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Exchange Rate Management. Exchange Rate Policy can be characterized along two dimensions. Currency Union (Euro). Commitment. Hard Peg (Yuan). Target Zone (Bretton Woods). Flexibility. Fixed Exchange Rates. Flexibility.

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Exchange rate policy can be characterized along two dimensions l.jpg
Exchange Rate Policy can be characterized along two dimensions

Currency Union (Euro)

Commitment

Hard Peg (Yuan)

Target Zone (Bretton Woods)

Flexibility


Fixed exchange rates l.jpg
Fixed Exchange Rates dimensions

Flexibility

With a hard peg,a currency’s price is held permanently at a fixed level. For example, the Chinese Yuan is pegged at

$1 = 8.28 Yuan

e

.1207

Time

Jan

Feb

Mar

Apr

May


Fixed exchange rates4 l.jpg
Fixed Exchange Rates dimensions

Flexibility

With a soft peg,a currency’s price is returned to the predefined parity at regular intervals (monthly, weekly, etc). For example, the Algerian Dinar is pegged at $1 = 76 Dinar

e

.012

Time

Jan

Feb

Mar

Apr

May


Fixed exchange rates5 l.jpg
Fixed Exchange Rates dimensions

Flexibility

With an adjustable peg,the parity price is adjusted as circumstances warrant (monthly, weekly, etc). The Bretton Woods System was an adjustable peg

e

Time

Jan

Feb

Mar

Apr

May


Fixed exchange rates6 l.jpg
Fixed Exchange Rates dimensions

Flexibility

With a crawling peg,a currency’s price is held permanently at a fixed level, but that parity level has prescheduled changes For example, the Mexican Peso followed a crawling peg in the 1990s

e

Time

Jan

Feb

Mar

Apr

May


Target zones l.jpg
Target Zones dimensions

Flexibility

With a target zone,a currency’s price is held permanently between an upper and lower bound. The Bretton Woods system used 2% bands

e

+2%

-2%

Time

Jan

Feb

Mar

Apr

May


Floating rates l.jpg
Floating Rates dimensions

Flexibility

  • Floating rates allow the market to determine exchange values

    • Managed (Dirty) Float: Central banks intervene periodically to correct fundamental misalignments (Russia, Singapore)

    • Pure Float: Central bank commits to zero currency interventions. (US, Europe)


Commitment l.jpg
Commitment dimensions

  • Policies can vary by the degree of commitment to the policy:

    • Fixed Exchange Rate: This is simply a policy decision of the government or central bank and can be easily reversed (China).

    • Currency Boards: A currency board is a monetary authority separate from (or in replacement of) a country’s central bank whose sole responsibility is maintaining convertibility of the country’s currency. (Hong Kong)

    • Dollarization: foreign money replaces domestic money as official currency (Panama)

Commitment



Currency baskets l.jpg
Currency Baskets dimensions

  • Some countries choose to peg to a “basket” of currencies rather that a single currency. This basket will have a price equal to a weighted average of the individual currencies

    • Latvia: SDR (Euro, JPY, GBP, USD)

    • Malta: Euro (67%), USD21%), GBP (12%)

    • Iceland: Euro + 6 other countries

  • Why peg to a basket?

    • Baskets or currency should exhibit less volatility that individual currencies.

    • The central bank has a wider choice for official reserves


Currency unions l.jpg
Currency Unions dimensions

  • Currency unions are groups of countries who have agreed to share a common currency. They are usually share geographic borders and have highly integrated economic policies

    • European Union (22 members in 2004): Euro

    • West African Economic and Monetary Union (7 countries): CFA Franc

    • East Caribbean Monetary Union (8 countries): East Caribbean Dollar

    • Gulf Cooperation Council Monetary Union

  • Unions Still in the Planning Stages

    • Central American Monetary Union

    • Asia Currency Union

    • North American Monetary Union?


Costs benefits of fixed exchange rates l.jpg
Costs/Benefits of Fixed Exchange Rates dimensions

  • Main Benefit

    • Reduces uncertainty with regard to cross border trade in both goods and assets

  • Main Cost

    • Eliminates a country’s ability to use monetary policy for domestic objectives


Internal vs external objectives l.jpg
Internal vs. External Objectives dimensions

  • Internal Objectives

    • Full Employment

    • High Output Growth

    • Low Inflation

  • External Objectives

    • Keep current account at “sustainable” levels. That is, current account deficits that are fully financed by willing capital inflows


Fixed exchange rates monetary policy l.jpg
Fixed Exchange Rates & Monetary Policy dimensions

  • As with the gold standard, the ability of a country to peg its exchange rate lies in its official reserves. For example, if the US were to peg to the Euro, we would need sufficient Euro reserves


Slide16 l.jpg

Suppose that the US decides to peg to the Euro at a price of $1.30 per Euro

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

E 5,000,000

X 1.30 $/E

$ 6,500,000

$ 3,500,000 (T-Bills)

$10,000,000

Currently, the reserve ratio is 65% (6.5M/10M)


Slide17 l.jpg

Long Run $1.30 per Euro

PPP holds

Relative Prices are constant. Therefore, the real exchange rate equals one

The nominal exchange rate returns to its “fundamentals”

Short Run

Commodity prices are fixed (PPP fails)

UIP and Currency markets determine exchange rates

If we are going to analyze the policy options, we need a structured framework to proceed.


