The Monetary Policy Measures - Term Paper Example

Under what circumstances might short term interest rates lose their potency as an instrument of policy control by central bank?..........FULL ESSAY TITLE BELOW (AREA: Economics/Banking/Finance, SPECIFICALLY: Interest Rates, Monetary Policy, Central Banks) Table of Contents Introduction: Liquidity Trap 3 Other Corrective Policy Options 4 Liquidity Trap Situations in the economies of US and Japan 6 Conclusion: Risk of using unconventional measures 10 References 11 Auerbach, A. J. & Feldstein, M. S. (2002) Handbook of public economics, Volume 3. Elsevier. 11 Rabin, A. A. (2004) Monetary theory. UK: Edward Elgar Publications. 12 Bibliography 12 Takayama, A. (1985) Mathematical economics. Cambridge University Press. 13 Introduction: Liquidity Trap Rate of interest is usually considered as one of the most reliable and accessible of all monetary policy measures, meant to instill financial stability within a nation. However, problem crops up when an economy in the middle of such a crisis fails to implement interest rate controlling tools due to some inherent issues already prevailing. One such inherent problem which dilutes the effectiveness of interest rates as a viable monetary policy instrument is a liquidity trap situation. Liquidity trap is a situation when the rate of interest falls too low to be used as a monetary policy tool. It is a situation when the nominal rate of interest becomes so close to zero so that the real rate of interest could almost be considered as negligible. The lower the rate of interest is higher is the amount of aggregate investment expected to be; but the problem in this instance is that commercial banks do not have ample funds to lend out to the investors. Hence, there are little chances of any stimulation in the aggregate level of investment and so of that of the aggregate output in the economy. Usually, the need for lowering the rate of interest arises when the nation in question is in an urgent need of financial stimulation. However, if the nominal rate of interest is already bound to zero and there is practically no room left for further depreciation, the multiplicative impact of an expansionary monetary policy goes in vain (Rabin, 2004). The LM curve diagram being depicted here shows that till the point when the rate of interest lingers above Rt, there are possibilities of the rate of interest being used as an effective expansionary monetary policy measure. However, at Rt, when the shape of the LM curve becomes almost horizontal, changes in aggregate demand for money from Ma to Mb and vice-versa, has no mushrooming impact at all. Hence, in such a situation, the stimulating power of rate of interest becomes almost zero. Quite obviously, the economy has to rely upon other measures to invigorate the financial condition in the economy and also initiate some steps to reinstate the corrective power of the rate of interest. Other Corrective Policy Options The Euler’s equation relates rate of interest with the aggregate level of output in a nation through the following equation, Yt = EtYt+1 – σ (rt - Etπt+1 – ute) Where, Y ≡ Aggregate output, r ≡ Real rate of interest, π ≡ Rate of inflation and u ≡ Exogenous shock. Here,‘t’ ≡ Current time ‘t + 1’ ≡ Succeeding time period and ‘e’ = Expected value of the variable. Hence, unless there is a fall in the rate of interest there are little chances of an appreciation in the aggregate output level in the current period and so expected future output will also fall. In simple words, if the current period rate of interest is low, people find it lucrative to consume now and save in the following period. But, if there are slim possibilities of a rise in the future rates of interest, people will deter from spending even in the future. Thus, it appears that people will hold back their levels of consumption in the present as well as in the future. But unfortunately, if the aggregate output remains low, there are lean possibilities of an appreciation in the general price level; thus, the nation will lurk behind in recession (Auerbach & Feldstein, ). Rate of interest is historically considered as one of the most dependable of all monetary policy measures. However, at times when this measure could not be implemented, there are rooms for utilizing other measures to stimulate financial position as well, though the degree of their effectiveness is quite questionable. The authenticity of such actions could be verified from the following aggregate income identity, Y ≡ C (Y – T) + I (r) + G + X (e, Y) – M Where, Y ≡ Aggregate Output, C ≡ Aggregate consumption, I ≡ Aggregate investment, G ≡ Aggregate government expenditure, X ≡ Aggregate exports, M ≡ Aggregate imports, r ≡ Rate of interest and e = Rate of exchange From the above identity, the factors which are independent of aggregate output and rate of interest could be realized and those are the very factors which could be utilized to inject inflation within the economy. The national government could instigate the aggregate economic output through injecting lumpsum amount of money within the nation, since government expenditures, G, hardly depend upon the rates of interest and is rather considered as an exogenous factor. In case of an open economy, there are also chances of increasing the contribution of trade balance (X - M) within the nation, through lowering the rate of exchange. However the problem in this case is that the export revenues might not change as dramatically as expected in theory. Hence, the net economic position might not alter much. The tax rates might also be reduced so as to stimulate the consumption levels through rise in the amount of disposable income. Thus, there are two effective measures that the national government could adopt – firstly, increase the amount of government expenditure and secondly, lower the tax rates. A point to be noted in this case is that the substitute policy measures are primarily fiscal in nature, since monetary policy tools work via fluctuations in the rate of interest, which is inert in a liquidity trap situation. Liquidity Trap Situations in the economies of US and Japan A situation when the nominal rate of interest deteriorated to a level almost as low as zero took place in the economies of US and Japan at two different points of time. In the US, liquidity trap situation took place during 1930s, a phase popularly termed as the Great Depression, when the nation sank back into deep recession. The adjoining diagram shows the trends in the rate of interest in USA over the long run and the period between 1935 and 1942 depicts nominal interest rate values almost close to zero. Corrective Monetary Policy Measure adopted by the US The global economy at that point of