ECON2026 Notes - Money And Banking (Australian National University) PDF

lOMoARcPSD|32252195 ECON2026 Notes - Entire course summary Money And Banking (Australian National University) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by James Clarke (jamesclarke673@g...

lOMoARcPSD|32252195 ECON2026 Notes - Entire course summary Money And Banking (Australian National University) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 ECON2026: Money and Banking Table of Contents Week 1: Overview of Money and Banking.............................................................................................2 Week 2: Interest Rates & Rates of Return..............................................................................................5 Week 3: Bond Maturities and Interest Rates.........................................................................................7 Week 4: The Stock Market...................................................................................................................10 Week 5: Part 1-Central Banks..............................................................................................................12 Week 5: Part 2-Money Supply Processes.............................................................................................13 Week 6: Monetary Policy.....................................................................................................................15 Price Stability...................................................................................................................................16 High Employment:...........................................................................................................................16 Economic Growth:...........................................................................................................................16 Stability of Financial markets and Institutions:................................................................................16 Interest Rate Stability......................................................................................................................16 Foreign-Exchange market Stability...................................................................................................16 Monetary Policy Tools......................................................................................................................17 Federal Funds Market......................................................................................................................17 OMO vs. other policy tools..............................................................................................................19 The Taylor Rule................................................................................................................................19 Lecture 7: Part 1- the FX Market..........................................................................................................20 Real exchange rate:..........................................................................................................................20 The Law of One Price and the Theory of Purchasing Power Parity..................................................20 Supply and Demand Model of Foreign Exchange Markets...............................................................21 The Interest Rate Parity Condition...................................................................................................23 Short Run Explanation.................................................................................................................23 Long Run Explanation..................................................................................................................25 Part 2: Exchange Rate Regimes and the International Financial System..............................................25 Foreign Exchange Intervention and Monetary Base........................................................................25 Methods of FX Intervention:........................................................................................................25 Exchange Rate Regimes...................................................................................................................26 Week 8: Part 1- IS Curves.....................................................................................................................26 Expenditure Concepts......................................................................................................................26 Simplifying C, I, G, NX...................................................................................................................28 Monetary Policy Curve.....................................................................................................................29 Week 9: Aggregate Demand and Aggregate Supply.............................................................................29 Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 AD....................................................................................................................................................29 Effects of Monetary Policy...............................................................................................................30 Phillips Curve...................................................................................................................................33 Three important conclusions...........................................................................................................33 Okun’s Law.......................................................................................................................................33 Week 1: Overview of Money and Banking Financial Markets: markets in which funds are transferred between people and firms, one side with excess funds and one side with insufficient funds.  