TRADE AND FINANCE - JAROS_Session 4 (1)

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• Course Title: AECO24A00: International Trade & Finance

  • Focus: Money, Interest Rates, Exchange Rates & Monetary Policy

  • Instructor: Boris Jaros

  • Audience: EBA Regular Use, Corporate Use

  • Date: 09/11/2024

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• Disclaimer:

  • Views expressed in this document are for educational purposes only.

  • They reflect the speaker’s personal views, not the official positions of the French Central Bank, the European Banking Authority, or other institutions.

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• International Finance Overview:

  1. International Finance & the International Monetary System (Chapters 13, 14, 19)

  2. Financial Globalisation (Chapters 20, 22)

  3. Optimum Currency Areas and the Euro (Chapter 21)

  4. Money, Interest Rates, Exchange Rates and Monetary Policy (Chapters 15-18)

  5. The Political Economy of Trade Policy (Chapters 10-12)

  6. Climate Change & International Finance (Key emerging topic)

  • Recommendation: Students should read relevant chapters before/after lectures.

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• Learning Objectives:

  • Understand key concepts for the determination of interest rates and exchange rates.

  • Explore supply and demand dynamics in foreign exchange and money markets.

  • Learn about monetary policy.

  • Reference Chapters: 15, 16, 17, 18

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• News Update (1):

  • ECB lowers interest rates to 3.25% as inflation slows.

    • ECB Monetary policy decision date: 17/10/2024.

    • Eurozone inflation fell to 1.7% by September, below 2% for the first time in over three years.

  • Euro slightly weaker, trading at $1.083 post-announcement.

  • Traders anticipate further rate reductions in December and January.

  • Quote from Christine Lagarde: "Have we broken the neck of inflation? Not yet."

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• News Update (2):

  • US stocks hit record highs post-Donald Trump victory (07/11).

  • The USD appreciated against euro, yen, and pound as traders anticipate increased tariffs and tax cuts.

  • European stocks declined due to negative outlook for exporters.

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• News Update (3):

  • Federal Reserve cuts interest rates to 4.5%-4.75% (07/11).

  • This was a reduction from the previous half-point cut made to mitigate job market weaknesses.

  • Fed refrains from providing specific future rate guidance.

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• Interest Rate Parity (IRP):

  • IRP equalizes expected return rates on dollar and euro deposits based on interest rates and expected exchange rate changes.

  • Covered Interest Rate Parity (CIRP) indicates a relationship between interest rates across countries and changes in forward versus spot exchange rates.

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• Graphic Representation:

  • Higher euro interest rates lead to dollar depreciation; Higher dollar interest rates lead to dollar appreciation.

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• Part I: Money and the Equilibrium of the Money Market.

  • Focus on the intrinsic link between money supply and demand, as well as its influence on interest rates.

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• What is Money?:

  • Functions of money: Store of value, unit of account, medium of exchange.

  • Definitions: Narrow (currency in circulation, checking deposits) and broader definitions of money including different monetary aggregates:

    • M1: Most liquid (cash and overnight deposits).

    • M2: Includes M1 + certain deposits.

    • M3: Broad money includes M2 + additional financial instruments.

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• What is the Money Market?:

  • Interest rates are determined by expected returns on monetary vs. non-monetary assets.

  • Risks mainly arise from unexpected inflation which impacts purchasing power.

  • Need for liquidity increases as transaction costs rise.

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• Continuation of Money Market:

  • Highlights continued assessment of risks, returns, and liquidity considerations in monetary asset valuation.

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• Aggregate Money Demand:

  • Understanding how real income changes affect the aggregate demand for money.

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• Effect on Aggregate Real Money Demand:

  • Insights on shifts in real income on money demand schedules.

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• Money Demand and Supply:

  • Factors determining the equilibrium exchange rate discussed.

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• Effects of Money Supply Changes:

  • Visual representation of impacts on interest rate variations caused by changes in money supply.

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• Money Market and Exchange Rate Linkages:

  • Examination of how changes in monetary policy affect both U.S. interest rates and the dollar/euro exchange rate.

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• Simultaneous Equilibrium:

  • Description of equilibrium conditions in the U.S. money and foreign exchange markets.

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• Exchange Rate Dynamics:

  • Analysis of how changes in European money supply impact dollar/euro exchange rates.

  • Increase in money supply leads to a necessary appreciation of the dollar against the euro.

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• Long Run vs. Short Run Dynamics:

  • Overview of time-related adjustments including wages, real output, and the inflationary response to changes in money supply.

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• Short Run and Long Run Effects:

  • Deep dive into adjustments of asset markets through interest rates and exchange rates over time.

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• Exchange Rate Overshooting:

  • Description of overshooting phenomenon in exchange rates due to immediate reactions to monetary policy changes.

  • Critique on volatility due to inertia in price levels.

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• Summary of Part I:

  • Recap of key themes covered in the first section of the course material.

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• Continuation of Summary of Part I:

  • Further elaboration on concepts discussed in previous slides.

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• Part II: Price Levels and Exchange Rates in the Long Run

• Overview of how price adjustments in response to market conditions shape exchange rates.

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• Long-Run Exchange Rate Behavior:

  • Definitions of the long-run in market terms; how adjustments lead to expected behaviors in market participants.

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• Quote:

  • "All models are wrong, but some are useful" - an aphorism regarding the limitations of economic models.

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• Law of One Price and Purchasing Power Parity (PPP):

  • Connection between international price consistency and the law of one price across countries.

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• Monetary Approach to Exchange Rates:

  • Use of relative supply and demand of monetary assets in determining the long-run exchange rate.

