Foundations of Monetary and Exchange Rate Policy

Question 1

What are the three functions of money?

Answer 1

• 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

Question 2

Money as a public good

Answer 2

• It benefits everyone
• Nonrival and nonexcludable
• Its creation and maintenance suffer from the collective action problem (both internationally and domestically)

Question 3

How money functions as a good

Answer 3

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

Question 4

How money is dependent on faith and expectations

Answer 4

• 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

Question 5

Definition of (domestic) monetary policy

Answer 5

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

Question 6

What happens if central banks increase money supply?

Answer 6

Money supply increases -> Interest rate decreases -> Consumption, Investment increase -> Price increases -> Inflation increases

Question 7

What happens if central banks decrease money supply?

Answer 7

Money supply decreases -> Interest rate increases -> Consumption, Investment decrease -> Price decreases -> Inflation decreases

Question 8

International monetary exchange historically

Answer 8

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

Question 9

What is the exchange rate regime?

Answer 9

• 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

Question 10

Types of exchange rate regimes

Answer 10

• Fixed
• Floating
• Fixed but adjustable
• Managed float

Question 11

Fixed exchange rate

Answer 11

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)

Question 12

Floating exchange rate

Answer 12

Governments do not intervene
- There are no limits on how much XR can move up or down

Question 13

Fixed by adjustable exchange rate

Answer 13

Governments intervene under a set of well-defined circumstances (eg. Bretton Woods for non-US countries)
- Sometimes called a “crawling peg”

Question 14

Managed float exchange rate

Answer 14

Governments intervene but there are no clear rules
- Most governments do this today
- Sometimes called a flexible float

Question 15

Fixing your exchange rate through adopting a foreign currency

Answer 15

• 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

Question 16

Balance of payments definition

Answer 16

The difference between the money entering and leaving the country

Question 17

Current account

Answer 17

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

Question 18

Capital and financial accounts

Answer 18

Records all financial flows between the home country and the rest of the world
- FDI, portfolio investment, loans and other investments

Question 19

What happens when the current and capital+financial accounts don’t match up?

Answer 19

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

Question 20

How the balance of payments differs in floating and fixed XR regimes

Answer 20

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

Question 21

Balance of payments, floating XR, deficit countries

Answer 21

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

Question 22

Balance of payments, floating XR, surplus countries

Answer 22

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

Question 23

Important benefit for BoP from floating XR

Answer 23

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

Question 24

Balance of payments, fixed XR

Answer 24

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

Question 25

Balance of payments, fixed XR, deficit countries

Answer 25

Deficit countries see a reduction in the money supply / increase in interest rates
- Less money chasing the same amount of goods
- The prices of domestic goods fall

Question 26

Balance of payments, fixed XR, surplus countries

Answer 26

Surplus countries see an increase in the money supply / decrease in interest rates
- More money chasing the same amount of goods
- The price of domestic goods rise

Question 27

The Unholy Trinity / Trilemma

Answer 27

Because the choice of XR relates to policy control, states are faced with a dilemma
- They can choose between 2 of 3 outcomes
– Fixed exchange rate
– Monetary policy autonomy
– Free capital flows
- Under no condition can they have all three

Question 28

The unholy trinity/trilemma combinations and XR we’ve seen

Answer 28

Classical gold standard
- Financial integration (capital mobility) + Fixed exchange rates
Bretton Woods
- Fixed exchange rates + Independent monetary policy
Floating rates
- Independent monetary policy + Financial integration (capital mobility)

Question 29

What happens if you try to implement all 3 aspects of the unholy trinity?

Answer 29

If you have free capital + MP autonomy + fixed XR, any effort to adjust interest rates or money supply to stimulate (or depress) the economy at home will change the international demand and supply of your currency

Question 30

Monetary policy to boost domestic economy (unholy trinity)

Answer 30

• Central bank lowers interest rates / increases money supply to boost employment and output at home
• Higher money supply makes currency less valuable internationall
• Lower interest rates make investment in the currency less valuable
  – Supply of currency up, demand for currency down

Question 31

How can the central bank maintain a fixed WR while capital is free? (unholy trinity)

Answer 31

• Decrease the money supply to match less demand
• 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

Question 32

Consequences of floating XR (assuming no capital control)

Answer 32

Effect on trade
- Makes trade harder because prices across countries are unstable
Effects on domestic prices
- Prices within countries are stable
Monetary policy
- Adjustments to improve domestic economic conditions possible

Question 33

Consequences of fixedXR (assuming no capital control)

Answer 33

Effect on trade
- Makes trade very easy because prices across countries are stable
Effects on domestic prices
- Prices within countries are unstable
Monetary policy
- No adjustments to improve domestic economic conditions possible