Classified into Bond and Stock Markets Why are financial markets important?  Promote economic efficiency.  Without financial markets parties demanding funds (insufficient funds) cannot interact with parties supplying funds (excess funds) o Firms cannot implement new ideas. o -> Economic inefficiency Why study financial markets?  Important in generating high growth and improve the living standards.  Directly effect individual’s wealth, business and consumer’s economic decisions and business cycles. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Structure of Financial Markets Debt and Equity Markets:  Debt instruments such as bonds and mortgage  Equities such as common stock Primary and Secondary Markets:  Primary markets: New issues of security such as a bond or a stock are sold to initial buyers.  Secondary markets: Previously issued securities are traded. o Exchange (one location) and OTC markets (dealers in different locations buy and sell securities to anyone willing to buy or sell)  Money and Capital Markets: o Money markets deal in short term debt instruments. o Capital markets deal in longer term debt and equity instruments. The Bond Market and Interest Rates A Security is a financial instrument is a claim on the issuer’s future income or assets. A bond is a debt security (allows you to lend money) that promises to make payments periodically for a specified period of time.  Foreign bonds: sold in foreign country and denominated in that country’s currency  Eurobond: bond denominated in a currency other than that of the country in which it is sold  Eurocurrencies: foreign currencies deposited in banks outside the home country An interest rate is the cost of the borrowing or the price paid for the rental funds.  Higher Risk rate dictates higher compensation in the form of higher interest rates  Mostly dictated by economic environment The Stock Market A share is a claim on the residual earnings of the company. Why study financial institutions and banking?  Financial intermediaries: institutions that borrow funds from people who have saved and make loans to other people o Banks: accept deposits and make loans o Other financial institutions: insurance companies, finance companies etc.  Financial innovation: new products and services  Financial crises Why study Money and Monetary Policy?  Money and monetary policy play an important role in the business cycle.  Recessions and expansions affect all of us.  Monetary theory ties changes in the money supply to changes in aggregate economic activity and the price level. Money, Busines cycles and Inflation Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195  The aggregate price level is the average price of goods and services in an economy.  A continual rise in the price level (inflation) affects all economic players.  Data shows a connection between the money supply and the price level.  Historically there is a positive relationship between the money growth rate (money supply) and the business cycle but there are times where there is a negative relationship. o Overall inflation and the business cycle have a relationship. o Money supply and inflation are directly positively correlated. Money and Interest Rates  Interest rates are the price of money.  Prior to 1980, the rate of money growth and the interest rate on long term Treasury bonds were closely tied.  Since then, the relationship is less clear, but the rate of money growth is still an important determinant of interest rates. Fiscal and Monetary Policy  Monetary policy is the management of the money supply and interest rates.  Fiscal policy deals with government spending and taxation: o Budget deficit is the excess of expenditures over revenues for a particular year. o Budget surplus is the excess of revenues over the expenditures for a particular year. o Any deficit must be financed by borrowing. M1 and M2 Money Supply M1 money supply: incorporates the all forms of currency that is liquid M2 money supply: incorporates M1 and all forms of currency that is less liquid Why Study International Finance  Financial markets have become increasingly integrated throughout the world.  The international financial system has tremendous impact on domestic economies: o How country’s choice of exchange rate policy affects its monetary policy? o How capital controls domestic financial systems and the economy?  World stock markets, different types of bonds Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Indirect Finance  Lower transaction costs o Economies of scale  Indirectly services  Reduce the exposure of investors to risk o Risk sharing: financial intermediaries o Diversification: financial intermediaries  Deal with asymmetric information problems o Adverse selection: try to avoid selecting the risky borrower  Gather information about the potential borrower o Moral Hazard: ensure the borrower will not engage in activities that will prevent them to repay the loan.  Sign a contract with restrictive covenants Week 2: Interest Rates & Rates of Return Interest rate on a loan should cover the opportunity cost of supplying credit so that the interest should compensate for:  Inflation  Default risk  Opportunity cost of waiting to spend the money. Future value is the value at some time in the future of an investment made today. = Principal (1+i) Present value is the value of funds today that will be received in the future. = FV/(1+i)^n The price of a financial asset is the PV of its future cash flows. YTM is the interest rate that makes the present value of the payments from an asset equal to the asset’s price today. A coupon bond is a debt instrument that requires multiple payments of interest on a regular basis and a payment of the face value at maturity.  