🚨 UPSC EXAM NOTES presents the July edition of our comprehensive monthly guide. Access it  to enhance your preparation. We value your input - share your thoughts and recommendations in the comments section or via email at Support@upscexamnotes.com 🚨

Critical Topics and Their Significance for the UPSC CSE Examination on August 10, 2024

Daily Insights and Initiatives for UPSC Exam Notes: Comprehensive explanations and high-quality material provided regularly for students

On monetary policy and financial markets

For Preliminary Examination: Current events of national and international Importance

For Mains Examination: GS III - Indian EConomy

Context:

The recent rapid turnarounds in global markets have come on the back of attempts by central banks to combat the problems of inflation and repressed economic activity using the tool of interest rates. It indicates the difficulty in implementing monetary policy in the presence of strong financial markets

Read about:

What is Monetary Policy Committee (MPC) ?

Significance of Monetary Policy Committee (MPC)

Key takeaways:

• Global financial markets may be showing signs of recovery after significant declines in value, but the global economy remains in uncertain territory. Job growth in the U.S. has been weaker than anticipated, posing a threat to the delicate post-pandemic recovery.
• The Bank of Japan's recent decision to raise interest rates after maintaining them at low levels for years has unsettled financial markets, triggering a reversal of equity flows and a downturn in Asian markets.
• These rapid shifts reflect the challenges central banks face in managing inflation and economic activity through interest rates. The current situation highlights the difficulty of implementing monetary policy amid global financial markets characterized by high volatility and swift asset value changes.
• The prevailing approach to monetary policy assumes a trade-off between unemployment and inflation. Central banks raise interest rates to curb inflation, which in turn reduces investment and slows aggregate demand. This decrease in demand for labor diminishes wage pressures, thereby easing inflationary concerns.
• However, there is considerable debate about the effectiveness of traditional monetary policy. Critics argue that using unemployment to combat inflation unfairly burdens workers already struggling with the cost-of-living crisis.
• They suggest that controlling inflation might be more effectively achieved by addressing corporate profit margins and breaking up monopolies.
• Accepting the current consensus on monetary policy, a recent jobs report showing lower-than-expected employment growth led to fears of a recession and a rapid sell-off in equity markets. Concerns about disappointing performances from major tech companies further exacerbated the market decline.
• It is important to note that the economy was not actually in a recession; rather, market expectations of one fueled the sell-off. The increase in unemployment rates triggered the "Sahm rule," which calls for automatic unemployment benefit disbursements when rates surpass a certain threshold. While this rule is linked to recession indicators, it does not confirm one. Nevertheless, the mere prospect of a recession was enough to incite investor panic.
• This illustrates the challenge of conducting monetary policy in the context of a powerful financial sector. The gradual reduction in inflation had been seen as evidence of successful policy, but a single quarter's disappointing employment data led to a swift market reaction that policymakers struggled to manage. The markets anticipated a recession without an actual economic downturn occurring.
• On the other side of the globe, Asian markets were destabilized by the Bank of Japan’s rate hike, which disrupted the “carry trade”—a practice where foreign investors borrow cheaply from Japan to invest elsewhere. This change led to increased selling in other markets as investors sought to manage higher borrowing costs.
• Such dynamics add complexity to policy management. Low Japanese interest rates, intended to counteract a prolonged economic slowdown, inadvertently supported foreign capital flows. This phenomenon shows how domestic policies in one country can have unintended effects on others through global finance.