commercial banks at a loss. ( Explain on discount rate, 2011) Open market operations.

Open market operations refer to a policy tool of the Central Bank to buy or sell government bonds on the open market to regulate reserves of commercial banks, thus adjust the money supply and interest rates. Open market operations are the most adopted tool of monetary policy in developed Western countries. Open market operations, the Central Bank according needs of monetary policy and the economic situation, choose the best time to buy or sell treasury and government bonds, to increase or decrease the money supply of the community.

For example, when you lack of funds in financial markets, Central Bank buying securities to put on the basis currency to the community, increase the money supply of the community; And vice versa. As a general tool of monetary policy, open money market operations with several important advantages: first, compared with discount rate policy, Central Bank control initiative on open market operations, size and scale of its operations fully controlled by the Central Bank. Second, open market operation less shock to economic compared with reserve requirement policy.

But open market operations inevitably exists limitations: first, slow conduction mechanisms, the impact can be effective over a period of time. Second, need premised on more developed securities markets. If market development is not enough, too few trading tools will constrain open market operations results. Third, when commercial bank’s actions are not in line with the Central Bank’s monetary policy, open market policy could not be brought into full play. (Describe the function of open market operation, 2007) In the final analysis, Central Bank monetary policy tools play a key role to control the State macro-control and inflation.

Appropriate use of monetary policy tools can be regulated the relationship between money supply and money demand under specific circumstances. The Central Bank is one and only institutions which issue currency. It plays a most important role in the community. Question2: Discuss critically what will happen to the inflation rate of the countries that join a Monetary Union and adopt a common currency such as the Euro. Inflation is a monetary phenomenon, money circulation more than actually needed in the amount of money that will caused by devaluation.

Inflation and price rises are different sectors of the economy, but has a certain link, most direct inflation is the caused price rises. (Inflation Rate, 2011) Inflation rate is the currency of excess part compared with the actual amount of money required to reflect levels of inflation and currency depreciation; in economics, the inflation rate is a measure of inflation. The main tends of International is monetary integration. Regional monetary integration is the important content and component of the reform of international monetary system.

It refers to in a certain area of the relevant countries and regions to coordinate and integrate the monetary and financial field to build a unity, and ultimately achieve a goal of unified monetary system. Its ultimate goal is to establish a unified monetary authorities issue a single currency, the implementation of the single monetary policy regional Monetary Union. (Background of Monetary Unions, 2011) Since the 1970 of the 20th century, along with the dissolution of the dollar international monetary system and the strengthening of regional economic integration, monetary integration trends are becoming evident.

There form a variety of regional currency in the area of international financial organizations. But judging from the degree of monetary integration, the European monetary integration is the more effective. (System of EMU, 2009) Facts show that European Central banks have been struggling to suppress inflation via various ways, and achieved results. So join in EMU will not be caused inflation rate change, such as European area.

It has many advantages: from the perspective of economic interest, a unified currency will bring the following benefits to EU: Enhance its economic strength and enhance our competitiveness; reduced internal contradictions, to prevent or defuse financial risks; simplify circulation procedures, reduce costs; increasing social spending, stimulate business investment. After the implementation of the common currency, not only saves huge amounts of transaction costs, and get best preparation for talent, capital, technology and resources, thus to obtain maximum economic benefits.

According to preliminary estimates, double its volume of trade within the single currency will make Europe very soon, even to the original 3 times. Second, help against the economic crisis of the EU, and win huge strategic interest for the EU. In the long term, the EU’s economic strength, fiscal balance, the balance of payments surplus, a stability-oriented monetary policy, the Euro has conditions which become a strong currency. Again, use of the euro not only promoted economic integration in Europe, but also promoting social culture of European integration.

Common currency be used in a borderless environment that allowing better exchange, discussion and expression. This can be seeing Euro naturally become the new driving force for promoting European integration. (Costs and Benefits of Monetary Union, 2009) While the common currency have brought many benefits to Member States, but the Euro also face many challenges. 1. Fiscal policy challenges Number of countries debt and fiscal deficit developed strict standards, but their control of the country’s fiscal policy by the Member States, coordination difficulties, this has two major problems.

This situation will cause coordination difficulties, this has two major problems. First, the Member States is difficult to deal with asymmetric shocks. So-called asymmetrical shocks refers to a specific country or sector economic shocks (such as war, natural disasters, worsening terms of trade, financial crisis, the oil crisis), due to the adverse economic impact, and other countries or sectors are not synchronized, that is not symmetric, that represent special economic policy adjustment is needed.

If asymmetric shocks came and other States did not form the EMU, that can use monetary policies such as adjust exchange rate and interest rate policies, fiscal policy. In the case of Monetary Union, because loss of monetary policy tools and financial policy measures is restricted, this country-specific or sector there will be serious economic problems. Second, the Governments of Member States appear pro-cyclical fiscal policies behavior and tendencies. In accordance with Keynesian economic theory, fiscal policy should be counter-cyclical. There need implementation of tighter fiscal policy in prosperous times to prevent

overheating of the economy; in recession times, implementation of expansionary fiscal policy to stimulate economic growth, so as to maintain economic stability and development. However, in the EMU, there are no restrictions on public spending and tax cuts in economic prosperity times, in the economic downturn times, the “Maastricht Treaty” forced Governments to reduce expenditure and increase tax revenues to meet budget deficit of not more than 3% of gross domestic product requirements. It is contrary to Keynes counter-cyclical fiscal policies. 2. Monetary policy challenges In terms of monetary policy, there are four major problems.

First problem is lender of last resort. In a sovereign State, the central banks to take on the role of lender of last resort; it has the responsibility to guarantee the liquidity of national payment systems. The country’s monetary resource of stock is the physical basis and final guaranteed. In name, lender of last resort is the European Central Bank in the euro zone, but “Maastricht Treaty” does not empower this right to European Central Bank, even if the European Central Bank is authorized to bear the responsibility, but also impossible to be shouldered the heavy responsibility because of their own capital and less reserved.

In fact, the Euro zone has no real lender of last resort; lender of last resort absence will weaken the Euro in the event of a liquidity crisis. Second problem is the financial regulation. Euro area lacks a unified central authorities on the regulation of the financial system, the European Central Bank under the “Maastricht Treaty” has certain regulatory functions, but the main regulatory powers assumed by the national central banks. This means that when it does happened financial crisis within the Euro zone, the solution to the problem will be very difficult, can hardly guarantee a fundamental stability of the Euro area financial system.

Third, the division right of monetary policy. In accordance with the “Maastricht Treaty”, European Central Bank independent to implement monetary policy, but the exchange rate determined by the Council of EU Finance Ministers. Fourth, the European Central Bank and Euro zone monetary policy decision making lacked purpose. (Challenges for monetary policy in Europe, 2003) If the Union Member States is not take measures to suppress inflation rate after use common monetary, then the inflation probability is much higher than before.

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