Face value: the amount to e repaid by the issuer of the bond at maturity.  Coupon: the annual dollar amount of interest paid by the issuer to the bond holder  Coupon rate: the value of the coupon expressed as a percentage of the par value of the bond. o =C/FV o Current yield = C/Price of bond  Maturity: the length of time before the bond expires and the issuer makes the face value payment to the buyer. o Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 For a bond that makes coupon payments (C) and matures in n years: When the coupon is priced at its face value, the yield to maturity equals the coupon rate. The price of a coupon bond and the YTM are negatively related: YTM > coupon rate = bond is priced below face value YTM < coupon rate = bond is priced above face value The return of the coupon from time0 to time1 is calculated as follows: Nominal interest rates make no allowance for inflation. Real interest rates are adjusted for inflation.  Ex ante is adjusted for forecasted changes in price levels.  Ex post is adjusted for actual changed in price levels. Fisher equation: the expected real interest rate equals the nominal interest rate minus the expected rate of inflation. Response of bonds to a business cycle expansion Supply and Demand in the Market for Money: The Liquidity Preference Framework Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Keynesian model that determines the equilibrium interest rate in terms of the supply and demand for money. There are two main categories of assets that people use to store their wealth money and bonds. Total wealth in the economy: Bond supply + Money Supply = Bond Demand + Money Demand Bs = Bd then the bond market is in equilibrium thus Ms = Md the money market is in equilibrium The Liquidity Preference Framework Demand for money in the liquidity preference framework:  As the interest rate increases: o The opportunity cost of holding money increases. Shifts in demand for money:  Income effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right.  Price-level effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right. (the higher prices are the more money is required to purchase G&S Shifts in supply for money:  Assume that the supply of money is controlled by the central bank.  An increase in the money supply engineered by the central bank will shift the supply curve for money to the right. Week 3: Bond Maturities and Interest Rates Bonds differ in terms of their risk structure and term structure (rate of maturity) Risk Structure of Interest Rates The risk structure of bonds is the relationship among the interest rates of bonds that have the same maturity but different characteristics. Why might bonds that have the same maturities have the different interest rates?  Risk  Liquidity  Information costs  Taxation Measuring Default Risk:  The default risk premium on a bond is the difference between the interest rates on the bond and on a Treasury bond with the same maturity.  A bond rating is an agency’s view of the issuers ability to make the payments of the bond. An increase in default risk causes yields to rise because investors must be compensated for bearing additional risk. An increase in liquidity will reduce the yield as investors incur lower costs in selling the bond. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 More information costs will cause yields to rise as investors must spend more resources to evaluate the bond. More tax liability will cause the yield to rise as investors care about after-tax returns and must be compensated for higher tax. Term Structure of Interest Rates The term structure is the relationship among the interest rates on bonds that have similar characteristics but different maturities. A yield curve shows the relationship of interest rates of bonds with varying maturities. An upward sloping yield curve shows that interest rates on short-term bonds are lower than that of long-term bonds. Visa-versa: LTR > STR (usually) LTR > or = STR (occasionally) STR and LTR move together Expectation Theory: Explains co-movements of short term and long term interest rates:  Interest rate on long-term bonds = Average of expected interest on short-term bonds Fails to explain the difference in interest rates between bonds with varying maturities Implies: Upward sloping yield curves = investors expect STR < LTR Flat yield curve = investors expect STR = LTR Downward yield curve = investors expect STR > LTR 2 Assumptions: Investors have same objectives & Bonds are perfect substitutes. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 iet= expected interest rate in period t Segmented Market Theory The interest rate on a bond of a particular maturity is determined only by the demand and supply of bonds of that maturity. Two related observations: Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195  Investors in the bond market do not all have the same objectives.  