Financial Innovations and Monetary Policy - Term Paper Example

FINANCIAL INNOVATIONS AND MONETARY POLICY [Insert al Affiliation] Question The financial system in the contemporary hi-tech society developed through years of incessant innovations to be what it is today. What started as an archaic barter economy where cumbersomeness in trading and inefficiency due to the need of double coincidence has undergone incarnations which saw the evolution of currency money (Mishkin, 2009). With new developments and unabated innovations, many people are considering it outmoded for cash to exchange hands, a reason that is compelling many people to anticipate a cashless society. The farfetched penetration of debit and credit card into the economy was seen as a major step as this was believed to significantly curb the risks associated with carrying cash and eliminate the losses incurred by investors due to destruction of money as a result of losing cash or fire epidemic. Use of cash is also dispirited due to the continual problem of counterfeiting and the often contested argument that it makes it easy for criminals such as prostitutes and drug dealers to conduct business (Mishkin, 2009; Goodhart, 2000). While the prognoses for the eradication of cash have demonstrated to be quite challenging, the boom in internet shopping has sent a clear signal to futurists that the cashless society is almost becoming an overpowering reality which will present its benefits and drawbacks to consumers and banks, particularly when the whole concept of monetary policies is taken into consideration (Goodhart, 2000). Many developed economies are presently striving towards an economy where cash will be minimal and e-money, which in its broadest sense is electronic money often exchanged electronically through technical devices including mobile handsets and computers, is also significantly reduced (Goodhart, 2000). A cashless society implies that coins and currency will be absent but that does not imply a backward development towards barter system, but rather a development towards a society with widespread use of EFTS (Electronic Funds Transfer System). In the US, for instance, only 7% of transactions are in cash as over 90% of transactions are sealed via e-money (Palley, 2011). Apparently, these transactions are low-value transactions involving only small amounts of money. People have accepted EFTS, and it is not surprising that organizations have been forced to use EFTS to remain competitive. However, as the move towards a cashless economy proceeds incrementally, it raises significant issues with regard to monetary policy, the consumer, and payment system threats. Under the monetary policy, moving towards a cashless society will ominously erode the connection between the traditional measures of transactions and money in a real economy. It will be more difficult to measure the transactions and money in the economy a factor that may destabilize the money demand linkages. Consequentially, central banks will lack a proper way of implementing monetary policies since there will be no cash and paper which the central banks currently varies their demand and supply to stabilize the economy. While a cashless system will ensure the safety and efficiency of local and global markets, the challenges it possess to central banks might see the collapse of some economies either due to excessive or inefficient money in supply as the definition of money must also be amended in such a system (Palley, 2011). Central banks will consequentially lose their meaning if they are not in a position to control money supply and demand. Inflations and the vicious cycle of poverty will go on unabated. A cashless system also presents imperative consumer issues that need to be addressed (Goodhart, 2000). In many countries, government bodies or departments, such as the Federal Reserve in America, have the responsibility of formulating and implementing protocols concerning electronic payments. Presently, the rights and duties of participants in prepaid cards, ATM-debit arrangements as well as credit card systems are ostensibly outlined (Mishkin, 2009). Adoption of a new payments system will necessitate the reexamination of the current policies and regulations, a factor that might prove to be a costly undertaking for central banks and eventually delay the attainability of the anticipated cashless society. Similarly, in a world of e-money, the access to payment systems to consumers who do not own bank accounts becomes a challenging factor. The banking system will have to devise ways through which everybody will easily access the payment systems as this is presently lacking. What’s more, the move towards e-money and a cashless society raises the question of who should have access and operate the payments system. According to Palley (2011), central bankers and bankers often claim that they should be allowed to maintain the regulation and control of the payments system. However, with the influx of new technologies, it will be difficult for banks and central banks to retain the control. Development of regulatory frameworks that keeps the necessary progresses including the electronic purse within the banking system will be exceedingly challenging. Thus, the regulation of the cashless society and use of e-money will present a major challenge to banks and central banks. However, I believe that a cashless society is still important and indispensable. Thus, rather than fighting the move towards such a society central banks and banks should strategize on how such an economy will operate before it becomes fully functional. Standardization of regulatory frameworks should also be considered. Question 2 The independence of the central bank