Foreign Exchange: A Practical Guide to the FX Markets

CHAPTER 11

The Economics of Exchange Rates and International Trade

From the time Bretton Woods became effective, it was inevitable it would break down. . . . It tried to achieve incompatible objectives: freedom of countries to pursue independent internal monetary policy; fixed exchange rates; and relatively free international movement of goods and capital.

—Milton Friedman (1975)

MONEY VERSUS CURRENCY

Currency is money, but money need not be currency. In the earlier chapters, we seemed to identify money and currency, but they are not the same. To an economist, money can be defined either narrowly or broadly. The U.S. central bank, which once closely tracked and even targeted the money supply as a policy instrument, draws these three distinctions in the definition of money (among others). (1) M-1 consists of currency in the hands of the public (but not the banks), checking accounts, which are also referred to as “demand deposits”, travelers checks, and automatic transfer service account balances. (2) M-2 consists of M-1 plus savings accounts, also referred to as “time deposits,” up to USD 100,000 (the maximum federally insured amount per account in the United States), money market mutual funds, and some overnight repo and EuroDollar accounts. (3) M-3 consists of M-2 plus time deposits exceeding USD 100,000, institutional money market funds, and longer-term repos and EuroDollar accounts. M-1 defines money rather narrowly; M-3 includes less liquid monetary instruments. Other central ...