4.1 (lec7) - foundations of monetary and exchange rate policy

Question 1

3 functions of money

Answer 1

1. medium of exchange
   - money resolves the “double coincidence of wants problem”
   (if you don’t have money you trade, this requires that each has something the other person wants)
2. store of value
   - money allows individuals to perishable goods into more durable goods
3. unit of account
   - money provides a standard relationship between various goods in the economy (money provides standard relationship of worth, of prices)

capitalist system would not work without money

having a currency is a PUBLIC GOOD:

• it benefits everyone
• nonrival and nonexcludable
• creation and maintenance suffer from the collective action problem (both internationally and domestically) => sometimes you need a hegemon to make sure it functions properly

Question 2

money is a good

Answer 2

money responds to same forces of supply and demand as other goods

• supply up -> value down
• supply down -> value up
• demand up -> value up
• demand down -> value down

just because we use currency to assign value, doesn’t mean currency’s value doesn’t change

domestically, price of money = interest rates (% you pay to borrow a Euro)

internationally, price of money = exchange rates (how many e.g. USD you need to get a Euro) = price of one currency in terms of another

Question 3

terminology for changes in the international value of currency

Answer 3

appreciate = gain value

• you can purchase more foreign currency for one unit of domestic currency

depreciate = loose value

• you can purchase less foreign currency for one unit of domestic currency

e.g.
exchange rate goes from 100 euro = 100 USD -> 80 euro = 100 USD

Euro appreciated

Question 4

domestic monetary policy

Answer 4

= adjustment of the money supply in order to change domestic price levels (impact inflation) and economic output

• counterpart = fiscal policy = gov decides how much to tax and spend
• manipulation the price of money by setting interest rates or by limiting money supply

in Europe the European Central Bank is in charge of monetary policy

Question 5

how do central banks pursue monetary policy?

Answer 5

interest rates = the price of domestic money

Central Bank can:

1. increase money supply
2. interest rates go down
3. consumption and DOMESTIC investment go up (money is cheaper: cheaper loans to buy larger things + earnings have less gains, more incentive to spend it)(also more investment bc loaning is cheaper + wanted to increase returns for their money)
4. production, employment and prices (input costs, wages) go up

or

1. decrease money supply
2. rising interest rate (bc demand is higher than supply)
3. decrease consumption and domestic investment (borrowing is more expensive + higher returns on savings on bank account)
4. decrease employment and production and prices (input costs and wages)
5. inflation goes down

Question 6

(short run) the Phillips Curve

Answer 6

there is a trade-off between inflation and unemployment

• when inflation is high, unemployment is low
• when inflation is low, unemployment is high

as inflation declines, unemployment rises (curvilinearly)

!relationship is not always there, after 2008 not much inflation, now this is no longer the case

Question 7

international monetary exchange

Answer 7

For the same reason why individuals need a common medium of exchange within in a country or economy, an international medium of exchange is beneficial for interactions between countries and economies.

• most countries have national currencies that are not generally accepted as legal payment outside the borders -> international monetary system provides inexpensive means of exchanging one national currency for another

When it’s easy to determine the value of goods in two different countries it’s easier to engage in Trade and Investment.

without common way to understand how diff currencies are worth -> difficult to trade and invest

for most of modern history, gold and silver backed paper currencies and served as the common medium of exchange between economies

• each country’s currency was worth a fixed amount of gold or silver (specie) -> exchange rates don’t fluctuate as much
• made it easy to determine the value of goods relative to each other domestically and internationally
• still, it required cooperation

today = most (developed) states have a floating currency system where the value of currency is determined by the market

• the US dollar serves as the primary unit of account and store of value

Question 8

Europe w/o the Euro

Answer 8

different and floating currencies

dutch firm makes a contract to purchase a boat for 1000 belgian Francs from a belgium firms with delivery in 7 months

• you need the currency of the exporter to be able to import
• at the time the exchange rate is 1000 belgian francs = 500 guildrs, so the Dtch firm expects to pay the equivalent of 500 guilders

in the intervening months the exchange rate changes in favor of the Belgian Franc

• 1000 B. Francs = 550 Guilders
• Dutch firm still needs to pay 1000 francs for its contract, it has just lost money
• Belgian firm gets richer bc the Belgian Francs it gets from the contract can buy more Dutch products in return

uncertainty over the profitability of investment will prevent firms from exploiting comparative advantage

purchases from domestic firms don’t have the same uncertainty but come with lost gains from trade

*(companies have way to circumvent this: can agree to exchange rates)

Question 9

exchange rate regimes

Answer 9

= set of rules overning how much national currencies can appreciat4e and depreciate in the foreign exchange market

