Monetary Policy and

Foreign Exchange Rates

FUNDAMENTAL ISSUES
What is the monetary approach to exchange-rate
determination?
What are the main assets and liabilities of central banks?
How do a central banks foreign-exchange market
interventions alter the monetary base and the money
stock?
What is the portfolio approach to exchange-rate
determination?
Should central banks sterilize foreign exchange
interventions?

Monetary Approach
The Monetary Approach focuses on the
supply and demand of money and the
money supply process.
The monetary approach hypothesizes that
exchange-rate movements result from
changes in money supply and demand.

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The Monetary Base

A nations monetary base can be measured by
viewing either the assets or liabilities of the central
bank.
Its assets are domestic credit (DC or DA),
comprised of domestic sovereign debt/bonds, and
foreign exchange reserves (FER or FACB),
comprised of foreign sovereign debt/bonds.
Its liabilities are currency in circulation (C) and
total reserves of member banks (TR).

Simplified Balance Sheet of a

Central Bank
Assets

Liabilities
Currency
(C)

Domestic Credit
(DC)
Foreign Exchange Total Reserves
Reserves (FER)
(TR)
Monetary Base
(MB)

Monetary Base
(MB)

Money Stock
There are a number of measures of a
nations money stock (M).
The narrowest measure is the sum of
currency in circulation and the amount of
transactions deposits (TD) in the banking
system.

Money Multiplier
Most nations require that a fraction of
transactions deposits be held as reserves.
The required fraction is determined by the
reserve requirement (rr).
This fraction determines the maximum
change in the money stock that can result
from a change in total reserves.

Money Multiplier
Under the assumption that the monetary
base is comprised of transactions deposits
only, the multiplier is determined by the
reserve requirement only.
In this case, the money multiplier (m) is
equal to 1 divided by the reserve
requirement,
m = 1/rr.

Relating the Monetary Base and the

Money Stock
Under the assumptions above, we can write
the money stock as the monetary base times
the money multiplier.
M = mMB = m(DC + FER) = m(C + TR).
Focusing only on the asset measure of the
monetary base, the change in the money
stock is expressed as
M = m(DC + FER).

Example - BOJ Intervention

Suppose the Bank of Japan (BOJ) wanted to
intervene to weaken the yen, what would it
do?
Buy Dollars ($) = Sell Yen

Spot Exchange Rate

Domestic currency units/foreign currency units

SFC
S2
S1

DFC
Q1 Q2

DFC

Quantity of
foreign currency.

Example - BOJ Intervention

This action increases the foreign exchange
reserves (FER) and total reserves (TR)
components of the BOJs balance sheet.

Example - BOJ Intervention

Suppose the Bank of Japan (BOJ)
intervenes to weaken the yen by buying 1
trillion US dollars from the private banking
system.

BOJ Balance Sheet

Assets

Liabilities

DC

FER
+1 million

TR
+1 million

MB
+1 million

MB
+1 million

BOJ Intervention
Because the monetary base increased, so
will the money stock.
Suppose the reserve requirement is 10
percent. The change in the money stock is
M = m(DC + FER),
M = (1/.10)(1 trillion) = 10 trillion.

BOJ Intervention
Other things equal, what happens when we
increase the money stock?
Answer: We increase aggregate demand. At
full employment, that means inflation.

BOJ Intervention
Other things equal, what happens when we
increase the money stock?
Answer: We increase aggregate demand. At
full employment, that means inflation.
So how do we sterilize the effect of
increasing foreign exchange reserves (FER)
on the money supply?

BOJ Intervention
The Bank of Japan (BOJ) would
compensate for buying 1 trillion US
dollars from the private banking system by
selling 1 trillion domestic bonds.

BOJ Balance Sheet

Assets

Liabilities

DC
-1 million
FER
+1 million

MB

TR
MB

BOJ Intervention
What effect would selling 1 trillion
domestic bonds have?

BOJ Intervention
What effect would selling 1 trillion
domestic bonds have?
C.P., Price of domestic bonds will fall,
yields rise, demand for yen increase, putting
greater pressure on BOJ to buy dollars.
This implies that BOJ can control exchange
rates (S) or interest rates, but not both.

