Should Central Banks Abandon Their Expansionary Policies Given That They Seem to Be Ineffective and Might Lead to Inflation?

Topics: Monetary policy, Central bank, Inflation Pages: 7 (2197 words) Published: October 1, 2012
Despite the unprecedented interventions by central banks following the onset of subprime crisis, world economy remains fragile. There are also persistent fears that these interventions will lead to inflation. Should central banks abandon their expansionary policies given that they seem to be ineffective and might lead to inflation?

Monetary Economics
Group Essay
Ayeshath Iqbal
Chowdhury Mohammad Sakib Anwar
Esther Siah Shuet Yi
Jarren Tam Keat Wen
Lim Kai Shen
Paul Ruben Mohanadasan

The University of Nottingham Malaysia

Monetary Policy as conducted by the Central Banks4
Open Market Operations (OMO)4
Cash Reserve Ratio5
Interest Rates6
Quantitative Easing8
Critical Analysis of the Effectiveness of Monetary Policy9

During the recent global financial crisis, increased uncertainty of loan defaults resulted in reluctance of banks to issue loans. Among other reasons, this stagnation of the financial market worsened economic stability and contributed to the recession that economies worldwide are still fighting to overcome today. With the decline in consumer confidence and freeze up of the interbank market, the responsibility fell on central banks to take bold and drastic steps to correct the failing economy.

In our essay, we outline the expansionary monetary tools used by the central bank which include open market operations (OMO), cash reserve ratio, interest rates and quantitative easing (QE). We discuss the resulting effects on the economy and conclude by critically analysing the effectiveness of these policies.

Monetary Policy as conducted by the Central Banks
Open Market Operations (OMO)
Open market operations are primarily used to control interest rates and indirectly the total supply of money in the market. It can also control the targeted rate of inflation. The Federal Open Market Committee (FOMC) implements monetary policy by buying and selling securities. To increase the money supply, they buy bonds to create credit in the market. So, expansionary monetary policy through open market operations includes buying bonds and securities from private banks. This injection of capital to banks enables them to provide loans to private individuals and businesses in the economy. With a higher availability of loans in the market, interest rates would be reduced. This leads to more borrowers have access to cheaper capital. Thus it leads to increased investments and stimulate growth.

Cash Reserve Ratio
The reserve requirements (RR) are the minimum amount of assets that commercial banks are required to keep as reserves (R) with themselves or as deposits at the central bank (Minimum liquidity requirement). Altering RR affects money supply by affecting the money creation process that banks undergo as well as the monetary base. Central banks (CBs) can alter monetary base (H) by controlling the amount of reserves in the economy and hence CBs can have some control over money supply (M) via the relationship stated below. CBs alter reserves in the economy by altering RR. * H=R(reserves)+C(cash)

* M={(c+1)/(c+b+e)}H
* Where {(c+1)/(c+b+e)}=money multiplier
* b=fraction of deposits held to make up the RR
* c=fraction of deposits held as cash
* e=fraction of deposits held as excess reserves
During expansionary monetary policies, central banks will reduce RR by increasing the excess reserves .Commercial banks would have more assets to contribute to the credit creation process, which increases money supply. Once RR has been reduced, commercial banks can either choose to keep the newly attained reserves as excess reserves, or loan it out. By keeping the reserves in excess, it increases “e”, this result in a stagnant state of money supply. They could also loan it out which decreases “b” resulting in an increase in the money multiplier.

Interest Rates...

Bibliography: China 's Central Bank cuts interest rates. (26 November, 2008). Retrieved 9 November, 2011, from The New York Times:
Fed cuts key rate to a record low
UK interest rates lowered to 0.5%. (5 March, 2009). Retrieved 20 November, 2011, from BBC News:
China Government Bond Yield
How do Open Market Operations affect US money supply? (n.d.). Retrieved 22 November, 2011, from
Public Data. (n.d.). Retrieved 22 November, 2011, from Google:
Quantitative Easing
Suranovic, S. M. (n.d.). International Finance Theory and Policy. Retrieved 07 November, 2011, from
T-Bills - What Are U.S
United States Inflation. (n.d.). Retrieved 21 November, 2011, from Trading Economics:
US-China Trade Statistics and China 's World Trade Statistics
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