III. Intermediate targets

------Monetary Aggregates (M1, M2)

------Interest rates (short term; e.g. fed funds rate

------May be linked to an intermediate target

 

IV. Goals

------Price Stability (reduced uncertainty about prices)

------High Employment (reduced uncertainty about incomes of households)

------Economic Growth (reduced uncertainty about future incomes, opportunities)

------Financial Market Stability (Systemically stable)

------Interest rate Stability (reduced uncertainty about prices)

------Foreign Exchange Market Stability (reduced uncertainty re: FX prices)

 

This outline above is displayed  in a choices/causes/effects graphic in Fig.2:

 Tools -> Policy Instruments -> Intermediate Targets -> Goals

 

 

============================================== 

p.413

 

*CRITERIA FOR CHOOSING THE POLICY INSTRUMENT

------Observability and Measurability

------Controllability

------Predictable effect on Goals

 

==============================================

pp. 414-416

*The Taylor Rule, (a) NAIRU (“natural” market rates of unemployment) theory, and the PHILLIPS CURVE (correlation between unemployment & inflation) theory

=>TAYLOR RULE TO SET the Federal funds target rate =  Sum of the following:

-------(1)  Inflation rate

-------(2)  Equilibrium fed funds rate

-------(3)  (1/2)x(inflation gap)

-------(4)  (1/2)x(output gap)

 

Taylor assumed the concepts of:

=(a) An inflation gap and

=(b) an output gap

------Stabilizing real output is an important concern

------Output gap is an indicator of future inflation as shown by Phillips curve ‘theory’ or statistical relationship

and the so-called NAIRU theory (non-accelerating-inflation rate of unemployment---a ‘natural’ result of market system)

------NAIRU is the Rate of unemployment at which there is no tendency for inflation to change

 

Fig. 5:  The Taylor Rule for the Fed funds rate, 1970-2008

(Mishkin believes it shows something clearly, but it is not made clear why he thinks so since evidence is lacking, although, since he appears to have helped put it into practice at the Fed, he sees some merit in it perhaps.}

==================================================== 

 

BUBBLES    BUBBLES    BUBBLES ---MUDDLED MUDDLED MUDDLED

 

CENTRAL BANK’S RESPONSE TO ASSET PRICE BUBBLES:

LESSONS FROM THE SUBPRIME CRISIS

-Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burst.

 

-Types of asset-price bubbles

------Credit-driven bubbles

-----------Subprime financial crisis

------Bubbles driven solely by irrational exuberance

 

-Should central banks respond to bubbles?

------Strong argument for not responding to bubbles driven by irrational exuberance

------Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same time….{Rock sees role here, even if Mishkin does not.}

------Monetary policy (too blunt an instrument) should not be used to prick bubbles.

 

{Rock NOTE:  Mishkin distinguishes between ‘MONETARY’ POLICY and ‘REGULATORY POLICY’ (over banks practices) even though central banks are sometimes responsible for both. His discussion here is a bit muddled, even in the 2010 edition he is a bit baffled it seems about what to do against it happening again, but he does consult with banks….so maybe a conflict of interest is at play. }

 

-Macropudential regulation: regulatory policy to affect what is happening in credit markets in the aggregate.  {Rock:  i.e. it sounds like STRONG REGULATION OF FINANCIAL MARKETS …to deal with financial institutions that can contribute to credit-fueled bubbles}

 

{Rock notes:

-Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction.  {Mishkin! =>And do what?}

-But thinks that the CB can let ‘irrational exuberance’ bubbles just explode without worry  (but Japan late 1980s seems to contradict this).   }

 

========================================================= 

========================================================= 

Notes by Rock and taking additional ideas from the Reorganized Chapter 16 in 2010 edition (Conduct of Monetary Policy: Strategy & Tactics) by Mishkin who finally addresses crises and bubbles in a more complicated way that points to great uncertainties about monetary and financial policies since the mainstream of economics almost universally missed warning signs of the latest crisis that might have led to more proactive policy to prevent the collapse. 

 

First, however, a narrative summary of the chapter’s main themes to accompany the notes in the previous section (outline form) above.

 

This chapter (16) outlines the strategy and tactics of central bank policymaking. It starts by discussing three strategies—monetary targeting, inflation targeting, and monetary policy with an implicit nominal anchor—that the Fed (led by chairman and free markets and minimal government ultra-neoliberal economist Alan Greenspan in 1986-2006) has tried to employ at different periods in time.

 

A type of summary of the mainstream economists’ debates about best policy choices is found in Table 1.

The chapter then discusses monetary policy tactics: in particular, what policy instrument should be chosen to conduct monetary policy, and what the trade-offs are since it is rarely possible to achieve everything simultaneously, and the choice of one policy goal, or even of one intermediate target may make another impossible to achieve (the “incompatibility”).  This can also be true of ‘tools’ one can use at the same time. 

 

The first (1st) tactical issue is summarized in Figures 2 and 3 that illustrate why (a) targeting on a monetary aggregate like nonborrowed reserves implies a loss of control of interest rates like the federal funds rate, while (b) targeting on the federal funds rate (the interest rates private banks charge each other for short-term loans among themselves) implies a loss of control of monetary aggregates. The analysis of this problem of incompatibility can also be done in terms of the supply and demand for reserves framework, which the author does.

