International Finance Internet

8/8/2019 International Finance Internet

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Sunday, August 15, 2010

International finance

International finance is the branch of economics that studies the dynamics of

exchange rates, foreign investment, and how these affect international trade. It alsostudies international projects, international investments and capital flows, and tradedeficits. It includes the study of futures, options and currency swaps. Internationalfinance is a branch of international economics.

Important theories in international finance include the Mundell-Fleming model,the optimum currency area (OCA) theory, as well as the purchasing power parity (PPP)theory. Whereas international trade theory makes use of mostly microeconomic methodsand theories, international finance theory makes use of predominantly macroeconomicmethods and concepts.

In finance, the exchange rates (also known as the foreign-exchange rate, forexrate or FX rate) between two currencies specifies how much one currency is worth interms of the other. It is the value of a foreign nations currency in terms of the homenations currency.[1] For example an exchange rate of 91 Japanese yen (JPY, ) to theUnited States dollar (USD, $) means that JPY 91 is worth the same as USD 1. Theforeign exchange market is one of the largest markets in the world. By some estimates,about 3.2 trillion USD worth of currency changes hands every day. :)

The spot exchange rate refers to the current exchange rate. The forwardexchange rate refers to an exchange rate that is quoted and traded today but for deliveryand payment on a specific future date.

Foreign direct investment (FDI) refers to long term participation by country Ainto country B. It usually involves participation in management, joint-venture, transfer oftechnology and expertise. There are two types of FDI: inward foreign direct investmentand outward foreign direct investment, resulting in a net FDI inflow (positive ornegative).

History

Foreign direct investment (FDI) is a measure of foreign ownership of productive

assets, such as factories, mines and land. Increasing foreign investment can be used asone measure of growing economic globalization. Figure below shows net inflows offoreign direct investment. The largest flows of foreign investment occur between theindustrialized countries (North America, Western Europe and Japan). But flows to non-industrialized countries are increasing sharply.


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US International Direct Investment Flows:

Period FDI Outflow FDI Inflows Net

1960-69$ 42.18 bn $ 5.13 bn + $ 37.04 bn

1970-79$ 122.72 bn $ 40.79 bn + $ 81.93 bn

1980-89$ 206.27 bn $ 329.23 bn - $ 122.96 bn

1990-99$ 950.47 bn $ 907.34 bn + $ 43.13 bn

2000-07$ 1,629.05 bn $ 1,421.31 bn + $ 207.74 bn

Total $ 2,950.69 bn $ 2,703.81 bn + $ 246.88 bn

Types

A foreign direct investor may be classified in any sector of the economy and could beany one of the following.

y an individual;y a group of related individuals;y an incorporated or unincorporated entity;y a public company or private company;y a group of related enterprises;y a government body;y an estate (law), trust or other societal organisation; ory any combination of the above.

Methods

The foreign direct investor may acquire 10% or more of the voting power of anenterprise in an economy through any of the following methods:

y by incorporating a wholly owned subsidiary or companyy by acquiring shares in an associated enterprisey through a merger or an acquisition of an unrelated enterprisey participating in an equity joint venture with another investor or enterprise

Foreign direct investment incentives may take the following forms:

y low corporate tax and income tax ratesy tax holidaysy other types of tax concessionsy preferential tariffsy special economic zonesy EPZ - Export Processing Zonesy Bonded Warehousesy Maquiladoras


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y investment financial subsidiesy soft loan or loan guaranteesy free land or land subsidiesy relocation & expatriation subsidiesy job training & employment subsidiesy

infrastructure subsidiesy R&D supporty derogation from regulations (usually for very large projects)

Benefits of FDI for low-income countries

Some countries have put restrictions on FDI in certain sectors. India, with itsrestriction on FDI in the retail sector is an example.[2] In a country like India, thewalmartization of the country could have significant negative effects on the overalleconomy by reducing the number of people employed in the retail sector (currently thesecond largest employment sector nationally) and depressing the income of people

involved in the agriculture sector (currently the largest employment sector nationally).[3]

International trade is exchange of capital, goods, and services acrossinternational borders or territories.[1]. In most countries, it represents a significant share ofgross domestic product (GDP). While international trade has been present throughoutmuch of history (see Silk Road, Amber Road), its economic, social, and politicalimportance has been on the rise in recent centuries.

Industrialization, advanced transportation, globalization, multinationalcorporations, and outsourcing are all having a major impact on the international tradesystem. Increasing international trade is crucial to the continuance of globalization.

Without international trade, nations would be limited to the goods and services producedwithin their own borders.

International trade is in principle not different from domestic trade as themotivation and the behavior of parties involved in a trade do not change fundamentallyregardless of whether trade is across a border or not. The main difference is thatinternational trade is typically more costly than domestic trade. The reason is that aborder typically imposes additional costs such as tariffs, time costs due to border delaysand costs associated with country differences such as language, the legal system orculture.

Another difference between domestic and international trade is that factors of production such as capital and labour are typically more mobile within a country thanacross countries. Thus international trade is mostly restricted to trade in goods andservices, and only to a lesser extent to trade in capital, labor or other factors ofproduction. Then trade in goods and services can serve as a substitute for trade in factorsof production. Instead of importing a factor of production, a country can import goodsthat make intensive use of the factor of production and are thus embodying the respectivefactor. An example is the import of labor-intensive goods by the United States from


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China. Instead of importing Chinese labor the United States is importing goods fromChina that were produced with Chinese labor.

International trade is also a branch of economics, which, together withinternational finance, forms the larger branch of international economics

International economics is concerned with the effects upon economic activity ofinternational differences in productive resources and consumer preferences and theinstitutions that affect them. It seeks to explain the patterns and consequences oftransactions and interactions between the inhabitants of different countries, includingtrade, investment and migration.

y International trade studies goods-and-services flows across international boundaries from supply-and-demand factors, economic integration, and policyvariables such as tariff rates and trade quotas.[1][2]

y International finance studies the flow of capital across international financial

markets, and the effects of these movements on exchange rates.

[3]

y International monetary economics and macroeconomics studies money and

macro flows across countries.[4][5][6][7]

. The Mundell-Fleming model is an economic model first set forth by RobertMundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereasthe traditional IS-LM Model deals with economy under autarky (or a closed economy),the Mundell-Fleming model tries to describe an open economy.

Typically, the Mundell-Fleming model portrays the relationship between the nominalexchange rate and an economy's output (unlike the relationship between interest rate and

the output in the IS-LM model) in the short run. The Mundell-Fleming model has beenused to argue that an economy cannot simultaneously maintain a fixed exchange rate, freecapital movement, and an independent monetary policy. This principle is frequentlycalled "the Unholy Trinity," the "Irreconcilable Trinity," the "Inconsistent trinity" or theMundell-Fleming "trilemma."

Basic set up

The traditional model is based around the following equations.

y Y= C+ I+ G + NX(TheISCurve)o Where Y is GDP, C is consumption, I is investment, G is government

spending andNXis net exports.

y (The LMCurve)


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o Where M is money supply, P is average price, L is liquidity, i is the

interest rate and Yis GDP.

y BoP= CA + KA (TheBoPCurve (Balance of Payments))o

Where CA is the current account andKA is the capital account.

IS components

y C= C(Y T,i E())o Where Cis consumption, Yis GDP, Tis taxes, i is the interest rate,E()

is the expected rate of inflation.

y I= I(i E(),Y 1)o Where I is investment, i is the interest rate,E() is the expected rate of

inflation, Y 1 is GDP in the previous period.

y G = Go Where G is government spending, an exogenous variable.

y NX= NX(e,Y,Y* )o WhereNXis net exports, e is the real exchange rate, Yis GDP, Y* is the

GDP of a foreign country.

