Published on: Mar 3, 2016
Transcripts - Naji-s-Paper
Central Banks Currency War
Swiss National Bank and European Central Bank
Adopting the Monetary Policy
Student Number: 14832454
Dr. Rob Hayward
Word Count: 3204
Table of Contents
The Role of the Monetary Policy 2
The Equilibrium of Money Supply and Money Demand 3
The Money Supply and the Exchange Rate 4
A Long-Run Exchange Rate Model Based On PPP 4
The Predictions of the Monetary Approach 4
The Swiss Franc Jumped 30 Percent 6
M3 and Eurozone Supply 7
Quantitative Easing Programme and Inflation levels 7
QE Process 8
Interest Rates 9
In general, monetary policy shows that the money is supplied by the central bank and
he takes the role of controlling it in the economy, the Central Bank regulates this amount
of money supplied, based on the money demanded by the people. Where the demand
for the money was explained simply by the quantity theory of money as an earliest
explanation for the money (Bofinger, Reischle and Schächter, 2001). Money is defined
in three different kinds relating to monetary policy money supply: money as means of
exchange (the most liquid), money as a store of value (least liquid) and money as a unit
of account which is widely used to measure a value (Krugman and Obstfeld, 2009).
The Role of the Monetary Policy
According to Paul Krugman there are three important factors that determine the demand
The interest rate: where the higher the interest rate, the lower the demand for
money, while low interest rate motivates people to demand more because it is
cheaper to hold and borrow.
The price level: which is related to the price of goods and services, if the prices
went up, people must spend more money than before on those goods and
services, so they will demand highly for money.
Real national income: if the GDP level rises, that means more goods and
services are sold in the economy, of course on the other side the demand for
money will rise (Krugman and Obstfeld, 2009).
The simple money demand equation below, shows that P is the price level, R is the
interest rate, and Y is the real GDP or the national income.
Md = P* L(R,Y)
Where L is a function for R and Y, the interest rate holds a negative relationship with
the money demand, and Y holds a positive relation with Md. In order to get the real
money demanded we can modify the formula by dividing the Md by P to get the real
demand for money in the economy.
Md/P = L(R, Y)
The Equilibrium of Money Supply and Money Demand
When the money supply set by the central bank, he wants to succeed an equilibrium
with the money demand.
If Md/P = L(R, Y) so Ms/P = L(R,Y)
In figure.1 is shown how the money demand and supply equilibrate at point 1, so if the
central bank increased the supply of money moving from Q1 to Q3 relating to the
aggregate demand curve R1 will go down to R3, on the other hand side if the demand
for money falls driving the supply of money from Q1 to Q2, people will get rid for the
excess amount of money by lending it to others and benefit from the shifting of R1 to
R2, so they can enjoy the gain (Krugman and Obstfeld, 2009).
Furthermore, there is a huge effect of the money supply and interest rate, if Q1 moved
to Q3, that means loads of funds are available to lend out and people are willing to get
low interest served by the bank to encourage the people to borrow money (Krugman
and Obstfeld, 2009), but supplying less money to Q2 will raise the interest level to
reduce the amount lent out to the economy a policy by the central bank to make lending
more expensive for people, for the output levels the higher amount the more demand,
leading the red line to shift to the right and there is going to be an excess demand, the
interest rates will increase after this shifting, overall increase in real output raises the
interest rates and vice versa.
The money supply and the Exchange Rate
In general, the exchange rate is the price of settling for international transactions, for
example: USD/EUR 1.5 it means for every 1 euro you get 1.5 dollars overall it tells
how much is the domestic currency worth to the foreign one.
How can the monetary change the rates? Where the increase in the money supply that
will depreciate the value of the currency in foreign exchange market, on the other side
reduction in the money supply will appreciate the value of it (Krugman and Obstfeld,
2009). According to the example above let’s suppose that USD/EUR moves to 2, that
means that euro can buys more dollars that ends with appreciation in the euro, where
the US have to pay more to get 1 euro, and if the USD/EUR went to 1.2, that means the
euro depreciated and it is cheaper than before to cost 1.2 dollars for 1 euro.
A Long-Run Exchange Rate Model Based On PPP
When the money demand and supply are combined with the theory of the purchasing
power parity (PPP), that will lead to a useful theory of how exchange rates and monetary
factors interact in the long run, why the long-run not the short one? Because prices in
the short-run are sticky, they might not create a full employment of equilibrium.
