EC3332 Lecture 7-11 Summary

8/15/2019 EC3332 Lecture 7-11 Summary

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Lecture 6: The money supply process

Three players in the money supply process

(1) CB: government agency that oversees the banking system andconducts monetary policy

(2)

Banks (depository institutions): financial intermediaries that acceptdeposits from individuals and institutions and make loans

(3) Depositors: individuals and institutions that hold deposits in banks

A simple model: creation of deposits (assuming 10% reserve requirement

and a $100 increase in reserves)

Critique of the simple model of multiple deposit creation•


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Lecture 7: Tools & Conduct of Monetary Policy

The market for reserves and the federal funds rateFed funds rate – primary instrument of US monetary policy

•

Interest rate on overnight loans of reserves from one bank to another(interbank market)

• Determined by demand and supply in the market for reserves

Conventional tools of monetary policy & its effect on federal funds rate(a) open market operations (OMO)

if intersection is at

the flat area vs downward-sloping


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(b) discount rate

if intersection is at:

vertical vs horizontal

(c) reserve requirements

(d) interest rate on reservesif intersection is at the

flat vs downward-sloping


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Nonconventional monetary policy tools (during the global financial crisis)

(1) liquidity provision

• The Fed implemented unprecedented increases in its lending facilitiesto provide liquidity to the financial markets

(a)

Discount window expansion (Aug 2007): Fed lowered thediscount rate to 50 basis points above the Fed funds rate(


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Hierarchical mandate: put the goal of price stability first, and then say that as

long as it is achieved other goals can be pursued

Dual mandates: aimed to achieve two coequal objectives

Primary, long-run goal of monetary policy: price stabilityEither type of mandate is acceptable as long as it operates to make pricestability the primary goal in the LR, but not the SR

Inflation-targeting

Recognition of price-stability as primary long-run goal of monetary policy has

led to monetary policy strategy known as inflation targeting

Involves 5 key elements:

(a)

public announcement of medium-term numerical target for inflation(b) institutional commitment to price stability as the primary, long-run

goal of monetary policy & a commitment to achieve the inflation goal

(c) information-inclusive approach in which many variables are used in

making decisions

(d) increased transparency of the strategy through communication with

public and financial markets

(e) Increased accountability of the CB for attaining its inflation objectives

e.g.,New Zealand (1990)

• Inflation was brought down & remained within the target most of the

time• Growth has generally been high & unemployment has come down

significantly

Canada (1991)

• Inflation decreased since then, some costs in terms of unemployment

United Kingdom (1992)

• Inflation has been close to its target

• Growth has been strong & unemployment decreasing

Advantages of inflation-targeting(1) reduces potential of falling in time-inconsistency trap

(2) highly transparent & easily understood by the public

(3) Increased accountability of the CB


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Disadvantages of inflation-targeting

(1) Delayed signaling as lag effects of monetary policy imply hat

outcomes are only revealed after substantial lags(2) Too much rigidity which restricts monetary policymakers in responding

to unforeseen circumstances(3) Potential for increased output fluctuations as sole focus on inflation

may lead to overly tight monetary policy

(4) Low economic growth even when low inflation is already achieved

The Fed’s monetary policy strategy: “Just Do IT”

The fed does not use an explicit anchor such as an inflation target

• Fed’s strategy involves an implicit nominal anchor in the form of an

overriding concern to control inflation in the LR (commitment to price

stability both in the SR and LR)• Forward-looking behaviour which involves close monitoring of signs of

future inflation & periodic “preemptive strikes” of monetary policy

against the threat of inflation

• The goal is to prevent inflation from getting started – hence, monetarypolicy needs to be forward-looking and preemptive

Advantages of the Fed’s approach

• Uses many sources of information to determine the best settings for

monetary policy • Forward-looking behaviour & stress on price stability help to

discourage overly expansionary monetary policy thereby reducing the

time-inconsistency problem

Disadvantages of the Fed’s approach

• Lack of transparency tends to generate a high level of uncertainty thus

leading to volatility in financial markets

• Heavy dependence on the preferences, skills and trustworthiness of

the individuals in charge of the CB

Tactics: choosing the policy instrument

Central bank directly controls the three tools of monetary policy

(1) Open market operations

(2) Reserve requirements

(3) Discount rate

To examine whether monetary policy is easy or tight, we can observe the

policy instrument (operating instrument)

