Central Bank and Monetary Policy - Research Paper Example

 Central Bank and Monetary Policy Central banks are public institutions. They are established by the government and are entrusted with responsibilities to perform specific functions in the economy. Initially, central banks were created to serve as bankers to the government, that is, manage government finances. However, over the years it added various other functions. A modern central bank also provides a range of services to commercial banks. In this regard it is the bankers’ bank. But the main reason why countries create their own central banks is to ensure control of their currency. The central bank is the only authority that can print money and such responsibility cannot be given to anyone else as the consequence may turn out to be disastrous. The role of the central bank evolved over time and the literature in monetary theory points out that central banks work to reduce the impact of economic fluctuations and to minimize volatility in the financial system. They pursue five objectives to ensure economic and financial stability. The goals of central banks are generally specified as price stability, stable real growth, financial stability, interest rate and exchange rate stability (Mankiw, 2011; Geraats, 2006, pp. 37-40). The main goal of this research project is to help understand how the central bank manages and controls the quantity of money in the economy and its relation to price stability. It also brings out the main tasks of central banks and the challenge they face in conducting monetary policy. Objectives of Central Bank: The major role of the central bank of any country in the world is to monitor the financial structure of the respective country. Central banks also control the volume of financial transactions which are made by all other banks in the economy. These other banks include commercial banks, other non-banking financial institutions. The most important objective of the central bank is to manage the amount of financial resources of the economy and thus to maintain the stability in the economy. This stability is maintained in the economy by the central bank of the country in respect to stability of prices of goods and services, stability of financial transactions and prices of these transactions. Also stability is required to be achieved by the central bank in terms of movements in nominal as well as real interest rates and stability in exchange rates. Finally, the most important role of the central bank is to maintain stability in the real growth of the economy (Mankiw, 2011). Central banks of different countries have long been correlated with secrecy. Even in regard to the present trend toward higher level of transparency of different monetary policies, it can be said that, this has not dispersed the inscrutability with which all central bankers often argue. Various researches have provided an economic explanation for different roles of oblique communication. Under the conceivable assumption that there exists imperfect common knowledge or information about the level of transparency, all economic outcomes have been decided by both actual as well as perceived transparency. It has been shown, in numerous researches, that it can be helpful to merge actual transparency with the perceived opacity. The optimal or most efficient communication strategy for the central bank is related to the process of providing clarity about the target level of inflation. But the role of the central is also related to the process of providing information with recognized ambiguity about the target of prevailing as well as expected output-gap and supply shocks. Therefore, “the central bank benefits from sustaining transparency misperceptions, which helps to explain why transparency of monetary policy has not eliminated the mystique of central bank speak” (Geraats, 2006, p. 38; Blanchard, 2007, pp. 69-75). Balance sheet of central bank: The balance sheet of the central consists of assets and liabilities. The asset side of the central bank consists of amount of gold asset, amount of foreign currency holdings and domestic currency holdings. On the other hand in the liability side of the central banks’ balance sheet, the amounts of foreign loans as well as amounts of domestic loans are expressed. Again these loans are divided into several sub-sections such as gold loans and currency loans (Banchs and Mollejas, 2010, 472-473; Stone et al., 2011, p. 31; Bindseil, 2004). Liabilities Assets Currency Gold Deposits of all Government Banks Loans and Advances, to all Government Banks Loans (including government securities) Investments in all Government Securities Other liabilities and capital accounts Foreign assets Paid-up capital reserves Other assets Total Liabilities Total Assets (Source: Jadhav, N. 2006, p.169) The monetary base is determined by the value of currency in the hands of the people living in the country and also by the amounts of monetary reserves at the central bank as the deposit of all government banks to the central bank. And the amounts of money supply is determined in the economy by the central bank by the monetary base and also by the amounts of loans disbursed by the central bank and all government banks of the economy. The role of the central bank in the money supply process is to price stability through appropriate changes