Free Essay On Contemporary Monetary Markets

Type of paper: Essay

Topic: Banking, Money, Economics, Policy, Finance, Central Bank, Investment, Monetary Policy

Pages: 5

Words: 1375

Published: 2020/12/18


Central banks play a crucial role in stabilizing an economy. That is through the application of monetary policy tools that controls money supply. In that view; the bank can apply the tools to address economic problems in different business cycles. To analyze the tools application, this essay seeks to demonstrate how the bank applies the tools and their application in the modern financial systems. That is achieved with reference to the UK banking system that is assumed to have ability to supply money by relying on liabilities. That would satisfy the increase or decrease in loan demand to accommodate the increase or slow down in the economy’s activities. Further, it considers that banking firms are limited in their response owing to the investors’ willingness to acquire and hold their liabilities. In that respect, the following discussion explains the central bank response in resolving the issue. I also explain whether the practice is consistent with the current Bank of England practices. (Thomas, 2000)

Bank of England response by altering money supply elasticity over the course of a business cycle.

Business cycles
Business cycles refer to the economic activities fluctuation experienced over a period in an economy. An economy grows in real terms during expansion excluding the inflation issue. That is evidenced by the increase in indicators such as employment, sales, personal income and industrial production. (Friedman, 1968). However, an economy experiencing a contraction has a need for addressing related problems by the relevant authorities with strategies that affect macro-factors. (McCallum & Edward, 1997) An expansion cycle is measured from the previous business cycle’s trough; the bottom to the current cycle’s peak while measuring of a recession is done from the peak to the trough. (Dornbusch & Fischer, 1990) To address the problems associated with a recession, the monetary authorities mainly focus on money supply control that influences funds availability for banks to advance loans. (Pollaro, 2014)

Money supply

Money supply increase typically lowers the interest rate and in turn generating more investments and increasing consumers’ money stimulating their spending. In response, businesses increase their production through demand for additional raw materials and as the result of the increase in business activities and labor demand. (Gordon, 1979) In the event of a fall in the money supply or decline in growth rate, the opposite occurs. However, a nation’s responsibility for determining the money supply and setting the monetary base rests with a central bank together through certain restrictions upholding the value of assets and liabilities held by commercial banks. (Rudiger, Fischer, & Startz, 2003)
The public dictates liquidity demand by the consumers, and it is a requirement for the small commercial banks to meet the demands of the consumers. That is through of certain conditions including setting interest rate that applies to the lending of bank liabilities. (Goodhart, 1984) The behavior of commercial banks is ultimately regulated by the central bank institution, and together with the consumer demand defines the total money stock, rate of interest and bank credit which shapes the economic condition of a nation. The monetary base and multiplier determines the money supply value. In achieving the objective, central banks applies here tools including the open market operations, the discount rate, and reserve requirements. (Williams,1997)

Open Market Operations

Open market operation is the most dominant tool used by central banks in their monetary policy implementation. (KIPPRA, 2006) The bank would sell government securities for cash to reduce the monetary base and limit commercial banks access to loanable funds. On the other hand, the monetary base would be expanded by purchasing the government securities. (Wieland, 1997)

The Discount Rate

Central banks have the responsibility of supplying enough currencies to commercial banks to meet customers demand. The central bank’s control of interest rate can dictate and meet the money demand by the consumers. An increase in money demand by consumers would be sparked by decrease in the interest rate while lessening of money demand would be by increase in the rate. (Wass, 2008) Interest rates also change the economies price levels hence influencing the business cycle. Any increase in money demand will cause a rise in prices as the spending level increases. On the other hand, money demand decrease results in a decrease in the price level as a result of slow spending. Thus, the adjusting of the rate would address an economy’s growth or slowdown as required. (Gali, 2008)

Reserve Requirements

Commercial banks have a responsibility to remit a certain fraction of all deposits as an account or cash with a central bank. Total money supply may be altered by the central bank by changing the required reserve of the total deposits. (Victoria & Scharfstein, 2010) A decrease in the monetary base will be caused by an increase in reserve requirement. On the other hand, while a decrease in the requirement will cause an increase in the monetary base hence reducing and increasing lendable funds respectively while addressing the business cycle as necessary. (Barron & Lynch 1989)

Policy consistency with the current practices of the Bank of England

Central banks mostly oblige holding of minimum reservation to the depository institutions against their liabilities at the banks predominantly in the form of balances. These reservation requirements roles have significantly evolved over time. In the economy that is modern, whenever a bank makes a loan, on the borrower's account, it simultaneously creates a depositing match, hence making new money. (Gavin, Keen & Pakko, 2005) Rather than banks saving and lending out deposits from households savings, deposits are created by banks lending. Central bank in normal times does not fix the circulating amount of money nor is the money of central bank “Multiplied up” into more deposits and loans. (European Central Bank, 2013).
Current commercial banks although using lending to create money; they do not do that freely without limit. For banks to remain profitable, in a banking system that is competitive, they are limited to the amount they can lend. (Gary & Metrick, 2011) Also for the financial system resilience maintenance, prudence regulations are necessary to act as banks activities constraints. (Thomas, 2000) Moreover, companies and households receiving money created through new lending affect the stock money through their actions – if they use it, for instance, to repay their debts, they would “destroy” money quickly. (IMF, 2002)
Thus, England’s monetary policy creation of money acts as the ultimate limit. Bank of England aims to ensure the amount of money in the economy been created consistency with stable and low economy. In normal times, Bank of England sets interest rates on Central Bank reserves in its implementation of monetary policy. (Victoria & Scharfstein, 2010) That influences interest rate range in the economy including banks loans. When rates are at their low in exceptional circumstances, money spending and the economy creation may be too low according to monitory policy objectives of the central bank. (Fair, 2005) Thus, the banks intention is to increase the amount of money, by purchasing assets, directly to the economy. Mainly from financial companies that are non-banking. That increases the initial amount of deposits in the bank for those companies. Then they wish to buy assets that are higher yielding to rebalance their assets portfolio, stimulating economies spending and raising those assets prices. (IMF, 2014)
In that view, Money creation has been one of the Bank of England’s objectives for monetary stability assurance. That has involved keeping price inflation on track to meet targeted 2% that is set by the government. As discussed, various measures have at a similar rate grown to nominal spending, determining pressure in the UK economy and inflation in medium terms. (Atkeson, Chari & Kehoe, 2007). So a stable credit creation of money is the ultimate results of the Bank of England’s appropriate monetary policy. In addition, the Bank’s Monitory policy committee (MPC), sets short-term interest rates in normal times, as it implements monetary policy thus setting specific rates paid by commercial banks. (Ireland, 1996)

Importance is the repo market to the activities of banking firms

Repo markets are part of the collateralized money markets that are crucial for fixed-income securities and equities trading. They are especially crucial for arbitrage in Treasury, and securities’ markets that are mainly mortgage-backed, thus enhancing market liquidity and price discovery. In that view, Repo transactions are the most relevant and significant type of transactions in the secured money market. In addition, financial institutions, enterprises, securities traders and other market participants use the repo markets for funding long-term investments or/and in managing their liquidity. The repos importance has grown in the past years owing to the continued trend of risks hedging by lending business that confines the banks to capital requirements. (Gary & Metrick, 2011)


In view of the analysis, Central Bank uses several monetary policy tools to control money’s supply and influence macro factors that are relevant to business cycles. Tools have been identified o include open market operations, setting the reserve requirement, as well as the base rate. The Bank of England currently applies that practice in its monetary policy role. Finally, the discussion has indicated repo markets to be crucial to financial institutions in their liquidity management as well as hedging.


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