Table of Contents
Question 1: Monetary Policy
An increase in the demand for bank reserves from the banks would give rise to the issuance of the former to the commercial banks by the central bank. The government, in most cases, provides bank reserves to the banks in order to sustain economy. The individual commercial banks, in their turn, lend the money to their clients. That is why there is a rise in the money supply. It is because the central bank gives the commercial banks the money reserves, which are then passed to citizens through loans hence increasing the money supply in the economy. Such situation is usually quite attractive to the commercial banks irrespective of the interest rate target.
The government through the central bank regulates money supply in the economy. When the economy is performing badly with high inflation rates hitting the country, the central bank adjusts the liquidity ratio. One of the best ways to do it is through reducing borrowing and encouraging saving among citizens (List 2009). In such case, central banks increase the interest rate at which most commercial banks are borrowing money and the latter, in their turn, set high interest rates for their clients hence reducing the lending in the country.
The costs of rediscount operations to the economy include rise of inflation rates, the high cost of living, high unemployment rates, and a weak currency. The progressive monetary policy leads to economic developments, strong economy, and high employment rates. The negative monetary policy results in unemployment, the high cost of living, slow development rate and a weak economy (Krugman & Wells 2015). The rate of unemployment would increase drastically because of the weakening economy and inability of employers to pay their employees. Consequently, excessive lending to banks causes high inflation rates, rise in prices, cheap national currency leading to decline in living standards.
Open market operations imply selling and buying of government securities. They are flexible as banks can opt to buy or sell their financial assets without many restrictions. The changes in reserve requirements are flexible as well because banks can avoid forming reserve funds or to keep them for emergencies. The central bank lending facilities are not flexible since the central bank obtains a bank’s assets as a guarantee for payments within a specified duration of time.
The open market operations are effective since a bank can easily invest in government securities and obtain a guaranteed profit at a particular time. They are also used by central banks to regulate the inflation rate in the country. The changes in reserve requirements are not as effective as open market operations thou they are also efficacious in that they help the banks settle their accounts on an emergency.The central banks lending facilities are the most effective since they guarantee an immediate assistance of central bank to a commercial one.
The open market operations are a gradual process that can be taken by central banks to stabilize the economy. The changes in reserve requirements are the best method that can be implemented very quickly because it does not involve many formalities. The central bank lending facilities, in their turn, would take a shorter period; however, rediscounting requires a certain procedure to be fully implemented.
The open market operations are easily reversible as a bank can buy or sell securities it bought previously. However, the central bank lending facilities are completely irreversible and they can only be settled through the clearance of loans provided. The changes in reserve requirements are reversible for both central banks and commercial banking institutions.
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Question 2: International Finance and the Exchange Rate
A large surplus in a county’s balance of payments poses some threats to the county’s economy. It can eventually lead to high inflation rates in a state. Inflation is triggered by the inability of a country to control its high rate of importing goods and services while a low rate of exporting its finished products. In the case of a surplus in the balance of payments, a state’s central bank is tasked with the responsibility of normalizing the balance of payments. However, this process can result in increased inflation rate due to the weakened currency of a country.
A large balance of payments surplus can contribute to a country’s level of inflation in that if the government decides to settle the surplus by buying international reserves. In such a case, the budget and projects in the state are greatly affected. The strength of that country’s currency would be weakened (Illes, Lombardi & Mizen 2015). The balance of payment contributes greatly to inflation rates of a state, especially if other countries refuse to trade with it because of a huge surplus in its balance of payments.
The pure flexible exchange rate system has no interference from the banks; the market sets the prices itself. Hence, the foreign market exchange is independent of the money supply. Irrespective of the amount of money available in supply, the banks have no control over it and cannot manipulate the system to favor them. Consequently, the prices are established at the market and banks are just price takers hence having no influence over money supply in the system.
Foreign exchange rates have an impact on a country’s economic policies as the monetary policies are drafted based on a state’s imports and exports and the strength of its currency. The foreign exchange market influences these aspects because the value of the US dollar against other currencies affects trade between countries. A strong US dollar discourages exporting the USA commodities to other nations while a weak USD encourages more exports to other countries. Hence, the monetary policy of a state is directly influenced by the foreign exchange market.
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Monetary unions are essential for countries with the same economic interest. It brings together states from different regions to share the same currency. Some of the benefits of monetary unions include transparency where consumers in the member states can easily compare prices for goods and services in various countries (Bache & George 2006). The unions also create many trade opportunities among their members, which involves job creation across borders.
The implications of a monetary union entail the fact that all member countries have to abandon their currencies and use one mutual monetary union’s currency. The borders of all the participating states ought to be free for crossing for all the member citizens. It can result in the dumping of goods and services as well as smuggling of illegal products. Another adverse effect is trade restrictions for other countries outside the monetary union. It implies that non-member states may find it difficult to trade with countries in monetary unions.
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According to Mundell, there exist four main criteria for the optimality of a currency area (Dellas & Tavlas 2010).
- Increased labour mobility among the states involved. It implies that restrictions on labour mobility would be removed from an optimal currency
- Openness concerning price and capital mobility and wage flexibility. The overall flow of financial services and resources among member states is encouraged so that market forces of supply and demand can easily be used to maintain an optimum balanced economic system.
- Promotion of a risk sharing system, where member countries can support states experiencing economic difficulties through the distribution of money to areas in trouble.
- Uniform business cycle which means that if there is high inflation rate, all member countries will experience it equally and at the same time.
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