Monetary Mechanism and Western Banks - Essay Example

Monetary Mechanism and Western Banks Contents Contents 2 Introduction 3 Discussion 3 The Monetary Policy 3 Approaches to the Monetary Transmission Mechanism 4 Inflation flexibility 4 Risk management 4 Quantitative Easing 5 Lower Interest Rate Mechanism 6 Episode of Low Interest’s Rates 7 Western Central Bank Experiences and The Effectiveness Of Monetary Policy 8 Conclusion 9 Reference List 10 Introduction Monetary economics is a distinct segment of macroeconomics that presents a framework to understand the importance of money in the economy. The concept of monetary economics is built on the ground of demand and supply of money as well as nominal and real interest rate. Monetary transmission mechanism is distinct segment of this monetary policy which signifies how changes in interest rate may affect inflation and other economic activities. The monetary transmission mechanism operates through the consequences that monetary policy has on exchange rates, bank lending and interest rates. The Bank of England which is the central bank of United Kingdom has paved the way to all the modern central banks worldwide regarding policy formulation and money mechanism for controlling the sustainability of the economy. In this paper, the monetary policy taken by the governments and central banks will be analysed in the light of monetary transmission mechanism and the recent incidents of Western central bank will be discussed for understanding effectiveness of the monetary policy. Discussion The Monetary Policy Monetary policy indicates the guidelines that a government and central bank of a country formulate in order to control and maintain stable economic and financial positions of the country. The main agenda of monetary policy is to accelerate economic growth by controlling money supply and this is achieved by keeping parity between inflation and interest rate. The monetary policy of United Kingdom formulated by Bank of England aims to maintain the balance between the level of consumer spending and aggregate demand through controlling interest rates. The policy formulators also seek to control the consumer price index to keep it within a limit of 2% (+/-1) in order to manage the macro economic variables such as unemployment and inflation. The Monetary Policy Committee (MCP) of Bank of England who formulates the postulations related to UK monetary policy acts independently for setting the interest rates. However, this governing body is bound to devise the variables in such a way that it becomes able to meet the inflation target set by government. In the post 2008 period, when the world including United Kingdom experienced severe economic downturn, the Bank of England introduced Quantitative Easing to stabilize the monetary policy of the economy (Howells and Bain, 2012). Approaches to the Monetary Transmission Mechanism Approaches to monetary transmission vary according to the requirement of the transmission. On various occasions, official interest rate decision influences the market rates. Such changes affect the consumption, spending as well as investment- savings pattern of individuals in the economy. Apart from all these, exchange rate movement, aggregate demand, domestic supply and state of labor market influence the approaches to the monetary transmission. Inflation flexibility The monetary policies, post recession were targeted towards remaining adequately inflation flexible. Inflation factors cannot be ignored since they are an essential part of the economy and it radically impacts interest’s values. This creates issues in respect of determining how the monetary policies should be targeted towards handling inflation. The U.K monetary policy has framed by targeting a monetary policy which is between 2% to 4%. It is essential to formulate monetary policies which are less influential upon the real interest’s rates and the existing price levels of commodities. Risk management The U.K monetary policies have been formulated in a manner such that timely actions can be taken according to the fluctuations which occur in the economy. Risk management involves analysing the market conditions and accordingly allowing policy makers to make shifts in different rates and reformulate and introduce new monetary policies so that financial markets operation remain stabilized. It is essential for the regulatory authorities to understand the prevailing economic conditions and accordingly make changes in policies so as to avoid conditions such as lack of liquidity and high interest’s rates. (Lysandrou, 2012) Quantitative Easing In simple words, quantitative easing is the process of introducing new money by the central bank into the economy (Goodhart, 2008). Central banks tend to promote the lending activities through lowering the interest rate in the economy. A lower interest rate discourages the savings intention of individuals and corporate and leads to increase the spending potential of them. However, when the interest rate cannot be lowered after a certain level, the only choice the central bank has is to inject fresh money into the economy. This process is known as quantitative easing. The process takes place with central banks buying assets such as government bonds from investors to increase the liquid cash in the financial system (Lavoie, 2010). The monetary transmission mechanism emphasizes the system that describes how short run nominal interest rate influences the real variables of the economy as a result of policy induced changes in nominal money stock (BBC News Business, 2014). Explicit channels of monetary transmission lead to operate interest and exchange rates in such a way that these will tend to maintain the macroeconomic equilibriums. With the initiative for quantitative easing, Bank of England initially pumped £75 billion of fresh money in the economy. For the purpose of infusion of money uniformly in UK economy to recover the financial health of the economy, the central bank estimated worth £200- £300 billion of bonds at the end of 2009 to enhance the economic output up to 2%. According to the central bank of UK, this decision of quantitative easing was “economically significant” in the process of recovery of the UK economy (Bank of England, 2014). (Joyce, Tong and Woods, 2011) However, the requirement of fresh capital further expanded up to the present level of £375 billion. The additional requirement was also met with the help of other asset purchase facilities from financial firms, insurance companies, high street banks and pension funds. In this way, the policy formulation of Bank of England stimulated the demand, helped the companies to grow and hire new talents as well (Fullwiler, 2013). Cost of borrowing was brought down to secure the interests of business and households. Forward guidance that indicates the lenders that how long they can expect the interest rate to hover around the current level was also introduced by the present governor Mr. Mark Carney to induce the economy further. Such imitative enhances the confidence level of the lenders to a great extent and alleviated the process of quantitative easing (Joyce, Tong and Woods, 2011). Lower Interest Rate Mechanism The European Central Bank and Monetary Policy Committee (MPC) of the Bank of England regulate the interest rate decisions through