currency policy and currency crises learning objectives 1.revise bop 2.forex markets: fixed and...

Currency Policy and Currency Crises

Learning Objectives

1. Revise BOP

2. Forex Markets: Fixed and Floating e-rates

3. Why care about e?

4. Current account & Competitiveness

5. Capital account & Interest rates

6. Currency Crises

7. Optimal Currency Areas

• Record of a country’s economic transactions with the rest of the world.

• Rule: receipt = positive (+) , payment = negative (-).– If receipts > payments = surplus.– If receipts < payments = deficit.

• At its most basic just an accounting system• 2 main accounts: current and capital.

– Different implications for the economy. The current account directly affects AD

– It is possible to have a current a/c deficit as long as there is a capital a/c surplus. Example, USA.

1. The Balance of Payments

Balance of PaymentsCurrent accountTrade a/cServices Freight Tourism RoyaltiesInvestment income Direct investment income National debt interestTransfers Balance on current account

Capital accountPrivate capitalOfficial capital Government securities sold abroadBanking transactions Balance on capital account

Leddin and Walsh Macroeconomy of the Eurozone, 2003

2. Foreign Exchange Market• Balance of payments and international

transactions underlie the foreign exchange market.

• Different ways of quoting exchange rates:– Indirect quote = ($/€).– Direct quote = (€/$). – Define e as the price of a euro in $ i.e how many $ per

€• There is a one to one correspondence between the

components of the BOP and the supply and demand for euros– Translate the “accounts” into “economics”– Explain the behaviour of each of the bits

• Easier to if we think in terms of the Irish £

• Any export will create an international demand for Irish pounds– Foreigners need £ to buy Irish goods

• Imports create a supply of Irish pounds– Irish people take £ to international markets

• Similarly foreign deposits in Ireland or Irish deposits aboard create a demand for or supply of £

• Therefore BOP balance implies S=D

Fixed vs Floating

• In a certain trivial sense the BOP always balances– Supply equals demand

• Current account surplus is counteracted by cap deficit and/or changes in reserves– US vs China

• For floating exchange rate this is achieved by the free market– E rate is such that S=D i.e. BOP=0

• For fixed exchange rates the government makes up the difference

S

D

Floating Exchange Rate

e1

The supply and demand for euro determines e. “Floating exchange rate.”

€ billions

Fixed Exchange Rates• Governments may try to fix the exchange

rate (why? See later)– Requires supplying foreign currency to market

when there is excess demand– Requires buy foreign currency when there is

excess supply– Can influence the exchange rate via interest

rates (EMS or dirty float)

• Mechanism by which an currency crisis can occur

S

D

Fixed e

e*

By co-incidence it is at market eqm. Not likely

€ billions


S

D

Fixed e

e*

Below market rate. CB print extra € and buy $

€ billions


S

D

Fixed e

e*

E above market value. CB must buy € with $

€ billions


Irish Exchange rate Policy

• 1920-79: Sterling Link – Currency Board

– Sensible: strong currency, major trading partner

– Have British inflation and interest rates.

• 1979: break with sterling– Seek lower inflation with Germany

– didn’t work: inflation diverged

– Interest rates converged only after 10 years

– Competitiveness declined


3. Why care about e? e affects the location of the AD curve.

e X and M (see over) AD real GNP, employment, unemployment and

inflation just as with any FP or MP• Note that this effect works through the current account• Thus e is another instrument of economic policy.

– See diagram– Policy-maker can contrive to improve competitiveness by under-

valuing e.– Over-valued e can have a detrimental effect on key

macroeconomic variables.

• A depreciation cause inflation in the log run• This would be very useful for Ireland during the current

crisis: Think of Iceland

• X rises following a depreciation (e falls)– Price in $ of goods produced in Ireland falls– Example: furry leprechaun €5– e=1.4– 1€ gets $1.4– leprechaun costs $5*1.4=$7– Depreciation e=1.2 implies €1 get $1.2– Cost is $5*1.2=6– Sales rise

YY*

LRAS

AD1

AD0

SRAS(e)

• First step in explaining why BOP flows occur

• Q: Why do people trade goods & services across borders?– Explaining the current account

• A: Prices• Countries with cheaper prices will tend to

have current account surpluses– Extra demand for their currencies– Appreciating currencies

4. Competitiveness

Prices (Competitiveness)

• Look in detail at the link between prices and exchange rates and their joint effect on output

• PPP: equal value for money for goods and services.– Prices of similar goods expressed in a common

currency should be the same.