usually has both positive and negative effects on inflation. However, this independence is sometimes undermined and affected by the economies with politically inferior institutions (Mishkin, 2009). A (seesaw) balancing effect is recognized in such cases where the fiscal and monetary policies worsen following the independence of the central bank and institutional reforms that are of necessity in the economic theories both in developed and developing countries (Mishkin, 2009). In contrast, some policymakers may form unfavorable trade policies, hyperinflation or deficit budget because of the thought that this will steer the economy upwards (Grilli, 1991). In most cases, adverse policies are adopted due to economic constraints and defamatory rewards to politicians in economies with weak financial policies and institutions. These flaws lead to incision of costly economic policies that are just beneficial to greedy and selfish politicians (Mishkin, 2009). For instance, reformation of the policies and change in method of operations of the institutions may promote economic growth and development mostly in developing economies. The reforms usually comprise of the open trade, reforms to the judiciary, privatization, easing of trade barriers, tax Reformation, changes to judiciary and the overall independence of the central bank (Mishkin, 2009). The introduction of central bank independence in most economies has helped to curb the inflationary rates and achievement of the economic goals, that is, price stability, full employment and the favorable balance of payments and trade (Mishkin, 2009). Analyzing the empirical evidence on the central bank independence have effects on inflation reduction though the effect is usually negligible or entirely absent in third world countries evident by their fragile political establishments. In comparison, there exists a bigger impact of the reform on economic stability and inflation control in economies with transitional political establishments. This model is commonly active to diverse methods of measurement of the independence of the central bank and the political afflictions and insertion of a variety of controls (Berger, 2001). It usually postulates that, consistency of public expectations on the basis of economic-political situation standpoint; there exist vital interrelations amid political establishments and success of these institutional reforms. Additionally, the balancing (seesaw) effects postulates and validates that the independence of the central bank is commonly in association with the economic development and the reduction of the inflation rates in combination of rising the government spending (Berger, 2001). On the other perspective, resistance by politicians against the reformation of the economy to favor a particular financial period will negate the benefits that can be derived from these reforms. However, this may fail to imply monotonic efficiency of political establishments its success in the reforms (Berger, 2001). Therefore, the interrelationship that exists between the efficiency of reformation of the policies and politically established institutions fails to be monotonic (Grilli, 1991). There is usually an expectation that the transformation of the policies will likely to be useful if the systems in the political establishments are feeble and a trial to reform will substantially be undermined and thus have no favorable impact on the economy. In conclusion, the fundamental economic, political hypothesis postulates that the reformation of the policy is only effective if the political condition is correct. In case this situation fails to be right and promotes political restraints and responsibility methodology so as to have a strong predisposition for adoption of good and favorable economic policies, then there occurs an insignificant room for reformation macroeconomic effects on price stability, favorable balance of payments, and full employment among others (Berger, 2001). On the other hand, if case the predisposition is awful that the political condition and policymakers fail to be representative then the reforms will likely be immaterial and irrelevant and can just be demoralized and curtailed (Grilli, 1991). Sometimes policymakers often employ other instruments that are distortionary to gratify similar political institutions that were served by influential politicians served up by the preceding alterations (Berger, 2001). Another vital lesson to learn from an economy that is characterized by politics is that it has firmly been criticized especially from a consensus held in Washington DC which suggested that these diverse reforms failed as a result of inadequacy and lack of correct remedies to deal with developing nations (Berger, 2001). Another point of discussion is that they in most cases fail due to their implementation in the condition of the similar politically economic upheavals and incidences that contributed to the alterations prior to their implementation. These conditions negate the various reforms that have been put in place by policymakers either indirect method or in the effects postulated in seesaw methodology or indirectly via the usage of substitute procedures and instruments. Question 3 For an efficient financial market to exist, banks must operate effectively by providing a clear risk assessment, proper lending and information requisite in economic investment. Governments have had an ostensible understanding of this even before the occurrence of the 2007/08 economic crisis and many blamed the protection of some banks that are considered to be “too big to fail” (TBTF) as a major cause of the crisis. The concept of TBTF is often met with applauses and condemnations on equal measures, but