Question

a) Differentiate between monetary targeting and interest rate targeting

b) Under monetary targeting, money supply is fixed not money demand. Explain this.

c) what is the relationship between Purchasing Power Parity and Quantity Theory of Money?

d) Differentiate Uncovered and Covered Interest Rate Parity.

Answer 1

a) Monetary targeting is a simple rule for monetary policy according to which the central bank manages monetary aggregates in such a way that ensures the achievement of price stability. In monetary targeting Comedy Central Bank announces that it will tell that an annual growth rate in a particular Monetary aggregate ( like M1 or M2). Once the target is set, the central bank is responsible for hitting this target.

Interest rate targeting is the process in which Monetary Authority targets desired level of interest rate . A target interest rate refers to a given level of interest rate ( for example, federal funds rate) with which the central bank seeks to influence short term interest rates as a part of its monetary policy strategy.

b) Because targetting money supply is possible for the central bank as quantity of money is fixed at a level largely determined by the central bank. Central bank has the power to add or remove money from the economy to keep it healthy. On the other hand Controlling demand for money is a way difficult as real GDP and velocity of money can't be controlled legally or politically . Central Bank won't be able to influence demand for money directly as it does in the case of money supply.

c) The PPP concept is a key element in the quantity theory analysis that developed the University of Chicago in the post Second World War years and that formed the theoretical backbone of Friedman and Schwartz's 'short monetary history of the United States'.

PPP theory states that " in places where money is kills goods will be cheaper than those where the old mass of money is bigger, and therefore it is unlawful to exchange a smaller sum of one country for a larger sum of another corresponding to the amount required to buy the same parcel of good that the latter must have bought if he had not delivered this money in exchange". This Mirrors the absolute PPP concept as currency exchange at a parity that allows the purchase of the same basket. When we connect the scarcity and abundance of money with the low and high price level ,this establishes a link that ascribes the relative PPP concept also to the quantity theory of money.

d) lnterest rate parity says that we expect foreign currency appreciation and depreciation should be equal to the interest rate differential between two countries. There are two versions of interest rate parity- covered interest rate parity and uncovered interest rate parity.

uncovered interest rate parity is a situation where currency risk cannot be covered with forward currency exchange contract .

Covered exchange interest rate parity is a situation where arbitrage would force the forward contract exchange rate to a level consistent with the difference between nominal rate of interest between two countries.