Question

Answer either a or b listed below:

a. Explain why a central bank must choose either a reserve aggregate or an interest rate as its policy instrument, but it cannot choose both at once. Feel free to use appropriate illustration to explain your answer. Label your illustration "R/I policy"

or

b. Which type of bubble poses a larger risk to the financial system/ What are arguments against using monetary policy to burst an asset bubble that is driven solely by irrational exuberance? What are appropriate policy responses to a credit driven bubble?

Answer 1

Ans b .

Let us understand this with the help of Financial crisis of 2008 since they were of similar nature.

Following the collapse of the credit bubble in 2008, a number of governments along with their central banks cut rates to (near) zero, including those in the United States and the United Kingdom. However, there was concern that the underlying economies might not respond to this drastic monetary medicine, mainly because the related banking crisis had caused banks to reduce their lending drastically. In order to kick start the process, both the Federal Reserve and the Bank of England effectively printed money and pumped it in to their respective economies. This “unconventional” approach to monetary policy, known as quantitative easing (QE), is operationally similar to open market purchase operations but conducted on a much larger scale.

The 2008–2009 global recession and financial crisis offers an extreme example of these velocity ambiguities. As the global economy slipped into recession, which held back the GDP numerator in velocity measures, central banks, most notably the Federal Reserve in the United States, tried to help financial institutions cope by injecting huge amounts of money into their respective financial systems, raising the velocity denominator. Velocity measures plummeted accordingly. The expectation is that subsequent GDP growth as economies and financial markets heal will bring velocity back to a more normal level and trend. That said, the fear is that the monetary surge will, over the very long run, lead to inflation. For policy makers, this situation has created a very difficult policy choice. On the one side, they need to sustain the supply of money to help their respective economies cope with the after effects of the financial crisis. On the other side, they need ultimately to withdraw any monetary excess to preclude potential inflationary pressures.

A definitive issue for monetary specialists as they attempt to control the flexibly of cash so as to impact the genuine economy is that they can't control the measure of cash that families and organizations put in banks on store, nor can they effectively control the readiness of banks to make cash by growing credit. Taken together, this likewise implies they can't generally control the cash gracefully. In this manner, there are unequivocal cutoff points to the intensity of monetary policy.