Chapter 5

Scare resources might be allocated by using any or some combination of the following methods:
- Market Price - Lottery
- Command - Personal characteristics
- Majority Rule - Force
- Contest - Sharing equally
- First-come, first-served

Demand, Willingness to Pay, and Value

- Value is what we get, Price is what we pay
- The Value of one more unit of a good or service is its Marginal Benefit
- We measure Value as the maximum price that a person is willing to pay
- But willingness to pay determines demand
- A Demand Curve is a Marginal Benefit Curve

- The Market Demand curve is the horizontal sum of the individual demand curves
- The Market Demand curve is the Marginal Social Benefit Curve

Consumer Surplus
- The value from a good in excess of the benefit received from a good over the amount paid for it
- It is measured by the area under the demand curve and the price paid, up to the quantity bought

Supply, Cost, and the Minimum Supply-Price

- Cost is what the producer gives up, Price is what the producer receives.
- The Cost of one more unit of a good or service is its Marginal Cost
- Marginal Cost is the minimum price that a firm is willing to accept
But the minimum supply-price determines supply:
Supply curve is a Marginal cost curve.

Efficiency of Competitive Equilibrium

- A competitive market creates an efficient allocation of resources at equilibrium
- In equilibrium, total surplus (producer surplus + consumer surplus) is maximized

- If the quantity is less than the equilibrium quantity, the marginal product is valued higher than its
costs to produce
- If the quantity is greater than the equilibrium quantity, the marginal product costs more than the
value people place on it

Market failure
- Markets dont always achieve an efficient outcome

Market Failure A market delivers an inefficient outcome

It can be caused by:
- Underproduction
- Overproduction
Deadweight loss the decrease in total surplus (is a social loss)
Obstacles that bring market failures
- Price and quantity regulations
- Taxes and subsidies
- Externalities
- Public goods and common resources
- Monopoly
- High transaction costs

Chapter 7: Global Markets in Action

Imports & Exports

Comparative advantage the fundamental force that generates trade between nations
If a nation has the ability to perform an activity or produce a good or a service at a lower opportunity
cost than any other nation it is called a National comparative advantage.

Effect of Imports:

Effect of Exports:

International Trade lowers the price of an imported good and raises the price of an exported good
-> Buyers of imported goods benefit, sellers of an exported good benefit
Surplus with Export:

International Trade Restrictions

Governments restrict international trade to protect domestic producers from competition by using 4
main tools:
1. Tariffs
2. Import quotas
3. Export subsidies
4. Other import barriers

Markets with(out) Tariffs:

Effects of a tariff
- Consumer loses
- Producer gains
- Consumer loses more than the producers gain
-> Society loses deadweight loss occurs
Effects of an Import Quota
- Consumer loses
- Producer gains
- Consumer loses more than the producers gain
-> Society loses deadweight loss occurs

Market with Subsidies:

The case against protection

- Helps an infant industry grow
- Counteracts dumping
- Save domestic jobs
- Allows us to compete with cheap foreign labour
- Penalises lax environmental standards
- Prevents rich countries from exploiting developing countries
- Reduces offshore outsourcing that sends UK jobs abroad

Chapter 26: Aggregate Supply & Demand

Aggregate Supply The relationship between the quantity of real GDP supplied and the price level
The quantity of real GDP supplied is the total quantity that firms plan to produce during a given
period.
Two time frames associated with different states of the labour market:
- Long-run aggregate supply
- Short-run aggregate supply

Aggregate Demand the quantity of real GDP demanded

Read through the slides of chapter 26 on dlwo (week 2.1) since its a repetition of last year.
Chapter 29: Fiscal Policy
Government Budgets an annual statement of projected outlays and receipts during the next year,
together with the laws and regulations that support them
Fiscal Policy use of the governments budget to achieve macroeconomic objectives, such as full
employment, sustained economic growth, etc.

