The Changing World of Central Banks

It seems week by week that central banking institutions are only becoming more uncertain about what kind of actions to take in the current economic climate.

There is considerable hesitancy surrounding the choice of the FED to leave the base rate unchanged, this had considerable international repercussions with having to continue handling its deteriorating situation with no clear resolution, while the ECB and Bank of England are waiting in the wings taking a strategy of what seems to be follow the FED.

Mark Carney has begun his warning to expect monetary tightening in the near future, continuing with a vague timeline. While commentators in the United States who have been investigating the FED’s books that have a two week lag are beginning to hypothesise that there won’t be a rate rise in early 2016.

The key element here is looking at the behaviour of inflation over 2015 with targets regularly missed, while lacking concrete explanations for why. Both UK and US economies are experiencing growth albeit at low rates. Therefore, acting upon base rate may seem to extreme at the moment. The Bank of England has instead taken up to involving itself in politics discussing the impacts of leaving or staying in the eurozone, while they haven’t made their stance that abundantly clear as some saw it as euro skeptic and others as reasons to stay in.

We are entering a unique period where these critical financial institutions are struggling to grip with conventional policy practice, and potentially look for better ways to understand the economic climate.

CNBC have a great report on the FED actions that I recommend reading, while Krugman had a great post along similar lines on Saturday

Monetary Transmission Mechanism

I am going to consider and evaluate the money transmission mechanism in regards to the use of a contractionary monetary policy. This will be in form of a hypothetical increase in the base interest rate set by a central bank, and the no change in money supply. This has a considerable effect on the value of currency, output of the economy, price level, and the factors that establish output.

The increase in the base rate of interest by a central bank does not directly affect the consumer, as it does not lend to individuals. However, the change in base rate does influence the interest rate at which retail banks will lend money, and may vary the cost of long term borrowing such as mortgages.

First there will be a direct effect on consumer spending as a result of the increase in the base rate, due to the influence on retail banks. In a sense the cost of borrowing money has increased, and therefore this will decrease demand for borrowing as people will not be able to afford it. This will considerable effect on households with mortgages, as the consumer will now have more of their income paying off the loan, thereby decreasing their disposable income. This does not only apply to mortgages but also those with short term loans, and even credit cards. The cost of money for the consumer has increased and this restricts their effective demand. In a large scale this would cause a contraction in aggregate demand, as consumer spending will decrease.

This monetary policy will also induce a fiscal effect. Higher interest rates would encourage people to save more of their money rather than to spend it. Fiscally this would be seen as a withdrawal which again would affect the level of aggregate demand. This would “cool-down” the economy and can be noted as part of a policy that would have both monetary and fiscal elements.

Furthermore, the manipulation of interest rates will have a direct consequence on the strength of the currency in regards to foreign exchange. The currency will strengthen as a result of increasing the interest rates, as money will enter the system for the purpose of saving at a lucrative interest rate. An example of this was seen in Australia where interest rates were high and as a result the currency continued to strengthen.

This has adverse effects on the balance of trade, as a result of a strong currency exports will decrease because domestic products are more expensive abroad, and imports will increase because foreign products are “cheaper”. Referring back to the example of Australia the government announced that it wanted to reduce the interest rate as the economy was becoming too dependent on imports and it also sought to increase exports.

In regards to aggregate demand, there would be a considerable contraction if this were to continue for a long period of time. As there is a decrease in consumer spending, and imports would exceed exports. However, the final factor could be seen in a decreasing level of firm investment.

The increase in interest rates will decrease a firm’s ability to borrow money, and so this will decrease the firms’ ability to invest in development, or research. This would mean that firm’s would not seek to increase production, or invest in new technologies to achieve greater productivity or efficiency. It could also possibly involve the freezing of employees wage rates.


However as a result of increasing national independence some of these effects may be magnified or reduced by the monetary policy of other countries. The most recent example is that of the United States and China as each is accusing the other of direct currency manipulation it order to ensure economic goals are met by possibly affecting other economies. It is possible that if one central bank in a major economic country such as Britain would raise the base rate, it might signal the European Central Bank to increase their base rate. There is to a degree a large scale of speculation, in regards to what international effect there may be. Australia is a rare example where government announcement was met with direct action as money began to flow out of savings and was reinvested into the stock markets in the U.S. and U.K. identified in the rise of the central indexes of the S&P 500, Dow Jones, and FTSE 100.

Previously mentioned was also the actions of firm, and the question must be raised to what degree would they decrease investment. There is still the entire complex of competition amongst firms, so as a result of this no firm within a given industry may reduce levels of spending as a there is a need to maintain competiveness and market share. It is also a different market in regards to loans for large corporations or small business, the increase in the cost of borrowing for a corporation or conglomerate  may be insignificant, but for a small business it may depend on cheap borrowing to maintain a the entrepreneurial plan for creating a new firm.

