Download Lecture 3 and 4 I.F

International Finance
Lecture 3 & 4
Chara Charalambous
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Learning Outcomes:
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Why study Money, Monetary and Fiscal Policy ?
Monetary Policy definition and tools.
Central Bank’s balance sheet.
Players in the money supply process.
Fiscal Policy definition and tools.
Impact of both policies in the money market and
goods market.
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Why study Money, Monetary and
Fiscal Policy ?
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Money, also referred to as the money supply, is defined as
anything that is generally accepted in payment for goods and
services or in the repayment of debts. Movements in Money
Supply affect interest rates and are also linked to changes in
other economic variables that affect all of us and are important to
the health of the economy. Deposits at Banks are by far the
largest component of the money supply.
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Monetary and Fiscal Policy are strategy sisters with which the
monetary authority of a country influences a nation's money
supply. These two policies are used in various combinations in
an effort to direct a country‘s economic goals.
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1. Monetary Policy
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Monetary Theory is the theory that relates changes in the
quantity of money to changes in aggregate economic activity
and the price level. Monetary Policy is the management of
money – supply and availability - and interest rates. Is one
of the tools that the monetary authority of a country uses to
influence its economy. Usually this goal is ‘macroeconomic
stability’: low unemployment, law rate of inflation-price stability,
economic growth and balance of external payments.
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Money and Inflation
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Data shows a connection between the money
supply and the price level
When we say that money affects prices we
mean the aggregate price level.
The aggregate price level is the average price
of goods and services in an economy
A continual rise in the price level (inflation)
affects all economic players
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FIGURE 1:
Aggregate Price Level and the Money
Supply in the United States,
1950–2008
Sources: www.stls.frb.org/fred/data/gdp/gdpdef;
www.federalreserve.gov/releases/h6/hist/h6hist10.txt.
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Money and Inflation
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Figure1 shows the movement of average prices in the
U.S economy from 1950 to 2005 : the prices of most
items are quite higher now than they were then.
What explains this (inflation)? As we can see in figure
1 the price level and the money supply generally rice
together. These data indicate that a continuing
increase in the money supply is an important factor
in causing the continuing increase in the price level
that we call inflation.
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Money and Interest Rates
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Interest Rates are the price /
cost of money!
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Why is the interest rate referred to as the
price of money?
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If you wanted an extra €100, you'd have to 'get' it from
someone else. Hence you're 'renting' their €100 from them,
for your use. Of course you have to pay them back, plus a
fee (interest) for them letting you use it. The price of
BORROWING money is the interest rate you will pay on a
fixed amount. Lower interest rates means more spending
today, which can lead to inflation. This all works backwards
if interest rates go up. Savers" want interest rates to go
up. "Spenders" want interest rates to go down.
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Thus as money supply increases, causing prices to
go (because people buy more things), the money
looses purchase power because we need more
money to buy anything and therefore the cost of
money, interest rates, falls..
As the money supply increases, money becomes
less scarce and easier to obtain. As with any other
good, as supply increases, while demand remains
constant, the price will fall. In this case the price of
the money is the interest rate.
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Money plays an important role in
interest rate fluctuations which are of
great concern to business and
consumers.
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Interest rate and quantity of money
How does the Monetary Authority (Central Bank) affect the Money Market?
Increasing the money supply .This will shift the money supply schedule
to the right and the interest rate falls.
Decreasing the money supply via contractionary monetary policy will
shift the money supply schedule to the left and will increase interest rate .
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Monetary Policy is referred to as either being expansionary or
contractionary. An expansionary policy increases the total supply of
money in the economy more rapidly than usual, and contractionary
policy expands the money supply more slowly than usual or even
shrinks it.
Expansionary policy is traditionally used to try to fight unemployment in
a recession of the economy by lowering interest rates, as a result of
money increase, in the hope that easy credit will attract businesses
into expanding. So the firms will undertake loans. As a result
investments increases, aggregate demand for goods and services
increases and therefore production increases and consequently
demand for labour increases and unemployment falls.
Contractionary policy is intended to slow inflation because if money
supply decreases then prices will also be reduced and interest rates will
be increased.
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Four Players in the Money Supply
process
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The Central bank – the government agency that supervises
the banking system and is responsible for the contact of
monetary policy (in the U.S is called Federal Reserve System)
Banks (depository institutions – the financial intermediaries
that accept deposits from individuals and institutions and make
loans: commercial banks, savings and loan associations.
Depositors – individuals and institutions that hold deposits in
Banks
Borrowers from Banks – individuals and institutions that
borrow from the depository institutions
Of the four players the Central Bank is the most important and
when it conducts Monetary Policy its actions affect it's Balance Sheet.
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Central Bank’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
Monetary Base
 Monetary Liabilities
Currency in circulation — the amount of currency in the hands of the public
Reserves — Consists of deposits of the commercial banks in the Central Bank and
currency that is physically held by Banks. All banks have an account in the CB that hold
deposits.
