Money and Banking

Monetary Policy

A central bank plays a significant role in a country’s economy because it has the authority to manage a state's currency, interest rates, and money supply. It also has the authority to supervise the operations of the commercial banking system (Burton & Brown 2014). It is important to note that central banks have administrative powers, which are employed in preventing bank runs and ensuring that commercial banks and other financial institutions do not take part in fraudulent behaviors. However, the main function of a central bank in any country is controlling the money supply, which is also known as monetary policy. The central bank is able to do this through its activities, which involve setting the reserve requirement, managing of interest rates, and being a lender of last resort to commercial banks, particularly during the financial crisis (Gowland 2013).

Bank Reserves and Money Supply

The central bank is involved in setting interest rate target to control the interest rate charged to customers by the commercial banks. The central bank also sets an interest rate target aiming to stabilize the economy of the country. The number of people borrowing from banks and other lending institutions depends on the rate of interest (Ingham 2013). It means that the lower the interest rate, the more the number of customers borrowing money. On the other hand, the higher the interest rate, the lower the number of borrowers. According to Martin, McAndrews and Skeie (2013), a low interest rate suggests that companies can secure loans to invest in their business and pay a reduced amount of interest for money borrowed. Thus, lowering the interest is considered to boost economic growth, and it is usually used during low economic growth (Burton & Brown 2014). On the other hand, high interest rate discourages economic growth. Thus, high interest rates are often used during high economic growth to avoid market bubbles in the economy.

Apart from the central bank’s action of regulating the interest rate target, central bank is also involved in other activities that can affect money supply in the economy. One of those activities relates to demand for bank reserves, which increases the money supply in the economy. It is important to note that changing of reserve ratio does not influence the money supply directly. Instead, a change in reserve ratio directly affects money multiplier (Martin, McAndrews & Skeie 2013). Another important thing to note is that interest rate charged by commercial banks and other lending institutions directly affects the money supply in the economy. The central bank has the mandate to regulate the interest rate charged to depositors. Thus, the connection between the interest rate and money supply can be used in explaining the effects of demand for bank reserves on money supply in the economy.

Bank reserve is the amount of money that the central bank requires to hold as reserves by other banks and financial institutions (Burton & Brown 2014). The reserve ratio is set by the central bank. An increase in reserve ratio means that banks and other financial institutions hold more money as reserves in the central bank. As a result, the amount of money available to borrowers decreases. According to Bekaert, Hoerova and Duca (2013), a reduction of reserve ratio results to the reduction of money supply. It means that a rise in the demand of bank reserves causes increasing money supply when the interest rate remains constant. Increase in reserve ratio and reduction of interest rate would encourage more people to borrow from commercial banks. As a result, there will be an increase in money supply in the economy.

Costs of Rediscount Operations

A central bank of a country usually lends money to banks to help them prevent bank panic. This activity of the central bank is known as rediscounting. It helps the banks to deal with the movement of the market, which has increased the demand for loans (Burton & Brown 2014). There is an opportunity of generating cash by rediscounting short-term securities when there is a low liquidity in the market. According to Karadi and Gertler (2015), rediscounting of short-term securities helps banks to raise the money, particularly during low liquidity periods. It is clear that rediscount operations by the central bank are helpful to the banks. Despite the benefits associated with it, rediscount operations have its costs. The major costs relate to helping poorly managed banks survive in the banking system.

Through rediscount operations, the central bank sometimes helps banks, which deserve to shut down, to survive. With the help of the central bank in preventing bank panics, poorly managed banks can raise money from short-term securities (Bekaert, Hoerova & Duca 2013). Helping the poorly managed banks to survive in the banking system creates a situation whereby a country’s banking system is made up of poorly run banks. It creates inefficiency in the industry, which negatively affects the services that customers get from commercial banks and other financial institutions. It means that customers are unable to transact with the bank efficiently thus influencing money supply in the economy. As a result, the performance of the economy receives a negative impact.

