1 the foreign exchange market. 2 3 asian currencies vs. u.s. dollar
TRANSCRIPT
1
The Foreign Exchange Market
2
3
Asian Currencies vs. U.S. Dollar
70
90
110
130
150
170
190
210
Jan-9
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Mar-
95
May-9
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Jul-95
Sep-9
5
Nov-
95
Jan-9
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Mar-
96
May-9
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Jul-96
Sep-9
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Nov-
96
Jan-9
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Mar-
97
May-9
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Jul-97
Sep-9
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Nov-
97
Jan-9
8
Mar-
98
May-9
8
Jul-98
Sep-9
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Nov-
98
Jan-9
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Mar-
99
May-9
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Jul-99
Sep-9
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Month
Ind
ex
MYR/USD
PHP/USD
SGD/USD
KRW/USD
TWD/USD
THB/USD
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The Foreign Exchange Market
Definitions:1. Spot exchange rate2. Forward exchange rate3. Appreciation4. Depreciation
Currency appreciates, country’s goods prices abroad and foreign goods prices in that country
1. Makes domestic businesses less competitive2. Benefits domestic consumers
FX traded in over-the-counter market1. Trade is in bank deposits denominated in different currencies
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The Foreign Exchange Market
Foreign exchange (dollars)
Exchange ratePeso/$
SDSupply of Dollars by people who want pesos
Demand for Dollars by people who have pesos
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Currency Depreciation and Appreciation
Currency depreciation is an increase in the number of units of a particular currency needed to purchase one unit of foreign exchange
Currency appreciation is a decrease in the number of units of a particular currency needed to purchase one unit of foreign exchange
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Changes in the Equilibrium Exchange Rate
Foreign exchange (dollars)
Exchange ratePeso/$ SD Supply of Dollars
by people who want pesos
Demand for Dollars by people who have pesos
S’
$ -depreciationPeso- appreciation
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Exchange Rate Regimes
Flexible (Floating) exchange rates.
Fixed exchange rates.– Currency Board– Monetary Union
Managed Float (Dirty Float) exchange rates.
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The Central Bank Can Intervene to Maintain Exchange Rates
Foreign exchange (pounds)
Exchange rate$/pound S
D’’D’
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China
Chinese Yuan to One U.S. Dollar
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7.5
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7.7
7.8
7.9
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Currency Crisis
Foreign exchange ($)
Exchange rateBaht/$
S
D’D
25
52
12
Asian Currencies vs. U.S. Dollar
70
90
110
130
150
170
190
210
Jan-9
5
Mar-
95
May-9
5
Jul-95
Sep-9
5
Nov-
95
Jan-9
6
Mar-
96
May-9
6
Jul-96
Sep-9
6
Nov-
96
Jan-9
7
Mar-
97
May-9
7
Jul-97
Sep-9
7
Nov-
97
Jan-9
8
Mar-
98
May-9
8
Jul-98
Sep-9
8
Nov-
98
Jan-9
9
Mar-
99
May-9
9
Jul-99
Sep-9
9
Month
Ind
ex
MYR/USD
PHP/USD
SGD/USD
KRW/USD
TWD/USD
THB/USD
13
Law of One Price
Example: American steel $100 per ton, Japanese steel 10,000 yen per ton
If E = 50 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen
Law of one price E = 100 yen/$
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Purchasing Power Parity (PPP)
PPP Domestic price level 10%, domestic currency 10%
1. Application of law of one price to price levels
2. Works in long run, not short run
Problems with PPP
1. All goods not identical in both countries: Toyota vs Chevy
2. Many goods and services are not traded: e.g. haircuts
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Big Mac Index
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PPP: U.S. and U.K
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Factors Affecting E in Long Run
Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E
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Exchange Rates in the Short Run
An exchange rate is the price of domestic assets in terms of foreign assets
Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other
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Expected Returns and Interest Parity
Re for
Francois Al
$ Deposits iD + (Eet+1 – Et)/Et iD
Euro Deposits iF iF – (Eet+1 – Et)/Et
Relative Re iD – iF + (Eet+1 – Et)/Et iD – iF + (Ee
t+1 – Et)/Et
Interest Parity Condition:
$ and Euro deposits perfect substitutes
iD = iF – (Eet+1 – Et)/Et
Example: if iD = 10% and expected appreciation of $, (Ee
t+1– Et)/Et, = 5% iF = 15%
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Deriving RF CurveAssume iF = 10%, Ee
t+1 = 1 euro/$Point
A: Et = 0.95, RF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00, RF = .10 – (1 – 1.0)/1.0 = .100 =10.0%
C: Et = 1.05, RF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%
RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF
Deriving RD CurvePoints B, D, E, RD = 10%: so curve is vertical
EquilibriumRD = RF at E*
If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et
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Equilibrium in the Foreign Exchange Market
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Shifts in RF
RF curve shifts right when
1. iF : because RF at each Et
2. Eet+1 : because expected
appreciation of F at each Et and RF
Occurs Eet+1 iF:
1) Domestic P , 2) Trade Barriers 3) Imports , 4) Exports , 5) Productivity
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Shifts in RD