in the amounts of money supply through the changes in the amounts of rate of interests and thus the amount of money in circulation in the economy. The central bank lowers (increases) the rate of interest in the money markets to give greater (lower) amounts of loans to the people and investors in the economy. This increases (reduces) the amount of money in circulation in the economy and thus increases (reduces) the amount of money supply in the economy. Hence, changes in the market rate of interest are important tools of monetary control used by the central bank. Apart from this tool, the central can also raise the rate of interest on loans which are given to the commercial banks and thus reduce the amount of money supply in the economy by reducing the amount of deposits to the commercial banks. Also the central bank can increase the rate of interest which it pays to the commercial banks when it takes loans from those commercial banks. In this way the central bank can raise the amount of bank deposits, thus amounts of loans and hence, the amount of money supply in the economy (Mankiw, 2011). Central bank and price stability: One of the most important roles of the central bank is to maintain stability of prices of goods and services which are produced and/or sold in the economy. There are different techniques which are used by the central bank in regard to management of price and financial stability within any economic structure. However, these techniques differ across countries according to the nature of the economy and also according to the economic or financial strength of the central bank of the economy. For the developed countries, such as United States of America, United Kingdom, Japan, Australia etc. these techniques do not differ much. Among these techniques one of the most important techniques which are used by most of the central banks in the world is related to management of reserve requirement (Mankiw, 2011). Reserve requirements are regarded as a prominent policy instrument of maintaining price as well as financial stability in many developed and emerging countries. For example, China raised its level of reserve requirements by six times in the year 2010. While in this year movement of interest rates happened in the country only once. “The Central Bank of Turkey” has recently reduced its level of policy interest rate. This central bank has increased the volume of reserve requirements during the same period of time. Among policymakers and economists, reserve requirements are considered under topic of discussion both in terms of financial stability tool. This has happened in the economy in particular, for the purpose of dealing with volatile flows of capital. Reserve requirement also acts as an “unconventional monetary policy tool” which is used for attaining price stability. This price stability is achieved in particular, when monetary policies in relation to interest rate are constrained by the lower bound (which is set at the zero level) or an objective in regard to the exchange rate. The most important objective of reserve requirements differs substantially across countries as well as over time. However, at times it becomes difficult to identify the most important purpose of using reserve requirements. For example, “the Central Bank of Malaysia” has recently announced that variations in reserve requirements only act as an objective of achieving financial stability. On the contrary, the interest rate can be used effectively for achieving price stability. Similarly, in Turkey, the central bank believes that the rate of interest is the main instrument in obtaining price stability and the secondary role of the interest rate id to achieve financial stability. In this context it has also been opined by this central bank that reserve requirements acts as the most important instrument for achieving financial stability. And the secondary role of reserve requirement is to achieve price stability (Glocker and Towbin, 2012, pp. 65-66). However, greater reserve requirement implies that the lesser amount of money is available in the market. Therefore lesser volume of loans can be provided by commercial banks. Hence, lesser amounts of money will be available to the companies which are willing to increase the volume of level of investments in the production process of goods and services in the economy. Although this reduction in investment can be regarded as one of the most significant problem, this reduction in investment reduces the volume of income generated within the economy. This reduction further reduces the demand for various goods and services and thus maintains the stability of prices of these goods and services in the economy. Also different policies of central banks in regard to use of reserve requirements, which are related to amount of reserve kept by the commercial banks to the volts of the central bank, creates positive effect on the movements of prices. These effects reduce the upward movement of these prices. Along with this greater level of financial stability is also achieved in the economy. Lesser amounts of loans provided by the financial intermediaries reduce the volume of financial transactions in the economy and thus financial stability is maintained (Mankiw, 2011). Various analyses on the process of establishing the effectiveness of use of banks’ reserve requirements