The role of monetary policy in managing the exchange rate

By the s, countries began to explicitly set credible nominal anchors. Economic development requires investment on a gigantic scale both by the public sector and the private sector.

The selective credit control, unlike quantitative credit control makes discrimination between essential and non-essential use of bank credit and helps the funds to flow into desirable channels and uses without affecting the economy as a whole.

The Bank of England exemplifies both these trends. Role of monetary policy in the economic development of a country are as follows: Monetary policy can help in narrowing the balance of payments deficit through high rate of interest. Further, qualitative methods of credit control can be used effectively to ensure flow of funds into desirable channels.

Effect of Monetary Policy

However, some economists from the new classical school contend that central banks cannot affect business cycles. So far a stimulus to savings is concerned, it may be mentioned that the volume of savings is more a function of the level of income rather than the rate of interest.

Note that foreign investors are often getting better rates of return than what might be readily apparent because the value of the domestic currency is falling relative to their own currency. There exists vast non-monetised sector in under-developed economies which is not responsive to changes in the quantity of money and interest rates and such, this sector remains outside the effective control of the Central Bank.

As a result, an imbalance is created between imports and exports which lead to disequilibrium in the balance in payments. Similarly, selective credit controls should be adopted to influence the pattern of investment and production by differentiating between the costs and availability of credit to different sectors and industries.

The commercial banks, mainly provide short-term credit requirements of businessmen and traders and are reluctant to provide medium and long-term credit to meet the financial requirements of industry and for manufacturing in general.

Besides, the rise in per capita income and increase in population during the development process also increases the demand for money to carry out day-to-day transactions.

However, these anchors are only valid if a central bank commits to maintaining them. Should a central bank use one of these anchors to maintain a target inflation rate, they would have to forfeit using other policies. Monetary policy is an important instrument for achieving price stability k brings a proper adjustment between the demand for and supply of money.

Thus there can be an advantage to having the central bank be independent of the political authority, to shield it from the prospect of political pressure to reverse the direction of the policy. These are essential for the success of a development oriented monetary policy which also includes debt management.

Creation and Expansion of Financial Institutions, 5. Commercial banks are also not in the habit of redics counting or borrowing from the central bank. The monetary authority can employ both traditional weapons of control such as bank rate, open market operations etc.

Monetary policy

Since there is dearth of complementary resources in such economies and the supply curve of goods is generally inelastic, the abnormal increasing effective demand generated by huge government expenditure paves the way for inflation. The primary aim of debt management is to create conditions in which public borrowing can increase from year to year.

Thus there can be an advantage to having the central bank be independent of the political authority, to shield it from the prospect of political pressure to reverse the direction of the policy. It became independent of government through the Bank of England Act and adopted an inflation target of 2.

Suitable Interest Rate Structure, 6. However, there are economists who suggest a policy of high interest rates on the following considerations: Thus a policy of low interest rates serves as an incentive to investment for economic development. Similarly, inflationary increase in prices leads to the frequent devaluation of the currency.

People have time limitations, cognitive biasescare about issues like fairness and equity and follow rules of thumb heuristics. The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment.

Thus the Central Bank by relying on both the quantitative and qualitative instruments of credit control can limit inflation and help the process of economic development. From the above discussion, it is clear that a wise monetary policy can go an long way in stimulating economic development.

A developing country generally suffers from balance of payments difficulties because of the high propensity to import and limited capacity to export.

Consequently, this results in domestic goals, e. Loss aversion can be found in multiple contexts in monetary policy.Monetary policy is the process by which the monetary authority of a country, typically the central bank or currency board, controls either the cost of very short-term borrowing or the monetary base, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

Monetary policy in an underdeveloped country plays an important role in increasing the growth rate of the economy by influencing the cost and availability of credit, by controlling inflation and maintaining equilibrium the balance of payments. For example, in the case of the United States 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.

Monetary policy, which is headed by the Federal Reserve and involves changing the money supply and credit availability to individuals can also affect the exchange rates.

Similar to fiscal policy, it can affect the exchange rates through three paths: income, prices, and interest rates. How do exchange rates affect monetary policy? The exchange rate is not a policy target of the ECB. This means that the ECB does not try to influence the exchange rate with its monetary policy operations.

The G20 group of major economies has committed to refraining from competitive devaluations and from targeting exchange rates for. Brief Review of Research on the Role of the Exchange Rate in Policy Rules I review the exchange rate implications of several recent normative policy evaluation studies: Laurence Ball (), Lars Svensson (), and myself (b).

The role of monetary policy in managing the exchange rate
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