Economy 320 Money and Banking Essay

The Federal Open market Committee has twelve voting members. Seven of these members are the board of governors who are appointed by the president and serve for terms that are fourteen years long. The appointment has to be approved by the senate. The reason as to why the terms are long is so that the committee can be freed from presidential and political influence. The years also end on 31st of every even year eliminating the possibility of a president appointing a majority of the board in their four year terms. The board members are permanent voters and vote every time the exercise is carried out. One of the remaining five positions is filled by the president of the Federal Reserve Bank of New York who is a permanent voter while the rest of the positions are filled by the remaining eleven Federal Reserve Banks on a rotation basis. These include the Reserve Federal Banks of Cleveland, Boston, Chicago, Philadelphia, Dallas, St. Louis, Atlanta, Richmond, Kansas City, San Francisco and Minneapolis. Chicago and Cleveland vote alternatively (vote once in every two years) while the rest of nine Reserve Banks vote after every two years (vote once in three years). This committee is important as it functions to formulate and regulate monetary policy for the country’s Federal Reserve System . which describes the actions implemented by the central bank. The committee also determines the capability of the Federal Reserve joining the Treasury department in the intervention of foreign exchange. It is important to note that the Federal Reserve is in charge of the monetary policy tools which include discount rate and the reserve requirements which are controlled by the board of governors of the Federal Reserve System. The third tool which is market operations is the third tool controlled by the Open Market Committee. Where does the power lie within this committee? The power lies with the president of the Federal Reserve Bank of New York. The New York Fed also acts as the vice chairman to the committee and is a permanent voting member. In the event he is not present during a voting session, his place can not be taken by another Fed, rather, one of his vice presidents votes in his place. This is because the New York Fed plays an important role in the system such as carrying out intervention in the foreign exchange market in the event it is required and conducting all the open market operations for the Federal Reserve. 2. If the Fed lends five banks an additional total of $100 million but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base? From the above question, there will an increase in the Reserves by $50 million, while the MB (Money base) is increased by $100 million. Banks Balance Sheet Assets Liabilities Reserves +$50 M Discount loans +$100 M Deposits -$50 M -$50 M Balance Sheet of Fed Assets Liabilities Discount loans + $100M Reserves +$ 50M Currency +$50M 3. What are the advantages AND disadvantages of inflation targeting? Advantages Inflation targeting unlike exchange rate peg makes it possible for the monetary policy to focus and concentrate on domestic considerations that need to be addressed and respond appropriately shocks that are affecting the domestic economy. When compared to money targeting, inflation targeting is advantageous in that its success is not hampered to a great extend by the stability in the relationship between money and inflation (Mishkin, 2007). This is because instead of depending on such relationships, it utilizes all the information that is available in determining the best strategy and settings for the monetary policy tools. Inflation targeting is also easy to explain to the public as it can easily be understood enhancing transparency. This increases accountability on the central bank’s part (Mishkin, 2007). It also makes it possible to eliminate the possibility of the central bank falling into traps such as time-inconsistency because of the enhanced transparency. Eliminating time-inconsistency which is usually caused by central bank being politically pressured to undertake monetary policy that is overly expansionary makes it possible for inflation targeting to focus and concentrate on political debate that is directed towards what the steps the central bank can take to address issues such as unemployment, increase output growth and external competitiveness through formulations of the monetary policy (Mishkin, 2007). Disadvantages Inflation targeting is associated with some disadvantages as a monetary policy strategy. The method is argued to be too rigid such that it has no allowance for changes in the event they need to be done fast. The method is also said to have the potential of allowing discretion which is not good as it hinders transparency hence accountability of the central bank (Mishkin, 2007). The strategy also feared to be capable of lowering the rate of economic growth as it has the potential of increasing the output instability. Inflation targeting is also argued by critics to only be able to produce weak accountability on the part of the central bank because of the fact that inflation can not easily be controlled and also because of the long lags that exist from the monetary policy tools to the outcome of the inflation. This is a serious problem specifically for countries that have emerging markets. Inflation targeting is also said to be incapable of preventing fiscal dominance (Mishkin, 2007). The exchange rate flexibility that must exist for the inflation targeting to be function can result to financial instability which is very crucial for emerging market countries. 4. You often read in the newspaper that the Fed has just lowered the discount rate. Does this signal that the Fed is moving to a more expansionary monetary policy? Why? One of the instruments used by the Fed to formulate the monetary policies is discount rate. This is the interest charged on loans given to depository institution by the Federal Reserve Bank. This interest is the only one Fed usually charges. Banks usually loan each other money and would not go to the Fed under normal circumstances. However during economic and financial crisis such as the current recession, most banks raise the interest charged on the loans they lend to other banks, in an effort to help banks especially the small ones which are not in a position to afford the high rates demanded by big banks, the Fed usually offer loans to these banks to enable them maintain the reserve requirement they need hence run their operations as usual. The interest rates on these loans are usually low making it easier for banks to borrow from the Fed what they need to remain in business. Market analysts and experts argue that as much as the Fed has the responsibility of lending money to banks in times of need, its announcement of lowered discount rate usually is an indication of a more expansionary monetary policy to come. This is because of the impact lowering discount rates have on the government’s finance. The effects are positive when well managed and if the country recovers quickly from the financial crises. This is because low discount rate is usually the last resort that banks turn to in the event of crises. A decline in interest rates also affects government finance. It is done to lower inflation rates as it increases the number of available projects at a cheap price attracting investors to invest so that there is no money floating around. This is based on the fact that the more money there is the higher the rate of inflation. Lowering the discount rate is hence signals another monetary policy on the way. 5. What happens to nominal GDP if the money supply grows by 20% but velocity declines by 30%? M*V = P*Y a %&? 