•

Policy instrument is a variable that responds to the CB’s tool andindicates the stance (easy or tight) of monetary policy


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Tactics: policy instruments, intermediate targets, and goals

Two basic types of policy instruments:

(1) reserve aggregates(2) interest rates

The policy instrument could be linked to an intermediate target (intermediatetargets can be any economic variable that is not directly controlled by the

central bank. Although not directly controlled by the central

bank, intermediate targets will often quickly adjust to policy changes and

behave in a predictable manner relative to the Federal Reserve's economic

goals) e.g., monetary aggregate like M2, or a long-term interest rate

The intermediate target, in turn, is closely linked to the goals of monetary

policy such as price stability, employment and economic growth

Linkages between central bank tools, policy instruments, intermediate targets

and goals of monetary policy

Criteria for choosing the policy instrument(1) Observability & measurability: quick observability & accurate

measurement of a policy instrument are important for signaling the

policy stance rapidly

(2) Controllability: central bank must be able to have effective controlover the policy instrument (i.e., variable) to ensure that the variable

stays on target if it gets off-track


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(3) Predictable effects on goals: critical to the usefulness of the policy

instrument, hence, is the most important characteristic of a policy

instrument

Tactics: the taylor ruleThe Fed conducts monetary policy by setting a target for short-term interest

rates like the fed funds rate

Federal funds rate target = inflation rate + equilibrium real fed funds rate +

! (inflation gap) + ! (output gap)

• Taylor assumed that the equilibrium real fed funds rate = 2%

•

As the


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(4) Lecture 8: Quantity theory, inflation and demand for money & themonetary policy & aggregate demand curves

Quantity theory of money

•

MV = PYAssumptions: V and Y are constant, thus change in price is determined solely by quantity of money

When the market money is in equilibrium, Md = M,

• Md = (1/V) x PY

Since 1/V is constant, the level of transactions generated by a fixed level of

PY determines Md

Thus, Md not affected by interest rate (according to Fisher’s model)!

The amount of money each individual decides to hold is independent ofinterest rate

budget deficits & inflation

Budget deficit = G (gov. expenditure) – T (tax revenue) = !MB + !B

How the government may finance a budget deficit:(1) raise revenue through: levying taxes

(2) borrowing through selling government bonds

(3)

creating money (printing?

Reveals two important facts:

(1) if government deficit is financed by increased bond holdings by thepublic, increase in B, no !MB! no change in money supply

(2) if government deficit is financed otherwise, increase in MB ! change

in money supply (increase)

hyperinflation

periods of extremely high inflation (>50%/month)arises when governments print money to finance their budget deficit

e.g., Zimbabwe in 2007 with hyperinflation of 1,500%

Keynesian theories of money demand

Keyne’s liquidity preference theory, abandoning the quantity theory view thatvelocity was constant

Why do individuals hold money?

(1)

transactions motive (medium of exchange)


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new methods of payment, payment technology , could also affect the

demand for money! transactions not proportional to income

(2) precautionary motive (cushion against unexpected wants)precautionary money proportional to income

(3)

speculative motive (store of wealth)assumption that money holds no interest, hence opportunity cost ofholding money relative to other assets (e.g., bonds) is the nominalinterest rate on bonds

as interest rate rises, then the opportunity cost of holding money

increases, resulting in a fall in quantity of money demanded

putting the three motives together

Keynes distinguishes between real and nominal quantities of money

Money is valued in terms of what it can buy (real terms)Md/P = f(i, Y)

Demand for real money is negatively related to i and positively related to Y

V = Y/f(i, Y)

Thus, velocity is not constant but will fluctuate with changes in interest rates • rise in i! L(i, Y) falls! V rises

• fall in i! L(i, Y) rises! V fallsProcyclical movements (expansions and recessions) should induce procyclicalmovements in velocity

Portfolio theories of money demand

Examine peoples’ decisions to hold a money asset (e.g., money) as part of

the overall portfolio of assets

Theory of portfolio choice & Keynesian liquidity preference

Theory of portfolio choice justifies the conclusion from Keynesian liquidity

preference function (Md/P = f(i, Y)) that demand for real money is negatively

related to i and positively related to Y

Factors affecting demand for money:

(1) (positive) wealth: W rises ! more resources to buy assets ! Md rises;

