Re: World Cash Reserves Increase
Anyone,
What are fiscal policies? What are monetary policies?
How do each influence the state of world economy in the face of pandemic?
How will each be able to help in recovery? or will they?
Thanks in advance.
OK I'll do my part. Here's a start from wikipedia on definitions of
- fiscal policy and
- monetary policy.
Is there anything more of importance on these topics in terms of what we should know in the 3 following phases?
- pre-pandemic phase,
- pandemic phase,
- post-pandemic phase
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http://en.wikipedia.org/wiki/Fiscal_Policy
Fiscal policy is the
economic term which describes the actions of a government in setting the level of
public expenditure and how that expenditure is funded.
It contrasts with
monetary policy, which describes the policies about the supply of money to the economy.
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Types of Fiscal Policy
Expansionary fiscal policy - an increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output.
Contractionary fiscal policy - a decrease in government purchases of goods and services, an increase in net taxes, or some combination of the two for the purpose of decreasing aggregate demand and thus controlling inflation.
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Methods of raising funds
Governments
spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as
transfer payments such as welfare benefits.
This expenditure can be
funded in a number of different ways:
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Funding of deficits
A fiscal deficit is often funded by issuing
bonds, like
Treasury bills or
consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too great, a nation may
default on its debts, most usually to foreign debtors.
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Economic effects of fiscal policy
Governments often use their fiscal policy to try to influence the economy towards economic objectives such as low inflation and unemployment.
According to
Keynesian economics, high government spending, funded by a deficit, can be beneficial to the economy by stimulating
aggregate demand and decreasing
unemployment, during a
recession.
A corollary of this is that, during a period of
inflation, a reduced deficit (or a budget surplus), can reduce inflation by reducing aggregate demand. This is a result of the
Phillips curve, which describes the link between inflation and output/unemployment.
The nature of fiscal policy has other economic effects, which are emphasised by other schools of economic thought. In particular:
- government borrowing is held to reduce private-sector borrowing and investment because of crowding out.
- the linkage between deficits and inflation via the Phillips curve is controversial
- Ricardian equivalence suggests that, since any fiscal deficit must ultimately be repaid, government borrowing will not affect the economy.
All these factors suggest that the long-run effect of borrowing is much less beneficial than the short-run effect. To stop governments
over-borrowing to meet short-term objectives, some nations have adopted
fiscal policy rules, like the
Golden Rule and the
Stability and Growth Pact.
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Monetary effects of fiscal policy
The fiscal policy of a government can affect the
monetary policy. Government borrowing competes for the same
loanable funds as other investment, so an increased deficit may result in a rise in
interest rates. Government debt also represents a form of
money on the
broad definition, increasing the money supply .
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Category:
Economic policy
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http://en.wikipedia.org/wiki/Monetary_policy
Monetary policy is the
government or
central bank process of managing
money supply to achieve specific goals?such as constraining
inflation, maintaining an
exchange rate, achieving
full employment or
economic growth. Monetary policy can involve changing certain
interest rates, either directly or indirectly through
open market operations, setting
reserve requirements, or trading in
foreign exchange markets. <sup id="_ref-fed_0" class="reference">
[1]</sup>
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.
1?
euro coin
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Overview
In any currency, there is a
supply of money, and an
interest rate, the price at which money can be borrowed. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like
economic growth,
inflation and
unemployment.
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.
There are several monetary policy tools available to achieve these ends. Increasing interest rates by fiat, reducing the
monetary base or 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 (like the
European Central Bank or the
Federal Reserve) 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.
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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. <sup id="_ref-bank_england_0" class="reference">
[2]</sup> 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'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. <sup id="_ref-fedact_0" class="reference">
[3]</sup> By this point the understanding of the central bank as the "lender of last resort" 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.
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:
A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar'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.
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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' 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' 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. <sup id="_ref-exchange_0" class="reference">
[4]</sup> 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.
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'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). The
Austrian school of economics, which includes
Friedrich von Hayek and
Ludwig von Misesan argument, but most economists fall into either the Keynesian or neoclassical camps on this issue.
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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.
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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.
<table border="0" cellpadding="2" cellspacing="1" style="background: rgb(192, 192, 192) none repeat scroll 0% 50%; -moz-background-clip: initial; -moz-background-inline-policy: initial; -moz-background-origin: initial; margin-left: 1em;"> <tbody><tr> <th>Monetary Policy:</th> <th>Target Market Variable:</th> <th>Long Term Objective:</th> </tr> <tr bgcolor="#ffffff"> <td width="180">Inflation Targeting</td> <td width="180">Interest rate on overnight debt</td> <td width="180">A given rate of change in the CPI</td> </tr> <tr bgcolor="#ffffff"> <td>Price Level Targeting</td> <td>Interest rate on overnight debt</td> <td>A specific CPI number</td> </tr> <tr bgcolor="#ffffff"> <td>Monetary Aggregates</td> <td>The growth in money supply</td> <td>A given rate of change in the CPI</td> </tr> <tr bgcolor="#ffffff"> <td>Fixed Exchange Rate</td> <td>The spot price of the currency</td> <td>The spot price of the currency</td> </tr> <tr bgcolor="#ffffff"> <td>Gold Standard</td> <td>The spot price of gold</td> <td>Low inflation as measured by the gold price</td> </tr> <tr bgcolor="#ffffff"> <td>Mixed Policy</td> <td>Usually interest rates</td> <td>Usually unemployment + CPI change</td> </tr> </tbody> </table> 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).
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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,
Sweden,
South Africa,
Norway and the
United Kingdom.
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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.
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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.
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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.
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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. This process is called open market operations.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
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.
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Mixed policy
In practice a mixed policy approach is most like "inflation targeting". 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.
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Monetary policy tools
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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. Note that open market operations are a relatively small part of the total volume in the
bond market, thus the central bank is not able to influence interest rates through this method.
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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 mortages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availablilty of loanable funds. This acts as a change in the money supply.
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Discount window lending
Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The lended funds represent an expansion in the monetary base. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.
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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 only
directly set the
discount rate; it engages in
open market operations to alter the
federal funds rate. This rate has some effect on other market interest rates, but there is no direct, definite relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By altering the interest rate(s) under its control, a monetary authority can affect the money supply.
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Currency board
<dl> <dd>
Main article: currency board</dd> </dl> 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'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'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.
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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 (
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 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's demand (
demand pull inflation) and a firm's costs (
cost push inflation), so inflation rises. Hence, if a policymaker'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 (e.g. larger budgets, a wage bonus for the head of the bank). A policymaker with a reputation for low inflation policy can make credible announcements because private agents will expect future behavior to reflect the past.
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Monetary policy used by various nations
- Australia - Inflation Targeting
- China - Targets a currency basket
- Eurozone - Inflation targeting
- Hong Kong - Fixed Exchange Rate (US dollar)
- New Zealand - Inflation Targeting
- United Kingdom - Inflation Targeting
- United States <sup id="_ref-frbsf_0" class="reference">[5]</sup> - Mixed policy
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References
- ^ "Monetary Policy", Federal Reserve Board, January 3, 2006.
- ^ "Bank of England founded 1694", BBC, March 31, 2006.
- ^ "Federal Reserve Act", Federal Reserve Board, May 14, 2003.
- ^ "Exchange Rates", The Library of Economics and Liberty, March 31, 2006.
- ^ "U.S. Monetary Policy: An Introduction", Federal Bank of San Francisco, 2004.
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See also
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Categories:
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