916; PY = %&? 916; M + %&? 916; V = 20% – 30% = -10% If the money supply grows by 20% and the velocity decreases by 30%, the nominal GDP will decrease by 10 percent. 6. If Mexicans go on a spending spree and buy twice as much French perfume, Japanese TVs, English sweaters, Swiss watches, and Italian wine, what will happen to the value of the Mexican peso? This would result to a negative value being reported during the trading period as the imports will have exceeded the exports resulting to a trade deficit. This would have a great impact on the Mexico’s foreign exchange market. A trade deficit as the one described above, Mexico will have to convert its peso to the currencies of the countries it is importing from. Since it is buying from many countries in large amounts, the supply and presence of the peso will increase on the forex markets causing the peso to lose value as they will no demand for it. The value of Mexican peso would therefore decrease against the French, Japanese English, Swiss and Italian currencies (Mishkin, 2007). 7. If the money supply is 250 and nominal income is 1,900, the velocity of money is v= (P ? Y)/M Where v is velocity, P = price level Y = 1,900 M = 250 Since the price level is not given, velocity of money can also be calculated by dividing the GDP value with that one of money in circulation. Hence v = GDP/ money supply, v=1900/250 v=7. 6 8. What are the key advantages of exchange-rate targeting as a monetary policy strategy? The advantages associated with exchange-rate targeting are several. They include the fact that its nominal anchor is able to fix the rate of inflation of goods that are traded internationally. This enables the strategy to keep country’s inflation rate under control. A credible exchange rate target has the potential of anchoring the inflation expectations to the rate of the anchor country that has its currency pegged (Mishkin, 2007). Exchange rate target has the potential of eliminating the occurrence of time-inconsistency of the central bank if commitment is present as it provides rules of conduct that should be complied with. Exchange rate target strategy is alas simple and clear making it easier for the public to understand hence increasing transparency and accountability of the central bank (Mishkin, 2007). 9. If a pill were invented that made workers twice as productive but their wages did not change, what would happen to the position of the short-run aggregate supply curve? Aggregate supply is used to determine the volume of products (goods or services) produced in an economy at a certain given price level (Mishkin, 2007). The relationship between the aggregate supply and the general price level is such that an increase in price levels implies that the business has to expand and increase its production so as to meet the demand for its products. Increased demand hence results to expansion in the economy’s aggregate supply. Aggregate supply can also be described as the total amount of goods and services present in an economy at all possible (low or high) price levels (Mishkin, 2007). In the short run, nominal wages of employees does not change while production output increases. This implies higher profits. In the event the event the price levels rise, the short-run aggregate supply curve would have an upward sloping because the nominal wages are fixed while the output (production) is rising. However in the event the prices of the products were not increasing, this curve would remain horizontal (Mishkin, 2007). 10. Explain the law of one price and the theory of purchasing power parity. Why doesn’t the purchasing power parity explain all exchange rate movements? What factors determine long-run exchange rates? The law of one price postulates that for a market to be efficient, all goods that are identical in functionality should be sold at one price (Mishkin, 2007). This law is very closely related to the out comes of globalization and the different free trade areas and markets. It seeks to explain that in future, all countries and market areas in the world will earn the same amount of money for equal amount of work/service, product and their quality (Mishkin, 2007). This implies that all sellers will look for markets that have prevailing high prices while the buyers will flock to sellers that are offering low prices for the goods and services. This will force the sellers to converge and agree on one price for the goods. Purchasing-power parity is a theory that explains how the exchange rate is determined and provides a way of comparing the cost of goods and services amongst countries. It postulates that when domestic purchasing power of a country is equivalent to that of another one at a particular exchange rate then the exchange rate between their currencies will be at equilibrium (Mishkin, 2007). This takes form of the law f one price eventuality in which at some point in life it is considered that similar goods will have the same price irrespective of the location or country. Purchasing power parity does not explain all exchange rate movements because the comparisons used in the method have the potential of being misleading (Mishkin, 2007). Most comparisons are usually based on the living standards of the citizens of the countries in context. It is done through assumption that the real value of the goods and services is the same in both the countries being compared. This can however be misleading as cultures vary such that what is considered to be a luxury may not be the same in the other country. Purchasing power parity has no allowance for this diversity hence the exchange rate based on this method differs depending on the goods chosen for use for the index. The major factors that determine long-run exchange rates are inflation and expectations. This is because a change in the levels of money supply causes price levels to change. Inflation also causes increase in the nominal interest rate to its long run rate during the phase of transition. Expectations of inflation usually result to increase in the expected returns on the foreign currency causing domestic currency to lose value (depreciate) before the transition phase (Mishkin, 2007). Since rate of inflation is always on the increase due to the increase in growth rate of money supplies, nominal interest rate also increases. Other factors include yield differentials (difference in interest rates) in the various countries, the flow money/funds used for buying stocks and bonds, the countries’ public debts band the trade balance merchandise (Mishkin, 2007). Word count: 2400. Reference