International Banking and Capital Markets - Lesson 3

Monetary Policy and Sovereign Risk

• Monetary policy deals with the determination of the money supply and its growth rate, affecting interest rates and the economy.
• The goals of monetary policy are:
  • Growth
  • Employment
  • Inflation control
  • Exchange rate stability
• Monetary policy is run by a central bank, which is independent from the government and its political targets.

Instruments and Transmission Channels of Monetary Policy

• Expansionary monetary policy aims to increase the money supply, reducing short-term interest rates and boosting private borrowing, investments, and consumption.
• Contractionary monetary policy aims to reduce the money supply, raising short-term interest rates and reducing private borrowing, investments, and consumption.
• The money multiplier reflects the preferences of banks and consumers with regards to financial assets and can be influenced by interest rates and technology changes.
• Central banks use four main instruments to run monetary policy:
  • Open market operations
  • Discount rate changes
  • Reserve requirements changes
  • Changes in foreign reserves
• Quantitative easing is an extension of open market operations, involving the purchase of securities from banks to reduce long-term interest rates.

Central Banks and Interest Rates

• Central banks operate on the foreign exchange market to move or stabilize exchange rates.
• The main key rates of central banks are:
  • Federal Reserve (Fed)
  • European Central Bank (ECB)
  • Bank of England (BOE)
• The total assets of major central banks have increased significantly since 2007.

Transmission Channels of Monetary Policy

• The transmission channels of monetary policy are:
  • Interest rate channel
  • Credit channel
  • Exchange rate channel
• The interest rate channel affects the cost of capital, household purchases, and firm investment.
• The credit channel affects the availability of bank loans and aggregate spending.
• The exchange rate channel affects net exports and the trade balance.

Interest Rate Determination

• Interest rates are affected by several factors, including:
  • Maturity
  • Market liquidity
  • Risk
  • Clauses and provisions
  • Lending costs
• The term structure of interest rates is the relationship between yields on comparable securities with different maturities.
• The yield curve is the graphical depiction of the term structure of interest rates.
• Yield curves can take different shapes, including:
  • Normal (positively sloped)
  • Inverted (negatively sloped)
  • Humped
  • Flat
• Yield curves can undergo parallel shifts, nonparallel shifts, and butterfly shifts.

Theories of Term Structure of Interest Rates

• There are four main theories explaining the term structure of interest rates:

  • Expectation hypothesis
  • Market segmentation theory
  • Preferred habitat theory
  • Liquidity premium theory### Goals of Monetary Policy and Role of the Central Bank

• The primary objective of the European Central Bank's (ECB) monetary policy is to maintain price stability.

• Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

• The ECB aims to maintain inflation rates below, but close to, 2% over the medium term.

European Central Bank vs. Federal Reserve Objectives

• The ECB's primary objective is to maintain price stability, with a clear hierarchy of objectives.
• The Federal Reserve has a multiple-objective mandate, including maximum employment, stable prices, and moderate long-term interest rates.

European Central Bank: Instruments

• The ECB uses open market operations, standing facilities, and minimum reserves to implement its monetary policy.
• Open market operations include:
  • Main refinancing operations (one-week maturity)
  • Longer-term refinancing operations (three months to 48 months)
  • Fine-tuning operations (ad hoc basis to smooth interest rates)
  • Structural operations (adjust the Eurosystem's structural position)
• Standing facilities include:
  • Marginal lending facility (overnight liquidity)
  • Deposit facility (overnight deposits)
• Minimum reserves are used to stabilize money market interest rates and create a structural liquidity shortage.

European Central Bank: Interest Rates

• The ECB sets key interest rates, including:
  • Main refinancing operations (MRO) rate
  • Deposit facility rate (floor)
  • Marginal lending facility rate (ceiling)
• The ECB exercises its monetary policy power through forward guidance, disclosing its forecasts to influence market expectations.

European Central Bank: Unconventional Instruments (Quantitative Easing)

• The ECB launched its Expanded Asset Purchase Programme (QE) in January 2015 to revive the euro area economy.
• The QE aims to positively impact the economy's growth and raise inflation back to the desired level.
• The programme is expected to perform through four main channels:
  • Signaling to market the ECB's commitment to keep interest rates low
  • Lowering government bonds yields, leading to a currency depreciation that boosts exports
  • Providing extra money to banks to finance more loans
  • Encouraging insurance companies and pension funds to rebalance their portfolios into riskier assets

Criticisms and Concerns on European Quantitative Easing

• Legality problems: is it a monetary policy measure falling within the scope of the ECB's mandate?
• Reduced scope of QE: government bonds yields already very low
• Limited development of European capital markets: scarce impact of lower cost of capital on investment decisions
• European banks short of capital, not liquidity: are they not willing to lend?

Monetary Policies Impact on the Real Economy

• The ECB's pandemic emergency purchase programme (PEPP) was initiated in March 2020 to counter the risks to the monetary policy transmission mechanism posed by the COVID-19 outbreak.
• The PEPP is a temporary asset purchase programme of private and public sector securities.