In regards to the use of credit cards and other types of short term loans, there may not be such a drastic decline in their use. In many cases consumers are dependent on the use of credit cards to maintain their lifestyle. This brings along the point that even though interest rates are higher so saving is more lucrative, there could be the case that people cannot afford to save. This takes into account the marginal propensity to save. This is the change in savings in regards to a change in income; the change in income would be a result of the increased cost of borrowing. So in a sense marginal propensity to save will decrease as individuals have less income and must use it so live.

The effect on individuals with mortgages may have a time delay, as a result of there being different types of mortgages. Those with variable rate mortgages would suffer immediately as now a greater portion of their income will be taken up with monthly payments, but those that have fixed rate mortgages for a given time period may benefit as their monthly payments have not changed. However, to analyse this it would be necessary to take into account how many people have fixed rate mortgages, and this would establish the aggregate effect on consumer spending.

Finally, there is also the factor of how quick the change in the base rate is. For example in Europe following the financial crisis the central bank quickly dropped the base rate, but in Japan during the 90s the change in the base rate was gradual. In Europe to avert full scale crisis dropping the base rate quickly had arguably aided in ensuring that demand was not completely wiped out as a result of crisis. Although, it is still questionable as times of crisis are unique situations as their causes and consequences differ. This is where there is a greater link between monetary policy and fiscal policy, and the most recent example of this can be seen in European austerity.

Currently in Europe the ECB’s base rate is at 0.5%, simply this means that the cost of borrowing is “cheap” and this falls in line with expansionary monetary policy aimed at achieving economic growth. However, at the same time there is a restriction on government spending and increased taxes to deal with debt, and this can be seen as a reduction in injection and an increase in withdrawals forming contractionary fiscal policy. This forms an obstruction in the money transmission mechanism in regards to trying to pursue growth, but keep inflation down, and reduce government debt.

The money transmission mechanism is a good example of the expected response in changes to monetary policy. However the current economic climate is a fine example of how it may not work as a result of other policies pursued. In the evaluation of the changes it could be noted that it is difficult to consider it on a whole market level as it has different effects for those on high or low incomes, and small or big businesses.

Monetary Policy Basics

Interest Rates:

The interest rate determines the rate of interest at which borrowers pay lenders.  This can be on a consumer level or a business level and may or may not involve the central banks or private banks. When the base interest rate is lowered by the central bank of a country, it can be noted that borrowing is in a sense cheaper. When the base interest rate is increased the cost of borrowing is seen to become more expensive.

Money Supply:

Money supply is the total amount of monetary assets within the economy during a given period of time.  It consists of bonds, investments, other financial instruments, as well as cash. Traditionally an increase in money supply sees the price level of an economy increase, as there is “more money, chasing the same amount of product”. Whereas maintaining a specific money supply or reducing it leads to the price level of an economy decreasing, as there is “less money, chasing the same amount of product” meaning that there is no longer effective demand.

Expansionary Monetary Policy:

This would be pursued in order to achieve increased economic activity in the pursuit of growth. One manner of pursuing expansionary policy is to increase the money supply, while lowering interest rates. This will increase the output of the economy, but consequently an inflationary response.

This would be noted as a shift in aggregate demand outwards as you are increasing factors such as consumer spending, and investing. However, this does not directly affect government spending and the balance of trade may not change.

Contractionary Monetary Policy:

This would be pursued in order to achieve a lower price level in the economy, and to induce a cool-off period for the economy. One manner of pursuing contractionary policy is to decrease or maintain money supply, while increasing interest rates. This will reduce the output of the economy, while reducing the price level. This can be noted as a deflationary response.

This would be noted as shift in aggregate demand inwards as you are reducing factors such as consumer spending, and investing as you are making it more difficult to obtain credit, and establish effective demand.

Monetary Policy:

The most popular type of monetary policy to pursue is currently inflation targeting, whether to induce inflation or reduce it. There are however other factors that come into play in regards to monetary policy, which increase its complexity and its possible results. There is the issue of the velocity of money throughout the economy, and this considers how and where the money is moved and what economic activity it actually participates in.

It was Irving Fisher in 1911 who had established the clear relationship between money supply, velocity of money, and inflation. This can be noted as MV=PQ where M represents money supply, V represents velocity of money; P represents the price level of the economy, and Q the total quantity of goods available.

There is also one key issue that is often debated in regards to monetary policy, and that is the role of the gold standard. Traditionally, the value of a currency had been derived from gold which held actual value and was in existence at any one point. The reset of a currency back to the gold standard has often been used to combat high levels of inflation or hyperinflation as it has a “real value”. However the use of the gold standard restricts our ability to create money in order to manipulate currency, and a common use of monetary policy today has been to decrease/increase the value of a currency to achieve economic goals such as increased exports.

It can be noted that keeping the gold standard is difficult as economies tend to grow faster than the supply of gold, and this results in deflation. This is shown in the case where money supply is reduced, as there is no longer the effective demand at current market prices. The gold standard does to a degree have transparency as it is difficult to manipulate, but it restricts economies when there is a need for higher debt in order to fund war efforts, or revive the economy.