Investors do not see bonds of different maturities as being perfect substitutes for each other. Segmented markets mean investors in the market for bonds of one maturity do not participate in the market for bonds of other maturities. Long term bonds are risker hence the yield curve will be upward sloping. More investors are in the market for short term bonds also causing the yield curve to be upward. Liquidity Premium Theory The interest rate on a long-term bond is an average of the interest rates investors expect on short term bonds over the lifetime of the long term bond, plus a term premium. Term premium is the additional interest investors require in order to be willing to buy a long term bond rather than a comparable sequence of short term bonds. Bonds are substitutes but not perfectly. Preferred Habit Theory Investors prefer short term bonds over long term bonds unless long term bonds provide a reasonable premium. Week 4: The Stock Market A stockholder has a claim on a firm’s profits and equity. Stocks are the units used to distribute and measure the ownership of firms. A stock market index is tracks the average of stock market performance that is used to measure the overall performance of the stock market. How does the stock market affect the economy? Fluctuations in stock market prices can affect household spending and savings:  Make up a large portion of household wealth Fluctuations can heighten uncertainty and lead households and firms to postpone their spending if markets are volatile. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 They provide an important source of funds for firms. How stock prices are determined? The PV of all future payments (dividends). The required return (equity cost of capital) on equities is the expected return necessary to compensate for the risk of investing in stocks. *Dividends have double tax as the company pays tax on their earnings and then distributes the dividend to the investor who then pays income tax on the dividend. So the effective tax rate is not what the individual or the firm alone pays. ** Higher dividend tax and higher capital gains tax = higher inefficiency and higher inequality. Equity premium is the additional return investors must receive above the rate of Treasury Bills. The equity premium for an individual stock has 2 components:  Systematic Risk: Risk factors that affect the whole market.  Unsystematic Risk: Risk factors that only affect the company. The price is set by the buyer who is willing to pay the highest price. The Efficient Market Hypothesis (EMH) A security’s price fully reflects all available information in an efficient market. Stock prices are not predictable. Prices today reflects all available information Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Stock prices instead follow random walk, which is the unpredictable movements of a price of a security. EMH implies:  Investors should diversify their portfolios until the have the optimal portfolio  It is better to buy and hold stocks over the long term rather than buy and sell in the short term  Stock recommendations by financial analysts are unlikely to outperform the market in the long term Actual Market Efficiency Pricing anomalies allow investors to earn consistently above average returns. Some price changed are predictable using available information. Price changes can be larger than fundamental change. Week 5: Part 1-Central Banks Central banks play an important role in the money supply process by conducing monetary policies to influence economies. Factors that motivate Central Banks  Public Interest View: o Maximise social and economic well-being of society. o Seeks economic goals that are in the public’s best interest  Principal Agent View: o Protect their own position and wellbeing. Eg, they may reduce the interest rate to stimulate the economy so that the incumbent government is re-elected. This would result in a politically orientated business cycle. o There can be central banks independent of the government who conduct policies irrespective of the government. Arguments for Central Bank Independence  Monetary policy is too important for politicians to determine.  Politicians may be short sighted, concerned with short-term benefits without regard for potential long-term costs.  Complete control of central banks by politicians may lead to political business cycles on the money supply which may not be economically favourable. Arguments against Central Bank Independence  In a democracy elected officials should make public policy be held responsible for the outcomes of their decisions.  Monetary policy could be coordinated and integrated with government taxing and spending policies. Week 5: Part 2-Money Supply Processes  M=mxB Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 o M=Money Supply o ‘m’= money multiplier o B=monetary base (determined by CB’s) The money multiplier is affected by the banking system, non-banking public and CB’s.  B= R + C o R = Reserves (Bank deposits with CB + vault cash) o = Required reserves (required for loan payments) + excess reserves o RR = r.D o Required reserve rates. (determined by CB) o D = deposits o C = Currency in circulation (Outstanding cash – vault cash) Central banks conduct monetary policy with Open Market Operations (OMO). *This directly affects the monetary base (B)  Buying and Selling securities which consist mainly of treasury bonds. And Discount Bonds:  Loans to financial institutions.  Central banks do not have direct influence on discount loans o But they can indirectly affect the level of discount bonds by changing the interest rate charged to banks  BR (borrowed monetary base) B = Bnon + BR  Bnon = OMO  BR = borrowed monetary base M = mB M = m(Bnon + BR) A Central Bank;s Balance Sheet and the Monetary Base The money supply is determined by three factors:  Central bank: controls the money supply and regulating the banking system  The banking system: responsible for the accounts which are major component of M1  Nonbank pubic: decides the form in which they hold money The Central Bank’s Balance Sheet and the Monetary Base The Money Supply Process  The process starts with the monetary base.  