BA Unit 1 2017 Final

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
1
Monetary Policy & International Finance
Mishkin, Chapter 1
2
Why study monetary policy ?
Money Supply
3
Money and inflation
• Increases in money supply are associated with increases in the

aggregate price level (inflation)
Reasons why Central Bank like postive inflation:

• Inflation affects the decisions of firms
- It makes wage negoations easier. Real cost of
− wages / labor demand labor has went down, if wages stay the same.
− prices and production - Hyperinflation: Prices need to be changed

serveral times.
− leverage and investment - Inflation also affects leverage. Usually bank will
factor in inflation into nominal rates
• Inflation affects the decisions of households

− labor supply
− consumption
− leverage, asset allocation
4
Money and inflation: Selected countries 2003 - 2013
Source: Mishkin (2015), Figure 1-5.
5
Money and inflation: USA 1950 - 2016
(Prices)
(Money Supply)
Reasons for the gap:
Money is used as a
mechanism for storing
wealth
Source: Mishkin (2015), Figure 1-4.
6
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
Inflation affects nominal rates, which in turn affects investment choices. Lower nominal rates makes investment more
attractive.
7
Money growth and interest rates: USA 1960 - 2016
(Money)
(nominal interest rate)
Source: research.stlouisfed.org
8
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
9
According to S&P 500, Low interest rates is accerlating
Switzerland 2000-2015 mortgage growth. Slashing of interest rates does not
seem to imply a spur in the mortgage market
(Investment decisions), maybe helps with sustaining
growth.
3.50
240.00
3.00
190.00 2.50
2.00
Libor 3-Month Rate

Index (2000=100)
140.00
1.50
100 in the
year 2000.
1.00
90.00
0.50
0.00
40.00
-0.50
-10.00 -1.00
2000 2003 2006 2009 2012 2015
Residential space - Rental apartments (1 to 5 rooms) - Total

Mortgage Credit Volume
3-Month Libor Rate (Interest Rates)
10
Why study international finance?
• Goods markets and financial markets are increasingly globalized
• Exchange rates affect Diversed Portfolio - Global investments

− 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 Appreciation of CHF /EUR has a
postive impact. (Next page)
− affect consumption and investment choices
11
Trade: Swiss imports/exports
• 2016: 298 bn CHF exports and 266 bn CHF imports
350
In bn CHF
300
250
200
150 Big jump happen in 2011,

as it includes trading of
gold and precious metal,
100
while previously it has
not been included.
50
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Imports Exports
Source: BFS - Statistisches Lexikon der Schweiz
12
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
13
Example:
Nestle invest in Local Infrastructure in
Capital flows: Foreign direct investment Germany (Foreign Direct Investment)
Nestle invest in US Government Bonds

(Portoflio 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
14
Exchange rates affects value of assets when denominated in
the foreign currency.
Exchange rate CHF: 2000 - 2017 Snce the Financial Crisis, CHF has significantly appreciated
against the EUR.
120
100
80
60
Index : Jan 2000 = 100
40
20
CHF/US CHF/EU CHF/GBP
Source: Quandl, 10.8.2017
15
Any exchnage rate changes will
Multinational corporations: Swiss examples affect the value of the assets of the
company.
Sources: Nestlé Annual Report 2016, Swatch Group Annual Report 2015
16
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
Discounts future revenue as well.
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
17
Exchange rate fluctuations and the real economy
Source: http://www.swissmem.ch/en/news-medien/news/mem-industrie-die-frankenstaerke-hinterlaesst-deutliche-spuren.html
18
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)
Example (Free Capital Flow,

Soverign Monetary Policy, No Trillema of International Finance
Fixed Exchange Rate) :
US , Switzerland
Example (Free Capital Flow,

Fixed Exchange Rate, No
Soverign Monetary Policy):
Bulgaria, Austria
Example(Fixed Exchange Rate,

Soverign Monetary Police, No
Free Capital Flow) :
China
Source: https://en.wikipedia.org/wiki/Impossible_trinity#/media/File:Impossible_trinity_diagram.svg
19
Financial Markets & Institutions
Mishkin Chapter 2
20
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
21
Direct finance: Financial markets
Typically, Firms do not directlly sell

product and lend money from
Lenders/Borrowers. Hence, there is a
need for Financial Intermediaries
Financial Financial
Intermediaries/ Intermediaries/
Investment Bank Investment Bank
Source: Mishkin (2015), Figure 2-1
22
Financial instruments & markets
Traditional Monetary Policy only targets the Money market only!
Debt instruments Equities

Short-term Commerical
(< 1 year) Paper, Treasury Money market
Bills
Capital market
Long-term Bonds,
(=> 1 year) Equities Capital market
• Debt vs. Equity: what are the differences ?