this has not prevented governments from protecting some financial institutions. The concept of TBTF became common in 1984 after being popularized by Stewart McKinney, a U.S. Congressman, in a conference that was convened to discuss the federal government’s bailout of the Continental Illinois (Hetzel, 1991). According to Hetzel (1991), the theory, some financial institutions are extremely enormous, interconnected and critical in the economy such that the failure of such institutions will result in an economic disaster. They must, therefore, benefit from economic and financial policies from central banks and governments whenever they are faced with possible failure so as to protect and preserve them from failing. Since the failure of such institutions will torpedo the economy, under the TBTF policy, the federal government must not allow the failure of such institutions and must instead provide a safety net to curb the perils (Mishkin, 2006). Protection of the banking system ensures that securities transfers, payments of services and goods, as well as transnational cash flows are safe from every deleterious effect. While the TBTF is often perceived to be a costly policy, those in favor of the policy present reasons why governments should continue protecting large financial institutions. Firstly, the benefits of prevention of the failure overshadow the cost of trying to restore a destabilized financial market that results from systematic risks (Zhou, 2010). If the government allows a large financial institution to fail, other financial institutions, and in extreme cases the entire economy, might fail. Investors will shun the economy every institution will find it exceedingly difficult to survive (Hetzel, 1991). The cost of restoring the economy or the financial system will be costly than the cost that the government would have incurred in protecting the institution. Secondly, the credit allocation to large financial institutions increases the welfare of the society in the long-run. Huge financial institutions expand their credit allocation capacity after receiving help from the government. This protects investors from imminent losses, makes it easy for small firms to acquire credit for expansion and improvement of productivity (Zhou, 2010). Consequently, employment increases and the availability goods and services increase contributing to the improvement of social welfare (Mishkin, 2006). If the government allows huge financial institutions to fail, small-scale businesses which have no alternative source of financing will inherently fail leading to a deeper, disheartening crisis and volatility. Moreover, TBTF allows banks to borrow on auspicious terms and function at a better leverage. The financial and economic stability and quick development that mushrooms from this has often seen policymakers striving to bail out the large financial institutions. Moreover, policymakers are bailing out financial institutions as a fundamental way of increasing public confidence and avert moral hazards (Hetzel, 1991; Mishkin, 2006). However, TBTF has its negative consequences which often make many people argue against it. Firstly, the TBTF concept creates the moral hazard which implies that banks operate carelessly as they are aware that their risks will be handled by the government. Since banks are protected from the bad outcomes of their actions, they result in taking more risks by failing to properly evaluate the creditworthiness of borrowers, giving more unsecured loans, and poor assessment of investment risks which increases the possibility of failure (Mishkin, 2006). The lack of proper assessment of creditworthiness and appropriate systematic risks evaluation criteria increases fraud and embezzlement which may not only result to the failure of the bank, but also disproportionate development. Moreover, the bailing out of financial institutions presents an extra cost to the struggling public. It leads to increase borrowings, an upsurge in taxes, or even result in the need to print more money which might fuel inflation (Zhou, 2010). These effects are borne by the present and future generations, and might forever be an impediment to individual’s economic prosperity. Similarly, bailing out banks creates the impression that the cost of failure will be borne by the entire society while profits are enjoyed individually. Banks may take more risks thus destabilizing the economy in the long-run (Hetzel, 1991). Apparently, TBTF results in unfair competition in the financial system as banks protected by the policy are less sensitive to risks and can undertake opportunities often avoided by small banks since they know that they are protected against failure. Consequently, small financial institutions find it extremely hard to survive and are liquidated, a rather devastating economic scenario. Question 4 The crisis that occurred from 2007-2008 is commonly referred by many economists as a crisis that affected all the nations globally, whether developed or underdeveloped, and is considered to be the most horrible after the economic upheavals of 1933 prior to the WW2. This crisis was characterized by massive unemployment, economic instability, price instability and general unfavorable balance of payments and trades (Kimball, 2013). Additionally, bank failures and drop of the stock rates was also evident in this period and therefore required fiscal in combination of monetary policy intervention to address the problem. The global crises was caused by a multifaceted interaction of diverse policies that trigged home tenure, promoting greater accessibility to loans to the borrowers, overvaluing mortgages on the basis of methodology that prices of the houses would escalate