W falls! less resources to buy assets! Md falls

(2) (positive) risk (of an asset relative to money assets): risk rises ! Md

rises; risk falls! Md falls(3) (negative) liquidity (of an asset relative to money assets): liquidity rises! Md falls; liquidity falls, Md rises

interest rates & money demand


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under the quantity theory of money ! interest rates do not affect money

demand! velocity is constant

however, the more sensitive money demand is to interest rates, the more

unpredictable velocity will be

stability of money demand

Keynes believed that the money demand function is unstable & undergoes

substantial unpredictable shifts

• rapid pace of financial innovation since 1970s! substantial instability

• velocity is not constant! unpredictable

• hence, quantity theory of money may not hold

*crucial to whether the Fed should:(1) target interest rates or

(2) money supply (however, this is very much dependent on the stability of

money demand )

hence, the Fed typically targets the interest rate, and has downgraded its

focus on money supply in its conduct of monetary policy since the level ofinterest rates provide more information about the stance of monetary policy

than the money supply

federal reserve & monetary policy

the Fed conducts monetary policy by setting the federal funds rate (the

interest rate at which banks lend to each other)

when the Fed lowers the ff rate, real interest rates fall

when the Fed raises the ff rate, real interest rates rise

monetary policy curve:

r = autonomous component of r + " (responsiveness of r to inflation) x #


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Curve shows how monetary policy, measured by the real interest rate, reacts

to the inflation rate, #

Taylor principle: upward-sloping monetary policy curve

Key reason: central banks seek to keep inflation stable

Taylor principle: nominal interest rates must rise when expected inflation

rises, so r rises when # rises

If a bank allows r to fall when # rises, then:# rises (while r falls due to non-intervention) ! AD rises ! # rises some more

(still no intervention in r)! AD rises some more ! worsening inflation

two types of monetary policy action that affects interest rates(1) automatic (taylor principle) changes! movements along the MP curve

(2) autonomous changes! shifts of the MP curve

• autonomous tightening of monetary policy (contractionary) that shifts

MP upward (in order to reduce inflation)• autonomous easing of monetary policy (expansionary) that shifts MP

downward (in order to stimulate the economy)

the aggregate demand curvedownward-sloping

represents the relationship between the inflation rate and aggregate demand

when the goods market is in equilibrium

the AD curve is central to aggregate demand and supply analysis ! explainshort-run fluctuations in both aggregate output and inflation

deriving the AD curve

(1)

MP curve(2) IS curve (investments/saving)


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Factors that shift the aggregate demand curve

Shifts in the IS curve:

(1) autonomous consumption expenditure(2) autonomous investment spending

(3)

government purchases(4) taxes(5) autonomous net exports

any factor that shifts the IS curve shifts the AD curve in the same direction

Shifts in the MP curve:(1) an autonomous tightening of monetary policy ! rise in real interest

rate at any given inflation rate ! shifts the AD curve to the left

(2) an autonomous easing of monetary policy ! fall in real interest rate at

any given inflation rate! shifts the AD curve to the right


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Lecture 9: Monetary policy theory

Response of monetary policy to shocksMonetary policy should try to minimize the inflation gap = difference

between inflation and inflation target (# - #T

)

AD shocks

LRAS shocks

• Policymakers can simultaneously pursue price stability & stability in

economic activity

SRAS shocks

• Policymakers can achieve either price stability or economic activity

stability, BUT NOT BOTH!!! • This tradeoff poses a dilemma for central banks with dual mandates (vs

hierarchical mandates: price stability as primary goal)

Short-run aggregate supply (SRAS) curve

# = #e + $(Y+ Y p) + %

SRAS curve is upward -sloping to reflect the increase in inflation which occurs

when the Y exceeds potential output (Y p

)

The SRAS equation indicates that a rise in expected inflation (#e) will shift the

SRAS curve up to the left


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Response to an AD shock

CB can respond to this shock in two possible ways:

(1) no policy response

(2) policy stabilizes economic activity & inflation in the SR


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Response to an LRAS shock

CB can respond to this shock in two possible ways:

(1) no policy response

(2) policy stabilizes inflation


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response to an SRAS shock

policymakers face a short-run trade-off between stabilizing inflation &

economic activity(1) no policy response

(2) policy stabilizes inflation (in the SR)

(3) policy stabilizes economic activity (in the SR)


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relationship between stabilizing inflation & stabilizing economic activity

(1) if most shocks to the economy are AD shocks or SRAS shocks, then

policy that stabilizes inflation will also stabilize economic activity, evenin the SR

(2)

if SRAS shocks are more common, then a central bank must choosebetween the two stabilization objectives in the SR

(3) in the LR, there is no conflict between stabilizing inflation & economic

activity in response to shocks

how actively should policy makers try to stabilize economic activity?