 

The second (2nd) tactical issue is how to set a target for the federal funds rate with the so-calledTaylor rule. The Fed often focuses on inflation but also on fluctuations around potential output. The role of the output gap in setting monetary policy follows from Phillips curve theory (that price inflation and the unemployment rate are highly correlated) and the theoretically assumed validity of the NAIRU concept.  (This theory holds:  that for any economy there is a relatively stable short-run ‘natural’ rate of unemployment and if policy seeks to lower unemployment below it, then only inflation occurs. Thus the “non-accelerating inflation rate of unemployment.” or NAIRU, refers to the lowest rate of unemployment that can be achieved without leading to rising inflation rates (and, even worse, if there is too-low unemployment, below the NAIRU, then the inflation will continue to grow even higher--getting even larger as time goes on, and thus “accelerating”) .  The adequacy (theoretical validity or accuracy) of the Phillips curve statistical correlation and NAIRU theory have become very controversial in recent years:  some argue that one or both are false or inaccurate descriptions of real world economies in all periods. 

 

The third (3rd) tactical (or better, ‘strategic’)  issue has been brought to the fore lately by the subprime financial crisis: that is, how should central banks respond to asset-price bubbles. Asset-price bubbles involve huge booms in asset prices and then crashes.

 

========================================  ============

In Class Rock spent a lot of time discussing the following.  These chapters (15 & 16) are the most clearly ‘ideological’ of the ones assigned in this course.  Mishkin writes as though he is mainly on the “Right” although at times he discusses ideas from the “Center” or ‘centrist economists’.  He does not really discuss the “Left” ideologies at all (although they often share some of the ideas of the Center, since some ‘centrists’ believe that market systems can be very unstable, and crisis may occur that needs strong government intervention at least temporarily).

 

 “RIGHT”----“CENTRISTS”-----“LEFT” 

 

ECONOMIC IDEOLOGIES

 

*DIFFERENT IDEOLOGIES WILL TEND TO differ about several things (completely different IDEAS or in some cases the RANKING THEY GIVE TO THINGS):

--different POLICY PRESCRIPTIONS (what are best policies to help market system), and

--different CORE VALUES (political philosophies that correlate with different priority social values and norms),

--different ideas on what can be expected from MARKET SYSTEMS or GOVERNMENTS,

--different FAVORITE THEORIES, METHODOLOGIES FOR ‘DOING ECONOMICS’,

--different PHILOSOPHIES OF WHAT IS APPROPRIATE EVIDENCE IN GENERAL

--different emphases about what are the most relevant cases the provide EVIDENCE FROM ECONOMIC HISTORY about how market systems work in practice.

 

Different Ideologies and How to Steer a Market-based Private-property dominated Economy and avoid Bubbles, Burstings, Banking Crises/Freezes, Possible Collapse and associated effects bringing about Real Economy Crises: 

 

The issue of what should be done about asset-price bubbles is very controversial

 

For example, two opposing views are:

---(I) that central banks should not respond at all (believing that financial markets will self-correct without government intervention), which is the position associated with Alan Greenspan and neoliberal economists and also with Milton Friedman and the ‘Monetarists’ who were influential in the 1970s and 1980s, and the ‘Rational Expectations’ or ‘Real Business Cycles’ theorists who were very influential in macroeconomics in the 1985-2007 period, or

---(II)that alternatively, monetary policy should try to preemptively prevent  bubbles (i.e. stop them before they can develop much at all) through tight regulatory control of practices of financial institutions as well as more aggressive monetary policy respecting the flows of credit that often inflate asset prices and lead to dangerous bubbles that may even threaten the entire financial system (moderate centrist ‘Keynesians’ viewpoint).  These are the ‘Centrists’.  They were most influential in the 1945-mid-1970s, and in fact never lost influence to a large degree about fiscal policies,  but in micro (markets regulations) policy-making, they did lose influence during the great deregulation of financial institutions from 1979-2007.

(These two—I & II—are the only two really treated at all  in Mishkin book)

 

There are more than these two, including:

---(III)  A more radical perspective calls for very profound policy reforms of financial institutions, their governance and compensation, of taxation on financial transactions, more punitive sanctions for illegal behavior in financial markets, and a variety of other policy changes.  Economies that have experienced policies dominated by this view include all of the Scandinavian countries (especially Sweden from 1932-1980, and then intermittently since then) and to some extent the Netherlands, Austria, and even Germany.  These policies are always contested (governments are elected for these policy approaches but may not rule for long periods when there are governments are elected by conservatives (free market optimists, like viewpoint I), and more centrist governments following standard moderate ‘Keynesian’ policies like viewpoint II). 

 

This ‘Left’ view is often joined with a more radical approach to the overall management of monetary policy than either of these two viewpoints (I and II, above), and can also argue for more aggressive focus onfiscal  policies AND the ‘real economy’ (in monetary policies, then full employment is part of the issues considered and employment effects are indirectly being targeted with accommodating monetary policies in in particular) and reforming the actual institutional features of the macroeconomy (e.g. the nature of any incomes policy). 

 

It can also argue that with a more equal national income distribution (very usual), an explicit “incomes policy” (negotiated macroeconomic distribution policies often shaped by labor movements and/or institutional features supporting them)and a less oligopolistic industrial structure (less frequently) will allow successful and somewhat alternative monetary theory and policies. 

