Monetary Policy Finance Essay

Reasons for short-term rate of interest emerging as the main instrument of monetary policy

Introduction:

One of the strengths of a country is its economy. In order to have a strong economy, the institutions through which finance is controlled may develop policies to stabilize the economy. Financial institutions like banks are of importance in this regard. This is because of the fact that they govern the manner in which money is treated; the value that money is worth is directly affected by bank policies.

In addition to bank policies and the way that banks control the economy, the people are also of importance because it is through them that the currency is circulated. The investments that go into banks and the loans that people receive are all governed by bank policies, but it is the intentions of the people that keep the economy going. So when policies are made, people react and it is this action and reaction that produced an effect in the economy. The intended effect on the part of the government is to strengthen the economy as much as they can. In the long run, this is what is hoped for through short-term rate of interest: a strong and stable economy, and a currency with better value.

Institutional Function:

Generally, interactions are known to create effects that can be amplified, and this depends on the nature of the active components, such as those in a major economy. When banks have the liberty write financial policies, other financial institutions are affected, and in turn, people too are presented with choices that might be confusing for them. The reason why policies might be confusing for people is because of the fact that they may not be able to understand why exactly things like interest rates are modified. They are well aware that they may not earn enough interest in this way, and feel that the government is deliberately denying them of maximizing their profits. For those that do understand why this interest rates are changed, they may simply be disinterested and search for alternative means of maximizing their interest/profits.

Financial Policies:

Financial policies, like those on short-term investment, indirectly control the economy and can keep inflation in check and also increase the value of currency. Therefore, short-term rate of interest policy is an effective means of controlling the economy. It is effective because of the fact that inflation is an important player in the economy. The government realizes this aspect as well as the fact that the Bank of England is the best tool for developing policies that could effectively deal with inflation. Since one of the Bank of England’s main concerns is monetary stability, it is the best body to make policies that would control the economy.

Worries over Inflation:

With a current inflation target of two percent, the Bank is apparently on target with its short-term rate of interest policy. It is hoped that confidence in the currency will be restored this way. The government is still keen on strengthening the economy and restoring confidence in the currency even though they are well aware of the present strength. However, it must be asserted that in order to be a strong and formidable competitor in the market, they need to set targets. Therefore, it can be asserted that the Bank of England and the government have agreements to strengthen the economy through short-term rate of interest.

Reducing Inflation protection in investment schemes:

It is believed first of all that short-term rate of interest is a method of avoiding inflation protection that is associated with long-term investment. Even investments such as insurance have inflation protection, but short-term investments can do away with it. In addition to short-term investment saving itself from investor demand for inflation protection, it helps in securing the economy. This is because of the fact that there is much less risk involved with short-term rate of interest. If, through short-term rate of interest, inflation stays low, the government can maintain its hold on price stability. This is understood on the basis of inflation being kept low; if inflation remains low, prices will remain stable.

Main Reasons for Short-term Rate of Investment:

While keeping prices stable is the government’s objective, the Bank of England wants to increase the value of the currency. Hence, together, they both are working towards aims that will benefit the economy and serve each other’s purpose.

The mechanism adopted is as follows:

  • The government wants to keep inflation low
  • So, the government allows the Bank to develop policies that would control inflation
  • By controlling inflation through short-term rate of interest policy, the value of currency is protected.

This has been made a reality because of the fact that the price of money in countries like the UK is controlled through interest rate. An important point to also remember is that low inflation is not an answer to economic problems and increasing the value of a currency. What one can say is that it is vital to encouraging stabilization of the economy in the long run. Short-term rate of interest seems to fit well when one talks about lowering inflation while long-term investments almost encourage inflation. This is to say that if investments are short-term, investors probably will not ask for inflation protection because the need does not arise. Stability will be secured on both sides, for the investor and the bank, because short-term agreements have fewer risks. Consider if a person wants to invest repeatedly, each time an investment is carried out, a new contract falls into place. This means that if there is a change in the state of the economy at any point, it can be applied in the next round investment.

In addition to this, the effects of an increase rates should also not be forgotten, and this is because of the fact that it can slow down an economy tremendously and impede investments. Markets and employment will also be adversely affected by the increase in rates.

Possible effects of Short-term Rate of interest:

Observing the reasons why short-term rate of interest has emerged, tells one that there is an all out effort to ameliorate the economy and bring about stability along with increasing the value of currency. However, the downside of the efforts through which this is achieved, are ones to take note off. This is because investments may be slowed down considerably. However, in contrast to this consideration, if stability is achieved in the economy, foreign investment is more than likely. This in itself would help to improve investments, which means that people within the UK who do not invest would simply be missing out on opportunity. They need to realize the number one priority is stability in the economy; once that is achieved, they can invest their money and receive returns safely. Foreign investors as well would have security in investments if the economy were stabilized.

One point that is necessary to make here is that in short-term investments, inflation can be addressed with each new term. Therefore, foreign investors stand to gain from investing in the UK; they would have a definite idea of what’s going on and be more aware of the value of the currency each time.

Coming back to the effects of short-term rate of interest on people in general, one can say that people would be affected by the fact that the curve of revenue available for loans would diminish. This is because of the fact that the banks will not be receiving the same amount of investment as they used to because of the new policy. So, there would obviously be a decline in the amount of revenue available for loans. In addition to this, another important consideration is that since investments are arranged on shorter terms, the period of time for which loans are given will have to be reduced in order to create a balance between revenue coming in and revenue going out.

In the long run, it is possible that the banks may not be able to allow loans in the manner that they have been doing. Those who wish to start small businesses with loans, for example, may not be able to do so, and this could impact the economy. Investors at the same time, might want to wait until the Bank of England changes its policies, and as a result investing can remain slow for a long time. However, it is hopeful that investors realize the long run advantage of short-term rate of investment and put their faith in this policy.

Conclusion:

Given that people need to be confident in the economy so that they would want to invest their savings, an economy has to be stable. This refers to foreign investors as well, as they need to feel confident in the economy where they invest. One of the known successful ways to develop a strong economy is through short-term rate of investment. Some of the things that have led to this method of strengthening the economy include the government’s need to combat inflation and develop currency value. These are shared interests of banks as well, which are the makers of policies that favor strengthening of the economy. With their policies for short-term rate of investment, they are creating a situation where perhaps the number of investors is lowered, but the value of currency is strengthened in the process. Also, the low inflation rate remains targeted along with the prices remaining in check. Such a scenario desired by the government justifies implementation of short-term rate of interest.

References

  • Adrangi, B. A. Chatrath & K. Raffiee. 1999, ‘Inflation, output, and stock prices: Evidence from two major emerging markets,’ Journal of Economics and Finance, vol. number: 23 (3): 266-78
  • Bank of England, 2005. Wray, L. Randall, 1998, Understanding Modern Money, Cheltenham, UK. Edward Elgar.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/monetary-policy-finance-essay.php


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