EFFECTS OF MONETORY POLICY

Monetary policy is the regulation of a country's money supply by the central bank of a country or
region. In the United States, the central bank is the Federal Reserve Board. Monetary policy tools
are used to help control the economy. The primary tools used by a central bank are changes to
the prime interest rate, changes to the amount of money in circulation and changes in the reserve
requirements for banks.

Control Inflation
1. One of the primary impacts of monetary policy is on inflation. The goal of monetary
policy is to control inflation, or the value of currency, through changes in monetary
policy tools. When inflation rises, the central bank typically raises interest rates. High
inflation makes the costs of goods higher. Central banks want to keep inflation low to
keep the prices of goods stable relative to the value of the currency.

Interest Rates
2. Monetary policy directly impacts interest rates. The central bank raises or lowers the
prime rate, or interest rate the central bank loans money to other banks, as a tool to
impact the economy. These actions have a trickle down effect on the interest rates
charged on loans, credit cards and any other financial vehicle that is tied to the prime rate.

Business Cycles
1. Business is cyclic in nature and goes through periods of expansion and contraction.
Monetary policy attempts to minimize the speed and severity of these expansions and
contractions to maintain steady growth or decrease a negative contraction. The goal is to
keep an economy on a slow, but steady growth pattern to prevent recessions during
periods of contraction.

Spending
2. Monetary policy impacts the amount of money spent in an economy. When a central
bank decreases interest rates, more money is typically spent in an economy. This increase
in spending can equate to better overall health for an economy. Likewise, when interest
rates are increased, spending declines, which could curtail inflation.

Employment
3. Employment levels relate to the health of an economy. When inflation is low and an
economy is stable or in an expansionary phase, employment levels are higher than when
inflation is high and an economy is in a contraction phase. Changes in monetary policy
that maintain economic stability and minimize inflation, tend to keep unemployment low.
Advantages
1. Transaction costs will be eliminated.
For instance, Uk firms currently spend about £1.5 billion a year
buying and selling foreign currencies to do business in the EU.
With the EMU this is eliminated, so increasing profitability of EU
firms.

Advice to young people: You can go on holiday and not have to

worry about getting your money changed, therefore avoiding high
conversion charges.
2. Price transparency.
Eu firms and households often find it difficult to accurately compare
the prices of goods, services and resources across the EU
because of the distorting effects of exchange rate differences.
This discourages trade. According to economic theory, prices
should act as a mechanism to allocate resources in an optimal
way, so as to improve economic efficiency. There is a far greater
chance of this happening across an area where E.M.U exists.

Advice to young people: We can buy things without wrecking our

brains trying to calculate what price it is in our currency.
3. Uncertainty caused by Exchange rate fluctuations eliminated.
Many firms become wary when investing in other countries
because of the uncertainty caused by the fluctuating currencies in
the EU. Investment would rise in the EMU area as the currency is
universal within the area, therefore the anxiety that was previously
apparent is there no more.
4. Single currency in single market makes sense.
Trade and everything else should operate more effectively and
efficiently with the Euro. Single currency in a single market seems
to be the way forward.
5. Rival to the "Big Two".
If we look out in the world today we can see strong currencies such
as the Japanese Yen and The American $. America and Japan
both have strong economies and have millions of inhabitants. A
newly found monetary union and a new currency in Europe could
be a rival to the "BIG TWO".
EMU can be self-supporting and so they could survive without
trading with anyone outside the EMU area.
This fact makes the Euro very strong already, and even George
Soros couldn't affect it (well, hopefully!!!!).
The situation that EMU is in is good as it seems that it can survive
on its own, with or without the help of Japan and U.S.A.
6. Prevent war.
The EMU is, and will be a political project. It's founding is a step
towards European integration, to prevent war in the union. It's a
well known fact that countries who trade effectively together don't
wage war on each other and if EMU means more happy trade, then
this means, peace throughout Europe and beyond (we hope).
7. Increased Trade and reduced costs to firms.
Proponents of the move argue that it brings considerable economic
trade through the wiping out of exchange rate fluctuations, but as
well as this it helps to lower costs to industry because companies
will not have to buy foreign exchange for use within the EU. For
them, EU represents the completion of the Single European
Market. It is vital if Europe is to compete with the other large trading
blocs of the Far East and North America.
8. The Political agenda.
There is also a political agenda to European bank (the European
System of Central Banks -ESCB), the complete removal of national
control over monetary policy and the partial removal of control over
fiscal policy. Individual nation states will lose sovereignty (i.e. the
ability to control their own affairs). It will be a considerble step down
the road towards political union. There are many in the EU who
faviour economica dn political union and they are very much in
facour ot EMU. There are also many who wish to keep national
sovereignty and are strugging to prevent EMU, whatever its merits
might be, from going ahead.
9. Inflation
From the mid-1980s onwards, there were a number of economists
and politicians who argued that, for the UK at least, EMU provided
the best way forward to achieve low inflation rates throughout the
EU. During the first half of the 1980s high inflation countries, such
as France and Italy were forced to adopt policies which reduced
their inflation rates to something approximating the German
inflation rates to something approximating the German inflation
rate. If they had not done this, the franc and the lira would have
had to be periodically devalued, negating the fixed exchange rate
advantages of the system. Effectively, the German central bank,
the Bundesbank, set inflation targets and therefore monetary
targets for the rest of the EU. At the time, there was much
discussion of why Germany had a better inflation record than many
other European countries. The consensus emerged that it was
because the Bundesbank, the German central bank, was
independant of the German Government. In countries such as the
UK and France, central banks were controlled by governments. If
the UK government decided to loosen monetary policy, for
example, by reducing interest rates, it had the power to order the
Bank of England to carry out this policy on its behalf. There have
always been especially strong pressures before an election for UK
governments to loosen the monetary reins and create a boom in
the economy, with the subsequent increase in inflation following the
election. The Bundesbank, in contrast, was independent of
government. By law it has a duty to maintain stable prices. It can
resist pressures from the German government to pursue reflation
policies if it believes that these will increase inflation within the
economy. Events of the early 1990s have shaken the naieve faith
that linkage to the independent ESBC, the central bank of Europe
would solve all inflationary problems. This is because German
inflation rates in the early 1990s rose to over 4% as Germany
strugged with the consequences of unification. In 1993, inflation
was nearly three times as high in Germany as in the UK and twice
as high as that in France. Some countries, such as France, have
made their central banks independent on the Germany model and
therefore arguably don't need to the EMU link to Germany to
maintained low inflation.The UK has gone a little way towards
giving more power to the central bank by publishing reports of
monthly meetings between the Chancellor of the Exchequer and
the Governenor of the Bank of England. This forces the
Government to justify its monetary policy publically and makes it
harder for it to use interest rates for short term political ends.