continually, dubious trade practices, inadequacy or total lack of holdings of the capital among others (Kimball, 2013) Questions about solvency of commercial banks and other financial institutions, demise of availability of credit facilities and self-assurance of investors still lingered in the minds of police-makers worldwide especially in OECD economies. This crisis is evident to have been caused by financial deregulation and corporate governance failures. Immediately after the financial crisis (2007/08) fiscal policies in combination with monetary policies were adopted to solve the situation and stimulate the economic development and growth that had been previously been distorted (Kimball, 2013). This encouraged the central banks of the OECD economies to reduce their interest rates greatly and their lending facing, that is, the Lombard facility and application of the OMO which are expansionary policies thus leading to increase in productivity levels hence increasing the aggregate demand in the direction of restoring the economy at full employment and acceptable rate of inflation (Kimball, 2013). The vital linkage between the money and good market needed to be promoted after the aftermath of the financial crisis to determine the level of the output in the commodity market and cash market hence determining the level of transactions and therefore affect the money demand in the market for money (Mishkin, 2009). Additionally the rate of interest which was to be determined after this crisis was to be set to be favorable to achieve the macroeconomic goals of the economies. In our discussion, there usually exists an indirect relationship amid the investment which is planned and rate of interest as a result of this rate of return determining the expenses of projects for investments (Bennett, 2009). After the crises, these projects were to be encouraged to encourage productivity which in turn promotes improvement on the aggregate demand and thus raising the employment rate therefore solving the massive unemployment problem that was persistent in this crisis. For instance, the USA after this financial crisis together with other European nations that form OECD steadily increased their government expenditure in combination with reduction of taxation rates which are considered contractionary fiscal policies to solve their economic woes. (Kimball, 2013)Additionally expansionary OMO were employed which are the fundamental tools of the monetary policies in which the government purchases its securities via the central bank thus more money in circulation for either investment or consumption. As a result of increase in money circulation the monetary base of the economies especially for OECD will thereby greatly improve more output, greater employment but inflation will rise as inflation and employment are usually inversely related. Also, the expansionary OMO through purchase of securities will push the central bank rate downwards below the equilibrium rate of interest. This usually makes the central bank to offer loans at a reduced rate thereby more money in circulation for lending. During this period, fiscal operations that were employed by the federal government and OECD governments affected the rate of interest afterwards. This can be argued by the application of the Keynes theory in his writings that shows and advocates for government intervention to solve the economic woes comprising of rampant unemployment and price instability. According to J.M Keynes the state government should consider a significant reduction in taxation and increase its expenditure. Use of policy-mix could address the problem if used appropriate and if the policymakers fully have understood the problem and the best solution to address the incidence. In this, according to followings of teachings of Keynes the economy would therefore start recovering afterwards (Mishkin, 2009). This in another case will make the central bank reduce its interest rate to encourage more private spending as the individuals have more disposable income to finance their daily transactions and therefore the advice to be offered by the government is to consider enhancement of sound economic policies to deal with crisis. Reference List Bennett, T. mcMallum (1989). Monetary Economics: Theory and Policy. Macmillan Publishing, New York Berger, H., de Haan, J. and S. Eijffinger, (2001): “Central Bank Independence: An Update of Theory and Evidence”, Journal of Economic Surveys, Vol. 15 (Issue 1), 3-38. Goodhart, C. 2000: “Can Central Banking Survive the IT Revolution?”, International Finance, Vol. 3 (Issue 2), 189-209. Grilli, V., Masciandaro, D. and G. Tabellini, (1991): “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries”, Economic Policy, Vol. 6 (Number 13), 341- 392. Hetzel, R. 1991: “Too Big to Fail: Origins, Consequences, and Outlook”, Economic Review, 3- 15. Kimball, M., (2013): “Breaking Through the Zero Lower Bound”, mimeo. Mishkin, F. (2009): The Economics of Money, Banking, and Financial Markets, 9 Edition, Addison-Wesley, chapter 15. Mishkin, F. 2006: “How Big a Problem is Too Big to Fail? A Review of Gary Stern and Ron Feldman’s Too Big to Fail: The Hazards of Bank Bailouts”, Journal of Economic Literature, Vol. 44 (Number 4), 988-1004. Mishkin, F. 2009: The Economics of Money, Banking, and Financial Markets, 9 Edition, Addison-Wesley, chapter 3. Mishkin, F., (2009): The Economics of Money, Banking, and Financial Markets, 9 Edition, Addison-Wesley, chapter 16. Palley, T. I. 2001: “The e-money revolution: challenges and implications for monetary policy”, Journal of Post-Keynesian Economics, Vol. 24, 217-233. Zhou, C. 2010: Are Banks Too Big to Fail? Measuring Systemic Importance of Financial Institutions. Read More