 Assets
Government securities — holdings by the CB: The CB provides reserves to the banking
system by purchasing securities (e.g. bonds) and thus increasing its holdings of these
assets. An increase in government securities held by the CB leads to an increase in the
money supply.
Discount loans — CB provide reserves to the banking system by making discount loans
to banks which bear interest rate. An increase in discount loans can also be the source
of an increase in money supply. (also called borrowed reserves)
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Three Policy Tools that CB uses
to conduct Monetary Policy
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Manipulation of many supply and Interest Rates through:
1) Open Market Operations: affect the quantity of reserves and
the monetary base= currency in circulation+reserves
2) Discount Rate Policy/Discount Lending: changes in borrowed
reserves which affect the monetary base
3) Reserve Requirements : changes in reserve requirements
affect the money multiplier (m) which tell us how much the
many supply changes for a given change in the monetary base
(MB).
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1st. Open Market Operations
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Is the primary tool for conducting monetary policy
A purchase of securities by CB is open market purchase and a sale of
securities by the CB is open market sale.
Open Market Purchase: If CB purchases € 100 bonds from a bank or
from the public the result is: increase of the reserves of the bank or
the increase of the currency in circulation and also increase of the
securities of the CB. So the Monetary Base increases! Hence Money
Supply expanded and Interest Rates are lowering!
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Open Market Sale: has the opposite results: The Monetary Base
decreases! Hence Money Supply lowers and Interest Rates are
becoming higher!
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Open market purchases and sales have permanent affects on the
monetary base, but sometimes the CB will want to change the
monetary
base
only
temporarily.
At
these
times,
it engages in two other types of transactions:
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Repurchase Agreement (repo) = The CB purchases government
securities with the agreement that the seller- Commercial Banks
will buy them back (repurchase them) at a specified price on a
specified date, usually within two weeks.
Reverse repo= The CB sells government securities with an
agreement that the buyer - Commercial Banks will sell them
back at a specified price on a specified date, again usually
within two weeks.
Both of them are carried out with the method of auction (bid)
A repo and a reverse repo are therefore a temporary open
market purchase and sale respectively, temporarily increasing
and decreasing the monetary base.
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2nd. Discount Policy
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The facility at which a bank receives a discount loan (borrow
reserves) from the CB is called the “discount window.”
The CB can affect the volume of discount loans by setting the
discount rate:
A higher discount rate makes discount borrowing less attractive to
banks and will therefore reduce the volume of discount loans.
A lower discount rate makes discount borrowing more attractive to
banks and will therefore increase the volume of discount loans.
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Discount lending is most important during financial panics:
When depositors lose confidence in the financial system, they will
rush to withdraw their money.
This large deposit outflow puts the banking system in great need of
reserves.
The CB stands ready to supply these reserves by making discount
loans.
In such situations, the CB acts
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a lender of last resort
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3rd . Changes in Reserved Requirements
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Central Bank sets the minimum reserves each commercial bank must
hold , rather than lend out, of customer deposits and notes. It is
normally in the form of cash stored physically in a bank vault or
deposits made with the central bank. This policy tool is influencing
the country's borrowing and interest rates by changing the amount of
funds available for banks to make loans with.
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A rise in reserve requirements reduces the money supply and raises
the interest rates and vice versa.
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Which of the 3 tools is most effective?
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Open market operations are by far the most effective tool with
which the CB can conduct monetary policy on a day-to-day
basis.
There are a number of advantages for open market operations
comparing with the other two:
They are under the direct and complete control of the Central
Bank.
They can be large or small.
They can be easily reversed.
They can be implemented quickly
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2. Fiscal Policy
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Fiscal Policy is the use of government
spending (G) and revenue collection (Ttaxes) to influence the economy.
The policy-maker in this case is the
government not the central bank.
Fiscal Policy also aims at
economic
objectives of price stability, full
employment and economic growth.
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Fiscal Policy
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This theory basically states that governments can
manipulate (influence and control) the level of aggregate
demand in the economy by increasing or decreasing tax
levels and public spending. While monetary policy
manipulates the money supply in order to reach its aims.
This influence, in turn, controls inflation , which
generally considered to be healthy when is at a level
between 2-3% , increases employment and maintains a
healthy value of money.
A budget deficit is the excess of government spending
over tax revenues for a particular time period, typically a
year, while a budget surplus arises when tax revenues
exceed government spending.
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Two fiscal Policy Tools:
1st Taxes
Distinguished in the two following categories:
Direct Taxes which are imposed directly to natural or legal
persons
based on their income (income taxes) or their
property (property tax) and they are paid directly to the state.
Indirect Taxes are imposed to products and charge indirectly
those who buy it and are paid to the state through third
parties. (e.g. vat, import duties)
If demand is low, the government can decrease taxes. This
increases disposable income, thereby motivating demand.