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• Monetary Approach - Three Scenarios:

  1. Impact of money supply on currency depreciation.

  2. Effects of rising interest rates leading to real appreciation.

  3. Influence of output increases on currency value and monetary asset demand.

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• Continuation of Monetary Approach - Three Scenarios:

  • Further details in relation to money supply and demand impacts on exchange rates.

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• Monetary Approach - Key Changes:

  • Explanation on how various economic scenarios impact monetary supply and price dynamics.

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• The Fisher Effect:

  • Relationship between inflation rates and nominal interest rates over the long term.

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• Fisher Effect - Hypothetical Scenario:

  • Explanation on how unexpected shifts in money supply lead to changes in national and exchange rate dynamics.

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• Long-Run Economic Variables Post Money Supply Increase:

  • Charting how rates, prices, and exchange rates stabilize after shocks to money supply.

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• Inflation and Expectations:

  • Summary of inflation dynamics in transitioning towards long-run equilibrium as influenced by monetary supply changes and investor expectations.

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• Shortcomings of PPP:

  • Insight into limitations present in using Purchasing Power Parity as a predictive tool.

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• Real Exchange Rate Approach:

  • Description of how nominal and real factors impact the evaluation of exchange rates.

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• Continuation of Real Exchange Rate Approach:

  • Expanded insights on fundamental considerations influencing exchange rates.

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• Factors Influencing Exchange Rates:

  • Examination of both domestic and international elements affecting currency values.

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• Further Influencing Factors:

  • Continued exploration of additional economic factors shaping exchange rate dynamics.

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• Long-Run Real Exchange Rate Determination:

  • Discussion of equilibrium points in global market conditions.

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• Real Exchange Rate Approach Summary:

  • Recap of how both real and monetary factors condition nominal exchange rate outcomes.

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• Effects of Monetary Factors on Nominal Exchange Rate:

  • Analysis of the relationships between monetary factors and nominal behavior of exchange rates.

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• Summation on Nominal Exchange Rate Effects:

  • Concentrated examination of overarching outcomes resulting from shifts in exchange rate conditions.

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• Real Interest Rates:

  • Discussions surrounding the nature and impact of real interest rates in economic analysis.

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• Part III: Output and the Exchange Rate in the Short Run

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• Connection Between Output and Exchange Rates:

  • Building on previous analysis; macro policies impacting economic interactions.

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• Aggregate Demand Overview:

  • Definition encompassing total demand factors impacting economic outputs including consumption, investment, and exports.

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• Aggregate Demand In Relation to Output:

  • Insights on the relationship observing lesser increases in aggregate demand compared to output growth, influencing overall economic dynamics.

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• Short Run Equilibrium:

  • Analysis of conditions determining equilibriums between aggregate demand and output.

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• Short-Run Equilibrium Dynamics:

  • Observations on how currency fluctuations influence aggregate demand and short-run economic production levels.

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• DD Schedule Definition:

  • Framework defining output and exchange rate relationships in equilibrium models.

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• Shifts in the DD Schedule:

  • Identifying how various economic changes (government spending, taxes) result in shifts within the aggregate demand landscape.

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• Asset Market Interrelations:

  • Connection between foreign exchange market behaviors and the money market equilibria.

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• AA Curve Dynamics:

  • Explanation of the AA curve and factors influencing its slope and positioning within the currency market frameworks.

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• Short-Run Equilibrium Intersection:

  • Discussion of achieving simultaneous equilibriums in output and currency markets.

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• Temporary Policy Changes:

  • Understanding the causative factors behind monetary and fiscal adjustments in ownership and macroeconomic stability.

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• Effects of Temporary Increases in Money Supply:

  • Predicted short-term impacts on currency depreciation and adjustments in aggregate output due to policy shifts.

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• Policies for Full Employment Restorations:

  • Different policy implications and economic responses to maintain employment levels.

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• Challenges to Maintain Employment:

  • Obstacles to achieving desired economic output through prescribed monetary or fiscal changes.

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• Liquidity Trap Explanation:

  • Conditions leading to ineffective monetary policy implementations due to stagnant economic conditions.

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• Part IV: Fixed Exchange Rate and Foreign Exchange Intervention Overview.

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• Sterilisation Defined:

  • Process whereby central banks neutralize impacts of foreign exchange actions on domestic money supplies.

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• Money Supply and Balance of Payments Dynamics:

  • Linkages between central bank activities and implications on national money supplies stemming from external balances.

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• Intervention Effects on Money Supply:

  • Detailed look at how direct interventions influence domestic monetary flows and central bank liabilities.

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• Demand for International Reserves Trends:

  • Examination of growth patterns in reserve acquisitions particularly in developing economies post-crises.

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• Monetary Policies Under Fixed Exchange Rates:

  • Limitations of monetary policy effectiveness when maintaining fixed currency values in foreign exchange markets.

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• Central Bank Operations for Fixed Exchange Rates:

  • Required interventions to uphold a stable currency amidst variations in demand for domestic assets.

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• Fiscal Policies Under Fixed Exchange Rate Conditions:

  • How fiscal policies can stimulate output more effectively under fixed systems compared to floating rates.

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• Managed Floating Explained:

  • Discussion about how central banks can balance monetary policies with exchange rate stability through managed floating regimes.

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• Sterilization Efficacy:

  • Assessing the impact of sterilized interventions and their effectiveness in influencing exchange rate behavior.

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• Gold Standard Referenced:

  • Historical perspective on the limitations of the gold standard in modern monetary systems.

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• Monetary Policy Trends:

  • Insights from recent discussions regarding central bank strategies amidst fluctuating inflation conditions.

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• Khan Academy Resource:

  • Promotion of Khan Academy for supplementary learning on topics of trade and finance.

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• Conclusion:

  • Acknowledgment of attendee participation and learning engagement.