time, largely depended upon their gold endowments. In fact, the domestic currency values and hence their rates of exchange were supported by their availability of gold. As soon as the economy of US sunk into Great Depression, the rate of exchange of the domestic currency soared up due to low market rates of interest. This could be explained with the help of the International Fischer Effect equation which states that, ef = (1 + rh)/ (1 + rf) Where, ef = Change in the value of foreign currency, rh = Domestic rate of interest and rf = Foreign rate of interest Thus, a fall in ‘rh’ leads to a fall in ‘ef’ and vice versa. So, when the rate of interest of US deteriorated, it led to a fall in the value of foreign currency too, implying an appreciation in the value of US dollars. Thus, the US economy had an advantage in this sphere and utilizing this aspect, it brought in a huge flow of gold stock. As the world was primarily dependent upon the gold standard during that era, it automatically boosted the monetary base of USA. Hence, the money supply within the nation went on increasing. Though the rate of interest was almost ineffective during that point of time, the national government utilized this increased supply of money to promote public sector investments so that the rate of unemployment in the nation also lowered drastically from 19% in 1938 to 14.6% in 1940. Hence, there was an automatic stimulation in aggregate demand and the level of economic output also went up, thus bringing the episode of Great Depression to an end. Corrective Monetary Policy Measure adopted by Japan The financial situation in Japan started deteriorating during the 1990s until the nominal rate almost reached zero by the end of the decade, indicating the financial situation as one identifiable with that of a liquidity trap such as the one that USA had faced during the 1930s. However the US had sought out its revival mantra from the gold standard that the world maintained during that point of time. In the present instance too, the target had been to infiltrate money into the nation which is why the Bank of Japan revised its target money stock by fourfold times. It initiated a large scale open market operation, where the financial body purchased huge amounts of government bonds so as to inject money into their hands. The financial authorities had the Quantity Theory relation in their minds while adopting such measure. The Quantity Theory of money is, MV = PY; where, M = Supply of money, V = Velocity of money, P = General Price level and Y = Aggregate output. But even after adopting such measures, the financial body of Japan failed to bring much difference in the economic scenario as is quite evident from the underlying diagram. Though the economy has boosted up its monetary base, it could not instill a considerable amount of money supply and so, the nation could also not recover its general price level. In fact, it seems that the nation cannot bring much variation in its financial situation through monetary policies; rather fiscal policies could serve as a savior in this case. The current account position of the nation had also been quite poor on account of the financial crisis that the region had experienced recently. Given the nation’s high export dependence however, an easy way-out had been to lower its rate of exchange artificially and continue with its high export volumes so as to increase the nation’s export revenues. But the problem in this case is that the net change in export revenues after exchange rate deterioration might not be enough to replenish the deteriorated money supply situation. Conclusion: Risk of using unconventional measures The national administrative bodies undertook alternative measures so as to stimulate the monetary situation in the respective nations. However there remain specks of doubt as to the reliability of such measures as have already been pointed out while discussing them in the previous section. The measure which the US economy undertook during Great Depression had been precarious since it required a fixed rate of exchange rather than a floating one which was nothing but flexible. Hence, once the economy was stuck into a crisis, it was difficult for it to revive from the situation. The Japanese economy adopted an expansionary monetary policy through increasing the money supply in the nation, but failed to trigger the general price level in the economy. Hence, a problem which could have probably cropped up in such a situation is reflected through a sudden rise in the aggregate output. But given the low rates of interest, there are little chances of a fall in the domestic rate of exchange and hence, the nation faces low export demand. Given a high aggregate output as well as a high rate of exchange, there are chances of further deterioration in the domestic price level, which is the one factor that the national authorities seek to appreciate. Moreover, a forcible deterioration of the rate of exchange also results to a sudden upshot in the price level implying a high rate of inflation which could also lead to a hyperinflationary situation. Actually, correcting the rate of interest from a liquidity trap situation is one of the toughest tasks for the monetary authorities of any nation and the only remedy which they could render to is long run in nature, through gradually increasing the monetary base of the nation. Such a step at least lowers the risk of adopting corrective steps. References Auerbach, A. J. & Feldstein, M. S. (2002) Handbook of public economics, Volume 3. Elsevier. OECD (n.d.) “Financial Indicators: Interest Rates”. Available at (Accessed: May 31, 2010). Rabin, A. A. (2004) Monetary theory. UK: Edward Elgar Publications. Bibliography Bank of England. Quantitative easing explained. No date. Bernanke, B.S. Laubach, T. Mishkin, F.S. and Posen, A.S. Inflation targeting: lessons from the international experience. Princeton University Press, 2001. Central Bank of Nigeria. WHAT ARE THE INSTRUMENTS OF MONETARY POLICY? No Date. 23 May 2006. Gramlich, E.M. Conducting Monetary Policy. 4 January, 2003. Board of Governors of the Federal Reserve System. 23 May 2006. KING, M. 2005. MONETARY POLICY: PRACTICE AHEAD OF THEORY MAIS LECTURE 2005. 23 May 2006. Kramer, C. and Stone, M. A post-reflation monetary framework for Japan, Issues 2005-2073. International Monetary Fund, 2005. Mishkin, F.S. Monetary policy strategy. MIT Press, 2007 Protze, L. Zero Lower Bound and Monetary Policy in the Euro Area. BoD – Books on Demand, 2008. Schaechter, A. Stone, M.R. and Zelmer, M. Adopting inflation targeting: practical issues for emerging market countries. International Monetary Fund, 2000. Takayama, A. (1985) Mathematical economics. Cambridge University Press. Read More