 

This perspective is associated with economic ideologies associated with ‘post-Keynesians,’ ‘left-Keynesians,’ ‘social-democratic egalitarian-system macroeconomists’ (of ‘scandinavian’ or ‘corporatist’ economic systems), and thinkers like Hyman Minsky, Paul Davidson, the ‘true’ Keynes and not the ‘bastard’ Keynes as named by Joan Robinson, and many others stressing ‘political economy’ (institutionally rich and often ‘negotiated economic relations and not the theoretical decentralized market determined results) rather than ‘pure free market economics theorizing’.  It also, for additional social welfare reasons, may advocate a much more egalitarian national and international distribution of household incomes and a well-developed welfare state system as additional social (and economic) goals that can improve economic performance as well. 

=========================== 

 

pp.420-428 (App.Ch.16) (NOT INCLUDED—Students not responsible for this below.)

 

HISTORICAL DEVELOPMENT OF MONETARY POLICY & THOUGHT

 

Historical Perspective 20th Century-today

-Discount policy and the real bills doctrine

-Discovery of open market operations

-The Great Depression 1930s

-Reserve requirements as a policy tool

------Thomas Amendment to the Agricultural Adjustment Act of 1933

-War finance and the pegging of interest rates  (WW II)

-Targeting money market conditions

------Procyclical monetary policy

-Targeting monetary aggregates (1970s-80s)

-New Fed operating procedures

------De-emphasis of federal funds rate

-De-emphasis of monetary aggregates

------Borrowed reserves target

-Federal funds targeting again

------Greater transparency

-Preemptive strikes against inflation

-Preemptive strikes against economic downturns and financial disruptions

------LTCM 1999

------Enron 2001

------Subprime meltdown 2007-2008

-International policy coordination  2008-2011

• (slightly revised version by Rock 2011-12-15):

KEY IDEAS for Chapters in Book for Students  for Learning & exams

Mishkin, 8th edition, Money, Banking and Financial Markets, 2007, but, with comments by Rock; also Mishkin changed treatments in 9th Edition (2010)

=============================================================

Ch17 (8th edition)   THE FOREIGN EXCHANGE MARKET

-In the 8th Ed Read the text material, pages 431-457

-Questions at end of chapter:  p.456

 

--(Note: In the 6th edition (Study guide) this chapter coverage is found in—Mish6ed_ch07_StGuide…

--(Note:  In the 9th edition, this chapter is the same number—This edition has several changes that make it more clear and comprehensible (section on Exchange Rates in the Short Run” and added a brief new section “Application: The Subprime Crisis and the Dollar”(p.454) It also dropped the section in the 8th edition called “The Euro, The first Seven years” [i.e. 1999-2006].  These changes can be read in the reading named  “Mish9ed_c17_ALMOSTallwSGsumOnly.pdf”. 

--(Note: Be sure to study the sample questions from Study guide in the new 9ed edition:  the document is named: Mish9ed_c17_SGALLwANS_017.pdf

======================== 

NOTES

 

*FOREIGN EXCHANGE

-Exchange rate {FX-rate}: price of one currency in terms of another

-Foreign exchange market: the financial market where exchange rates are determined

-Spot transaction: immediate (two-day) exchange of bank deposits

------Spot exchange rate

-Forward transaction: the exchange of bank deposits at some specified future date

-------Forward exchange rate

-Appreciation: a currency rises in value relative to another currency

-Depreciation: a currency falls in value relative to another currency

------Devaluation = usually refers to a action by a country to bring about the depreciation of its currency

-When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa

-Over-the-counter market (a decentralized market with many buyers and sellers; mainly banks) is where most trade in foreign exchange (buying and selling deposits in different currencies) occurs.

 

====================================================

***The FOREIGN TRADE approach to EXCHANGE RATE DETERMINATION

 

p.437

*EXCHANGE RATES IN THE LONG RUN

*Law of one price (arbitrage eliminates any price differences in identical products)

------Economists usually start their logic here for discussing foreign exchange

*Theory of Purchasing Power Parity (PPP) (goods should cost the same no matter what country they are purchased in; if not then we can say the real exchange rate is different than the market exchange rate); this theory can be true with a perfect competition market assumptions and no other complications; it includes these additional assumptions:

------All goods are identical in both countries

------Trade barriers and transportation costs are low

------All goods and services are traded across borders

 

p.436 (9ed 438)

Figure 2 of domestic & foreign price levels and exchange rates over time (1973-current) of the US and UK.

This data show that the PPP exchange rate calculation (the chart uses the relative price levels of the two countries CPI-UK/CPI-US as the measure of relative PPP) is NOT very accurate in the short run since the relative prices of the two countries are often quite different than the market FX rate for the US $ and the UK Pound…even though the trend line for both curves is the same (UK prices and UK Pound both rose relative to the US prices and $).

 

*Why doesn’t the PPP theory predict prices in the short run?

-All the goods and services in different countries are not identical

-There are trade barriers (both tariffs and ‘non-tariff barriers’)

-Some goods and services are not traded between countries (housing, land, and many services.

-It leaves out the possibility of other reasons for foreign exchange transactions, namely the desire by investors to make investments in other countries’ assets. (So we develop another more inclusive theoretical model just below.)

