Introduction

Money, Banking and Financial Markets:

Monetary Policy and International Finance (3,168)
Unit 1
Fall term 2017
Prof. Dr. Martin Brown
Todays lecture

• Monetary policy and international finance

• Financial markets and financial institutions

Monetary Policy and International Finance (3,168), Prof. Dr. Martin Brown
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Monetary Policy & International Finance
Mishkin, Chapter 1

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Why study monetary policy ?

Money Supply

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Money and inflation

• Increases in money supply are associated with increases in the

aggregate price level (inflation)
Usually 1-2%

Reasons why Central Bank like postive inflation:

• Inflation affects the decisions of firms - It makes wage negoations easier. Real cost of labor
has went down, if wages stay the same.

− wages / labor demand - Hyperinflation: Prices need to be changed serveral

times.
− prices and production
- Inflation also affects leverage. Usually bank will
− leverage and investment factor in inflation into nominal rates

• Inflation affects the decisions of households

− labor supply
− consumption
− leverage, asset allocation

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Money and inflation: Selected countries 2003 - 2013

Source: Mishkin (2015), Figure 1-5.

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Money and inflation: USA 1950 - 2016

Source: Mishkin (2015), Figure 1-4.

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Money and interest rates

• Changes in the money supply are associated with changes in

interest rates

• Alters the cost of borrowing and the return on savings

• Changes in interest rates affect the investment choices of firms

• Changes in interest rates affect the consumption and investment

choices of households

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Money growth and interest rates: USA 1960 - 2016

Source: research.stlouisfed.org

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Money, interest rates and financial fragility

“.. by lowering the cost of credit and increasing the value of assets, low
interest rates could provide the breeding ground for asset price and credit
booms. In this regard, the current developments in Swiss mortgage and real
estate markets are telling: real estate prices and mortgage credit have been
growing with considerable momentum for several years already.
Importantly, the growth rates of both prices and credit volumes are at
levels which cannot be fully explained by fundamental factors. This has led
to the built-up of imbalances which increase the risk of a substantial price
corrections and of loan losses. “

Jean-Pierre Danthine, 14.11.2013

at Swisscanto Market Outlook 2014

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• Please add a graph here showing for Switzerland 2000 – 2015
(annual data)
− Mortgage credit volume (indexed to 100 in 2000)
− House prices (indexed to 100 in 2000)
− Reference interest raes (e.g. 3 or month libor)

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Why study international finance?

• Goods markets and financial markets are increasingly globalized

• Exchange rates affect

− the price of exported and imported goods
− the value of assets and liabilities denominated in foreign currencies

• Changes in exchange rates affect the revenues, production and

investment choices of firms

• Changes in exchange rates affect the income / wealth of

households as well as relative prices of goods
− affect consumption and investment choices

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Trade: Swiss imports/exports

• 2016: 298 bn CHF exports and 266 bn CHF imports

60%

50%

40%
Share of GDP

30%

20%

10%

0%
1990 1995 2000 2005 2010 2015
Imports Exports

Source: BFS - Statistisches Lexikon der Schweiz

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Capital flows: Portfolio and other investment

• 2016: Portfolio investment 1,282 (1,106) bn CHF Assets (Liabilities)

• 2016: Other investment 837 (1,215) bn CHF Assets (Liabilities)

300%
Portfolioinvestment \ GDP

250%

200%

150%

100%

50%

0%

Portfolioinvestments_Assets Portfolioinvestments_Liabilities
Other_Investment_Assets Other_Investment_Liabilities

Other investment: Currency and deposits of SNB and banks; Loans of SNB,
public sector and other sectors Sources: snb.ch; GDP from seco.ch

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Capital flows: Foreign direct investment

• 2016: 1,120 (794) bn CHF Assets (Liabilities)

200%
180%
160%
140%
FDI / GDP

120%
100%
80%
60%
40%
20%
0%

Swiss_FDI_abroad
FDI_in_Switzerland

Sources: snb.ch; seco.ch

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 Exchange rate CHF: 2000 - 2017

120

100

80

60
Index : Jan 2000 = 100

40

20

CHF/US CHF/EU CHF/GBP

Source: Quandl, 10.8.2017

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Multinational corporations: Swiss examples

Sources: Nestlé Annual Report 2016, Swatch Group Annual Report 2015

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Exchange rate fluctuations heavily affect MNCs