Outlays
1. Expenditures on goods and services
2. Transfer payments
3. Debt interest

Budget Balance equals receipts minus outlays

- Budget surplus: receipts > outlays
- Budget deficit: outlays > receipts
- Balanced budget: receipts = outlays

Fiscal Stimulus the use of fiscal policy to increase production and employment
It can be either:
- Automatic: triggered by the state of the economy with no government action
- Discretionary: initiated by the government

Tax revenues and means-tested spending change automatically with the state of the economy
Automatic Changes in Tax Revenues
- When real GDP increases in an expansion, incomes and tax revenues increase
- When real GDP decreases in a recession, incomes and tax revenues decrease

Means-tested spending
The government creates programmes that pay benefits to qualified people and businesses. These
transfer payments depend on the economic state of the economy.
- When the economy is in an expansion, unemployment falls, so needs-tested spending decreases
- When the economy is in a recession, unemployment rises, so needs-tested spending increases

Cyclical and Structural Balances

The Structural surplus or deficit is the budget surplus or deficit that would occur if the economy
were are full employment. That is, budget surplus or deficit that would occur if real GDP equalled
potential GDP.

Chapter 23: Finance, Saving, and Investment

Study of finance how do households and firms obtain and use financial resources and how they
cope with the risks that arise in this activity
Study of money how do households and firms use it, how much do they hold of it, how banks
create and manage it, and how its quantity influences the economy
Physical capital the tools, instruments, machines, etc. that are used today to produce goods and
services
Financial capital the funds that firms use to buy physical capital
Gross investment total amount spent on purchases of new capital and on replacing depreciated
capital
Net investment is the change in the quantity of capital (gross investment depreciation)

Read the rest of the slides on dlwo (week 3.1) since its a repetition of last year.

Chapter 25: International Finance

Foreign exchange rate the price at which one currency exchanges for another
Currency depreciation fall in the value of one currency in terms of another currency
Currency appreciation .

Demand in the Forex market

Depends on:
- Exchange rate
- World demand for export
- Interest rates in a country and other countries
- Expected future exchange rate

Law of demand: other things remaining the same, the higher the exchange rate, the smaller is the
quantity of a currency demanded in the foreign exchange market

The exchange rate is affected by:

- Export effect
The larger the value of a countrys exports, the greater is the quantity of the currency
demanded on the foreign exchange market.
The lower the exchange rate, the greater is the value of a countrys exports and the greater
is the quantity of the currency demanded.
- Expected profit effect
For a given expected future exchange rate, the lower the exchange rate, the greater is the
expected profit from holding.
The greater the expected profit, the greater is the quantity of the currency demanded on the
foreign exchange market.

Supply in the Foreign Exchange Market

Depends on:
- The exchange rate
- Demand for imports
- Interest rates in a country and other countries
- The expected future exchange rate

Law of Supply of Foreign Exchange: Other things remaining the same, the higher the exchange rate,
the greater is the quantity of the currency supplied in the foreign exchange market.

Exchange rate is affected by:

- Imports effect
The larger the value of a countrys imports, the larger is the quantity of the currency
supplied on the foreign exchange market.
The higher the exchange rate, the greater is the value of the countrys imports, so the
greater is the quantity of the countrys currency supplied.

- Expected profit effect

For a given expected future currency exchange rate, the lower the exchange rate, the
greater is the expected profit from holding the currency.
The greater is the expected profit from holding a currency, the smaller is quantity of the
currency supplied on the foreign exchange market.

Changes in demand:
- World demand for exports
- Domestic interest rates relative to the foreign interest rate
- The expected future exchange rate

At a given exchange rate, if world demand for exports increases, the demand for domestic currency
increases and the demand curve shifts rightward.

Changes in Supply
- Domestic demand for imports
- Domestic interest rate relative to the foreign interest rate
- The expected future exchange rate

At a given exchange rate, if the domestic demand for imports increases, the supply of domestic
currency increases and the supply curve shifts rightward.
The exchange rate changes when it is expected to change. These expectations are driven by deeper
forces, two such forces are:
- Interest rate parity
The return on a currency is the interest rate on that currency plus the expected rate of
appreciation over a given period.
When the rates of returns on two currencies are equal, interest rate parity prevails.