 

======================================================== 

***The ASSET MARKETS MODEL of EXCHANGE RATE DETERMINATION

 

This chapter explains behavior in the foreign exchange market by using the asset-market approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in economics literature, and it has major advantages over the more conventional treatment of the foreign exchange market typically found in money and banking textbooks.

The asset-market approach, in contrast to earlier approaches emphasizing import and export demand (PPP approach), can be used to explain a feature of the foreign exchange market that has received much attention in the press in recent years: the high volatility of exchange rates even in the short run. This is not well explained by the earlier flow approach because it does not predict that exchange rates should be highly volatile.

The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates. The key idea is that the demand for domestic currency (say dollar) assets is determined by the relative expected return on these assets.

 

p.437 (9th ed. p. 439)

*FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN

--(1)Relative price levels in different countries (higher US prices compared to foreign prices tends to make $ Depreciate)

--(2)Trade barriers (more barriers relative to other countries makes $ appreciate)

--(3)Consumer Preferences for domestic versus foreign goods

------Higher Foreign demand for US-made goods (compared to foreign-made ones) tends to make the $ Appreciate

-----------(=rising export demand for US goods->Appreciation

------Higher US demand for Foreign-made goods (compared to US-made ones) tends to make $Depreciate)

-----------(= rising import demand for foreign goods US consumers -> Depreciation)

--(4)Productivity differences in countries (output/labor, or output/capital; or output/(all factors of production)

------Higher productivity by US labor or capital (relative to other countries) tends to  make $ appreciate

 

p.438

*EXCHANGE RATES IN THE SHORT RUN: A SUPPLY AND DEMAND ANALYSIS

-This views the exchange rate as the price of domestic assets in terms of foreign assets

-The Supply curve for domestic assets

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

--------This supply of dollar-assets in the U.S. is mainly the quantity of (i) bank deposits, (ii) bonds and other debt instruments, and, (iii) equities or corporate stock shares. {The relatively fixed (in short run) and relatively more liquid kinds of assets, not including many in things like real property of land, rental properties, which are more like long term foreign investment placements.)

-The Demand curve for domestic assets

--------Most important determinant is relative expected return of domestic assets

--------At lower current FX values of the dollar (everything else equal), the quantity demanded of dollar assets is higher

 

 

p.439

*COMPARING EXPECTED RETURNS on DOMESTIC and FOREIGN ASSETS

-The basic idea here is that from a U.S. (domestic resident) investor’s point of view (or any investor in any country) what matters ultimately is the expected returns from assets in his/her own (domestic) currency.

---Thus these returns can be seen as the interest earned in one’s own currency whether it is earned directly in domestic assets or earned, first in foreign assets and then finally turned into domestic currency. 

---So the domestic investor will invest wherever they can get the highest return in terms of their own currencies (assuming they will do most or all of their consuming in their own currency)

 

---For this course you can forget all of the algebra in this section except for the crucial formula the captures almost all these ideas in one equation:

 

p.441

*The INTERST PARITY CONDITION

{i-rate-domestic}  = {i-rate-foreign} MINUS ( % change in FX-rate}

 

[where ‘FX-rate’ =  the (Foreign Currency/Domestic currency) ratio  ]

 

In words:  The domestic interest rate EQUALS the foreign interest rate MINUS the expected appreciation of the domestic currency

(In relation to this foreign currency, ‘appreciation’ means the ‘FX-rate’ rises).

 

{NOTE:  You are not responsible for all the rest of the algebra, unless you find it clarifies things for you since some are mathematically inclined.  I will not ask you algebraic questions about this condition, but you should understand the intuition and be able to estimate the direction  of any changes, although not the quantity of changes.}

 

Fig. 3 Graph: 

Quantity of US Assets (US)  on horizontal

Price of Euros in dollars (i.e. FX here is Euros/$ rate) on vertical

àLower FX (dollar lower value in Euros) then demand great for $-assets (less for Euro-assets)

àHigher FX (dollar is higher value in Euros) then demand for $-assets is less (and in contrast Euro-assets appear relatively good deal to buy) 

 

 

*EXPLAINING CHANGES IN EXCHANGE RATES USING ASSET-MARKET MODEL

*{Why do economist put forward a short run theory of FX changes that can differ from the one for long run changes?  Some reasons: (1) Because the FX rate DOES change in the short run, from day to day and it can be quite volatile.  (2) The amount of FX transactions daily is much greater (>25x greater) than imports and exports traded, so there are likely other reasons for currency trading than just supporting international trade.

-CAUSES of Shifts in the demand for domestic assets:

--------(a) Domestic interest rate changes à      {if domestic interest rates rise, then the demand curve for domestic assets has an increase: a shift to right [e.g. see Fig. 4.] so that at every exchange rate the quantity of domestic assets demanded is greater}

--------(b) Foreign interest rate changes à        {if foreign interest rates rise, then demand curve for domestic assets has an decrease: a shift to left [e.g. Fig. 5.] so that at every exchange rate the quantity of domestic assets demanded is less}

--------(c) Expected future exchange rate changes  à  {anything that causes a rise in the expected  future exchange rate means that the Euros/$ ratio is expected to rise and thus the dollar appreciates, leading to a rise in the relative rate of return in dollar-assets and thus demand curve for domestic assets has an increase: a shift to right [e.g. Fig. 6.] }

--------------Note that all of the 4 long run determinants of the exchange rate can also affect the expected future exchange rate also so any changes in these could have a positive or negative effect on the demand for dollar-assets.

