My comments on the above link :- Cutting interest rates can only do so much to stimulate the economy when consumer confidence is low. See my notes on the the basic rationale and mechanics of interest rate as a financial tool.
Principles of monetary economics ( Part 1 of 2 ) :- Basic working principles of monetary economics
The government can influence the general direction of the economy in two main ways. One is by fiscal spending which we have already dealt with in section ( 6 ) of this paper and the other is through monetary policy which involves the use of interest rates to regulate the supply of money and credit through the banking system. We shall deal with the theorectical side of monetary policies in this section and the more practical aspects of money and banking in the next section.
Most countries and economically independent regions like Hong Kong have a central bank or a monetary authority ( in the case of Hong Kong ) to regulate the money supply and credit availability. The central bank may be called by different names. The
central bank of Australia is known as the Reserve Bank of Australia. In the USA monetary policies are decided by the US Federal Reserve Board and executed mainly by the US Treasury and a whole network of US Federal Reserve Banks. Apart from the primary function of being in charge of monetary policies another important function of the central bank is to act as the lender of last resort to throw a life line to faltering banks and other financial institutions if it is deemed to be in the public interest to do so.
Interest is the cost of holding money. When the interest rate is high people tend to hold on to money to earn more interest income and will be less likely to spend them. Less consumer spending means a weaker demand for goods and services in the economy and hence fewer business investments will be made resulting in a fall of total employment and slower rate of economic growth.The same argument is also applicable to investment spendings as well. On the other hand, when interest rate is reduced total consumption will usually increase because people will find that they are earning less interest on their bank deposits so that the cost of parting with their money is lower. Even the costs of borrowing for the individual and businesses will come down. It becomes easier for them to make business investments or purchase more durable goods like home appliances, etc. In short, credit facilities will be easier to come by for more investment or consumption.
Before we proceed, we should learn about a very important economic concept called elasticity of demand. The demand for a product or services is called elastic when a decrease in its selling price will bring about a more than proportional increase in its demand. Conversely, for a product with an inelastic demand an increase in its selling price will bring about a more than proportional decrease in its demand. Demand elasticity is important to the extent that for commodities with an elastic demand a lowering of price can increase total sale revenue and vice versa. Normally, the demand for essential goods is elastic while that of luxury products are inelastic. Knowing the elasticity of demand for a particular product or that of the aggregate demand curve of an entire economy will enable us to decide when and how much the price of a product should be lowered to obtain the maximum effects in the increase in sales revenue or income. Furthermore, by lowering the interest rate a country can reduce the value of its currency to the appropriate level to increase its exports. A reduction in the value of a country's currency will mean an across the board cut in the prices of its products and exports. This will make the country's exports more attractive to buyers from other country's thus contributing in a positive way to any existing balance of payment problems which we have discussed in the previous section.
Thus, the government can lower interest rates in times of a downturn in the economy to encourage increase in consumption. In times of an economic boom when upward inflationary pressure is high the government can raise interest rates to dampen the over comsumption to keep price level steady. That is a good and subtle way of suppressing demand without directly interfering with the market resources. The reader will note that since the start of the present financial tsunami many governments of large economies have reduce their official interest rate drastically several times to encourage more consumer demand. On top of interest rate reductions, most governments also resort to fiscal spending such as China's proposal to spend US$ 870 billion and the USA US$ 880 billion in a rescue package to boost their economies to avoid the on set of a recession.
The founder of the monetarism is the American Nobel Prize laureate, Milton Friedman who pioneered the use of monetary policies to regulate the economy in an indirect way back in the 1960s. He is also the leader of the distinguished Chicago School of economic philosophy, having done most of his economic research at the University of
Chicago. He favoured monetary policy because he held the view that governments should not meddle with the free market economy. His philosophy can be summed up as “ positive non-intervention “. The government should only be allowed to take economic action when the circumstances are such that automatic adjustments by the free market forces do not appear likely. Even so, the government must interfere with the slightest possible disturbances to the economy and must allow the market forces of supply and demand to work through the price system to achieve the necessary equilibrium. Therefore, he advocated the indirect intervention through the use of monetary policies to motivate consumers to do the right thing. Economists have compared monetary policies to the scalpel used in surgery and fiscal policies to the hammer used in construction work. The former is good for fine tuning while the latter for heavy duty assigments.