Exchange rate fundamentals l.jpg
Exchange Rate Fundamentals $1.30 per Euro

  • Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency

Domestic Money Market

Foreign Money Market

M

(1+i)

M*

(1+i*)

P

=

P*

=

Y

Y*

PPP

P = eP*

M

(1+i)

eM*

(1+i*)

=

Y

Y*


Currency fundamentals l.jpg
Currency Fundamentals $1.30 per Euro

  • Taking the previous expression and solving for the exchange rate, we get

(1+i)

M

Y*

e

=

M*

Y

(1+i*)

Relative Money Stocks

Relative Interest Rates

Relative Output


Long run exchange rate management l.jpg
Long Run Exchange Rate Management $1.30 per Euro

(1+i)

M

Y*

e

=

M*

Y

(1+i*)

The US is pegging at $1.30/Euro. This explicitly defines a monetary policy!

(1+i)

M

Y*

1.30

=

M*

Y

(1+i*)

(1+i*)

Y

M

=

1.3M*

Y*

(1+i)


Long run exchange rate management21 l.jpg
Long Run Exchange Rate Management $1.30 per Euro

(1+i*)

Y

M

=

1.3M*

Y*

(1+i)

Suppose that US economic growth is 4% per year while Europe is 1% per year.

To maintain the peg, the US would have to increase the US money supply by 3% relative to Europe


Slide22 l.jpg

This increase could be done through either an open market purchase of T-Bills, or an acquisition of foreign assets (whatever combination stabilizes the exchange rate)

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

E 5,000,000

X 1.30 $/E

$ 6,500,000

$ 3,500,000 (T-Bills)

$10,000,000

The reserve ratio is 63% (6.5M/10.3M)

+ $300,000 (Currency)

+ $300,000 (T-Bills)


Slide23 l.jpg

Mama knows best! purchase of T-Bills, or an acquisition of foreign assets (whatever combination stabilizes the exchange rate)

“If Billy jumped off the Brooklyn Bridge, would you do it to?”

(1+i*)

Y

M

=

1.3M*

Y*

(1+i)

Suppose that Europe was following an irresponsible monetary policy (excessive money growth). If the US was pegging to the Euro, we would be forced into the same irresponsible behavior!


Slide24 l.jpg

You need to choose a currency regime that is compatible in the long run with your economic fundamentals

e

Time

Jan

Feb

Mar

Apr

May

Mexico’s crawling peg to the US was due to its high inflation rate relative to the US (high inflation is a result of low economic growth and high money growth


Short run management l.jpg
Short Run Management the long run with your economic fundamentals

  • Suppose the Federal Reserve conducts an open market purchase of $1,000,000 in Treasuries to increase the money supply


Slide26 l.jpg

The Fed Conducts an open market purchase of T-Bills the long run with your economic fundamentals

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

+ $1,000,000 E 5,000,000

X 1.30 $/E

$ 6,500,000

$ 3,500,000 (T-Bills)

$10,000,000

+ $1,000,000 (T-Bills)

The reserve ratio drops to 59% (6.5M/11M)


A monetary expansion l.jpg
A Monetary Expansion the long run with your economic fundamentals

  • The increase in money increases income (this worsens the trade balance as imports increase) and lowers domestic interest rates (this worsens the capital account by cutting off foreign investment)

  • With a BOP deficit, Federal Reserve must use Euro reserves to buy dollars in order to maintain the peg


Slide28 l.jpg

The Fed Conducts an open market purchase of Dollars the long run with your economic fundamentals

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

+ $1,000,000 E 5,000,000

- $1,000,000X 1.30 $/E

$ 6,500,000

$ 3,500,000 (T-Bills)

$10,000,000

+ $1,000,000 (T-Bills)

- $1,000,000 (Euros)

The reserve ratio drops to 55% (5.5M/10M)

Note: The money supply returns to $10M


Fixed exchange rates money supply l.jpg
Fixed Exchange Rates & Money Supply the long run with your economic fundamentals

  • Currency depreciations (appreciations) force the central bank to buy (sell) its currency. This creates a loss (gain) of foreign reserves and contracts (increases) the money supply.