 

p. 448 {9th ed., p.447}

Summary Table 2.   {With additional factors from later in chapter}

 This table summarizes nearly all of the factors (long run factors and the short run ones also) that cancause shifts in the demand for domestic assets.

 

-Factors leading to an increase in the Euro/$ exchange rate ($-appreciation), Ceteris paribus(assuming all else remains the same):

---1. Domestic interest rate increase

---2. Expected domestic trade barriers increase (relative to foreign)

---3. Expected export (of domestic-produced goods) demand increase

---4. Expected productivity increase (domestic relative to foreign)

---5. Expected domestic inflation Decrease (=>higher expected real domestic interest rates)

 

-Factors leading to a Decrease in the Euro/$ exchange rate ($-Depreciation), Ceteris paribus(assuming all else remains the same):

---a. FOREIGN interest rate increase

---b. Expected DOMESTIC (U.S.) price increases in goods/services

---c. Expected import (of foreign-produced goods) demand increase

---d. Expected domestic inflation increase (=>lower expected real domestic interest rate)[see Fig.7]

 

How to best learn this model?  Role Play an Investor: 

 

For help in understanding why the relative expected return on domestic assets determine exchange rates think of them acting through their effects on the demand curve for domestic assets.   These effects will cause shifts in the demand curve for domestic currency in order to buy more (or less) assets on the domestic market.  (And, since they are nearly perfectly negatively correlated, simultaneously the increase in demand for domestic currency will be associated with an equivalent decrease in the demand curve for foreign currency as it allows a decrease in the demand for foreign-currency assets, and thus the shift moves in the  opposite direction).  Students should put themselves in the shoes of an investor who is thinking about putting his or her money into foreign or domestic assets, since this can help in understanding the theory in practical terms.

 

When a factor changes, ask yourself whether at the same exchange rate, you would earn a higher expected return on domestic assets—if so, the demand curve has shifted to the right (for domestic currency). This kind of thinking will help you  predict which way the exchange rate changes.

 

Several summary tables in the chapter should help to master the material. Make sure you can explain each of these effects in practical terms for an investor. (Obviously the demand curves are the total of all investors in the market, but assuming full rationality and equal expectations held by all investors any time [not true in reality of course], they would all move in the same direction in the foreign exchange market.

 

--------------------------------

pp.447–449  (9th ed.,  p.448-450)

*APPLICATIONS: CHANGES IN THE EQUILIBRIUM EXCHANGE RATE

Example One:

*I.  Changes in INTEREST RATE (Nominal change)

----Need to remember that the market (or ‘Nominal’) interest rate is really the  combination (Fisher equation as economists call it) of two components: 

----Nominal i-rate =  Sum of (1) Real i-rate PLUS (2) price inflation

----So when there is a Nominal i-rate increase the resulting effect on exchange rates depends on what the source of the change comes from:

 

--------(Source 1) When domestic REAL interest rates rise, the domestic currency appreciates.

èThis is shown graphically (Fig.4, go back to p.444)

 

--------(Source 2) When domestic interest rates rise due to an expected increase in INFLATION, the domestic currency Depreciates

èThis is shown graphically (Fig.7, p.450)

 

--------------------------

pp.449-451  (9th ed. pp.450-451)

*APPLICATIONS: CHANGES IN THE EQUILIBRIUM EXCHANGE RATE

Example Two:

*II.  Changes in the MONEY SUPPLY

-Exchange Rate Overshooting

-Monetary Neutrality

-----In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level

-The exchange rate falls by more in the short run than in the long run

-Helps to explain why exchange rates exhibit so much volatility

 

-Higher domestic money supply causes the domestic currency to depreciate.

---(A) Short Run & Long Run effects:  An increase in the money supply is assumed to lead to an equal change of a higher domestic price level (inflation) (this idea of equal percentage changes in money supply and price level is called “money neutrality”) and this, in turn, causes a decrease in the expected future exchange rate (shift of demand curve for domestic assets—decrease in demand).  Net effect: Domestic currency Depreciation.

 

---(B) Short run, BUT Temporary Effect:  As the money supply is increased the price level may take time to rise, so in effect, temporarily the real money supply (i.e. = M-supply/Price-Level) will rise for some time.

-------(C) But, continuing with this reasoning, from (B), the rise in the real money supply is also assumed to cause the nominal and real domestic interest rates to fall; this will cause a decrease in the expected relative rate of return from domestic assets and so this will be an additional reason for decrease in the expected future exchange rate (shift of demand curve for domestic assets—decrease in demand).

-------------(D) But in the longer run, the real money supply is assumed to return to its original level as prices rise (i.e. the bottom part of the ratio rises eventually in  this ratio: = M-supply/Price-Level).  The real interest rate rises back to its original level and thus the demand for domestic assets returns to original level (considering only the effect of the real money supply and its effect on interest rates)

 

-Fig.8, p. 450 (9th ed., p. 451) represents these changes: 

----from equilibrium 1 to 2 effects of (A), (B),  and (C)

----while from equilibrium point 2 to point 3 represents the final effect of  (D).