BoP components

y CA = NXo Where CA is the current account andNXis net exports.

y KA = z(i i * ) + ko Where z is the level of capital mobility, i is the interest rate, i * is the

foreign interest rate, kis capital investments not related to i, an exogenousvariable

Mechanics of the model

One important assumption is the equalization of the local interest rate to the globalinterest rate.


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Under flexible exchange rate regime

We speak of a system of flexible exchange rates when governments (or centralbanks) allow the exchange rate to be determined by market forces alone.

Changes in money supply

An increase in money supply shifts the LM curve downward. This directlyreduces the local interest rate and in turn forces the local interest rate lower than theglobal interest rate. This depreciates the exchange rate of local currency through capitaloutflow. (Hot money flows out to take advantage of higher interest rate abroad and hencecurrency depreciates.) The depreciation makes local goods cheaper compared to foreigngoods and increases export and decreases import. Hence, net export is increased.Increased net export leads to the shifting of the IS curve (which is Y = C + I + G + NX)to the right to the point where the local interest rate equalizes with the global rate. At thesame time, the BoP is supposed to shift too, as to reflect(1)depreciation of home currency

and (2)an increase in current account or in other word, the increase in net export. Theseincrease the overall income in the local economy.

A decrease in money supply causes the exact opposite of the process.

Changes in government spending

An increase in government expenditure shifts the IS curve to the right. The shiftcauses the local interest rate to go above the global rate. The increase in local interestcauses capital inflow, and the inflow makes the local currency stronger compared toforeign currencies. Strong exchange rate also makes foreign goods cheaper compared to

local goods. This encourages greater import and discourages export and hence, lower netexport. As a result, the IS returns to its original level, where the local interest rate is equalto the global interest rate. The level of income of the local economy stays the same. TheLM curve is not at all affected. A decrease in government expenditure reverses theprocess.

Changes in global interest rate

An increase in the global interest rate causes an upward pressure on the localinterest rate. The pressure subsides as the local rate closes in on the global rate. When apositive differential between the global and the local rate occurs, holding the LM curve

constant, capital flows out of the local economy. This depreciates the local currency andhelps boost net export. Increasing net export shifts the IS to the right. This shift continuesto the right until the local interest rate becomes as high as the global rate. A decrease inglobal interest rate causes the reverse to occur.


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Under fixed exchange rate regime

We speak of a system of fixed exchange rates when governments (or centralbanks) announce an exchange rate (the parity rate) at which they are prepared to buy orsell any amount of domestic currency.

Changes in money supply

Under the fixed exchange rate system, the local central bank or any monetaryauthority only changes the money supply to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply ofdomestic currency exceeds its demand in foreign exchange markets, the local authoritybuys domestic currency with foreign currency to decrease the domestic currency's supplyin the foreign exchange market. This returns the domestic currency's exchange rate backto its original level. If there is pressure to appreciate the domestic currency's exchangerate because the currency's demand exceeds its supply in the foreign exchange market,

the local authority buys foreign currency with domestic currency to increase the domesticcurrency's supply in the foreign exchange market. This returns the exchange rate back toits original level.

A revaluation occurs when there is a permanent increase in exchange rate andhence, decrease in money supply. Devaluation is the exact opposite of revaluation.

Changes in government expenditure

Increase in government spending forces the monetary authority to flood themarket with local currency to keep the exchange rate unchanged.

Increased government expenditure shifts the IS curve to the right. The shift resultsare a rise in the interest rate and hence, an appreciation of the exchange rate. However,the exchange rate is controlled by the local monetary authority in the framework of afixed system. To maintain the exchange rate and eliminate pressure from it, the monetaryauthority purchases foreign currencies with local currency until the pressure is gone, i.e.,back to the original level. Such action shifts the LM curve in tandem with the direction of


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the IS shift. This action increases the local currency supply in the market and lowers theexchange rateor rather, return the rate back to its original state. In the end, theexchange rate stays the same but the general income in the economy increases.

The reverse is true when government expenditure decreases.

Changes in global interest rate

To maintain the fixed exchange rate, the central bank must offset the capital flows(in or out), which are caused by the change of the global interest rate to the domestic rate.The central bank must restore the situation where the real domestic interest rate is equalto the real global interest rate to stop net capital flows from changing the exchange rate.

If the global interest rate increases above the domestic rate, capital flows out totake advantage of this opportunity.(Hot money flows out of the economy) This woulddepreciate the home currency, so the central bank may buy the home currency and sell

some of its foreign currency reserves to offset this outflow. This decrease in the moneysupply shifts the LM curve to the left until the domestic interest rate is the global interestrate.

If the global interest rate declines below the domestic rate, the opposite occurs.Hot money flows in, the home currency appreciates, so the central bank offsets this byincreasing the money supply (sell domestic currency, buy foreign currency), the LMcurve shifts to the right, and the domestic interest rate becomes the global interest rate.

Differences from IS-LM

It is worth noting that some of the result from this model differs from the IS-LMbecause of the open economy assumption. Result for large open economy on the otherhand falls within the result predicted by the IS-LM and the Mundell-Fleming models. Thereason for such result is because a large open economy has both the characteristics of anautarky and a small open economy.

In the IS-LM, interest rate is the key component in making both the moneymarket and the good market in equilibrium. Under the Mundell-Fleming framework ofsmall economy, interest rate is fixed and equilibrium in both market can only be achievedby a change of nominal exchange rate.

Example

A much simplified version of the Mundell-Fleming model can be illustrated by asmall open economy, in which the domestic interest rate is exogenously predeterminedby the world interestrate (r=r*).


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Consider an exogenous increase in government expenditure, the IS curve shiftsupward, with LM curve intact, causing the interest rate and the output to rise (partialcrowding out effect) under the IS-LM model.

Nevertheless, as interest rate is predetermined in a small open economy, the LM*

curve (of exchange rate and output) is vertical, which means there is exactly one outputthat can make the money market in the equilibrium under that interest rate. Even thoughthe IS* curve can still shift up, it causes a higher exchange rate and same level of output(complete crowding out effect, which is different in the IS-LM model).

The example above makes an implicit assumption of flexible exchange rate. TheMundell-Fleming model can have completely different implications under differentexchange rate regimes. For instance, under a fixed exchange rate system, with perfectcapital mobility, monetary policy becomes ineffective. An expansionary monetary policyresulting in an outward shift of the LM curve would in turn make capital flow out of theeconomy. The central bank under a fixed exchange rate system would have to intervene

by selling foreign money in exchange for domestic money to depreciate the foreigncurrency and appreciate the domestic currency. Selling foreign money and receivingdomestic money would reduce real balances in the economy, until the LM curve shiftsback to the left, and the interest rates come back to the world rate of interest i*.

In economics, an optimum currency area (OCA), also known as an optimalcurrency region (OCR), is a geographical region in which it would maximize economicefficiency to have the entire region share a single currency. It describes the optimalcharacteristics for the merger of currencies or the creation of a new currency. The theoryis used often to argue whether or not a certain region is ready to become a monetaryunion, one of the final stages in economic integration.

An optimal currency area is often larger than a country. For instance, part of therationale behind the creation of the euro is that the individual countries of Europe do noteach form an optimal currency area, but that Europe as a whole does form an optimalcurrency area.[1] The creation of the euro is often cited because it provides the mostmodern and largest-scale case study of the engineering of an optimum currency area, and provides a comparative before-and-after model by which to test the principles of thetheory.

In theory, an optimal currency area could also be smaller than a country. Someeconomists have argued that the United States, for example, has some regions that do notfit into an optimal currency area with the rest of the country.

The theory of the optimal currency area was pioneered by economist RobertMundell.[2][3] Credit often goes to Mundell as the originator of the idea, but others pointto earlier work done in the area by Abba Lerner.[4]


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Models

Mundell came up with two models.

