Foundations Of Monetary And Exchange Rate Policy 2024 PDF

Foundations of Monetary and Exchange Rate Policy Block II 2024 Dr. Toenshoff Review Questions 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...

Foundations of Monetary and Exchange Rate Policy Block II 2024 Dr. Toenshoff Review Questions 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 3 The Function of Money: Money serves THREE functions: 1. A medium of exchange 1. Money resolves the “double coincidence of wants problem” 2. Store of value 1. Money allows individuals to convert perishable goods into more durable goods 3. Unit of account 1. Money provides a standard relationship between various goods in the economy 4 The Function of Money: Having a Currency is a PUBLIC GOOD!!! It benefits everyone! nonrival and nonexcludable Its creation and maintenance suffer from the collective action problem (both internationally and domestically) 5 Money is a Good Money responds to the same forces of supply & demand as other goods. Supply up, value down Supply down, value up Demand up, value up Demand down, value down Just because we use currency to assign value, doesn’t mean currency’s value doesn’t change. Domestically, price of money = interest rates (% you pay to borrow a Euro) Internationally, price of money = exchange rates (how many e.g. USD you need to get a Euro) 6  A Note on Terminology Terminology for changes in the international value of a currency:  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 Exchange rate goes from 100€ = 100$ to 80€ = 100$ Did the Euro appreciate or depreciate? 7  Domestic Monetary Policy Definition:  Adjustment of the money supply in order to change domestic price levels (inflation) and economic output Whois in charge of Monetary Policy in Europe?  The European Central Bank 8  How do Central Banks do it? Interest Rates = the price of domestic money Production, employment Money supply Interest rate Consumption Inflation Dom. Investment Price (input costs, wages) The Central Production, Bank employment Money supply Consumption Inflation Interest rate Dom. Investment Price (input costs, wages) 9 Let’s see if we got that 10 The Phillips Curve This tells us that there is a trade off between inflation and unemployment. Rate of Inflation Unemployment 11 International Monetary Exchange 12  International Monetary Exchange For the same reason why individuals need a common medium of exchange within in a country or economy, an international medium of exchange is beneficial for interactions between countries and economies. When it’s easy to determine the value of goods in two different countries it’s easier to engage in Trade and Investment. 13  Think about about Europe w/o the Euro With different & floating currencies. A Dutch firm makes a contract to purchase a boat for 1000 Belgian Francs from a Belgium firm with delivery in 7 months At the time, the exchange rate is 1000 Belgian Francs = 500 Guilders, so the Dutch firm expects to pay the equivalent of 500 Guilders In the intervening months the exchange rate changes in favor of the Belgian Franc  1000 B. Francs = 550 Guilders  The Dutch firm still needs to pay 1000 Francs for its contract. It has just lost money.  The Belgian firm gets richer, because the Belgian Francs it gets from the contract can buy more Dutch products in return. Uncertainty over the profitability of investment will prevent firms from exploiting comparative advantage. Purchases from domestic firms don’t have the same uncertainty but come with lost gains from trade. 14  International Monetary Exchange For most of modern history, Gold and Silver backed paper currencies and served as the common medium of exchange between economies Each country’s currency was worth a fixed amount of gold or silver (specie) This made it easy to determine the value of goods relative to each other domestically and internationally Still, it required cooperation (More on that when we talk history) Today, most states have a floating currency system where the value of currency is determined by the market… The US dollar serves as the primary unit of account and store of value 15  International Monetary Exchange Exchange rate regime: A set of rules governing how much national currencies can appreciate and depreciate in the foreign exchange market. The relationship between a country’s currency and a foreign/international currency/commodity Types of exchange rate regimes: Fixed Floating Fixed-but-Adjustable Managed Float 16  Exchange Rate Regimes Fixed Fixed but Managed Float adjustable Float 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 later (hard peg) Floating  Governments do not intervene. There are no limits on how much XR can move up or down (US$, EURO – externally) Fixed-but-Adjustable  Governments intervene under a set of well-defined circumstances (ex. Bretton Woods for non-US countries). (soft peg) Managed Float  Governments intervene but there are no clear rules. Most governments do this today. 17 18 Balance of Payments 19 Balance of Payments The difference between the money entering and leaving the country. The Balance of Payments Explained (0:50-4:10) 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 Capital and Financial Accounts: Records all financial flows between the home country and the rest of the world FDI, portfolio investment, loans & other investments Current & Capital/Financial Accounts are the mirror image of each other When they don’t match up, a government has an imbalance of payments 20 10 Minute Break Balance of Payments The exchange rate regime determines, in part, how balance in the BoP is maintained…. In Floating XR regimes:  BoP adjustment occurs through exchange rate movements. In Fixed XR regimes:  BoP adjustment occurs through changes in domestic prices. 22 Current Account Exchange Rate When you export, the buyers exchange their currency for your currency to purchase your products more demand for your currency When you import, you exchange your home currency for another country’s currency to purchase their products more supply of your currency So, when you export more than you import, relative demand for your home currency [increases/decreases]. That means there is pressure for your home currency to [appreciate/depreciate]. When you import more than you export, relative demand for your home currency [increases/decreases]. That means there is pressure for your home currency to [appreciate/depreciate]. 