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2nd Spending:
Distinguished in the two following categories:
Current Expenditure: is the public consumption to cover current needs
such as salaries and wages of state personnel, purchases of goods
and services, interest on state loans and the transfer payments of
allowances, pensions, scholarships and so forth. Capital Expenditure:
spending on goods and services for the construction of projects such
as roads, ports, airports, hospitals e.t.c which will satisfied the needs
of the state for a long period.
If inflation is high, the government can reduce its spending thereby
removing itself from demand for resources in the market of goods
and services. This is a contractionary policy that would lower prices.
Conversely, when there is a recession and aggregate demand is
declining, increased government spending in transportation projects
(roads and rails network) would lead to higher demand and
employment.
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Fiscal Policy
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Both tools affect the fiscal position of
the government i.e. the budget deficit
goes up whether the government
increases spending or lowers taxes. This
deficit is financed by debt: the
government borrows money to cover
the deficit in its budget.
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The Impact of Monetary Policy in the
Economy
According to the Monetary Transmission Mechanism there is a direct
link between the money market and the goods and services market
explained below:
An increase in the money supply means interest rates falls and this
encourage investment because the cost of borrowing is low. The
increased investment is an injection to new spendingconsumption so aggregate demand in goods market increases
and therefore prices increases. But the fall in interest rates makes
the domestic currency to depreciate and therefore exports of
domestics goods are more attractive to other nations and so
they are increasing.
The above transmission channel makes GDP to rise and therefore
unemployment decline and wages are greater than before.
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Impact of Monetary Policy
Recall GDP= Y=AD=C+I+G+(X-M)
monetary policy, used
separately or together, in an expansionary policy
exertion increase the amount of money in
circulation with corresponding reduce in interest
rates. This combination of extra money and lower
interest rates stimulate the economy and makes
CDP to increase.
All
three
tools
of
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Monetary Stimulus
7
6
0
E1
E2
Demand
for money
g1 g2
Quantity Of Money
More investment increases
aggregate demand
(including multiplier effects)
Aggregate
Supply
7
Investment
demand
6
0
I1 I2
Rate Of Investment
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Price Level
Interest Rate
Supply of
money
A reduction in the rate
of interest stimulates
investment
Interest Rate
An increase in the
money supply lowers
the rate of interest
AD1
Y1
AD2
Aggregate
Demand
Y2
Income (Output)
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The Monetarists’ Transmission Mechanism (cont.)
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There can only be a short-run increase in real GDP due
to an expansionary monetary policy because in the end
the public cannot buy more of everything: people simply
bid up prices so the price level rises.
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Impact of contractionary Monetary Policy
Contractionary monetary policy is a decrease in the quantity
of money in circulation, with corresponding increases in interest
rates, for the expressed purpose of putting the brakes on an
overheated business-cycle expansion and to address the
problem of inflation.
A decrease in the money supply means decreased Aggregate
Demand, Decreased Real GDP, decreased Prices and an
increase in unemployment
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The impact of Fiscal Policy
Expansionary Fiscal Policy: a combination of
increased government spending and reduced taxes. Is
the remedy for the contraction (reduction) of the
business cycle
G
increase in government spending (both government
purchases and transfer payments) causes AD to
increase and shift to the right
T decrease in taxes raises income and consumption and
thus causes AD to increase and shift to the right
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The impact of Fiscal Policy
Contraction Fiscal Policy needed when demand-pull
causes inflation.
A in G reduces AD and shifts it back left and the
price level returns to its pre-inflationary level but
GDP remains at full – employment level.
An in T will reduce income and then consumption.
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.
When we have a downturn, expansionary fiscal
policy means more spending than tax. When we have a
boom, contractionary fiscal policy keeps taxation above
spending. Simplified model of budget and growth is below:
G
T
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Who Does Fiscal Policy Affect?
Taxes
Unfortunately, the effects of any fiscal policy are not the same on everyone.
Depending on the political orientations and goals of the policymakers, a tax
cut could affect only the middle class, which is typically the largest economic
group. In times of economic decline and rising taxation, it is this same group
that may have to pay more taxes than the wealthier upper class.
Government Spending
Similarly, when a government decides to adjust its spending, its policy may
affect only a specific group of people. A decision to build a new bridge, for
example, will give work and more income to hundreds of construction
workers. A decision to spend money on building a new space shuttle , on the
other hand , benefits only a small, specialized group of experts, which would
not do much to increase the aggregate levels of employment in a nation.
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Conclusion
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So now it is clear that there is a difference in the
tools of monetary and fiscal policy and the way
they influence economy ( through manipulation
of different economic values) but the two
policies are dependent to each other. As we
show in previous slide monetary policy is
dependent on fiscal policy for price stability.
Fiscal Policy on the other hand needs monetary
to control budget deficit.
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