Lecture 6: The money supply process

Three players in the money supply process

(1) CB: government agency that oversees the banking system and
conducts monetary policy
(2) Banks (depository institutions): financial intermediaries that accept
deposits 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

Lecture 7: Tools & Conduct of Monetary Policy

The market for reserves and the federal funds rate
Fed 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

(b) discount rate

if intersection is at:
vertical

vs

horizontal

(c) reserve requirements

(d) interest rate on reserves

if intersection is at the
flat

vs

downward-sloping

Nonconventional monetary policy tools (during the global financial crisis)

(1) liquidity provision
The Fed implemented unprecedented increases in its lending facilities
to provide liquidity to the financial markets
(a) Discount window expansion (Aug 2007): Fed lowered the
discount rate to 50 basis points above the Fed funds rate
(<normal 100 bp)
(b) Term auction facility (TAF) (Dec 2007): Enable banks to
borrow at a rate lower than the discount rate ! raise bank
capital
(c) New lending programs: lending to investment banks (e.g.,
J.P. Morgan to assist in purchase of Bear Stearns)
(2) Asset purchases
Fed established:
(a) Government-sponsored entities purchase program: buy
US$1.25 trillion of mortgage-backed securities (MBS)
(b) Quantitative easing program to buy long-term Treasury
bonds so as to lower long-term interest rates
The price stability goal and the nominal anchor
As the social and economic costs of inflation become increasingly evident,
policymakers are now concerned with maintaining a stable price level ! goal
of economic policy
Role of nominal anchor: a nominal variable (e.g., inflation rate or money
supply) which ties down the price level to achieve price stability
Other goals of monetary policy
(1) high employment & output stability: maintain output at the natural
rate of output which is consistent with the natural rate of
unemployment
(2) economic growth: encourage savings and investment thereby
promoting growth in the economy
(3) stability of financial markets: to channel funds for productive
investments: to channel funds for productive investments
(4) interest-rate stability: to reduce uncertainty in savings and investment
decisions
(5) stability in foreign exchange markets: to support the development of
international trade
Should price stability be the primary goal of monetary policy?

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 stability
Either type of mandate is acceptable as long as it operates to make price
stability 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

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 Feds monetary policy strategy: Just Do IT
The fed does not use an explicit anchor such as an inflation target
Feds 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, monetary
policy needs to be forward-looking and preemptive
Advantages of the Feds 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 Feds 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 CBs tool and
indicates the stance (easy or tight) of monetary policy

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 (intermediate
targets 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 control
over the policy instrument (i.e., variable) to ensure that the variable
stays on target if it gets off-track

(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 rule

The 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

(4) Lecture 8: Quantity theory, inflation and demand for money & the
monetary policy & aggregate demand curves
Quantity theory of money
MV = PY
Assumptions: 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 Fishers model)
! The amount of money each individual decides to hold is independent of
interest 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 the
public, 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
Keynes liquidity preference theory, abandoning the quantity theory view that
velocity was constant
Why do individuals hold money?
(1) transactions motive (medium of exchange)

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 of
holding money relative to other assets (e.g., bonds) is the nominal
interest 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 falls
Procyclical movements (expansions and recessions) should induce procyclical
movements 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

10

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 of
interest 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

11

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 curve

downward-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 ! explain
short-run fluctuations in both aggregate output and inflation
deriving the AD curve
(1) MP curve
(2) IS curve (investments/saving)

12

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

13

Lecture 9: Monetary policy theory

Response of monetary policy to shocks
Monetary 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+ Yp) +
SRAS curve is upward-sloping to reflect the increase in inflation which occurs
when the Y exceeds potential output (Yp)
The SRAS equation indicates that a rise in expected inflation (e) will shift the
SRAS curve up to the left

14

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

15

Response to an LRAS shock

CB can respond to this shock in two possible ways:
(1) no policy response

(2) policy stabilizes inflation

16

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)

17

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, even
in the SR
(2) if SRAS shocks are more common, then a central bank must choose
between 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 to
eliminate high unemployment when it develops
Lags and policy implementation
Several types of lags prevent policy makers from shifting the AD curve
instantaneously
data lag: time needed to obtain data indicating what is happening in
the 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 policy
instruments 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 can
bring high inflation
the following two types of inflation can result from an activist stabilization
policy to promote high unemployment:

18

(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

expansionary policies that raise AD

policy

makers

pursuing

19

Lecture 10: Role of expectations in monetary policy

Lucas critique of policy evaluation
Macro-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 right
decision in the situation
Types of rules
Examples of rules:
(1) Milton Friedmans constant money-growth-rate rule ! money supply
is kept growing at a constant rate regardless of the state of the
economy
(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 rules
Argument #1: Lead to desirable long-run outcomes ! avoids timeinconsistency 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 to
pursue 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

20

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

have better inflation performance in the LR if it doesnt try to
surprise people with an unexpectedly expansionary policy, but
instead 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 are
often 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 to
changes 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 Mishkin
Constrained 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

21

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 the
public), 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+ Yp) +
Inflation = expected inflation + (output gap) + price shock
In response to positive AD shock, the appropriate policy response is to
tighten 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.

22

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 back
to 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 will
not shift. Credibility has the benefit of stabilizing inflation when faced with
negative demand shocks in the SR.

If the bank is not credible: the public will see an easing of monetary policy to
increase 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.

23

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, so
the upward shift of SRAS will be large, resulting in even higher inflation and
lower 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 supply
shocks when the price of oil rose sharply.

24

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 policy

Consider 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 is
supposed 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.

25

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 to
AS3 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, longrun 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)

26

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.

27

Lecture 11: The international role of money

Foreign exchange market
Foreign exchange market: the financial market where exchange rates we
determined
Exchange 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 of
exports 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 of
domestic & foreign assets at any given time
*Assume: domestic assets denominated in $US, foreign assets in euros
Supply curve for domestic assets
Quantity 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)

28

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 analysis
of 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 to
explain 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 on
foreign 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

29

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

30

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

31

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

higher relative expected return on domestic assets vis--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 Europe
Result: US dollar depreciated
mid-2008: interest rates fell in the Europe; increased demand for US
treasuries ! 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

32

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 currency
at Epar
Assume initially that the demand curve shifted to the left to D1
(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 must
intervene 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, thus
shifting the demand curve to the right to D2 where Epar is established

33

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 relative
expected 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

34

Exchange rate effects on monetary policy

Direct effects of the foreign exchange market on monetary policy:
To avoid depreciation, CB should pursue a contractionary monetary
policy 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 higher
than 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 timeinconsistency 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 a
significant 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 will
have 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 high
unemployment as well
Currency speculators might exploit the targeting countries
governments intolerance to high unemployment !
depreciation
Thus, this would encourage speculative attacks against the
currencies 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 banks policy actions.
Public is less able to keep watch on the central banks stance on
monetary policy ! monetary policy more likely to be overlyexpansionary

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