All economists have similar policy goals (high unemployment & price

stability), YET they often disagree on the best approach to achieve those

goals

Nonactivists (e.g., classical economists who believe wages and prices are fully

flexible) argue that government action is unnecessary to eliminate

unemployment

Activists (e.g., Keynesians who believe that the price adjustments are slow &

wage & prices are stick) argue that government action is necessary toeliminate high unemployment when it develops

Lags and policy implementationSeveral types of lags prevent policy makers from shifting the AD curve

instantaneously

• data lag: time needed to obtain data indicating what is happening inthe economy

• recognition lag: time needed to be sure of what the data are signaling

about the future course of the economy

• legislative lag: the time needed to pass legislation to implement a

particular policy

•

implementation lag: time needed for policy makers to change policyinstruments once they have decided on the new policy

• effectiveness lag: time needed for policy to actually have an impact

causes of inflationary monetary policy

primary goal of most governments is high employment HOWEVER this canbring high inflation

the following two types of inflation can result from an activist stabilization

policy to promote high unemployment:


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(1) cost-push inflation results either from

a. negative SRAS shock

b. workers push for wage hikes beyond what productivity gains

can justify

(2) demand-pull inflation results from policy makers pursuingexpansionary policies that raise AD


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Lecture 10: Role of expectations in monetary policy

Lucas critique of policy evaluationMacro-econometric models are used by economists to:

•

forecast economic activity• evaluate the potential effects of policy options

HOWEVER

Lucas argues that econometric models are unreliable for evaluation of policy

options if they do not incorporate rational expectations . Further, when

policies change, public expectations will shift as well , and such changing

expectations (ignored by conventional econometric models) can have a real

effect on economic behaviour & outcomes

Policy conduct: rules or discretion?

Policy rules : binding plans that specify how policy will respond (or not) to

particular data such as unemployment & inflation

Policy discretion: applied when policymakers make no commitment to future

actions, but instead make what they believe in that moment to be the rightdecision in the situation

Types of rulesExamples of rules:

(1) Milton Friedman’s constant money-growth-rate rule ! money supply

is kept growing at a constant rate regardless of the state of theeconomy

(2) Variants of the Friedman rule, as proposed by Bennett McCallum and

Alan Meltzer, allow the rate of money supply growth to be adjusted

for shifts in velocity

Case for rulesArgument #1: Lead to desirable long-run outcomes ! avoids time-

inconsistency problem (the tendency to deviate from long-term plans when

making short-term decisions )

• policymakers are often tempted to pursue expansionary policy

to boost output in the short run but the best policy is not topursue it

• unexpected expansionary policy will raise workers & firms’

inflation expectations, thus driving up wages and prices and the

end result will be higher inflation but no increase in output


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• Thus, the time-inconsistency problem suggests that a policy will

have better inflation performance in the LR if it doesn’t try to

surprise people with an unexpectedly expansionary policy, butinstead sticks to a certain rule to keep inflation under control

Argument #2: Policymakers and politicians cannot be trusted ! strong

incentives to pursue expansionary policy if it can help them win the next

election. Thus, political business cycle, in which expansionary policies areoften adopted just before elections, tend to result in higher inflation during

election years

Case for discretion

Argument #1: Rigidity disallows for contingency

Argument #2: Judgment based on reliable sources of information require

time, and may not be accessible by policymakers! not incorporated

Argument #3: True model of the economy unknown

Argument #4: Structural changes in the economy over time would lead tochanges in the coefficients of the model (regardless of whether the model

was correct initially)

Constrained discretion (best of both worlds??? RULES + DISCRETION)

Developed by Ben Bernanke & Frederic MishkinConstrained discretion imposes a conceptual structure and inherent

discipline on policymakers while allowing some (constrained) discretion

• Discretion is afforded to policymakers within a clearly-articulated

framework in which the general objectives and tactics of policymakers(though not the specific actions) are committed in advance


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The role of credibility & a nominal anchor