- Purchasing power parity

When two quantities of money can buy the same quantity of goods and services, the
situation is called purchasing power parity, which means equal value of money.

Exchange Rate Policy

- Flexible exchange rate
Permits the exchange rate to be determined by demand and supply with no direct
intervention in the foreign exchange market by the central bank.

- Fixed exchange rate

Pegs the exchange rate at a value decided by the government or central bank and is
achieved by direct intervention in the foreign exchange market to block unregulated forces
of demand and supply.

- Crawling peg
Follows a path determined by a decision of the government or the central bank and is
achieved by active intervention in the market.

European Monetary Union

Benefits of the Euro:
- Improves transparency and competition
- Decreases transactions costs
- Eliminates foreign exchange risk

Economic costs of the Euro:

- Loss of sovereignty
- Inability to respond to national shocks

Balance of Payments
When we but something from another country, we use the currency of that country to make the
transaction. We record international transactions in the balance of payments accounts.
A countrys balance of payments accounts records its international trading, borrowing, and lending.

- Current account
Records the receipts from the sale of goods and services to foreigners, the payments for
goods and services bought from foreigners, income and other transfers received from- and
paid to foreigners.
The current account balance equals the sum of exports minus imports, net income, and net
transfers.
- Capital and financial account
Records investment abroad and foreigners investments.

- Reserve assets account

Shows the net increase or decrease in a countrys holdings of foreign currency reserves,
which come about from the official financing of the difference between the current account
and the capital and the account balances.

Chapter 1: Mishkin
Why study financial markets?
- To examine how financial markets such as bond, stock, and foreign exchange markets work
- To examine how financial institutions such as banks, investment, and insurance companies work
- To examine the role of money in the economy

Financial Markets Markets in which funds are transferred from people to firms, who have an
excess of available funds, to people and firms who are in need of them

Security A claim on the issuers future income or assets

Bond A debt security that promises to make payments periodically for a specified period of time
Interest Rate The cost of borrowing or the price paid for the rental of funds

The Stock Market

- Common stock represents a share of ownership in a corporation
- A share of stock is a claim on the residual earnings and assets of the corporation

Why study financial institutions and banking?

Financial Intermediaries: institutions that borrow funds from people who have saved and make
loans to other people
- Banks: Accept deposits and make loans
- Other financial institutions: Insurance companies, pension funds, mutual funds, and
investment companies
Financial Innovation: the development of new financial products and services
- Can be an important force by making the financial system more efficient

Money and Monetary Policy

- Evidence suggests that money plays an important role in generating business cycles
- Monetary theory ties changes in the money supply to changes in aggregate economic activity and
the price level

Money, Business Cycles, and Inflation

- 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
- Data shows a connection between the money supply and the price level
Fiscal Policy and Monetary Policy
- Monetary Policy is the management of the money and interest rates
- Fiscal Policy deals with government spending and taxation
- Budget deficit is the excess of expenditures over revenues for a particular year
- Budget surplus is the excess of revenues over expenditures for a particular year
- Any deficit must be financed by borrowing

The foreign exchange market

- Where funds are converted from one currency into another
- The foreign exchange rate is the price of one currency in terms of another currency
- The foreign exchange market determines the foreign exchange rate

The International Financial System

- Financial markets have become increasingly integrated throughout the world
- The international financial system has tremendous impact on domestic economies:
- How a countrys choice of exchange rate policy affects its monetary policy?
- How capital controls the impact of the domestic financial systems and therefore the
performance of the economy?
- Which should be the role of the international financial institutions, like the IMF?