 

-This is an example of what is called Exchange Rate Over-shooting when one change (money supply increase) can cause a change in one direction  but then over time also a readjustment back in the other direction.  {“Over-shooting” means to go beyond the place (equilibrium) where system will come finally over time to rest.}

----Net total effect of money supply increase:  Domestic currency Depreciation

-------------------------- 

 

p.451

*Application: Why are Exchange Rates so Volatile?

-When anything affects the expected relative returns on domestic assets compared to foreign assets, things will change in the asset markets and hence in exchange markets and the FX-rate. Expectations alone can cause FX-rate changes.

 

----------------------------

p.452

*Application: The Dollar and Interest Rates

While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced

 

Fig. 9, p.452

Value of the Dollar and Interest Rates (from 1973-2005)

Relationship among (a) Nominal interest rate; (b) Real interest rate; and (c) ‘Effective Exchange Rate (calculated as an Index number)

 

{NOTE: For later data since 2005, see 9th edition, Fig. 9, p. 453: Same chart but through 2008. 

    Since 2005,  all three of these indicator changed drastically: 

---(a) nominal rates rose several percent and then collapsed downward quite sharply in 2008;

---(b) real interest rates rose sharply and then, in 2008 fell and became sharply negative (nearly zero nominal, meant real rates 2-3% below zero) and

---(c) the effective exchange rate fell (dollar depreciation) also from 2005-2008, …BUT since 2008 (data still not in 9th edition of 2010) there has been a strengthening of the dollar (appreciation) in the so-called ‘flight from risk’ in much of the world,

 

---------------------------------------  

*Application:  The Euro’s first Seven years  [1999-2006] {and Rock’s update}

-Author explains the changes in the FX-rate (dollars vs. euros) in terms of the ‘asset markets’ and the difference in interest rates in the US and the EU over the whole period of 1999-2006. 

 

-In this period The Euros/Dollar rate fluctuated and has continued to do so:

---1999:  Began at 1.15 dollars per euro

---1999-2000, by mid 2000 the rate fell to 0.83 dollars per euro (Low)

---2000-2005:  rose to over 1.20 dollars per euro by end of 2005

---{Since then, fluctuations between 1.20 and 1.50

2005-2011 the rate has risen as high as about 1.50 dollars per euro and most recently it is back down to under 130 dollars per euro.}

---{In this year, 2011, alone, the dollars per euro rate went from 1.29 in January, to a high of 1.48 (about a 20% rise) and now this week it is down to 1.30 Dec.14, 2011, about a 15% decline from the peak.)

 

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*Application: The Subprime Crisis and the Dollar (only in 9th edition, p.454)

-With the subprime mortgage-backed-securities collapse in prices began in late 2007, the effects on the dollar exchange rates led to a depreciation of the dollar.

----The fall in prices of securities (and their falling liquidity) was a “balance sheet asset depreciation” since these assets were held by financial institutions.

----“Subprime” (definition):  Loans to bad credit risk people.  People got mortgage loans, but who normally would not get a loan due to being bad credit risk…i.e. adverse selection occurred.  This was often with the collusion of lenders (mainly brokers for the ultimate lenders), who sometimes on purpose targeted bad risk borrowers because it was easy to convince them to borrow and others could make higher profits also on these.  So, mortgage brokers just wanted to maximize the number of loans, which they could pass along to others and hence not keep these risky loans themselves.)

-Dollar DEPRECIATION:  The Dollar fell for a year Aug.2007-July 2008 (between 6-10% against several currencies) to a new low in value by mid-July 2008 against the Euro. This was when the perception was that it was only the USA that would be seriously harmed by the financial crisis.

-But then a REVERSAL:  From July to October 2008 (when US financial firms were going famously bankrupt: Lehman Brothers (investment bank) most famously) the DOLLAR APPRECIATED quite strongly, by over 20% against the Euro and some 15% against most other currencies. 

-WHY DID THIS HAPPEN?

---(a) The author argues that many central banks lowered interest rates in anticipation of liquidity and real economy problems; hence the “asset markets” theory can explain part of the story.

---(b) But the author also argues that in very troubled times, investors run scared to what they consider the most stable and secure assets in a very uncertain time.  Thus this “flight to quality”  (moving to those assets “perceived to be least risky”) could also explain the dollar appreciation after mid-2008 as investors and other financial institutions wish to park their wealth more and more in US Treasuries (U.S. government debt).   

 

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The new changes to this chapter (changes in 9th edition (2010) can be found among readings for the course and the document is named:  Mish9ed_c17_ALMOSTallwSGsumOnly.pdf

Начало формы

Ch.18 PART 1

 

KEY IDEAS for Chapters in Book for Students to focus on for Learning & exams

Mishkin, 8th edition, Money, Banking and Financial Markets, 2007

(But, with some comments by Rock and also attention to the real world events and research that haschanged some of the treatments in the 9th Edition (2010).