An important way to constrain discretion is by committing to a nominal

anchor (a nominal variable that ties down the price level or inflation to

achieve price stability )

If the commitment to a nominal anchor has credibility (believed by thepublic), it will have the following benefits:

• help overcome the time-inconsistency problem by providing an

expected constraint on discretionary policy

• help to anchor inflation expectations, leading to smaller fluctuations in

inflation and aggregate output

Credibility and positive AD shocks

Recall SRAS: # = #e + $(Y+ Y p

) + % Inflation = expected inflation + $(output gap) + price shock

In response to positive AD shock, the appropriate policy response is totighten monetary policy so that the short-run AD curve shifts back while

inflation falls back down to the inflation target, #t

If bank is credible: then #e will remain unchanged , and SRAS will not shift. Credibility has the benefit of stabilizing inflation when faced with positive demand shocks in the SR.

If bank is not credible: then #e will rise as the public is unsure whether action

will be taken to drive AD back down, thus resulting in SRAS shifting up, #

rises.


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Credibility & negative AD shocks

In response to a negative AD shock and to stabilize output and inflation, the

appropriate policy response is to ease monetary policy to move the AD backto its original position, while inflation rises back up to the inflation target, #t.

If the bank is credible: then #e will remain unchanged so that the SRAS willnot shift . Credibility has the benefit of stabilizing inflation when faced withnegative demand shocks in the SR.

If the bank is not credible: the public will see an easing of monetary policy toincrease AD as the central bank losing its commitment to the nominal anchor! will pursue inflationary policy in the future! #e rises! SRAS shifts left

Thus, weak credibility causes a negative demand shock to produce an even

larger contraction in economic activity in the SR.


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Credibility and negative SRAS shocks

SRAS shifts left but how much depends on the amount of credibility of CB

If the credibility of the nominal anchor is strong (credible), #e will not rise

much, so the upward shift of SRAS will be small

If the credibility of the nominal anchor is weak (not credible), #e will rise, sothe upward shift of SRAS will be large, resulting in even higher inflation andlower output

Hence, monetary policy credibility has the benefit of producing better

outcomes on both inflation and output in the SR when faced with negative

supply shocks .

Application: a tale of three oil price shocks

In 1973, 1979, and 2007, the US economy was hit by 3 major negative supplyshocks when the price of oil rose sharply.


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1973, 1979 episodes: weak credibility ! unable to keep inflation under

control

2007 episode: strong credibility ! Fed able to keep inflation low and stable

for a long period of time.

Hence, arguable that the 2007 oil price shock had a smaller impact on

inflation as monetary policy had been more credible.

Credibility and anti-inflation policyConsider an economy with current inflation of 10% (pt. 1). Suppose the

central bank decides to reduce inflation down to 2% by tightening monetary

policy, which shifts AD to the left from AD1 to AD4, and the economy issupposed to move to pt. 4 in the LR (where inflation is 2%)

If central bank is not credible/very little credibility ,Public will not be convinced that the CB will stay the course to reduce

inflation and #e will not be revised down from the 10% level. Hence, SRAS

remains unchanged at AS1, and the economy will move to pt. 2, where

inflation falls to #2 and aggregate output will decline to Y2.


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If central bank is credible,

Public believes that the CB will do whatever it takes to lower inflation, thus #e

will be revised down from the 10% level. Hence, SRAS will shift downwards toAS3 as the economy moves to pt. 3.

Basically: the greater the credibility of the CB with regards to inflation

reduction, the more rapid the decline in inflation will be. Additionally,achieving the same inflation target would result in a lower loss of output (Y is

closer to the natural rate of unemployment)

Establishing central bank credibility

(1) Inflation targeting

Strategy that involves:

• Public announcement of medium-term numerical targets for

inflation

•

An institutional commitment to price stability as the primary, long-run goal of monetary policy

• Increased transparency of the monetary policy strategy through

communication with the public and the markets

• Increased accountability of the CB for attaining its inflation

objectives

• E.g., New Zealand, Canada and the UK

(2) Appoint “conservative” central bankers who are “hawkish” on inflation

(strong aversion to inflation)


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• The public will then expect that the “conservative” central banker

will be less tempted to pursue expansionary monetary policy and

will try to keep inflation under control• Hence inflation expectations will be held down at low levels with

actual (realized) inflation remaining low in the long run.