Chapter 2: An Overview of the Financial System

Function of Financial Markets
- Perform the essential function of channelling funds from economic players, who have saved surplus
funds, to those that have a shortage of funds.
- Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them
securities
- Promotes economic efficiency by producing an efficient allocation of capital, which increases
production
- Directly improve the well-being of consumers by allowing them to time purchases better
Structure of Financial Markets
Debt and Equity Markets:
- Debt instruments (maturity)
- Equities (dividends)

Primary and Secondary Markets:

- Primary Markets issue of new stocks or bonds
- Secondary Markets trading in stocks or bonds that have already been issued

Exchanges and Over-the-Counter (OTC) Markets:

- Exchanges NYSE, Chicago Board of Trade
- OTC Markets Foreign exchange, Federal funds

Money and Capital Markets:

- Money markets deal in short-term debt instruments
- Capital markets deal in longer-term debt and equity instruments

Financial Instruments: Money Market

- Treasury Bill
- Certificate of deposit (CD)
- Repurchase Agreement
- Federal Funds

Financial Instruments: Capital Market

- Stocks
- Mortgages
- Corporate Bonds
- Government Bonds
- Bank Loans

Internationalization of Financial Markets

Foreign Bonds sold in a foreign country and denominated in that countrys currency
Eurobond bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies foreign currencies deposited in banks outside of the home country
- Eurodollars: U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches
Of U.S. banks
World Stock Markets help finance the federal government

Indirect Finance
Lower transaction costs (time and money spent in carrying out financial transactions)
- Economies of scale
- Liquidity services

Reduce the exposure of investors to risk

- Risk sharing (asset transformation)
- Diversification
Dealing with Asymmetric Problems
Before the transaction: Adverse Selection try to avoid selecting the risky borrower
- Gather information about the potential borrower
After the transaction: Moral Hazard ensure the borrower will not engage in activities that will
prevent him/her to repay the loan
- Sign a contract with restrictive covenants

Regulation of the Financial System

To increase the information available to investors:
- Reduce adverse selection and moral hazard problems
- Reduce insider training (SEC)

To ensure the soundness of financial intermediaries:

- Restrictions on entry (chartering process)
- Disclosure of information
- Restrictions on Asset and Activities (control holding of risky assets)
- Deposit insurance (avoid bank runs)
- Limits on competition
- Branching
- Restrictions on interest rates

Chapter 3: What is Money?

Money is different than
- Wealth: the total collection of pieces of property that serve to store value
- Income: flow of earnings per unit of time

Functions of Money
Medium of Exchange:
- Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs)
- Promotes specialization

A medium of exchange must:

- Be easily standardized
- Be widely accepted
- Be divisible
- Be easy to carry
- Not deteriorate quickly

Unit of Account
- Used to measure value in the economy
- Reduces transaction costs

Store of Value
- Used to save purchasing power over time
- Other assets also serve this function
- Money is the most liquid of all assets but loses value during inflation
Evolution of Payments System
Commodity Money: valuable, easily standardized, and divisible commodities (e.g. precious metal,
cigarettes)
Fiat Money: paper money decreed by governments as legal tender
Check: an instruction to your bank to transfer money from your account
Electronic Payment: (e.g. online bill pay)
E-money: debit card, stored-value card, E-cash

Measuring of Money

Chapter 4: Understanding Interest Rates

Measuring Interest Rates
- Present value: a dollar paid to you one year from now is less valuable than a dollar paid to you
today.

Four types of Credit Market Instruments

1. Simple Loan
2. Fixed Payment Loan

3. Coupon Bond

4. Discount Bond
Yield to Maturity The interest rate that equates the present value of cash flow payments received
from a debt instrument with its value today

Rate of Return isnt YTM

The return equals the yield to maturity only if the holding period equals the time to maturity.
A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to
maturity is longer than the holding period.
The more distant a bonds maturity, the greater the size of the percentage price change associated
with an interest-rate change. But also a lower the rate of return that occurs as a result of an increase
in the interest rate.
Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise.

