Comprehensive Notes on Exchange Rates, Monetary Policy, and International Finance

Factors of production: capital and labor.
Aggregate supply depends on:
- Technology.
- Capital.
- Labor.
In the short run (e.g., within the next two to three months), these factors are difficult to change.
- New technology cannot be developed quickly.
- New capital cannot be acquired rapidly.
- Labor force changes, like students getting degrees, take years.
The government or central bank manages the economy to align with market demand through fiscal policy.

Fiscal policy: involves government spending (G) and taxes (T).
- Consumption depends on taxes.
- Government may adjust G or T to influence the economy.
Monetary policy: involves adjusting the interest rate to boost investment.
- If interest rates are reduced, investment may increase.
- Investment decisions are influenced by investors' perceptions of the economy.
Investment is driven by:
- Policy (e.g., interest rates).
- Investors' perception of economic prospects.
If demand increases: income (Y) increases.

The relationship between domestic and foreign interest rates is:
- $\text{Domestic Interest Rate} = \text{Foreign Interest Rate} + \text{Expected Appreciation} \text{ or } \text{Depreciation}$
Capital flows into a country (e.g., Australia) when people buy its currency, increasing its price.
The central bank may intervene in the foreign exchange market to manage money supply and prevent inflation.

Central banks manage excess money supply by selling bonds: banks buy these bonds and pay the central bank, stabilizing the economy.
Under a flexible exchange rate system, the price of a currency (\text{e.g.,} \, $13) will increase, leading to currency appreciation.
- To offset this increase, the central bank sells bonds in the money market to reduce money supply.

Until the 1970s, a strictly fixed exchange rate system was common.
In 1944, 44 countries met to establish:
- The World Bank: for long-term loans.
- The International Monetary Fund (IMF): for short-term loans in case of balance of payment difficulties.
- The General Agreement on Tariffs and Trade (GATT): later renamed the World Trade Organization (WTO) on January 1, 1995.

Exchange rates are flexible but within boundaries.
Central banks buy or sell bonds to manage assets:
- Domestic assets (bonds).
- Foreign exchange assets.

The purpose is to protect the value of a currency from becoming too high.
Foreign direct investment (long-term) benefits a country by creating jobs.
However, investments in bonds and shares are often speculative, aimed at making a profit.
Many countries have regulations on capital inflow; for example, in Australia, declaring amounts over $\$10,000$ is required for economic reasons.

The DDAA (Demand, Devaluation, Absorption, Adjustment) model is used to explain how devaluation improves the current account.
The XX line represents the current account balance; any point on the line indicates equilibrium.
Points above the line indicate currency depreciation; points below indicate appreciation.
Depreciation increases exports and decreases imports, improving the current account.
Appreciation decreases exports and increases imports, worsening the current account.

Devaluation: is a deliberate policy action by the central bank.
Depreciation: results from market forces affecting the demand and supply of a currency.

The incompatible trinity suggests that a country can only choose two of the following three policies:
1. Free capital flow.
2. Fixed exchange rate.
3. Autonomous monetary policy.
If capital is freely flowing into Australia and the exchange rate is fixed: the central bank loses control over monetary policy.

Temporary and permanent fiscal expansions have different effects under fixed versus floating exchange rate systems.

Expectations influence market behavior; for example, rising housing prices lead to expectations of further increases, encouraging more buying.

Devaluation increases exports and decreases imports.
Imports become more expensive; leading to inflation.
Inflation leads to higher interest rates.
- If home loan interest rates are 6% and housing prices are rising at 10%: it is still attractive to buy a house.

Tariffs are imposed to encourage domestic production by reducing demand for foreign goods.
Putting tariffs appreciates the currency, which damages exports.
Economists generally view tariffs negatively because they appreciate the currency, harming exports.

Countries may turn to the IMF when facing economic difficulties.
Taking a loan from the IMF involves yielding some control over economic policies because the IMF dictates terms and monitors progress.
The IMF is intended for short-term balance of payment difficulties.

Trade disruptions can lead to increased prices and shortages of goods.
Countries should specialize in what they produce most efficiently to avoid trade disruptions.

Devaluation can increase export earnings, leading to higher foreign exchange reserves.

A central bank's assets include:
- Domestic bonds.
- Foreign exchange reserves (including gold).
Substitute assets mean it doesn't matter whether you keep foreign currency or domestic.
To pay for imports, you need foreign exchange reserves.

Fixed exchange rates are usually fixed against the US dollar.
Some countries may fix their currency against a basket of currencies of their major trading partners.
This is sometimes undisclosed to prevent speculation.
Fixed exchange rates among multiple countries require similar economic conditions; otherwise, it is difficult to manage.

Under the gold standard, currency is 100% backed by gold.
Central banks are liable to take back currency.
The gold standard was abandoned because:
- Gold supplies declined.
- It was difficult to keep up with economic growth.
- It restricted the economy's ability to print more money.

When money demand increases: interest rates increase.
To keep exchange rates fixed: central banks sell their currency and buy foreign exchange to depreciate their currency.
Central banks decrease the money supply to maintain a fixed exchange rate.