Monetary Policy and Nominal Exchange Rates

Federal Open Market Committee used to maintain a steady increase of the Federal Reserve’s balance sheet based on a policy of quantitative easing, which involves buying a considerable amount of assets, in order to increase the money supply, but it decided to reduce the pace of new purchases of assets, as a reaction to the recent economic growth. With this policy, FED will continue to buy assets but in a more moderate way so there will be less money injected in the economy. This means that the money supply increases now less than before but the impact in the short-­‐term interest rates won’t be significant. However, in the long run, the situation is different, it is like as if you are decreasing the money supply because there’s a reduction in the injection of money in the economy by reducing purchases of assets. (This behaviour reduces the money supply and increases the demand for money. If the demand for money increases, the demand for assets will decrease, their price will increase what leads to an increase of the short-­‐ term interest rates. In the long run the same happens, but the long-­‐term interest rates will be even higher (as usually) because the risk associated is higher.) Consequently, in the long run, prices, labour supply and consumption will decrease and then GDP will decrease too.

With the reduction of purchases of assets and the increase in long-­‐term interest rates, there are no incentives to investment and, consequently, capital flow movements will decrease. This decrease in money available in the economy leads to a decrease of capital availability as it becomes more expensive to obtain. On the other hand, if U.S. interest rates are high, it ́s better to keep money in the banks and not to invest it. The increase in U.S. interest rates implies less money in the economy, so we need less dollars to buy one euro, which caused an appreciation of the dollar.

The ECB problem is the low-­‐inflation policy trap because its attempt to maintain low inflation rates could lead to deflation and consequently to a stagnation of the economy. The easiest solution used to be printing more money (despite some bad consequences). As it is not possible now, there are several other ways of combating this problem. First, if the ECB decides to decrease the refinancing interest rate (rate at which banks borrow money from the ECB), which would increase borrowing from commercial banks that can hereafter make loans, people will have more money to spend what makes an upward pressure in inflation. However, this measure has already been applied and some economists think that it’s not good to apply it now. Others have the opposite opinion so this measure is a little controversial. Hence, this might not be the best solution. Second, ECB should lower the deposit facility rate (rate paid by the ECB to banks for their deposits in ECB) to negative digits (as it is already close to zero) to incentive banks to lend the money to institutions and to grant credit instead of parking their excess funds at the central bank (because in this case they will not receive any interest, they will pay). Third, the ECB should stop sterilizing purchases of government bonds in secondary markets. But we need to understand what this policy really is. Sterilizing policy usually is used to maintain the money supply unchanged and,

with this, the CB can attain its goal of inflation target. Hereupon, stop-­‐sterilizing purchases of bonds should be taken into consideration because when these purchases occur, the number of loans increases which introduces more money in the economy what makes upward pressure in inflation. In conclusion, the first measure has the problem that I have already announced, the second one was never tested because the deposit facility is already close to zero and doesn’t make much sense to lower it to negative digits so the best solution might be the third one as the sterilization policy only makes sense until the point that it maintains the inflation target and not when we are at a point where exists risk of deflation. This third measure is good because it boosts the inflation, without propelling a valuation of the euro.

Argentina’s economy was in a troubled period in January. The gap between the official and the unofficial exchange rate was increasing because the exchange rate was overvaluated due to the higher demand for dollars. The BCRA has consistently liquidated reserves in order to prop up the official exchange rate. But then, it has been obliged to devaluate the peso (depreciate its currency) to preserve the international reserves because they are the only source that the government has to pay to foreign creditors. This devaluation also means high inflation rates. Therefore, the government loosened the currency controls, allowing people to have foreign currencies, encouraging them thereby to keep the money in Argentina. This devaluation has other consequences: on one hand we have more exportations what increases competitiveness but on the other hand we have higher prices which means that people have less purchase power and they will consume less. In the end, devaluation is only positive if it is higher than inflation. The widening of the emerging markets’ government bonds yields occurred due to a decrease of the price of dollar bonds. Furthermore, if inflation is increasing, bonds’ yields are expected to increase as well. b) The BCRA needs to take some measures to counter this situation that they have faced. First it needs to depreciate the peso to stabilize its exchange rate and also to make exports more competitive in the international market. Second, it needs to ease the demand on dollar to increase its reserves. Third, BCRA could raise the interest rates and relax the currency control to incentive people to maintain the money in the country what leads to an increase of the reserves and also to a decrease in the gap between the official and the unofficial exchange rate.