BOJ Intervention
There is an exception: where locals are averse
to exchange risk, i.e., they have a strong
preference for home currency. BOJ can
keep this policy up as long as interest on
FER is higher than on DC. Which is as long
as Japanese savers prefer lower yield
Japanese debt to higher yield foreign debt.

The Portfolio Approach to

Exchange-Rate
Determination

The Portfolio Approach

The portfolio approach expands the
monetary approach by including other
financial assets.
The portfolio approach postulates that the
exchange value is determined by the
quantities of domestic money and domestic
and foreign financial securities demanded
and the quantities supplied.

The Portfolio Approach

Assumes that individuals earn interest on
the securities they hold, but not on money.
Assumes that households have no incentive
to hold the foreign currency.
Hence, wealth (W), is distributed across
money (M) holdings, domestic bonds (B),
and foreign bonds (B*).

The Portfolio Approach

A domestic households stock of wealth is
valued in the domestic currency.
Given a spot exchange rate, S, expressed as
domestic currency units relative to foreign
currency units, a wealth identity can be
expressed as:
W M + B + SB*.

The Portfolio Approach

The portfolio approach postulates that the
value of a nations currency is determined
by quantities of these assets supplied and
the quantities demanded.
In contrast to the monetary approach, other
financial assets are as important as domestic
money.

An Example
Suppose the domestic monetary authorities
increase the monetary base through an open
market purchase of domestic securities.
As the domestic money supply increases, the
domestic interest rate falls.
With a lower interest, households are no longer
satisfied with their portfolio allocation.
The demand for domestic bonds falls relative to
other financial assets.

Example - Continued
Households shift out of domestic bonds.
They substitute into domestic money and foreign
bonds.
Because of the increase in demand for foreign
bonds, the demand for foreign currency rises.
All other things constant, the increased demand
for foreign currency causes the domestic currency
to depreciate.

Spot Exchange Rate

Domestic currency units/foreign currency units

SFC
S2
S1

DFC
Q1 Q2

DFC

Quantity of
foreign currency.

Interest Rates

Interest Rates I
Instrument Yields and Financial Instrument Prices
1. Alternative Measures of Interest Yields
a.
Nominal Yield
b.
Coupon Return
c.
Current Yield
d.
Yield to Maturity
2. Discounted Present Value
3. Price of a Bond
4. Term to Maturity
5. Interest Rate Risk

Interest Rates II
Term Structure of Interest Rates
1. Yield Curves
2. Segmented Markets Theory
3. Expectations Theory
4. Preferred Habitat Theory

Interest Rates III

Risk Structure of Interest Rates
1. Default Risk
2. Liquidity
3. Tax Differentials

Nominal rate (iNom)

Stated in contracts, and quoted by banks
and brokers.
Not used in calculations or shown on time
lines
Periods per year (m) must be given.
Examples:
8%; Quarterly
8%, Daily interest (365 days)

Periodic rate (iPer )

iPer = iNom/m, where m is number of compounding
periods per year. m = 4 for quarterly, 12 for
monthly, and 360 or 365 for daily compounding.
Used in calculations, shown on time lines.
Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 = 0.021918%.

Effective Annual Rate (EAR = EFF%)

The EAR is the annual rate which causes PV to
grow to the same FV as under multi-period
compounding Example: Invest $1 for one year at
12%, semiannual:
FV = PV(1 + iNom/m)m
FV = $1 (1.06)2 = 1.1236.
EFF% = 12.36%, because $1 invested for one year
at 12% semiannual compounding would grow to
the same value as $1 invested for one year at
12.36% annual compounding.

 An investment with monthly payments

is different from one with quarterly
payments. Must put on EFF% basis to
compare rates of return. Use EFF%
only for comparisons.
Banks say interest paid daily. Same
as compounded daily.

How do we find EFF% for a nominal rate

of 12%, compounded semiannually?

(
(

)
)

iNom
EFF% = 1 +
-1
m
2
= 1 + 0.12 - 1.0
2
= (1.06)2 - 1.0
= 0.1236 = 12.36%.

EAR (or EFF%) for a Nominal Rate of

of 12%
EARAnnual

= 12%.

EARQ

= (1 + 0.12/4)4 - 1

= 12.55%.

EARM

= (1 + 0.12/12)12 - 1

= 12.68%.

EARD(365)

= (1 + 0.12/365)365 - 1 = 12.75%.