setting the repo rate at which commercial banks of United Kingdom borrows money from the BoE. All the savings and borrowing rates in UK economy are determined by this repo rate of Bank of England. The monetary policy meets once in every month to monitor the economic circumstances and decide whether there is any requirement for altering the interest rate. The main importance to bring changes in interest rate is the level of inflation in the economy. If the inflation goes above the targeted inflation rate of 2%-3%, then interest rates are increased to increase the cost of borrowing in order to control public spending and enhance savings (Fontana, 2003). (Fontana, 2003) This mechanism leads to reduce the incremental aggregate demand. In contrast, if the inflation rate reduces, the MPC tends to decrease the interest rate in order to enhance public spending, aggregate demand and to accelerate economic growth at large. Episode of Low Interest’s Rates The economy of U.K had not been made flexible to the interest rates fluctuations from the very beginning. Changes in the interests’ rates were seen to radically impact the economy causing liquidity issues and debt issues frequently. In the year 1930, due to certain reformulations made in the economic policies, banks had experienced liquidity issues. The economic policies of the U.K were not formulated with adequate flexibility so as to be able to accommodate the impacts of rapid globalization. The existence of low interests rates were seen to induce liquidity issues and lack of solvency of different underlying mortgage assets. However since the magnitude of the issues were not very high, it failed to gain the attention of financial regulatory authorities. Moreover the instant steps taken by the central bank had brought back the economy to normalcy. The common aspects between the 1930 economic crisis and the economic downfall of 2008 were the shortage of liquidity and low interest rates. When the global recession hit in the economy in 2008, the MPC reduces the interest rate at a level of 5%. The first rate cut was made by Bank of England immediate after the incident of bankruptcy of Lehman Brothers of United States (Fullwiler, 2013). Further cuts were initiated when the financial system ceased to exist due to fierce outspread of the economic downturn. In the beginning of 2009, unemployment rose sharply breaking the consumer confidence. Commercial banks started holding onto their funds. With the economy still in depression, the central bank had to introduce some steady measurement for the economy recovery. Hence, the company introduced the quantitative easing and monetary mechanism program in order to initiate the recovery process along with the last rate cuts to 0.5% (Bank of England, 2014). The most common among all these incidents are the central bank’s decision to mould interest rate according to the demand of the situation. This is the most effective weapon of monetary policy that leads to control inflation and money supply of the economy from time to time and helps to bring price stability. For the purpose of running the mechanism again and aging as a result of economic need, the policy makers needs to sterilize the economy through open market operations. In this way, the central bank of the country will be able to eliminate the detrimental capital inflows, control currency appreciation, inflation as well as external shocks arising out of export pressure etc in order to manage money supply within the economy. Western Central Bank Experiences and The Effectiveness Of Monetary Policy Western central banks had mainly faced the issue of rapidly declining liquidity levels. The increased default rates on mortgage loans were seen to be the primary reason for such a situation. Considering such aspects, central banks of the western nation felt the need to radically reshape the economic policies. Since central banks played a highly important role in providing finance and to keep the economy functioning normally, their financial stability was radically essential. Central banks therefore took upon the responsibility of managing the crisis by taking a number of reform measures. The primary steps taken were the reformulation of the policies associated with mortgages. This was done to bring the subprime crisis under control. Subsequently a number of measures were taken to consolidate the activities of the different central banks and to facilitate equilibrium in the European Union. The independence of the central banks was a primary change that was witnessed during this phase. It was primarily due to this independence that the central bank was capable of solving a number of issues of the economy. Central banks were seen to develop a systematic approach to the issue of sovereign debt crisis. Measure taken had slowed down the impact of the weak liquidity condition and had facilitated a slow rise in the interest rates. Purchase of a number illiquid debt instruments was the primary tool used by the central banks to bring back the economy to the normal condition. Central banks also played a key role in enforcing the policies formulated by the financial regulators. Additionally the central banks also advice the monetary authorities in respect of the manner in which the fiscal policies were set. Advice in relation of banks rate, statutory liquidity rate and open market operations were frequently provided by the central banks to the financial regulators. The central banks were also an important medium of communication between the regulatory authorities of the government and the commercial banks (Herr and Kazandziska, 2011). A number of outright policies implemented by the central banks were seen to facilitate enhancing liquidity position of the commercial banks. They also implemented a number risk management tools so that commercial banks could judge credit worthiness of firms and individuals better. Conclusion Studying the economic policies and monetary transmission mechanism, it can be concluded that the world economy has survived the severe financial and economic downturn on various occasions only due to strict monetary policies adopted by the governments and central banks of the country. Monetary transmission mechanism and its ability to break down interest rate while needed helps a country to control inflation and stabilize money supply into the economy. Different incidents sighted in the main paper; especially the steps taken by Western central banks to control their economies in the post recession period clearly indicates the effectiveness of monetary policy. If the economies can formulate their monetary policies according to prevailing financial situation, the world economy will become stronger in upcoming future. 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Joyce, M., Tong, M. and Woods, R., 2011. The United Kingdom’s quantitative easing policy: design, operation and impact. [PDf] Retrieved from: < http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb110301.pdf> [Accessed 22 January 2015]. Lavoie, M., 2010. Changes in Central Bank Procedures During the Sub-prime crisis and Their Repercussions on Monetary Theory. International Journal of Political Economy, 39(3), pp. 3-23. Lysandrou, P., 2012. The primacy of hedge funds in the subprime crisis. Journal of Post Keynesian Economics, 34(2), pp. 132-141. Read More