RD shifts right when
1. iD ; because RD at each Et
Assumes that domestic e unchanged, so domestic real rate
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Foreign Exchange I
Exchange rate—price of one currency in terms of another
Foreign exchange market—the financial market where exchange rates are determined
Spot transaction—immediate (two-day) exchange of bank deposits
– Spot exchange rate Forward transaction—the exchange of bank deposits
at some specified future date– Forward exchange rate
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Foreign Exchange II
Appreciation—a currency rises in value relative to another currency
Depreciation—a currency falls in value relative to another currency
When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa
Over-the-counter market mainly banks
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Exchange Rates in the Long Run
Law of one price
Theory of Purchasing Power Parity– Assumes all goods are identical in
both countries– Trade barriers and transportation costs
are low– Many goods and services are not traded across
borders
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Factors that Affect Exchange Rates in the Long Run
Relative price levels
Trade barriers
Preferences for domestic versus foreign goods
Productivity
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Factors that Shift RF and RD
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Response to i Because e
1. e , Eet+1 , expected
appreciation of F ,RF shifts out to
right
2. iD , RD shifts to
right
However because e > iD , real rate , Ee
t+1 more than iD RF out > RD out and Et
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Response to Ms
1. Ms , P , Eet+1
expected appreciation
of F , RF shifts
right
2. Ms , iD , RD shifts
left
Go to point 2 and Et
3. In the long run, iD
returns to old level,
RD shifts back, go
to point 3 and get
Exchange Rate
Overshooting
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Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting
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The Dollar and Interest Rates
1. Value of $ and real rates rise and fall together, as theory predicts
2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises
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Chapter 18
The International Financial System
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Unsterilized Foreign Exchange Intervention
A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base
A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base
Federal Reserve System Federal Reserve System
Assets Liabilities Assets Liabilities
Foreign Assets
-$1B Currency in circulation
-$1B Foreign Assets
-$1B Deposits with the Fed
-$1B
(International Reserves)
(International Reserves)
(reserves)
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Unsterilized Intervention
An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency
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Sterilized Foreign Exchange Intervention
To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation
There is no effect on the monetary base and no effect on the exchange rate
Federal Reserve System
Assets Liabilities
Foreign Assets Monetary Base
(International Reserves) -$1B (reserves) 0
Government Bonds +$1B
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Balance of Payments
Current Account– International transactions
that involve currently produced goods and services
Trade Balance
Capital Account– Net receipts from capital
transactions
Sum of these two is the official reserve transactions balance
Monetary Policy Strategy: The International Experience
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Role of a Nominal Anchor
Ties Down Expectations
Helps Avoid Time-Consistency Problem1. Arises from pursuit of short-term goals which lead to bad
long-term outcomes
2. Time-consistency resides more in political process
3. Nominal anchor limits political pressure for time-consistency
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Exchange-Rate Targeting
Advantages1. Fixes for internationally traded goods
2. Anchors expectations
3. Automatic rule, avoids time-consistency
4. Easy to understand: “sound currency” as rallying cry
5. Helps economic integration
6. Successful in reducing
France, UK, Mexico
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Exchange-Rate Targeting
Disadvantages1. Loss of independent monetary policy
Problems after German reunification: UK, French monetary policy too tight
2. Open to speculative attacksEurope, Sept. 1992; Mexico: 1994; Asia: 1997
3. Successful speculative attack disastrous for emerging market countries because it leads to financial crisis
4. Weakened accountability: lose exchange-rate signal
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Currency Boards vs. DollarizationCurrency Boards
1. Domestic currency exchanged at fixed rate for foreign currency automatically
2. Fixed exchange rate with very strong commitment mechanism and no discretion
3. Usual disadvantages of fixed exchange rate4. Still subject to speculative attack5. Lose ability to have lender of last resort
Dollarization1. Even stronger commitment mechanism2. No possibility of speculative attack3. Usual disadvantages of fixed exchange rtae4. Lose seignorage
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Summary: Advantages and Disadvantages of Different Monetary Policy Strategies
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Summary: Advantages and Disadvantages of Different Monetary Policy Strategies
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Monetary TargetingCanada
1. Targets M1 till 1982, then abandons it2. 1988: declining targets, M2 as guide
United Kingdom1. Targets M3 and later M02. Problems of M as monetary indicator