• Stock prices at SIX Swiss Exchange in CHF of globally vs nationally

oriented Swiss companies after the removal of the CHF/EUR floor

110

105

100
Index 1.1.2015 = 100

95 Swisscom
90 Nestle
Swatch
85
CHF/USD
80

75

70
02.01.2015 17.01.2015 01.02.2015 16.02.2015

Sources: yahoo finance

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Exchange rate fluctuations and the real economy

Source: http://www.swissmem.ch/en/news-medien/news/mem-industrie-die-frankenstaerke-hinterlaesst-deutliche-spuren.html

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International finance and monetary policy

• A country cannot independently choose its monetary policy,

exchange rate regime (fixed, floating) and currency regime (free
capital account vs. capital controls)

Source: https://en.wikipedia.org/wiki/Impossible_trinity#/media/File:Impossible_trinity_diagram.svg

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Financial Markets & Institutions
Mishkin Chapter 2

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Relevance for monetary policy

• The conduct of monetary policy occurs primarily through financial

market operations

• The supply of money depends strongly on the credit activity of

financial institutions

• The volume of available “money” is strongly connected to the

liability structure of financial institutions

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Direct finance: Financial markets

Source: Mishkin (2015), Figure 2-1

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Financial instruments & markets

Debt instruments Equities

Short-term
(< 1 year) Money market
Capital market
Long-term
(=> 1 year) Capital market

• Debt vs. Equity: what are the differences ?

− seniority of claim
− fixed vs. ‘variable’ income

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Financial instruments and monetary policy

Debt instruments Equities

Short-term
(< 1 year) Money market
Capital market
Long-term
(=> 1 year) Capital market

• Conventional monetary policy operates mainly through the money

market

• Unconventional monetary policy may target the capital market

directly (i.e. long-term debt)

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Money market instruments

Source: Mishkin (2015)

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Capital market instruments: USA

Source: Mishkin (2015)

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Capital and money market: Switzerland

Outstanding Amount
In bn CHF 2000 2008 2013
Capital Market
Shares and other equity (domestic
341 436 571
issuers)
Debt securities (domestic issuers excl.
238 267 287
Gov.)
Debt securities General Government 103 138 133

Money Market
Money market instruments (Swiss bank
54 93 78
liab.)
Interbank lending (Swiss bank liab.) 525 664 407

Source: SNB Swiss Financial Accounts Table 1

Banks in Switzerland Table 18

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Financial market structure and monetary policy

• Primary market: Issuance of new securities

− primary dealers: government debt
− investment banks: equity, corporate debt

• Secondary market: Trading in existing securities

− exchange: listed stocks
− over the counter (OTC): bonds. unlisted stocks, repo

• Monetary policy is mainly implemented via OTC transactions in

secondary markets

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Indirect finance: Financial intermediaries

Source: Mishkin (2013)

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Financial intermediaries: Rationale

• Lower transaction costs

− economies of scale

• Deal with asymmetric information Brokerage

− adverse selection (before the transaction)
− moral hazard (after the transaction)

• Risk sharing
− interest rate risk
− liquidity risk
Asset
transformation
− credit risk

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Financial intermediaries: US

Source: Mishkin (2015)

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 Asset structure: Swiss banks December 2015

Regional-
Big banks Cantonal Raiffeisen-
in % of total assets Big banks and savings
(domestic only) banks banks
banks
Cash 11% 19% 15% 9% 8%
Customer Loans (incl.
45% 65% 70% 86% 74%
mortgages)
Interbank Loans 11% 5% 3% 2% 11%
Tradable Securities 8% 3% 2% 0% 1%

Total assets in bn CHF 1424 479 537 113 202

Sources: SNB

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 Liability structure: Swiss banks December 2015

Regional-
Big banks Cantonal Raiffeisen-
in % of total assets Big banks and savings
(domestic only) banks banks
banks
Liabilities from financial
8% 0% 1% 0% 0%
instruments

Interbank Liabilities 9% 6% 11% 6% 5%

Savings and Sight deposits 38% 61% 51% 55% 56%

Time deposits 8% 3% 5% 2% 7%
Bonds and central mortgage
17% 7% 15% 20% 12%
institution loans

Total Liabilities 1424 479 537 113 202

Sources: SNB

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Key messages

• Monetary policy affects inflation and interest rates

− influence the behavior of firms and households and thus real
economic outcomes
− also influences financial stability

• Goods and capital markets are increasingly globalized

− changes in exchange rates influence the behavior of firms and
households and thus real economic outcomes

• Monetary policy is mainly implemented via over the counter,

secondary financial markets
− the credit activity and liability structure of financial institutions also
influences money supply

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Self-Study 1

• Impact of monetary policy on a Swiss pension fund

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