Monetary Policy and Exchange Rate Determination

• The impact of interest rate differentials on exchange rates can be represented by the formula: Cra/f = Cpd/f * (1 + i¿ *t) / (1 + i, *t)

Monetary Policy and Sovereign Risk

• Monetary policy deals with the determination of the money supply and its growth rate, affecting interest rates and the economy.
• The goals of monetary policy are:
  • Growth
  • Employment
  • Inflation control
  • Exchange rate stability
• Monetary policy is run by a central bank, which is independent from the government and its political targets.

Instruments and Transmission Channels of Monetary Policy

• Expansionary monetary policy aims to increase the money supply, reducing short-term interest rates and boosting private borrowing, investments, and consumption.
• Contractionary monetary policy aims to reduce the money supply, raising short-term interest rates and reducing private borrowing, investments, and consumption.
• The money multiplier reflects the preferences of banks and consumers with regards to financial assets and can be influenced by interest rates and technology changes.
• Central banks use four main instruments to run monetary policy:
  • Open market operations
  • Discount rate changes
  • Reserve requirements changes
  • Changes in foreign reserves
• Quantitative easing is an extension of open market operations, involving the purchase of securities from banks to reduce long-term interest rates.

Central Banks and Interest Rates

• Central banks operate on the foreign exchange market to move or stabilize exchange rates.
• The main key rates of central banks are:
  • Federal Reserve (Fed)
  • European Central Bank (ECB)
  • Bank of England (BOE)
• The total assets of major central banks have increased significantly since 2007.

Transmission Channels of Monetary Policy

• The transmission channels of monetary policy are:
  • Interest rate channel
  • Credit channel
  • Exchange rate channel
• The interest rate channel affects the cost of capital, household purchases, and firm investment.
• The credit channel affects the availability of bank loans and aggregate spending.
• The exchange rate channel affects net exports and the trade balance.

Interest Rate Determination

• Interest rates are affected by several factors, including:
  • Maturity
  • Market liquidity
  • Risk
  • Clauses and provisions
  • Lending costs
• The term structure of interest rates is the relationship between yields on comparable securities with different maturities.
• The yield curve is the graphical depiction of the term structure of interest rates.
• Yield curves can take different shapes, including:
  • Normal (positively sloped)
  • Inverted (negatively sloped)
  • Humped
  • Flat
• Yield curves can undergo parallel shifts, nonparallel shifts, and butterfly shifts.

Theories of Term Structure of Interest Rates

• There are four main theories explaining the term structure of interest rates:

  • Expectation hypothesis
  • Market segmentation theory
  • Preferred habitat theory
  • Liquidity premium theory### Goals of Monetary Policy and Role of the Central Bank

• The primary objective of the European Central Bank's (ECB) monetary policy is to maintain price stability.

• Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

• The ECB aims to maintain inflation rates below, but close to, 2% over the medium term.

European Central Bank vs. Federal Reserve Objectives

• The ECB's primary objective is to maintain price stability, with a clear hierarchy of objectives.
• The Federal Reserve has a multiple-objective mandate, including maximum employment, stable prices, and moderate long-term interest rates.

European Central Bank: Instruments

• The ECB uses open market operations, standing facilities, and minimum reserves to implement its monetary policy.
• Open market operations include:
  • Main refinancing operations (one-week maturity)
  • Longer-term refinancing operations (three months to 48 months)
  • Fine-tuning operations (ad hoc basis to smooth interest rates)
  • Structural operations (adjust the Eurosystem's structural position)
• Standing facilities include:
  • Marginal lending facility (overnight liquidity)
  • Deposit facility (overnight deposits)
• Minimum reserves are used to stabilize money market interest rates and create a structural liquidity shortage.

European Central Bank: Interest Rates

• The ECB sets key interest rates, including:
  • Main refinancing operations (MRO) rate
  • Deposit facility rate (floor)
  • Marginal lending facility rate (ceiling)
• The ECB exercises its monetary policy power through forward guidance, disclosing its forecasts to influence market expectations.

European Central Bank: Unconventional Instruments (Quantitative Easing)

• The ECB launched its Expanded Asset Purchase Programme (QE) in January 2015 to revive the euro area economy.
• The QE aims to positively impact the economy's growth and raise inflation back to the desired level.
• The programme is expected to perform through four main channels:
  • Signaling to market the ECB's commitment to keep interest rates low
  • Lowering government bonds yields, leading to a currency depreciation that boosts exports
  • Providing extra money to banks to finance more loans
  • Encouraging insurance companies and pension funds to rebalance their portfolios into riskier assets

Criticisms and Concerns on European Quantitative Easing

• Legality problems: is it a monetary policy measure falling within the scope of the ECB's mandate?
• Reduced scope of QE: government bonds yields already very low
• Limited development of European capital markets: scarce impact of lower cost of capital on investment decisions
• European banks short of capital, not liquidity: are they not willing to lend?

Monetary Policies Impact on the Real Economy

• The ECB's pandemic emergency purchase programme (PEPP) was initiated in March 2020 to counter the risks to the monetary policy transmission mechanism posed by the COVID-19 outbreak.
• The PEPP is a temporary asset purchase programme of private and public sector securities.

Monetary Policy and Exchange Rate Determination

• The impact of interest rate differentials on exchange rates can be represented by the formula: Cra/f = Cpd/f * (1 + i¿ *t) / (1 + i, *t)