Fixed exchange rates and fiscal policy l.jpg
Fixed Exchange Rates and Fiscal Policy the long run with your economic fundamentals

  • Suppose that the US Government runs a deficit (either spending increases or tax cuts) to stimulate the economy

    • Increased spending increases the trade deficit

    • Higher government debt raises the interest rate (this attracts foreign capital)


Case 1 high capital mobility l.jpg
Case #1: High Capital Mobility the long run with your economic fundamentals

  • The increase in domestic interest rated creates sufficient capital inflow to finance the trade deficit. The dollar begins to appreciate

Interest Rate

BOP Surplus

BOP = 0

BOP Deficit

Trade Balance


Slide32 l.jpg

The Fed Conducts an open market sale of Dollars to maintain the peg with the Euro

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

+ $1,000,000 E 5,000,000

X 1.30 $/E

$ 6,500,000

$ 3,500,000 (T-Bills)

$10,000,000

+$1,000,000 (Euros)

The reserve ratio rises to 68% (7.5M/11M)


Case 2 low capital mobility l.jpg
Case #2: Low Capital Mobility the peg with the Euro

  • With low capital mobility, high US interest rates are unable to attract sufficient financing for the trade deficit. A BOP deficit causes the dollar to depreciate

Interest Rate

BOP = 0

BOP Surplus

BOP Deficit

Trade Balance


Slide34 l.jpg

The Fed Conducts an open market purchase of Dollars to maintain the peg with the Euro

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

- $1,000,000 E 5,000,000

X 1.30 $/E

$ 6,500,000

$ 3,500,000 (T-Bills)

$10,000,000

-$1,000,000 (Euros)

The reserve ratio falls to 61% (5.5M/9M)

The purchase of dollars contracts the money supply


Sterilization l.jpg
Sterilization maintain the peg with the Euro

  • In the previous example, the intervention to defend the dollar resulted in a monetary contraction. This raises domestic interest rates and lowers domestic GDP. Is it possible to intervene in currency markets without affecting the domestic money supply?


Slide36 l.jpg

The Fed Conducts an open market purchase of Treasuries to “Sterilize” the currency intervention

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

  • $1,000,000

    + $1,000,000 E 5,000,000

    X 1.30 $/E

    $ 6,500,000

    $ 3,500,000 (T-Bills)

    $10,000,000

    -$1,000,000 (Euros)

    +$1,000,000 (T-Bills)

    The reserve ratio falls to 55% (5.5M/10M)


Fixed exchange rates bop shocks l.jpg
Fixed Exchange Rates BOP shocks “Sterilize” the currency intervention

  • Suppose that foreign investors view US debt as too risky?

    • Financial flows reverse, the US runs a BOP deficit requiring a purchase of dollars

Interest Rate

BOP = 0

Trade Balance


Slide38 l.jpg

The Fed Conducts an open market purchase of dollars to stabilize the exchange rate

LiabilitiesAssets

$ 10,000,000 (Currency) E 2,000,000 (Euro)

E 3,000,000 (ECB Bonds)

  • $1,000,000 E 5,000,000

    X 1.30 $/E

    $ 6,500,000

    $ 3,500,000 (T-Bills)

    $10,000,000

    -$1,000,000 (Euros)

    The reserve ratio falls to 61% (5.5M/9M)

    The money supply contracts


Devaluations l.jpg
Devaluations stabilize the exchange rate

  • Suppose that, due to repeated attempts to defend the dollar, Fed reserves of Euro are running low. The Fed could fix this problem by devaluing the dollar (i.e. raising the dollar price of Euro)

    • The drop in value would hopefully stop the selling

    • The devaluation would also improve the Fed’s reserve position


Slide40 l.jpg

Foreign Reserves are dangerously low! stabilize the exchange rate

LiabilitiesAssets

$ 6,100,000 (Currency) E 1,000,000 (Euro)

E 1,000,000 (ECB Bonds)

E 2,000,000

X 1.30 $/E

$ 2,600,000

$ 3,500,000 (T-Bills)

$6,100,000

The reserve ratio is at 42% (2.6M/6.1M)


Slide41 l.jpg

A devaluation from $1.30 to $1.50 helps stabilize the exchange rate

LiabilitiesAssets

$ 6,100,000 (Currency) E 1,000,000 (Euro)

E 1,000,000 (ECB Bonds)

E 2,000,000

X 1.50 $/E

$ 3,000,000

$ 3,500,000 (T-Bills)

$6,500,000

The reserve ratio is at 49% (3M/6.1M)


Speculation and peso problems l.jpg
Speculation and “Peso Problems” stabilize the exchange rate

  • Even a strong currency can become the victim of a speculative attack.

  • If the market believes that a currency might devalue in the future, they will sell that country’s currency and assets.

  • The resulting balance of payments deficit forces the country to devalue (self fulfilling prophesy)


Short run management43 l.jpg
Short Run Management stabilize the exchange rate

  • Currency Pegs work well as long as times are good

    • A country can maintain an appreciating currency forever

  • Currency pegs are not terribly successful during tough times

    • You can’t maintain a depreciating currency forever – and markets know this!

    • A peg forces you to follow policies that tend to make economic conditions worse (tight money, balanced government budgets)


Slide44 l.jpg

Pearls of wisdom from “The Karate Kid” stabilize the exchange rate

“Daniel-san, must talk. Man walk on road. Walk left side, safe. Walk right side, safe. Walk down middle, sooner or later, get squished just like grape. Same here. You karate do "yes," or karate do "no." You karate do "guess so," just like grape. Understand?”


Slide45 l.jpg

Committed Floater stabilize the exchange rate

Committed Pegger

Uncertain Pegger


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