Outline for 10/29: International Money 1

Some Monetary Basics

Exchange Rate Systems

Floating

Fixed

Intermediate

Money and Capital

What is money?

1. Medium of exchange

2. A way to store value

The interest rate ( i ) is a price. For what?

3. A commodity that can be traded

The exchange rate ( e ) is also a price. For what?

What is capital?

Any form of wealth that can be converted to money

Examples: Cash, bonds, stocks, art, houses, production equipment

What is liquidity?

International Capital Mobility (ICM)

Definition – the ability of investors to move their money across the national borders,

typically involves exchanging one currency for another.

Implication: if money can move across national borders, then there will be pressure on the exchange rate ( e ).

Why would governments want to keep their capital market open?

Why would governments want to keep their capital market closed?

How might governments try to close their capital markets?

Exchange Rate Systems

Compare operation of floating, fixed and intermediate systems

Discuss prominent examples of each

System Example

Floating United States post-1971

Fixed China’s current system

Intermediate European Monetary System 1979-99

Floating Exchange Rates

Set entirely by market forces, the government does not intervene.

When demand increases relative to supply, the exchange rate will appreciate.

When demand decreases relative to supply, the exchange rate will depreciate.

What factors lead to currency appreciation?

Who benefits from a currency appreciation?

What factors lead to currency depreciation?

Who benefits from a currency depreciation?

Examples of floating exchange rate systems?

US dollar relative to Canadian dollar since 1971

http://www.forecasts.org/data/cdollextrnd.htm

Fixed Exchange Rates

The government chooses a preferred exchange rate and uses monetary policy to keep the exchange rate constant.

What is monetary policy?

If market forces want the exchange rate to appreciate, then the government must increase the money supply to offset this pressure.

How can the government increase the money supply?

If market forces want the exchange rate to depreciate, then the government must decrease the money supply to offset this pressure.

How can the government decrease its money supply?

The government uses its supply of foreign currencies (forex) to buy back the domestic currency available in the international market

China’s Fixed Exchange Rate System

The yuan is fixed to the US dollar $1 buys 6.24 yuan or1 yuan buys $0.16 dollars

But market forces want the yuan to appreciate (e.g. $1 / 5 yuan) Why?

How does the Chinese government stop the yuan from appreciating?

Increase the supply of yuan available in international markets by buying US dollar denominated assets (T-bills)

Why does China want the yuan to be undervalued?

Is this good or bad for the United States?

Can China sustain the yuan’s undervaluation?

http://www.economist.com/blogs/dailychart/2011/10/america-and-china

Dollar/Yuan exchange rate over time

Which currency has strengthened since 07? Which currency has weakened?

Advantages Disadvantages

Floating No govt. intervention needed, monetary policy can be used for other things

Price volatility

Fixed Prices more stable Govt. intervention required. Monetary policy must be directed towards the exchange rate.

Advantages and Disadvantages of Floating versus Fixed Exchange Rates

Intermediate Exchange Rate Systems

Market forces determine the exchange rate with occasional government intervention

Governments set upper and lower values for their national currency

No monetary intervention as long as the exchange rate stays within these bands

But the government will intervene if the currency gets too high or too low

What must the government do if its currency hits the upper band?

What must the government do if its currency hits the lower band?

European Monetary System (EMS) 1979-1999

EMS replaced the “Snake” 1972-1978 and was replaced by EMU in 1999.

EMS governments negotiated exchange rates and then set bands ± 2.25 %

German DM tended to appreciate

What did Germany need to do to keep the DM within the bands?

French franc and Italian lira tended to depreciate

What did France and Italy need to do to stay within the bands?

This intermediate system did not work very well, so a new exchange rate system set in place.

What was this system?