FIN320 Final Study Guide ：Help me complete the study guide with each questions

Monetary Policy and Foreign Exchange

Lamont Black FIN320 Week 9

Monetary Policy

Monetary Policy

•  “Monetary policy” is the central bank controlling the “money supply” to manage the economy – Trying to avoid “boom and bust” business cycle – Think of Goldilocks – not “too hot” and not “too cold”

•  Most central banks now target interest rates rather than “money supply,” but you can think of it in similar terms – Lowering interest rates increases money supply – Raising interest rates reduces money supply

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FOMC

•  The Federal Open Market CommiOee meets 8 Qmes a year to “set interest rates”

•  Open market opera,ons (OMOs) – the purchase and sale of government securiQes (Treasuries) that affect both interest rates and the amount of reserves in the banking system

Federal Funds Rate •  Open market operaQons are the most important policy tool for controlling the money supply –  the buying and selling Treasuries in the interbank market –  used to achieve the target federal funds rate –  affects interest rate on short-term loans

•  Federal funds rate (FFR) is the interest rate on overnight loans from one bank to another

•  Target vs. effecQve FFR (NY Fed adjusts the supply of reserves)

The Market for Reserves and the Federal Funds Rate

•  How do changes in this tool of monetary policy affect the federal funds rate?

•  The Fed controls the supply of reserves.

•  Open market purchase is an increase in the supply of reserves (causing FFR to fall)

•  Open market sale is a decrease in the supply of reserves (causing FFR to rise)

The Interbank Market •  The federal funds rate (FFR) is the overnight interest rate in

the interbank market

•  The interbank market is where banks can borrow and lend reserves (money)

•  By controlling the supply of reserves in the banking system, the Fed controls the cost of borrowing reserves –  More supply of reserves, lower cost of borrowing –  Less supply of reserves, higher cost of borrowing

•  Therefore, the Fed can “set” the FFR through OMOs

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OMOs and Monetary Policy

•  OM Purchase will decrease FFR = monetary loosening

•  OM Sale will increase FFR = monetary ,ghtening

2017-2018 “Rate hikes” •  Open market sale of Treasury bills to primary dealers – decreases supply of reserves –  increases federal funds rate

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The Conduct of Monetary Policy •  The Fed has a “dual mandate” (i.e., two goals)

•  “Price stability” –  Low and stable inflaQon –  A 2% inflaQon target –  A nominal anchor limits Qme-inconsistency –  “Forward guidance” (vs. surprises)

•  “Maximum employment” –  Natural rate of unemployment (NRU) –  NonacceleraQng inflaQon rate of unemployment (NAIRU) –  High, stable real growth –  Unemployment below 4%??

Federal Funds Rate (FFR) •  The FFR is the key tool of convenQonal monetary policy in the U.S.

•  Economy too cold? Lower rates

–  Increase reserves in the system (open market purchase) –  Increase the amount of money in circulaQon –  Increase inflaQon and employment growth –  Reduce cost of borrowing (hurt savers) –  Terms: loosening, easing, sQmulus, accommodaQon

•  Economy too hot? Raise rates –  Reduce reserves in the system (open market sale) –  Reduce the amount of money in circulaQon –  Slow down inflaQon and employment growth –  Increase cost of borrowing (benefit savers) –  Terms: monetary ,ghtening, monetary contrac,on

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FOMC Announcements •  What is an “FOMC Statement”?

•  How did the most recent one change?

•  What are the “projecQon materials”?

•  What is the “dot plot”?

•  What is the expectaQon for the upcoming meeQngs?

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Foreign Exchange

Foreign Exchange Market

•  The buying and selling of different currencies – Exchange one currency for another

•  History – Gold standard (1876 to 1914) – BreOon Woods (1945-1971): pegs to the dollar

•  Created the InternaQonal Monetary Fund (IMF) •  Richard Nixon cancelled the internaQonal converQbility of the U.S. dollar to gold in 1971

– FloaQng exchange rates (current)

Foreign Exchange Rates •  Exchange rate: price of a currency relaQve to another currency

•  EURUSD (“EURO” on WSJ Qcker) is the “spot” exchange rate between Euros and U.S. Dollars – “the price of 1 EUR in USD”

•  Spot transac,on is the immediate (two-day) exchange of bank deposits

•  Forward transac,on is exchange of bank deposits at specified future date

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Exchange rates

•  Apprecia,on: rise in currency value •  Deprecia,on: fall in currency value

•  Strong currency means exports become more expensive and imports become cheaper

•  Core of FX is a “cash market” (spot market) – An over-the-counter (OTC) interbank market

•  One of largest markets on the planet

Recent Examples

•  Brexit, Summer 2016, and the pound

•  The Trump elecQon and the Mexican Peso

•  “Currency wars” (like trade war)

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The U.S. Dollar •  Is the U.S. Dollar “strengthening” or “weakening”?

•  Why?

•  How does this affect interna,onal trade? •  How does this affect corporate profits?

•  How does this affect commodity prices? •  How does this affect infla,on?

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Factors in FX

•  What factors increase/decrease demand?

•  Rela,ve infla,on rates – Increase in U.S. inflaQon increases demand for foreign currency

Increase in •  DomesQc price level è deprecia(on

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Factors in FX (2)

•  What factors increase/decrease demand?

•  Rela,ve real interest rates – Real rate = nominal rate – inflaQon rate – Economic producQvity – Increase in U.S. rates increases demand for dollars

Increase in •  DomesQc real rate è apprecia(on

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Factors in FX (3)

•  What factors increase/decrease demand?

•  Rela,ve monetary policy – Monetary Qghtening tends to strengthen currency – Monetary loosening tends to weaken currency

Increase in •  Federal funds rate è apprecia(on

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Foreign Exchange Risk

•  Hedging/speculaQng foreign exchange rates

•  Can use currency futures and opQons – G7 “hard currencies” – Emerging market currencies

•  Changes in FX “policy” are the biggest risks 21

FX Policy (1)

•  Foreign exchange market interven,on: policy acQon by a central bank to influence the exchange rate

•  Interna,onal reserves: assets that are denominated in a foreign currency

•  If PBoC wants to prevent decline in yuan, it can increase the demand for yuan by selling foreign assets and buying yuan in internaQonal currency markets.

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FX Policy (2)

•  On August 11, 2015, the People’s Bank of China (PBoC) surprised markets with three consecuQve devalua,ons of the yuan renminbi (CNY), reducing its value by 3%.

•  A devalua,on is a government FX policy change due to reduced support for the domesQc currency

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FX Policy (3)

•  InternaQonal Monetary Fund (IMF)

•  Major intervenQons – Asian financial crisis (1998) – European sovereign debt crisis (2010)

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