− seniority of claim
− fixed vs. ‘variable’ income
23
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)
24
Money market instruments
REPO
Agreements
Source: Mishkin (2015)
25
Capital market instruments: USA
26
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
27
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
28
Indirect finance: Financial intermediaries
29
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
30
Financial intermediaries: US
31
Asset structure: Swiss banks December 2016
Regional-
Big banks Cantonal Raiffeisen-
in % of total assets Big banks and savings
(domestic only) banks banks
banks
Cash 13% 25% 15% 10% 9%
Customer Loans (incl.
43% 57% 70% 85% 80%
mortgages)
Interbank Loans 10% 5% 3% 2% 3%
Tradable Securities 7% 3% 2% 0% 1%
Total assets in bn CHF 1454 546 553 116 215
Sources: SNB
32
Liability structure: Swiss banks December 2016
Regional-
Big banks Cantonal Raiffeisen-
in % of total assets Big banks and savings
(domestic only) banks banks
banks
Liabilities from financial
8% 0% 0% 0% 1%
instruments
Interbank Liabilities 8% 6% 10% 5% 6%
Savings and Sight deposits 38% 54% 51% 56% 56%

Time deposits 4% 3% 4% 2% 7%
Bonds and central mortgage
18% 7% 16% 17% 11%
institution loans
Total Liabilities 1454 554 553 116 215
Sources: SNB
33
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
34
Self-Study 1
• Impact of monetary policy on a Swiss pension fund
35

BA Unit 1 2017 Final

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BA Unit 1 2017 Final

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Introduction

Money, Banking and Financial Markets:

• Monetary policy and international finance

• Financial markets and financial institutions

• Increases in money supply are associated with increases in the

Reasons why Central Bank like postive inflation:

− prices and production - Hyperinflation: Prices need to be changed

• Inflation affects the decisions of households

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

Reasons for the gap:

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

• Changes in the money supply are associated with changes in

• 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

(nominal interest rate)

Jean-Pierre Danthine, 14.11.2013

Libor 3-Month Rate

Residential space - Rental apartments (1 to 5 rooms) - Total

• Goods markets and financial markets are increasingly globalized

• Exchange rates affect Diversed Portfolio - Global investments

• Changes in exchange rates affect the revenues, production and

• Changes in exchange rates affect the income / wealth of

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

150 Big jump happen in 2011,

Source: BFS - Statistisches Lexikon der Schweiz

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

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

Nestle invest in US Government Bonds

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

Sources: snb.ch; seco.ch

CHF/US CHF/EU CHF/GBP

Source: Quandl, 10.8.2017

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

Sources: yahoo finance

• A country cannot independently choose its monetary policy,

Example (Free Capital Flow,

Example (Free Capital Flow,

Example(Fixed Exchange Rate,

• The conduct of monetary policy occurs primarily through financial

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

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

Typically, Firms do not directlly sell

Source: Mishkin (2015), Figure 2-1

Debt instruments Equities

• Debt vs. Equity: what are the differences ?

Debt instruments Equities

• Conventional monetary policy operates mainly through the money

• Unconventional monetary policy may target the capital market

Source: Mishkin (2015)

Source: Mishkin (2015)

Source: SNB Swiss Financial Accounts Table 1

• Primary market: Issuance of new securities

• Secondary market: Trading in existing securities

• Monetary policy is mainly implemented via OTC transactions in

Source: Mishkin (2013)

• Lower transaction costs

• Deal with asymmetric information Brokerage

Source: Mishkin (2015)

Total assets in bn CHF 1454 546 553 116 215

Interbank Liabilities 8% 6% 10% 5% 6%

Savings and Sight deposits 38% 54% 51% 56% 56%

Total Liabilities 1454 554 553 116 215

• Monetary policy affects inflation and interest rates