International Economics Quiz

Foundations of Monetary and Exchange Rate Policy

• The course covers the foundations of monetary and exchange rate policy.
• Block II of the 2024 course is taught by Dr. Toenshoff.

Review Questions (Latin America vs East Asia)

• Latin America pursued import substitution industrialization (ISI) while East Asia pursued export-oriented industrialization (EOI).
• Latin America had stronger political interests in the manufacturing sector.
• East Asia had access to larger export markets.
• East Asia had a readily available unskilled workforce.
• Latin America had larger local markets.

Review Questions (Comprehensive Sanctions)

• Comprehensive sanctions are not inherently less humane than targeted sanctions.
• They can be less good than targeted sanctions, due to issues with efficiency, effectiveness, and working through corruption.
• They are not necessarily better in democracies.
• Sanctions have been used since before 9/11.

The Plan

• The plan outlines topics for the course:
  • What is Money (and an exchange rate regime) Good For?
  • Domestic Monetary Policy
  • International Monetary Exchange
  • Balance of Payments Adjustment
  • The Unholy Trinity

The Function of Money

• Money serves three key functions:
  • Medium of exchange: Resolves the "double coincidence of wants problem".
  • Store of value: Allows individuals to convert perishable goods into more durable goods.
  • Unit of account: Provides a standard relationship between various goods in the economy.
• Having a currency is a public good. It benefits everyone and is nonrival and nonexcludable, but its creation/maintenance suffers from the collective action problem.
• 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.
• Domestically, price of money = interest rates
• Internationally, price of money = exchange rates

A Note on Terminology

• Appreciate = Gain value = Purchase more foreign currency for one unit of domestic currency.
• Depreciate = Lose value = Purchase less foreign currency for one unit of domestic currency.

Domestic Monetary Policy

• Definition: Adjustment of the money supply to change domestic price levels (inflation) and economic output.
• Who is in charge of Monetary Policy in Europe? The European Central Bank (ECB).

How do Central Banks do it?

• Interest rates = the price of domestic money.
• Money supply → Interest rate → Consumption → Dom. Investment → Production, employment → Price (input costs, wages) → Inflation

Let's see if we got that

• As a central bank, increase money supply and decrease interest rates to boost production and employment.
• As a central bank, decrease money supply and increase interest rates to fight high inflation.
• Employment and domestic production decrease when the central bank raises interest rates to fight inflation.

The Phillips Curve

• The Phillips Curve shows a trade-off between inflation and unemployment.

International Monetary Exchange

• A common medium of exchange is beneficial for interactions between countries and economies.
• Easy determination of the value of goods in different countries makes trade and investment easier.

Think about Europe w/o the Euro

• With different and floating currencies, a Dutch firm might experience an exchange rate change impacting their profitability.

International Monetary Exchange (Continued)

• For most of modern history, gold and silver-backed paper currencies served as the common medium of exchange between economies.
• Each country's currency had a fixed amount of gold or silver (specie). This made it easier to determine relative values.
• Today, most states have a floating currency system. The value of the currency is determined by market forces. USD serves as the primary unit of account and store of value.

International Monetary Exchange (Exchange Rate Regimes)

• Exchange rate regime: Set of rules governing how much national currencies can appreciate and depreciate in the foreign exchange market.

Exchange Rate Regimes

• Fixed: Governments buy/sell currencies to maintain a fixed price.
• Floating: Governments do not intervene in the exchange rate.
• Fixed-but-Adjustable: Governments intervene under specific circumstances.
• Managed Float: Governments intervene, but there are no clear rules.

Balance of Payments

• Definition: The difference between the money entering and leaving a country.
• Current Account: Imports, exports, services, interests, fees, profit, remittances, and foreign aid.
• Capital & Financial Accounts: Direct investment, portfolio investment, loans, and other investments. (financial flows). The current and capital/financial accounts are a mirror image of each other.

Balance of Payments (Floating XR)

• Floating XR regimes: BoP adjustment through exchange rate movements.
• Fixed XR regimes: BoP adjustment through changes in domestic prices.

Current Account ➡ Exchange Rate

• Exports increase demand for home currency; thus, more demand.
• Imports increase supply of home currency; thus, more supply.

Exchange Rate ➡ Current Account

• Currency appreciation leads to less export demand; more imports.
• Currency depreciation leads to more export demand; less imports.

Balance of Payments, Floating XR

• Deficits see depreciation in currency (global markets)
• Surplus countries see appreciation in currency (excess demand for the currency)

BoP Adjustment, Floating XR

• Adjustments occur through exchange rate movements in a floating system.

Balance of Payments, Floating XR (Continued)

• Balance is restored as exchange rates adjust for deficits and surpluses.
• Domestic prices of goods & services remain rather stable.
• Governments are free to use monetary policy to target employment or control inflation.

Balance of Payments, Fixed XR

• Adjustment occurs through price changes, rather than exchange rate movements.
• Deficit countries have reduced money supply/increased interest rates
• Surplus countries have increased money supply/reduced interest rates
• Government can manipulate their currency’s exchange rate through buying/selling it on the exchange market, adjusting interest rates, or imposing capital controls.

Changes in Money Supply ➡ Exchange Rates

• Central banks, e.g. ECB, can manipulate money supply to influence exchange rates.
• If increasing money supply, print more Euros, exchange them for US dollars.
• If decreasing money supply, sell Euros for US dollars; fewer euros.

