Question

Money and banking

1. As the world economy slows down we notice a novel and more energetic intervention by central banks to prop up the economies of developed economies in particular. The most notable cases are the interventions of the FED in the US, of the ECB in the European Union and of the Bank of Japan in Japan. Though there are many similarities in the instruments, magnitudes and modalities of intervention among these central banks, one very important difference stands out: while the ECB and the Bank of Japan allow interest rates to fall below zero, the FED insists on keeping interest rates above zero. Please explain and compare the reasons and justifications for the policy of keeping interest rates above zero and the reasons and justifications for the policy of allowing interest rates to fall below zero. Finally, add your own comments and opinion. 2. Throughout the semester you have been following a monetary institution or organization you selected at the start of classes. Based on the information you have gathered i. Point out 3 major issues the institution or organization which you have been following has faced ii. ii. Describe how these issues have been resolved iii. iii. Point out at least 2 lessons you can draw from the experience of the institution or organization which you have followed. (You need to provide at least 10 dated and hand written reports on the organization you have been following in order to receive the grade for this question. You may use the facilities of the e-mail or Moddle in sending t5hese to me.)

Answer 1

1. The Federal reserve is not willing to let interest rate to fall below zero to keep financial market stable. A negative interest rate can discourage savings in one hand and thus supply of loanable funds may decrease. Cash holding may increase in the economy, which may reduce the strength of money multiplier. Secondly, a negative rate creates downward pressure on yield curve narrow down the the returns that financial institutions can earn from lending.

A negative interest rate policy was implemented by the ECB and Central Bank of Japan. This policy indicates that financial institutions have to pay interest if they want to keep excess reserves with the central bank. Therefore, the central bank wants to induce commercial banks to lend as most as they can and not to hold excess reserves to boost lending in the economy. Excess reserved held by banks therefore will be penalised in this policy. This policy is perhaps undertaken to increase money supply in the economy.

It can be commented that drop is interest rate is good to boost up investment activities in the economy, where output and employment opportunities can be created. However, too low interest discourage savings and reduce consumer welfare. Consumers are even charged for depositing money in the banks. The objective of savings is to smooth future consumption. Drop in savings thus may impose pressure on future consumption of the consumers. Hence, negative interest rate is not suggested.