When the money multiplier is stable, the CB can control the money supply by controlling the monetary base.  There is a close connection between the monetary base and the CB’s balance sheet. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Simple Deposit Multiplier  The money multiplier helps us understand the factors that determine the money supply.  The money multiplier is determined by the actions of three actors in the economy: the CB, banking system and the nonbanking public.  Multiple deposit certain occurs when an increase in bank reserves results in subsequent rounds of bank loans made to other banks and individuals and the creation of checkable deposits. o Therefore, an increase in the money supply is a multiple of the initial increase in reserves. rrD = Required Reserve Ratio Realistic Deposit Multiplier The realistic deposit multiplier accounts for the nonbank public’s desire to hold checkable deposits relative to currency, the banks’ desire to hold excess reserves and the link between the monetary base and the monetary supply. M = m.B m=M/B m=(C+D)/(C+R) m = ( C + D ) / ( C + RR + ER) x ( 1 – D) / ( 1 – D) m = [ (C + D) +1 ] / [(C / D) + ( RR / D) + (ER / D)] * RR/D is the required reserve ratio (rrD) C/D is affected by the nonbanking public ER/D is determined by the banking system Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 An increase in C/D causes the value of the money multiplier and the money supply to decline An increase in rrD causes the value of the money multiplier and the money supply to decline An increase in ER/D causes the value of the money multiplier and the money supply to decline Money Supply Process for M2 M2 incorporates the non transaction accounts  N = savings and small time deposits  MM = money market deposit accounts and similar accounts M2 = C + D + N + MM Week 6: Monetary Policy 6 monetary policy goals:  1st priority Price stability  2nd priority High employment  Economic growth Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195  Stability of financial markets and institutions  Interest rate stability  Foreign-exchange market stability Price Stability Inflation erodes the value of money, therefore most economies set price stability as a policy goal. Problems caused by inflation:  Inflation makes prices less useful as signals for resource allocation.  Uncertain future prices complicate decisions households and firms have to make.  Inflation can arbitrarily distribute income.  Hyperinflation can severely damage an economy’s productive capacity. High Employment:  High employment, or a low unemployment rate is another key monetary policy goal.  Unemployment reduces output and causes financial and personal distress.  Monetary policy cannot solve frictional and structural unemployment.  Monetary policy aims to lower cyclical unemployment associated with the business cycle. Economic Growth:  Economic growth is an increase in the economy’s output of goods and services over time.  Economic growth provides the only source of sustained real increases in household incomes.  Economic growth depends on high employment.  With high unemployment, businesses have unused productive capacity and are much less likely to invest in capital improvements.  Stable growth allows firms and households to plan accurately and encourages long-term investment. Stability of Financial markets and Institutions:  When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources.  The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. Interest Rate Stability  Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms.  Central banks’ goal of interest rate stability is motivated by political pressure and a desire for a stable financial environment.  Sharp interest rate fluctuations cause problems for financial institutions. So, stabilising interest rates can help to stabilise the financial system. Foreign-Exchange market Stability  In the global economy, stability in the foreign-exchange value of the local currency is an important monetary policy goal.  A stable currency simplifies planning for commercial and financial transactions.  Fluctuations in the currency’s value affect the international competitiveness of that country’s industries. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 All these policy goals are related to 2 broad goals: price stability and maximum employment. This is called the Fed’s Dual Mandate. Monetary Policy Tools 3 traditional policy tools are:  Open market operations are the CB’s purchases and sales of securities in financial markets.  Discount policy: ie. Cash rate which is the rate at which the CB lends to banks.  Reserve requirements: the regulations requiring banks to hold a fraction of checkable deposits as vault cash or deposits with a CB. o Interest on reserve requirements (interest rate RBA pays to banks): increasing the interest rate increases the level of reserves banks are willing to hold, thus restricting bank lending and money supply. Federal Funds Market Banks demand reserves:  To meet legal obligations  To meet liquidity needs If the cash rate < interest rate on reserves, banks will not lend at all as they can make guaranteed profit from the federal funds market. Central Banks: Supply side of the federal funds market  Non-borrowed reserves through OMO’s  Borrowed reserves through discount lending. Banks: Demand side of the federal funds market  Borrow from each other paying the cash rate (dictated by the CB)  Banks borrow from CB paying the discount rate.  