Monday, November 3, 2008

II. Derivatives and Monetary Policy: Implications for the Transmission Mechanism of Monetary Policy

The goal of the monetary policy is to ensure non-inflationary growth in the economy.  The intentions of the monetary policy are mostly transmitted through the financial sector, mainly through influencing the interest rates, exchange rates and availability of bank credit. Though there are wide variances in the financial structures in various countries, these issues assume greater significance in almost all the institutional arrangements.

Through Interest Rates:

With their low transaction costs and flexibility of product designs, derivatives increase the speed of portfolio adjustments and thus lead to the faster transmission of interest rate changes. On the other hand, financial derivatives are also the perfect instruments for the individuals who now can seperate the interest rate risk of an investment from its production risk at least for a while. The influence of monetary policy will sooner or later will get reflected in the real economy because the insurance obtained through derviatives will eventually expire. Moreover, the monetary policy so heavily influences the cost of such insurance. In a way financial derviatives provide inexpensive and efficient transmission of information to the modern and globalized economy.

Through Exchange Rates:

In the world with financial derivatives, it is much easier to engage in speculative positions on a particular country's currency without having any relationship to that country. It is not posible in the world without such derivative products. These kind of transactions effectively transmits the impulses of monetary policy to other parts of the region.

Through Bank Credit:

Monetary policy influences the volume and structure of bank credit if it were to control credit costs. The availability of financial derivatives in such an economy would likely to undermine the efforts of monetary policy given their capacity for substitution. This implies greater significance for the 'interest rate channel' than a 'credit chennel'.

(The author is greatly benefited from the writings of Gerd Hausler)

Constructive comments and suggestions are encouraged!!

No comments: