International money and finance
In International Money and Finance, we are interested in the connections between financial markets
(money markets, capital markets and currency markets), financial institutions(banks) and the economy
(GDP growth, inflation, unemployment).
Lecture 1 – basic concepts
Why should a manager or entrepreneur study international economic & financial developments?
because these events are a large source of corporate uncertainty.
Risks:
1. Aggregate
2. Idiosyncratic
For all firms aggregate uncertainty is an important determinant of firm performance and survival; for
large firms aggregate uncertainty is the dominant of uncertainty.
Measuring economic activity
Global financial marketplaces are critical for the conduct of exchange of product, services, and capital
through markets.
One way to characterize the global financial marketplace is through:
1. Assets
2. Institutions
3. Linkages
Assets:
Heart of the global capital markets
Debt securities issued by governments
Low-risk / risk-free assets from the foundation for the creation, trading and pricing of other
financial assets like:
Bank loans
Corporate bonds
Equities (stock)
- Health and security of the global financial system relies on the quality of these assets
Institutions:
Central banks
- Create and control each country’s money supply
Commercial banks
- Take deposits and extend loans to business, both locally and global
Multitude of other financial institutions
- Created to trade securities and derivatives
- Health and security of the global financial system relies on the stability of these
financial institutions
Linkages:
Link between financial institutions
Most necessary element: exchange of currencies in the global marketplace
Core component of the global financial system
Measuring all economic activity:
- Per country: GDP: gross domestic product
1
, - Nominal versus real (=deflated). Nominal: current price levels, inflation. Real GDP is mostly
taken, try to measure with constant price levels. How output changes over time.
- Expenditure approach
Y= C(onsumption) + I(nvestment) + G(overnment) + X(exports) – M(imports)
Economic growth: percentage change in real GDP.
- Useful to analyse the business cycle (explain and, if possible, predict).
Higher interest rate and lower housing price can lower consumption.
Prosperity: GDP per capita. Useful for international welfare comparisons.
Economic growth
Economic growth depends in the long run on (production factors):
Employed population + skill level
Invested capital
Technological progress
These together determine productive capacity.
Depends in the short run (0-5 years) on the state of the business cycle (demand-determined):
Too much demand given capacity economy “overheats” prices rise (inflation)
Too little demand given capacity recession depression prices decline (deflation)
Short term demand graph. Supply went up: supply shock. For given
level GDP everything became more difficult to be delivered. Huge
negative supply shock in covid time. Also, negative demand shock.
Since the lock downs were over, and due to vaccinations: demand
went up, people got salaries and did not spend it. Savings were high.
People started spending again. Negative demand changed to positive
demand shock. This will result in inflation.
Inflation was underestimated. High inflation would be temporary
phenomenon, was thought. Recovery demand shock also pushed up inflation. Now were stuck with the
risk is that inflation gets its own momentum.
Shocks like covid, energy, or Ukraine war, can be easily understood with a supply and demand graph.
Supply becomes more costly.
Money markets
Money markets are global and is between big institutions. Short-term liquidity is traded, short-term
loans (1 day – up to 1 year). If it is longer than 1 year, bond market. Central bank is dominant player
and controls the interest rates in these markets.
Short terms loans between professional parties, like banks. Central bank is dominant player, can
always create money. Have the power to create it. Can always extend credit. Extends credit at a short-
term interest rate (Is). At ECB it’s called the refinancing rate. However, there has also been very long
term in which policy rate was close to 0 and not changed. Central banks used different instruments to
set monetary policy started moving away from money markets to bond markets.
2
, What happens if you go below 0? people will withdraw their money. It’s difficult to push below 0,
customers have incentive to withdraw their money. They can avoid a negative interest rate. Also
called: zero lower bound. You can no longer stimulate economy. You can try to move to the bond
market.
Banks are now giving low interest rates for savings. At ECB, ING gets 3.25% but customer of ING
0.75%. why is it not passed on to the customer? In the US Apple introduced an account for savers and
they partner with golden Saks and Apple is collecting lots of savings and get close to 4%. Golden Saks
is using the money for money markets, which also have a high rate. In the Netherlands you can’t do it,
lack of competition in banking sector.
Real interest rates are still very low compared to inflation. It’s not matched.
Bank always have some interest rate risk. Maturity of deposits long term loans. If you don’t do it
carefully, you can fail.
If the price of a bond goes up, interest rate long term goes down. Discount factor/yield goes down.
When interest rate goes down, bond price goes up. And vice versa.
Central banks: 2 types of tools, unconventional (interest rate 0) and conventional policy.
How does the central bank set interest rates? Taylor rules
The Taylor rule: specifies a link between interest rates and inflation and the output gap. A decision
rule for the central bank, ties central bank rate to inflation and output. If inflation is higher than central
bank wants it to be, it increases interest rates to pull down economy.
R = b + c ( - † t) + c * Y
R: interest rate
: inflation
t: inflation target
Y: output gap
C: summarize responsiveness of interest rates to inflation and output respectively
Typical values for b and c are 1.5 and 0.5
Key feature Taylor rule = real interest rates should rise to reduce inflation.
Booming economy, high inflation and output should increase interest rates.
Debt is nominal, inflation is bad for people with debt. Deflation is very bad for economy.
Monetary policy and the business cycle
The ECB reduces interest rates, either Is (interest rate short term) or il (interest rate long term) through
QE (quantitative easing)
- Transmission through the financial system and the financial markets, then credit becomes
cheaper (in normal times)
- Currency may become weaker
- Demand for goods increases
Economic growth and/or inflation increase.
3
