central banking

Discussion in 'Economics' started by morganist, Jul 4, 2009.

  1. This is an extract of a paper I wrote about the problems the credit crunch creates for economic control. The extract is about 1,070 words.

    "Problems with the interest rate mechanism:

    (1) If large numbers of loan defaults occur the alteration needed to have the same result on inflation is greater than before the loans defaulted. For example if half of the loans defaulted a half percent Interest Rate change is needed to have the same affect that a quarter percent Interest Rate change would have had before the defaults occurred.

    (2) If Interest Rates rise to control inflation it can damage businesses that have borrowed as they will have to pay more interest back than previously would have been required. Some businesses might downsize or lose the ability to operate altogether. Also it makes starting up businesses harder and as a result can prevent economic recovery.

    (3) If the Interest Rate is low for long periods of time it can discourage saving as the return is not sufficient to entice lending. This can lead to shortages of credit due to decreased investment and also damage economic security in the future as fewer assets would have been put aside for a later date.

    (4) Interest Rate alterations are controlled by three main tools OMO’s (open market operations), the reserve requirement (the amount of money banks hold) and the discount rate on bonds. To alter the Interest Rate one or all three of these tools have to be altered to affect the level of liquidity and in turn the interest rate. This can cause further implications to the economy than the Interest Rate mechanism alone, which is linked to banking Interest Rates but does not necessarily affect them.

    (5) Interest Rate changes can increase the amount that people have to pay back on loans, this in turn puts some people in a position where they cannot pay back the required payment resulting in bankruptcies or repossessions sometimes both.

    (6) By altering monetary policy, fiscal policy may have to change to maintain the required levels of liquidity needed to sustain economic prosperity. This can impact the governments revenue and as a result its expenditure limiting governmental options.

    (7) Interest Rates affect the cost of borrowing, which in turn affects the cost to businesses. If businesses have large amounts of debt capital the value of the business can decline if Interest Rates rise. This can affect the chances of the business borrowing money in the future as well as the current cost, as its current value has been reduced as a result of the Interest Rate rise affecting the ability of the business to pay back debts as a result increasing risk. This can be very damaging to businesses if they have high levels of debt capital or if they are involved with lending e.g. Banks.

    (8) It is questionable whether the Bank of England has real control of Interest Rates. It controls the base rate, this does not mean that the rate banks charge is the same, in fact only about half of rates have to fall in line with the base rate and most of those only have to conform within two percent. Therefore alterations of the base rate do not always have the desired effect on inflation and may not meet the aimed target.

    (9) Interest Rates and credit require targets that have to be met to keep the system running. A certain level of inflation is targeted and a certain level of credit is required. Sometimes these two targeted factors can conflict and create economic havoc if they are not both in line with the market. It is therefore inevitable that economic instability will occur when these two factors conflict and it is not advisable to control both through one mechanism.

    Benefits of not using interest rates to control inflation:

    (1) Interest rates are used to control the amount of liquidity in an economy by increasing and decreasing the cost of borrowing by reducing the base rate or raising the base rate respectively. This mechanism requires debt and must have a high level of debt for the interest rate alterations to have a strong impact on the level of liquidity to deflate or inflate the economy. As this mechanism is dependent on debt it is a reason for great concern now that the availability of credit is diminishing.

    It is also important to note that credit only has to be tightened to have devastating consequences on the economy due to greater alterations in interest rates being needed to have the same desired result when there is less debt in comparison to when there was more debt. For example if half of the loans in the country defaulted a 2 % increase in the interest rate would be needed to have the same result as a 1 % increase would have had before the defaults occurred. Unfortunately if the rate is needed to be increased by a greater amount it will create even more defaults and will result in further defaults triggering a continued reduction in the effectiveness of interest rates to control the economy.

    (2) If interest rates are no longer used to control inflation the interest rate will be based on supply and demand and will stabalise this in turn will stabalise the credit market and ease the credit conditions the country is facing at the moment. The inflation target and the credit targets no longer conflict with each other as they are now no longer linked by the interest rate, at least not as a direct function for economic control. This would ease the conditions in the economy significantly.

    (3) & (4) If interest rates are no longer used to control inflation the alterations in the interest rate are less likely to be as extreme due to not having as much pressure to move to control the amount of liquidity to alter inflation. As a result the market and economy is far more stable and does not create the pressures on other sectors of the economy for example the bond market which has a negative correlation with the interest rate.

    (5) If interest rates are no longer used to control inflation the tools that are used to alter the interest rate no longer have to be used. There are three main tools that the bank of England uses. (1) OMO’s or open market operations. (2) The reserve requirement that banks can have in their deposits. (3) The discount rate of bonds. These tools affect the economy and can have a negative effect."