9. exchange rate determination and policy

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Exchange Rate Determination

and Policy

Colin F. Bullock



Learning Objectives

• PPP and long run exchange ratedetermination.

• The market for domestic assets and exchange

rate determination in the short run.• The Mundell-Fleming Model and monetary,

fiscal and trade policy under fixed and floating

exchange rates.• Fixed vs floating exchange rates in small open

economies.



Introduction

• Exchange rates are the rate at which one country’s currencytrades for another country’s currency.

• The exchange rate may either be expressed as units of foreign currency per unit of local currency (US$/J$) or units

of local currency per unit of foreign currency.• An increase in US$/J$ is an appreciation of the Jamaica

dollar and an increase in J$/US$ is a depreciation of theJamaica dollar.

• The spot market is for settlement in two days while the

forward market may be for settlement for longer periods,usually over thirty days.

• Depreciation makes exports cheaper abroad and importsmore expensive at home. Appreciation does the opposite.



Exchange Rates in the Long Run

• The Law of one price: for two countriesproducing an identical commodity with notrade restrictions and transport costs, the

exchange rate ensures that price is the samein both countries.

• Purchasing Power Parity (PPP): An applicationof the law of one price to the general pricelevel (the cost of an identical basket of goods)in two countries.



Limitations of PPP

• Product differentiation; goods not identical.

• Transport costs are not likely to be minimal

•

Countries use tariffs and quotas to restricttrade.

• The general price level includes many non-

traded goods that do not influence theexchange rate.



Exchange Determinants in the Long

Run

• A factor that increases the demand for domesticgoods relative to foreign goods will appreciatethe exchange rate (and vice versa).

• A rise in the country’s price level relative to othercountries depreciates the currency.

• Increased restrictions on trade cause anappreciation of the currency.

• Increased preference for a country’s productsappreciates the currency.

• Increased productivity appreciates the country’scurrency.



Summary of Long Range Influences on

the Exchange Rate



Short Run Influence of the Market for

Domestic assets



Impact of Increased Domestic Interest

Rate



Impact of Increased Foreign Interest

Rate



Impact of Expected Increase in

Exchange Rate



Mishkin Summary of Influences I



Mishkin Summary II



Domestic vs Real Interest rates

• Recall the Fisher equation:

in = ir + ∏e

•

If the increase in the nominal interest rate isdue to an increase in the real interest rate, it

appreciates the domestic currency.

• If it is due to an increase in the expected rate

of inflation, it depreciates the domestic

currency.



Money Supply and Expected Inflation



The Mundell-Fleming Model of the

Small Open Economy

• r = r* (Domestic interest rate = world interest

rate)

• IS Curve: Y = C(Y-T) + I(r*) + G + NX(e)

• LM Curve: M/P = L (r*,Y)



Derivation of the IS Curve



Derivation of the LM Curve



Mundell-Fleming Equilibrium



Fiscal Policy Under Floating Exchange

Rates



Monetary Policy Under Floating

Exchange Rates



Trade Policy Under Floating Exchange

Rates



Fixed Exchange Rate Governs the

Money Supply



Fiscal Expansion Under Fixed Exchange

Rates



Monetary Expansion Under Fixed

Exchange Rates



Trade Restrictions Under Fixed

Exchange rates



Mundell-Fleming Policy Effects

Summary



Fixed Exchange Rates for Developing

Countries?FOR Against

Facilitates price stability Prices stability depends on the true market

exchange rate and not merely the official

exchange rate.

Stability reduces uncertainty and

encourages investment.

There is a loss of independent exchange

rate policy.Avoids independent monetary policy

that a small country may not be able to

manage.

There is a loss of independent monetary

policy.

Discourages irresponsible fiscal and

monetary policy that is inconsistent with

exchange rate stability.

Policy is entirely dependent on fiscal policy

which may be driven into deficits by shocks.

A disincentive for political

irresponsibility.

Structural inflationary impulses may cause

a loss of competitiveness.

Encourages hard work and productivity

in the absence of inflationary gains.

May require costly exchange control to

defend exchange rate



Floating Exchange Rates for

Developing Countries?For Against

Allows independent exchange rate policy Facilitates exchange rate instability and

price uncertainty.

Allows independent monetary policy. Independent monetary policy is likely to

be irresponsible and inflationary.

Policy is more flexible in the face of

shocks.

Flexibility allows for postponement of

difficult decisions in the face of shocks.

Policy can more easily retain price

competitiveness.

Exchange rate policy cannot sustain

enhanced competitiveness in face of high

import price dependence.

There is greater capacity to avoid the

development of parallel fx markets.

On-going exchange rate depreciation may

encourage dollarization and loss of

monetary policy.

The budget may be balanced over time

rather than constantly.

The facilitation of fiscal deficits may

become endemic through the build-up of

external debt.



From Peg to Float in Jamaica

• Jamaica entered independence with an exchangerate fixed to the British pound (1:1).

• In the late 1960s, the “peg” was switched to the

United States Dollar at (J$0.7 = $US$1).• Foreign exchange pressures in the 1970s and

1980s elicited a variety of foreign exchangesystems with devaluation to J$6 = US$1.

• With very negative NIR, minimal gross reservesand an active // market, Jamaica liberalized its fx.system between Sept 1990 and Sept 1991.



Performance Under Managed Float

• Liberalization in less than ideal circumstancesre tightness of macroeconomic policy andfinancial sector regulation.

• This facilitated exchange rate slippage, tripledigit inflation and loose financial institutionmanagement culminating in crisis.

•

Beneficial results in NIR moving from negativeto positive and the elimination of the parallelmarket in foreign exchange.



Should Jamaica Return to a Peg?•

Concern about slippage in exchange rate over time and impacton inflation and uncertainty.

• Negative comparisons with Barbados and other fixed exchange

rate economies.

• Perspectives on the ineffectiveness of depreciation in fostering

competitiveness.

• In reality, Jamaica lost capacity to fix due to inappropriate fiscal

policy and low productivity which is what drives depreciation.

• These factors will create problems in peg or float.

• Barbados retained peg because of more effective fiscal policy

and even now has competitiveness issues.

• Floating has benefitted NIR and fx. market and success of fix or

float depends on effective fiscal policy.



Readings

• Mishkin Ch. 17

• Mankiw (7th ed.), Macroeconomics Ch. 12

• Ghatak and Sanchez-Fung Ch. 10

• Articles by Hon. Edward Seaga and Colin

Bullock in Mona School of Business Review

Vol. I, #1.

9. exchange rate determination and policy

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