– Based on arbitrage. Buy cheap, sell expensive to make profit.

– Actions should lead to a convergence of prices

• How expensive is Ireland?

Absolute PPP

• Pirl e = Pw

• Prices, adjusted for the exchange rate, should be the same in different countries.

• Example: Levi Jeans, • Pirl = €10 in Dublin, • Pus = $20 in New York. • If e = $/€ = 2 then PPP holds.• If e 2, PPP does not hold.


Real Exchange Rate• Compare price levels of different countries

– In a common currency (usually US$)

• Related to the concept of purchasing power parity (PPP)– Law of one price

• Simple example is the Hamburger index– What is the US$ price of a Big Mac in various

countries– $PIRL=€ PIRL*e– Is $PIRL >$PUS

• What does this tell you?– “competitiveness”– Are one country’s goods cheaper than

another’s?

• Do for all goods in a basket and calculate the ratio– i.e. CPI or GDP or wages

• Look at R for Ireland over time– Level doesn’t tell much– Trend does

US

IRL

US

IRL

P

P*e

$P

$PR

• What is the effect of an increase in real e rate?– competitiveness– Our goods more expensive– Their goods relatively cheaper– Expect exports to fall and imports to rise– Better off?

• What causes R to change– e changes– Prices change i.e. inflation can erode

competitiveness– productivity

PPP as an Economic Theory: Under Fixed Exchange Rates

• PPP becomes a theory of inflation. irl = w - e• If e is fixed, irl is determined by w.• Ireland is a price taker on international

markets.• One of the main reasons for fixed e

– EMS & EMU.

• Leads to currency crises when doesn’t work!

Ireland’s Competitiveness• How expensive is Ireland?• Big mac index

– Economist magazine• Balassa-Samuelson theory

– Expect richer countries to be more expensive– Deviation from PPP because of “non-tradable”– Susan O'Carroll thesis

• Real Effective E-rate• Current situation

– Euro appreciated– High but falling(?) costs

Competitiveness

0.000

50.000

100.000

150.000

200.000

250.000

NEER

REER

4. Capital Flows and Interest Rates

• Interest rates can be used to influence capital flows and therefore defend a currency.

• ieuro > ius Capital inflow e

• ieuro < ius Capital outflow e

• Usually used to prevent depreciation of the exchange rate.

Capital Account

• So far have paid most attention to current account– Competitiveness affects current account and

AD

• Historically this was the most important part of BOP– Nowadays capital flows account for most BOP

flows– Recent phenomenon– Capital controls were the norm until 1980

Interest Rate Parity• Capital account is driven by differences in

interest rates• A comparison of domestic and foreign

interest rates must allow for the expected change in the exchange rate.

• Compare a domestic (Eurozone) and a foreign (US) investment.

• Domestic investment: (1 + iez)

• €1,000(1 + 0.1) = €1,100


Foreign Investment

• 1st January: Convert € into $ using the spot exchange rate et.

• Invest $ in the USA. Total return (1 + ius).

• 31st December: Convert the total $ return back into €. (1/ee

t+1). Note it is the expected e as the exchange rate 12 months from now is unknown.

• US return measured in Euro is:

• (1 + ius)et/ee t+1.


Two Parts to the Foreign Investment

• 1. Interest rate.• 2. Gain or loss on the foreign exchange

market.• Arbitrage should now ensure:• (1 + iez) = (1 + ius)et/ee

t+1

• Rearrange:• (ee

t+1 - et)/et = (ius - iez)/(1 + iez)


Implications• Difference between the future and current

exchange rates equals the interest rate differential.

• If ius < iez Expect € depreciation• If ius > iez Expect € appreciation• The interest rate differential gives an

indication of how the market expects the exchange rate to move.

• This is key to understanding currency crises


Implication: Fixed e

• UIP gives another rationale for fixed exchange rates• Interest rate will track that of the larger country

• With a single currency in the Eurozone, it is not possible for interest rates to diverge between countries.