24 Exchange Rate Current Account When your currency appreciates, your exports become [more/less] expensive and imports become [more/less] expensive When your currency depreciates, your exports become [more/less] expensive and imports become [more/less] expensive So, when your currency appreciates, your exports [increase/decrease] and your imports [increase/decrease] When your currency depreciates, your exports [increase/decrease] and your imports [increase/decrease] Balance of Payments, Floating XR: The adjustment occurs through Exchange Rate Movements Deficit countries see a depreciation in their currency on global markets (less demand 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 26  BoP Adjustment, Floating XR EZ has Excessive Demand Disproportionate Appreciation of in EZ for British Demand for British GBP vis-à-vis Euro Pounds (GBP) Goods/Services Higher Relative Contraction of BoP Cost of British Surplus Goods In Floating XR systems, the adjustment occurs through exchange rate movements. 27  BoP Adjustment, Floating XR UK has Excessive Appreciation of Disproportionate Demand in UK Euro vis-à-vis Demand for EZ for Euro GBP Goods/Services Higher Relative Contraction of Cost of Euro BoP Surplus Goods In Floating XR systems, the adjustment occurs through exchange rate movements. 28 Balance of Payments, Floating XR: 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 29 Balance of Payments, Fixed XR Adjusting the BoP under fixed XR: The government maintains a fixed XR by using monetary policy: It has a couple of avenues: 1. Governments buy/sell each other’s currency (thus changing the money supply and prices in each country) that they store in reserve 2. Countries can change interest rates, thereby also changing domestic prices. 1. Interest rates go up in deficit countries, they go down in surplus countries 3. They can impose capital controls or change commercial policy that limits financial transactions with other countries 30 Changes in Money Supply Exchange Rates Central banks can intervene by manipulating the money supply. E.g. ECB:  To INCREASE the money supply of Euros: print more Euros. Exchange Euros for US Dollar ➔More Euros in global circulation, more US Dollars in ECB’s reserve To DECREASE the money supply of Euros: sell the US Dollars in your reserve for Euros ➔Fewer Euros in global circulation, more US Dollars in circulation, fewer US Dollars in ECB’s reserve NOTE: This is asymmetric: A central bank can always print more, but it can only decrease the money supply if it has enough foreign reserves! 31 1) Adjustment in reserves If XR between Pound and Euro was Fixed: Excessive Upward Bank of England Demand in EZ Pressure on GBP buys Euros for British vis-à-vis Euro using Pounds Pounds (GBP) More currency Market demand but the same Supply in (partly) is offset amount of goods Pounds by Bank’s to sell increases intervention British exports UK Prices Pressure on XR decrease, British Increase is relieved imports increase 32 Changes in Interest Rates Exchange Rates: 2 Types of Investors International Investors Domestic Investors (Portfolio/FDI) Borrow money/use their Take money from their home savings in the home country, exchange it for currency to invest in capital foreign currency to invest in foreign market Interest rates  -> Interest rates  -> Return on borrowing more expensive, foreign investment  & foreign saving more lucrative & investment  domestic investment  Interest rates  -> Return on foreign investment  & foreign Interest rates  -> investment  borrowing less expensive, saving less lucrative & domestic investment  33  Changes in Interest Rates Exchange Rates Interest rates  -> [more/less] demand for currency by foreign investors Interest rates  -> [more/less] demand for currency by foreign investors 34  2) Changes in Interest Rates Excessive Upward Bank of England Demand in EZ Pressure on GBP lowers interest for British vis-à-vis Euro rates Pounds (GBP) More domestic UK Prices Increase consumption and investment Less demand for GBP by foreign investors Adjustment of Capital Account (less investment) and Current Account (fewer exports, more imports) Pressure on XR is relieved 35 3) Capital Controls Excessive Bank limits EZ Demand in EZ for purchase of British Pounds Sterling (GBP) Market exchange Upward Pressure rate remains on GBP vis-à-vis fixed Euro is restricted 36 Balance of Payments, Fixed XR & No Capital Controls The adjustment occurs through price changes Not through changes in the value of currencies The value of the currency has to remain fixed! (to a precious metal or other currency) Deficit countries see a reduction in the money supply/increase in interest rates The prices of domestic goods fall Surplus countries see an increase in the money supply/decrease in interest rates The prices of domestic goods rise 37 The Unholy Trinity 38  The Unholy Trinity/Trilemma 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 39  The Unholy Trinity/ Trilemma Financial integration (capital mobility) Classical Gold Standard Floating Rates (1900 - 1914) (1971- ) Trilemma Fixed exchange rates Independent monetary policy Bretton Woods (1945-1971) 40  The Unholy Trinity What happens if you try to implement all 3? 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 41  Monetary Policy to Boost Domestic Economy 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 the currency less valuable Supply of currency up, demand for currency down To maintain a fixed exchange rate while capital is free, the 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 OR it can impose capital controls (hard in the long-run) Central Bank has to give up one of the three corners  The Unholy Trinity/ Trilemma Financial integration (capital mobility) Trilemma Fixed exchange rates Independent monetary policy 43  Summary Balance of Payments Adjustment Fixed vs. Floating: Each has different consequences (winners/losers) In a globalized economy, capital controls are very difficult to maintain long- term. Assuming no capital controls: Fixed XR Floating XR Effect on Trade Makes trade very easy Makes trade harder because prices across because prices across countries are stable countries are unstable Effects on Domestic Prices within countries Prices within countries Prices are unstable are stable Monetary Policy No adjustments to Adjustments to improve domestic improve domestic economic conditions economic conditions possible possible The politics of monetary policy largely center around these differences 44 What to Know Well: Types of XR regimes XR regimes determine how states adjust balance of payments and influence price levels at the domestic and international level Adjusting BoP under fixed XR & no capital controls: prices adjust to deal with surplus/deficit Adjusting BoP under floating XR: XR adjusts to deal with surplus/deficit The policy dilemma known as the UNHOLY TRINITY/TRILEMMA 45 Next: History of the Monetary System 46