BGIE Review: Monetary Policy Exchange Rates

1. Ted Berk James Ratcliffe February 4-5, 2001 BGIE Review: Monetary PolicyExchange Rates

2. Introduction • Who we are: • Ted Berk (OD), eberk@mba2001.hbs.edu, 868-8577 • James Ratcliffe (OC), jratcliffe@mba2001.hbs.edu, 492-2974 • What these reviews are for: • Focus on the basic tools • i.e. what you need to know for BGIE as it’s taught at HBS • Geared towards people who feel like they aren’t “getting it” • NOT for folks with macroeconomics courses in their past • NOT for debating the arcane details of macroeconomic theory • Slides are on the web at: www.mba2001.hbs.edu/jratcliffe/bgie.html

3. Agenda • Previous topics: • BGIE math (CAGRs, real vs. nominal) • National income and product accounting • Balance of payments accounting • Fiscal policy overview • Today: • Monetary policy / interest rates • Exchange rates • Next week: • Midterm review

4. Money overview • What is money? • Key functions of money: medium of exchange, store of value, unit of account, standard of deferred payment • In earlier eras, money could be taken to the central bank and converted into other assets (usually precious metals), so money is a liability of the central bank • Now, money can be thought of as an agreed fiction – a $20 bill is worth $20 because we all agree it is – really, it’s just a piece of paper • The interest rate can be thought of as the “price” of holding money • Results from the demand for money in the economy and the supply of money as managed by the central bank • Monetary policy is the government tool for setting interest rate targets • Why does it matter? • Changing interest rates will impact the level of national output • Y = C + I + G + X – M • As borrowing becomes more expensive, firms will invest less, people may save more and consume less, etc.

5. FEDERAL RESERVE COMMERCIAL BANK Assets Gold Foreign currency US Treasury bills Assets Loans Reserves at Fed Cash Liabilities US currency Bank reserves Liabilities Deposits Equity Simplified bank balance sheets

6. Tools of monetary policy • Monetary policy can be a more flexible tool than fiscal policy • In the United States, the independent central bank can set and change policy without all the long debates and compromises of Congress • However, the Fed remains independent only as long as everyone agrees that it should • Discount rate: the rate at which the central bank loans money to other banks • The Fed can raise the discount rate to increase the cost of funds to banks, raising the “price” of borrowing money • Open market operations • Government securities are a large portion of the central bank’s asset base • By buying or selling these securities, the central bank can put money into the economy, or take it out • Reserve requirements • % of its deposits that a bank must hold as reserves • Reserves can be held as currency or deposited with the central bank • The higher this % is, the less money banks can lend

7. Money multiplier • Defining the monetary base – types of money • M0 = currency (actual cash in circulation) • M1 = currency and demand deposits – most frequently used • M2 = M1 + time deposits <$100k (i.e. CDs) • When reserve requirements change, the portion of a deposit that a bank can lend back out will change • People deposit money in banks, which then lend it out to others, who deposit in another bank, which lends it out, etc. • Level of money multiplier depends on leakages • Reserves that banks of required to hold (tool of monetary policy) • Money that people don’t deposit in banks but hold under mattress • Mathematically, 1 / (reserve ratio + other leakages) • Not to be confused with the Keynesian multiplier • Keynes’ theory focuses on the impact on Y of changes in G • Changes in G have no impact on the money supply

8. Inflation and monetary policy • Inflation is an increase in the overall price level • Measured by a number of indices: GDP deflator, CPI, PPI, etc. • Inflation has costs • Uncertainty: companies can’t plan effectively • Impact on savings: people want to spend, rather than save • Impact on fixed incomes: real value of fixed incomes erodes (retirees) • Hoarding: people hold assets in goods, rather than money • Speculation: can become more profitable than productive work • An increase in the supply of money may boost Y in the short run • As prices are sticky, then additional money will lead to additional activity • But if prices will adjust in the long run, then ↑M leads to inflation • Basic money identity: M x V = P x Q • Amount of money x number of times it changes hands (velocity) = nominal prices x real output level

9. Exchange rates overview • Ratio of one currency to another, i.e. the price of currency A in terms of currency B • US$1.00 = GB£0.68, or GB£1.00 = $1.47 • People need to convert into foreign currencies to buy or sell foreign goods and assets • Ferrari needs to pay its workers in Italian Lira, so to import a car from them to the US, you need to pay Ferrari in Lira • The U.S. government buys goods and services in dollars, so to lend money to the government (buy Treasury bills), foreigners need dollars • Most simplistically, exchange rates should equalize the price of goods and services across all countries • Otherwise, one could buy a good in the “cheaper” country and sell at a profit in the more “expensive” (arbitrage) • Example: A Big Mac costs $2.50 in the United States. At a rate of $0.94 dollars = 1 euro, how much should a Big Mac cost in France? • 2.66 euros • BUT, certain goods are not easily tradable, and competition is not always perfect in every country…. So a Big Mac costs 2.61 euros only.

10. Fixed vs. flexible exchange rates • Under a fixed-rate regime, countries agree to peg their currency to a known price • e.g. to the price of gold (Gold Standard) or to the dollar (Bretton Woods) • Should reduce exchange-rate risk and facilitate trade and international investment • Maintaining a fixed-rate regime requires active participation by central banks • Balance of payments deficit  central bank must raise interest rates to attract foreign exchange and restore payments balance • Under a floating-rate regime, balance of payments deficit  excess supply of dollars  dollar depreciates • Central bank can target exchange rates or interest rates but not both. • Flexible rates are determined by the supply and demand for a currency in the market, driven by: • Relative interest rates • Trade balances • Expectations of future exchange rates (and of 2 factors above)

11. Exchange rate examples Flexible exchange rates • Alan Greenspan recently lowered the Fed’s target interest rates in the United States. All other things being equal, what should happen to the value of the dollar? • As the value of the dollar declines, what should happen to the trade balance? • If inflation were to increase in the United States, what should happen to the value of the dollar, all other things being equal? • If the European Central Bank were to intervene in the foreign exchange market and buy euros, what would happen to the value of the euro? Fixed exchange rates • Suppose all exchange rates were pegged to the dollar (i.e. Bretton Woods) and the US were running a large balance of payments deficit to Germany. What would you expect to happen to the money supply in Germany? What impact would this have on the German economy overall?

12. Questions? Note schedule for Midterm Reviews: Thursday, time & place TBD Sunday, 5pm, Aldrich 109