• So as EMU comes closer interest rates will converge• Eastern Europe now


Dutch, German, and Irish Interest Rates converged as EMU approached and it was

anticipated that E would be “irrevocably fixed”

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1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

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1998

Irl

NL

D

Interest Rates

0.000

2.000

4.000

6.000

8.000

10.000

12.000

14.000

16.000

18.000

20.000

1970

1972

1974

1976

1978

1980

1982

1984

1986

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1998

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2002

2004

2006

Germany

Ireland

Nominal interest rates

0

5

10

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25

30

1979

Q

1

Q2

Q3

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1984

Q

1

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Q4

1989

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1

Q2

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1994

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1

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Q3

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1999

Q

1

Austria

Belgium

Finland

France

Germany

Ireland

Italy

LuxembourgNetherlandsPortugal

Spain


Currency Crises• UIP & Competitiveness help explain how

currency crises arise.• Basic story

– Country in a recession with fixed e rate

– Markets expect that gov will devalue to boost AD

– Expectation of devaluation leads to higher interest rates

– Makes recession worse

– Speculators try to sell their holdings of the domestic currency

– Self fulfilling prophecy

– Devaluation usually but not always occurs.

EMS Crisis 1992• Background to EMS

– Objective is to stabilise exchange rates.– Reduce e uncertainty and thereby encourage

international trade.– Key point is that for the system to work, there

must be similar inflation, interest rates and growth rates.

– In turn, this requires policy co-ordination: (fiscal, monetary policies)

– Why?

EMS until 1992

• Seen as step on way to EMU– Not fixed– Limit movement to band of +/- 2.25% around central rate– Possible to adjust central rate

• 1979-87: numerous realignments mostly involving an appreciation of the DM. Ir£ devalued twice. March 1983 and August 1986. – Usual reason: no co-ordination of fiscal and monetary policies.

• 1987-92: no realignments. System was a success. Look forward to EMU.

• All ended with the currency crisis of September 1992.


Currency Crisis of 1992-93• German unification in 1990 lead to huge budget

deficit.– Could not be financed by increasing taxes – AD shifts right.

• Bundesbank raises interest rates to combat inflation i (by 3%).– AD shift to left

• Because of fixed exchange rates, the increase in interest rates was transmitted to rest of Europe– The FP was not– Everyone else’s AD shifts left.

• Europe has recession (worse for UK)

YY*

LRAS

AD1

AD0

SRAS(e)

Germany 1992

YY*

LRAS

AD0

AD1

SRAS(e)

UK 1992

• However, the UK was in recession, needed lower not higher i.

• Speculators took view that DM/Stg£ e was not sustainable. – Expect that gov will boost AD by devaluation and/or reduction in

interest rates– Attacked the currency.– Try to sell stg and buy DM

• Situation becomes self re-enforcing– As speculators fear a devaluation, sell stg (supply increases)– CB has to use up more reserves– Anticipation of devaluation pushes up int rates making recession

worse, making devaluation more likely– Conspiracy: George Soros moves the market

• Black Wednesday. – Bank of England spends £10b of reserves and then gives up– Stg£ withdrawn from ERM. – Immediately depreciated to low level. – Speculators made a killing. – Economy rebounds as AD pushed up– Political death of gov

S

D

Stg/DM

e*

E above market value. CB must buy £ with DM

£ billions


The Irish Pound and the Crisis of 1992-93

• Example of SOE• Sterling’s dropped EMS in September and the

currency depreciated by 15%• Market attacked Irish Pound

– Likely that Irish pound was likely to be devalued to avoid competitive loss (AD curve shifts left)

– strangle Celtic tiger at birth– U still high (12%) so not credible to keep e overvalued– Hence, funds flowed out of Ireland in anticipation of a

devaluation of the Irish pound. • Despite this severe misalignment, the government

decided on this occasion to resist devaluation.


Irish and German interest rates during the currency crisis

051015202530354045

%

Implications of the No Devaluation Stance

• If continued lead to recession– e was overvalued– i high in anticipation of devaluation– Both shift AD to left

• The Central Bank’s external reserves fell from £3.05 billion at the end of August to £1.07 billion at the end of September, despite significant foreign borrowing.

• Short-term interest rates were raised to unprecedented heights to defend the currency from speculative attacks. – One-month inter-bank interest rates peaked at 57 per cent on 12 January

1993. – Overnight interest rates on the Euro-Irish pound market rose to 1,000 per

cent. • The combination of an overvalued currency and penal interest rates

was seriously damaging the Irish economy.• Eventually had to devalue


(Wrong)Arguments against Devaluation

• There was no guarantee that the devaluation would be accepted by the markets. There would be no significant inflow of funds and interest rates would not fall.

• The currency was not overvalued.

• Speculators could not be allowed to destroy the ERM, which was regarded as the stepping stone to EMU.

