Exchange-Rate Systemsand Currency Crises

Chapter 15

Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Exchange Rate Systems

2) floating ratea) determined by market forcesb) float independently or with a group

of other currencies

1) fixed rate a) also known as pegged exchange rateb) anchored to the value of one other

currency or a group of currencies

IMF Principles

2) Members should intervene to counteract disruptive short term exchange rate movements

1) Member nations must avoid manipulating exchange rates in order to impact balance of payments

3) Members should take into account the impact of intervention policies on other members

Impossible Trinity

1) free capital flows

2) a fixed exchange rate

3) independent monetary authority

It is not possible for a country to maintain all three of the following:

Impossible Trinity (continued) A country can choose any two of the three:

Impossible Trinity (examples)

2) Hong Kong has a fixed exchange rate & allows free flow of capital but does not have independent monetary authority

1) U.S. allows free flow of capital & maintains monetary authority but does not have a fixed exchange rate

3) In the past, China had a fixed and maintained monetary authority but did not allow the free flow of capital

Fixed Exchange Rates Fixed exchange rates are the norm for developing economies. By tying their currencies to a key currency – that of a larger, more developed nation they promote

1)a means of international settlement

2)stabile prices for imports/exports

3)limits on inflationary pressure

Fixed Exchange Rates (continued) Under a fixed exchange rate system governments maintaino par value for their currencies

o an official exchange rate determined by comparing par values

o an exchange rate stabilization fund to buy and sell foreign currencies in order to preserve the official exchange rate

Preventing Depreciation If the demand for the euro increased, the value of the euro would rise and the value of the dollar would fall.

In order to maintain the fixed exchange rate, the U.S. would use its reserve of euros to buy dollars.

$1.70

Q

$1.50

Market for Euros

D1

S1

P

D2

S2

Preventing Appreciation If the supply of the euro increased, the value of the euro would fall and the value of the dollar would rise.

In order to maintain the fixed exchange rate, the U.S. would use dollars to buy euros.

$1.25

Q

$1.50

Market for Euros

D1

S1

P

D2

S2

Devaluation & Revaluation Devaluationo legal reduction of a currency’s par valueo market impact termed depreciationo counters a balance of payment deficit by making exports less expensive

Revaluationo legal increase of a currency’s par valueo market impact termed appreciationo counters a balance of payment surplus by making imports less expensive

Bretton Woods System1) response to crises of Great Depression when

floating exchange rates had been unsuccessful

2) Bretton Woods created a semi-fixed system

known as adjustable pegged exchange rates

3) currencies values tied to each other

4) nations to use fiscal and monetary policies first

to address balance of payments disequilibria

5) last resort was to re-peg currencies; greater than

10% change required IMF permission

Floating Exchange Rates o also known as flexible exchange ratesoequilibrium exchange rate determined by demand for and supply of home currencyochanges in exchange rate correct payments imbalance by changing the effective cost of imports and exportsowill not fluctuate erratically unless there is significant instability in financial markets

Depreciation & Exports If real income in the U.S. increased, then demand for imports and demand for the euro would increase. The value of the euro would rise and the value of the dollar would fall.

$1.70

Q

$1.50

Market for Euros

D1

S1

P

D2

Depreciation & Exports (cont.)Since more dollars are required to purchase a euro, the dollar has depreciated.

1)As a result, U.S. goods will become less expensive to European citizens leading to more exports from the U.S.2)European goods will become more expensive to U.S. citizens leading to fewer imports to the U.S.

$150 U.S. auto partbefore $150 = 100 € after $150 = 88.2 €

(150÷170)

100€ French winebefore 100 € = $150after 100 € = $170

Appreciation & Imports If real income in the U.S. declined, then demand for imports and demand for the euro would also decrease. The value of the euro would fall and the value of the dollar would rise.

$1.25

Q

$1.50

Market for Euros

D2

P

D1

S1

Appreciation & Imports (cont.)Since fewer dollars are required to purchase a euro, the dollar has appreciated.