We must also bear in mind that monetary policies work indirectly and also slowly. Policy makers must be very patient to assess the results of any monetary measure taken before deciding to go further or hold back. It could take up to 6 months in many cases before the full results of any monetary moves made by the government have their full effects. This is because monetary policies are passive in nature. This characteristic is both their strength and weakness. Being passive and leaving all economic choices to the consumer it is not intrusive on the economy. Conversely, their passive nature alsomake them slow working. For example, when there is an interest rate cut the increase in available credit must flow through the banking and financial system one step at a time. Then the consumers will have to size up the effects of the rate cut with respect to their investment portfolio and asset position. Whether or not they will increase spending is entirely up to the consumers. They usually do when there is a rate cut but if the economic future is highly uncertain like the present financial tsunami consumer confidence may be shattered so that cutting interest rates will not have their usual and full effects in boosting consumption. At such perilous times, cash is king as the saying goes. There is a very useful economic indicator called the consumer confidence index which is created by asking a representative random sample of consumers whether or not they think ( just based on their spontaneous feeling ) they will be better off in three months' time. An index to measure people confidence in the economy is prepared by taking a particular date as the starting basis point of 100 which serves as a basis for comparison in future and regular surveys. Many different countries have been keeping such an index for the reference of both government and private sector.
Principles of monetary economics ( Part 2 of 2 ) :- In applying monetary policy as the mainstay economic strategy the government needs to set certain targets in respect of the five economic goals of acceptable inflation rate for consumer prices, target economic growth rate, tolerable unemployment rate, equitable distribution of national income and the degree of commitment to environmental protection. Each one of these economic goals has to be weighed against the others by reference to the available resources and the value judgment for the majority of the citizens. For example, my adopted country of Australia places much emphasis on price stability, fair distribution of income and resources over and above economic growth while China puts a lot of weight on economic growth. As regards the acceptable targets for each economic goal it differs for each country but the prevailing economic thinking as proposed by international organisations ( such as International Monetary Fund, World Bank and UN ) indicate that the acceptable long term inflation rate should be within the range of 3% to 4%. Long term unemployment rate should not exceed 5 % of the able bodied work force. The long term economic growth rate is preferrably 2.5 % to 3 %. Regarding the fair income distribution index, the ideal position should be gauged by the percentage of the population earning the median income. The higher the percentage of the population earning the median income the
better. This means that the middle class is strong and economically healthy in such a country. Anything above 40 % will be considered satisfactory. There is also another index which can act as a litmus test for distribution of income. It is to ascertain the percentage of the population holding 10 % of the country's wealth. If 10 % of the country's wealth is held by fewer than 10% of the population it means that wealth is highly concentrated in the hands of only a few. The higher the percentage of the population holding in total 10 % of the country's wealth the more evenly is the country's wealth distributed. Each country can set their own targets in these economic areas and then the government will regulate the supply of money and credit in the economy through periodic changes in interest rates along different parts of the economic cycle to boost or dampen demand.
Before we leave this very brief discussion on monetary policies let us take a look at why monetary policies are so passive by nature. There are many technical details in the execution of monetary policies such as the auctioning of US treasury bonds, working of the complicated Federal Reserve System, bank liquidity ratio directives and inter-bank borrowings, etc. From just a few examples of these monetary mechanisms the reader should realise the indirect way the effects of monetary policies filter through the long chain of the banking and financial systems. Apart from the above technical details the consumer decision making process also has an important bearing on the passive and sometimes unpredictable nature of monetary policies. Their long term effects are pretty reliable but their short term influence can be erratic. Human behaviour is very hard to predict. For consumer decision making it appears to be contingent upon the decisions and behaviour of others. Economically speaking a consumer's decision to enter the market does not depend on their current income alone but mainly on expectation of future income. Even if they are earning a lot of money now they are not willing to keep to the current pattern of spending if they expect a fall in their future income. Furthermore, there is an element known as wealth effect that plays an important part in their decision to spend. Suppose the stock market or the property market is booming. This will make the shares and properties owners more valuable by market standards. This feeling of increased wealth will induce them to spend more although they may not actually sell their investments to realise the gain. The shares market and the property market can fall later but very often this feeling of being richer at this moment will induce us to spend more. It may sound illogical but that is the way our minds operate.
