Economic Question.?

Please help me anyone!!!

Suppose the central bank wants to achieve an inflation rate equal to 1% and the current growth rate of real GDP is 2%. If the quantity theory of money holds, what should the Fed set the money growth rate equal to? (Hint: Use the equation of exchange in growth-rate form.)

THankyou so much in advance!!!

Economic Question.?student finance

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Economic Question.? loan

IS/LM model

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The IS curve moves to the right, causing higher interest rates and expansion in the %26quot;real%26quot; economy (real GDP).The IS/LM model, first developed by Sir John Hicks and Alvin Hansen, has been used from 1937 onwards to summarize a major part of Keynesian macroeconomics.

Contents [hide]

1 Formulation

2 Shifts

3 History

4 Related Models

5 External links

[edit] Formulation

It can be presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is labelled Y%26#039;. The vertical axis represents the real interest rate, i%26#039;.

The IS schedule is drawn as a downward-sloping curve. The initials IS stand for %26quot;Investment/Saving equilibrium%26quot; but since 1937 have been used to represent the locus of all equilibria where total spending (Consumer spending + planned private Investment + Government purchases + net exports) equals an economy%26#039;s total output (equivalent to income, Y, or GDP). To keep the link with the historical meaning, the IS curve can represent the equilibria where total private investment equals total saving, where the latter equals consumer saving plus government saving (the budget surplus) plus foreign saving (the trade surplus). Either way, in equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation (i.e., no general glut of goods and services).[1] The level of real GDP (Y) is determined along this line for each interest rate.

Thus the IS schedule is a locus of points of equilibrium in the %26quot;real%26quot; (non-financial) economy. Given expectations about returns on fixed investment, every level of interest rate (i) will generate a certain level of planned fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like. Income is at the equilibrium level for a given interest rate when the saving consumers choose to do out of that income equals investment (or, more generally, when %26quot;leakages%26quot; from the circular flow equal %26quot;injections%26quot;). A higher level of income is needed to generate a higher level of saving (or leakages) at a given interest rate. Alternatively, the multiplier effect of an increase in fixed investment raises real GDP. Either way explains the downward slope of the IS schedule. In sum, this line represents the line of causation from falling interest rates to rising planned fixed investment (etc.) to rising national income and output.

The LM schedule is an upward-sloping curve representing the role of finance and money. The initials LM stand for %26quot;Liquidity preference/Money supply equilibrium%26quot; but is easier to understand as the equilibrium of the demand to hold money as an asset and the supply of money by banks and the central bank. The interest rate is determined along this line for each level of real GDP.

Rising GDP (Y) implies an increased transactions demand for money and liquidity preference. With a given and inelastic money supply curve, the equilibrium interest rate (i) rises. This explains the upward slope of the LM curve.

The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as labor markets). In IS/LM equilibrium, both product markets and money markets are in equilibrium. Both the interest rate and real GDP are determined.

[edit] Shifts

One Keynesian hypothesis is that a government%26#039;s deficit spending has an effect similar to that of a lower saving rate or increased private fixed investment, increasing the amount of aggregate demand for national income at each individual interest rate. An increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate (from i1 to i2) and national income (from Y1 to Y2), as shown in the graph above.

The graph indicates one of the major criticisms of deficit spending as a way to stimulate the economy: rising interest rates lead to crowding out 鈥?i.e., discouragement 鈥?of private fixed investment, which in turn may hurt long-term growth of the supply side (potential output). Keynesians respond that deficit spending may actually %26quot;crowd in%26quot; (encourage) private fixed investment via the accelerator effect, which helps long-term growth. Further, if government deficits are spent on productive public investment (e.g., infrastructure or public health) that directly and eventually raises potential output.

The IS/LM model also allows for the role of monetary policy. If the money supply is increased, that shifts the LM curve to the right, lowering interest rates and raising equilibrium national income.

In all this, the price level is assumed as fixed and no inflation is taken into consideration. To include them and other crucial issues, several further curves and diagrams are needed. To keep everything in one sheet, one has to shift from the representation through diagrams (in Cartesian spaces) to graphs (nodes and arrows), as defined by Graph theory. An interactive graph of all IS-LM variables and their linkages is provided at http://www.economicswebinstitute.org/ess...