Basically:
- Interest rate up = Bond price down
- Longer maturity = Larger price change
- Longer maturity = Lower rate of return
- Rate of return can become negative

Interest Rate Risk

- Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
- There is no interest rate risk for any bond whose time to maturity matches the holding period.

The Distinction Between Real and Nominal Interest Rates

- Nominal interest rate makes no allowance for inflation
- Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of
borrowing.

- Ex ante real interest rate is adjusted for expected changes in the price level.
- Ex post real interest rate is adjusted for actual changes in the price level

Chapter 5: The Behaviour of Interest Rates

Determinants of Asset demand:
- Wealth: growing wealth = demand curve to the right
- Expected return: higher expected IRs in the future lower the expected return in the long-term =
demand curve to the left
- Risk: increase in risk = demand curve to the left
- Liquidity: increase = demand curve to the right

Supply and Demand in the Bond Market

- At lower prices (high interest rates), ceteris paribus (the quantity demanded of bonds) is higher: an
inverse relationship
- At lower prices (high interest rates), ceteris paribus (the quantity supplied of bonds) is lower: a
positive relationship
Shifts in the supply of bonds:
- Expected profitability (of investment opportunities): in an expansion the supply curve shifts right
- Expected inflation: increase = supply curve shifts right
- Government budget: increased budget deficits = supply curve shifts right

Demand for money in the liquidity preference framework

As the interest rate increases:
- The opportunity cost of holding money increases
- The relative expected return on money decreases
-> The quantity demanded of money decreases

Shifts in the demand for money:

Income effect a higher level of income cause the demand for money at each interest rate to
increase and the demand curve to shift to the right
Price-level effect a rise in the price level causes the demand for money at each interest rate to
increase and the demand curve to shift to the right

Shifts in the supply of money:

- Assume that the supply of money in controlled by the central bank
- An increase in the money supply engineered by the Federal Reserve will shift the supply curve for
money to the right

Look through all the graphs in the Slides of Chapter 5, week 5 on dlwo!

Chapter 6: The Risk Structure of Interest Rates

Bonds with the same maturity have different interest rates due to:
1. Default risk
Probability that the issuer of the bond is unable or unwilling to make interest payments or
pay off the face value.
Risk Premium: the spread between the interest rates on bonds with default risk and the
interest rates on (same maturity) treasury bonds
2. Liquidity
The relative ease with which an asset can be converted into cash
- cost of selling a bond
- number of buyers/sellers in a bond market
3. Income Tax rules
- Interest payments on municipal bonds are exempt from federal income taxes

An Increase in Default risk makes demand for bonds decrease bond price falls interest rate
increases

Bonds with identical risk and liquidity may have different interest rates, because the time remaining
to maturity is different
Yield curve a plot of the yield on bonds with differing terms to maturity but with the same risk,
liquidity, and tax considerations
- YC = term structure of interest rate = interest rate curve
- The Yield curve is a leading indicator of the economy

Upward sloping: short-term rates < long-term rates

Flat: shot-term rates = long-term rates
Inverted: short-term rates > long-term rates

Video on yield curves: http://www.investopedia.com/video/play/yield-curve/

Chapter 11: Banking and the Management of Financial Institutions

A banks balance sheet

Bank reserves

Required reserve ratio bank reserves / checkable deposits

- Excess reserves can be lent out
- When a bank receives additional deposits, it gains an equal amount of reserves
- When a bank loses deposits, it loses an equal amount of reserves

How do banks make profit?

