Foundations of Monetary and Exchange Rate Policy Flashcards
What are the three functions of money?
- A medium of exchange
– Money resolves the “double coincidence of wants problem” - Store of value
– Money allows individuals to convert perishable goods into more durable goods - Unit of account
– Money provides a standard relationship between various goods in the economy
Money as a public good
- It benefits everyone
- Nonrival and nonexcludable
- Its creation and maintenance suffer from the collective action problem (both internationally and domestically)
How money functions as a good
Money responds to the 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
How money is dependent on faith and expectations
- The value of currency is also dependent on expectations
– Your belief and others’ belief that the government won’t devalue (increase the supply) the currency in the future
– Or faith in others to continue valuing the currency or basis of currency (like gold) - This is especially true today, since we use government-issued money that has low intrinsic value
Definition of (domestic) monetary policy
Adjustment of the money supply in order to change price levels (inflation) and economic output
- Who is in charge of monetary policy in Europe?
– The European Central Bank
What happens if central banks increase money supply?
Money supply increases -> Interest rate decreases -> Consumption, Investment increase -> Price increases -> Inflation increases
What happens if central banks decrease money supply?
Money supply decreases -> Interest rate increases -> Consumption, Investment decrease -> Price decreases -> Inflation decreases
International monetary exchange historically
For most of modern history, gold and silver backed paper currencies and served as the common medium of exchange between economic
– Each country’s currency was worth a fixed amount of gold or silver
– This made it easy to determine the value of goods relative to each other domestically and internationally
– This still required cooperation
What is the exchange rate regime?
- A set of rules governing how much national currencies can appreciate and depreciate in the foreign exchange market
- The relationship between a country’s currency and a foreign/international currency/commodity
Types of exchange rate regimes
- Fixed
- Floating
- Fixed but adjustable
- Managed float
Fixed exchange rate
Government allows for only small changes
- The government maintains this fixed price by buying and selling currencies in the foreign exchange market (eg. gold standard)
Floating exchange rate
Governments do not intervene
- There are no limits on how much XR can move up or down
Fixed by adjustable exchange rate
Governments intervene under a set of well-defined circumstances (eg. Bretton Woods for non-US countries)
- Sometimes called a “crawling peg”
Managed float exchange rate
Governments intervene but there are no clear rules
- Most governments do this today
- Sometimes called a flexible float
Fixing your exchange rate through adopting a foreign currency
- Some countries simply use the currency of another country as their own
– Many developing countries us the $US - This is a form of fixed exchange rate (ie. your exchange rate with the US is fixed at 1:1)
- It comes with the same potential benefits and drawbacks as other types of fixed exchange rates
Balance of payments definition
The difference between the money entering and leaving the country
Current account
Records all current (non-financial) transactions between the home country and rest of the world
- Imports and exports of goods and services, royalties, fees, interest payments, profits, remittances, foreign aid grants
Capital and financial accounts
Records all financial flows between the home country and the rest of the world
- FDI, portfolio investment, loans and other investments
What happens when the current and capital+financial accounts don’t match up?
Because the current and capital/financial accounts are the mirror image of each other when they don’t match up there is an imbalance of payments
How the balance of payments differs in floating and fixed XR regimes
The exchange rate regime determines, in part, how balance in the BoP is maintained
- In floating XR regimes:
– BoP adjustment occurs through exchange rate movements
- In fixed XR regimes:
– BoP adjustment occurs through changes in domestic prices
Balance of payments, floating XR, deficit countries
Deficit countries see a depreciation in their currency on global markets (excess supply of currency lowers the “price” or XR of the currency)
- Prices of exports fall for foreign consumers - demand for exports rises
- Prices of imports rise for domestic consumers - demand for imports drops
Balance of payments, floating XR, surplus countries
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 drops
- Prices of imports fall for domestic consumers - demand for imports rises
Important benefit for BoP from floating XR
The government 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 ok under a floating XR
Balance of payments, fixed XR
The government maintains a fixed XR by using monetary policy, and it has a couple avenues to achieve this:
- Governments buy/sell each other’s currency (thus changing the money supply and prices in each country) that they store in reserve
- Countries can change interest rates, thereby also changing domestic prices
– Interest rates go up in deficit countries, they go down in surplus countries
- They can impose capital controls or change commercial policy that limits financial transactions with other countries
