Special Topics in Economics Special Topics in Economics Econ. 491Econ. 491

Chapter 5:Chapter 5:Exchange Rate PolicyExchange Rate Policy

I. Foreign Exchange MarketI. Foreign Exchange Market Foreign Exchange Market:Foreign Exchange Market:

A market in which trading of currency and bank A market in which trading of currency and bank deposits denominated in particular currencies takes deposits denominated in particular currencies takes place.place.

There are 2 kinds of exchange rate transactions:There are 2 kinds of exchange rate transactions:1. 1. Spot Transactions: Spot Transactions: involve the immediate (two-day) involve the immediate (two-day)

exchange of bank deposits.exchange of bank deposits.2. 2. Forward Transactions: Forward Transactions: involve the exchange of bank involve the exchange of bank

deposits at some specified future date.deposits at some specified future date.

There are 2 kinds of exchange rates:There are 2 kinds of exchange rates:

1. 1. Spot Exchange Rate: Spot Exchange Rate: is the exchange rate for the spot is the exchange rate for the spot transaction.transaction.

2. 2. Forward Exchange Rate:Forward Exchange Rate:  is the exchange rate for the   is the exchange rate for the forward transaction.forward transaction.

How is Foreign Exchange Traded?How is Foreign Exchange Traded?

The foreign exchange market is organized as The foreign exchange market is organized as an over the counter market.an over the counter market.

There are several hundred dealers (mostly There are several hundred dealers (mostly banks) stand ready to buy and sell deposits banks) stand ready to buy and sell deposits denominated in foreign currencies.denominated in foreign currencies.

II. The Demand & Supply in the Foreign II. The Demand & Supply in the Foreign Exchange MarketExchange Market Simple standard demand & supply framework to Simple standard demand & supply framework to

analyze the foreign exchange market.analyze the foreign exchange market.

II.i Under Flexible Rate RegimeII.i Under Flexible Rate Regime

Demand for & supply of each currency in the foreign Demand for & supply of each currency in the foreign exchange market determine the exchange rate .exchange market determine the exchange rate .

Case One: Consider R= 0.5Case One: Consider R= 0.5 A shortage of foreign exchange would cause individuals to bid up its price as they A shortage of foreign exchange would cause individuals to bid up its price as they

offer to buy Euro denominated deposits in exchange for dollar-denominated ones.offer to buy Euro denominated deposits in exchange for dollar-denominated ones.

Case Two: Consider R= 1.5Case Two: Consider R= 1.5•A surplus of foreign exchange would cause the price to fall as individuals A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-offered to sell Euro denominated deposits in exchange for dollar-denominated ones.denominated ones.

ResultResult: : The price of mechanism equates the quantity demanded of The price of mechanism equates the quantity demanded of each currency with the each currency with the quantity supplied, thus the foreign quantity supplied, thus the foreign exchange market clears. exchange market clears.

II.ii Under Fixed Rate RegimeII.ii Under Fixed Rate Regime

The pegged or fixed exchange rate is a practice that works The pegged or fixed exchange rate is a practice that works much like fixing the price of any good.much like fixing the price of any good.

Demand & supply of foreign exchange still exist, but do not Demand & supply of foreign exchange still exist, but do not determine the exchange rate as they would in the flexible determine the exchange rate as they would in the flexible regime.regime.

Central banks must stand ready to absorb any excess demand Central banks must stand ready to absorb any excess demand for or supply of a currency to maintain the pegged rate.for or supply of a currency to maintain the pegged rate.

Central banks must step into the market , such action called a Central banks must step into the market , such action called a policy of intervention policy of intervention in the foreign exchange market.in the foreign exchange market.

Case OneCase One: Suppose the US government decides to peg : Suppose the US government decides to peg the exchange rate between dollars & Euros at 1.5the exchange rate between dollars & Euros at 1.5

Case TwoCase Two: Suppose the US government decides to peg : Suppose the US government decides to peg the exchange rate between dollars & Euros at 0.5 the exchange rate between dollars & Euros at 0.5

Case One: Consider R= 1.5Case One: Consider R= 1.5 The quantity supplied of euro exceeds the quantity demanded. Dollar denominated The quantity supplied of euro exceeds the quantity demanded. Dollar denominated

deposits are more attractive relative to the euro ones. Thus, surplus of euro in the deposits are more attractive relative to the euro ones. Thus, surplus of euro in the foreign exchange market at (R=1.5) creates a tendency for the exchange rate to fall as foreign exchange market at (R=1.5) creates a tendency for the exchange rate to fall as individuals try to sell euro deposits in exchange for dollar ones.individuals try to sell euro deposits in exchange for dollar ones.