• It was the government’s desire to break our dependence on the UK and become a hard-core EMS country.

• Devaluation was ineffective as it resulted in only a short-term competitive gain.

• The rise in prices could lead to higher wage demands resulting in a wage-price spiral.


The Alternative to Devaluation• The over-valuation of the sterling/Irish pound exchange

rate results in a loss of competitiveness relative to the UK and this reduces Irish exports and increases imports. – This shifts the aggregate demand (AD) curve down to the left.– Real wages increase because the inflation rate falls while the

nominal wage remains unchanged.

• If workers were to accept a cut wages nominal wages so as to restore the original real wage, the aggregate supply (AS) curve would move down to the right. – The economy would return to the natural real growth rate. – Same argument as with any recessionary shock – Workers are not any worse off because the original real wage has

been restored.

• Devaluation is easier to implement


YY*

LRAS

AD0

AD1

SRAS(e)

Ireland 1992

Summary• All crises have a common structure• Start with a problem in the real economy

– Asymmetric shock– AD is low, recession or danger of one– e is fixed but over-valued (current deficit)– Reasonable to expect it to fall in a free market

• Self re-enforcing process of capital flows– UIP causes i to rise (making recession worse)– Cap outflows– Downward pressure on e– Eventually reserves depleted an e rate cannot be

maintained• Conspiracy?

– Market size

EMU

• EMU is fixed e rate regime– But more: difficult to leave so more credible

• Economic: Single market in persons, goods, services and capital.

• Single currency and CB. – European Central Bank (ECB) responsible for

monetary policy (money supply, interest rates, inflation).

– Liberalisation of all capital (money, equity) markets and transactions.


Economic Benefits• Price transparency.

– Should lead to a convergence of prices in Eurozone.

– Indirect taxes still a serious problem.

• Elimination of exchange rate transaction costs. – Savings of about 0.5% of GDP.

• Reduction in exchange rate uncertainty.– Should stimulate trade and investment.

– But little evidence to support this view. Trade between USA and Japan has grown dramatically even though the exchange rate is flexible.

– 80 % of Irish trade is outside the Eurozone.


• Scale economies.– Firms spread plants around Europe to hedge against

currency movements. Now build plants to reap economies of scale.

– Lead to regional specialisation and an efficiency gain.

• Low inflation. – In effect, Irish inflation is determined by the German

rate.

– Argued that this is better than an anti-inflation policy based on internal rules (doing it for ourselves).

– Note that Ireland had achieved a low inflation rate prior to EMU entry.


Inflation in the Eurozone Countries1979 - 2001

-2.0

3.0

8.0

13.0

18.0

23.0

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

%

AUSTRIA

BELGIUM

FINLAND

FRANCE

GERMANY

IRELAND

ITALY

LUXEMBOURG

NETHERLANDS

PORTUGAL

SPAINEMU entry criteria: inflation rate of less than 2.7%


• Low interest rates. – Given the single currency, there can be only one interest rate in

the Eurozone. – The current rate represents a significant fall for high interest rate

countries like Ireland, Spain, Portugal and Italy. – In 2002, real interest rates are negative in several Eurozone

countries.– Represents a transfer of resources from savers to borrowers.– Also major implications for macroeconomy: bubble?


Nominal Interest Rates in the Eurozone Countries1979 - 2002

0.0

5.0

10.0

15.0

20.0

25.0

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

%

Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain


Costs• Problem of adjustment within a

monetary union.– With any fixed e regime– Economy cannot have currency crisis but can suffer

asymmetric shocks. • Think of the 1992 crisis if had EMU at the time

– German interest rates would have spread to rest of Europe causing recession

– No currency crisis but still a recession– No opportunity to use MP– No opportunity to use e rate– Little opportunity to use FP (Stability and Growth pact)– Rely on the self adjustment mechanism: “flexibilty”


• EMU results in a loss of economic independence.– No longer have control over interest rates or the

exchange rate.

– Fiscal policy is constrained by the Growth and Stability Pact.

• Burden of adjustment switches from monetary and fiscal policy to the “wage adjustment” effect – But the labour market is much less flexible than the

money market.

– Result is that the economy may be slow to adjust.

• Obviously relevant to the current situation– Currency crisis in absence of EMU

– Shorter recession


currency policy and currency crises learning objectives 1.revise bop 2.forex markets: fixed and...

Documents

d slide

s d fixed e e

floating erates

difference slide

free market e rate

market rate

irish exchange rate

capital account leddin