as a policy mechanism vary along three most important dimensions. The first dimension – the most important dimension – is related to the financial as well as monetary structure of the economy. The first case, which is considered by the researchers, exists where there is no financial frictions. This absence of financial friction is related to the economic structure of the system “apart from the assumption that savings have to be intermediated through banks and the requirement for banks to hold reserves”. In this context researchers incorporate the financial accelerator mechanism into the structure of financial management system of the economy in regard to the domestic currency debt. This fact is regarded as the second case and with regard to the debt in relation to foreign currency as the third case. The second dimension of the financial structure is considered as one of the most important objectives of the central bank. In respect to the first example, the standard objective of the central bank has been closely associated with the policy of minimization of “weighted average of inflation and output variability”. Also in case of the second instance, the variability of credits or loans enters additionally into one of the most significant objectives of the central bank. The third dimension, which is regarded by economists as well as by researchers as operational, incorporates different variables, controlled as well as monitored by the central bank as well as mechanisms which are used by the central bank as main policy instruments (Glocker and Towbin, 2012, pp. 85-86). Researchers have started their research on explaining objectives of the central bank of countries all over the “world by analyzing how the effects of changes in reserve requirements on the real economy depend on the use of other monetary policy instruments in an economy without a financial accelerator” (Glocker and Towbin, 2012, p. 86). Divergences in reserve requirements are expected to create two effects. The first effect is related to the fact that this minimum amount of reserve requirement influences the supply of money in the economy. For the given level of monetary base prevailing in the economy, higher level of reserve requirements, imposed by the central bank upon the commercial banks and other financial government-registered financial intermediaries in the country, imply level of broad money aggregates. In this context economic policymakers expect to experience an economic contraction in the country. In the situation where “the rate of reserve remuneration” is lower than “the market interest rate”, the second effect occurs within the economic structure of the country. In case of the second effect, the reserve requirements react as an imposed tax on the system of financial transactions of the banking sector of the economy and drive a block between the prevailing deposit rates and the lending rates in the economy. These two effects again act according to the nature of monetary policy used as the main macroeconomic or monetary policy by the central bank (Glocker and Towbin, 2012, p. 86). Under the standard rule of using interest rate polices, the determined rate of interest by the central bank, commercial banks are forced to lend according to this assigned rate of interest. In the situation when the central bank raised the rate of interest on loans which are given by the central bank to the commercial banks of the country. When the rate of interest set by the central bank is higher compared to that prevailing in the market, the commercial banks are more likely to lend to the central bank aiming at getting greater amounts of interest rate after a certain specified time period (Palley, 2001). Financial stability and central bank: The policy of the central bank towards making greater degree of financial stability into the system of financial transactions of the economy is another important objective. Higher degree of financial stability is also achieved by the central bank with the help of monetary and financial policies. These policies are also related to use of stricter reserve requirement policies as well as stricter policies in regard to banking transactions. At the time of financial crisis in the economy central bank provides greater volume of financial services to the government as well as to the private enterprises of the country. Financial policies are taken by the central bank in order to reduce the dependence of the economy on the external sources of financial resources, such as external borrowing from other countries. This external borrowing also includes taking loans from international financial intermediaries and international financial resource holders, such as International Monetary Fund (IMF), the World Bank (WB), and United Nations Development Bank (UNDB) etc. Also some international financial programs, such as United Nations Development program (UNDP), help economies to acquire greater volume of financial resources and to increase the rate of growth of these economies. However, in the face of establishing financial regulations within the economic transactions of the economy under consideration, the role of the central bank includes restriction of use of external loans. This restriction is expected to reduce the volume of money supply in the economy (Mankiw, 2011). Determination of Money Supply by the central