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Economics of Banking and Money

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Task 1

In deciding the degree of economic growth in a country, banking and non-banking financial institutions play a pivotal role. It is a common theory that a part of the money is saved by persons or households. The numerous commercial banks in the economy mobilise certain deposits. In exchange, banks sell the surplus funds to the nation’s future buyers. A certain amount of interest on the loans given to them is, therefore, paid to borrowers. Investments are a boon for the economy’s progression. This does not mean that, in order to raise investment thresholds in the region, commercial banks will charge negative interest rates to borrowers. Banking institutions can, at zero interest rates, provide loans. A zero interest rate strategy pursued by a country’s central bank is a circumstance in which they charge a low nominal interest rate (Woodford, 2001). When the rate of economic growth is low in a country, this is correlated with stimulating the economy. A negative interest rate paid on loans is a potential state where the bank will make discounts on loans charged to buyers or creditors. Interest rates should never be negative. This would not only entail the depletion of a bank’s gross reserve, but could contribute to non-potential economic investments. Commercial banks will wind up providing guarantees for expensive and unviable enterprises and will also be compelled to provide tacit bail-outs for certain economic projects that have collapsed. That would leave the economy’s total investment market unclear. Therefore, the amount of interest paid on loans should never be negative.

The Taylors law is a model used in the calculation of economic interest rates; it was introduced in 1992 by John Taylor. This law clarified, based on the principle of reasonable assumptions in macroeconomics, the separate interest rates that the Federal Reserve will possibly set in the United States in the future. Taylor framed his model with the premise that the potential economy would still have optimistic aspirations for all economic actors in the market. The Taylors model can not take into consideration an economy’s long-term prospects (Asso, Kahn and Leeson, 2010). As taken in this essay, the Taylors formula is:

r=p+0.75(5.5%-u) + 0.5(p-2) + 2. Where r = Federal funds rate.

u= Unemployment rate.

p= Rate of inflation.

Fig 1: Federal Fund Interest Rates by Taylors Rule

Years Federal Fund Rate  ®
01/03/10 -1.24
01/06/10 -1.48
01/09/10 -1.48
01/12/10 -1.40
01/03/11 0.02
01/06/11 -1.25
01/09/11 -1.18
01/12/11 -0.80
01/03/12 0.19
01/06/12 -0.58
01/09/12 -0.28
01/12/12 -0.28

(Source: STLOUISFED, 2013a; STLOUISFED, 2013b)

The above table indicates the various quarterly interest rates that, according to the Taylors Law, the Federal Reserve may have set in 2010, 2011 and 2012. Yeah,” according to the above schedule, it can be concluded that in recent years, the Taylors rule suggested keeping the federal funds rate negative.” This is since, in recent years, the economy has faced recessionary business directions. A negative interest rate would mean that the Federal Reserve could develop expansionary monetary policy and accelerate the pace of capital circulating in the U.S. economy.

Task 2

In normal market circumstances, Taylor’s rule indicated that the pace of federal funds could be such that the economy’s inflation and actual interest rates would be 2 percent and the economy’s natural unemployment rate would be 6 percent. However, the Taylors law has indicated that the federal funds rate would be negative to encourage quantitative easing in the U.S. crisis economy, taking into consideration the existing recessionary trails in the sector. For much of the policies framed by the federal bank, the Taylors rule has been an essential fundamental help. The Federal Bank’s study of various economic results, though, is far broader than those of the other central banks in the world. Taylor’s rule assumed that in recent years, the U.S. economy was in recession, it was beneficial for the U.S. central bank to simply adopt expansionary monetary policies in the economy. The Federal Reserve has abided by the norms of Taylors rule. They have adopted the policy of Quantitative Easing in the recent years. By this tool, the Federal Reserve has offered loans to different financial institutions at a very lower rate of interests, in return they have demanded worthy government bonds from the institutions. With the help of this policy commercial banks in U.S. have been able to offer loans at low interest rates to the potential investors. At the same time a rise in demand for government bonds has helped to increase the bond prices in U.S. With the fall in the prices of the bonds, the interest rates charged in the market have fallen, even for the private lending institutions. This is because bond price is inversely related to the rate of interest. Though the view of the Taylors rule and the Federal Reserve has been same, but the interest rates charged by the U.S. central bank have not gone negative (Arnold, 2008).

