Merry Monetary Policy :)

A belated Merry Christmas to everyone, hope Santa got you tonnes of presents, from the latest flat screen telly, to that book you always wanted. Of course, who can forget the candy canes melting in the cups of hot chocolate, as one sees the crystalline structures of water (read: snowflakes), deposit themselves on your window ledges, and rooftops? Alas, the holidays are around, time for happiness, joy, and cheer. Moreover, Happy Boxing day so get your cars drive to the nearest mall, and spend more money AFTER Christmas gifts on things that are not really that darn cheap after all. Trust me, a 70% off at Tommy Hilfiger, still means forking out some wads of cash, some people call me a damper on Boxing Day, others call me cheap, I agree with both. Nonetheless, I digress I must refocus on something else I wish to blog about today. C’est la politique monétaire, or as most English speakers know, monetary policy. Monetary policy is a little tool used by our modern day government, in particular, by the Central Bank, to regulate interests, and affect economic activity within a nation.  Interest rates affect economic activity through affecting capital inflows and outflows from a nation, and by regulating levels of business investment, consumer expenditure, and even governmental spending. As I explain monetary policy, I’ll explain the jargon in more detail, which should assist in understanding of the topic. The central bank has a balance sheet, think of it as a form of record of all the assets and liabilities that the bank posses. The assets usually include bonds that the bank owns, and issues to other chartered banks, and loans issued by the bank, that function as a receivable for the central bank. Moreover, the bank has foreign assets, in the form of reserves (reserves are usually held in the form of foreign currency, or gold). Traditionally, the US dollar is used as a reserve currency; although most banks keep a mix of the US dollar, Euro, and the Japanese Yen, and a small ratio of other nations’ currencies. The other side consists of liabilities, in the form of bank reserves that other chartered banks deposit at the central bank, and currency in circulation (the dough in your purses), whose valuation is again the responsibility of the central bank.  Now, let’s see how monetary policy works:

Consider a country like Canada, whose central bank (Bank of Canada), hereinafter referred to as BOC, has an interest rate of 0.25%. Now, consider another country, such as France, with its central bank (European Central Bank), hereinafter referred to as ECB, with the interest rate at 0.25% as well.

To begin, consider a scenario where Mark Carney feels that the global economic recovery is weak, and needs some stimulus to allow business activity to gain strength, and resurrect the fragile economy. He might order that the interest rate be lowered to a measly, 0.05%, a drop of 2000 basis points. This is of course a huge drop, and is rarely ever seen, but for the sake of our understanding this shall suffice. A drop in Canadian interest rate means that, Canadian chartered banks begin to offer lower interest rates on securities, and the treasury bills offered by the BOC see a drop in yield as well. This prompts Canadian investors, and international investors to pull money out of Canada (capital outflow from Canada), and deposit it in ECB’s treasury bills, and French chartered banks, which earn a higher interest rate (capital inflow into France). This means that the Canadian money supply increases as money locked up in savings accounts is pulled out, and is shuffled abroad. Leading to people’s need to convert Canadian dollars to Euros; thus, there are more Canadian dollars to go around. Moreover, a drop in interest rates means that the Canadian people are willing to borrow a lot more money at the cheap interest costs. This borrowing of money leads to increases in consumption, and businesses find it easier to finance investment. Therefore, the lower interest rate means more people willing to use their credit cards, and businesses rushing to the bank to take out loans to build more factories, which will hire more people and reduce unemployment. However, this virtuous loop is not infinitely cyclical and does come to an end, as the markets rebalance. Of course, there are other nuances and intricacies in the aforementioned paragraphs that I have skipped, and I will explain them in more detail when I post about monetary policy again. This post is just meant to function as a quick crash course into interest rates and their effect on our economy, via monetary policy.

Conversely, consider the scenario where Mark Carney increases interest rates, as he feels that inflation is threatening the economy. This would lead to capital inflows into the Canadian economy, and capital outflows from France. The French currency, Euro’s supply increases, and Canadian dollars are locked away in interest earning instruments. Thus, business activity is dampened, and inflation is averted. Voilá, the world of monetary policy! So the next time you pick up the telegraph, or le monde, or the financial times and see an interest rate change announcement, or story. Read it, and feel proud that you understand one of the fundamental instruments of macroeconomic policy.

Ramble: Usually, after a serious post similar to the one above I love to ramble out random thoughts in my head.  I’m going through a phase where I’m fascinated by the European culture, geography, politics, and immigration laws. I know that the last ones seem weird, but immigration laws float my boat. Did you even know that in India, certain places exist where in order to protect the local culture the government does not allow foreign nations to enter those regions of the country? Not only are foreign nationals not allowed, Indian citizens who live in other states, are not allowed to visit those regions. Regions off limits include Arunachal Pradesh, Mizoram, Andamman and Nicobar Islands, and other little bitty crannies of India. Hmmm, what else? I’m reading a book on Fermat’s Last Theorem, and the quest for its proof that was ended by Andrew Wiles. It is an interesting read, and has a section devoted to female mathematicians. I’m sorry if I sound ignorant, but there are not many female mathematicians that come to my head when I try to think of mathematical breakthroughs. I’m sure that there are quite a few female mathematics professors in the modern world, but very few mathematicians, with two X chromosomes, have been documented for their achievements in mathematics. Nonetheless, my scrimmaging through lead to an interesting find: Danica McKellar, the girl who played Winnie Cooper in the Wonder Year, is actually a holder of a degree in mathematics summa cum laude from UCLA! She has published various math exercise books, and has a whole theorem dedicated to her, check out the link for more info. (http://www.nytimes.com/2005/07/19/science/19math.html?_r=1) I was quite pleased to find this, after years of imagining that mathematicians were people with weird OCD’s who sat in rooms and worked on numbers all day (sort of like me), it was refreshing change to find a mathematicienne who looks like this! :D