🪅Global Monetary Economics Unit 1 – Intro to Monetary Economics

Key Concepts and Definitions

• Money serves as a medium of exchange, unit of account, and store of value
• Fiat money is currency backed by the government that issued it, not linked to physical reserves (gold)
• Monetary policy involves central bank actions to influence money supply and interest rates to achieve economic goals
• Inflation is a sustained increase in the general price level of goods and services over time
  • Deflation is the opposite, a sustained decrease in the general price level
• Exchange rates represent the value of one currency in terms of another currency
• Monetary aggregates are broad categories that measure the money supply, such as M1, M2, and M3
• Liquidity refers to the ease with which an asset can be converted into cash without affecting its market price

Historical Context of Money and Banking

• Ancient societies used various objects as money, including cowrie shells, beads, and metal coins
• Goldsmiths in the 17th century began issuing receipts for gold deposits, which evolved into early banknotes
• The Gold Standard, prevalent from the 1870s to the 1930s, linked currency values to gold reserves
  • Countries could exchange their currency for a fixed amount of gold
• The Bretton Woods system, established in 1944, created a fixed exchange rate regime with the U.S. dollar pegged to gold
• The Nixon Shock in 1971 ended the convertibility of U.S. dollars to gold, leading to the current fiat money system
• The 2008 Global Financial Crisis highlighted the interconnectedness of modern banking and monetary systems

Functions and Types of Money

• Money serves three primary functions: medium of exchange, unit of account, and store of value
  • As a medium of exchange, money facilitates transactions by eliminating the need for barter
  • As a unit of account, money provides a standard measure for pricing goods and services
  • As a store of value, money allows individuals to save and preserve purchasing power over time
• Commodity money has intrinsic value, such as gold or silver coins
• Representative money is backed by a commodity, such as gold certificates
• Fiat money derives its value from government decree and is not backed by a physical commodity
• Near money refers to highly liquid assets that can easily be converted into cash (savings accounts, money market funds)

Monetary Systems and Policies

• Monetary systems are the set of institutions, policies, and mechanisms that govern the money supply and exchange rates
• Monetary policy is conducted by central banks to manage the money supply, interest rates, and inflation
  • Expansionary monetary policy increases the money supply to stimulate economic growth
  • Contractionary monetary policy decreases the money supply to combat inflation
• Open market operations involve central banks buying or selling government securities to influence the money supply
• The reserve requirement is the portion of deposits that commercial banks must hold in reserve
• Interest rates, such as the federal funds rate, influence borrowing costs and investment decisions

Central Banks and Their Roles

• Central banks are responsible for conducting monetary policy and maintaining financial stability
• The Federal Reserve System (Fed) is the central bank of the United States
  • The Federal Open Market Committee (FOMC) sets monetary policy by targeting the federal funds rate
• The European Central Bank (ECB) manages monetary policy for the Eurozone countries
• Central banks act as lenders of last resort, providing liquidity to financial institutions during crises
• Central banks regulate and supervise commercial banks to ensure the stability of the banking system
• Many central banks aim for price stability, often targeting a specific inflation rate (2% for the Fed and ECB)

Money Supply and Demand

• The money supply is the total amount of money available in an economy
• Monetary aggregates (M1, M2, M3) measure different components of the money supply
  • M1 includes currency in circulation and demand deposits
  • M2 includes M1 plus savings deposits, money market funds, and small time deposits
  • M3 includes M2 plus large time deposits and institutional money market funds
• Money demand represents the desire to hold money for transactions, precautionary, and speculative purposes
• The quantity theory of money states that the money supply multiplied by velocity equals nominal GDP ($MV = PY$)
• The money multiplier is the ratio of the change in the money supply to the change in the monetary base

Inflation and Deflation

• Inflation is a sustained increase in the general price level of goods and services over time
  • Cost-push inflation occurs when production costs rise, leading to higher prices
  • Demand-pull inflation occurs when aggregate demand exceeds aggregate supply
• Hyperinflation is extremely high and rapid inflation, often due to excessive money supply growth
• Deflation is a sustained decrease in the general price level, which can lead to delayed consumption and investment
• Central banks use monetary policy tools to manage inflation and maintain price stability
• The Fisher equation relates nominal interest rates to real interest rates and expected inflation ($i = r + \pi^e$)

Exchange Rates and International Monetary Systems

• Exchange rates determine the value of one currency in terms of another
  • Fixed exchange rates are pegged to another currency or a basket of currencies
  • Floating exchange rates are determined by market forces of supply and demand
• Appreciation occurs when a currency increases in value relative to another currency
• Depreciation occurs when a currency decreases in value relative to another currency
• The balance of payments records a country's transactions with the rest of the world
  • The current account includes trade in goods and services, income, and transfers
  • The capital account includes transactions involving assets and liabilities
• The Mundell-Fleming model analyzes the effectiveness of monetary and fiscal policy under different exchange rate regimes

Current Challenges in Monetary Economics

• Unconventional monetary policies, such as quantitative easing, have been used to stimulate economies after the 2008 financial crisis
• Negative interest rates have been implemented by some central banks to encourage lending and investment
• Cryptocurrencies and digital currencies pose challenges to traditional monetary systems and policies
  • Central Bank Digital Currencies (CBDCs) are being explored as a potential response to private cryptocurrencies
• Globalization and the interconnectedness of financial markets complicate monetary policy decisions
• The effective lower bound on interest rates limits the ability of central banks to stimulate economies during downturns
• The COVID-19 pandemic has led to unprecedented monetary and fiscal policy responses, with long-term implications yet to be seen