1)As a result, U.S. goods will become more expensive to European citizens leading to fewer exports from the U.S.2)European goods will become less expensive to U.S. citizens leading to more imports to the U.S.

$150 U.S. auto partbefore $150 = 100 € after $150 = 120 €

(150/125)

100€ French winebefore 100 € = $150after 100 € = $125

Arguments on Floating ExchangeAdvantages Disadvantages

Fixed • simplicity and clarity of • loss of independent

exchange-rate target monetary policy • automatic rule for • vulnerable to

monetary policy speculative attacks • controls inflation

Floating • continuous adjustment • conducive toin balance of payments inflation • simplified institutional • disorderly marketsarrangements can disrupt trade and

investment patterns • independent monetary • reckless financial

and fiscal policies policies by government

Managed Floating Systemo intervention to stabilize rates in short run with

market forces determining rates in long runo informal guidelines established by IMFo clean float – free-market forces of supply and

demand determine equilibriumo dirty float – central banks intervene to promote

depreciation of their currencieso leaning against the wind – intervention to reduce

fluctuations in the short run only

Managed Float Example

permanent change in demand to D1 – exchange rate allowed to increase

temporary increase in demand - central bank sells francs while demand is D1 until return to D0

Monetary Policy

if demand for pounds decreasesFed increase MS lowering ratesdecreasing demand for dollars

if demand for pounds increasesFed decrease MS raising ratesincreasing demand for dollars

Crawling Peg o uses small, frequent changes in par value to correct balance of payments disequilibria oprimarily nations with high inflationodiffers from adjustable pegged rates under which par values change infrequently ocrawling peg is appropriate for developing nations but not for industrialized nations whose currencies provide international liquidity

Currency Crises o also known as speculative attacks oweak currency depreciates significantly as

a result of sellingocan substantially reduce economic growthousually ended by official devaluation or

adoption of a floating rateoextreme cases => currency crashes

Causes of Currency Crises 1) speculation2) deficit financed by inflation3) weak financial systems4) recent deregulation of financial markets5) weak economic performance6) political factors7) external factors such as interest rates8) choice of exchange rate system

Capital Controls 1) also known as exchange controls2) barriers to foreign savers investing in

domestic assets3) pro: government can control its balance of

payments position and possibly prevent speculative attacks

4) con: weakened confidence in the government may actually cause an increase in capital outflows

Question of Foreign Exchange Tax 1) volatile capital movements lead to severe

repercussions across economies2) a tax on inflows or outflows would reduce

the number of transaction based on short term speculation

3) such a tax would still allow market forces to influence investment and exchange rates over the long term

4) how much volatility is acceptable

Currency Board 1) monetary authority that issues notes

convertible into a foreign anchor currency at a fixed rate

2) anchor currency chosen for stability and acceptability

3) government finance only by taxation and borrowing – not by printing money

4) implies elimination of discretionary monetary policy by domestic government

Case Study – Hong Kong1) Hong Kong adopted a currency board

system in 19832) U.S.$ = 7.75 to 7.85 HK$3) reversed lack of confidence in the

economy despite anticipation of control shifting from the U.K. to China

4) contributed to significant economic growth in Hong Kong; per capita real GDP of $37,300 ranks 13th of 216 nations

Case Study – Argentina1) adopted currency board in 1991 to limit

inflation2) 1 U.S.$ = 1 Argentine Peso3) issues: dollar appreciated, U.S. interest

rates rose, domestic commodity prices fell, and Brazil’s currency depreciated

4) U.S. fiscal & monetary policy ill suited to conditions in Argentina

5) results: deficits, borrowing, default and economic chaos

Dollarization 1) partial dollarization indicates use of the

U.S. dollar alongside domestic currency2) full dollarization indicates use of the dollar

and elimination of domestic currency3) benefits:

a) lower inflationb) decreased transactions costsc) greater openness

Effects of Dollarization o U.S. monetary policy would not

necessarily be appropriate for a foreign economy

o Federal Reserve is not the lender of last resort for that economy

o loss of seigniorage which is the income that would have been derived from interest bearing foreign reserves