Financial and Macroeconomic Stability - Research Paper Example

Financial and macroeconomic stability of the Table of Contents Table of Contents 2 Introduction 3 Improved macroeconomic conditions 4 Impact of financial structure 4 Regulation and intermediation 6 Efficiency of monetary policies 6 Performance improvements 7 Conclusion 8 References 9 Introduction The past decade has witnessed a high growth in the macroeconomic conditions. Globalization of business sectors has further increased industrialization in both developed and developing nations. Inflation and real growth has been more stable now. Economists are of the view that the dramatic change in the economic conditions have occurred due to the restructuring of the financial structure. Monetary policy makers have been more accurate in their decision making and have imposed regulations which have helped in stabilizing the economy. The policy improvement suggests that there has been a rise in the proficiency of central banks of different nations. However the ability of the policy makers and financial regulators to implement different rules depends upon the control they have upon reducing inflation and output volatility. The transmission of interest rate fluctuations to output levels and prices depends upon a country’s policies regarding banking and management of financial markets. For most policy makers, in majority of the nations, controlling the interest rates in the short run is considered to be most important. Policy development and interest rate changes are however effective only when they lead to an increase the level finance available to firms and individuals who are willing to invest in projects or shift consumption. In many nations it is observed that the banking system is guarded from the impact caused by monetary policies through barriers which are created by the government (Iakova & Wagner, 2001). Monetary policy which gets transmitted to the real economy and thereby impacts the lending policies of the bank requires to be altered as they hinder growth. When the government sheds the assets of the bank, they indirectly create scope for the central banks to bring about stability in output and inflation rates. Therefore establishing a control over the assets possessed by the bank is a suitable way by which it is possible to manage the macro-economic environment. The deposit insurance system is also identified as a crucial factor in the financial regulatory system which affects the economy. The absence or the presence of a deposit regulatory system affects the readiness of bank managers to undertake risks. Subsequently the access available to firms to raise finance through equity and bonds may also get affected. Financial regulators are frequently seen to use bank loans as a tool to implement monetary policies. Therefore if firms are more dependent upon banks, then the efficient implementation of monetary policies becomes facilitated (Ahmed, Levin & Wilson, 2004). Improved macroeconomic conditions Studies conducted upon the effect of financial structure on macroeconomic conditions reveal that the implementation of regulatory policies has caused the development of a more stable economic condition globally. Most nations across the globe have experienced a reduction in the inflation rates. The variability in the level of output has also declined over the years. This indicates that the central banks of most nations have realized the importance of controlling inflation and using the same as a tool for economic growth and development. However the changes in the inflation rates and output variability are seen to vary highly between nations. The variance occurs due to the dissimilarity existing between the financial structures and the manner in which policies are implemented (Rudebusch & Wu, 2008). Impact of financial structure Central banks of all nations agree unanimously that their action affects the manner in which the economy functions and the conditions existing in the economy such as interest rates, inflation rates, exchange rates and the risk factor. Since industries operate on a globalized platform, the risks and other economic factors gets transmitted across borders, thereby affecting the economic conditions prevailing in other nations as well. Hence when central banks formulate different monetary policies to regulate the financial markets, it becomes important to consider the ripple effect such policies generate across different industries and nations. Traditional theories have focused upon the impact of changes in interest rates and exchange rates upon the economy. The modern views gives more emphasis on the lending policies of banks and states that the economic conditions are mainly affected by the availability of finance in the economy. The lending policies can be studied from two different perspectives. Firstly the impact of the changes in policies upon the balance sheet of the borrowing requires to be studied. The second perspective is mainly to focus upon banks loans and their impact on the microeconomic conditions. From both the viewpoints of analysis, it is understood that the efficiency of policies depends upon the level of imperfections existing in the capital market. Such imperfection either facilitates borrowing or hampers the same. A firm’s balance sheet plays an important role in obtaining external finance. If the balance sheet exhibits high liquidity and profitability, it becomes convenient for firms to obtain finance. A firms liquidity factors also depends upon market conditions such as access to accurate information and bankruptcy laws. The net worth of an organization gets lowered if the nominal value of interest rates is raised (Micco & Panizza, 2006). It is also seen that there exists an asymmetry in the information possessed by banks and firms regarding a given investment proposal and its profitability. Such asymmetry of information makes the internal financing option cheaper than obtaining finance through external sources. Also as the net worth of firm’s decline, their credit worthiness also decline and as a result they rely on internal finance. When projects are financed internally, the risk aspect associated with the same is considered to be significantly high. Many at times it is seen that regulatory authorities do not match the requirement of loan existing in the market with the excess deposits which banks have. When the government raises the minimum reserve requirements, it shrinks the excess reserves. It is essential, that these excess reserves are able to satisfy the need for finance existing in the external environment (Gai, et al., 2008). Regulation and intermediation Financial regulations