• the relationship between a county’s currency and a foreign’/international currency/commodity

types of exchange rates:

from fixed to completely freely floating

1. fixed = gov only allows for tiny changes in the currency: intervenes to maintain the price by buying and selling currencies in the foreign exchange market
   - value is pegged to a basket of currencies or e.g. gold standard
2. fixed but adjustable = in specified circumstances the central bank lets the value of a currency depreciate or appreciate
   - soft peg: kind of pegged but when market forces really pressure the value, you can let it adjust
   - e.g. Bretton Woods for non-US countries
3. managed float = gov intervene but no clear rules
4. float = gov does not intervene, no limits on how much XR can move up or down (e.g. USD+ Euro externally)

main take-away = fixed and floating

Question 10

balance of payments, two diff accounts

Answer 10

= the difference between the money entering and leaving the country
- diff of inflows and outflows of money into the economy

• records if financial flows are outgoing or incoming

current account = records all current (non-financial) transactions between hoome country and the rest of the world

• imports and exports of goods (trade account) and services (service account) = biggest category
• also: royalties, fees, interest payments, profits, remittances, foreign aid grants (income account)
• exporter positive sign, importer negative sign

capital (and financial) account = records all financial flows between the home country and the rest of the world

• FDI
• portfolio investment
• loans and other types of investment
• if you take savings and invest internationally, this shows up as a negative sign on your capital account (acquisition, capital outflow) bc you are sending the money out (even though you will eventually profit from this)
• the investment in the receiving country it is positive (liability, capital inflow) (even though they have to pay later on)

in the long run, current and capital account have to balance each other out (bc pure market forces)

• US has current account deficit (export<import), only way this is sustainable is that it has similar size capital account surplus (people invest in the US more than people in the US invest in other countries)
• NL export>import, only possible in long run bc capital account deficit (take money from access export and put it back in other countries so that they can keep buying our exports)

when the accounts don’t match up, government has an imbalance of payments

Question 11

exchange rate regimes determines in part how balance in the Balance of Payment is maintained:

Answer 11

floating XR regimes = Balance of Payment adjustment occurs through exchange rate movements

fixed XR regimes = Balance of Payment adjustment occurs through changes in domestic prices

Question 12

relationship between exchange rates and current account

Answer 12

When you export, the buyers exchange their currency for your currency to purchase your products -> more demand for your currency

-> when you export more than you import, relative demand for your home currency increases
that means there is pressure for your home currency to appreciate

-> when your currency appreciates, exports become more expensive and imports become less expensive

When you import, you exchange your home currency for another country’s currency to purchase their products -> more supply of your currency

-> when you import more than you export, relative demand for your home currency decreases
that means there is pressure for your home currency to depreciate

-> when your currency depreciates, your exports become less expensive and imports become more expensive

SO when your currency appreciates, your exports decrease and your imports increase

SO when your currency depreciates, your exports increase and your imports decrease

Question 13

Balance of Payments, Floating XR

Answer 13

adjustments through exchange rate movements

deficit countries see a depreciation in their currency on global markets (less demand of currency lowers the “price” or XR of the currency) = bc they are importing more than they are exporting

• prices of exports fall for foreign consumers - demand for export rises
• prices of imports rise for domestic consumers - demand for import drops

-> rebalances the trade deficit

surplus countries see an appreciation in their currency (excess demand for the currency increases the “price” or XR of the currency)

• prices of exports rise for foreign consumers - demand for exports drop
• prices of imports fall for domestic consumers - demand for import rises

e.g. EZ has disproportionate demand for British goods/services (we want to buy Mini car) -> excessive demand in EZ for British Pounds -> appreciation of GBP vis a vis Euro -> higher relative cost of British goods -> contraction of balance of payment surplus

e.g. UK has disproportionate demand for EZ drop -> excessive demand in UK for Euro -> appreciation of Euro vis a vis GBP -> higher relative cost of Euro goods -> contraction of Balance of Payment surplus

!does not change prices at home

Question 14

summary + benefit Balance of Payments, Floating XR

Answer 14

summary:

• deficit countries see imports decrease and exports increase
• surplus countries see imports increase and exports decrease

-> prices of domestic goods and services remain stable

benefit = gov is free to pursue domestic policy goals (employment) by using monetary policy

• address recessions by increasing money supply/control inflation by increasing interest rates
• changes in money supply/interest rates also affect exchange rates, but that’s okay under a floating XR

Question 15

balance of payments, fixed XR

Answer 15

gov has to use monetary policy to maintain the fixed XR

can do so by:

1. gov buys/sells each other’s currency (thus changing the money supply and prices in each country) that they store in reserve
2. countries can change interest rates, thereby also changing domestic prices
   - interest rates go up in deficit countries, they go down in surplus countries
3. they can impose capital controls or change commercial policy that limits financial transactions with other countries
   - least chosen option

rewatch?