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Ch18 (8th edition) THE INTERNATIONAL FINANCIAL SYSTEM

 

--(Note: In the 6th edition (Study guide) this chapter coverage is found in 2 chapters—Mish6ed_ch19_StGuide_019.pdf and Mish6ed_ch20_StGuide_020.pdf

--(Note: Be sure to study the sample questions from Study guide to chapter 17 in new 9ed edition:  the document is named: Mish9ed_c18_SGALLwANS_018.pdf

--(In this 9th edition there is only a small change in the text, an additional half page titled “Global The Subprime Financial Crisis and the IMF” and found in another reading named “Mish9ed_c18_TXTnewIMFsubpriNSGSum.pdf”

-Read text material, pages 463-490

-End of Chapter Questions:  pp.488-489

-EndChKeyQs: Key Questions are

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NOTES:

=This chapter shows why international financial transactions have important implications for the conduct of monetary policy.  This is also true for the structure of the international financial system. 

=============== 

pp.459-463

**INTERVENTION IN THE FOREIGN EXCHANGE MARKET—Central Banks:

 

=The beginning of the chapter explains how foreign exchange market CENTRAL BANK INTERVENTION affects both the exchange rate, a country’s international reserves, and the money supply.

--“International Reserves”: holdings of the Central Bank of assets denominated in foreign currencies.

================================================

 

*UNSTERILIZED Foreign Exchange Intervention (p.462)

=> ”Unsterilized”   This means that the central bank’s foreign exchange intervention leads to a equal change (down or up) of the monetary base (MB):

 

--(a) Lower MBase:    A central bank’s PURCHASE of domestic currency and CORRESPONDING SALE of foreign assets in the foreign exchange market leads to an EQUAL DECLINE in its international reserves and the monetary base

-------See the T-accounts on pages 460-461 to show this equivalency  (does not matter whether the central bank buys currency or bank deposits, the effect on monetary base is the same in both cases)

-------Note that the effect on the monetary base is the same in this case as when the central bank sold domestic assets (bonds); the monetary base declines (less currency or deposits with the central bank are held by banking system)

 

--(b) Rise in MBase:   A central bank’s SALE of domestic currency to purchase foreign assets in the foreign exchange market results in an EQUAL RISE in its international reserves and the monetary base

-------This is just the opposite of the intervention in that above (a)

-------The monetary base rises by this same amount (more currency, or deposits held by banking system)

 

--(c) So, an UNSTERILIZED INTERVENTION (by Central Bank) in which domestic currency is SOLD to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

 

=======================================

*STERILIZED FOREIGN EXCHANGE INTERVENTION  (p.463)

=> “sterilized”  This means that when the central bank buys or sells foreign assets to sell or buy domestic currency (or deposits), it offsets  the net effect on the monetary base by selling or buying domestic bonds (‘open market operations’ by the FED in the U.S.). 

--So, to counter (counteract, or ‘offset’) the effect of the foreign exchange intervention, conduct an offsetting open market operation

--Then, there is no effect on the monetary base and no effect on the exchange rate

 

--e.g.  The Central bank sells foreign assets and then buys domestic currency and then to sterilize this decline in the monetary base it offsets this effect by buying a domestic bond with domestic currency, thus leaving the Monetary Base unchanged.

--------See the T-account on the bottom of page 461 for the changes to the balance sheet of the US central bank, the Fed that shows the results of the initial purchase of currency and then the sale of the same amount.

 

============================================== 

p.462

*UNSTERILIZED Intervention

--An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

--------e.g. See results of this in the dollar-denominated asset market in Fig.1, p. 462 (and notice that the intervention produces essentially identical results seen in Chapter 17, Fig.8  (then, it was the effect of an increase in the money supply, by, for example the purchase of domestic bonds with currency by the central bank; now it is almost the same although foreign assets are the source (their sale) )

============================================== 

*STERILIZED Foreign Exchange Intervention (p.463)

--To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation

--There is no effect on the monetary base and no effect on the exchange rate

 

--(NOTE:  This analysis ignores the effect of this sterilization on the ratio of domestic securities to foreign securities (the so-called ‘portfolio balance effect’) that could in theory have an impact on some variables or expectations, but the text leaves aside this complication noting that empirical work indicates that the effect is minimal if anything, and adds that the size of the US asset market is so great that any effect would be a raindrop in the ocean. See footnote, p. 463)

============================================== 

pp.464

The chapter then discusses the balance of payments, a technical issue, but with a discussion of (the box on page 465, 8th ed.) on why large current account deficits worry economists.

 

 

*BALANCE OF PAYMENTS

--Current Account

--------International transactions that involve currently produced goods and services

--------Trade Balance {= merchandise or goods trade balance = (exports – imports)

-------------if exports < imports of goods, then there is a trade deficit

---------Other Items: Net receipts from (i) investment services, (ii) services transactions, (iii) net transfers

---Total Current account balance:

------------- = (goods & services exported)-(goods & services imported)

------------- if this balance is negative (it’s a Current Account Deficit);

------------- if this balance is positive (it’s a Current Account Surplus)

 

--Capital Account

--------Net receipts from all capital {financial, monetary) transactions (purchases of stocks, bonds, bank loans, etc.)

 

--BOTH together: the Sum of these two (Current + Capital Accounts) is the official reserve transactions balance ( = net change in government international reserves)

 

p.465

‘Global: Why Current Account Deficit worries economists (and humans too! ;-)

--The deficit is one of trade imbalance and the country with the deficit has to pay for this excess consumption/purchases by borrowing somehow. 

