The 2008 UK bank bailout and rediscount operations

Monetary Policy and International Exchange Rate

Monetary Policy

A factor leading to an increase in a supply of money is a rise in a demand for the bank reserves influencing an increase in the money supply. To prevent a rise in the money supply, the central bank will purchase bonds to increase the quantity of non-borrowed reserves in the economy thereby shifting the amount of money reserves to the right preventing the central bank fund rates from rising. The strategy is to use the open market purchase to make the money supply and monetary base to rise. As being revealed in Fig 1, if the goal of the central bank is to maintain the interest rate target at r1, the central bank will reduce the quantity of the money supplied in the economy especially when an economy is experiencing a recession.

Fig 1: Interest Rate Target

Moreover, when the central bank decides to maintain an interest rate target at r1, the central bank will need to reduce the supply of money during the recession shifting MS1 to MS2 and eliminate the fall of the interest rates. Thus, the new equilibrium will shift from E1 to E3 and the interest rate will be at the target rate r1.

II. Benefits and Costs of Rediscount Operations

The 2008 and 2009 financial crisis forced the UK government to make a decision to bail out the distressed financial institutions to prevent the country's financial systems from collapsing and allow banks continuing functioning. The bailout was essential because the businesses, households, and governments relied on bank services to carry out everyday businesses activity. However, the UK government cannot implement the bailout to prevent the bank panics without using the pubic funds. On October 2008, the UK government approved the total of £500 billion as the bailout package to rescue the distressed banks from collapsing. The policy decision was very critical because there was a major fall in the UK stock markets towards the end of September 2008, and in the first week of October, there was a major fall in the stock markets heightened a concern about the stability of the UK financial institutions. One of the major benefits of the bailout process was to restore the confidence in the British banking system as well as guarantee the inter-bank lending. Moreover, the bank bailout using the rediscounted operations was to prevent bank panics that may have a negative consequence to the economy.

Despite the benefits associated with the rediscounted operations in the UK, the costs of this strategy are to prevent banks that deserve going out of businesses due to a poor management to remain in business. Chennells, & Wingfield, (2015) argue that bailout of banks and other financial institutions is undesirable. The method is an incentive to allow banks to be imprudently, and take excessive risks. The more hidden cost of the bailout program is that the government has created a moral hazard problem by giving banks an incentive to be more reckless in their management in the future. For example, some banks began offering riskier investments and loans shortly after the bailout program. Thus, the approval of the program actually led to an increase in a risk taking.

The additional cost of the bailout was that the government faced many criticisms from both from the economic and financial cycle. Shortly after the bailout program, many people in the UK criticized the action of the government for using the taxpayer fund to bail out the distressed banks on the ground that these banks got into problems because of their greediness, and poor risk management. Moreover, the bailout program has resulted into frictions between the UK government and some governments outside the UK. When the UK government approved the rescue plan for the distressed banks, the Icelandic government also rescued the Icelandic bank Icesave from collapsing. When the bank was about to collapse in 2008, the Icelandic government compensated their nationals by absorbing their losses. However, the government did not compensate all creditors, and only compensated their nationals and did not absorb the losses of the UK creditors. The issue caused a lot of friction and political confrontations between the UK and Icelandic government, culminating the UK government to apply "the Anti-terrorism, Crime and Security Act 2001 to freeze Icelandic assets in the UK." (House of Common, 2009 p 22). Despite the associated costs of the bailout, its benefits outweigh the costs because the UK government made more than £27 billion profits from the bank bailouts. (Hyde, 2010).

I. Method balance of payments surplus affects the Inflation Rate

A country may require a balance of payments surplus to finance their surplus to gain international reserve. The consequence is that this action will make the central bank to supply more money into the circulation making more money to chase few goods. The policy will increase the monetary base and money supply leading to an increase in inflation. By definition, inflation is a consistent increase in the price of goods and service, when there is a rise in the money supply through a balance of payment supply, there will be an increase in the price of goods and services.

II. "Pure Flexible Exchange Rate System"

In the foreign exchange system, the central bank does not have a direct intervention in the operation, and exchange rate system because the law of demand and supply is influencing this. Thus, a change in international reserves, which affects the monetary base is lacking. Moreover, foreign exchange market may affect the monetary policy because monetary authorities may intend to manipulate the exchange rates by changing the interest rates and money supply.

III. Main Cost and Benefits of Monetary Union

A monetary union entails a collaboration of multiple countries to form a common currency union thereby ceding their monetary rights to a common authority. The Euro union is an example of a monetary union where 19 members forgo their national currencies and accept Euro currency as their currency. (Bergin, 2015). The major benefits of a monetary union are that the member countries will enjoy a fixed exchange rate thereby overcoming the problem of exchange rate fluctuation. Moreover, a monetary union helps businesses to eliminate the transaction costs that organizations and people incur when exchanging two or more currencies to carry out the international transactions.

Despite the associated benefits of the monetary union, the cost is that countries will lose a control of their national currencies. Moreover, the participating countries will lose the authorities to control the supply of money in the circulation. For example, a German government will not be able to use the monetary instruments to influence the employment, inflation and interest rates because the country has ceded their authorities to Euro union.

The main criteria of the optimal currency areas are as follows:

Increased mobility easing movement of labor across the currency area. For example, a member of EU can travel to member countries without visa thereby easing a free movement of labor across member countries. Moreover, there is a free movement of capital and financial resources between areas boosting the trade and economies of the member countries. A currency risk sharing is other criteria of monetary union alleviating the economy problems of the member states.

Conclusion

The goal of a country is to increase the employment rate, reduce inflation, and boost the productivity. This paper provides different strategies that a country can employ to achieve these objectives. The 2008 and 2009 financial crisis made the UK government to implement a policy to bail out the distressed banks preventing the bank panics that will consequently collapse the economy. The paper discusses the benefits and costs of the bank bailout. Moreover, the paper discusses different monetary instruments used to stabilize the economy. The open market operation is one of the most effective monetary tools to control the money supply. The study also discusses the costs and benefits of monetary union. The benefits include the elimination of transaction costs and fluctuation of currency exchange rates. The member countries also enjoy fixed exchange rates.

List of References

Bergin, P. (2015). The Monetary Union. The Concise Encyclopedia of Economics. Library Economic Liberty.

Chennells, L. & Wingfield, V. (2015). Bank failure and bail-in: an introduction. Quarterly Bulletin 2015 Q3:228-241.

Frederic S. M. (2007). The Economics of Money, Banking and Financial Markets. (8th edition). Pearson Education.

House of Common (2009). Banking Crisis: The Impact of the Failure of the Icelandic Banks: Fifth Report of Session 2008-09; Report, Together with Formal Minutes. Treasury Committee.

Hyde, D. (2010). Taxpayer to make £27 billion profit from bank bailouts. Citywire. UK.