Lecture 7 Flashcards
Three functions money
Medium of exchange
* Money resolves “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 is a public good
Nonrival
Nonexcludable
Creation and maintenance suffer collective action problem
Money is a good
Responds to same forces of supply and demand as other goods
Just because we use currency to assign value, doesn’t mean currency’s value doesn’t change
Terminology note
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
Money is dependent on faith and expectations
Value of currency is also dependent on expectations
* Your belief and others’ belief that government wont devalue the currency
Is especially true today, since we use government issued money that has low intrinsic value
Domestic currency
Definition
* Adjustment of the money supply in order to change price levels (inflation) and economic output
o How do central banks do it?
Interest rates = price of domestic money
Phillips curve
Tradeoff between inflation and unemployment
International monetary exchange
o For the same reason why individuals need a common medium of exchange within a country or economy, an international medium of exchange is beneficial for interactions between countries and economies
o Remember, a functioning monetary system is a public good
o When it’s easy to determine the value of goods in two different countries it’s easier to engage in Trade and Investment
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
Fixed
Government allows for only very small changes. The government maintains this fixed
price by buying & selling currencies in the foreign exchange market (Ex. Gold
Standard) – more on this in a minute
Specific form of fixing your exchange rate
Some countries use currency of another country as their own
Example – developing countries use the US dollar
This is a form of fixed exchange rate, your exchange rate with US dollar is fixed at 1:1
Comes with same potential benefits and draw backs as other types of fixed exchange rates
Current account
o Current account:
Records all current (non-financial) transactions between the home country and rest of the world
* Imports & exports of goods & services, royalties, fees, interest payments, profits, remittances, foreign aid grants
Balance of payments
o Difference between money entering and leaving the country
Capital and financial acounts
and Financial Accounts:
Records all financial flows between the home country and the rest of the world
* FDI, portfolio investment, loans & other investments
o Current & Capital/Financial Accounts are the mirror image of each other, when they don’t match up, a government has an imbalance of payments
Exchange rate regime determines in part how balance in BoP is maintained
Floating XR regimes
* Adjustment through exchange rate movements
Fixed XR regimes
* Adjustment through changes in domestic prices
Floating XR
Adjustment through exchange rate movements
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
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
Adjusting BoP under floating XR
- Balance is restored as exchange rates adjust and:
- Deficit countries see imports go & exports go ,
- Surplus countries see imports go & exports go
- Prices of domestic goods & services remain stable
- Important Benefit: 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
Adjusting BoP fixed XR
Adjusting BoP in Fixed XR
* Government maintains fixed XR by using monetary policy
Couple of avenues
* Governments buy/sell each others currency (changing 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
Adjustment in reserves, if XR between pound and euro was fixed
Balance of payments, fixed XR
Adjustment through price changes
* Not through changes in value of currencies
* Value of currency has to remain fixed (precious meta)
Deficit countries see a reduction in money supply/increase in interest rates
* Less money chasing the same amount of goods
* The prices of domestic goods fall
Surplus countries see an increase in the money supply/decrease in interest rates
* More money chasing the same amount of goods
* The prices of domestic goods rise
Prices of goods rise and fall
Unholy trinity
o Because the choice of XR relates to policy control, states are faced with a dilemma.
They can choose between two of three outcomes
* Fixed Exchange Rate
* Monetary Policy Autonomy
* Free Capital Flow
Remember capital controls are one way to manage imbalances
Under NO condition can they have all THREE
Trying all 3 of unholy trinity
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 & supply of your currency
Monetary policy to boost economy
Central bank lowers interest rates/increases money supply to boost employment and output at home
Higher money supply makes currency less valuable internationally
Lower interest rates make investment in currency less valuable
Supply of currency up, demand for currency down
To maintain a fixed exchange rate while capital is free, central bank can
* 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
The relationship between a country’s currency and a foreign/international currency/commodity
Managed float
- Managed Float
Governments intervene but there are no clear rules. Most governments do this today.
Sometimes called a flexible float
The relationship between a country’s currency and a foreign/international currency/commodity
Fixed but adjustable
- Fixed-but-Adjustable
Governments intervene under a set of well-defined circumstances (ex. Bretton Woods
for non-US countries). Sometimes called a “crawling peg”
The relationship between a country’s currency and a foreign/international currency/commodity
Float
- Floating
Governments do not intervene. There are no limits on how much XR can move up or
down (US$, EURO – externally)
Interest rates domestic currency
- Low interest rates boost production and wages, because high demand, but can also increase inflation
- High interest rates depresses production and employment, because less demand, but this can cause inflation to decrease