Keep reserves and earn the interest on reserve requirements. If the cash rate > policy rate then no banks will borrow from each other. If the federal funds rate < discount rate then banks will borrow from each other. **Note: The maximum fluctuation of the cash rat is between the reserve rate and the discount rate. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 OMO vs. other policy tools  The benefits of OMO include flexibility, control and ease of implementation  Discount loans depend on the willingness of banks to request loans form the CB which is not under the CB’s control  The CB can make both large and small OMO. Where dynamic operations require large purchases or sales whereas small operations are for defensive operations.  Reversing OMO is simple compared to discount loans and reserve requirement changes  The CB can implement its OMO with no administrative delays. Changing the discount rate or reserve requirements has longer implementation periods. There is an information lag and impact lag associated with monetary policy The Taylor Rule A summary measure of the CB Policy:  Actual CB deliberations are complex and incorporate many factors about the economy.  The Taylor Rule is a monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate.  It is essentially an estimate of the value of the federal funds rate to be consistent with real GDP being equal to potential real GDP in the long run.  The Fed should set its current federal funds rate target equal to the current inflation rate, the equilibrium real federal funds rate and two additional terms.  The first of these terms is the inflation gap- the difference between current inflation and a target rate; the second is the output gap- the percentage different of real GDP from potential real GDP. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195  The inflation gap and the output gap are each given “weights” that reflect their influence on the federal funds target rate. With weights of one half or both gaps, we have the following Taylor Rule. o Federal funds rate = Current inflation rate + Equilibrium real funds rate + (1/2 x inflation gap) + (1/2 output gap) Lecture 7: Part 1- the FX Market Real exchange rate: The rate at which goods and services in one country can be exchanged for goods and services in another country. Real exchange rate = [Australian CPI x pound per AUD (nominal exchange rate or quoted exchange rate)] / British CPI The Law of One Price and the Theory of Purchasing Power Parity The law of one price is the idea that identical products should sell for the same price everywhere. The law of one price is the basis for the theory of purchasing power parity (PPP). PPP states that exchange rates move to equalise the purchasing power of different currencies. I.e. In the long run an exchange rate should be at a level that the equivalent amount of any country’s currency can buy the same amount of goods and services. EXAMPLE If a bottle of coke in Australia is $1.50 and is £1 in London then PPP suggests that $1.50 AUD = £1 GBP. Therefore, E = 1/1.5 = 0.66 (1 AUD = 0.66 GBP) Suppose that e = 1 (i.e., 1AUD = 1GBP) This means that coke in London is cheaper than coke in Australia as 1 coke in London is equivalent to only 1 AUD. Therefore, the arbitrage profit opportunity is $1.5 - $1 = $0.5 So, investors will exchange dollars to pounds to buy coke in London and then sell them in Australia. If this is the case, then demands for pounds will appreciate till the exchange rate becomes E = 0.66. INFLATION (development of PPP) Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 If domestic inflation > foreign inflation, the domestic currency will depreciate. If domestic inflation rate = foreign inflation rate then: Supply and Demand Model of Foreign Exchange Markets Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Response to an increase in Domestic Interest Rate: Increased interest rate attracts foreign investors who wish to capitalise on interest gains in the domestic currency. Hence the demand for the domestic currency increases which subsequently appreciates as a result. Response to an increase in the Foreign Interest Rate: Domestic investors are attracted to interest gains in foreign countries. Etc.. The demand for domestic currency falls and the domestic currency depreciates. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Response to an Increase in the Expected Future Exchange Rate: If the domestic currency is expected to rise then the demand for the currency will increase etc. Effects of changes in interest Rates on the Equilibrium Exchange Rate:  Changes in Interest Rate o When domestic real interest rates raise, the domestic currency appreciates. o When domestic interest rates rise due to unexpected inflation then the currency depreciates.  