have a considerable impact upon the functions performed by intermediary firms. Government decisions to insure banking liabilities is seen to be either through direct ownership or by way of deposit insurance. Through deposit insuring, the liability holders of banks are less likely to request returns. However insuring the deposit amounts may cause the banks to undertake low risk activities and therefore only allow the payment of lower interest rates to depositors. In this manner, money gets channeled away from the financial markets with banks as an intermediary. Direct ownership of the bank by the government also has similar impacts. If the rates of loan are not determined through market forces, it disrupts the objectives of the monetary policies. Overall it becomes clear that the changes in the involvement of the government impact the functions of intermediaries. The degrees to which banking activities are driven by the financial markets have changed considerably across the globe. Many nations consider shedding their bank assets and restructuring deposit insurance so that they are able to increase the effectiveness of the monetary policies (Alfaro, et al., 2004). Efficiency of monetary policies Economists claim that one of most effective ways of improving the affectivity of monetary policies is by combining output volatility and inflation fluctuations. Banks must establish monetary policies by considering the needs of the economy and the potential risks which may arise in the economy. The financial crisis which triggered a debt crisis in the U.K was due to the aspect that the market has insufficient liquidity. Central banks are seen to alter the rate of interest so as to monitor the liquidity. However at times, a fall in the rates may cause an increase in the demand for products and services. Hence money from banks gets trapped in products and services. If the revenue earned by firms and individuals are not aligned with the finance procured by them, it becomes difficult to repay the loans. Eventually a liquidity crisis gets developed in the economy. When banks reduce the rates of interest it becomes essential that the productive capacity of the economy also is increased. This increase the excess money available to consumers at large and also increases the profits earned by organizations. Monetary policies can move the conditions existing in the market in two directions which are either towards generating demand or increasing supply. Both rise in demand and supply must be at par with the needs of the market. Only then can it be ensured that the flow of money is continuous and productive. The objective of the regulatory authorities must be to establish policies in a manner such that they help in increasing the value of the organization. The movement of demand and supply must be such that inflation conditions existing in the market are not aggravated (Kwapil & Scharler, 2010). Performance improvements A well established financial structure exiting in the banking sector and financial markets paves way towards the development of proper macroeconomic conditions. Regulatory authorities expect that a reduction in the governmental ownership of banks and the introduction of explicit deposit insurance induces a positive impact upon the economy. Economists prefer to consider that the monetary policies induce a positive impact when the inflation rates and the output levels are stable. Regulatory authorities must also consider the aspect that organizations operate on a global platform. Hence fund flows for one economy to the other. Therefore if the economic condition of one nation is weakened, it impacts other nations as well (Park & Sehrt, 2001). Conclusion Macroeconomic conditions have improved globally alongside of the developments in the financial systems. Regulatory authorities have primarily modified the intervention of the government. Studies have shown that changes in government interventions in financial systems have caused stable economic outcomes. When the state ownership of bank assets is reduced, inflation and output volatility also gets impacted. Changes in financial regulations are brought about through different tools of the central banks. The failure of fiscal policies and the lack of forecasting were the primary reasons behind the financial crisis of 2008. Global and local phenomenons are both considered to be important aspects which influence the fiscal policies across the globe. Regulatory authorities must analyze the needs of the economy before imposing changes in the financial policies. In developing nations, regulatory authorities find it extremely challenging to maintain fiscal policies in a manner such that they not only help in controlling inflation and are also supportive of growth. Developing nations require consistent support from the central banks in order to give effect to economic growth. As a result provide financial support and maintaining low rates of interest is necessitated. However providing cheap loans may induce volatility in the existing levels of inflations causing them to rise upwards. This impacts the market negatively. Regulatory authorities are therefore required to undertake a discriminatory policy towards determining the areas where central banks must invest or provide financial assistance so that the overall economic conditions remain stable. References Ahmed, S., Levin, A. & Wilson, B. A. (2004). Recent US macroeconomic stability: good policies, good practices, or good luck? Review of economics and statistics, 86(3), 824-832. Alfaro, L., Chanda, A., Kalemli-Ozcan, S. & Sayek, S. (2004). FDI and economic growth: the role of local financial markets. Journal of international economics, 64(1), 89-112. Gai, P., Kapadia, S., Millard, S. & Perez, A. (2008). Financial Innovation, Macroeconomic Stability and Systemic Crises. The Economic Journal, 118(527), 401-426. Iakova, D. M. & Wagner, N. L. (2001). Financial sector evolution in the Central European economies: Challenges in supporting macroeconomic stability and sustainable growth. Washington D.C.: International Monetary Fund. Kwapil, C. & Scharler, J. (2010). Interest rate pass-through, monetary policy rules and macroeconomic stability. Journal of International Money and Finance, 29(2), 236-251. Micco, A. & Panizza, U. (2006). Bank ownership and lending behavior. Economics Letters, 93(2), 248-254. Park, A. & Sehrt, K. (2001). Tests of financial intermediation and banking reform in China. Journal of Comparative Economics, 29(4), 608-644. Rudebusch, G. D. & Wu, T. (2008). A Macro‐Finance Model of the Term Structure, Monetary Policy and the Economy. The Economic Journal, 118(530), 906-926. Read More