Introduction
International trade refers to exchange of services and goods across countries. Increased globalization has increased cross border trade. The numerous advantages that accrue from international trade have also stimulated growth of international trade. However, there are certain limitations of international trade that has made it necessary or countries to protect their local economies from the adverse effects of international trade. On the other hand, monetary policy refers to decisions that are undertaken by the central bank and the government in order to influence the country’s economy by manipulating credit cost and availability of money. This paper discusses the factors that explain the choices made by governments on monetary policy decision. It further discusses the trade-offs between openness and insulation by canvassing the advantages of openness and the reasons for protection. Lastly, it will discuss the types of decisions we would expect states to make in the current international system.
Factors that influence the choice monetary policy decisions
The first one is the macroeconomic goals that the government seeks to advance. They are four main macroeconomic goals that any government seeks to advance; full employment, price stability, favourable balance of payment and economic growth. Attainment of any of the macroeconomic goals will require the use of different monetary policy. For example if the government seeks to control inflation then it may use a contractionary monetary policy. A contractionary monetary policy may take the form of selling government securities through the open market operations, raising the bank reserve ratio or raising federal bank rate. This will result in a reduction in money supply, reduce demand and consequently reduce the inflation rate. On the other hand, if the government wants to reduce the unemployment rate then it may use an expansionary monetary policy. An expansionary monetary policy may take the form of buying government securities through the open market operations, reducing the bank reserve ratio or reducing federal bank rate. This will increase the money supply and increase demand which will encourage producers to increase production thus creating employment and consequently reducing unemployment.
The second influence is the nature of the problem that the government seeks to solve. For example the policy that will be used to remedy demand-push inflation is different from the policy that will be used to remedy cost-push inflation. Contractionary monetary policy will be effective in solving demand-push inflation. This is because a contractionary monetary policy will reduce the money supply and consequently reduce demand. A reduction in demand will reduce the average price levels in the economy thus controlling inflation. However, such a policy may be ineffective in solving cost-push inflation. On the contrary, the government may opt to reduce the Federal Reserve rate to reduce the cost of borrowing which will contribute in reducing the cost of production thus resulting in a reduction in the general price levels.
The third and last factor that may influence monetary policy decision is politics. Governments are run by politicians. Therefore, politics will play a central role in monetary policy decisions. The president may emphasis on one macroeconomic objective over another depending on his or her campaign pledges, political ideology and political party. For example, in the U.S.A, there are two main political parties, Republican Party and Democratic Party, which have different political ideology. Republicans believe in capitalism and free market mechanism. Therefore, it is expected that if the government of the day is run by a Republican, then a liberal monetary policy that does not interfere with the working of the market mechanism will be adopted.
Advantages of openness
Firstly, it allows the country to specialize in areas that it has a comparative advantage. In this way, the country can export those commodities to other countries and use the obtained earnings to purchase services and goods that it has a comparative disadvantage. This way, it will be able to ensure optimal use of its national resources. Secondly, opening up the economy to facilitate international trade will provide the country’s commodities with a wider market hence the country will be able to exploit economies of scale. The country will, therefore, be in a position to fully utilize its productive capacity and benefit from lower long run production costs. Thirdly, opening up the economy will encourage efficiency. This is because international trade results in exposure to international competition. Therefore, domestic producers will have to be cost efficient so as to compete in the same platform as foreign producers. Consumers stand to benefit from increased efficiency through reduced prices. Fourthly, opening up the economy improves consumer sovereignty and utility. The consumer will have a broader variety of goods to choose from; goods produced locally and in other countries. Lastly, opening up the economy will improve peaceful relations with other countries hence improving diplomacy. Unrestricted international trade ensures that countries depend on each other. Countries that depend on each other are less likely to engage in conflict due to their mutual coexistence.
Reasons for insulation
The first reason is cheap labour. It is frequently argued that any economy should be insulated from imports that have been produced using cheap or ‘sweated” labour. Buying foreign goods from low wage regimes not only amounts not only to unfair competition but also encourages the exploitation of cheap labour in those regimes as well as undermines the living standards of those in high wage economies. The second reason is to minimize structural unemployment. Decline of highly localized industry because of international trade causes regional or structural unemployment. In case it take long or its impossible to re-locate the labour to other productive work, then this can put the existing government under significant political and humanitarian pressure to limit importation of goods that are causing that industry to deteriorate.
The third reason is to avoid dumping. Dumping refers to selling goods on a foreign market far below their production costs. It is usually undertaken by foreign monopolists using high profits in their local market to subsidize exports strategic or political reasons. Dumping could result in the complete eradication of the home industry making the country dependent on foreign goods. The foreign producer would normally increase prices after eliminating the local industry. Countries in which those goods are “dumped” feel vindicated to protect their economies. The fourth reason is balance of payment deficit. If a country has a persistent balance of payment deficit, it is improbable that the country will finance the deficits from its limited financial reserves. Therefore, it is necessary for it adopt some form of restriction on imports such as quotas, tariffs or foreign exchange restrictions. Another reason a country may opt to insulate its economy is the danger of over-specialization. A nation may feel that to protect its long-term interests it must not be too specialized. Therefore, the government may be unwilling to abandon production of key commodities even if foreign products are more competitive to avoid overdependence on imports. It is for this sole reason that most countries desire to remain largely self-sufficient in production of food. Similarly, an exporting country may not want to become overspecialized in the production of a particular product. Although, such over specialization may make sense today, in the future, demand for that product may diminish hence that country will suffer disproportionally. The last reason is strategic reasons. For strategic or political reasons, any country may not desire to be overly dependent on imports. Therefore, it may protect its home industries even if they are inefficient. Several countries maintain industries for strategic reasons. Industries such as agriculture, the steel industry, shipping, energy industries among others have used often this strategic defence argument.
Types of decisions we would expect states to make in the current international system
It is expected that the government should adopt an expansionary monetary policy. In the current state, there is high unemployment and almost negligible economic growth rate. An expansionary monetary policy, in the form of buying government securities through the open market operations, reducing the bank reserve ratio or reducing federal bank rate. This will increase money supply, increase demand which will encourage producers to increase production thus creating employment and consequently reducing unemployment and increase economic growth. As regards, international trade, it is important to adopt both openness and insulation. Although, there are several advantages that accrue from openness, it may be necessary to insulate certain industries for strategic reasons.
Works Cited
Hall, Robert E and Marc Lieberman. Macroeconomics: Principles & Applications. revised. London: Cengage Learning, 2009.
Jan. Economic Analysis for Management and Policy. Illustrated. Newyork: McGraw-Hill International, 2005.