Basically, PPP under the form of E$/€=P$/P€, which is the exchange rate based on the
change in the prices of the dollar as a domestic currency and euro as foreign one, if the
dollar prices went up by 10% the exchange rate will raise by 10%, if a product cost
$200 in U.S and £160 in UK the exchange rate will be $1.25 per GBP. If the product
went up in the US to $600 the exchange rate will be $3.75 per GBP, in other words the
dollar depreciated (Krugman and Obstfeld, 2009), so it will be more costly for US
residents to import from Great Britain because they have to pay more to get one GBP,
while it will be less costly for UK residents.
The Predictions of the Monetary Approach
1. Money supplies: Ms/P= L(R,Y) the formula of the money supply, then by
deriving it to make P= Ms/L(R,Y), and the money supply rises the prices will
rise and based on the PPP equation the exchange rate will rise too in the long-
run, so the money supply rise by 10% prices will rise by 10% and the exchange
will rise too by 10%. Thus that will depreciate the currency according to
example of the USD/GBP.
2. Interest rates: It has a negative relation with the money supply which means a
rise in the interest rates, and money supply is constant, will lower the demand
for the currency, P= Ms/L(R,Y) the equation shows on the long-run price levels
will increase, because the opportunity cost of holding the money will be higher,
leading to an increase to the exchange rate, and relating that to the exchange rate
equation in USD/GBP example the dollar will depreciate against the pound.
3. Output levels: A rise in the level of the output, will increase the money demand
L(R,Y) leading to a fall in the long-run price levels, back to the USD/GBP
example PPP will increase causing an appreciation of the dollar against the
pound, reversely for the UK output increase will depreciate the dollar against
the pound (Krugman and Obstfeld, 2009).
The equation above explain everything, where S is the change in the exchange rate
affected by the changing variables for the domestic country and the foreign countries,
if the money supply increased in the domestic country and was not met by the foreign
country will lead to an increase in the exchange rate so the currency will depreciate,
and the same for the output levels, but on the contrary side of the interest rate that holds
a negative relation, suppose the domestic country reduced the interest rate levels that
was not met by the foreign country will cause an increase in the exchange rates, because
of the money demanded and injected in the economy that led to a depreciation in the
In general, the exchange rate is domestic currency of foreign money, so naturally
increase in the supply of foreign money will appreciate the domestic currency (ie. lower
the exchange rate), while increase in the demand for foreign money will results to a
depreciation for the domestic currency (ie. Increase in the price of the foreign
A theory was written by Michael Mussa, who explained a good relation between the
monetary approach and the balance of payments, he said that the increase in the money
supply to meet the money demanded, but that will create and excess in the balance
account of the country from the surplus side, but might do an increase in the exchange
rates simply because the currency value depreciated, but the monetary policy can
protect that by buying foreign sources to balance its account (Mussa, 1976).
One of the biggest examples on that, what happened to the Swiss franc in 1974, that
appreciated against other European currencies because of the demand to hold the franc
at the old exchange rate, but that demand was not met by the supply causing an
appreciation of the franc.
The views says that exchange rates are principally affected by the money supply, the
policy idea how the exchange rates prices and the overseas trade interact towards the
exports (Budd and Burns, 1977), if we assumed the money supply that will make the
currency depreciated causing an increase in the exchange rate, resulting into a cheaper
exports for foreigners whom maintained constant money supply will enjoy their
stronger currency to import.
The Swiss Franc Jumped 30 Percent
of January 2015, the Swiss national bank stunned the markets by scrapping
the three years peg of 1.20 CHF/EUR, and the euro would not allowed to fall below or
depreciate below 1.20 francs per euro. The SNB was printing money on regular basis
and buying euros to make sure and maintain that value. But what happened that the
franc soared by around 30% suddenly by trading 0.805 CHF/EUR, moreover they cut
the interest rate to -7.5%, the Swiss stock market plummeted, shares in every company
listed on the Swiss stock exchange lost value, furthermore 60% of Switzerland exports
are to Europe, right now the franc is much stronger than the euro, causing the overnight,
Swiss products, watches, cheese, machine tools, even skiing holidays will be 20% more
expensive than before.(BBC News, 2015). Back to 2005 David Dodge the Governor of
the Canadian central bank explained, a growing demand for X country goods and
services, let us suppose Switzerland here, that will tend to cause an appreciation of its
currency (CHF always strong), but when the demand falls that will depreciate the
currency, the SNB has be careful (Dodge, 2005).
