International Exchange Rate and Monetary Policy Term Paper

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Monetary Policy and International Exchange Rate

Monetary Policy

A factor leading to an increase in a supply of money is a rise in a demand for the bank reserves influencing an increase in the money supply. To prevent a rise in the money supply, the central bank will purchase bonds to increase the quantity of non-borrowed reserves in the economy thereby shifting the amount of money reserves to the right preventing the central bank fund rates from rising. The strategy is to use the open market purchase to make the money supply and monetary base to rise. As being revealed in Fig 1, if the goal of the central bank is to maintain the interest rate target at r1, the central bank will reduce the quantity of the money supplied in the economy especially when an economy is experiencing a recession.

Fig 1: Interest Rate Target

Moreover, when the central bank decides to maintain an interest rate target at r1, the central bank will need to reduce the supply of money during the recession shifting MS1 to MS2 and eliminate the fall of the interest rates. Thus, the new equilibrium will shift from E1 to E3 and the interest rate will be at the target rate r1.

II. Benefits and Costs of Rediscount Operations

The 2008 and 2009 financial crisis forced the UK government to make a decision to bail out the distressed financial institutions to prevent the country's financial systems from collapsing and allow banks continuing functioning. The bailout was essential because the businesses, households, and governments relied on bank services to carry out everyday businesses activity. However, the UK government cannot implement the bailout to prevent the bank panics without using the pubic funds. On October 2008, the UK government approved the total of £500 billion as the bailout package to rescue the distressed banks from collapsing. The policy decision was very critical because there was a major fall in the UK stock markets towards the end of September 2008, and in the first week of October, there was a major fall in the stock markets heightened a concern about the stability of the UK financial institutions. One of the major benefits of the bailout process was to restore the confidence in the British banking system as well as guarantee the inter-bank lending. Moreover, the bank bailout using the rediscounted operations was to prevent bank panics that may have a negative consequence to the economy.

Despite the benefits associated with the rediscounted operations in the UK, the costs of this strategy are to prevent banks that deserve going out of businesses due to a poor management to remain in business. Chennells, & Wingfield, (2015) argue that bailout of banks and other financial institutions is undesirable. The method is an incentive to allow banks to be imprudently, and take excessive risks. The more hidden cost of the bailout program is that the government has created a moral hazard problem by giving banks an incentive to be more reckless in their management in the future. For example, some banks began offering riskier investments and loans shortly after the bailout program. Thus, the approval of the program actually led to an increase in a risk taking.

The additional cost of the bailout was that the government faced many criticisms from both from the economic and financial cycle. Shortly after the bailout program, many people in the UK criticized the action of the government for using the taxpayer fund to bail out the distressed banks on the ground that these banks got into problems because of their greediness, and poor risk management. Moreover, the bailout program has resulted into frictions between the UK government and some governments outside the UK. When the UK government approved the rescue plan for the distressed banks, the Icelandic government also rescued the Icelandic bank Icesave from collapsing. When the bank was about to collapse in 2008, the Icelandic government compensated their nationals by absorbing their losses. However, the government did not compensate all creditors, and only compensated their nationals and did not absorb the losses of the UK creditors. The issue caused a lot of friction and political confrontations between the UK and Icelandic government, culminating the UK government to apply "the Anti-terrorism, Crime and Security Act 2001 to freeze Icelandic assets in the UK." (House of Common, 2009 p 22). Despite the associated costs of the bailout, its benefits outweigh the costs because the UK government made more than £27 billion profits from the bank bailouts.

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(Hyde, 2010).

III. Comparative Analysis Open-market-operations, Rediscounting), and Reserve Requirements

Open market operations are the economic and monetary instruments to control the supply and demand of money in circulation. For example, when the government wants to decrease the monetary supply in the circulation, they will sell the Treasury bill to the commercial banks and other financial institutions. By implementing this policy, the commercial banks will buy the treasury bills from the government from their available cash and liquidity thereby reducing the money in the circulation. However, when the government wants to increase the money in circulation, the government will buy the treasury bills from the commercial banks. By paying the commercial banks cash, the government will inject more money into the circulation.

While the open market operation is beneficial for the stability of an economy, other monetary instruments are very critical for the economic stability. For example, rediscounted window policy assists an open market operation to be effective by placing a limitation on the amount of money that banks can borrow from the central bank. Rediscounted policy is different from the open market operation because it is used to prevent a financial panic. When a government notices that a banking institution is in a financial distress, the open market operation will not be effective, thus, the government will use a rediscounted policy in this case.

The reserve requirement is similar to the open market operation because it is being traditionally used to control money in the circulation. Depending on the assets of a bank, the central bank can impose the reserve requirement making a ceiling on the quantity of reserve that a bank should hold. Similar to the open market operation, the strategy is to control the money supply. In other words, the reserve requirements is an alternative to open market operation. However, the reserve requirement can place a bank to competitive disadvantages in the industry. Thus, the open market operation is more effective than other monetary instruments because it is reversible, flexible and its speed of implementation is higher than other monetary instruments. For example, reserve requirements are less effective than the open market operations. Moreover, the central bank cannot control the rediscounted policy. More importantly, the reserve requirements are not binding on most banks, and there is a recommendation to eliminate the reserve requirement. However, the open market operation is binding on all banks and is a being an effective monetary instrument practiced for more than a century.

Question 2.

I. Method balance of payments surplus affects the Inflation Rate

A country may require a balance of payments surplus to finance their surplus to gain international reserve. The consequence is that this action will make the central bank to supply more money into the circulation making more money to chase few goods. The policy will increase the monetary base and money supply leading to an increase in inflation. By definition, inflation is a consistent increase in the price of goods and service, when there is a rise in the money supply through a balance of payment supply, there will be an increase in the price of goods and services.

II. "Pure Flexible Exchange Rate System"

In the foreign exchange system, the central bank does not have a direct intervention in the operation, and exchange rate system because the law of demand and supply is influencing this. Thus, a change in international reserves, which affects the monetary base is lacking. Moreover, foreign exchange market may affect the monetary policy because monetary authorities may intend to manipulate the exchange rates by changing the interest rates and money supply.

III. Main Cost and Benefits of Monetary Union

A monetary union entails a collaboration of multiple countries to form a common currency union thereby ceding their monetary rights to a common authority. The Euro union is an example of a monetary union where 19 members forgo their national currencies and accept Euro currency as their currency. (Bergin, 2015). The major benefits of a monetary union are that the member countries will enjoy a fixed exchange rate thereby overcoming the problem of exchange rate fluctuation. Moreover, a monetary union helps businesses to eliminate the transaction costs that organizations and people incur when exchanging two or more currencies to carry out the international transactions.

Despite the associated benefits of the monetary union, the cost is that countries will lose a control of their national currencies. Moreover, the participating countries will lose the authorities to control the supply.....

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