Can the effective rate ever be equal to

the nominal rate?
Yes, but only if annual compounding is
used, i.e., if m = 1.
If m > 1, EFF% will always be greater than
the nominal rate.

When is each rate used?

iNom:

Written into contracts, quoted

by banks and brokers. Not
used in calculations or shown
on time lines.

When is each rate used?

iPer: Used in calculations, shown on
time lines.
If iNom has annual compounding,
then iPer = iNom/1 = iNom.

The amount of credit extended via the

purchase of a financial instrument is the
A.
B.
C.
D.

front load.
present discounted value.
principal.
sum of the coupons
Answer: C

The coupon yield divides the coupon value by the

________ whereas the coupon value divides the
coupon by the ________.
A. bonds face value; price of the bond
B. price of the bond; bonds face value
C. nominal interest rate; real interest rate
D. sum of the coupons; sum of the coupons and
principal
Answer: A

The rate of return that the owner of and instrument

would earn by holding the instrument until maturity
is called the

A.
B.
C.
D.

coupon yield.
coupon value.
nominal rate of return.
yield to maturity.
Answer: D

To calculate the price of an instrument

one must find the
A. present discounted value of the stream of coupon
payments and principal.
B. sum of the coupons divided by the principal.
C. sum of the coupons plus the principal.
D. principal plus the present discounted value of the coupons

Answer: A

A bond with no fixed maturity date is

called a
A.
B.
C.
D.

treasury bill.
callable bond.
perpetuity.
discount bond.
Answer: C

A bond with an infinite payment life will

have a price
A. that is arbitrarily high, as it will produce coupon
payments forever.
B. of the present discounted value of its principal.
C. of the coupon amount divided by the interest rate.
D. of the coupon amount divided by one plus the interest
rate.

Answer: C

Suppose the price of a perpetuity is $1,000 and that

the perpetuity pays $60 per year. The interest rate on
this bond is

A.
B.
C.
D.

0.06%
0.60%
6%
60%
Answer: C

The interest rate on a perpetuity is 5% and its

price is $1,500. The annual coupon must
therefore equal
A.
B.
C.
D.

$75.
$300.
$750.
$30,000.
Answer: A

A perpetuity pays $100 per year and its

interest rate is 8%. Its price is therefore
A.
B.
C.
D.

$80.
$125.
$800.
$1,250.
Answer: D

Zero-coupon bonds have the

distinguishing feature that they
A.
B.
C.
D.

Make no periodic interest payments.

have an indefinite life.
are issued only by the Treasury.
pay only coupons that carry an interest rate
equal to the real interest rate.
Answer: A

A measure of the average time during which

all payments of coupons and principal on a
financial asset are made is referred to as the
A.
B.
C.
D.

term to maturity.
duration.
extension.
average markup.
Answer: B

The yield curve displays the relationship

among yields on bonds that differ only in their
A.
B.
C.
D.

default risk.
duration.
bond rating.
country of origin.
Answer: B

The segmented markets theory is

grounded in the assumption that
A. bonds with different maturities are nonsubstitutable.
B. investors have identical preferences for all bond maturities.
C. inflation will be prevalent in only certain
long-term bonds.
D. domestic investors prefer domestic bonds.

Answer: A

The preferred habitat theory suggests

that investors
A. have a preference for domestic over foreign bonds.
B. will only select bonds over a small range of terms to
maturity.
C. have a preferred maturity length but are willing to move
away from this if the interest rate differential is high
enough.
D. have a select group of firms whose bonds they prefer to
hold all else being equal.

Answer: C

Because of the possibility of default and

low liquidity, some bonds carry a
A.
B.
C.
D.

no callable clause.
risk premium.
margin account.
lower interest rate.

Answer: B

The primary reason that municipal bonds earn

a lower interest rate than treasury bonds is
that
A.
B.
C.
D.

municipal bonds have less risk.

treasury bonds are in greater supply.
municipal bonds are often serial type bonds.
the interest earned on municipal bonds is
tax-exempt.

Answer: D

Reinvestment risk arises from a situation

in which
A. long-term instruments prohibit taking advantage
of increases in interest rates.
B. an investor cannot be guaranteed the same interest
rate when rolling-over short-term instruments.
C. the investor suffers from an inability to liquidate
short-term instruments at opportune times.
D. an instrument cannot be transferred back into the domestic currency immediately.

Answer: B