Task 3

Fig 2: U.S. Forecasted Federal Funds Rates

Years Federal Funds Rate with Pessimistic Views Federal Funds Rate with Optimistic Views
2013 2.95 3.03
2014 3.10 2.95
2015 3.33 2.95
2016 4.08 2.58
2017 4.45 3.18
2018 4.38 3.10
2019 4.53 3.03
2020 4.60 2.95
2021 5.05 2.88
2022 5.13 2.80

(Source: STLOUISFED, 2013a; STLOUISFED, 2013b)

The above schedule is a forecasted schedule of ten years from 2013 to 2022. The forecast is made considering the present inflation rate in U.S., which is 2% (BIS, 2013). It includes the pessimistic view that assumes high inflation, high unemployment rate in future and the optimistic view that assumes upcoming lower inflation, unemployment rates. It is observed that the desired Federal Funds rates in future would be increasing according to Taylors rule following pessimistic ideologies. This is because when the rate of inflation in the economy will be high, the circulation of money in the market will be excessive (Economics, n.d.) A high rate of interest set by the bank on loans will reduce the volume of loans sanctioned. At the same time the bond prices in the economy would fall, so in the open market the state will be able to squeeze excessive money and reduce inflation rates. As with lower purchasing power, the demand for the scarce available goods and services will fall in the economy. Thus, increasing the interest rates, the Federal Reserve would be able to reduce the inflation rate of the economy. The explanations are exactly opposite to the above mentioned case in the situation of optimistic forecasts. This is the situation that exhibits lower federal interest rates in future.

Fig 3: Forward Curves for the Three Economies

Economics of Banking and Money

(Source: BIS, 2013)

In the recent period the central banks of almost all the developed economies are taking decisions to increase the interest rates. Like the Federal Reserve has declared to reduce the level of Quantitative Easing. This means the economists and analysts in U.S. have forecasted pessimistic views about inflation and unemployment rates. In the above diagram it is clearly visible that the nominal interest rates are increasing in all the four economies.

Task 4

The first limitation of Taylors rule is that it includes only a single measure of inflation. The price index used in the Taylors formula is GDP deflator, while most of academic researchers and even Federal Reserve calculates inflation with Consumer Price Index or on the basis of Personal consumption expenditures. Both equilibrium interest rate and output level are unobservable variables but Taylors rule requires both values for calculating the federal funds interest rates. Taylor assumed that interest rate in the economy can only be calculated by inflation and unemployment rates but in general the rate of interest depends on various other factors. Thus, though the Taylors rule has priceless contribution in determination of policies but policymakers must consider other determinants while formulating norms in the economy (Federal Reserve, 2013).

Reference List
  • Arnold, R. A., 2008. Macroeconomics. Connecticut: Cengage Learning.
  • Asso, P. F., Kahn, G. A. and Leeson, R., 2010. The Taylor Rule and the Practice of Central Banking. [pdf] Available at <http://www.kc.frb.org/Publicat/Reswkpap/PDF/RWP10-05.pdf > [Accessed 31 August 2013].
  • BIS, 2013. Monetary Policy at its Crossroads. [online] Available at <http://www.bis.org/publ/arpdf/ar2013e6.pdf> [Accessed 31 August 2013].
  • Economics, n.d. Topic 3. The Taylor Rule. [online] Available at < http://www.economics.utoronto.ca/jfloyd/modules/trul.html> [Accessed 31 August 2013].
  • Federal Reserve, 2013. Board of Governors of the Federal Reserve System. [online] Available at <http://www.federalreserve.gov/releases/h15/20130805/ > [Accessed 31 August 2013].
  • STLOUISFED, 2013a. Unemployment Rate. [online] Available at <http://research.stlouisfed.org/fred2/categories/32447> [Accessed 31 August 2013].
  • STLOUISFED, 2013b. Consumer Price Indexes (CPI and PCE). [online] Available at <http://research.stlouisfed.org/fred2/categories/9> [Accessed 31 August 2013].
  • Woodford, M., 2001. The Taylor Rule and Optimal Monetary Policy. [pdf] Available at < http://citeseerx.ist.psu.edu/viewdoc/download?rep=rep1&type=pdf&doi=10.1.1.28.9392> [Accessed 31 August 2013].

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