Changes in Money Supply: o A higher domestic money supply causes the domestic currency to depreciate. The Interest Rate Parity Condition The interest rate parity condition states that differences in interest rates on similar bonds in different countries reflect the expectations of future changes in exchange rates. This also means:  Interest rate on domestic bond = Interest rate on foreign bond – expected appreciation of the domestic currency. If , then investors can make arbitrage profits. There are other risks in the FX market such as default & liquidity risk, transaction costs, exchange- rate risk which can be accounted for with a currency premium. So, the equation becomes:  Interest rate on domestic bond = Interest rate on foreign bond – expected appreciation of the domestic currency – Currency premium Short Run Explanation Domestic country interest rate = (AUD) Current exchange rate = Expected exchange rate = Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Foreign country interest rate = (Euros) Expected rate of appreciation/ depreciation = CASE A: Expected returns on $ assets in terms of Euros:  Domestic return = = Expected returns on foreign assets in terms of Euros:  Foreign return = Relative expected return on $ assets in terms of Euros: = = - Therefore, leads to demand for domestic assets ($ AUD) from foreign investors. CASE B: Expected returns on $ assets in terms of $:  = Expected returns on Euro assets in terms of $;  - Relative expected return on assets in terms of dollars: = - Therefore: = FURTHERMORE: If in terms of Euros > in terms of Euros, then demand for $ assets will increase Hence, the equilibrium states that in terms of Euros = in terms of Euros Therefore: = + = - Rearrangement of either equation gives: = This explains short run fluctuations in exchange rates. From the formula we can conclude  If then Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195  If then  If then Long Run Explanation PPP: Part 2: Exchange Rate Regimes and the International Financial System Foreign Exchange Intervention and Monetary Base  Foreign exchange market intervention is a deliberate action by a central bank to influence the exchange rate.  International reserves are central bank assets that are denominated in a foreign currency and used in international business transactions.  If the CB wants the foreign exchange value of the dollar to fall it can increase the supply of dollars by buying foreign assets which injects more dollars into the international financial system.  These transactions also affect the domestic money base. Methods of FX Intervention: Unsterilised intervention: The monetary base (B) will change ( EG. Typical OMO CB buys $1 billion of foreign securities (i.e. selling domestic currency on the FX market exchange rate). Central Bank T-ledger Assets Liabilities Foreign securities + $1 billion Bank CB Reserves + $1 billion Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 B = R + Currency in Circulation Buying foreign assets (money supply) = mB (m = money multiplier) Demand for domestic assets Sterilised intervention: The monetary base is not changed. EG. sale of $1 billion of Foreign assets (buying $) B (therefore this is a contractionary policy)  CB wants to make sure the ‘B” doesn’t change Thus the CB will conduct an OMP (open market purchase) of $1 billion of Treasury Bonds. B  Net change in B = 0 End result is that exchange rate does not change. Exchange Rate Regimes Exchange-rate regime is a system for adjusting exchange rates and flows of goods and capital among countries.  Fixed exchange rate regime: Pegged to another currency.  Floating exchange rate regime: currency is allowed to fluctuate against other currencies.  Managed float regime: Attempt to influence exchange rates by buying and selling currencies. Week 8: Part 1- IS Curves The IS curve tracks the interest rate and the level of GDP or Aggregate Demand which comprises of Investment (I) and Savings (S). It illustrates why fluctuations happen and the role of monetary policy correcting fluctuations. Expenditure Concepts Domestically produced goods and services are demanded by:  Households  Businesses  Foreigners  Governments Consumption Expenditures (Households) = C = C = marginal propensity of consumption Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Investment (Businesses) Fixed investment (always planned)  Equipment  Structures  Housing  Etc. Inventory Investment (can be unplanned)  Raw materials  Parts  Finished products I = (planned) fixed investment + (planned) inventory investment = ‘d’ = responsiveness of investment [0 d 1] Firm’s Decision Firms without excess funds (need to borrow)  Invest if the rate of return > Firms with excess funds  Invest of the rate of return > opportunity cost of investing. ‘r’ = real interest rate  Asymmetric information o Adverse selection o Moral hazard Net Exports  X = responsiveness of NX   ‘r’ = real interest rate Explanation: Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Government: Simplifying C, I, G, NX Rewriting C: Goods market equilibrium: Y= The IS Curve: Movement along C Shifts in IS (IS shifts right) (IS shifts right) Monetary Policy Curve Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Week 9: Aggregate Demand and Aggregate Supply AD  Consumption  Planned investment spending  Government purchases  Net exports Effects of Monetary Policy  Prices (inflation)  GDP (Output) Aggregate Demand and Aggregate Supply curve shows relationship between inflation and GDP. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 Phillips Curve Shows the negative relationship between unemployment and inflation When labour markets are tight, the unemployment is low. Firms will raise wages to attract workers. Three important conclusions There is no long-run trade-off between unemployment and inflation. Downloaded by James Clarke ([email protected])  lOMoARcPSD|32252195 There is a short-run trade-off between unemployment and inflation. There are two types of Phillips curves, long run and short run. Okun’s Law Shows the negative relationship between the unemployment gap and the output gap. Okun’s law states that for each percentage point that output is above potential, the unemployment rate is one-half of a percentage point below the natural rate of unemployment. Alternatively for every percentage point that unemployment is above its natural rate, output is two percentage points below potential output. 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