OCA with stationary expectations

Published by Mundell in 1961, this is the most cited by economists. Hereasymmetric shocks are considered to undermine the real economy, so if they are tooimportant and cannot be controlled, a regime with floating rates is considered better,because the global monetary policy (interest rates) will not be fine tuned for the particularsituation of each constituent region.

The four often cited criteria for a successful currency union are:[5]

y Labor mobility across the region. This includes physical ability to travel (visas,workers' rights, etc.), lack of cultural barriers to free movement (such as different

languages) and institutional arrangements (such as the ability to havesuperannuation transferred throughout the region) (Robert A. Mundell). In thecase of the Eurozone, while capital is quite mobile, labour mobility is relativelylow, especially when compared to the U.S. and Japan.

y Openness with capital mobility and price and wage flexibility across the region.This is so that the market forces of supply and demand automatically distributemoney and goods to where they are needed. In practice this does not workperfectly as there is no true wage flexibility. (Ronald McKinnon). The Eurozonemembers trade heavily with each other (intra-European trade is greater thaninternational trade), and most recent empirical analyses of the 'euro effect' suggest

that the single currency has increased trade by 5 to 15 percent in the euro-zonewhen compared to trade between non-euro countries.[6]

y A risk sharing system such as an automatic fiscal transfer mechanism toredistribute money to areas/sectors which have been adversely affected by thefirst two characteristics. This usually takes the form of taxation redistribution toless developed areas of a country/region. This policy, though theoreticallyaccepted, is politically difficult to implement as the better-off regions rarely giveup their revenue easily. Theoretically, Europe has no bail-out clause in theStability and Growth Pact, meaning that fiscal transfers are not allowed, but it isimpossible to know what will happen in practice. Of course, during the 2010

European sovereign debt crisis, the no bail-out clause was de facto abandoned inApril 2010.[7]

y Participant countries have similar business cycles. When one country experiencesa boom or recession, other countries in the union are likely to follow. This allowsthe shared central bank to promote growth in downturns and to contain inflationin booms.


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While Europe scores well on some of the measures characterising an OCA, it haslower labour mobility than the United States and similarly cannot rely on fiscalfederalism to smooth out regional economic disturbances. Also, its Gini coefficient of 31should have a stabilizing effect;[citation needed] in comparison, the USA has a Gini index of46.9 (a lower measure indicates a more even distribution of wealth).

Additional criteria suggested[by whom?] are:

y Production diversification (Peter Kenen)y Homogeneous preferencesy Commonality of destiny

Applied to the European Union

This theory has been most frequently applied in recent years to the euro and theEuropean Union. Despite the promenience of the EU as the primary case study of a OCA,

many have argued that the EU does actually not meet the criteria for an OCA.[8]

By thesecriteria the European Union does not constitute an Optimal Currency Area and thereforethe euro should be a suboptimum union of currencies.[citation needed] However it is hopedthat the creation of the euro will in itself help encourage the conditions enumerated byMundell.

Applied to the United States

Kouparitsas considered the United States as divided into the eight regions of theBureau of Economic Analysis.[9] He found that five of the eight regions of the countrysatisfied Mundell's criteria to form an Optimal Currency Area.[10] However, he found the

fit of the Southeast and Southwest to be questionable. He also found that the Plains wouldnot fit into an optimal currency area.

Criticism

The primary criticism of Mundell's theory is that the only area that has optimalconditions for a single currency is one that already has a single currency, a circularargument. Furthermore, many existing currency areas do not fulfill these requirements.

OCA with international risk sharing

Here Mundell tries to model how exchange rate uncertainty will interfere with theeconomy; this model is less often cited (publication in 1973).

Supposing that the currency is managed properly, the larger the area, the better. Incontrast with the previous model, asymmetric shocks are not considered to undermine thecommon currency because of the existence of the common currency. This spreads theshocks in the area because all regions share claims on each other in the same currencyand can use them for dumping the shock, while in a flexible exchange rate regime, the


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cost will be concentrated on the individual regions, since the devaluation will reduce itsbuying power. So despite a less fine tuned monetary policy the real economy should dobetter.

A harvest failure, strikes, or war, in one of the countries causes a loss of real

income, but the use of a common currency (or foreign exchange reserves) allows thecountry to run down its currency holdings and cushion the impact of the loss, drawing onthe resources of the other country until the cost of the adjustment has been efficientlyspread over the future. If, on the other hand, the two countries use separate monies withflexible exchange rates, the whole loss has to be borne alone; the common currencycannot serve as a shock absorber for the nation as a whole except insofar as the dumpingof inconvertible currencies on foreign markets attracts a speculative capital inflow infavor of the depreciating currency. (Mundell, 1973, Uncommon Arguments forCommonCurrencies p. 115)

Robert A. Mundell is found in both sides of the debate about the euro. Most

economists cite preferentially the first (stationary expectations) and conclude against theeuro[citation needed], yet Mundell advocates this one, and concludes in favour of the euro.

Rather than moving toward more flexibility in exchange rates within Europe theeconomic arguments suggest less flexibility and a closer integration of capital markets.These economic arguments are supported by social arguments as well. On every occasionwhen a social disturbance leads to the threat of a strike, and the strike to an increase inwages unjustified by increases in productivity and thence to devaluation, the nationalcurrency becomes threatened. Long-run costs for the nation as a whole are bartered awayby governments for what they presume to be short-run political benefits. If instead, theEuropean currencies were bound together disturbances in the country would be

cushioned, with the shock weakened by capital movements. (Robert A. Mundell, 1973, APlan fora European Currency pp. 147 and 150)

Criticism

Keynesian

The notion of a currency that does not accord with a state, specifically one largerthan a state formally, of an international monetary authority without a correspondingfiscal authority has been criticized by Keynesian and Post-Keynesian economists, whoemphasize the role of deficit spending by a government (formally, fiscal authority) in the

running of an economy, and consider using an international currency without fiscalauthority to be a loss of "monetary sovereignty".

Specifically, Keynesian economists argue that fiscal stimulus in the form ofdeficit spending may be necessary to fight unemployment, which is not possible if statesin a monetary union are not allowed to run sufficient deficits. The Post-Keynesian theoryof Neo-Chartalism holds that government deficit spending creates money, that ability toprint money is fundamental to a state's ability to command resources, and that "money


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and monetary policy are intricately linked to political sovereignty and fiscal authority".[11]Both of these critiques consider the transactional benefits of a shared currency to beminor compared to these drawbacks, and more generally place less emphasis on thetransactionalfunction of money (a medium of exchange) and greater emphasis on its useas a unit of account.

Austrian

Offering a contrary criticism, Austrian economists have supported thedisassociation of currencies from political entities entirely.[12] Whereas Keynesians seeflaws in supranational currencies, Austrians see flaws in any centrally planned currencynot determined by a free market process.[13] This alternative approach seeks to limitdeficit spending, as well as to increase the accountability of currency makers to theirusers in the same way that markets for other goods maximize the accountability ofbusinesses to their customers. Founding Austrian economist Friedrich Hayek advocateddenationalization of money reasoning that private enterprises which issued distinct

currencies would have an incentive to maintain their currencys purchasing power andthat customers could choose from among competing offerings.[14] Thus, the Austriancritique of optimal currency areas does not prejudice any particular arrangement so longas it is arrived at by a fair and competitive market process. From "The Failure of OCAAnalysis" (The Quarterly Journal of Austrian Economics):

Monetary unification enhances the welfare of individuals only if it springsnaturally from the voluntary actions of the money users...On a free market, entrepreneurswill try to respond properly to the demands of their customers, providing goodsincluding moneyof the type, quantity, and quality desired. Therefore, only on a freemonetary market would it be possible to discover what is the optimum circulation of a

certain currency...OCA theory fails to acknowledge this, precisely because it conflatesthe proper nature of money, focusing exclusively on a single type of money, namely fiatgovernment-produced money.[15]

Purchasing power parity (PPP) is a theory of long-term equilibrium exchangerates based on relative price levels of two countries. The idea originated with the Schoolof Salamanca in the 16th century [1] and was developed in its modern form by GustavCassel in 1918.[2] The concept is founded on the law of one price; the idea that in absenceof transaction costs, identical goods will have the same price in different markets.

