BFF5916 · International Banking
Monetary Policy and FX
Strip away the jargon and an exchange rate is just a price — the price of one currency in another. From that single idea flows the dealer's two-way quote (the mantra is 'Banks Buy at the Bid'), the bid/ask spread you can read three ways (absolute, in pips, and as a percentage), and the choice between fixing and floating. The deepest idea is the monetary trilemma: a country can hold at most two of a fixed exchange rate, free capital mobility and an independent monetary policy — keep any two and you must surrender the third. The chapter classifies regimes and their history (gold standard → Bretton Woods → the post-1976 float, plus hard pegs like currency boards and dollarization), and the institutions that run the system (IMF for short-term crisis lending with conditionality, World Bank for long-term development, WTO for trade, and the euro with its Maastricht criteria). It then turns to central banks: inflation and the CPI basket, the yield curve (inverted = recession signal), the central-bank balance sheet and the monetary base, the cash-rate transmission chain, and FX intervention (which works like a domestic open-market operation). It closes with the parity conditions — CIP (covered, the locked forward), UIP (uncovered, the expected spot) and PPP (price levels) — and the exam traps of direct-vs-indirect quotes and CIP-vs-UIP.
What this chapter covers
- 01FX as a price — bid/ask, spread three ways, pips, 'Banks Buy at the Bid'
- 02The monetary trilemma — pick two of three
- 03Regimes and history — gold → Bretton Woods → float; hard pegs
- 04The institutions — IMF vs World Bank, WTO, the euro & Maastricht
- 05Inflation and the CPI basket; the yield curve
- 06The central bank's balance sheet, monetary base and transmission
- 07The parity conditions — CIP, UIP and PPP; the exam traps
Worked example: reading a dealer's two-way FX quote
- +1(a) Which side: you sell your USD to buy the base currency AUD, so you transact at the ask = 0.6526. Banks buy the base at the bid; the customer always buys the base at the (higher) ask.
- +1Absolute spread = Ask − Bid = 0.6526 − 0.6520 = 0.0006 USD per AUD.
- +1In pips = 0.0006 / 0.0001 = 6 pips.
- +1Percentage spread = (Ask − Bid) / Bid × 100 = 0.0006 / 0.6520 × 100 = 0.092% — the dealer's cut on a round trip.
Key terms
- The monetary trilemma (impossible trinity)
- A country can hold at most two of a fixed exchange rate, free capital mobility, and an independent monetary policy. Keep fixed FX + free capital and you import the anchor's rates (no independent policy); keep free capital + independent policy and the rate must float; keep fixed FX + independent policy and you need capital controls.
- Bid / ask and the spread
- A dealer's two-way quote: 'Banks Buy at the Bid' — the dealer buys the base currency from you at the lower bid and sells it at the higher ask, and the gap is its margin. The customer buys the base at the ask and sells at the bid. One pip is usually 0.0001.
- CIP vs UIP
- Covered interest parity uses the locked forward rate, which offsets the interest-rate gap exactly so there is no arbitrage — it holds tightly. Uncovered interest parity uses the expected future spot rate: the high-rate currency is expected to depreciate by the gap. Same interest-gap right-hand side; CIP is covered/riskless, UIP is uncovered/risky and often fails empirically.
- Purchasing power parity (PPP)
- Exchange rates adjust so price levels equalise. In its relative form, the percentage change in the spot rate roughly equals the inflation differential between the two countries — the higher-inflation currency tends to depreciate.
- Yield curve (term structure)
- Government-bond yield plotted against maturity, with the short end anchored near the policy/cash rate. A normal (upward) curve carries a term premium; an inverted curve — short yields above long — prices rate cuts ahead and is the classic recession signal.
Monetary Policy and FX FAQ
What is the monetary trilemma?
It says a country can have at most two of three things: a fixed exchange rate, free capital mobility, and an independent monetary policy. If you want all three, the third forces a contradiction and markets break the weakest leg. Hong Kong keeps a fixed rate and free capital, so it gives up independent policy (it tracks the Fed); Australia keeps free capital and an independent RBA, so the AUD floats; a country that wants a fixed rate and independent policy must impose capital controls.
Which side of a quote do I trade on, bid or ask?
The mnemonic is 'Banks Buy at the Bid'. The dealer buys the base currency from you at the lower bid and sells it to you at the higher ask, so the customer always transacts on the worse side: you buy the base at the ask and sell the base at the bid. The spread (ask minus bid) is the dealer's margin — bigger spreads mean higher transaction cost, not a different rate level.
What is the difference between CIP and UIP?
Both relate the interest-rate gap to the currency, but CIP uses the forward rate (locked, riskless — you are covered) while UIP uses the expected future spot rate (a forecast, risky — uncovered). CIP holds tightly because arbitrage enforces it; UIP often fails empirically (the forward-premium puzzle), which is why carry traders can earn the interest gap until it snaps. Same right-hand side, different left-hand side.
Why is an inverted yield curve a recession signal?
The yield curve plots bond yield against maturity, and its short end sits near the central bank's policy rate. When short yields rise above long yields the curve inverts, which means markets are pricing rate cuts ahead — typically expected because a slowdown is coming. So an inversion is the market's forecast of weaker growth, which is the most-tested one-line read of the curve.
Exam move
Follow one reflex for every FX question: quote → regime → parity. (1) Read the quote — which side do you transact on ('Banks Buy at the Bid', so the customer buys the base at the ask), and spread it three ways (absolute, pips, percentage). (2) Classify the regime — fixed or float, and which two of the trilemma the country is keeping (then name the casualty). (3) Apply the right parity — CIP (the locked forward, holds) vs UIP (the expected spot, often fails), with PPP setting the long-run direction. Memorise the one-liners that buy marks: inverted = recession, FX intervention = a domestic open-market operation, IMF = short-term crisis lending vs World Bank = long-term development. And keep the direct-vs-indirect trap settled: anchor on what one unit of the named currency buys — if it buys less, that currency has depreciated.