[edit] History

The IS/LM model was born at the Econometric Conference held in Oxford during September, 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John Maynard Keynes%26#039; General Theory of Employment, Interest, and Money. Hicks, who had seen a draft of Harrod%26#039;s paper, invented the IS/LM model. He later presented it in %26quot;Mr. Keynes and the Classics: A Suggested Interpretation%26quot; (Econometrica, April 1937).

Hicks later agreed that the model missed important points from the Keynesian theory. The problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty. A shift in the IS or LM curve will cause change in expectations, causing the other curve to shift. Hicks therefore created a new Hicks-Hansen IS-LM Model to resolve some of the problems. Most modern macroeconomists see the IS/LM model as being at best a first approximation for understanding the real world.

Although the model is generally not taught at the graduate level, a few graduate programs (UNC Greensboro, Auburn University, Florida State,) continue to use it as part of the macroeconomics curriculum. It is also still the dominant paradigm in undergraduate macroeconomics textbooks, although many dynamicists would insist that it is past its prime even in an undergraduate context.

As a growing number of economists have begun to question the %26quot;math for math%26#039;s sake%26quot; approach advocated in modern modeling and used in major texts such as Romer, Ljungqvist and Sargent, as well as Stokey and Lucas, the simplicity of the IS/LM approach has begun to see a renewed appreciation. The purity with which it communicates economic theory and the effects of policy decisions is an invaluable tool for instructors and students alike. The very utilitarian nature of the model makes it an ideal basis for learning- be it at the graduate or undergraduate level.

[edit] Related Models

AD-IA Model

[edit] External links

Elmer G. Wiens: IS-LM Model - An On-line, Interactive IS-LM Model of the Canadian Economy.

The Hicks-Hansel IS-LM Model: [2] in-depth comment and explanation.

Retrieved from %26quot;http://en.wikipedia.org/wiki/IS/LM_mode...

AD-IA Model

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The AD-IA model builds on the concepts of the IS/LM model and the AD-AS models, essentially in terms of changing interest rates in response to fluctuations in inflation rather than as changes in the money supply in response to changes in the price level.

Contents [hide]

1 The Model

2 More Advanced

3 Related Models

4 See Also

[edit] The Model

The AD-IA model is a Keynesian method used to explain economic fluctuations. Essentially, this model is used to show undergraduate students how shifts in demand or shocks to prices can effect real GDP around potential. The model assumes that when inflation rises the interest rate rises (monetary policy rule). It also assumes that when real GDP exceeds potential, there is upward pressure on the inflation rate and vice versa.

The model features a downward-sloping demand curve (AD) and a horizontal inflation adjustment line (IA). The point where the two lines cross is equal to potential GDP. A shift in either curve will explain the impact on real GDP and inflation in the short run.

Shifts in Demand

A shift in demand can occur for the following reasons:

A change in government spending

A change in consumption

A change in taxes

A change in the monetary rule

Example: Suppose the government were to cut taxes. This would lead to an increase in expenditures and thus an increase in demand. The demand curve would therefore shift to the right and real GDP would be growing above potential. The inflation adjustment line would then shift upward (reflecting an increase in the inflation rate) causing a movement along the new demand curve until real GDP was equal to potential.

[edit] More Advanced

This model is further advanced in higher levels of undergraduate studies.

Economist David Romer proposed in the Journal of Economic Perspectives in 2000 that the LM curve be replaced in the IS-LM model. Romer suggested that although the Federal Reserve uses open market operations to impact the federal funds rate, they are not targeting money supply, but rather the interest rate. Therefore, he suggests removing the LM curve and replacing it with the MP curve.

[edit] Related Models

IS-LM

Real Business Cycle Theory

[edit] See Also

Short-Run Fluctuations, David Romer, August 1999. Revised January 2006. [Paper][1] [Figures][2]

Monetary policy

Federal Reserve System

Monetary policy

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Any material not supported by sources may be challenged and removed at any time.Public finance

Tax

Income tax

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Monetary policy

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Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals鈥攕uch as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. (Usually the goal of monetary policy is to accommodate economic growth in an environment of stable prices.) Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, acting as a last-resort lender (i.e. discount window lending), or trading in foreign exchange markets. [1]

Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy has the goal of raising interest rates to combat inflation (or cool an otherwise overheated economy). Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Contents [hide]

