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Monetary policy is a set of policies aimed at management of the quantity of money in the country as well as control over interest rates. Apart from the quantity of money (which is also called the money supply) and interest rates, monetary policy has an impact on inflation and business cycles (Mishkin & Eakins, 2012). It is necessary to note that it affects the development of the economy as well as the pace of this development.
Monetary policy is also aimed at sustainable economic growth of the country and it involves the focus on stable pricing and maximum employment. Hence, monetary policy can increase or decrease the level of economic activity in the country (Burton, Nesiba & Brown, 2010). There are several major tools used in terms of monetary policy.
These instruments involve management of funds that are available as reserves, the control over credit rates and management of the optimal reserve ratio (Burton et al., 2010). The authority that is responsible for development and implementation of monetary policy is the central bank. The European Union also has the European Central Bank that aims at implementation of monetary policy of member states of the union.
In the United States, the structure of the central bank is very specific, as there is the Federal Reserve System (also referred to as the Fed). It consists of several bodies.
Historically, Americans distrusted centralized power and, hence, 12 Federal Reserve Banks were created to ensure availability of reserves in case of financial constraints (Mishkin & Eakins, 2012). At present, apart from 12 Federal Reserve Banks, the Federal Reserve System includes FOMC (the Federal Open Market Committee) and the Board of Governors.
The Central Bank
Some researchers refer to it as the “lender of last resort”, which means that, in the period, of severe financial constraints, this authority gives the necessary credits to banks that most need it (Burton et al., 2010, p. 73). At the same time, the Central Bank is an authority that controls credits and implements monetary policy of the country.
Clearly, it helps the government implement the necessary policies to ensure sustainable growth of the country’s economy. The Central Bank affects operations of private banks and various financial institutions. The major functions of the central bank include the following: currency regulation, general banking of the state, management of monetary reserves, lending money to banks, control over operations carried out between banks (Mishkin & Eakins, 2012).
As for currency regulation, the central bank issues notes and controls people’s supply of money. It also sets exchange rates for other currencies. The central bank provides general banking for the state through paying on behalf of the state. It also manages the country’s gold reserve. It also assists the government in development and implementation of policies aimed at management of inflation, financing and so on.
As has been mentioned above, the central bank lends money to banks in the periods of financial constraints to support the banking system of the country. It also implements control over operations of commercial banks and other financial institutions. Of course, it manages the country’s monetary reserves.
It is noteworthy that in different countries the role of the central bank and its responsibilities may vary as in some countries the control implemented by the central bank is very strict while in others commercial banks and institutions have more freedom.
Adverse Selection and Moral Hazard
Adverse selection is associated with the so-called asymmetric information. Asymmetric information is a common situation when actors in the financial market do not have sufficient information to make sound decisions. This is mainly related to lenders who are often unaware of the real risks.
Lenders do not have extensive information on borrowers’ capability to pay back and operations they are engaged in. This often makes them reluctant to give loans. Adverse selection occurs before the lending takes place (Mishkin & Eakins, 2012). Adverse selection takes place when the least reliable borrowers (who are likely to fail to pay back) are the most active seekers of credits, which makes them more successful in getting the necessary loan.
It is also quite common that after making unsuccessful decisions, lenders stop giving loans even if there are a few risks. Asymmetric information can also cause issues after the lending takes place. This situation is called moral hazard. It involves the risk that the borrower will operate in an undesirable way and whose actions may lead to inability to pay back.
For instance, if a lender suspects the borrower of investing the money in a risky way, the lender may refrain from giving a loan. Clearly, adverse selection and moral hazard create various obstacle for proper functioning of the financial market.
Thus, companies in need of loans may fail to receive them and will inevitably go bankrupts even though they could be capable of paying back to lenders and could contribute to development of the country’s economy. However, asymmetric information makes lenders more reluctant to give loans, which can also have quite negative effects for them as they lose the interest they could earn.
Reference List
Burton, M., Nesiba, R.F., & Brown, B. (2010). An introduction to financial markets and institutions. New York, NY: Routledge.
Mishkin, F.S., & Eakins, S.G. (2012). Financial markets institutions. Boston, MA: Pearson/Prentice Hall.
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