Foundations of Monetary and Exchange Rate Policy

Foundations of Monetary and Exchange Rate Policy

• The lecture covers the foundations of monetary and exchange rate policy.
• Money serves three main functions: a medium of exchange, a store of value, and a unit of account.
• A medium of exchange solves the "double coincidence of wants problem."
• A store of value allows for converting perishable goods into more durable goods.
• A unit of account provides a standard relationship between goods in the economy.
• Currency is a public good, benefiting everyone, but its creation and maintenance face collective action problems.
• Money, like other goods, responds to supply and demand. Supply up, value down; supply down, value up; demand up, value up; demand down, value down.
• Exchange rates reflect the relative value of currencies. Appreciation means a gain in value, and depreciation means a loss in value.
• Domestic monetary policy adjusts money supply to influence inflation and economic output.
• The ECB is responsible for monetary policy in Europe.
• The central bank influences economic conditions using interest rates and money supply.
• The Phillips Curve illustrates the trade-off between inflation and unemployment.
• International monetary exchange facilitates trade and investment between nations.
• The balance of payments tracks the flow of money into and out of a country. The current account records current transactions, and the capital/financial account tracks financial flows.
• Exchange rate regimes (fixed, floating, fixed-but-adjustable, managed float) dictate how a country's exchange rate moves.

The Function of Money

• A currency is a public good, benefiting everyone.
• It's both non-rival (consumption by one person does not reduce availability to others) and non-excludable (difficult to prevent people from benefiting from it).
• Public goods often face collective action problems, both internationally and domestically.

The Plan

• What is Money (and an exchange rate regime) Good For?
• Domestic Monetary Policy
• International Monetary Exchange
• Balance of Payments Adjustment
• The Unholy Trinity

Exchange Rate Regimes

• Exchange rate regimes govern currency appreciation and depreciation.
• Different regimes include:
  • Fixed
  • Floating
  • Fixed-but-adjustable
  • Managed float

Balance of Payments

• The balance of Payments (BoP) shows the difference between money entering and leaving a country.
• The current account tracks current transactions (imports/exports, services, etc.).
• The capital and financial accounts track financial flows.

The Unholy Trinity/Trilemma

• States face a dilemma when choosing between fixed exchange rates, monetary policy autonomy, and free capital flow.
• They can only maintain two of these three simultaneously.

Changes in Interest Rates

• Changes in interest rates can affect exchange rates, particularly for domestic and international investors.

Capital Controls

• Capital controls constrain financial transactions between countries to potentially stabilize exchange rates.

Summary Balance of Payments Adjustment

• Fixed exchange rates make trade easier, but prices adjust within countries.
• Floating exchange rates make trade harder, but prices are stable within countries.

What to Know Well:

• XR regimes affect how states manage balance of payments and domestic/international price levels.
• Exchange rate regimes impact how countries adjust to BoP surpluses or deficits.
• The Unholy Trinity/Trilemma is the policy dilemma central banks face when managing their currency.

Monetary Policy

• Central banks use monetary policy to influence interest rates and money supply to boost the domestic economy.
• Higher money supply makes the currency less valuable on international markets.
• Lower interest rates make investment less attractive.

This quiz explores the fundamental concepts of monetary and exchange rate policies. It covers the functions of money, the dynamics of supply and demand, and the role of exchange rates in economic contexts. Participants will deepen their understanding of how these elements influence inflation and economic stability.