In its "absolute" version, the purchasing power of different currencies is equalized

for a given basket of goods. In the "relative" version, the difference in the rate of changein prices at home and abroadthe difference in the inflation ratesis equal to thepercentage depreciation or appreciation of the exchange rate.

The best-known and most-used purchasing power parity exchange rate is theGeary-Khamis dollar (the "international dollar").


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PPP exchange rate (the "real exchange rate") fluctuations are mostly due todifferent rates of inflation between the two economies. Aside from this volatility,consistent deviations of the market and PPP exchange rates are observed, for example(market exchange rate) prices of non-traded goods and services are usually lower whereincomes are lower. (A U.S. dollar exchanged and spent in India will buy more haircuts

than a dollar spent in the United States). Basically, PPP takes into account as if there wasastandard internationalCurrency used by all countries and determining the cost for thatmeasure. In other words, PPP is the amount of a certain basket of basic goods which canbe bought in the given country with the standard international currency.[3]

There can be marked differences between PPP and market exchange rates.[4] Forexample, the World Bank's World DevelopmentIndicators 2005 estimated that in 2003,one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing powerparity[5] considerably different from the nominal exchange rate. This discrepancy haslarge implications; for instance, GDP per capita in the People's Republic of China isabout US$1,800 while on a PPP basis it is about US$7,204. This is frequently used to

assert that China is the world's second-largest economy, but such a calculation wouldonly be valid under the PPP theory. At the other extreme, Denmark's nominal GDP percapita is around US$62,100, but its PPP figure is only US$37,304.

PPP measurement

The PPP exchange-rate calculation is controversial because of the difficulties offinding comparable baskets of goods to compare purchasing power across countries.

Estimation of purchasing power parity is complicated by the fact that countries donot simply differ in a uniform price level; rather, the difference in food prices may be

greater than the difference in housing prices, while also less than the difference inentertainment prices. People in different countries typically consume different baskets ofgoods. It is necessary to compare the cost of baskets of goods and services using a priceindex. This is a difficult task because purchasing patterns and even the goods available topurchase differ across countries. Thus, it is necessary to make adjustments for differencesin the quality of goods and services. Additional statistical difficulties arise withmultilateral comparisons when (as is usually the case) more than two countries are to becompared.

When PPP comparisons are to be made over some interval of time, proper accountneeds to be made of inflationary effects.

Big Mac Index

An example of one measure of PPP is the Big Mac Index popularized by TheEconomist, which looks at the prices of a Big Mac burger in McDonald's restaurants indifferent countries. If a Big Mac costs US$4 in the United States and GBP3 in theUnited Kingdom, the PPP exchange rate would be 3 for $4. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily


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tracked in many countries, includes input costs from a wide range of sectors in the localeconomy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue andwhite collar), advertising, rent and real estate costs, transportation, etc. However, someemerging economies western fast food represents an expensive niche product price wellabove the price of traditional staplesi.e. the Big Mac is not a mainstream 'cheap' meal

as it is in the west but a luxury import for the middle classes and foreigners. Although itis not perfect, the index still offers significant insight and an easy example to theunderstanding of PPP.

Need for PPP adjustments to GDP

The exchange rate reflects transaction values for traded goods amongcountries incontrast to non-traded goods, that is, goods produced for home-country use. Also,currencies are traded for purposes other than trade in goods and services, e.g., to buycapital assets whose prices vary more than those of physical goods. Also, differentinterest rates, speculation, hedging or interventions by central banks can influence the

foreign-exchange market.

The PPP method is used as an alternative to correct for possible statistical bias.The Penn World Table is a widely cited source of PPP adjustments, and the so-calledPenn effect reflects such a systematic bias in using exchange rates to outputs amongcountries.

For example, if the value of the Mexican peso falls by half compared to the U.S.dollar, the Mexican Gross Domestic Product measured in dollars will also halve.However, this exchange rate results from international trade and financial markets. Itdoes not necessarily mean that Mexicans are poorer by a half; if incomes and prices

measured in pesos stay the same, they will be no worse off assuming that imported goodsare not essential to the quality of life of individuals. Measuring income in differentcountries using PPP exchange rates helps to avoid this problem.

PPP exchange rates are especially useful when official exchange rates areartificially manipulated by governments. Countries with strong government control of theeconomy sometimes enforce official exchange rates that make their own currencyartificially strong. By contrast, the currency's black market exchange rate is artificiallyweak. In such cases a PPP exchange rate is likely the most realistic basis for economiccomparison.

Difficulties

The main reasons why different measures do not perfectly reflect standards of livingare

y PPP numbers can vary with the specific basket of goods used, making it a roughestimate.


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y Differences in quality of goods are hard to measure and thereby reflect in PPP.

PPP calculations are often used to measure poverty rates.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods ofdifferent types:

1. Local, non-tradable goods and services (like electric power) that are produced andsold domestically.

2. Tradable goods such as non-perishable commodities that can be sold on theinternational market (e.g. diamonds).

The more a product falls into category 1 the further its price will be from the currencyexchange rate. (Moving towards the PPP exchange rate.) Conversely, category 2 products

tend to trade close to the currency exchange rate. (For more details of why, see: Penneffect).

More processed and expensive products are likely to be tradable, falling into thesecond category, and drifting from the PPP exchange rate to the currency exchange rate.Even if the PPP "value" of the Chinese currency is five times stronger than the currencyexchange rate, it won't buy five times as much of internationally traded goods like steel,cars and microchips, but non-traded goods like housing, services ("haircuts"), anddomestically produced crops. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect, and gives a big cost advantage to labour intensive production of

tradable goods in low income countries (like China), as against high income countries(like Switzerland). The corporate cost advantage is nothing more sophisticated thanaccess to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustainedfor longer than would be the case otherwise. (This is another way of saying that the wagerate is based on average local productivity, and that this is below the per capitaproductivity that factories selling tradable goods to international markets can achieve.)An equivalent cost benefit comes from non-traded goods that can be sourced locally(nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid).These act as a cheaper factor of production than is available to factories in richercountries.

PPP calculations tend to overemphasise the primary sectoral contribution, andunderemphasise the industrial and service sectoral contributions to the economy of anation.


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Clarification to PPP Numbers of the IMF

The GDP number for all reporting areas are one number in the reporting areaslocal currency. Therefore, in the local currency the PPP and market (or government)exchange rate is always 1.0 to its own currency, so the PPP and market exchange rateGDP number is always per definition the same for any duration of time, anytime, in thatarea's currency. The only time the PPP exchange rate and the market exchange rate candiffer is when the GDP number is converted into another currency.

Only because of different base numbers (because of for example "current" or"constant" prices, or an annualized or averaged number) are the USD to USD PPPexchange rate not 1.0, see the IMF data here: [1]. The PPP exchange rate is 1.023 from1980 to 2002, and the "constant" and "current" price is the same in 2000, because that's

the base year for the "constant" (inflation adjusted) currency.

Microeconomics (from Greek prefix micro- meaning "small" + "economics") is abranch of economics that studies how the individual parts of the economy, the householdand the firms, make decisions to allocate limited resources,

[1]typically in markets where

goods or services are being bought and sold. Microeconomics examines how thesedecisions and behaviours affect the supply and demand for goods and services, whichdetermines prices, and how prices, in turn, determine the supply and demand of goodsand services.[2][3]

This is a contrast to macroeconomics, which involves the "sum total of economicactivity, dealing with the issues of growth, inflation, and unemployment. [2]Microeconomics also deals with the effects of national economic policies (such aschanging taxation levels) on the before mentioned aspects of the economy.[4] Particularlyin the wake of the Lucas critique, much of modern macroeconomic theory has been builtupon 'microfoundations' i.e. based upon basic assumptions about micro-levelbehaviour.

