Exchange Rate Regimes: the Central Bank - Assignment Example

Exchange Rate Regimes: the Central Bank 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 lead to a rise the money supply because the bank reserves’ demand causes an open market purchase as the government, through the central bank, raises government funds target. In order to keep the federal funds rate at the target rate, the supply will increase (Mishkin, 2007). This is illustrated in the figure below: Market federal funds rate Discount rate Target Rate Reserve Demand Deposit rate Reserves (Q) From the figure above, when the demand for bank reserves increases, the demand curve represented by the red curve will shift to the right. As a result, open market purchase of the reserves increase. The government buys bonds in through open market operations in order to increase the amount of non-borrowed reserves (Mishkin, 2007). The vertical portion of the demand curve will also shift to the right in order to keep the federal funds at the federal reserves’ target rate. In this regard, the federal government injects money into the economy by purchasing bonds from the public, and money supply will increase. Therefore, it is clear that the main reason why an increase in demand for reserves leads to a rise in the money supply when the central bank has an interest-rate target is because the central bank will buy bonds through the open market operations as a way of achieving the target federal funds rate, causing the amount of money in the economy to increase. II. The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs? One of the costs of central banks’ lending to banks is that it causes banks that deserve to go out of business to continue operating through federal discounting (Mishkin, 2007). In this case, the Central Bank offers credit to banks that are almost collapsing due to the mistakes of management, in order to eliminate panic and prevent the collapse of those banks. The cost incurred in this case is that the central bank supports poorly managed companies, and instead of going out of business, such banks continue their poor management practices and cause mismanagement of funds of the public and the Fed (Mishkin, 2007). This causes waste of resources in the economy, which is essentially costly for the federal government to support. Poor management causes inefficient banking systems, and if the collapse of such banks is prevented through rediscount operations, then the cost of losing essential financial resources is inevitable. The second cost of the rediscounting operations is that it causes negative signal conveyed about the back to other banks, investors and liquidators. If these groups of stakeholders realize that the bank has borrowed from the central bank to avoid bank panic, they lack trust in the bank, causing confidence and support for the bank to decline significantly (Mishkin, 2007). The bank may lose its customers and investors, causing financial losses that would be provided by the lost customers and investors. This fear of banks that they may create a negative signal for borrowing from the central bank is referred to as stigma. 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. Open Market Operations is the most powerful and the most flexible tool of Federal Reserve used to control money supply. It enables the central the Central Bank to adjust the level of reserve balances in the financial market in order to offset seasonal, cyclical or permanent shifts in reserve balances’ supply and affecting the short-term interest rates (Mishkin, 2007). The Open Market Operations is also the most effective tool because it influences the level of reserve balances directly. OMO is easily reversible because a temporary purchase in open market operations can be reversed, especially if the central bank makes a mistake in conducting an OMO. If the central bank realizes that it has made too many purchases leading to a low federal funds rate, it can easily correct that by conducting new open market sales (Mishkin, 2007). OMO can also be quickly implemented because there are no administrative delays. The discount lending is not as effective as open market operations but its effectiveness depends on whether the demand curve cuts the supply curve at the in the vertical section rather than the flat section (Mishkin, 2007). It is effective because it helps in bank panic, but its effectiveness is affected by the costs involved, including helping banks with management problems. Discount lending is not effective in achieving its objectives in this case. This method is also not easily reversible because once credit has been offered to banks through the discount window it is not easy to reverse. In terms of implementation, discount lending is not quickly implemented because it takes process for banks to apply for discounting and the central bank to investigate. Reserve requirements are powerful and effective in influencing money supply and interest rates. However, it is not easily reversible because it takes time for the decision of changing reserve requirements by the central bank to be agreed. It is also inflexible and takes time to implement because it involves administrative process to implement. Question 2: International Finance and the Exchange Rate I. How can a large balance of payments surplus contribute to a country’s inflation rate? Balance of payment surplus occurs when there is a higher amount of receipts than payments in international transactions. This means that a country experiences an increased value of the local currency increases and the foreign exchange rate decreases (Mishkin, 2007). Inflation is the state of general rise in price levels within the economy. One of the causes of inflation is increase in money supply in the economy. A balance of payment surplus causes inflation in the economy through the actions used by the government through the central bank to finance the surplus in foreign exchange rate markets. A balance of payment surplus can therefore contribute to the country’s inflation rate because it affects the country’s exchange rate. A balance of payment surplus can be financed by selling the country’s currency in the foreign exchange market in order to increase its exchange rate in the foreign exchange market. This ensures that the country gains international reserves. When the currency is sold to the foreign exchange market, it means that the central bank supplies its currency in the economy, causing a rise in monetary base (Rodrik, 2006. This causes an increase of money supply and a general rise in price level in the economy, which is a source of high inflation in the economy. In this case, foreign exchange rate affects money supply and inflation rates through the monetary policies of the central bank. 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? Money supply is usually affected by the actions of the central bank or intervention of the central bank in financial markets and the economy in general. In a pure flexible exchange rate system, foreign exchange market has no direct effects on the monetary base and money supply because the central bank has no intervention in a pure flexible exchange rate system (Fischer, 2001). In this case, international reserves that could have otherwise affected monetary base and money supply do not change. International reserves are the assets held by central banks in different reserve currencies in order to back its liabilities. They affect the monetary base because they can be used to influence local currencies and cause changes in monetary supply (Carbaugh, 2012). However, without the intervention of the central bank, e.g. in a purely flexible exchange rate system the central bank cannot influence the change of the reserve and the supply of domestic currency cannot be influenced. In purely exchange rate system the market forces of demand and supply of currency in the foreign exchange market affect the amount of international reserves, and monetary policy has no influence. Despite the lack of influence of central bank intervention on monetary base and money supply in a pure flexible exchange rate regime, the foreign exchange market can have an impact on monetary policy. Monetary policy can be affected by the foreign exchange market because the central bank and monetary authorities of a country may influence exchange rates through changes in the money supply and interest rates (Fischer, 2001. OMO, discounting operations and reserve requirements can be used to increase or decrease money supply and interest rates, leading to changes in foreign exchange rates. III. What are the main benefits and costs of monetary union? What are the main criteria for the optimality of a currency area? One of the benefits of a monetary union is that it enables members of the union to maximize economic efficiency (Ricci, 2008). In this case, it enables member countries to use single currencies to make economic commercial exchange. This causes exchange to be easier and efficient in terms of resource allocation and usage. Decisions made in the monetary union regarding financial dealings among member countries, making economic dealings more efficient and optimal. Another benefit is that it does not allow for more exchange rate between members because a single currency is used, leading to higher competition, lower prices, price transparency, fewer transaction costs, low uncertainty of exchange rate, and increased international investment (Ricci, 2008). It also allows for greater economic unification, higher levels of political integration and increased global status. In terms of costs, monetary union may lead to increased economic fluctuations, mismatch between monetary policy and individual needs of a country and budget deficits. Monetary union may also cause moral hazards as a result of legislation and implementation of government budgets (Ricci, 2008). A country may also lose its identity and culture through a monetary union. The criteria for the optimality of a currency area include: labor mobility, capital mobility, wage and price flexibility, risk sharing system and similar business cycles. In terms of labor mobility, the ability of goods, workers and rights to move from one country to another causes the need for optimality of a currency area (Ricci, 2008). Capital mobility and flexibility of prices and wages ensure that the demand and supply forces in the market causes effective distribution of goods and services. Automatic fiscal transfer mechanism is also important to allow for the redistribution of money to key sectors of the economy. References list Carbaugh, R. 2012. International Economics. Cengage Learning. Fischer, S. 2001. “Exchange rate regimes: is the bipolar view correct?” Journal of Economic Perspectives, Vol. 15, pp. 3-24. Mishkin, F., 2007. “Everything You Wanted to Know about Monetary Policy Strategy, but Were Afraid to Ask”, in F. Mishkin, Monetary Policy Strategy. MIT Press, Massachusetts. Ricci, L.A. 2008. “A Model of an Optimum Currency Area”, Economics: the Open-Access, Open-Assessment E-Journal, Vol. 2, No. 8, pp. 1–31. Rodrik, D. 2006. “The social cost of foreign exchange reserves”, International Economic Journal, Vol. 20, no. 3, pp. 253-266. Read More