The difference between financial stability and monetary stability
Monetary stability refers to the stability of the value of money. That is the ability of a country’s currency to maintain its value in the world markets. Money usually loses its value due to high rates of inflation whereby a country has a lot of money in circulation and thus making commodities expensive to purchase. On the other hand, financial stability takes a wider view in that it occurs when there is stability in the value of money and the rate at which people are employed coincides with the growth of the economy.
Moreover, financial stability is achieved when the financial markets like the foreign stocks exchange and banking institutions are operating effectively. Another element that constitutes financial stability is the ability to maintain the price changes of real and financial assets like houses and equity (Eichengreen 2002).
Objectives of the central bank in relation to financial and monetary stability
One of the Central Bank’s objectives is to create monetary policies that will help maintain the price stability in the economy. These policies should thus be dedicated to the reduction of levels of inflation in the economy to ensure that the value of money is not lost. In addition, the central bank should put in place adjustable exchange rates which will be in a position to accommodate the changes that are affected by the rise and fall of demand and supply in the financial markets.
This can only be achieved through improvement of the banking sector by giving the banks financial support and making structural adjustments so that they can provide better and quality services (Jonas 2006).
The central bank acts as the lender of the last resort and a source of immediate liquidity. This serves as a rescue to banks when they have no money to sustain the environment. Thus the objective is to protect the customers’ funds and to boost their confidence in the banking sector and the financial markets of the country. In addition, the central banks serve as a regulator of payment made by banks as well as manage the level of capital inflows that enters a country. This is because unregulated payments can result in financial imbalances and a rise in the level of credit risks (Friedman & Schwartz 1963).
The central bank of any country serves as an effective mechanism in the regulation of the financial sector. It protects the interests of the people and maintains sustainable economic growth.
The nature of Quantitative easing
Most people refer to it as printing of more money but in the actual sense, no money is printed. What takes place is an asset swap. The central bank purchases these assets from the private sector and the government at low-interest rates. Quantitative easing is thus a monetary policy that is used by the central bank to inject money into the economy by increasing the level of money in the banks and thus reducing the pressure those banks are subjected to.
The central bank controls the interest and bank rates to enhance the high level flow of money in the economy. It creates a lot of money which it in turn uses it to buy treasury bonds as an investment which are later sold to provide finances to control the rate of inflation and deflation. The central bank also enforces rules and regulations to the commercial banks for maintenance of a certain level of deposits. That is, deposit limits are put to ensure that the commercial banks do not lend excessive money to an extent that they turn to the central bank as the last resort.
The central bank also controls the flow of money to the corporate bond markets to ensure effective operation of companies as they can easily access money with low interest rates. In addition the capital markets benefit from extra cash that boost their stocks performance as more people will be willing to invest in stocks due the desirable picture depicted of them(King 1996).
The reason why Bank of England considered it necessary to introduce quantitative easing in 2009 and the effects expected on the banking system and the UK economy generally.
The Bank of England introduced quantitative easing to reduce the threats of deflation through the increase of the money supply in the circulation.This was because the reduction of interest rates and bank rates that were offered by the banking industry did not effectively ensure a good supply of money to the economy. In addition the United Kingdom’s economy faced long times of recession periods and thus the Bank of England wanted to restart the economy and stimulate growth.
The Bank of England expected that through the broad supply of money, the banks would expand their supply of credits to the borrowers and thus they would in turn benefit from the interest paid from the rendered money. In addition the central bank was to increase the banks reserves of their countries in which the banking industry would improve, as it would create a good outward picture to the investors, who would have greater confidence to invest their money.
This would also position the banking sector in a desirable place where they would advertise and sell their services effectively to their customers thus earning their loyalty.
The Bank of England also expected that other banks would be in a position to pay off their debts. This would be through the enacting of preventive measures to reduce the fall in prices and the rate of deflation. This is due to the fact that such falls in prices results to high cost of commodities which hinder people from purchasing them.
In addition a fall in prices leads to devaluation of the country’s currency whereby the country is forced to pay a lot of money to their creditors leaving the country with little or no foreign reserves. This in turn results to imbalance of payments which can depict a bad state of economy in the world markets and investors. Thus the Bank of England expected to boost the UK economy in the eyes of other world economies (Koo 2009).
The banking system was also expected to change due to recapitalization through the increased monetary base of the banks’ equity and thus increasing the lending capacity of these banks. This was an effort to benefit banks through spread of lending’s and would thus be in a good position to maintain strong balance sheets that would attract customers, prospective investors and other interested parties. The Bank of England thus intended to improve their banking industry as most these banks had run out of money and was even afraid to lend the little they had to avoid bad debts.
The Bank of England wanted to effect change to the whole UK economy. Through quantitative easing the bank intended to stimulate the growth of the economy. This was to be achieved by improving all sectors through channeling money to these sectors. To start with the central bank would buy corporate bonds to ensure that most companies got money to finance their operations. That is, the companies would be empowered to buy materials, pay their rent and electricity bills as well as meets their personnel needs.
On the other hand the central bank gives money to the equity markets to boost their operations in the buying and selling of stocks. More importantly the support that the central bank gives to the banking sector is beneficial as banks serves a major role in the growth of economy. This is because the banks encourages savings, offer loans to business people to start and expand their businesses and create employment opportunities to a wide range of people.