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Lecture 11: The international role of money

Foreign exchange marketForeign exchange market: the financial market where exchange rates we

determinedExchange rate: price of domestic assets in terms of foreign assets

Appreciation: a currency rises in value relative to another currency

Depreciation: a currency falls in value relative to another currency

Asset market approach to exchange rate determination

In the past, the supply and demand approaches to exchange rate

determination emphasized the role of import and export demand ! flows ofexports and imports

Mishkin used the modern asset market approach to exchange rate

determination! stock of assets

Why? Export and import transactions are small relative to the amount ofdomestic & foreign assets at any given time

*Assume: domestic assets denominated in $US, foreign assets in euros

Supply curve for domestic assetsQuantity of dollar assets supplied is primarily the quantity of bank deposits ,bonds and equities in the US

*Assume: amount of domestic assets is fixed (supply curve is vertical )


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Demand curve for domestic assets

• Most important determinant: relative expected return of domestic

assets • A lower value of the exchange rate (e.g., E*) implies that the dollar is

more likely to appreciate• The greater the expected appreciation of the dollar, the higher the

relative expected return on the domestic assets

• With higher relative expected returns, the theory of portfolio choice

suggests that dollar assets are relatively more desirable to hold

• Hence, the quantity demanded of dollar assets is higher when the

current exchange rate falls

Explaining changes in exchange rates

Exchange rate changes can be explained by the demand and supply analysisof the foreign exchange market.

• Assume: supply of domestic dollar assets is fixed (supply is vertical at a

given quantity and does not shift)

Hence, only factors that shift the demand curve for domestic dollar assets toexplain exchange rate changes over time

Factors that result in a shift in the demand for domestic assets (at any given

exchange rate)

(1)

domestic interest rate (iD

)• suppose the domestic dollar assets pay interest rates iD

When iD rises, the return on domestic assets increases relative to return onforeign assets

• People desire more domestic assets relative to foreign assets

• Demand for domestic assets rise (D1 ! D2)

• Equilibrium exchange rate rises from E1 to E2

• Domestic currency appreciates


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When iD falls, the return on domestic assets decreases relative to return on

foreign assets

• People desire fewer domestic assets relative to foreign assets• Demand for domestic assets fall (D1 ! D2)

•

Equilibrium exchange rate falls from E1 to E2 • Domestic currency depreciates

(2) foreign interest rate (iF)

•

suppose the foreign assets pay interest rate iF

When iF rises, the return on foreign assets increases relative to return on

domestic assets

• people desire fewer domestic assets relative to foreign assets• demand for domestic assets falls (D1 ! D2)

• equilibrium exchange rate falls from E1 to E2

• domestic currency depreciates


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When iF falls, the return on foreign assets decreases relative to return on

domestic assets

• people desire more domestic assets relative to foreign assets• demand for domestic assets rises (D1 ! D2)

•

equilibrium exchange rate rises from E1 to E2 • domestic currency appreciates

(3) expected future exchange rate (Eet+1)

When Ee

t+1 rises, the expected appreciation of domestic currency• higher relative expected return on domestic assets vis-à-vis return on

foreign assets

• people desire to more domestic assets relative to foreign assets• demand for domestic assets rises (D1!D2)

• equilibrium exchange rate rises from E1 to E2

• domestic currency appreciates


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When Eet+1 rises, the expected appreciation of domestic currency

• higher relative expected return on domestic assets vis-à-vis return on

foreign assets• people desire to more domestic assets relative to foreign assets

•

demand for domestic assets rises (D1!D2)• equilibrium exchange rate rises from E1 to E2• domestic currency appreciates

Application: Global financial crisis and the dollar

2007: interest rates fell in the US and remained unchanged in EuropeResult: US dollar depreciated

mid-2008: interest rates fell in the Europe; increased demand for UStreasuries! “flight to equality”

Result: US dollar appreciated

Exchange rate regimes in the international finance system

Classified into two basic types:

(1)

Fixed exchange rate regime• Value of a currency is pegged relative to the value of one other

currency (anchor currency)

(2) Floating exchange rate regime

• Value of a currency is allowed to fluctuate against all other currencies


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Intervention in the foreign exchange market under fixed exchange rate

regime

When exchange rate is overvalued (Epar > E1)