bank: Considering the “Post Keynesian endogenous money theory” the fact has been suggested by researchers that fluctuations or variations in the monetary aggregates and money supply can be forced endogenously. This fact possesses large number of implications. Firstly, observation in regard to the ‘correlation between macroeconomic failure and contraction of monetary aggregates proves nothing about policy as cause, which challenges monetarist claims that macroeconomic failures are largely due to poorly executed central bank control of the money supply’. Secondly, the endogeneity of supply of money implies that attempts to manage the economy with the help of monetarist styled rules of money supply and targets are most likely fail. This fact suggests that the policy authorities should look for other means of monetary control. Interest rate policy has been regarded as one instrument of monetary control, but there might also be the place for greater quantitative regulation. Thirdly, endogenously driven fluctuations in relation to the money supply play a significant role in business cycle as well as it can contribute to the instability of the money market. Regrettably, the dynamic sector of the implication of “Post Keynesian monetary theory” is moderately immature. Hence, central banks also have its monetary policy prescriptions, and this fact has ‘diminished the Post Keynesian contribution to the debate over operational monetary policy’ (Palley, 2001, p. 3; Hasek and Dodd, 1952, p. 256). Determination of money supply by the Central Bank: The central bank determines the money supply with the help of the Keynesian endogenous money supply determination process. The choice of the particular form of money supply is one basis of endogeneity of money in the “competitive general equilibrium model”. The determination of “the quantity of money” is another important source of endogeneity. This fact can be illustrated with the help of the gold standard economy where the total stock of the gold asset is given at any specific point of time; however, the allocation between non-monetary and monetary uses is determined endogenously by creating a balance between the opportunity cost of possessing the gold which is correlated with the money as opposed to the rate of interest which can be earned with the help of placement of gold on the deposit at a bank. This procedure of shaping the allotment and circulation of the gold asset stock, endogenously, can be described in the following three-equation system: - + - + + + (1) “G = GN(i, y, 1/P) + GM(i, y, 1/P)” [Allocation of stock of gold] + + (2) “GM(i, y) = GB” [Banking sector equilibrium] - + (3) “GB = kPL(i, y)” [Bank demand for gold] ;where, G = “total stock of gold”, GN = “non-monetary gold demand”, GM = “deposits of gold with the financial and banking system”, GB = “demand for gold by the banking systems”, i = “interest rate”, y = “level of income”, P = “general price level”, k = “fiduciary ratio”, L = “demand for money balances” (Palley, 2001, pp. 6-7). The role of the central bank in money supply determination: Signs of above functional arguments express signs of the partial derivatives. Equation (1) reveals that the total stock of gold is allocated between non-monetary and monetary uses. Equation (2) reveals that the demand for gold banking system equals the gold supply which is available to the financial and banking system of the country. Equation (3) ensures that the demand for gold by the banking system is proportionally related to the ‘demand for inside money’ in the country. The non-monetary gold’s demand depends on the rate of interest, negatively; it depends positively on the level of income, and also depends negatively on relative prices of gold in comparison to commodities. The price of a given stock of gold is regarded as fixed at unity (Palley, 2001, pp. 7-8). The role of the central bank in the process of determination of optimum level of money is related to the fact that the central bank determines the market rate of interests on loans, savings and investments. These interest rates are expected to create most important effects upon the demand for monetary assets in the economy and also to the level of prices of different goods and services produced and marketed (Mankiw, 2011). Determination of money supply by the Central Bank in open economy: One of the most important aspects of determination of endogenous money supply by the central bank (The Federal Reserve) is related to the notion of open economy. The previous form of endogenous money in the open economy is “Hume’s specie flow account of the gold standard”, where the gold has been flowing out of economies having deficits in trade to countries having trade surpluses. This reduces the supply of money as well as the price level in economies which are losing gold, and this raises the supply of money as well as the price level in economies gaining gold. These relative prices as well as money supply adjustments then restore the balance of payments and money market equilibrium. This economic and equilibrium logic is also important at the foundation of the notion of global monetarism (Palley, 2001, pp. 16-17). Behavior of the Central bank in respect to money supply: The behavior of central banks in response to economic developments generates a completely different form of endogeneity. Within macro models