As a result, US Fed steps in to buy up the surplus euro denominated As a result, US Fed steps in to buy up the surplus euro denominated deposits(individuals sell euro denominated deposits to the Fed in return for dollar deposits(individuals sell euro denominated deposits to the Fed in return for dollar ones at R=1.5).ones at R=1.5).

The distance between points B and G at R=1.5 represents the level of required The distance between points B and G at R=1.5 represents the level of required intervention.intervention.

What is the case of revaluation of the dollar?What is the case of revaluation of the dollar?

Case Two: Consider R= 0.5Case Two: Consider R= 0.5

• A surplus of foreign exchange would cause the price to A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones.deposits in exchange for dollar-denominated ones.

ResultResult: : The price of mechanism equates the quantity demanded of The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign each currency with the quantity supplied, thus the foreign exchange market clears. exchange market clears.

Case Two: Consider R= 0.5Case Two: Consider R= 0.5 The quantity demanded for euro exceeds the quantity supplied. Euro denominated deposits are more The quantity demanded for euro exceeds the quantity supplied. Euro denominated deposits are more

attractive relative to the Dollar ones. Thus, shortage of euro in the foreign exchange market at (R=0.5) attractive relative to the Dollar ones. Thus, shortage of euro in the foreign exchange market at (R=0.5) creates a tendency for the exchange rate to increase as individuals try to buy euro deposits in exchange for creates a tendency for the exchange rate to increase as individuals try to buy euro deposits in exchange for dollar ones.dollar ones.

As a result, US Fed steps in to sell euro denominated deposits (from where Fed has them ) by buying dollar As a result, US Fed steps in to sell euro denominated deposits (from where Fed has them ) by buying dollar denominated deposits.denominated deposits.

The distance between points H and C at R=0.5 represents the level of required intervention.The distance between points H and C at R=0.5 represents the level of required intervention.

What is the case of devaluation of the dollar?What is the case of devaluation of the dollar?

Case Two: Consider R= 0.5Case Two: Consider R= 0.5•A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones.denominated deposits in exchange for dollar-denominated ones.

ResultResult: : The price of mechanism equates the quantity demanded of The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign each currency with the quantity supplied, thus the foreign exchange market clears. exchange market clears.

III. Classification of Exchange Rate III. Classification of Exchange Rate Arrangements Arrangements The existing literature on regime choices has usually used The existing literature on regime choices has usually used

the International Monetary Fund’s classification of the International Monetary Fund’s classification of exchange rate regimes.exchange rate regimes.

Prior to 1999, member countries of the IMF declared their Prior to 1999, member countries of the IMF declared their exchange rate policies to the IMF according to their official exchange rate policies to the IMF according to their official or or de jurede jure exchange rate arrangements.exchange rate arrangements.

The former IMF classification identifies three major The former IMF classification identifies three major exchange rate arrangements: fixed policies, limited exchange rate arrangements: fixed policies, limited flexibility policies (fluctuated within a range), and more flexibility policies (fluctuated within a range), and more flexible policies (either managed or free float).flexible policies (either managed or free float).

However, the former IMF exchange rate classification However, the former IMF exchange rate classification does not distinguish between the announced exchange does not distinguish between the announced exchange rate policy (rate policy (de jurede jure exchange rate exchange rate) and the actual ) and the actual exchange rate policy (exchange rate policy (de facto de facto exchange rateexchange rate) ) undertaken by the country.undertaken by the country.

Another drawback of the pre-1999 classification is Another drawback of the pre-1999 classification is that it does not distinguish between the varieties of that it does not distinguish between the varieties of fixed exchange rate regimes.fixed exchange rate regimes.

The new IMF classification distinguishes between The new IMF classification distinguishes between various pegging policies and also distinguishes various pegging policies and also distinguishes between between eight eight categories ranging from hard peg categories ranging from hard peg regimes to free floating regimes:regimes to free floating regimes:

Exchange Rate Regime Description

1 .No Separate Lender Tender i.e., Formal dollarization

2 .Currency Board Fixed to a specific foreign currency at a fixed rate

3 .Conventional Fixed Pegs Fixed to a single currency or a basket of currencies as with band at most +/- 1%

4 .Fixed Within Horizontal Bands Fixed with bands at least +/- 1%

5 .Crawling Pegs Fixed with central parity periodically adjusted in small amount at fixed rate or in response to changes in selective quantitative indicators

6 .Crawling Bands Crawling peg associated with bands at least +/- 1%

7 .Managed Floating Influencing the exchange rate without a specific target or pre-announced path of the exchange rate

8 .Independently Floating Determining exchange rate through the market

•Table: The Revised IMF Classification of Exchange Rate Arrangements

•Source: IMF Exchange Rate Classification (1999)