Open-Market-Operations, Rediscounting and Changes in Reserve Requirements

Open market operations (OMO) involve buying and selling of government securities with the aim of expanding contracting or the amount of money available in the banking system. Busing of government securities injects cash into the banking system and helps in encouraging growth (Ionescu 2015). On the other hand, selling of government securities drains money from the banking system. Compared to rediscounting, OMO provide flexibility in monitoring the money supply. It can be explained by the fact that when there is increased money supply, a sale of government securities is done to drain money from the banking system. In contrast, in a situation when there is reduced money supply, the central bank purchases the government securities to stabilize the money supply (Gowland 2013). The method can be reversed easily by selling government securities to reduce money supply. Additionally, the method can be implemented quickly since its implementation only requires sale or purchase of government securities.

Rediscount involves providing short-term debt securities to a bank with the aim of helping them deal with an increasing demand for loans. Compared to OMO, rediscount is less flexible in monitoring the money supply (Burton & Brown 2014). Rediscounting method is not easily reversible since it is usually employed by banks when they are faced by increased demand of loans. This method can be implemented quickly because it only involves application of short-term debt securities by the banks and other lending institutions from the central bank.

A change in reserve requirements is a method used by the central bank to monitor the money supply. The central bank increases or reduces reserve requirements to regulate money supply in the economy. Just like OMO, change in reserve requirements is a very flexible method of controlling the money supply. The method is easily reversible. Compared to rediscounting, change in reserve requirements is fast to implement.

International Finance and the Exchange Rate

In case a country has a favorable payments balance, there is more money in its economy. Increase in money supply leads to a decrease in the exchange rate with regard to the currencies of other nations (Burton & Brown 2014). An upsurge in the money supply can cause an increased rate of inflation in the economy.

Pure Flexible Exchange Rate System and Monetary Policy

A flexible exchange rate is determined by global demand and supply of currency (MacDonald & Marsh 2013). The pure flexible exchange rate exists when there are no official sales or purchases of currency. The system of pure flexible exchange rate is not related to foreign exchange market directly. Therefore, it does not affect money supply in the country. Nevertheless, the monetary policy is not influenced by the lack of direct connection between foreign exchange market and pure flexible exchange rate. Foreign exchange market influences the global economy. It means that foreign exchange market can affect the economy of a particular country (Burton & Brown 2014). Depending on the performance of a country’s economy, its central bank can regulate the money supply.

Benefits and Costs of Monetary Union

The main benefits of monetary union are derived from fixed exchange rates. Thus, the main benefits of monetary union include transparency, certainty and investment, lower transaction costs, trade creation, discipline against inflation, and job creation. The costs of monetary union include loss of a country’s capacity to choose inflation rate (Mahadeva & Sterne 2012). The other costs relate to the loss of exchange rate tool as an adjustment instrument.

Criteria for Optimal Currency Area

Use of single currency in a particular geographic area can lead to great economic benefit (Snaith 2014). According to Fisher (2012), the use of national currency in every country is not an efficient economic arrangement. Fisher (2012) maintains that optimal currency area (OCA) facilitates closer incorporation of capital markets and simplifies trade between member countries. There are criteria that should be followed for a region to successfully attain optimal currency area.

The first criterion relates to improved labor mobility throughout the region. Simplicity of labor mobility relates to the capacity of people to travel using simplified visas, elimination of cultural barriers, for example, institutional policies and different languages that hinder free movement. The second criterion relates to capital mobility and wage and price flexibility. Free movement of financial resources between areas that trade regularly with each other can simplify trade and boost economies (Snaith 2014).
The third criterion relates to currency risk-sharing arrangement across countries. According to Fisher (2012), a risk-sharing arrangement in a currency union facilitates the distribution of currency to regions faced with economic difficulties. The fourth criterion relates to similar business cycles. In this criterion, all member countries in optimal currency area must have similar business cycles to ensure that economic benefits are shared. It also ensures that the OCA’s central bank can effectively offset economic recessions by containing inflation and stimulating growth.

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