this form of endogeneity is captured in the central bank's policy response function. There is a substantial literature on this subject, initiated by Palley (2001), examining the question of optimal monetary stabilization policy. The monetary authority lacks direct control over the money supply, and instead influences it indirectly through control over the monetary base. Central bank reactions fuse concerns of "endogeneity" with those of "controllability". The money supply may be endogenous through the central banks response function and perfectly controllable. Alternatively, it may be endogenous and imperfectly controllable. In the former case, endogeneity is exclusively the product of the central bank's response function. In the latter case, endogeneity is partly autonomous, reflecting money supply disturbances generated from within the economy and outside of central bank control (Palley, 2001, pp. 9-10). Money supply and the intervention of the central bank: One of the most important forms of endogeneity of money may be described as the "fiscal endogeneity". It focuses on the budget constraint of the government and this fact is related to the notion that government deficits and/or surpluses have greater implications for stocks in the asset markets. These features are explained by Palley (2001). The budget constraint of the government is given by: (6) “D = G - T + iB = dB + dM”; where D = the amount of deficit or surplus, G = the amount of government spending, T = total amounts of tax revenues, i = market rate of interest, B = the amount of total national debt, dB = amount of change in total amount of the national debt, and finally dM = amount of change in the amount of monetary base in the economy (Palley, 2001, pp. 10-11; Thomas, 2005, pp. 355-368). To the extent these deficits are considered as to be financed by money, these increase the amount of money supply in the economy. Kaldor (1970) focused on this fiscal endogeneity in the initial critique of the monetarism. Monetarists have opined that “money is all that matters”. They have also argued that fiscal policy becomes more irrelevant in this context. Kaldor has also argued that the evident statistical significance of supply of money is reflected through the operation of government budget constraint, having increased money supplies which are consisted of the outcome of government spending that is money financed. Tobin (1970) also highlighted the role of government budget constraint in the process of rejecting monetarist claims regarding the significance of money which is predicated on leads as well as lags in the growth of money (Palley, 2001, pp. 11-12; Masson et al., 1990, pp. 29-35). Relationship between money supply and prices: The level of money supply in an economy is closely associated with the level of prices of different goods and services. According to many economists, such as Blanchard, there exists a positive relationship between the amount of money supply available in the economy and the level of prices of various goods and services. The greater the amount of supply of money in the hands of the people, the larger will be demand for various goods and services and hence, given the production of these goods and services constant, atleast in the short run, the greater will be prices of these goods and services imposed by the producers. However, several economists, including Mankiw, have revealed their view that greater is the supply of the money in the economy, the larger will be the demand for different goods and services and thus the larger will be the level of production of these goods and services, even in the short run, and thus the larger will be the economies of scale enjoyed by those producers. Hence, the lower will be the prices of different goods and services because of achievement of greater costs-efficiency in the production process (Mankiw, 2011). Prices Stability and other goals of central bank: There are several other goals or objectives of central bank, apart from maintaining price stability in the economy. These works are essentially related to the overall improvement of the concerned economy. One of the most important goals of the central bank is to maintain the balance between the amounts of foreign assets and the domestic assets. These assets are basically approximated by the holding of foreign exchange and the domestic currency and also the holding of gold exchange. The balance between these assets is also related to the goal of the central bank, called the maintenance of price stability. The greater is the stability of prices in the economy, the greater is the balance between the domestic assets and foreign assets. This is because, greater price stability implies that the greater is the efficiency of the market and hence the lower is the need for the central bank to intervene in the market through exchanges of monetary assets – both domestic and foreign assets (Mankiw, 2011). UAE and central bank’s policies: Table 1: Money supply growth of UAE Year/MA (bns of dirhams) M1 M2 G1 G2 2000 34.1 127.0 12.6 15.3 2001 39.5 146.0 15.8 15.3 2002 47.1 169.3 19.2 15.6 2003 58.3 196.6 23.8 16.1 2004 80.8 242.2 38.7 23.2 2005 91.7 278.6 13.5 15.0 2006 120.0 399.3 14.9 23.2 2007 137.1 480.9 14.2 20.4 2008 208.0 674.0 14.6 19.2 2009 223.0 741.0 7.4 9.8 2010 233.0 786.0 4.2 6.2 2011 260.0 862.0 11.6 9.6 (Source: UAE