1) Adjustment in reserves

• XR between Pound and Euro was fixed; excessive demand for GBP → upward pressure on GBP → Bank of England buys Euros, using GBP → Supply increase → prices of British goods increase → British exports decrease, British imports increase → Pressure on XR relieved.

Changes in Interest Rates ➡ Exchange Rates

• Domestic investors borrow money, using home currency for capital investments.
• International investors take money from home, exchange for foreign currency, to invest in foreign market.
• Higher interest rates cause increased demand for domestic currency; thus, pressure to increase XR, and vice versa.

2) Changes in Interest Rates

• Excessive demand for British pounds in EZ; upward pressure on GBP → Bank of England lowers interest rates → More domestic consumption and investment → Less demand for foreign investors → Pressure on XR relieved

3) Capital Controls

• Excessive demand in EZ for GBP → Bank limits EZ purchase of Sterling → Market exchange rate remains fixed → upward pressure on GBP vis-à-vis Euro is restricted

Balance of Payments, Fixed XR & No Capital Controls

• Adjustment happens through changes in price, rather than exchange rates.
• Deficit countries see a decline in money supply, increased interest rate, and decreasing domestic good prices
• Surplus countries see an increase in money supply and reduced interest rates; thus, increasing domestic good prices.

The Unholy Trinity/Trilemma

• States face a dilemma when choosing exchange rates relating to policy control.
• There are three possible outcomes of the trilemma: fixed exchange rate, monetary policy autonomy, and free capital flow.
• Under no conditions can these three outcomes be obtained simultaneously.

The Unholy Trinity/Trilemma (continued)

• If free capital + MP autonomy + fixed XR, any effort to adjust interest rates/money supply to stimulate activity will change international demand and supply of the currency.

Monetary Policy to Boost Domestic Economy

• Central bank lowers interest rates/increases money supply to boost employment and output domestically.
• Higher money supply makes the currency less valuable internationally.
• Lower rates make investment less valuable.
• Interest rate, money supply adjustment to maintain fixed exchange rates; but doing so makes investment elsewhere more attractive
• This negates policy objectives

The Unholy Trinity/Trilemma (Illustrative diagram)

• Shows the relationship, tradeoff, between Fixed exchange rates, Independent monetary policy, and Financial integration (capital mobility)

Core Take Aways Bretton Woods

• Fixed exchange rates are hard to maintain with capital mobility and democratic pressure.
• The US, backed the Bretton Woods, but had an inability to ensure long-term cooperation.

POST BW

• Most major economies floated their currency following BW; Europe tried to organize regional monetary cooperation around German policy.
• Most countries pegged to US/European currencies; despite floating XR, global imbalances.

Summary: Increasing Democracy & Capital Mobility

• There is a graph showing the relationship between fixed/floating exchange rates and capital mobility. Data related to the time periods: Post WW I and post WW II respectively.

Central Banks

• Democracy demands monetary policy autonomy.
• Monetary policy manipulation can lead to runaway inflation—this drags on long-run growth/investment

Central Banks: The Problem

• Democracy leads to the demand for monetary policy autonomy.
• Monetary manipulation can lead to runaway inflation.
• This drags on growth and investment in the long run despite short-run benefits.

Upward spiral of inflation

• Keynes assumed a stable relationship between unemployment and inflation.
• Stagflation in the 1970s showed this assumption was incorrect.

Upward spiral of inflation (Illustrative diagram)

• A graph demonstrating long-run Phillip’s Curve and the short-run Phillip’s Curve

The Problem: Time Inconsistency

• Governments want price stability long term, and employment in the short term.
• Adopting a fixed exchange rate ties your hands from using expansionary monetary policy; to avoid this problem, use an independent central bank

The Solution

• Governments might adopt an independent central bank.

Central banks as commitment mechanisms

• Political independence to maintain monetary policy without undue political pressure
• Central Banks differ in their independence
• Freedom to choose economic objectives (inflation & employment).
• Freedom to set monetary policy.
• Reversibility of the policy decisions.

Other Examples:

• Swiss National Bank: Highly independent
• Reserve Bank of Australia: Highly subordinate.
• Reserve Bank of India: Not constitutionally independent
• Central Bank of Republic of Turkey: Highly subordinate

Central banks as commitment mechanisms (Does Central Bank Independence Work?)

• Central bank independence provides certainty over monetary policy.
• Is this associated with decreased inflation and growth?

Inflation & CBI in Developing Countries 1980-2013 (Illustrative graph)

• Data on inflation and CBI average across a sample of developing countries

Crypto = Future of Currencies?

• Fixed money supply is not a good thing as it results in either reduced growth (e.g., deflation) or reduced price stability.
• People’s willingness to use crypto depends on trust.

Conclusion: To the Moon?

• Crypto is a speculative asset subject to regulation.
• Crypto is not an ideal investment for retirement.

Example Short Answers Qs

• Outline the objectives of the Doha Round (focus on economic development relating to intellectual property and environmental protections).
• Reasons for the stalling of Doha negotiations: unwillingness of developed/industrialized countries to liberalize agriculture and difficulties with procedural hurdles.
• Countries turned to RTAs due to Doha negotiations’ failure; RTAs might be better for developing countries as it’s an agreement amongst a smaller number of participants rather than the whole world. They are less complex than WTO agreements.

Next up: Societal Interests in Monetary Policy & EMU

• Topics for the subject.