Disadvantages
1. The instability of the system.
Throughout most of the 1980s the UK refused to join the ERM
(Exchange rate mechanism). It argued that it would be impossible
to maintain exchange rate stability within the ERM, especially in the
early 1980s when the pound was a petro-currency and when the
UK inflation rate was consistently above that of Germany. When
the UK joined the ERM in 1990 there had been three years of
relative currency stability in Europe and it looked as though the
system had become relatively robust. The events of Sept. 1992,
when the UK and Italy were forced to leave the system, showed
that the system was much less robust than had been thought.
2. Over estimation of Trade benefits.
Some economists argue that the trade and cost advantages of
EMU have been grossly over estimated. There is little to be gained
from moving from the present system which has some stability built
into it, to the rigidities which EMU would bring.
3. Loss of Sovereignty.
On the political side, it is argued that an independent central bank
is undemocratic. Governments must be able to control the actions
of the central banks because Governments have been
democratically elected by the people, whereas an independent
central bank would be controlled by a non elected body. Moreover,
there would be a considerable loss of sovereignty. Power would be
transferred from London to Brussels. This would be highly
undesirabel because national governments would lose the ability to
control policy. It would be one more step down the road towards a
Europe where Brussels was akin to Westminster and Westminster
akin to a local authority.
4. Deflationary tendencies.
Perhaps the most important economic argument relates to the
deflationary tendencies within the system. In the 1980s and 90's
France succeeded in reducing her inflation rates to German levels,
but at the cost of higher unemployent, For the UK, it can be aruged,
that membership of the ERM between 1990 and 1992 prolonged
unnecessarily the recessional period. This is because the
adjustment mechanism acts rather like that of the gold standard.
Higher inflation in one ERM country means that it is likely to
generate current account deficits and put downward pressure on its
currency. To reduce the deficit and reduce inflation, the country has
to deflate its economy. In the UK, it could be argued that the battle
to bring down inflation had been won by the time the UK joined the
ERM in 1990. However, the UK joined at too high an exchange
rate. It was too high because the UK was still running a large
current account deficit at an exchange rate of around 3 Dm to the
pound. The UK government then spent the next two years
defending the value of the pound in the ERM with interest rates
which were too high to allow the economy to recover. Many
forecasts predicted that, had the UK not left the ERM in Sept 1992,
inflation in the UK in 1993 would have been negative (ie prices
would have fallen).The economic cost of this would have been
continued unemployment at 3million and a stagnant economy.
When the UK did leave the ERM and it rapidly cut interest rates
from 10% to five and a half %, there was strong economic growth
and the current account position improved, but there was an
inflation cost.

Another problem that the early 1990s highlighted was that the
needs of one part of Europe can have a negative impact on the rest
of Europe. In the early 1990s, the Germans struggled with the
economic consequences of German reunification. There was a
large increase in spending in Germany with a consequent rise in
inflation. The Bundesbank responded by raising German interest
rates. As a result, there was an upward pressure on the DM as
speculative money was attracted into Germany. Germansy's ERM
partners were then forced to raise their interst rates to defend their
currencies. However, higher interest rates forced most of Europe
into recession in 1992 - 1993. Countries such as France couldn't
then get out of recession by cutting interest rates because this
would have put damaging strains on the ERM. The overall result
was that Europe suffered a recession because of local reunification
problems in Germany. Critics of the ERM and EMU argue that this
could be repeated frequently if EMU were ever to be achieved.
Local economies would suffer economic shocks because of
policies, forced on them, designed to meet the problems of other
parts of Europe.
One way around this would be to have large transfers of money
from region to region when a local area experienced a recession,
e.g. N. Ireland which suffered structural unemployment for most of
the post war period, has had its economy propped up by large
transfers of resources from richer areas of the UK with lower
unemployment. However, regional transfers are very small at the
moment unfortunately. Moreover to approximate the regional
transfers which occur at the moment in, say, Britain, there would
have to be a huge transfer of expenditures from national
governments to Brussels - just what anti Europeans are opposed
to.