•

Suppose the domestic currency is fixed relative to an anchor currencyat Epar

• Assume initially that the demand curve shifted to the left to D 1

(perhaps due to a rise in foreign interest rate which lowers the relative

expected return on domestic assets)

• Thus, the exchange rate fixed at Epar is overvalued

Intervention by central bank: buy domestic assets by selling foreign assets

(loses international reserves )

•

To keep the exchange rate fixed at Epar , the central bank mustintervene in the foreign exchange market

• Similar to open market sale: reduces the money supply thereby

causing a rise in the interest rate on domestic assets (iD)

• The rise in iD increases the relative return on domestic assets, thusshifting the demand curve to the right to D2 where Epar is established


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When exchange rate is undervalued (Epar < E1)

• Suppose the domestic currency is fixed relative to an anchor currency

at Epar• Assume initially that the demand curve shifted to the right to D1

(perhaps due to a fall in foreign interest rate which raises the relativeexpected return on domestic assets)

• Thus, the exchange rate fixed at Epar is undervalued

Intervention by central bank: sell domestic assets by buying foreign assets

(gains international reserves )

• To keep the exchange rate fixed at Epar , the central bank must

intervene in the foreign exchange market

• Similar to open market sale: increases the money supply thereby

causing a fall in the interest rate on domestic assets (iD

)• The fall in iD decreases the relative return on domestic assets, thus

shifting the demand curve to the left to D2 where Epar is established


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Exchange rate effects on monetary policy

Direct effects of the foreign exchange market on monetary policy:

• To avoid depreciation, CB should pursue a contractionary monetarypolicy to raise domestic interest rate thereby strengthening its

currency• To avoid appreciation, CB should pursue a expansionary monetary

policy to cut domestic interest rate thereby weakening its currency

To peg or not to peg? Exchange-rate targeting as an alternative monetary

policy strategy

Two monetary policy strategies to promote price stability

(1) Inflation targeting

(2) Exchange-rate targeting

Exchange-rate targeting

Different forms of exchange rate targeting:

(1) Fix the value of the domestic currency to that of a large, low-inflation

country (a.k.a. the anchor country, e.g., US)(2) Crawling target/peg: domestic currency is allowed to depreciate at a

steady rate so that the inflation in the pegging country can be higherthan that in the anchor country

Advantages of exchange-rate targeting(1) Keeping inflation under control : by tying the inflation rate for

internationally traded goods to that found in the anchor country

(2) Automatic rule for conduct of monetary policy that reduces time-inconsistency problem:

Forces:

• a tightening of monetary policy when there is a tendency

for the domestic currency to depreciate

• easing when there is a tendency for the domestic

currency to appreciate• CB may be tempted to deviate from LR objective of price

stability to expand output and employment in the SR

(3) Simplicity & clarity : exchange rate target is easily understood by the

public

Disadvantages of exchange-rate targeting

(1) Shocks to anchor country are transmitted to the targeting country

Any shock to the anchor country are directly transmitted to the

targeting country because changes in interest rates in the anchor


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country lead to a corresponding change in interest rates in the

targeting country

Key example: 1990 German reunification

•

Massive fiscal expansion to rebuild East Germany led to asignificant rise in German interest rates in 1991

• Shock (rise in interest rates) to Germany (the anchor country)

was transmitted directly to other countries in the exchange rate

mechanism (ERM) whose currencies were pegged to the

German mark and which caused interest rates to rise in those

countries

(2) Open to speculative attacks on currency

•

Exchange rate targeting implies that the targeting countries willhave to maintain similar monetary policy stances

• Thus, when the anchor country maintains tight monetary policy

(to control inflation) which causes high unemployment, the

targeting countries must do the same, resulting in highunemployment as well

• Currency speculators might exploit the targeting countries’governments’ intolerance to high unemployment !

depreciation

•

Thus, this would encourage speculative attacks against thecurrencies of the targeting countries in selling these currencies

before the likely depreciation occurred.

(3) Weakens the value of exchange rate as a signal for monetary policy

• Under a floating exchange rate regime, the exchange rate will

depreciate in response to overly-expansionary monetary policy! early warning signal

• However, exchange rate targeting fixes the exchange rate thus

making it hard to ascertain the central bank’s policy actions.

• Public is less able to keep watch on the central bank’s stance on

monetary policy!

monetary policy more likely to be overly-expansionary

Documents

EC3332 Lecture 7-11 Summary