Japan1. Forecasts M2 + CDs2. Innovation and deregulation makes less useful as monetary indicator3. High money growth 1987-1989: “bubble economy,” then tight money policy
Germany and Switzerland1. Not monetarist rigid rule2. Targets using M0 and M3: changes over time3. Allows growth outside target for 2-3 years, but then reverses overshoots4. Key elements: flexibility, transparency, and accountability
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Monetary Targeting
Advantages1. Able to cope with domestic considerations
2. Signals are immediate
3. Immediate accountability of central bank
Disadvantages1. Big if: all advantages require reliable relationship between
goal and targeted aggregate
2. In many countries, weak relationship between goal and M-aggregate
Poor communications device and accountability
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Inflation Targeting
Five Elements1. Public announcement of medium-term š-
target
2. Institutional commitment to price stability
3. Information inclusive strategy
4. Increased transparency through public communication
5. Increased accountability
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Inflation Targeting in New Zealand, Canada, and the UK
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Inflation Targeting
Advantages1. Allows focus on domestic considerations
2. Not dependent on reliable relationship between M-aggregate and inflation
3. Readily understood by public
4. Reduce political pressures for time-consistent policy
5. Focus on transparency and communication
6. Increased accountability of central bank
7. Performance good: and e , and stays low in business cycle upturn
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Inflation Targeting
Disadvantages1. Delayed signalling2. Too much rigidity3. Potential for increased output fluctuations4. Low economic growth
Nominal GDP Targeting1. Close to inflation targeting with concern about output
fluctuations2. Problem of announcing specific target for real GDP growth3. Harder for public to understand
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Monetary Policy with an Implicit Nominal Anchor
Forward-Looking and Preemptive to Deal With Long Lags
Advantages1. Focus on domestic considerations
2. Has worked very well in the U.S.
3. If It Ain’t Broke Why Fix It?
Disadvantages1. Lack of transparency and accountability
2. Dependence on personalities
3. Inconsistent with democratic principles
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Comparing Expected Returns I
Dollar assets pay an interest rate of iD and do not have any capital gain
Foreign assets have an interest rate of iF and there is no capital gain
To compare the expected returns on dollar assets and foreign assets
the returns must be converted into the currency unit used
Etthe spot exchange rate
Et+1
the exchange rate for the next period
Et+1e - E
t
Et
the expected rate of appreciation for the dollar
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Comparing Expected Returns II
The expected return on dollar assets RD in terms of foreign currency
is the sum of the interest rate on dollar assets
plus the expected appreciation of the dollar
RD in term of euros = iD E
t1e E
t
Et
The expected return on foreign assets RF is iF
Relative RD iD iF E
t1e E
t
Et
As the relative expected return on dollar assets increases, foreigners
will want to hold more dollar assets
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Comparing Expected Returns III
The expected return on foreign assets RF in terms of dollars
is the interest rate on foreign assets iF plus the expected appreciation
of the foreign currency, equal to minus the expected appreciation of the dollar
RF in terms of dollars = iF E
t1e E
t
Et
The expected return on the dollar assets RD is iD
Relative RD iD (iF E
t1e E
t
Et
) iD iF E
t1e E
t
Et
Which is the same as previously
Relative expected return on dollar assets is the same whether it is
calculated in terms of euros or in terms of dollars
As the relative expected return on dollar assets increases, both foreigners and
domestic residents will want to hold more dollar assets
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Interest Parity Condition
iD iF
Et1e E
t
Et
Capital mobility with similar risk and liquidity the assets are perfect substitutes
The domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency
Expected returns are the same on both domestic and foreign assets
An equilibrium condition
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Demand and Supply for Domestic Assets
Demand– Relative expected return– At lower current values of the dollar (everything
else equal), the quantity demanded of dollar assets is higher
Supply– The amount of bank deposits, bonds,
and equities in the U.S.– Vertical supply curve
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Exchange Rate Overshooting
Monetary Neutrality– In the long run, a one-time percentage rise in the money
supply is matched by the same one-time percentage rise in the price level
The exchange rate falls by more in the short run than in the long run
– Helps to explain why exchange rates exhibit so much volatility
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The Dollar and Interest Rates
While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced
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Exchange Rate Regimes
Fixed exchange rate regime– Value of a currency is pegged relative to the value of one
other currency (anchor currency)
Floating exchange rate regime– Value of a currency is allowed to fluctuate against all other
currencies
Managed float regime (dirty float)– Attempt to influence exchange rates by buying and selling
currencies
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Past Exchange Rate Regimes
