Banking and expanding the money supply is a method used by central banks to stimulate the economy. This method increases the money supply, lowering interest rates and borrowing costs, thus encouraging consumption and investment. Expanding the money supply can be accomplished by means of the central bank buying public sector securities from the market (open market operations), lending to banks at lower interest rates (discount rate), or reducing the amount of reserves banks have to hold at the central bank (required reserve ratio).
The effect of expanding the money supply is seen through the monetary base and money multiplier. The monetary base is the sum of money in circulation and bank reserves. The money multiplier represents the rate at which the monetary base is converted into the money supply. The value of the money multiplier varies depending on the preferences of the central bank, banking sector, and households. While the central bank determines the monetary base, the banking sector determines the tendency to hold reserves to meet the loan demand, and the households determines the tendency to hold cash.
The economic effects of expanding the money supply can be studied through monetary transmission channels. Monetary transmission channels are mechanisms that explain the impact of monetary policy on the real economy. These channels are:
- Interest rate channel: Expanding the money supply lowers interest rates, which in turn increases investment spending.
- Exchange rate channel: Expanding the money supply devalues the local currency, which increases exports and decreases imports.
- Asset prices channel: Expanding the money supply raises asset prices, which creates a wealth effect and increases consumption expenditures.
- Expectations channel: Expanding the money supply raises inflation expectations, which in turn lowers real interest rates and increases consumption expenditures.
- Credit channel: Expanding the money supply increases the lending capacity of banks, which in turn increases credit demand and consumption expenditures.
Expanding the money supply has both advantages and disadvantages. These disadvantages are:
- Inflation risk: Excessive expansion of the money supply raises inflation, which reduces the purchasing power of money and destabilizes the economy.
Exchange rate risk: An overexpansion of the money supply overestimates the value of the local currency, which in turn raises the price of imported goods.
In this blog post, I will explain what currency risk is and how it can be managed. Exchange rate risk is the financial loss resulting from the depreciation or appreciation of a country's currency relative to another currency. This risk is a major problem for exporters, importers, investors and borrowers.
There are several ways to manage exchange rate risk. Some of these are those:
- Futures contracts: In these contracts, the parties undertake to buy and sell a certain amount of currency at a certain price on a certain date in the future. In this way, they are protected from exchange rate fluctuations.
- Options contracts: In these contracts, the parties buy the right to buy and sell a certain amount of currency at a certain price on a certain date in the future. In this way, they can take advantage of exchange rate fluctuations or limit their losses.
- Currency swaps: In these transactions, the parties swap their debts or assets in different currencies. In this way, they can reduce or eliminate exchange rate risk.
Exchange rate risk is an inevitable reality in the globalizing world. However, with appropriate strategies, this risk can be managed and financial performance can be maintained.