- borrow short, lend long
General principles of bank management
- Liquidity management
- Asset management
- Liability management
- Capital adequacy management
- Credit risk
- Interest-rate risk

Liquidity management
Shortfall in reserves
- Reserves are a legal requirement and the shortfall must be eliminated
- Excess reserves are insurance against the costs associated with deposit outflows

Borrowing
- Cost incurred is the interest rate paid on the borrowed funds

Securities sale
- Cost of selling securities is the brokerage (commission or fee paid to a broker) and other
transaction costs

Federal Reserve
- Borrowing from the Fed also incurs interest payments based on the discount rate

Reduce loans
- Reduction of loans is the most costly way of acquiring reserves
- Calling in loans antagonizes customers
- Other banks may only agree to purchase loans at a substantial discount

Asset management: 3 goals, 4 tools

Goal 1: Seek the highest possible return on loans and securities
Goal 2: Reduce risk
Goal 3: Have adequate liquidity
- Tool 1: Find borrowers who will pay high interest rates and have a low possibility of defaulting (the
failure of not being able to pay interest when due)
- Tool 2: Purchase securities with high returns and low risk
- Tool 3: Lower risk by diversifying
- Tool 4: Balance need for liquidity against increased returns from less liquid assets

Liability management
- Recent phenomenon due to rise of money centre and banks
- Expansion of overnight loan markets and new financial instrument (such as negotiable CDs)
- Checkable deposits have decreased in importance as source of bank funds

Capital adequacy management

- Bank capital helps prevent bank failure
- The amount of capital affects return for the owners of the bank (equity holders)
- Regulatory requirement
Managing credit risk
- Screening and monitoring
- Long-term customer relationships
- Loan commitments
- Collateral and compensating balances
- Credit retioning

Chapter 14: Central Banks and the Federal Reserve System

Resistance to establishment of a central bank
- Fear of centralized power
- Distrust of moneyed interests

No lender of last resort

- Nationwide bank panics on a regular basis
- Panic of 1907 so severe that the public was convinced a central bank was needed

Federal Reserve Act of 1913

- Elaborate system of checks and balances
- Decentralized

Functions of the Federal Reserve banks

- Clear checks
- Issue new currency
- Withdraw damaged currency from circulation
- Administer and make discount loans to banks and their districts
- Evaluate proposed mergers and applications for banks to expand their activities
- Act as liaisons between the business community and the Federal Reserve System
- Examine bank holding companies and state-chartered member banks
- Collect data on local business conditions
- Use staff of professional economists to research topics related to the conduct of monetary policy

Federal Reserve Banks and Monetary Policy

- Directors establish the discount rate
- Decide which banks can obtain discount loans
- Directors select one commercial banker from each district to serve on the Federal Advisory Council,
which consults with the Board of Governors and provides information to help conduct monetary
policy
- Five of 12 bank presidents have a vote in the Federal Open Market Committee (FOMC)

Board of Governors of the Federal Reserve System

- Seven members headquartered in Washington, D.C.
- Appointed by the president and confirmed by the Senate
- 14-year non-renewable form
- Required to come from different districts
- Chairman is chosen from the governors and serves four-year term

Duties of the Board of Governors

- Votes on conduct of open market operations
- Sets reserve requirements
- Controls the discount rate through review and determination process
- Sets margin requirements
- Sets salaries of president and officers of each Federal Reserve Bank and reviews each banks
budget
- Approves bank mergers and applications for new activities
- Specifies the permissible activities of bank holding companies
- Supervises the activities of foreign banks operating in the U.S.

Chairman of the Board of Governors

- Advises the president on economic policy
- Testifies in Congress
- Speaks for the Federal Reserve System to the media
- May represent the U.S. in negotiations with foreign governments on economic matters

Federal Open Market Committee (FOMC)

- Meets 8 times a year
- 7 members of the Board of Governors, the president of the Federal Reserve Bank of New York and
the presidents of 4 other Federal Reserve Banks
- Chairman of the Board of Governors is also the chairman of FOMC
- Issues directives to the trading desk at the Federal Reserve Bank of New York

Independency of the Fed

- Instrument and independence
- Independent revenue
- Feds structure is written by Congress and is subject to change at any time
- Presidential influence:
- Influence on Congress
- Appoints members
- Appoints chairman although terms are not concurrent

Should the Fed be independent?