Question 16

fixed XR: changes in money supply to influence exchange rates

Answer 16

central banks can intervene by manipulating the money supply

e.g. ECB (if XR between Euro and USD was fixed):

to increase the money supply, we print more euros
exchange new euros for US dollar -> increases euros in circulation + more US dollars in ECB reserve

to decrease the money supply of euros: sell the US dollars in your reserve for Euros
-> fewer Euros in global circulation, more US dollars in circulation, fewer US dollars in ECB reserve

!this is asymmetric: central bank can always print more, but it can only decrease the money supply if it has enough foreign reserves

e.g. adjustment in reserves (if XR between Pound and Euro was fixed)

1. excessive demand EZ for British Pounds (GBP)
2. upward pressure on GBP vis a vis Euro
3. bank of England buys Euros using pounds (prints more pounds)
4. market demand (partly) is offset by Bank’s intervention (by increase in supply) + pressure on XR is rerlieved
5. supply in pounds increases (also in the UK)
6. more currency but the same amounts of goods to sell
7. UK prices increase (domestic prices)
8. British exports decrease, British imports increase
9. Pressure on XR is relieved

Question 17

fixed XR: influence exchange rates by changing interest rates

Answer 17

domestic investors

• borrow money/use their savings in the home currency to invest in capital
• increase interest rates -> borrowing more expensive + savings more lucrative -> less domestic investment
• decrease interest rates -> borrowing less expensive, saving less lucrative -> domestic investment increases

international investors (portfolio/FDI)

• take money from their home country, exchange it for foreign currency to invest in foreign market
• increase interest rates -> return on FDI increases -> foreign investment increases bc it becomes more lucrative
• decline interest rates -> return on FDI decreases -> foreign investment declines

when interest rates increase -> more demand for currency by foreign investors

when interest rates decrease -> less demand for currency by foreign investors

e.g.

1. excessive demand in EZ for British pounds (GBP) (bc we want to buy mini’s)
2. upward pressure on GBP vis a vis Euro
3. bank of England lowers interest rates
4. less demand for GBP by foreign investors + more domestic consumption and investment (inflation)
5. adjustment of capital account (less investment) and current account (fewer exports, more imports)
6. pressure on XR is relieved

Question 18

fixed currency: capital controls

Answer 18

bank can limit the amount of a currency that others can purchase

e.g.

excessive demand in EZ for British pounds -> bank limits EZ purchase of Sterling -> upward on GBP vis a vis Euro is restricted -> Market exchange rates remains fixed

hardest thing to do: high cost??

Question 19

balance of payments, fixed XR and no capital controls

Answer 19

the adjustment occurs through price changes

• not through change in the value of currencies
• the value of the currency has to remain fixed

deficit countries see a reduction in the money supply/increase in interest rates

• the prices of domestic goods fall

surplus countries see an increase in the money supply/decrease in interest rates

• the prices of domestic goods rise

Question 20

the unholy trinity/trilemma

Answer 20

bc choice of XR relates to policy control, states have a dilemma:

can only choose 2 of 3 outcomes

• fixed exchange rate
• monetary policy autonomy (can use monetary policy to steer the domestic economy)
• free capital flows = financial integration / capital mobility

under no condition can you have all three

e.g.

• classical gold standard = financial integration and fixed exchange rates (but no independent monetary policy)
• Bretton Woods = fixed exchange rates and independent monetary policy (but no financial integration / capital mobility)
• floating rates = independent monetary policy and financial integration (but no fixed exchange rates)

what happens if you try to implement it all?
when you want to boost domestic economy:

• central bank lowers interest rates / increases money supply to boost employment and output at home
• higher money supply makes currency less valuable internationally -> pressure to depreciate
• lower interest rates make investment in the currency less valuable
  = supply of currency up -> demand for currency down
• to maintain a fixed exchange rate while capital is free, CB can decrease money supply to match less demand OR increase interest rates to make investment in the country more attractive and thus increase demand

but this cancels out the ?high-interest rates? / ?lower money supply? the central bank tried to implement domestically

or it can impose capital controls (hard in the long-run)
-> central bank has to give up one of the corners

Question 21

summary balance of payments adjustment

Answer 21

fixed vs floating = each has diff consequences (winners/losers)

in a globalized econ, capital controls are very diff to maintain long-term: assuming no capital controls:

effect on trade

• fixed XR = makes trade very easy because prices across countries are stable
• floating XR = makes trade harder because prices across countries are unstable

effects on domestic prices

• fixed XR: prices within countries are instable
• floating XR: prices within countries are stable

monetary policy

• fixed XR: no adjustments to improve domestic economic conditions possible???
• floating XR: adjustments to improve domestic economic conditions possible???

Question 22

what to know well:

Answer 22

• types of XR regimes
• XR regimes determine how states adjust balance of payments and influence price levels at the domestic and international level
• adjusting BoP under fixed XR and no capital controls: prices adjust to deal with surplus/deficit
• adjusting BoP under floating XR: XR adjust to deal with surplus/deficit
• the policy dilemma known as the unholy trinity/trilemma

Question 23

stuff added from book

Answer 23

exchange-rate system = set of rules governing how much national currencies can appreciate and depreciate in the foreign exchange market
- trade-off between XR stability and domestic economic autonomy

foreign exchange reserves = countries hold a stock of other countries’ currencies

current and capital accounts must be mirror images of each other bc:

• current-account deficit -> need for surplus in capital account: others need to invest in the US, otherwise it is not able to import, and the deficit will disappear
• current-account surplus -> need for deficit in capital account: NL needs to invest in other countries, otherwise they don’t have enough to keep importing, and te surplus will disappear