Lecture 1A: The basics and the course

This first lecture has two parts. Part A is about central banks: what they want to achieve, which tool they use (an interest rate), how they make sure banks actually pay that rate, and how a simple formula, the Taylor rule, describes their decisions. Part B is about how a country deals with the rest of the world: the balance of payments, the current account and the net international investment position (NIIP). These two parts belong together: a country that buys more from abroad than it sells must borrow from foreigners, and whether foreigners want to lend depends on interest rates and the exchange rate, which is exactly what central banks influence.

This summary assumes no prior knowledge. Every term is explained the first time it appears. Take it step by step: first the basic vocabulary, then the central bank, then the international accounts.

The basics you need first

• Central bank: the "bank of the banks" of a country or currency area. Ordinary banks hold accounts at the central bank, and the central bank decides on monetary policy: the price of money (the interest rate). The US central bank is the Federal Reserve (Fed); for the euro area (the countries that use the euro) it is the European Central Bank (ECB) in Frankfurt.
• Interest rate: the price of borrowing money, as a percentage per year. If you borrow €100 at 4%, you pay back €104 after a year. A higher rate makes borrowing more expensive, so people and firms borrow and spend less; that slows the economy and lowers inflation. A lower rate does the opposite.
• Inflation: the percentage by which the general price level rises over a year. It is measured with a price index: the price of a fixed basket of goods and services. Inflation of 3% means the basket costs 3% more than a year ago. Headline inflation includes everything; core inflation leaves out food and energy, whose prices jump around a lot, so core shows the underlying trend better.
• Price indices used in this course: in the US the PCE (personal consumption expenditures price index, the one the Fed targets) and the CPI (consumer price index); in the euro area the HICP (harmonised index of consumer prices, the one the ECB targets).
• Nominal versus real interest rate: the nominal rate is the rate you see (e.g. 4%). The real rate corrects for inflation: real rate ≈ nominal rate − inflation. At 4% interest and 3% inflation, your money really grows by only about 1% in buying power. The real rate is what actually matters for spending decisions.
• Basis point (bp): one hundredth of a percentage point. 25 bp = 0.25 percentage points; a rate going from 3.75% to 4.00% is a 25 bp increase.
• GDP and potential output: GDP is the total value of everything an economy produces in a year. Potential output is what the economy can produce when all workers and machines are used at a normal, sustainable intensity.
• Output gap: the percentage difference between actual GDP and potential output. A positive gap (e.g. +1%) means the economy runs "too hot" (overheating, which pushes up prices); a negative gap (e.g. −2%) means there is slack (unemployment, idle machines), typical of a recession.
• Reserves: the money that commercial banks keep in their own account at the central bank. Banks use reserves to pay each other.
• Interbank market and "overnight": banks that have more reserves than they need lend them to banks that are short, often only until the next day ("overnight"). The interest rate on these loans is the most important short-term market rate.
• Collateral and repo: collateral is something of value (usually a bond) that a borrower pledges; if the borrower does not pay, the lender keeps it. A repo (repurchase agreement) is a short-term loan secured by such a bond. A reverse repo is the same deal seen from the lender's side.
• Bond: a tradable IOU. The buyer lends money to the issuer (often a government) and gets interest. US government bonds are called Treasuries (short-term ones: Treasury bills). They are seen as very safe, so they pay a low return.
• Exchange rate: the price of one currency in another, e.g. 2 dollars per euro. If it becomes 1 dollar per euro, the euro has depreciated (lost value) and the dollar has appreciated.
• Flow versus stock: a flow is measured over a period (your income this year); a stock at a moment in time (your savings today). The flows add up to the stock, like water flowing into a bathtub. This distinction comes back in Part B.

About the course

• Goals: understand how central banks work and how monetary policy reaches the economy; compare the ECB and the Fed; estimate Taylor rules with real data; read central bank statements and research.
• Topics later in the course: the New Keynesian model (the standard model of the economy behind modern monetary policy), the open economy and exchange rates, inflation and expectations (the Phillips curve), ECB and Fed independence and credibility, instruments such as quantitative easing (QE: the central bank buying large amounts of bonds) and forward guidance (announcing future policy), and monetary union (the euro). Data come from FRED, the ECB Data Portal, Eurostat and the BIS, and are analysed in Stata.
• Assessment: final exam out of 10, plus a midterm bonus (November, up to +1.0) and a project bonus (up to +1.5). Bonuses only count if the exam is at least 4.0; the maximum grade is 10. The project estimates a central bank's reaction function (how its rate responds to the economy); AI may only support (fixing code or grammar) and must be declared.