To recapitulate the main points of this section, monetary policies are very useful tools for achieving economic goals because of their non-intrusive and subtle nature but they usually have a longer time lag than fiscal policies to have their effects on the economy. Therefore, in times of great urgency to fix up snowballing problems like the present financial tsunami monetary policies must be supplemented by heavy fiscal spending to stop the situation from further deterioration. However, monetary policies are still the best economic tool for achieving long term economic goals. In the past 30 to 40 years most governments of the world including USA and Europe had relied heavily on monetary policies to regulate their economies to varying degrees of success. Unfortunately, there has obviously been a mortal mistake on the part of the US government in not properly regulating her financial sector. This is a very tragic end to a long period of successful implementation of monetary policies in USA to bring about successive economic booms. Of course, there are some economists who have now put blame on the long period of low interest rates in the USA. This long period of easy credit that has led to the sustained economic growth without high inflation has at the same time created a credit bubble which has now burst due to negligence in proper regulation of her financial sector by the US government.
JKHC.
better. This means that the middle class is strong and economically healthy in such a country. Anything above 40 % will be considered satisfactory. There is also another index which can act as a litmus test for distribution of income. It is to ascertain the percentage of the population holding 10 % of the country's wealth. If 10 % of the country's wealth is held by fewer than 10% of the population it means that wealth is highly concentrated in the hands of only a few. The higher the percentage of the population holding in total 10 % of the country's wealth the more evenly is the country's wealth distributed. Each country can set their own targets in these economic areas and then the government will regulate the supply of money and credit in the economy through periodic changes in interest rates along different parts of the economic cycle to boost or dampen demand.
Before we leave this very brief discussion on monetary policies let us take a look at why monetary policies are so passive by nature. There are many technical details in the execution of monetary policies such as the auctioning of US treasury bonds, working of the complicated Federal Reserve System, bank liquidity ratio directives and inter-bank borrowings, etc. From just a few examples of these monetary mechanisms the reader should realise the indirect way the effects of monetary policies filter through the long chain of the banking and financial systems. Apart from the above technical details the consumer decision making process also has an important bearing on the passive and sometimes unpredictable nature of monetary policies. Their long term effects are pretty reliable but their short term influence can be erratic. Human behaviour is very hard to predict. For consumer decision making it appears to be contingent upon the decisions and behaviour of others. Economically speaking a consumer's decision to enter the market does not depend on their current income alone but mainly on expectation of future income. Even if they are earning a lot of money now they are not willing to keep to the current pattern of spending if they expect a fall in their future income. Furthermore, there is an element known as wealth effect that plays an important part in their decision to spend. Suppose the stock market or the property market is booming. This will make the shares and properties owners more valuable by market standards. This feeling of increased wealth will induce them to spend more although they may not actually sell their investments to realise the gain. The shares market and the property market can fall later but very often this feeling of being richer at this moment will induce us to spend more. It may sound illogical but that is the way our minds operate.
To recapitulate the main points of this section, monetary policies are very useful tools for achieving economic goals because of their non-intrusive and subtle nature but they usually have a longer time lag than fiscal policies to have their effects on the economy. Therefore, in times of great urgency to fix up snowballing problems like the present financial tsunami monetary policies must be supplemented by heavy fiscal spending to stop the situation from further deterioration. However, monetary policies are still the best economic tool for achieving long term economic goals. In the past 30 to 40 years most governments of the world including USA and Europe had relied heavily on monetary policies to regulate their economies to varying degrees of success. Unfortunately, there has obviously been a mortal mistake on the part of the US government in not properly regulating her financial sector. This is a very tragic end to a long period of successful implementation of monetary policies in USA to bring about successive economic booms. Of course, there are some economists who have now put blame on the long period of low interest rates in the USA. This long period of easy credit that has led to the sustained economic growth without high inflation has at the same time created a credit bubble which has now burst due to negligence in proper regulation of her financial sector by the US government.
JKHC.
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