Tools of Monetary Policy Essay Example | Topics and Well Written Essays - 1000 words

Tools of Monetary Policy - Essay Example The effect of increasing the discount rate on the money supply is shown below in diagram 1. In part (a), the demand for reserves is not high enough and as a result there are no changes in the equilibrium reserve holdings. In part (b) there is a high demand for reserves and as a consequence, there is a decline in the equilibrium reserve holdings. Figure 1: Impact of increases in the discount rate In the diagram above, there is an increase in the discount rate from to . Consequentially the supply of reserves schedule rises from to . However, observe that in part (a) the demand for reserves are lower than in part (b). In particular the demand for reserves schedule is not high enough in part (a) to substantiate any efficacy of increasing the discount rate. In fact in such a scenario, a decline in the discount rate could have an impact by increasing the equilibrium reserve holdings if the rate is lowered below the bank rate. However, this will make sense if the resulting effect of increas ed money supply is the desired result. As a result, albeit the increase in the discount rate leads to a rise in the supply of reserves, there is no change in the equilibrium holdings. Thus, there is no discount lending in this case. In part (b) the increase in the supply of reserves leads to a reduction in the equilibrium discount reserve holdings from R0 to R1. Note that in this case lowering the discount rate would have had an impact as well but of the opposite kind. Alternatively, the central banking authority of an economy has to right of denying or controlling the amount of loans directly. Thus it has a control over the money supply of the nation directly via a control over the sanctioning of discount loans. In particular, loans forwarded to financial institutions by the central banks belong to any of the following three classes: a) primary loans, b) secondary loans and c) seasonal loans. Primary loans are the credit supplies to healthy or financially stable banks or financial institutions. Secondary credits are the loans that are forwarded with a designated purpose only in which the credit accepting institution can put the loan in use. Finally, seasonal loans are the short term credit that is forwarded under discount rates generally to help institutions overcome temporary liquidity shortages and emergencies. Thus by controlling the amount of reserves financial institutions have, the central bank can restrict the amount of money supply in the economy. How may central Bank help prevent bank panics by acting as a lender of last resort? Support your answer using examples of such events. Bank runs or panic runs to the bank are caused by the fear that the bank will become insolvent and will fail to return the amount of deposits. The central problem is that this has a cascading effect and actually becomes a self fulfilling prophesy since as the number of people withdrawing their funds increases, the liquidity of the bank decreases. Further with the number of wi thdrawals rising, other customers fearing insolvency also begin withdrawing their own deposits. Since banks never hold all of the depositors' money as reserves at any point of time, if a large number of customers begin withdrawing all their funds, the bank does become insolvent fast. This phenomenon was a central problem

The Theories of Financial Intermediation Essay Example | Topics and Well Written Essays - 2250 words

The Theories of Financial Intermediation - Essay Example A lot of these imperfections direct towards specific kinds of transaction costs. These asymmetries can produce unfavourable selection, they can be temporary, generate moral exposure, and they can result a costly verification and enforcement. As proven on different studies, financial intermediaries come out to at least partially surmount these costs. Based on the interpretation of Leland and Pyle (32); financial intermediation act as an alliance of information-sharing, and intermediary coalitions as argued by Diamond (51) can attain economies of scale. He also projected that financial intermediaries can effectively monitor returns by acting on behalf of ultimate savers. Hart (1995) explained that savers optimistically value the intermediations in terms of ultimate investments. According to Campbell and Kracaw (863-882) financial intermediations can create a useful incentive result of short-term debt on banker's behalf. The deposit funding can turn out the right incentives in managing the bank. A subtle financial organization necessary to control the bank managers produced illiquid assets (Diamond 393; Miller 21). In instances where the borrower in the bank chose direct finance; the role of a brokerage is in acted by financial intermediaries as explained by Fama (39-58) as investment banks. On this situation, reputation is at risk and according to Campbell and Kracaw (885) in financing, the financier's reputation as well as the borrower's is relevant. Second Principle: The Transaction Costs Approach This approach agrees with the concept of complete markets unlike the initial approach specified. It agrees that transaction process is of no convexities. In this approach, the financial intermediaries using economies of scale in the transaction process work in coalitions with borrowers. Many experts explained that the concept of transaction costs comprises not only monetary transaction costs, but at the same time covers auditing, searches and monitoring costs. Therefore, the function of the financial intermediaries is to transform specific financial claims into a so-called qualitative asset in this example. It is called offering diversified opportunities through liquidity as Ross (23-40) stated. The provision of liquidity is a main function for investors and savers and highly for corporate customers, in which the provision of diversification is welcomed in institutional as well as personal financing. Oldfield and Santomero (WP #95) in their submitted work paper stipulated that this l iquidity plays a key role in asset pricing theory. Financial intermediation then becomes exogenous with transaction costs. Third Principle: Principle in accordance to the regulation of money production Regulation affects solvency and liquidity inside the financial market or organization. Diamond (414) argued that the capital of the bank affects its refinancing ability, bank safety, and ability to extract repayment from the borrowers. Regulation as viewed on the basis of legality convenes as a vital factor in financial economy. However, the actions of the