Quantitative easing is thus a monetary policy that can effect some changes in a country’s economy that has exhausted all other means of stimulating growth but it is a short term strategy. It should thus be applied with a lot of caution otherwise it can bring more harm than good.
The problems and potential risks of using quantitative easing as a tool of monetary policy
The consistent use of quantitative easing can result to rise in the level of inflation as well as hyperinflation. This is because the increase supply of money in the economy with an increase in the rate at which it changes hands results to a loss of value of money. Thus to ensure that inflation and hyperinflation does not occur the central bank should ensure that the velocity of circulation of the money falls as the level of money in the circulation increases. A country should always advocate for lower levels of inflation as it leads to a lower interest rates and favorable competitive exports that earns it a desirable foreign exchange (Kuttner 2004).
Quantitative easing also can lead to a fall in the value of money. This in turn lowers the investor’s confidence to invest in a country as they are afraid that their money will lose value in the future.due to the devaluation of currency the countries imports become expensive and the prices of commodities rises up. It also tempts the potential investors to raise the interest rates on money borrowed thus making it hard for the business people to borrow loans as the costs of obtaining them are high.
The devaluation of currency also causes a weak credit rating of a country as it will have difficulty in the payment of its international debts. It is not a wonder that such countries cannot make foreign investments as other competitive world economies will not entertain them to invest in their countries (Kocenda & Valachy 2006).
The other problem brought about by quantitative easing is the loss of political independence. This is because when the central bank purchases the government bonds, it means that it is indebted to the government of which it is run by the politicians. These politicians may dictate the buying and selling of these bonds thus the central bank will be deemed ineffective in its regulation of financial mechanisms. This loss of political independence can result to unequal distribution of wealth and resources as most of the politicians will be given the first priority to purchase the government bonds thus disadvantaging the less popular citizens that would be able and be interested to buy.
High inflations also pose a great danger in a country as it can result to high rates of unemployment. This is because many businesses will incur high operating costs in terms of buying commodities, advertisement costs, payment of rent and electricity bills and payment of the work force. This may thus force these employers to layoff some of their employees to cut off costs.
These can result to very adverse effects in any country not to say retardation in economic growth. In addition these business people will not only sack their employees but they will be reluctant to establish more channels to extend their businesses. This is a big hindrance to the development of the economy.
It is not always that the increase in the money supply to the banks leads to an increase in borrowings. Thus it is not obvious that the banks will benefit from interests earned from the money lend as most people will be afraid to acquire loans in which they will be forced to repay with high interests. This therefore will result to underdevelopment of the banking industry as banks will not be at a position to sell their services. It is important to take monetary policies that their advantages outdo the problems that will be inflicted in a country’s economy.
Consequently quantitative easing can also lead to extensive taxation of the tax payers. This is because when a country experiences inflation, prices of commodities rises up forcing the common people to dig deep into their pockets even in the purchase of basics products. This in turn will undermine the standard of living of people as they do not have an easy access of products and services due to high costs of importation. In addition people will be forced to exhaust their salaries to buy basic commodities leaving no money to save. It is unfortunate for a country that its people do not save as it is hard for it to make developments.
The problems of quantitative easing have far more reaching effects in any given country. Though it is deemed to help a collapsing economy to restart again but if not checked it can distort the economy beyond rectification. It is unfortunate that as countries try to fight deflation through increasing the money in circulation they end up inflating the economy and thus their currency loses the purchasing power. A currency that has a low purchasing power causes a country to lag behind in its economic activities as it is more prone to financial crisis. This is because the country experiences financial instability whereby the operations of financial markets and institutions are altered (Svensson 1999).
The banks may lose a lot of money because of the massive lending’s that follows after quantitative easing. This is because most people will borrow loans from banks with a low repayment interest rate. Unfortunately these funds may be borrowed during inflationary period when there is a lot of money in the circulation but come the repayment time the country may be in a period of deflation. This is an implication that banks will suffer loses as the money they lend are repaid at the same interest rates yet the money may have earned a little value.
Eichengreen, B., 2002. Financial Crises and What to do about them. New York: Oxford University press.
Friedman, M. & Schwartz, A. J., 1963. Monetary history of the United States. New York: University of Chicago Press.
Jonas, J. 2006. Euro adoption and Maastricht criteria: Rules or discretion? Economic Systems, 30(4), pp. 328-345.
King, M. A., 1996. How should central banks reduce inflation?–Conceptual issues: New Challenges for Monetary Policy. A Symposium sponsored by the Federal Reserve Bank of Kansas City, Kansas City, Missouri, pp. 53-92.
Kocenda, E. & Valachy, J., 2006. Exchange rate volatility and regime change: Vise grad comparison. Journal of Comparative Economics, 34(4), pp.727-753.
Koo, R., 2009. The Holy Grail of Macro Economics. Singapore: John Wiley & Sons.
Kuttner, K. N., 2004. The role of policy rules in inflation targeting. Federal Reserve Bank of St. Louis Review, 86(4), pp. 89-111.
Svensson, L., 1999. Inflation targeting as a monetary policy rule. Journal of Monetary Economics, 43(3), pp. 607-654.