Lecture 5ECN160B

1
ECN 160B Lecture 5International Macroeconomics

• Galina A. Schwartz
• Department of Economics
• University of CA, Davis

2
Money I a brief review

• Q Why do we need to refresh our understanding of
  money?
• In this course we focus on factors that determine
  exchange rates
• Since exchange rates are relative prices of
  moneys, money demand and supply are one of the
  most important factors in exchange rate
  determination.
• We have learned already that exchange rates are
  affected by
• Interest rates
• Expectations about future exchange rates
• Clearly, demand supply for money are relevant
  for determination of both, interest rates
  expectations.

3
Money II

• Expectations of future exchange rates depend on
  monetary and non-monetary factors (for example
  technology)
• Chapter 14 focuses on monetary factors only.

4
Money III Functions

• Functions of money KO, p. 358
• Money as a Medium of Exchange money are
  standardized and convenient (as universally
  accepted) means of payment. Important in exchange
  economy barter is inefficient!
• Money as a Unit of Account. Think of Ch. 13
  calculations (sweater/jeans) and imagine the need
  to analyze relative prices for ALL goods and
  services that you consume. Appreciate the role of
  money as a unit of accounting!

5
Money IV Functions (cont.)

• Money as a Store of Value we talked of this
  function of money in your previous lecture. Money
  as the most liquid asset. (Think of
  hyperinflation) High inflation erodes the role of
  money as a store of value.
• Q Why these days Central banks are getting more
  responsible (i.e., less inflationary) than in
  the past?
• A Globalization Relative ease of switching to
  another, more valuable currency.

6
Money IV

• Monetary aggregates money and near-money
• M1 currency and checking deposits of firms and
  households about 11 of GNP
• M2 includes less liquid assets (such as time
  deposits, which have a penalty for early
  withdrawal)
• M3 even broader measure

7
Money V Assumptions

• To simplify, KO, Chapter 14, assumes
• Money supply is fixed by Central Bank as the
  desired level
• We assume that money market is in equilibrium
  (KO, p. 362), and
• We take price level as given
• WE take output level as given

8
The Role of Central Bank

• KO, Ch. 12, pp. 313-316. By definition, Central
  Bank is an institution responsible for the supply
  of money. In US Central Bank is called Federal
  Reserve System (or Fed).
• Official ForEx intervention by Central Bank is
  its selling or purchasing international reserves
  in private markets aiming to affect macroeconomic
  conditions. Also, ForEx intervention is a way to
  add or withhold money from circulation. Official
  ForEx intervention is summed in official
  settlements balance, which is identical to the
  BoP.

9
Intervention I

• KO, Ch. 12, p. 314.
• Although US Treasury can intervene, to simplify,
  we assume that only Central Bank alone holds
  foreign reserves and can intervene. Throughout
  the textbook, KO assumes that only central banks
  can intervene.
• Q Why Central Banks intervene?
• A Signaling role of intervention, KO. Ch. 17, p.
  510-511. And, because it works! (see below). We
  will return to this and be more specific (and
  technical), when we will study Ch. 17

10
Intervention II

• Sterilized vs. non-sterilized
• KO, Ch. 17, p. 487-488, p. 505 Sterilized
  intervention is such ForEX intervention by
  Central Bank that leaves money supply unaffected.
• In sterilized intervention, Central Banks carry
  out equal foreign and domestic asset transactions
  to nullify the effects on money supply, see KO,
  Ch. 17, p. 487
• When sterilized intervention can be effective? In
  the world where risk matters. For example, when
  returns on domestic and foreign bonds differ.
  I.e., in the case when asset substitutability is
  imperfect that is when it is possible to have
  assets which expected returns in equilibrium are
  different.
• Thus, when IRP holds, sterilized intervention
  cannot be affective

11
Intervention III

• Sterilized vs. non-sterilized
• KO, Ch. 17, p. 510-511 Evidence
• Bonds denominated in different currencies are NOT
  perfect substitutes
• Sterilized interventions have reliable effects on
  exchange rates
• Another effect of ForEx intervention signaling
  This effect is important when government is
  unsatisfied with exchange rate level and plans to
  alter monetary or /and fiscal policies to bring
  about the change. Example when Central Bank
  purchases foreign currency, it lends credibility
  to its intend to bring a depreciation of the home
  currency. (If the currency appreciates, the banks
  would incur losses)

12
Intervention IV

• Another application Central Bank can use
  sterelized intervention to hold exchange rate
  FIXED, while it varies the money supply to
  achieve domestic objectives such as full
  employment, KO, P. 510.

13
Next Lecture

• Global Capital Markets
• why global?
• Features of offshore and onshore
• problems
• Limits of Government regulation
• Problems of Regulation
• Pros and cons
• Your preparation Read KO Ch. 21

14
Summary of Today

• Money a short Review
• Why to hold
• Trade-offs
• Concepts
• Money Demand
• Money Supply
• Equilibrium
• Relevant variables
• Money and interest rates
• Have a Nice Weekend