Annual Monetary Growth: 2000 – 2011) The above table represents the data of money supply and monetary aggregates over the time period of 2000 to 2011 for the UAE. The table reveals several facts regarding the management of financial and monetary policies of the central bank of the country. This reveals that within the time period of 2000 and 2004 there volume of money supply in the country increased to a significant level. However, after 2005 onwards this value started to increase at much higher rate in the country. This policy has been supported by the fact that during the latter half of the first decade of 2000, the central bank of the country started to reduce the rate of interest on loans and therefore companies and people started to take loans from financial intermediaries of the country and thus the volume of investment rose to a significant level in the country (UAE Annual Monetary Growth: 2000 – 2011; Parkin and Zis, 1976, p. 24). Considering the Table 2 in relation to the GDP index at current as well as at constant prices which are related to the fact how these aspects are revealing their performance in relation to the monetary policies taken by the central bank of the country. The GDP values for the country have shown that over the time period of 2003 onwards the country has revealed significant progress in terms of GDP growth rate. This fact has been revealed in regard to both at constant prices of 2005 as well as current prices of calculation of these GDP values. However, the implicit price deflator has also revealed the fact that prices of goods and services during this time has risen too. This created little concern regarding the effectiveness of various monetary policies in regard to raising the level of income in the country. However, in the face of the fact that the money supply in the country during this time has risen significantly and therefore the demand for goods and services in the country has been augmented significantly and therefore the prices of these goods and services increased too (UAE Annual Monetary Growth: 2000 – 2011). Table 2: Economic performance of UAE Country or area Year Currency GDP Index at current prices GDP Index at constant 2005 prices Implicit Price Deflator United Arab Emirates 1995 UAE Dirham 36 56 65 United Arab Emirates 1996 UAE Dirham 41 60 68 United Arab Emirates 1997 UAE Dirham 44 65 67 United Arab Emirates 1998 UAE Dirham 42 66 64 United Arab Emirates 1999 UAE Dirham 47 69 68 United Arab Emirates 2000 UAE Dirham 58 77 75 United Arab Emirates 2001 UAE Dirham 57 78 73 United Arab Emirates 2002 UAE Dirham 61 80 76 United Arab Emirates 2003 UAE Dirham 69 87 79 United Arab Emirates 2004 UAE Dirham 82 95 86 United Arab Emirates 2005 UAE Dirham 100 100 100 United Arab Emirates 2006 UAE Dirham 123 110 112 United Arab Emirates 2007 UAE Dirham 143 113 126 United Arab Emirates 2008 UAE Dirham 174 117 149 United Arab Emirates 2009 UAE Dirham 150 115 130 United Arab Emirates 2010 UAE Dirham 165 117 141 (Source: Client’s source) Conclusion: Central bank is considered as the most important source of power of banking as well as financial regulations in countries across the globe. With greater influence upon the financial system of the country and also upon the markets for monetary transactions through use of different monetary policies and strategies, central banks are expected to control the level of increase in prices of goods and services. Also the rate of growth of GDP is also related to these policies and strategies of the central bank. With altering level of reserve requirement and different rates of interests on government loans, the central bank monitors the strength of the money market of the country under consideration. These regulations directly affect the volume of money supply available in the economy and thus affect the buying power of domestic consumers. These further affect the demand for different goods and services produced domestically and in abroad. This hence affects the amounts of GDP generated in the economy and the level of foreign exchange earned in net amount by the country. These facts again affect the growth of the economy. Hence, monetary mechanism of the central bank is considered as one of the most important factor in terms of providing greater volume of monetary support to the economy and also to the process of development of economic agents of the country. In the United Arab Emirates (UAE), softer monetary policies taken by the central bank of the country (including lowering the market rate of interest on loans) have been creating greater level of influence upon the growth of the economy with the help of greater growth of GDP and money supply. However, the problem of inflation also created significant negative effects on the financial system of the country. But the structure of market economy has helped the country to achieve its current status of higher growth which made the country an economically developed nation. References: Banchs, A. G. and Mollejas, L. M. 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A Review of the Experience So Far, USA: International Monetary Fund Thomas, L. B. (2005), Money, Banking And Financial Markets, USA: Cengage Learning United Arab Emirates and the IMF, (2012), International Monetary Fund, retrieved on April 17, 2012 from http://www.imf.org/external/country/are/index.htm Read More