MONETARY THEORY AND POLICY

Monetary Theory and Policy

Monetary Theory and Policy

Introduction

Monetary policy is one of the tools that the national government uses to influence its economy. Using its monetary authority to control the supply and availability of funds, government attempts to influence the overall level of economic activity in accordance with its political goals. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth and external balance of payments. Monetary policy is usually administered by government appointed the Central Bank, Bank of Canada and Federal Reserve Bank in the United States. According to the Encarta definition of monetary policy is the following economic principles and policies adopted by the Government, which control the growth of its money supply, credit availability and interest rates. In the United States, the Federal Reserve determines monetary policy.

Exchange Rate Regimes

Until 1997, the Asian financial crisis, most East Asian currencies were pegged to the dollar with varying degrees of fixity. After the crisis, however, affected countries have tended to move to a free floating exchange rates and liberalization of capital markets and foreign exchange. Furthermore, other developing countries that were previously selected with respect to a fixed exchange rate regimes are also moved in less than fixed regimes.

Currency trading takes place on auction markets, known as foreign exchange markets, where annual turnover now exceeds global domestic product (GDP) by a factor in excess of forty. The exchange-rate regime refers to the public management of exchange rate relations, and thus shapes the context for trading on the foreign exchange market. The prevailing exchange-rate regime is determined by the decisions of governments, usually acting collectively under the auspices of an international agreement. On certain occasions, however, economically powerful countries have been able to reconfigure the exchange-rate regime while acting unilaterally.

The academic literature tends to focus on the difference between two types of exchange-rate regime: fixed versus floating. A fixed regime locks in the relative value of domestic currencies, hence determining the price at which they are exchanged. The classical gold standard, in operation in its purest form between 1870 and 1914, provided the basis for one fixed exchange-rate regime. Each currency had a set price in relation to gold and, because gold acted as a common denominator, each currency also had a set price in relation to one another. The postwar international economic order, which was negotiated at Bretton Woods in 1944, was also underpinned by a fixed exchange-rate regime. This time, however, the relationship between the U.S. dollar and gold, rather than gold alone, acted as the lynchpin of the system. By 1971, inflationary pressures in the United States undermined the effective value of the dollar, prompting investors to attempt to convert dollars into gold to protect the value of their assets. U.S. reserves, depleted by the country's first trade deficit of the twentieth century, plus the financial cost of the Vietnam War, were insufficient to meet the demand for dollar convertibility. As a response, U.S. President Richard Nixon reneged on his country's Bretton Woods' commitments ...