Analyzing Monetary Policy & International Finance and Exchange Rate Term Paper

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Monetary Policy & International Finance and Exchange Rate

Monetary Policy

If the central bank has an interest rate target, why would an increase in the demand for bank reserves lead to a rise in the money supply? (Use demand & supply graph)

A rise in the demand for reserves will increase the federal funds target. So as to preclude this, the central bank will purchase bonds, in so doing, increasing the amount of non-borrowed reserves, which in turn shifts the supply curve for reserves to the right, and in so doing, maintaining the funds rate of the central bank from rising. The open market purchase will as a result cause the monetary base and the money supply to rise (Schwartz, 2008).

MS1 MS2

Interest Rate (4%) L2 (Y1)

L1 (Y1)

M/P

As indicated in the diagram, the assumption is that the central bank targets an interest rate of 4% per annum. Taking this into consideration, the money demand increases are offset by a change in the money supply. In the diagram above, the initial money supply level is indicated by MS1. The increase in demand level causes a shift of the money demand curve to L2 (Y1). This instance has a tendency of causing the interest rate to increase. When the central bank perceives the increase in the interest rate, it goes on to increase the money supply in reaction to decrease the interest rate back to its targeted rate, in this case assumed to be 4%. If the central bank succeeds in doing this, it causes the money supply to increase to MS2 (Schwartz, 2008).

II. The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs?

The costs of these rediscount operations are that banks that are worthy of going out of business or liquidated for the reason that they have been having poor management all through, may end up surviving for the reason that the Fed discounting will prevent panics. In turn, this might result in an ineffective banking system with several banks that are being poorly run and operated.

III. Compare the use of open-market-operations, central bank lending facilities (rediscounting), and changes in reserve requirements to control the money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of implementation

The central bank conducts open market operations by purchasing and selling United States government securities, particularly United States Treasury bills. The central bank has total control over the volume. This is compared to the central bank lending facilities in which the Fed sets the price at which to borrow, but does not have direct control over how much the banks can actually borrow. Secondly, the open market operations are flexible and precise as they can be used to sanction both small changes and large changes in the monetary base. Open market operations are also easily reversed. This is for the reason that the mistakes can be promptly rectified and corrected in a manner that would not have been conceivable with the other tools of monetary policy such as reserve requirements or discount lending. In addition, the open market operations can be implemented quickly. This is for the reason that there is no delay in terms of administration for conducting the open market operations. The orders go to the trading section in New York and are implemented instantaneously. With regard to rediscounting, the changes in the discount rate have to be proposed by the central banks or the Fed, prior to being approved or sanctioned by the Board Governors. As a result, it is for this particular reason that rediscounting is not considered to be neither easily reversible nor quickly implemented (Ireland, n.d).

As for reserve requirements being a monetary policy tool, they can be reversed, however, not so easily, as they have to attain approval from the Congress, if there are large changes in reserves. Therefore, for this reason, large changes in the reserve requirements cannot be undertaken promptly and easily. In addition, if a bank holds a very minimal amount of excess reserves and the fed increases the required reserve ratio, the bank is forced to quickly be in acquisition of reserves by borrowing, selling securities or also decreasing its loans. These aforementioned options are all expensive and disruptive. Therefore, the changes in reserve requirements can instigate problems and not be deemed effective as it makes management of liquidity more difficult (Ireland, n.d). In conclusion, open market operations are without a doubt the most effective tool with which the Fed can undertake monetary policy on an everyday basis.

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As a result, when it comes down to using effective tools, the Fed counts most heavily on open market operations in conducting monetary policy (Ireland, n.d).

Question 2: International Finance and the Exchange Rate

I. How can a large balance of payments surplus contribute to a country's inflation rate? (use graph)

A large balance of payments surplus might necessitate a country to provide funding for the surplus by selling its currency in the foreign exchange market. This as a result, leads to the acquisition of international reserves. The end result is that the central bank will have supplied more of its currency to the general public, and therefore as a result, the monetary base will increase. The subsequent increase in the money supply can instigate the price level to increase, bringing about a higher rate of inflation.

Exchange Rate

Supply

D1

D

Quantity

Q Q1

The diagram above indicates the increase in money supply, which also causes an increase in the price level as indicated in the increase in the exchange rate. This is due to the selling of the currency in the foreign exchange market, which in the end will bring about an increase in currency supply by the central bank.

II. Why is it true that in a pure flexible exchange rate system, the foreign exchange market has no direct effects on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy?

In a pure flexible exchange rate system, the foreign exchange market has no direct effect on the money supply for the reason that there is no central bank intervention. Within an exchange rate system that is pure floating, the rates are calculated as the ratio that balances a currency's private market requirement with supply from private market. The central bank does not have an essential role to play in the determination of a pure floating exchange rate. However, this does not mean that the foreign exchange market has no effect on monetary policy. The central bank can employ an indirect approach to increase or decrease the exchange rate by means of domestic money supply changes. With regard to monetary policy and floating exchange rates, increases in the domestic U.S. money supply will give rise to an increase in E$/£, or in other words, a dollar depreciation. In the same way, a decrease in the money supply will give rise to a dollar appreciation (Mishkin, 2007).

III. What are the main benefits and costs of monetary union? What are the main criteria for the optimality of a currency area?

The benefits that encompass monetary union are made up of four key elements. The first element is that there is a decrease in the costs for transaction for changing currency. Secondly, there is the reduction of exchange risk, which results in a greater investment in terms of trade and foreign investment with other nations across the region or expanse. It also gives rise in a lower risk premium that is exemplified in the cost of increasing capital. The third benefit is that there is increased transparency with regard to comparison of prices. Lastly, there is also the political gain or benefit in terms of having closer union and better cooperation. This, in turn brings about greater closeness with regard to economic associations within the monetary union (Minford, 2002).

There are four distinctive costs that have been identified with regard to monetary union. To begin with, there is the difficulty of coping with shocks, devoid of the use of independent interest rate and exchange rate movements. Secondly, there are the impacts or effects of harmonization endeavors that are linked with monetary union (Bogetic, 2002). Third of all, there are the concerns that could be included or encompassed in continental nations being bailed out due to financial problems, and especially with regard to state pension deficits. Finally, there is the fact that monetary union is usually planned and organized by continental main characters that already have the joy of having substantial power by means of prevailing European Union institutions, as an overture to a political union that the people might not want or desire (Minford, 2002).

Optimality of a currency area encompasses the manner in which a certain geographical region or expanse would make the most of its economic efficiency to have the whole region end up sharing a single currency. In essence, it delineates the optimal feature for the….....

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