One of the goals of microeconomics is to analyze market mechanisms thatestablish relative prices amongst goods and services and allocation of limited resourcesamongst many alternative uses. Microeconomics analyzes market failure, where marketsfail to produce efficient results, and describes the theoretical conditions needed for perfect competition. Significant fields of study in microeconomics include generalequilibrium, markets under asymmetric information, choice under uncertainty andeconomic applications of game theory. Also considered is the elasticity of productswithin the market system.


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Assumptions and definitions

The theory of supply and demand usually assumes that markets are perfectlycompetitive. This implies that there are many buyers and sellers in the market and noneof them has the capacity to significantly influence prices of goods and services. In manyreal-life transactions, the assumption fails because some individual buyers or sellers havethe ability to influence prices. Quite often a sophisticated analysis is required tounderstand the demand-supply equation of a good model. However, the theory workswell in simple situations.

Mainstream economics does not assume a priori that markets are preferable toother forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard

(highways are the classic example, profitable to all for use but not directly profitable foranyone to finance). In such cases, economists may attempt to find policies that will avoidwaste directly by government control, indirectly by regulation that induces marketparticipants to act in a manner consistent with optimal welfare, or by creating "missingmarkets" to enable efficient trading where none had previously existed. This is studied inthe field of collective action. It also must be noted that "optimal welfare" usually takes ona Paretian norm, which in its mathematical application of Kaldor-Hicks Method, does notstay consistent with the Utilitarian norm within the normative side of economics whichstudies collective action, namely public choice. Market failure in positive economics(microeconomics) is limited in implications without mixing the belief of the economistand his or her theory.

The demand for various commodities by individuals is generally thought of as theoutcome of a utility-maximizing process. The interpretation of this relationship between price and quantity demanded of a given good is that, given all the other goods andconstraints, this set of choices is that one which makes the consumer happiest.

Modes of operation

It is assumed that all firms are following rational decision-making, and will produceat the profit-maximizing output. Given this assumption, there are four categories in whicha firm's profit may be considered.

y A firm is said to be making an economic profit when its average total cost is lessthan the price of each additional product at the profit-maximizing output. Theeconomic profit is equal to the quantity output multiplied by the differencebetween the average total cost and the price.

y A firm is said to be making a normal profit when its economic profit equals zero.This occurs where average total cost equals price at the profit-maximizing output.


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y If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. Thefirm should still continue to produce, however, since its loss would be larger if itwere to stop producing. By continuing production, the firm can offset its variablecost and at least part of its fixed cost, but by stopping completely it would lose the

entirety of its fixed cost.y If the price is below average variable cost at the profit-maximizing output, the

firm should go into shutdown. Losses are minimized by not producing at all, sinceany production would not generate returns significant enough to offset any fixedcost and part of the variable cost. By not producing, the firm loses only its fixedcost. By losing this fixed cost the company faces a challenge. It must either exitthe market or remain in the market and risk a complete loss.

Opportunity cost

Main article: Opportunity cost

Opportunity cost of an activity (or goods) is equal to the best next alternativeforegone. Although opportunity cost can be hard to quantify, the effect of opportunitycost is universal and very real on the individual level. In fact, this principle applies to alldecisions, not just economic ones. Since the work of the Austrian economist Friedrichvon Wieser, opportunity cost has been seen as the foundation of the marginal theory ofvalue.

Opportunity cost is one way to measure the cost of something. Rather than merelyidentifying and adding the costs of a project, one may also identify the next bestalternative way to spend the same amount of money. The forgone profit of this next best

alternative is the opportunity cost of the original choice. A common example is a farmerthat chooses to farm her or his land rather than rent it to neighbors, wherein theopportunity cost is the forgone profit from renting. In this case, the farmer may expect togenerate more profit alone. Similarly, the opportunity cost of attending university is thelost wages a student could have earned in the workforce, rather than the cost of tuition,books, and other requisite items (whose sum makes up the total cost of attendance). Theopportunity cost of a vacation in the Bahamas might be the down payment money for ahouse.

Note that opportunity cost is not thesum of the available alternatives, but ratherthe benefit of the single, best alternative. Possible opportunity costs of the city's decision

to build the hospital on its vacant land are the loss of the land for a sporting center, ortheinability to use the land for a parking lot, or the money that could have been made fromselling the land, orthe loss of any of the various other possible usesbut not all of thesein aggregate. The true opportunity cost would be the forgone profit of the most lucrativeof those listed.

One question that arises here is how to assess the benefit of disse must determinea dollar value associated with each alternative to facilitate comparison and assess


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opportunity cost, which may be more or less difficult depending on the things we aretrying to compare. For example, many decisions involve environmental impacts whosedollar value is difficult to assess because of scientific uncertainty. Valuing a human lifeor the economic impact of an Arctic oil spill involves making subjective choices withethical implications.

It is imperative to understand that nothing is free. No matter what one chooses todo, he or she is always giving something up in return. An example of opportunity cost isdeciding between going to a concert and doing homework. If one decides to go theconcert, then he or she is giving up valuable time to study, but if he or she chooses to dohomework then the cost is giving up the concert. Opportunity Cost is vital inunderstanding microeconomics and decisions that are made.

Opportunity cost principle

Opportunity cost principle argues that a decision to accept an employment for any

factor of production is profitable if the total reward of the factor in that occupation isgreater or at least no less than the factor's opportunity cost. Opportunity cost being theloss of the reward in the nest best use of that resource.

Applied microeconomics

Applied microeconomics includes a range of specialized areas of study, many ofwhich draw on methods from other fields. Applied work often uses little more than the basics of price theory, supply and demand. Industrial organization and regulationexamines topics such as the entry and exit of firms, innovation, role of trademarks. Lawand economics applies microeconomic principles to the selection and enforcement of

competing legal regimes and their relative efficiencies. Labor economics examineswages, employment, and labor market dynamics. Public finance (also called publiceconomics) examines the design of government tax and expenditure policies andeconomic effects of these policies (e.g., social insurance programs). Political economyexamines the role of political institutions in determining policy outcomes. Healtheconomics examines the organization of health care systems, including the role of thehealth care workforce and health insurance programs. Urban economics, which examinesthe challenges faced by cities, such as sprawl, air and water pollution, traffic congestion,and poverty, draws on the fields of urban geography and sociology. The field of financialeconomics examines topics such as the structure of optimal portfolios, the rate of returnto capital, econometric analysis of security returns, and corporate financial behavior. The

field of economic history examines the evolution of the economy and economicinstitutions, using methods and techniques from the fields of economics, history,geography, sociology, psychology, and political science.


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Macroeconomics (from Greek prefix "macr(o)-" meaning "large" + "economics") is abranch of economics that deals with the performance, structure, behavior and decision-making of the entire economy, be that a national, regional, or the global economy.

[1][2]

Along with microeconomics, macroeconomics is one of the two most general fields ineconomics.

Macroeconomists study aggregated indicators such as GDP, unemployment rates, andprice indices to understand how the whole economy functions. Macroeconomists developmodels that explain the relationship between such factors as national income, output,consumption, unemployment, inflation, savings, investment, international trade andinternational finance. In contrast, microeconomics is primarily focused on the actions ofindividual agents, such as firms and consumers, and how their behavior determines pricesand quantities in specific markets.

While macroeconomics is a broad field of study, there are two areas of research thatare emblematic of the discipline: the attempt to understand the causes and consequences

of short-run fluctuations in national income (the business cycle), and the attempt tounderstand the determinants of long-run economic growth (increases in national income).