1 Overview

2 History of monetary policy

3 Trends in central banking

4 Developing countries

5 Types of monetary policy

5.1 Inflation targeting

5.2 Price level targeting

5.3 Monetary aggregates

5.4 Fixed exchange rate

5.5 Managed Float

5.6 Gold standard

5.7 Mixed policy

6 Monetary policy tools

6.1 Monetary base

6.2 Reserve requirements

6.3 Discount window lending

6.4 Interest rates

7 Currency board

8 Monetary policy theory

9 Monetary policy used by various nations

10 References

11 See also

[edit] Overview

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Further monetary policies are described as accommodative if the interest rate set by the central monetary authority is intended to spur economic growth, neutral if it is intended to neither spur growth nor combat inflation, or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends. Increasing interest rates by fiat, reducing the monetary base, and increasing reserve requirements all have the effect of contracting the money supply, and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. And even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank or the Federal Reserve System in the United States) exist which have the task of executing the monetary policy independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

Usually the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, however, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight. However the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

[edit] History of monetary policy

Monetary policy is associated with currency and credit. For many centuries there were only two forms of monetary policy: decisions about coinage, and the decision to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. [2] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation%26#039;s peg to the gold standard, and to trade in a narrow band with other gold back currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.

During the 1870-1920 period the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913. [3] By this point the understanding of the central bank as the %26quot;lender of last resort%26quot; was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which focused on how many more, or how many fewer, people would make a decision based on a change in the economic trade-offs. It also became clear that there was a business cycle, and economic theory began understanding the relationship of interest rates to that cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often been described as trying to steer an oil tanker with a canoe paddle.)

The advancement of monetary policy as an engineering discipline has been quite rapid in the last 150 years, and it has increased especially rapidly in the last 50 years. Monetary policy has grown from simply increasing the monetary supply enough to keep up with both population growth and economic activity. It must now take into account such diverse factors as:

short term interest rates;

long term interest rates;

velocity of money through the economy;

exchange rates;

credit quality;

bonds and equities (corporate ownership and debt);

government versus private sector spending/savings;

international capital flows of money on large scales;

financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar%26#039;s fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail.

Most economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk; they can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved.

[edit] Trends in central banking

The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks%26#039; reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks%26#039; reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (basically loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when the exchange rate is floating. [4] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best %26quot;lean against the wind%26quot; in a world where capital is mobile.

Accordingly, the management of the exchange rate will influence domestic monetary conditions. In order to maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.

In the 1980s, many economists began to believe that making a nation%26#039;s central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence. Independence has not stunted a thriving crop of conspiracy theories about the true motives of a given action of monetary policy.

In the 1990s central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. That is, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5%.

The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Misesan%26#039;s arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.

[edit] Developing countries

Developing countries may have problems operating monetary policy effectively. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, central banks in developing countries have had a poor record in managing monetary policy.

However, recent attempts at liberalising and reforming the financial markets particularly the recapitalisation of banks and other financial institutions in Nigeria and elsewhere are gradually providing the leeway required to implement monetary policy frameworks by the relevant central banks.

[edit] Types of monetary policy

In practice all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency is called open market operations.

Constant market transactions by the monetary authority modify the liquidity of currency and this impacts other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables.

The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target. Targeting being the process of achieving relative stability in the target variable.

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI

Price Level Targeting Interest rate on overnight debt A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange Rate The spot price of the currency The spot price of the currency

Gold Standard The spot price of gold Low inflation as measured by the gold price

Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonised consumer price index).

[edit] Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, at a particular level.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are done in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target.

This monetary policy approach was pioneered in New Zealand. It is currently used in the Eurozone, Australia, Canada, New Zealand, Norway, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

[edit] Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.

Something like price level targeting was tried in the 1930s by Sweden, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.

[edit] Monetary aggregates

In the 1980s several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

Whilst most monetary policy focuses on a price signal of one form or another this approach is focused on monetary quantities.

[edit] Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. Currency is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsibility for monetary policy to a foreign government.

This type of policy was used by China. The Chinese yuan was managed such that its exchange rate with the United States dollar was fixed.

See also: List of fixed currencies

[edit] Managed Float

Officially, the Indian Rupee (INR) exchange rate is supposed to be %26#039;market determined%26#039;. In reality, the Reserve Bank of India (RBI) trades actively on the INR/USD with the purpose of controlling the volatility of the Rupee - US Dollar exchange rate - within a narrow bandwidth. ( i.e pegs it to the US Dollar )

Other rates - like the INR/Pound or the INR/JPY - have volatilities which reflect the volatilities of the US/Pound and the US/JPY respectively.