For:
The strongest argument for an independent central bank rests on the view that subjecting it to more
political pressures would impart an inflationary bias to monetary policy

Against:
Proponents of a Fed under control of the president of Congress argue that it is undemocratic to have
a monetary policy controlled by an elite group that is responsible to no one

Structure and Independence of the European Central Bank

- Patterned after the Federal Reserve
- Central banks from each country play a similar role as the Fed banks
- Executive board
President, vice-president and four other members
Eight year, non-renewable terms
- Governing Council

Differences between the EU system and the Fed system

- National Central banks control their own budgets and the budget of the ECB
- Monetary operations are not centralized
- Does not supervise and regulate financial institutions

How independent is the ECB?

- Established in 1999
- Most independent in the world
- Members of the executive board have long terms
- Determines own budget
- Less goal independent
Price stability
- Charter cannot be changed by legislation; only by revision of the Maastricht Treaty

Chapter 15: The Money Supply Process

Three players in the Monetary Supply process
- Central bank (Fed)
- Banks
- Depositors
The Feds Balance Sheet

Liabilities
- Currency in circulation
- Reserves; bank deposits at the Fed and vault cash

Assets
- Government securities: holdings by the Fed that affect money supply and earn interest
- Discount loans: provide reserves to banks and earn the discount rate

Control of the monetary base

High powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system

Open market purchase

- The effect of an open market purchase on reserves depends on whether the seller of the bonds
keeps the proceeds from the sale in currency or in deposits
- The effect of an open market purchase on the monetary base always increases the monetary base
by the amount of the purchase.

Open market sale

- Reduces the monetary base by the amount of sale
- The effect of open market operations on the monetary base is much more certain than the effect
of reserves
- Reserves remain unchanged

The Feds ability to control the monetary base

- Open Market operations are controlled by the Fed
- The Fed cannot determine the amount of borrowing by banks from the Fed
- Split the monetary base into two components
MB - BR
- The money supply is positively related to both the non-borrowed monetary base (MB) and to the
level of borrowed reserves (BR) from the Fed.
Factors that determine the money supply
- Changes in the non-borrowed monetary base (MBn)
The money supply is positively related to the MBn
- Changes in borrowed reserves from the Fed
The money supply is positively related to the level of BR from the Fed
- Changes in the required reserves ratio
The money supply negatively related to the required reserve ratio
- Changes in currency holdings
The money supply I negatively related to the currency holdings
- Changes in excess reserves
The money supply is negatively related to the amount of excess reserves

The money multiplier

- Define money as currency plus checkable deposits: M1
- Link the money supply (M) to the monetary base (MB) and let m be the money supplier
M = m x MB

Chapter 19: The International Financial System

Foreign exchange intervention
- Sell international reserves
- A central banks sale of domestic currency to purchase foreign assets in the foreign exchange
market results in an equal rise in its international reserves and the monetary base

Unsterilized foreign exchange intervention

- An unsterilized intervention in which domestic currency is sold to purchase foreign assets lead to a
gain in international reserves, an increase in money supply, and a depreciation of the domestic
currency

Sterilized foreign exchange intervention

- No impact on the monetary base and the money supply
- To counter the effect of foreign exchange intervention, conduct an offsetting open market
operation

Balance of payments
Current account
- International transactions that involve currently produced goods and services
- Trade balance

Capital account
- Net receipts from capital transactions

The sum of these two is the official reserve transactions balance

Fixed exchange rate regime

- Value of a currency is pegged relative to the value of one other currency
Floating exchange rate regime
- Value of a currency is allowed to fluctuate against all other currencies
Managed float regime
- Attempt to influence exchange rates by buying and selling currencies

Fixed exchange rate regime

When the domestic currency is overvalued, the central bank must;
- purchase domestic currency to keep the exchange rate fixed
Or;
- conduct a devaluation

When the domestic currency is undervalued, the central bank must;

- sell domestic currency to keep the exchange rate fixed
Or;
- conduct a revaluation