Macroeconomic models and their forecasts are used by both governments and largecorporations to assist in the development and evaluation of economic policy and businessstrategy.

Macroeconomic policies

To try to avoid major economic shocks, such as The Great Depression, governmentsmake adjustments through policy changes they hope will stabilize the economy.

Governments believe the success of these adjustments is necessary to maintain stabilityand continue growth. However, despite government's divine intentions, government policies only hamper and stagnate stability and growth. This economic retardation isachieved through two types of governmental strategies:

y Fiscal policyy Monetary policy

In economics, fiscal policy is the use of government expenditure and revenuecollection to influence the economy.[1]

Fiscal policy can be contrasted with the other main type of macroeconomicpolicy, monetary policy, which attempts to stabilize the economy by controlling interestrates and the supply of money. The two main instruments of fiscal policy are governmentexpenditure and taxation. Changes in the level and composition of taxation andgovernment spending can impact on the following variables in the economy:

y Aggregate demand and the level of economic activity;y The pattern of resource allocation;


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y The distribution of income.

Fiscal policy refers to the use of the government budget to influence the first of these:economic activity.

Stances of fiscal policy

The three possible stances of fiscal policy are neutral, expansionary andcontractionary. The simplest definitions of these stances are as follows:

y A neutral stance of fiscal policy implies a balanced economy. this results in alarge tax revenue. Government spending is fully funded by tax revenue andoverall the budget outcome has a neutral effect on the level of economic activity.

y An expansionary stance of fiscal policy involves government spending exceedingtax revenue.

y A contractionary fiscal policy occurs when government spending is lower than taxrevenue.

However, these definitions can be misleading because, even with no changes inspending or tax laws at all, cyclical fluctuations of the economy cause cyclicalfluctuations of tax revenues and of some types of government spending, altering thedeficit situation; these are not considered to be policy changes. Therefore, for purposes ofthe above definitions, "government spending" and "tax revenue" are normally replaced by"cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus,for example, a government budget that is balanced over the course of the business cycle

is considered to represent a neutral fiscal policy stance.

Methods of funding

Governments spend money on a wide variety of things, from the military and policeto services like education and healthcare, as well as transfer payments such as welfarebenefits. This expenditure can be funded in a number of different ways:

y Taxationy Seigniorage, the benefit from printing moneyy

Borrowing money from the population or from abroady Consumption of fiscal reserves.y Sale of fixed assets (e.g., land).

All of these except taxation are forms of deficit financing.


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Borrowing

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols andgilt-edged securities. These pay interest, either for a fixed period or indefinitely. If theinterest and capital repayments are too large, a nation may default on its debts, usually to

foreign creditors.

Consuming prior surpluses

A fiscal surplus is often saved for future use, and may be invested in local (samecurrency) financial instruments, until needed. When income from taxation or othersources falls, as during an economic slump, reserves allow spending to continue at thesame rate, without incurring additional debt.

Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in theeconomy, in an effort to achieve economic objectives of price stability, full employment,and economic growth. Keynesian economics suggests that increasing governmentspending and decreasing tax rates are the best ways to stimulate aggregate demand. Thiscan be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards fullemployment. In theory, the resulting deficits would be paid for by an expanded economyduring the boom that would follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things: to slow the pace of strongeconomic growth, and to stabilize prices when inflation is too high. Keynesian theory

posits that removing spending from the economy will reduce levels of aggregate demandand contract the economy, thus stabilizing prices.

Some classical and neoclassical economists argue that fiscal policy can have nostimulus effect; this is known as the Treasury View[citation needed], which Keynesianeconomics rejects. The Treasury View refers to the theoretical positions of classicaleconomists in the British Treasury, who opposed Keynes' call in the 1930s for fiscalstimulus. The same general argument has been repeated by neoclassical economists up tothe present. From their point of view, when the government runs a budget deficit, fundswill need to come from public borrowing (the issue of government bonds), overseas borrowing, or the printing of new money. When governments fund a deficit with the

issuing of government bonds, interest rates can increase across the market, becausegovernment borrowing creates higher demand for credit in the financial markets. Thiscauses a lower aggregate demand for goods and services, contrary to the objective of abudget deficit. This concept is called crowding out.

In the classical view, expansionary fiscal policy also decreases net exports, whichhas a mitigating effect on national output and income. When government borrowingincreases interest rates it attracts foreign capital from foreign investors. This is because,


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all other things being equal, the bonds issued from a country executing expansionaryfiscal policy now offer a higher rate of return. In other words, companies wanting tofinance projects must compete with their government for capital so they offer higher ratesof return. To purchase bonds originating from a certain country, foreign investors mustobtain that country's currency. Therefore, when foreign capital flows into the country

undergoing fiscal expansion, demand for that country's currency increases. The increaseddemand causes that country's currency to appreciate. Once the currency appreciates,goods originating from that country now cost more to foreigners than they did before andforeign goods now cost less than they did before. Consequently, exports decrease andimports increase.

[2]

Other possible problems with fiscal stimulus include the time lag between theimplementation of the policy and detectable effects in the economy, and inflationaryeffects driven by increased demand. In theory, fiscal stimulus does not cause inflationwhen it uses resources that would have otherwise been idle. For instance, if a fiscalstimulus employs a worker who otherwise would have been unemployed, there is no

inflationary effect; however, if the stimulus employs a worker who otherwise would havehad a job, the stimulus is increasing labor demand while labor supply remains fixed,leading to wage inflation and therefore price inflation.

Fiscal Straitjacket

The concept of a fiscal straightjacket is a general economic principle that suggestsstrict constraints on government spending and public sector borrowing, to limit orregulate the budget deficit over a time period. The term probably originated from thedefinition of straitjacket: anything that severely confines, constricts, or hinders.[3] Variousstates in the United States have various forms of self-imposed fiscal straightjackets.

Monetary policy is the process by which the central bank or monetary authorityof a country controls the supply of money, often targeting a rate of interest. Monetary policy is usually used to attain a set of objectives oriented towards the growth andstability of the economy.[1] These goals usually include stable prices and lowunemployment. Monetary theory provides insight into how to craft optimal monetarypolicy.

Monetary policy is referred to as either being an expansionary policy, or acontractionary policy, where an expansionary policy increases the total supply of moneyin the economy rapidly, and a contractionary policy decreases the total money supply or

increases it only slowly. Expansionary policy is traditionally used to combatunemployment in a recession by lowering interest rates, while contractionary policyinvolves raising interest rates to combat inflation. Monetary policy is contrasted withfiscal policy, which refers to government borrowing, spending and taxation.[2]


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Overview

Monetary policy rests on the relationship between the rates of interest in aneconomy, that is the price at which money can be borrowed, and the total supply ofmoney. Monetary policy uses a variety of tools to control one or both of these, to

influence outcomes like economic growth, inflation, exchange rates with other currenciesand unemployment. Where currency is under a monopoly of issuance, or where there is aregulated system of issuing currency through banks which are tied to a central bank, themonetary authority has the ability to alter the money supply and thus influence theinterest rate (to achieve policy goals). The beginning of monetary policy as such comesfrom the late 19th century, where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supplyor increases it only slowly, or if it raises the interest rate. An expansionary policyincreases the size of the money supply more rapidly, or decreases the interest rate.Furthermore, monetary policies are described as follows: accommodative, if the interest

rate set by the central monetary authority is intended to create economic growth; neutral,if it is intended neither to create growth nor combat inflation; or tight if intended toreduce inflation.

There are several monetary policy tools available to achieve these ends:increasing interest rates by fiat; reducing the monetary base; and increasing reserverequirements. All have the effect of contracting the money supply; and, if reversed,expand the money supply. Since the 1970s, monetary policy has generally been formedseparately from fiscal policy. Even prior to the 1970s, the Bretton Woods system stillensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Bank ofEngland, the European Central Bank, Reserve Bank of India, the Federal Reserve Systemin the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank ofAustralia) exist which have the task of executing the monetary policy and oftenindependently of the executive. In general, these institutions are called central banks andoften have other responsibilities such as supervising the smooth operation of the financialsystem.