Gold standard– Fixed exchange rates– No control over monetary policy– Influenced heavily by production of gold and
gold discoveries
Bretton Woods System– Fixed exchange rates using U.S. dollar as
reserve currency– International Monetary Fund (IMF)
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Past Exchange Rate Regimes (cont’d)
Bretton Woods System (cont’d)– World Bank– General Agreement on Tariffs and Trade (GATT)
World Trade Organization
European Monetary System– Exchange rate mechanism
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How a Fixed Exchange Rate Regime Works
When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result, it loses international reserves
When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves
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How Bretton Woods Worked
Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments)
Loans from IMF to cover loss in international reserves
IMF encourages contractionary monetary policies
Devaluation only if IMF loans are not sufficient
No tools for surplus countries
U.S. could not devalue currency
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Managed Float
Hybrid of fixed and flexible– Small daily changes in response to market– Interventions to prevent large fluctuations
Appreciation hurts exporters and employment
Depreciation hurts imports and stimulates inflation
Special drawing rights as substitute for gold
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European Monetary System
8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar
ECU value was tied to a basket of specified amounts of European currencies
Fluctuated within limits
Led to foreign exchange crises involving speculative attack
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Capital Controls
Outflows – Promote financial instability by forcing
a devaluation– Controls are seldom effective and may increase capital
flight– Lead to corruption– Lose opportunity to improve the economy
Inflows– Lead to a lending boom and excessive risk taking by
financial intermediaries
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Capital Controls (cont’d)
Inflows (cont’d)– Controls may block funds for productions uses– Produce substantial distortion and misallocation– Lead to corruption
Strong case for improving bank regulation and supervision
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The IMF: Lender of Last Resort
Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in this function
May be able to prevent contagion The safety net may lead to excessive risk
taking (moral hazard problem)
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How Should the IMF Operate?
May not be tough enough Austerity programs focus on tight
macroeconomic policies rather than financial reform
Too slow, which worsens crisis and increases costs
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Direct Effects of the Foreign Exchange Market on the Money Supply
Intervention in the foreign exchange market affects the monetary base
U.S. dollar has been a reserve currency: monetary base and money supply is less affected by foreign exchange market
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Balance-of-Payments Considerations
Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong
U.S. deficits mean surpluses in other countries large increases in their international reserve holdingsworld inflation
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Exchange Rate Considerations
A contractionary monetary policy will raise the domestic interest rate and strengthen the currency
An expansionary monetary policy will lower interest rates and weaken currency
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Advantages of Exchange-Rate Targeting
Contributes to keeping inflation under control
Automatic rule for conduct of monetary policy
Simplicity and clarity
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Disadvantages of Exchange-Rate Targeting
Cannot respond to domestic shocks and shocks to anchor country are transmitted
Open to speculative attacks on currency
Weakens the accountability of policymakers as the exchange rate loses value as signal
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Exchange-Rate Targeting for Industrialized Countries
Domestic monetary and political institutions are not conducive to good policy making
Other important benefits such as integration
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Exchange-Rate Targeting for Emerging Market Countries
Political and monetary institutions are weak
Stabilization policy of last resort
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Currency Boards
Solution to lack of transparency and commitment to target
Domestic currency is backed 100% by a foreign currency
Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate
Money supply can expand only when foreign currency is exchanged for domestic currency
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Currency Boards (cont’d)
Stronger commitment by central bank Loss of independent monetary policy
and increased exposure to shock from anchor country
Loss of ability to create money and act as lender of last resort
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Dollarization
Another solution to lack of transparency and commitment
Adoption of another country’s money Even stronger commitment mechanism Completely avoids possibility of speculative attack on
domestic currency Lost of independent monetary policy
and increased exposure to shocks from anchor country
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Dollarization (cont’d)
Inability to create money and act as lender of last resort
Loss of seignorage
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Appendix
Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book.
They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.