Lecture 24: Interest Rates, Exchange Rates & The Balance of Payments Benjamin Graham Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Housekeeping New syllabus is posted 3 Khan academy videos for Friday Why start with supply and demand? Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Reading Quiz (1) How would you describe the interest rates the U.S. government was paying on its debt in 2012 (and currently): a. Historically low b. Historically high c. Historically average d.Extremely volatile -- i.e. historically high some months, historically low others Lecture 13: Balance of Payments Benjamin Graham

Reading Quiz (2) If a country is running a current account surplus, then... a. The deposits in the current account exceed what is necessary to cover foreign exchange liabilities. b. It is exporting more than it is importing c. It is importing more than it is exporting d. It has more savings in the current account than the past account. Lecture 13: Balance of Payments Benjamin Graham

Reading Quiz (3) The Trump administration wants to renogiated NAFTA in ways that reduce the US trade deficit with NAFTA countries. Which statement is true: A. The US is currently running a trade deficit with both Mexico and Canada B. The U.S. is currently running a trade deficit with Mexico and a trade surplus with Canada C. The U.S. is actually already running a trade surplus within NAFTA, it is just China with whom we have a large trade deficit D. NAFTA doesn’t actually affect the trade deficit, so this whole debate is a bit of a red herring Lecture 13: Balance of Payments Benjamin Graham

Review Question: Who controls the money supply in the US? A. The federal reserve (i.e. the central bank) B. The executive branch C. Congress D. Both Congress and the Executive Branch Lecture 13: Balance of Payments Benjamin Graham

Causes of Inflation and Deflation If the supply of money increases slower than the supply of other goods/services, we get deflation 1896 Cross of Gold speech If the money supply increases faster than the supply of goods & services, we get inflation This is common with fiat currencies One of the greatest speeches in american history, and its on... bimetalism Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Dollar-Gold System (1946-1971) After WWII, trade was growing quickly, supply of gold was not We didn’t want deflation Bretton Woods: Dollar became international reserve currency Instead of being backed by gold directly, other currencies were back by dollars By 1965, there were more dollars overseas than gold in U.S. reserves In 1971, Nixon announced the U.S. would no longer redeem dollars for gold Dollar becomes a fiat currency No intrinsic value Not exchangeable for anything else at a fixed rate Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Inflation and Fiat Currencies 1:4 before WWI, 1-1 trillion in 1923. Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Interest Rates and Inflation Nominal interest rate: How much do I have to pay you next year tomorrow to get money today? Real interest rate = nominal interest rate - inflation Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Clicker Question If I have a mortgage at a 3.5% nominal interest rate, and inflation is 2%, what is my real interest rate? A. 0% B. 1.5% C. 2% D. 3.5% E. 5.5% What about if inflation went to 5%? Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Interest Rates and the Money Supply If interest rates are low, people borrow more Money comes out of banks (MB) and becomes cash in people’s hands (M0) Velocity of money increases If interest rates are high, people save Money goes out of people’s hands (M0) and into banks (MB) Velocity of money slows Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Inflation and the Economy (key points) Low real interest rates stimulate the economy (i.e. cause growth). Firms borrow money and buy factories, etc Low interest rates cause inflation They increase the money supply (via the velocity of money) However, governments in debt may want inflation for its own sake Federal Reserve is politically independent Dual mandate: Keep inflation low and unemployment low These two things are tradeoffs Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Philipps Curve One of the greatest speeches in american history, and its on... bimetalism Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

The big bad Fed Politicians are too willing to trade inflation later for growth and low unemployment now So we don’t want them in control But the Fed is undemocratic and super powerful So Ron Paul is freaked out about that And they make a good scapegoat Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

The Volcker Disinflation In 1979, inflation was at 9% Volcker cranked up the interest rate, drove down inflation But it hurt a lot Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Exchange Rates The U.S. has a “floating” exchange rate Some other countries peg to the U.S. Dollar Upside: stability, which allows borrowing & investing Downsides: 1. no flexibility to have inflation during recessions 2. Currency crises Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Currency Unions Many countries use the Euro, some use the US Dollar An unbreakable peg Upsides: stability, ease of borrowing & trade Downsides: No inflation during recession Also M3, which includes some other large time deposits and long-term deposits Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

Current Account Balance X-M Exports - Imports Y - (C + I + G) Total income – (private consumption + investment + government spending) A current account surplus is when exports are greater than imports A current account deficit is the reverse Note: The government’s surplus/deficit is T - G (taxes - government spending) This is different that the current account balance, but it affects the current account balance Also M3, which includes some other large time deposits and long-term deposits Lecture 13: Balance of Payments Benjamin Graham

Capital Account Balance Current Account refers to goods and services (trade) Capital account refers to capital If you run a current account deficit you have to borrow to cover it That borrowing is a capital account surplus (take in more capital than you send out) And vice versa Also M3, which includes some other large time deposits and long-term deposits Lecture 13: Balance of Payments Benjamin Graham