The primary tool of monetary policy is open market operations. This entailsmanaging the quantity of money in circulation through the buying and selling of variousfinancial instruments, such as treasury bills, company bonds, or foreign currencies. All of

these purchases or sales result in more or less base currency entering or leaving marketcirculation.

Usually, the short term goal of open market operations is to achieve a specificshort term interest rate target. In other instances, monetary policy might instead entail thetargeting of a specific exchange rate relative to some foreign currency or else relative togold. For example, in the case of the USA the Federal Reserve targets the federal fundsrate, the rate at which member banks lend to one another overnight; however, the


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monetary policy of China is to target the exchange rate between the Chinese renminbiand a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i) Discountwindow lending (lender of last resort); (ii) Fractional deposit lending (changes in the

reserve requirement); (iii) Moral suasion (cajoling certain market players to achievespecified outcomes); (iv) "Open mouth operations" (talking monetary policy with themarket).

Theory

Monetary policy is the process by which the government, central bank, ormonetary authority of a country controls (i) the supply of money, (ii) availability ofmoney, and (iii) cost of money or rate of interest to attain a set of objectives orientedtowards the growth and stability of the economy.[1] Monetary theory provides insightinto how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in aneconomy, that is the price at which money can be borrowed, and the total supply ofmoney. Monetary policy uses a variety of tools to control one or both of these, toinfluence outcomes like economic growth, inflation, exchange rates with other currenciesand unemployment. Where currency is under a monopoly of issuance, or where there is aregulated system of issuing currency through banks which are tied to a central bank, themonetary authority has the ability to alter the money supply and thus influence theinterest rate (to achieve policy goals).

It is important for policymakers to make credible announcements, and deprecate

interest rate targets as they are non-important and irrelevant in regarding to monetarypolicies. If private agents (consumers and firms) believe that policymakers are committedto lowering inflation, they will anticipate future prices to be lower than otherwise (howthose expectations are formed is an entirely different matter; compare for instancerational expectations with adaptive expectations). If an employee expects prices to behigh in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behaviorbetween employees and employers (lower wages since prices are expected to be lower)and since wages are in fact lower there is no demand pull inflation because employees arereceiving a smaller wage and there is no cost push inflation because employers are payingout less in wages.

To achieve this low level of inflation, policymakers must have credibleannouncements; that is, private agents must believe that these announcements will reflectactual future policy. If an announcement about low-level inflation targets is made but notbelieved by private agents, wage-setting will anticipate high-level inflation and so wageswill be higher and inflation will rise. A high wage will increase a consumer's demand(demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence,


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if a policymaker's announcements regarding monetary policy are not credible, policy willnot have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have anincentive to adopt an expansionist monetary policy (where the marginal benefit of

increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have thisincentive. Hence, private agents know that if they anticipate low inflation, anexpansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agentsexpect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output).Hence, unless credible announcements can be made, expansionary monetary policy willfail.

Announcements can be made credible in various ways. One is to establish an

independent central bank with low inflation targets (but no output targets). Hence, privateagents know that inflation will be low because it is set by an independent body. Centralbanks can be given incentives to meet targets (for example, larger budgets, a wage bonusfor the head of the bank) to increase their reputation and signal a strong commitment to apolicy goal. Reputation is an important element in monetary policy implementation. Butthe idea of reputation should not be confused with commitment. While a central bankmight have a favorable reputation due to good performance in conducting monetarypolicy, the same central bank might not have chosen any particular form of commitment(such as targeting a certain range for inflation). Reputation plays a crucial role indetermining how much would markets believe the announcement of a particularcommitment to a policy goal but both concepts should not be assimilated. Also, note thatunder rational expectations, it is not necessary for the policymaker to have established itsreputation through past policy actions; as an example, the reputation of the head of thecentral bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued[3] that to prevent some pathologiesrelated to the time-inconsistency of monetary policy implementation (in particularexcessive inflation), the head of a central bank should have a larger distaste for inflationthan the rest of the economy on average. Hence the reputation of a particular central bankis not necessary tied to past performance, but rather to particular institutionalarrangements that the markets can use to form inflation expectations. Despite the frequentdiscussion of credibility as it relates to monetary policy, the exact meaning of credibilityis rarely defined. Such lack of clarity can serve to lead policy away from what is believedto be the most beneficial. For example, capability to serve the public interest is onedefinition of credibility often associated with central banks. The reliability with which acentral bank keeps its promises is also a common definition. While everyone most likelyagrees a central bank should not lie to the public, wide disagreement exists on how acentral bank can best serve the public interest. Therefore, lack of definition can leadpeople to believe they are supporting one particular policy of credibility when they arereally supporting another.[4]


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History of monetary policy

Monetary policy is primarily associated with interest rate and credit. For manycenturies there were only two forms of monetary policy: (i) Decisions about coinage; (ii)Decisions to print paper money to create credit. Interest rates, while now thought of as

part of monetary authority, were not generally coordinated with the other forms ofmonetary policy during this time. Monetary policy was seen as an executive decision, andwas generally in the hands of the authority with seigniorage, or the power to coin. Withthe advent of larger trading networks came the ability to set the price between gold andsilver, and the price of the local currency to foreign currencies. This official price couldbe enforced by law, even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired theresponsibility to print notes and back them with gold, the idea of monetary policy asindependent of executive action began to be established.[5] The goal of monetary policywas to maintain the value of the coinage, print notes which would trade at par to specie,

and prevent coins from leaving circulation. The establishment of central banks byindustrializing nations was associated then with the desire to maintain the nation's peg tothe gold standard, and to trade in a narrow band with other gold-backed currencies. Toaccomplish this end, central banks as part of the gold standard began setting the interestrates that they charged, both their own borrowers, and other banks who required liquidity.The maintenance of a gold standard required almost monthly adjustments of interestrates.

During the 1870-1920 period, the industrialized nations set up central bankingsystems, with one of the last being the Federal Reserve in 1913.[6] By this point the roleof the central bank as the "lender of last resort" was understood. It was also increasingly

understood that interest rates had an effect on the entire economy, in no small partbecause of the marginal revolution in economics, which demonstrated how people wouldchange a decision based on a change in the economic trade-offs.

Monetarist macroeconomists have sometimes advocated simply increasing themonetary supply at a low, constant rate, as the best way of maintaining low inflation andstable output growth.[7] However, when U.S. Federal Reserve Chairman Paul Volckertried this policy, starting in October 1979, it was found to be impractical, because of thehighly unstable relationship between monetary aggregates and other macroeconomicvariables.[8] Even Milton Friedman acknowledged that money supply targeting was lesssuccessful than he had hoped, in an interview with the Financial Times on June 7,

2003.[9][10][11]

Therefore, monetary decisions today take into account a wider range offactors, such as:

y short term interest rates;y long term interest rates;y velocity of money through the economy;y exchange rates;y credit quality;


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y bonds and equities (corporate ownership and debt);y government versus private sector spending/savings;y international capital flows of money on large scales;y financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people

[who?]

advocate for a return to the gold standard (theelimination of the dollar's fiat currency status and even of the Federal Reserve Bank).Their argument is basically that monetary policy is fraught with risk and these risks willresult in drastic harm to the populace should monetary policy fail. Others

[who?] see anotherproblem with our current monetary policy. The problem for them is not that our moneyhas nothing physical to define its value, but that fractional reserve lending of that moneyas a debt to the recipient, rather than a credit, causes all but a small proportion of society(including all governments) to be perpetually in debt.

