Goals of Monetary Policy Goals 1.High Employment 2.Economic Growth 3.Price Stability 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict
Monetarists vs. Keynesians Monetarists Stabilize prices through controlling the money supply. A stable economic environment is a necessary condition for economic growth. Keynesians Deficit spending during recessions. Wage & price controls for inflation.
MV = PT “Inflation is always and everywhere a monetary phenomenon.” --- Milton Friedman 16
Balance of Payments Current account (receipts from exports, payments from imports) Capital account (receipts from investments in U.S., payments from investment by Americans in foreign countries) Official transaction account (receipts from sale of U.S. $, payments from purchase of U.S. $
Three equilibrating mechanisms 1.Specie flow mechanism under an old fashioned gold standard. 2.Central bank coordination under a fixed rate regime (e.g. Bretton Woods). 3.Exchange rate adjustments under flexible exchange rates.
1. Old-fashioned Gold Standard: Specie Flow Mechanism U.S. importer buys French wine with dollars. French wine exporter takes dollars to French bank to exchange for francs. French bank goes to U.S. bank to exchange dollars for gold. The gold reserves at the bank are reduced forcing a reduction in the money supply; a deflation ensues. Goods and assets are cheaper in U.S. stimulating a demand for American goods and assets by the French. Equilibrium is achieved when gold inflows equal gold outflows.
2. Central bank coordination under a fixed rate regime (e.g., Bretton Woods) U.S. buys more goods and assets from abroad, than it sells. Foreigners sell their U.S. $’s and foreign central banks buy them with their own currency to keep the exchange rate at its fixed level. Foreign central banks are forced to expand their money supplies.
3. Exchange rate adjustments under flexible exchange rates US buys more goods and assets than it sells. Foreigners sell the U.S.$’s and the value of the $ falls. Foreign goods and assets become more expensive so Americans demand less, and, at the same time, American goods become cheaper for foreigners so foreigners buy more. The value of the dollar stops falling when the payments have become balanced.
International Monetary Fund Created at Bretton Woods in 1944. An international central bank. Located in Washington, D.C.
IMF continued A lender of last resort on a global scale. If a country was running a deficit in the balance of payments, it would need to buy its own currency to maintain the exchange rate. But to buy its own currency, it needs foreign exchange. The IMF stood ready to lend foreign exchange.
The IMF after Bretton Woods. Case Study: The Asian Crisis