Monetary policy Assignment Example | Topics and Well Written Essays - 2500 words

Monetary policy - Assignment Example The implications of bank lending involve a situation whereby many bank borrowers do not have close substitutes for bank funding. This force the banks undergo challenges especially when they are monitoring their borrowers. Individuals also rely on the banks for credit and many small firms do not access to the capital. Another implication is that contractionary monetary policy reduces the quantity of reserves and deposits in the banking systems (Hammonds, 2006). In addition, banks mend their balance statement by reducing loans and securities holdings therefore, changes in bank lending has got resultant effects on investment spending small firms and debt financed spending. Consequently, the bank lending channel of monetary policy operates in a manner that if the monetary policy contracts, banks cost of refinancing increases hence lending rates also rises. High rates of interest aggravate problems of moral hazard and adverse selection. This is shown below by the following graph: In addit ion, banks cannot tell honest and dishonest borrowers apart since the mix of honest and dishonest borrowers rely on the interest rate. Therefore, at high interest rates majorly high risk borrowers come forward. In this case, increasing the loan rate may reduce bank expected profit (Haan & Eijffinger, 2005). ... What are the lessons for monetary policy from the experience of the international financial crisis? Taylor’s rules are those instrumental principles that are used to determine and formulate the right model for monetary policy that measures the output gap and measures the rate of inflation in the economy (Keel, 2012). These rules are used to determine whether the monetary policies used by various countries are tight or loose. If the monetary policies are tight then it means that financial institutions such as banks will not under go a financial crisis while when the policies are loose then they are like to cause a financial crisis. Taylor’s rule of inflation Taylor rule concerning federal funds rate since 1980 to 1992 is precisely matched by this rule: it = r* + ?T + ? (yt-y*) + ?(?t- ? T) Where by r* =equilibrium real interest rate of 2% ?T =target inflation rate of 2% (Yt-Y*)=output gap (?t -?T)=inflation gap The power of the two gaps (? and ?) is about 0.5. This model suggests that the central bank can care about output and inflation or it can use the output gap to forecast the future inflation (Jadhav, 2006). It is therefore, noted that Taylor’s rule can be used to make decisions on various economic conditions such as inflation. This model also determines whether a policy has transformed after targeting inflation or not. Open economy Taylor rules are to respond on the role of international spill over while non-linear rules are used to respond to aspects of inflation or deflation. Empirical evidence of Taylor’s rule Taylor’s principles in United States practice, have been used to inform policy decisions and therefore, not a mechanistic rule.