According to Thomson Reuters data, the great drop in the figure below from 1.20
CHF/EUR to about 0.9 CHF/EUR and that was after the fixing in few hours which
recorded about 0.8 CHF/EUR, but the interesting level when it was stable through last
couple of years because of the capping 1.20 francs for the euro, the figure down below
Figure.2 (Thomson Reuters, 2015)
But the question why is that? According to the move by the European central bank to
buy bonds in order to stimulate the economy of the Eurozone by quantitative easing
which is meant to decrease the borrowing cost to encourage the people and businesses
to borrow, by doing that for sure the euro will depreciate and the Swiss national bank
Close Price CHF/EUR
is not confident about that, because the euro is already depreciating and when the SNB
is printing francs and keeps buying the certain amount of euros to maintain a balance
in their balance sheet that will be more likely to the liability side, those reserve amounts
will lose their value because the SNB is holding , but on the other side the ECB is
aiming to boost the exports, because investors will be happy to spend the euro cheaper.
M3 and Eurozone Money Supply
According to Thomson Reuters, the chart below shows how the Eurozone maintained
the same levels of the broad money supply since September 2011 the SNB held the
floor of 1.20 CHF/EUR, and the rise will be expected on the next few months charts,
where the blue line of the Eurozone will go sharply up according to the quantitative
easing program, and the orange line will decrease against the blue line because of the
appreciation of the CHF.
Figure.3 (Thomson Reuters, 2015)
Quantitative Easing Programme and Inflation levels
The ECB aims to buy €60 billion bonds each month, until September 2016.
The figures were showing that Eurozone are facing deflation, ECB President Mario
Draghi said “The programme would begin in March”. And he pledged to maintain about
2% inflation level, which is very good. The Figure below analysed through excel from
Thomson Reuters, shows inflation and deflation levels of Europe.
As the heart of the monetary policy, the basic idea is to keep inflation levels stable and
low, to do that they aim to maintain a rough balance between demand and supply in the
economy, when total demand exceeds the supply there would be a deficit that might
create a deflation in the long-run and that what was happening with Greece in Figure.4,
Broad money supply
Euro area (19 countries) Switzerland
while if there is too little aggregate demand relative to the supply, the economy will
operate a boom that also might lead to high inflation levels in the long-run, then the
Central bank would ease the policy to stimulate demand in order to close the gap, and
that is what the ECB wants to do.
Figure.4 (Thomson Reuters, 2015)
Where the ECB aims to inject money to the market by buying bonds from Italy, Greece
and others, whom they are almost deflated in figure.4, to boost their economy, then
interest rates will fall leading those businesses and countries to borrow, by spending
France Germany Greece Italy United Kingdom Switzerland
more, creating jobs and paying wages, the improvements more likely to appear the next
couple of years in the unemployment levels that might shrinks.
Relatively to the theory, when the SNB reduced the interest rate he aims to make the
franc less attractive to the investors whom they aim to hold deposits with the safe haven
currency, therefore there will be less demand for the franc, for the next few months the
fall is expected in the exchange rate by making the exports competitive and imports
more expensive, from here that might help the aggregate demand, (AD) = C+I+G+(X-
M) by increasing the (C) (I) and (X-M).
From the figure below, the volatile movements of the interest rates that is showing us
the decline in the rates of the Eurozone, and according to what is happening now the
interest rate for the QE program might reach to zero, to motivate people for investing
and spending more money, on the other side there is a big point behind the falling of
the interest rate in Switzerland to -7.5%, as I mentioned before people are wishing to
hold the safe haven currency (Swiss franc), but at this point the SNB wants to hold a
stable balance of payments because people are placing deposits in CHF currency and
on the other side the SNB will be more likely to buy euros to balance the sheet, and
what is expected the euro will lose its value more, while the SNB is not considerable,
and less confident to hold undervalued euros against the francs. The SNB said
“lowering interest rates significantly to ensure that the discontinuation of the minimum
exchange rate does not lead to an inappropriate tightening of monetary conditions”
(Wigglesworth et al., 2015), this movement is to discourage the people from getting
new flows to the Swiss franc on some deposits that will be held at the central bank by
commercial ones, through making the interest rate in Switzerland less attractive than
European one (BBC News, 2014).
Figure.5 (Thomson Reuters, 2015)
Switzerland Euro zone
We might assume that if a country interest rate is -7.5%, it is going to be very interesting
to do a carry trade by borrowing Swiss francs and deposit in a high country interest rate,
but on the other side that might cost you more than the return that you might get,
because back to figure.2 a massive fall happened in hours not days, weeks or months,
so if you want to convert the loan into your domestic currency it will be costly, for an
example the 1 franc is equal to 73.5 rubles, where Russia it has a high interest rate but
it will be risky to invest over there, the currency it is really volatile.