The pegged exchange rate is accompanied by an elaborate system of capital controls.

- On the current account, there are no currency conversion restrictions hindering buying or selling foreign exchange (though trade barriers do exist).

- On the capital account, %26quot;foreign institutional investors%26quot; have convertibility to bring money in and out of the country and buy securities (subject to an elaborate maze of quantitative restrictions).

- Local firms are able to take capital out of the country in order to expand globally.

- Local households have quantitative restrictions( which are being relaxed in recent times) in their ability to do global diversification . ( example while local firms can buy real estate - individuals may not). However they are able to purchase items ( mainly consumer items - say a laptop) and services reasonably freely ( there are quantitative restrictions ). Most of these transactions happen through credit cards through the internet.

Owing to an enormous expansion of the current account and the capital account, India is increasingly moving into de facto convertibility. However - it still cannot be considered a fully convertible currency.

The INR is not a highly traded currency - beyond India. It is traded by way of Forwards through inter bank transactions. ( again the US Dollar exchange rate determines the INR / other Crosses exchange rate )

As any currency traded in the international market - the INR does trade at a market determined premium / discount for the forward months.

[edit] Gold standard

The gold standard is a system in which the price of the national currency as measured in units of gold is kept constant by the daily buying and selling of base currency. (i.e. open market operations, cf. above).

The gold standard might be regarded as a special case of the %26quot;Fixed Exchange Rate%26quot; policy. And the gold price might be regarded as a special type of %26quot;Commodity Price Index%26quot;.

Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.

[edit] Mixed policy

In practice a mixed policy approach is most like %26quot;inflation targeting%26quot;. However some consideration is also given to other goals such as economic growth, unemployment and asset bubbles.

This type of policy was used by the Federal Reserve in 1998.

[edit] Monetary policy tools

[edit] Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.

[edit] Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply.

[edit] Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.

[edit] Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates.

Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal Funds Rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market.

In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage lending. Both of these effects reduce the size of the money supply.

[edit] Currency board

Main article: currency board

A currency board is a monetary authority which is required to maintain an exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.

The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country%26#039;s terms of trade, irrespective of economic differences between it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country%26#039;s subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasised the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders.

Currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.

[edit] Monetary policy theory

It is important for policymakers to make credible announcements regarding their monetary policies. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behaviour between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages.

However, to achieve this low level of inflation, policymakers must have credible announcements, that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer%26#039;s demand (demand pull inflation) and a firm%26#039;s costs (cost push inflation), so inflation rises. Hence, if a policymaker%26#039;s announcements regarding monetary policy are not credible, policy will not have the desired effect.

However, if policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation). However, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Therefore, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behaviour) and so there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet their targets (for example, larger budgets, a wage bonus for the head of the bank) in order to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much would markets believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from her or his ideology, professional background, public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985. %26quot;The Optimal Commitment to an Intermediate Monetary Target%26quot; in %26#039;Quarterly Journal of Economics%26#039; #100, pp. 1169-1189) that in order to prevent some pathologies related to the time-inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations.

[edit] Monetary policy used by various nations

Australia - Inflation Targeting

Canada - Inflation Targeting

China - Targets a currency basket

Eurozone - Inflation Targeting

Hong Kong - Fixed Exchange Rate (US dollar)

New Zealand - Inflation Targeting

United Kingdom[5] - Inflation Targeting, although with some focus on wide issues

United States [6] - Mixed policy

[edit] References

^ %26quot;Monetary Policy%26quot;, Federal Reserve Board, January 3, 2006.

^ %26quot;Bank of England founded 1694%26quot;, BBC, March 31, 2006.

^ %26quot;Federal Reserve Act%26quot;, Federal Reserve Board, May 14, 2003.

^ %26quot;Exchange Rates%26quot;, The Library of Economics and Liberty, March 31, 2006.

^ %26quot;Monetary Policy Framework%26quot;, Bank Of England, 2006.

^ %26quot;U.S. Monetary Policy: An Introduction%26quot;, Federal Bank of San Francisco, 2004.

[edit] See also

Contractionary monetary policy

Currency devaluation

Digital gold currency

Macroeconomic policy instruments

Expansionary monetary policy

Monetary base

Monetary policy of the Eurozone

Monetary policy of the USA

Monetary policy of Sweden

Money

Quantity theory of money

International reserve system

Private currency

Inconsistent trinity

Hafsa Begum

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