A Case Study Of Costa Rica's Monetary Policy Through The Identification And Estimation Of Its Money Demand Function

Central banks intervene in foreign exchange markets by “influencing the monetary funds transfer rate of a nation’s currency” with the purpose of building reserves, keeping the exchange rate stable, to correct imbalances, to avoid volatility and keep credibility. It implies changing the value of a currency against another one. It creates demand or supply of a currency by buying or selling the country’s currency in the foreign exchange market. (Foreign Exchange Intervention)

Since the Central Bank has the exclusive right to issue money in the economy, it can have extensive influence on the determination of interest rate in financial markets and in the economy as a whole, by adjusting the interest rate on short-term loans to financial institutions. Central Bank interest rates on these loans therefore have the most immediate impact on other short-term interest rates in the money market. By influencing interest rates, monetary policy then has an effect on the savings and expenditure decisions of individuals and corporate.

On April 1, 1991, Argentina’s Congress, with Domingo Cavallo as Minister of Economy, enacted the Convertibility Law (or Ley de Convertibilidad) legally adopting the currency board (Hornbeck, 2002). This legislation essentially pegged the Argentinean peso to the U.S. dollar. The government guaranteed the convertibility of the peso to U.S. dollar at a one-to-one exchange rate, limiting the printing of pesos to only those necessary to purchase dollars in the foreign exchange market. Thus, the central bank was required by law to hold foreign reserves to cover its peso liabilities (Hanke and Schuler, 2002). With this fixed exchange rate, the Argentinean government was hoping to preserve the value of their currency and stabilize inflation. The peg was initially successful, as it cured hyperinflation that occurred at the end of the 1980s and provided price stability needed for economic growth in the early 1990s. However, by the late 1990s,

Nations trade with one another because it is mutually advantageous for both parties when one is more efficient at producing a certain good and at a lower cost, and the other is proficient at producing a different good or service more efficiently. This is based on Ricaro’s theory of comparative advantage.

The internet has allowed the money market to operate 24 hours a day. It has been noted however that exchange rate volatility has increased,[v] which makes it more difficult for the government to set monetary policy.

If the economy suffers from inflation, the Government will like to check it. Then its Central Bank should adopt tight or contractionary monetary policy. To control inflation the Central Bank of a country can reduce money supply through open market operations by selling bonds or government securities in the open market and in return gets currency funds from those who buy the bonds. In this way liquidity in the banking system can be reduced.

Central banks use a money based policy to minimize inflation. They have diverse ways that they do this. For example, the most common way is by raising the rates of the interest and selling securities through open operations in the market. The use of a multiplication of related money within a policy to lower unemployment and avoid the period where people and businesses make less money. The lower the rates of interest will only buy securities from different banks and cause liquidity to increase. In a perfect world, a money based policy should work beside with the national government's policy. However, it rarely works this way. That's because government leaders get re-elected for decreasing taxes and expanding spending. This would mean rewarding people that actually vote and obtain series of actions to reach a goal of contributors that result in a direct, but in an upsetting way. As a result, a policy like a Monetary Policy is usually involves expansion related topics. However, to avoid a great inflation, the policy must be serving to severely limit or control

Costa Rica was home to by an estimated four hundred thousand Indians when Columbus found it in 1502. The Spanish began their conquering of the country in 1524. The region grew very slow and was governed as a Spanish province. Costa Rica took their independence in 1821 but was engrossed for two years by the Mexican empire. It became a republic in 1848. It was ruled by the dictator Tomás Guardia from 1870 to 1882 with the help of his massive army. (Costa Rica, 2014) Since then, Costa Rica has enjoyed one of the most democratic governments in Latin America. In the 1970s the price of oil went up, international prices skyrocketed above the normal tier, and inflation hurt the fragile economy. Efforts have since been made to reduce the countries

Costa Rica was home to by an estimated four hundred thousand Indians when Columbus found it in 1502. The Spanish began their conquering of the country in 1524. The region grew very slow and was governed as a Spanish province. Costa Rica took their independence in 1821 but was engrossed for two years by the Mexican empire. It became a republic in 1848. It was ruled by the dictator Tomás Guardia from 1870 to 1882 with the help of his massive army. (Costa Rica, 2014) Since then, Costa Rica has enjoyed one of the most democratic governments in Latin America. In the 1970s the price of oil went up, international prices skyrocketed above the normal tier, and inflation hurt the fragile economy. Efforts have since been made to reduce the countries reliance on coffee, banana, and beef exports. Tourism is now one of the most lucrative markets in Costa Rica.

Monetary Policy, in the United States, is the process by which the Federal Reserve controls the money supply to promote economic growth and stability. It is based on the relationship between interest rates of the economy and the total supply of money. The Federal Reserve uses a variety of monetary policy tools to control one or both of these.

Mexico’s inflation rate is rising at its highest level in 8 years, with annual consumer prices increasing by 5.82% as of April. As a result, Banco de Mexico (Mexico’s Central Bank) has implemented a contractionary (tight) monetary policy to reduce demand-pull inflation. Demand-pull inflation is the rise in average price levels in an economy caused by increased demand of goods and services, pushing the Aggregate Demand curve to the right. Contractionary monetary policy is the control of the money supply and interest rates in an economy by a central bank to control inflation and economic growth.

Monetary policy, ‘The government’s policy relating to the money supply, bank interest rates, and borrowing’ (Collin: 130), is another tool available to the government to control inflation. Figure 4 shows, that by increasing the interest rate (r), from r1 to r2, the supply of money (ms) is reduced from Q1

Monetary and fiscal policy and their applications to the third world countries with a huge informal sector

dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions. 6. Emerging market exchange rate regimes. High capital mobility is forcing emerging market nations to choose between free-floating regimes and currency board or dollarization regimes. What are the main outcomes of each of these regimes from the perspective of emerging market nations? There is no doubt that for many emerging markets a currency board, dollarization, and freely-floating exchange rate regimes are all extremes. In fact, many experts feel that the global financial marketplace will drive more and more emerging market nations towards one of these extremes. As illustrated by Exhibit 2.5, there is a distinct lack of “middle ground” left between rigidly fixed and freely floating. In anecdotal support of this argument, a poll of the general population in Mexico in 1999 indicated that 9 out of 10 people would prefer dollarization over a floating-rate peso. Clearly, there are many in the emerging markets of the world who have little faith in their leadership and institutions to implement an effective exchange rate policy.

A fixed exchange rate regime will offer an economy greater stability in international prices and therefore encourage trade. Additionally, for developing countries a fixed rate will assist in promoting institutional discipline as the country will adopt restrictive monetary and fiscal policies that foster an anti-inflationary environment. A significant weakness of a fixed rate is that it is subject to destabilizing speculative attacks which could lead to financial meltdowns and devastating economic contractions. A floating exchange rate regime allows central banks to combat macroeconomic factors such as unemployment, inflation, and interest rates without having to worry about the effect on exchange rates. However, developing countries whose economies depend on trade will be reluctant to allow their exchange rates to fluctuate freely.