The rising value of the franc motivate people to import from abroad because they will
enjoy their strong currency, and that might decrease the demand for domestic products,
so Switzerland has to be careful about facing deflation in the future. More over the
wonderful watches, cheese, and chocolates they are going to be more expensive to
export, so back to the balance of payments theory if the imports were more that might
result into trade deficit (The Japan Times, 2015).
For the GDP levels, without any doubt we cannot compare the numbers between
Switzerland as a single country with 18 Eurozone country that is why two single charts
were used. The statistics down below shows the effect of the cap on the franc since
2011, the Swiss economy was growing effectively, residents, companies and everyone
were importing products from the stable franc, but unfortunately people are afraid from
the fall in the gross production for Switzerland after the currency increase. For the
Eurozone expectedly the economy will grow more and more, but the fear until now
from few unstable economies.
OECD (2015), Gross domestic
product (GDP) (indicator). doi:
on 08 February 2015)
2007 2008 2009 2010 2011 2012 2013
But the greatest hit was on the Swiss stock market where a bubble was created in the
Swiss index, which led to huge losses for the share prices. They were trading at 9500
for the index and they were sharply decreased to 7900 by creating great losses,
including watchmakers Swatch, and luxury goods as Richemont, by slumping down
their share prices about 11-16 percent as the franc surged against the euro (Reuters,
2015) loads of investors lost the value of their shares in the stock market, and those
companies they will find difficulties for their shares to European customers.
Figure.8 (Thomson Reuters, 2015)
To sum up this paper, we have seen how can the monetary policy of one country
affect not just the exchange rate of the domestic economy, but it can make big and
wide changes in the worldwide economies, and the biggest example in this thesis is
the Swiss national bank, who wanted to protect his currency from the QE program
that will force him to print and supply more money in order to maintain the old cap,
the theory that was used works in some cases, like the money supply, but for the
interest rates and output levels might work in the medium or the long-run because the
foreign demand for the Swiss goods and services will appreciate the currency, but in
response increasing relative prices that will offset some of higher demand and
dampening exports. Finally a good point has been realized during this paper is that the
monetary policy always aims to achieve a good and stable economic growth using the
balance of payments and inflation levels.
BBC News, (2014). Swiss interest rate to turn negative. [online] Available at:
http://www.bbc.co.uk/news/business-30528404 [Accessed 5 Feb. 2015].
BBC News, (2015). Swiss fear hangover as ECB injects cash. [online] Available at:
http://www.bbc.co.uk/news/blogs-eu-30942018 [Accessed 5 Feb. 2015].
Bofinger, P., Reischle, J. and Schaˆجchter, A. (2001). Monetary policy. Oxford:
Oxford University Press, pp.21-48.
Budd, A. and Burns, T. (1977). MONETARY AND EXCHANGE RATE POLICY.
Economic outlook (London. 1977), 2(2), pp.3-5.
Dodge, D. (2005). Monetary Policy and Exchange Rate Movements. Bank of Canada
Krugman, P. and Obstfeld, M. (2009). International economics. Boston: Pearson
Mussa, M. (1976). The Exchange Rate, the Balance of Payments and Monetary and
Fiscal Policy under a Regime of Controlled Floating. The Scandinavian Journal
of Economics, 78(2), pp.229-248.
Reuters, (2015). UPDATE 5-Swiss shares post biggest one-day fall since 1989 on
franc furore. [online] Available at:
idUSL6N0UU2OS20150115 [Accessed 5 Feb. 2015].
The Japan Times, (2015). Shocking Switzerland | The Japan Times. [online] Available
switzerland/#.VM_oGp2sUp4 [Accessed 5 Feb. 2015].
Wigglesworth, R., Rovnick, N., Thomas, N., Stovin-Bradford, R., Blackden, R.,
Badkar, M., Platt, E., Yuk, P., McGee, P. and Thompson, J. (2015). Swiss
National bank abandons currency ceiling. [online] Fast FT. Available at:
[Accessed 5 Feb. 2015].
The CHF big shock
Euro area (18
2007 357994.3836 11389854.93
2008 385739.3429 11907039.71
2009 386566.2869 11638915.92
2010 401586.2011 12000666.78
2011 431626.791 12493990.49
2012 447148.5894 12580132.62
2013 460604.8013 12676187.58