Impact of Monetary Policy on the Czech Republic

Posted: August 25th, 2021

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Impact of Monetary Policy on the Czech Republic

Question 8. WasIt In The Countries Interest To Abandon The Independent Monetary Policy?

In the 1990s, the German dominance in the Europe monetary system was a subject of controversy. The German,the dominant economic hypothesis, was developed as a theory to guideEuropean nations in their quest to attain price stability and economic growth(Alichi, Ali, et al. 177).As a result, mostcountries in Europe including Czech abandoned their independent monetary policy to pursue the European monetary system.

European Monetary System (EMS)

To achieve currency exchange rate stability in the European market, member countries in the Eurozone decided to adopt a European monetary systempolicy. The policy championed by Jenkins Europeancommission involved the membercountries linking their currencies to prevent price fluctuations (Feenstra& Taylor 146). It was during the EMS era that the German hypothesis dominance started. Being a dominant economic powerhouse in the European market, German-controlled the exchange rate in the region with other countries being forced to implement the monetary policy implemented by the Bundesbank.The impact of the policy on the Czech Republic was a drastic drop in the national output reaching an all-time low in 1992 (Alichi 28).

Further, the EMS had its internal weakness with experts warning of a looming disaster in the member countries’economies. The exit of Britain from EMS in 1992 exposed the cracks within the system. The effects of Britain’s exit were felt in most countries including Czech, and this led to the collapse of the system.

Moreover, the system led to substantialnational deficits in the Czech Republic. Since the EMS prohibited a bailout of hailing economies, the Czechs economy continued to shrinktill in 1997 when the CBN decided to implement the immediate inflation target strategy.The adoption of the quick inflation strategy led to economic transformation in Czech (Feenstra& Taylor 217). The low inflation rate experienced in the country, coupled with a rising economy in the Europe member countries, led to the economic transformation which lasted for a decade in the years 1997-2008.Beforethe economic crisis in 2008, the economy enjoyed a high exchange rate combined with a strong banking sector.

Thus, it was not in the best interestof Czech to give up its monetary policy independence and adopt the Euro system. The Euro system was designed mainly to control the exchange rate in member countries. However, the system worked in favour of German which was the economic powerhouse at the time. Othercountries including Czech,struggled to cope with increasing deficits in their national output. The policy inhibiting bailout of countries worsened the situation for Czech. Additionally, being on different economic and political levels with Germany made it difficult for the Czech economy to cope with the European monetary system.

Question 9. Prediction If the Country Had Adopted a Different Policy

The best monetary policy that Czech should have pursued is the interest rate policy. Accordingto Adsei (87),the interest rate policy is an adequate and effective monetary policy in the wake of a shrinking economy. Following the economic meltdown in 2008, Czech adopted an interest rate policy as a tool to attain economic growth. In the years before the 2008 economic crisis, the interest rate experienced in the century reached a whole time low, reaching a negative interest rate by 2013.

Adopting interest policy as a monetary tool, mainly by lowering interest rate, stimulates economic growth in two ways; first, low-interest rates causes a reduction in the inflation rate, and secondly, it results in the stimulation of local borrowing. In the case of the Czech Republic, low-interest rates led to a decline in inflation reaching the lowest point in 2012.With low inflation, price stability was achieved thus boosting the purchasing power of the households.

Consequently, the low inflation rate encourages a reduction in the price of exports, making them competitive in the international marketand, subsequently, the decrease in the cost of goods in the economy. As a result, exports in the Czech Republic to other European markets increased, reaching a whole time high in 2012 (Feenstra& Taylor 123).With a low price in exports, the demand for goods in the international market was high leading to high foreign exchange earnings.Thus, like in other established economies, pursuing aninterest rate cap would have been a better strategy to be adopted by the Czech Republic.

However, there is a downside to the interest rate as a monetary policy. Loweringthe interest rate can reduce the risk of appetite by commercial banks (Chen & Sun 97). The lending decision is mainly a combination of expected return and perceived risk. If banks view a borrower as riskier compared to the expected return, then the choice is to decline an application with the intent of mitigating the risk of losing funds (Feenstra& Taylor 97-105). Accordingly, interest rate capping led to a shrinking market in the financial sector in the Czech Republic. Most financial institutionspreferred lending to the government by buying treasury bonds as opposed to lending to households.With limited access to credit, most SME(small and medium enterprises) experienced a decline in working capital hence leading to negative growth (Chen & Sun 103). It is critical to note that the rate of return in interest should be high enough to motivate depositors to transact their assets as fixed assets. However, if the rate of return is low due to a lower interest rate, the investors opt to invest in other alternative assets with a higher return. Thus, the economy experiences the opposite of the expected results, and this was the case in the Czech Republic.

Additionally, instead of stimulating economic growth in the economy, the low-interest rate led to a drop in money supply as investors openedinvestment in long-term assets with a higher return (Chen & Sun 103). Therefore, in 2013, Czech experienced the lowest GDP in history forcing the government to pursue a different policy.Hence, interest rate control was the best policy for Czech to adopt. Though it has some drawbacks, the economy can withstand the hindrances of a negativeinterest rate. Besides, when combined with other monetary policies, the low-interest rate policy can be the best monetary policy to pursue.

Question 10. Analysis of the Argument

Abandoning the independent monetary policy was a mistake in the Czech Republic. The European monetary system adopted by the country was a replica of the German monetary system. The two countries were under different economic levels. Hence it was hard to pursue a similar policy. It was theright decision for the Czech to abandon the EMS and pursue an independent policy. Though the interest rate policy stimulated some level of economic growth, there are some drawbacks to the system.The best monetary policy that the Czech Republicshould have adopted is a combination of low-interest rates and the exchange policy. In 2013, when the country decided to adopt a combination of these two policies, the country enjoyed substantial economic growth.

Works Cited

Alichi, Ali, et al. Frontiers of Monetary Policymaking: Adding the Exchange Rate as a Tool to Combat Deflationary Risks in the Czech Republic. Washington, D.C: International Monetary Fund, 2015. Print.

Chen, X. & Sun, Y., M.Conference proceedings. Lancaster: DEStech Publications, 2013. Print.

Feenstra, R., C. & Taylor, A., M. International Macroeconomics. Fourth Edition. New York: Worth Publishers. Macmillan Learning, 2017.