Central
banks have played a key role in shaping public policy by performing a mixture
of monetary policies that have helped their economies from exiting recessions,
and maintaining stability in their financial institutions. For example, during
the recession of 2002 – 2005, the US Federal Reserve kept interest rates so low,
to a point of being negative. These low rates gave rise to “free money”,
created an inflationary gap and finally caused the bubbles in the economy, like
that of housing. The same occurred in Spain with excessive low rates which caused
also inflated housing prices.
In comparing the European Central bank to that
of the US Federal reserve, the ECB reduced interest rates at a slower pace than
did the FED. Earlier this month, the United States reported better than
expected jobs report. The unemployment dropped to +6.1%, but the US FED did
nothing to interest rates. This had a positive impact on the US dollar. The
European ECB left rates unchanged also, making monetary policy less effective.
Despite low rates in the Eurozone, banks are unwilling to lend to the real
economy until they become fully recapitalized. Once they are in a position to
lend, their profits will increase and their balance sheets will be enhanced,
and their stocks will start to look attractive again.
Central
banks espouse a desire for sustained inflation at 2% and adjust their monetary
policy accordingly. June Consumer price index in the US was 2.1%, year on year.
There is also the so called creeping inflation, which is wage growth, and the
relationship between wages and the unemployment rate. Brazil’s central bank in
its June central monetary policy committee said that interest rates will stay
unchanged for the remaining of the year. Its benchmark Selic rate is at 11%.
Other economic data like inflation at 6% and Q1 industrial production weaker,
said that raising rates risks a recession. Its currency has been depreciated
and is a concern for inflation.
Monetary
policies of central banks have either a dual mandate, which is inflation
control and GDP growth, or, single mandate, pursuing only inflationary policy.
The tools of central banks are to change the money supply, and with the
intersection with money demand, set the interest rate in the market. Three
tools at its disposal to move the money supply is the discount rate, the
reserve ratio, and open market operations.
Lower
rates may not be as effective in GDP because low rates may not cause banks to
lend, or increase in GDP during recessionary gaps. When the economy is
overheated (actual GDP > potential GDP) there is a restrictive fiscal and
monetary policy reinforcing each other. This creates a sharp decline in
aggregate demand, in inflation and GDP growth. In an expansive fiscal and
monetary policy there is an increase in aggregate demand, inflation rises,
government spending rising, or cutting taxes to stimulate the economy. From a
monetary point of view, a cut in interest rates have an influence in the value
of the currency. When interest rates move the demand for the currency will
change.
If
interest rates rise foreign investors will invest their savings in the currency
so demand for the currency, and its value, will rise. On the opposite, exports
will go down due to a higher value in price. Imports become cheap so aggregate
demand for exports shifts leftward. A rise in the value of a currency is a restrictive
policy for the economy. This helps with energy prices hence inflation will
decline.
If
central banks cut interest rates foreign investors in the currency market pull
off their assets. Demand for the currency declines, the value falls, exports
will rise as they become cheaper. Aggregate demand increases and imports are
falling since they are now expensive, and inflation rises.
Structural
reforms are important in as far as the aggregate supply is concerned. When
production costs change, financing costs, energy costs, complying with government
regulations, all are affecting aggregate supply. If aggregate supply shifts
inward, GDP decreases, unemployment rises, a combination known as stagflation.
When aggregate supply shifts outward to the right, GDP expands, inflation
decreases and unemployment drops.
