Lecture 7

Question 1

Three functions money

Answer 1

 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

Question 2

Money is a public good

Answer 2

 Nonrival
 Nonexcludable
 Creation and maintenance suffer collective action problem

Question 3

Money is a good

Answer 3

 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

Question 4

Terminology note

Answer 4

 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

Question 5

Money is dependent on faith and expectations

Answer 5

 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

Question 6

Domestic currency

Answer 6

 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

Question 7

Phillips curve

Answer 7

Tradeoff between inflation and unemployment

Question 8

International monetary exchange

Answer 8

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

Question 9

Exchange rate regime

Answer 9

 A set of rules governing how much national currencies can appreciate and depreciate in the foreign exchange market.

Question 10

The relationship between a country’s currency and a foreign/international currency/commodity

Answer 10

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

Question 11

Specific form of fixing your exchange rate

Answer 11

 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

Question 12

Current account

Answer 12

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

Question 13

Balance of payments

Answer 13

o Difference between money entering and leaving the country

Question 14

Capital and financial acounts

Answer 14

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

Question 15

Exchange rate regime determines in part how balance in BoP is maintained

Answer 15

 Floating XR regimes
* Adjustment through exchange rate movements
 Fixed XR regimes
* Adjustment through changes in domestic prices

Question 16

Floating XR

Answer 16

 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

Question 17

Adjusting BoP under floating XR

Answer 17

• 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

Question 18

Adjusting BoP fixed XR

Answer 18

 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

Question 19

Balance of payments, fixed XR

Answer 19

 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

Question 20

Unholy trinity

Answer 20

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

Question 21

Trying all 3 of unholy trinity

Answer 21

 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

Question 22

Monetary policy to boost economy

Answer 22

 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

Question 23

The relationship between a country’s currency and a foreign/international currency/commodity
Managed float

Answer 23

• Managed Float
   Governments intervene but there are no clear rules. Most governments do this today.
  Sometimes called a flexible float

Question 24

The relationship between a country’s currency and a foreign/international currency/commodity
Fixed but adjustable

Answer 24

• Fixed-but-Adjustable
   Governments intervene under a set of well-defined circumstances (ex. Bretton Woods
  for non-US countries). Sometimes called a “crawling peg”

Question 25

The relationship between a country’s currency and a foreign/international currency/commodity
Float

Answer 25

• Floating
   Governments do not intervene. There are no limits on how much XR can move up or
  down (US$, EURO – externally)

Question 26

Interest rates domestic currency

Answer 26

• 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