In fact, many economists[who?] disagree with returning to a gold standard. They arguethat doing so would drastically limit the money supply, and throw away 100 years of

advancement in monetary policy. The sometimes complex financial transactions thatmake big business (especially international business) easier and safer would be muchmore difficult if not impossible. Moreover, shifting risk to different people/companiesthat specialize in monitoring and using risk can turn any financial risk into a knowndollar amount and therefore make business predictable and more profitable for everyoneinvolved. Some have claimed that these arguments lost credibility in the global financialcrisis of 2008-2009.

Trends in central banking

The central bank influences interest rates by expanding or contracting the

monetary base, which consists of currency in circulation and banks' reserves on deposit atthe central bank. The primary way that the central bank can affect the monetary base isby open market operations or sales and purchases of second hand government debt, or bychanging the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation orcrediting banks' reserve accounts. Alternatively, it can lower the interest rate on discountsor overdrafts (loans to banks secured by suitable collateral, specified by the central bank).If the interest rate on such transactions is sufficiently low, commercial banks can borrowfrom the central bank to meet reserve requirements and use the additional liquidity toexpand their balance sheets, increasing the credit available to the economy. Loweringreserve requirements has a similar effect, freeing up funds for banks to increase loans or

buy other profitable assets.

A central bank can only operate a truly independent monetary policy when theexchange rate is floating.[12] If the exchange rate is pegged or managed in any way, thecentral bank will have to purchase or sell foreign exchange. These transactions in foreignexchange will have an effect on the monetary base analogous to open market purchasesand sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate,


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central banks and monetary authorities can at best "lean against the wind" in a worldwhere capital is mobile.

Accordingly, the management of the exchange rate will influence domesticmonetary conditions. To maintain its monetary policy target, the central bank will have to

sterilize or offset its foreign exchange operations. For example, if a central bank buysforeign exchange (to counteract appreciation of the exchange rate), base money willincrease. Therefore, to sterilize that increase, the central bank must also sell governmentdebt to contract the monetary base by an equal amount. It follows that turbulent activityin foreign exchange markets can cause a central bank to lose control of domesticmonetary policy when it is also managing the exchange rate.

In the 1980s, many economists[who?] began to believe that making a nation'scentral bank independent of the rest of executive government is the best way to ensure anoptimal monetary policy, and those central banks which did not have independence beganto gain it. This is to avoid overt manipulation of the tools of monetary policies to effect

political goals, such as re-electing the current government. Independence typically meansthat the members of the committee which conducts monetary policy have long, fixedterms. Obviously, this is a somewhat limited independence.

In the 1990s, central banks began adopting formal, public inflation targets withthe goal of making the outcomes, if not the process, of monetary policy more transparent.In other words, a central bank may have an inflation target of 2% for a given year, and ifinflation turns out to be 5%, then the central bank will typically have to submit anexplanation.

The Bank of England exemplifies both these trends. It became independent of

government through the Bank of England Act 1998 and adopted an inflation target of2.5% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smooth business cyclesor not. A central conjecture of Keynesian economics is that the central bank can stimulateaggregate demand in the short run, because a significant number of prices in the economyare fixed in the short run and firms will produce as many goods and services as aredemanded (in the long run, however, money is neutral, as in the neoclassical model).There is also the Austrian school of economics, which includes Friedrich von Hayek andLudwig von Mises's arguments, but most economists fall into either the Keynesian orneoclassical camps on this issue.

Developing countries

Developing countries may have problems establishing an effective operatingmonetary policy. The primary difficulty is that few developing countries have deepmarkets in government debt. The matter is further complicated by the difficulties inforecasting money demand and fiscal pressure to levy the inflation tax by expanding themonetary base rapidly. In general, the central banks in many developing countries have


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poor records in managing monetary policy. This is often because the monetary authorityin a developing country is not independent of government, so good monetary policy takesa backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establishcredible monetary policy may institute a currency board or adopt dollarization. Such

forms of monetary institutions thus essentially tie the hands of the government frominterference and, it is hoped, that such policies will import the monetary policy of theanchor nation.

Recent attempts at liberalizing and reforming financial markets (particularly therecapitalization of banks and other financial institutions in Nigeria and elsewhere) aregradually providing the latitude required to implement monetary policy frameworks bythe relevant central banks.

Monetary policy - Types

In practice, all types of monetary policy involve modifying the amount of basecurrency (M0) in circulation. This process of changing the liquidity of base currencythrough the open sales and purchases of (government-issued) debt and credit instrumentsis called open market operations.

Constant market transactions by the monetary authority modify the supply ofcurrency and this impacts other market variables such as short term interest rates and theexchange rate.

The distinction between the various types of monetary policy lies primarily withthe set of instruments and target variables that are used by the monetary authority to

achieve their goals.

Monetary Policy:Target Market

Variable:Long Term Objective:

Inflation TargetingInterest rate on overnightdebt

A given rate of change in the CPI

Price LevelTargeting

Interest rate on overnightdebt

A specific CPI number

MonetaryAggregates

The growth in moneysupply

A given rate of change in the CPI

Fixed ExchangeRate

The spot price of thecurrency

The spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by thegold price

Mixed Policy Usually interest rates Usually unemployment + CPI change


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The different types of policy are also called monetary regimes, in parallel toexchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Goldstandard results in a relatively fixed regime towards the currency of other countries on thegold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the

management of the relevant foreign currencies is tracking the exact same variables (suchas a harmonized consumer price index).

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency.There are varying degrees of fixed exchange rates, which can be ranked in relation tohow rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authoritydeclares a fixed exchange rate but does not actively buy or sell currency to maintain the

rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,import/export licenses, etc.). In this case there is a black market exchange rate where thecurrency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. Thistarget rate may be a fixed level or a fixed band within which the exchange rate mayfluctuate until the monetary authority intervenes to buy or sell as necessary to maintainthe exchange rate within the band. (In this case, the fixed exchange rate with a fixed levelcan be seen as a special case of the fixed exchange rate with bands where the bands areset to zero.)

Under a system of fixed exchange rates maintained by a currency board every unitof local currency must be backed by a unit of foreign currency (correcting for theexchange rate). This ensures that the local monetary base does not inflate without beingbacked by hard currency and eliminates any worries about a run on the local currency bythose wishing to convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term"dollarization") is used freely as the medium of exchange either exclusively or in parallelwith local currency. This outcome can come about because the local population has lostall faith in the local currency, or it may also be a policy of the government (usually to

rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authorityor government as monetary policy in the pegging nation must align with monetary policyin the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capitalmobility, openness, credit channels and other economic factors.


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See also: List of fixed currencies

Gold standard

Main article: Gold standard

The gold standard is a system in which the price of the national currency ismeasured in units of gold bars and is kept constant by the daily buying and selling of basecurrency to other countries and nationals. (i.e. open market operations, cf. above). Theselling of gold is very important for economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed ExchangeRate" policy. And the gold price might be regarded as a special type of "CommodityPrice Index".

Today this type of monetary policy is not used anywhere in the world, although aform of gold standard was used widely across the world between the mid-1800s through1971.

[14]Its major advantages were simplicity and transparency. (See also: Bretton

Woods system)

The major disadvantage of a gold standard is that it induces deflation, whichoccurs whenever economies grow faster than the gold supply. When an economy growsfaster than its money supply, the same amount of money is used to execute a largernumber of transactions. The only way to make this possible is to lower the nominal costof each transaction, which means that prices of goods and services fall, and each unit ofmoney increases in value. Deflation can cause economic problems, for instance, it tends

to increase the ratio of debts to assets over time. As an example, the monthly cost of afixed-rate home mortgage stays the same, but the dollar value of the house goes down,and the value of the dollars required to pay the mortgage goes up. William JenningsBryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standardmade it harder for everyday citizens to start new businesses, expand their farms, or buildnew homes.

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