--The danger comes from persistent deficits, where one country is continuously borrowing.  At some point borrowing may be impossible and then the adjustment (in both financing and perhaps trade also) may be very disruptive of markets and even develop into a major crisis, depending on the balance sheets of the private sector companies and banks involved in the borrowing processes. 

--In theory, the exchange rate can change to help bring about a balancing of trade (the current account deficit country’s currency depreciates allowing it to increase its exports and tending to reduce its imports; or on the other side, the surplus country’s currency could appreciate; or both together [actually one implies the other]).  However, this does not always work smoothly or quickly so that imbalances can lead to international crises (working their mayhem through debt crises, banking crises, currency crises) involving sudden movements in financial/monetary variables due to markets seizing up or agents’ defaults, etc.). 

--{Rock:  Keynes recognized this problem and worked hard to convince the US representatives to ‘Bretton Woods’ negotiations from 1943-45 to consider a mechanism to deal with the problem of both persistent trade deficit countries (and the other side of the coin) the trade surplus countries.  He wanted incentives as well as punitive measures to be established to deal with this ‘IMBALANCE’ problem of the modern world of trade and money/credit/finance/currencies.  He even proposed an international currency that could have helped deal (in part) with the ‘imbalance persistence problem’.}

 

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pp.465-

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*Basic Types of EXCHANGE RATE REGIMES  (methods of dealing with Exchange Rates)

--(I)  FIXED exchange rate regime

--------Value of a currency is pegged relative to the value of one other currency (anchor currency) or to a weighted ‘basket’ of currencies (several, often representing one’s main trade partners)

---------Alternative is fixing one’s currency to the currency (a ‘major’ international currency) and promising not to remove this single ‘anchor’

--(II) FLOATING exchange rate regime 

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

--------Sometimes referred to as ‘free’ of fully ‘liberalized’ exchange rate—effectively the exchange rate for one’s currency is set by buyers and sellers of it in markets alone.

 

--(III) MANAGED FLOAT regime (sometimes referred to as a ‘dirty float)

--------Attempting to influence exchange rates by buying and selling currencies (central bank)

 

-----------------  

The chapter then goes on to discuss the historical evolution of the international financial systemwith a more detailed analysis of different ‘regimes’ for exchange rates that have been practiced by countries.

pp.465-467

*PAST EXCHANGE RATE REGIMES

 

--Gold standard

--------Fixed exchange rates (since money linked to gold; but linkage/ratio could be changed by countries)

--------No control over monetary policy (banks depended on their issued banknotes being backed by gold so bullion, in effect acted as a sort of fundamental ‘monetary base’)

--------Influenced heavily by production of gold and gold discoveries (money restricted in being issued by current supplies of gold….led to movements to add other precious metals to bank reserves, like silver {e.g. movement of western US farmers in late 1800s to remove this ‘cross of gold’ that appeared to be a crucifix that was killing their opportunities)

--------At end of gold system (i.e. 1700s & 1800s; finally ending ca. 1913-1931) the British pound had become a sort of de facto international currency accepted nearly everywhere, since the British had trade surpluses until the 20th century and recycled much of their surplus into international investments (e.g. lending for mining, resource exploitation) and colonial activities.

 

--Bretton Woods System  (1944 to Present)

--------Fixed exchange rates using U.S. dollar as reserve currency until 1970s (fixed rates) and with US dollars convertible into gold (by central banks, governments) but this gold-connection feature ended in 1971.

--------International Monetary Fund (IMF) as international lender of last resort for countries (originally to promote trade via rules for fixed exchange rates; also to help countries with loans when in balance of payments difficulties (deficits)).

-------Floating rates, began in 1970s and became standard practice by most major currencies by 1990s

--World Bank (Int’l. Bank for Reconstruction and Development; for post WW II rebuilding; then for ‘developing countries’ lending)

--General Agreement on Tariffs and Trade (GATT) (Mechanism to negotiate lower tariffs and reduced non-tariff barriers to international trade)

--World Trade Organization (1994-on; replaced GATT and added Enforcement mechanisms)

 

--EUROPE:  

----European Monetary System (1979-1990)

--------Exchange rate mechanism (ERM) although in practice the members pegged their currencies to the very stable German (Deutsch) Mark.

--------Britain’s (and others’) currency overvalued by early 1990s and came under attack by financial investors, some of whom made billions by betting against the UK pound

 

EU and creation of the Eurozone and the Euro and the European Central Bank (ECB)

----Euro, ECB, and Maastricht Treaty of  late 1980s put this into action

-------Euro currency introduced in 1999 (no more foreign exchange rates among the 17 members since all used a common currency, the ‘euro’.)

----Euro currency is common, but each of the 17 countries has a separate fiscal system (taxes and spending are national) while monetary policy is unified (with the highly independent ECB

------------------- 

======================================= 

 

Then is a section on:  how fixed exchange rate systems work.

pp.467-470

*How a Fixed Exchange Rate Regime Works

--When the domestic currency is overvalued, the central bank must

--------purchase domestic currency to keep the exchange rate fixed (it loses international reserves), or

--------conduct a devaluation

--When the domestic currency is undervalued, the central bank must

--------sell domestic currency to keep the exchange rate fixed (it gains international reserves), or

--------conduct a revaluation

 

Fig. 2, p. 468: