Monetary policy involves how the monetary authority controls the money supply through targeting interest rates in order to promote economic stability, and growth. The main goals of monetary policy include stabilizing prices and maintaining low levels of unemployment. It includes two policies namely; expansionary policy and contractionary policy. Expansionary policy is where the supply of money in an economy becomes increased rapidly in order to combat recession and unemployment, through lowered interest rates. Contractionary policy, on the other hand, includes expansion of money supply slowly with an intention of lowering down inflation.
In the United States, monetary policy gets implemented by the Federal Reserve, established in 1913. It comprises of twelve independent and private banks. The banking corporations are all accountable to the Congress. Federal Reserve manipulates the supply of money through three mechanisms. First, it sells securities from the treasury in order to reduce the monetary base. This happens because accepting securities means paying a hard currency. The other mechanism is changing the discount rate. The final mechanism involves adjustment of reserve requirement, which affects money multiplier. However, this rarely happens.
Interest rates get influenced by the Federal Reserve by use of open market operations to change the reserve balances. A target of federal funds rate gets announced regularly by the Open Market Committee. These provide the rates by which inter banking lending takes place. The capacity of Federal Reserve to change lending rates is unlimited. The rates, however, stay within a certain range, below and above the target rate. In a closed economy, interest rates go down whenever there is an increase in money supply. In such a situation, consumers and businesses have low capital cost, and can thus improve spending on capital projects, which encourages growth (short term). However, interest rates go up whenever the supply of money falls. This leads to low investment and spending (Clapham, 2007).
Central bank provides funding to the economy through funding the commercial banks to cover a shortage in money supply. Central bank is, therefore, the backbone of a country’s banking system. Central bank’s primary role is providing a country’s currency and price stability through controlling inflation. Central bank is also a regulatory authority in monetary policy. The bank is also the printer and provider of coins and notes, which are in circulation. In order to perform these functions effectively, central bank must remain independent from political, and government influence. Central bank should also not have an interest in commercial banking.
Central bank has got two main functions namely; macroeconomic and microeconomic functions. Macroeconomic functions come in when the central bank regulates price stability, and inflation. Microeconomic function is when the bank becomes the lender of last resort. The central bank regulates inflation through controlling the supply of money. This happens through contractionary and expansionary policies. In order to increase the money in circulation, the central bank decreases the rates of interest. The central bank can also buy government bonds, and bills. This, however, increases the rate of inflation in a country. When it becomes necessary to reduce inflation, the central bank sells government bonds in an open market. Consequently, this leads to increased interest rates, which discourages borrowing. Open market operations help the central government to control the money supply, inflation, and stability of prices.
Central bank influences microeconomics by lending to the commercial banks, which lend to consumers, and businesses. In case commercial banks do not have enough funds to lend to their clients, they borrow money from the central bank. This maintains stability in an economy. Reserves by commercial banks remain held by the central bank, but the case is different in UK. The central bank also determines the discount rate, the rate at which commercial banks borrow short-term funds.
Adverse selection and moral hazard
Adverse selection is a situation where the seller values an item highly than the buyer because he understands the value of that good. This leads to a situation where the seller will not be willing to part with the good at a price lower than the value he attaches to the good. On the other hand, the buyer will not be willing to buy the item at that price because he does not know the exact value of that good. The buyer fears that the good could be of a lower value. This prevents a transaction from taking place.
Moral hazard occurs on services such as warranties and insurance. Here, the one who buys the insurance cover may become careless because of the insurance cover. He knows that in case damages occur the insurance company will pay all or part of the loss. The problem, in this case, is not prior information, but the fact that the insurance provider cannot control and monitor the behavior of the insured. This leads to market failure just as in case of adverse selection. In adverse selection, the person who possesses much information is the seller, but in case of moral hazard, the buyer has much control.
Some situations exist where adverse selection relates to moral hazard. An excellent example here would be health insurance cover. The person covered person may engage in unhealthy activities, which are attractive to him but not to the insurance company. This would be adverse selection because the insured has more information than the insurance provider. With the insurance cover, the person may become careless about his health by smoking and drinking heavily, which expose him to health problems. This is moral hazard. Adverse selection occurs in a situation like where the buyer is purchasing a second hand vehicle. He may not be able to know the exact value of the vehicle without purchasing it first (Froeb & McCann, 2009).