The foreign exchange market and exchange rates
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The Foreign Exchange Market and Exchange Rates. Balance of Payments : 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.

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The foreign exchange market and exchange rates

The Foreign Exchange Market and Exchange Rates

  • Balance of Payments:

    • 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.

  • 2 main accounts: currentand 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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Balance of Payments

Current account

Trade a/c

Services

Freight

Tourism

Royalties

Investment income

Direct investment income

National debt interest

Transfers Balance on current account

Capital account

Private capital

Official capital

Government securities sold abroad

Banking transactionsBalance on capital account

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Foreign exchange market

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 €

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Foreign Exchange Market

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

S

e1

D

€ billions

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Fixed vs floating

Fixed vs Floating

  • In a certain trivial sense the BOP always balances

    • Supply equals demand

  • For floating exchange rate this is achieved by the free market

    • For fixed exchange rates the government makes up the difference

  • Current account surplus is counteracted by cap deficit and/or changes in reserves

    • US vs China


Fixed erates

Fixed Erates

  • 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


The foreign exchange market and exchange rates

Fixed e

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

S

e*

D

€ billions

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Fixed e

Below market rate. CB print extra € and buy $

S

e*

D

€ billions

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Fixed e

E above market value. CB must buy € with $

S

e*

D

€ billions

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Irish exchange rate policy

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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Effect of e on ad

Effect of e on AD

  • 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

  • Thuse 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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

  • 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


The foreign exchange market and exchange rates

LRAS

p

SRAS(pe)

AD1

AD0

Y*

Y


Determinants of exchange rates

Determinants of Exchange Rates

  • At most fundamental level:

    • BOP determines Supply and demand for euro (€)

    • foreign exchange market determines e.

    • Receipts (e.g. Exports): Demand for Euro.

    • Payments (e.g. Imports): Supply of Euro.

  • Factors that influence the supply and demand include:

    • Interest Rates (UIP)

    • Prices (Competitiveness)

    • Growth:.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Prices

Prices

  • Relative inflation rates.

    •    X and M

    • Demand curve to the left,

    • Supply curve to the right.

  • Result is e depreciation.

  • Countries with high inflation rates tend to have weak exchange rates.

  • PPP theory (see later)

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Interest rates

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Output

Output

  • Two effects:

    • Economic growth leads to an increase in imports (via MPM), a current a/c deficit and depreciation.

    • Economic growth is reflected in high company profits, a rising stock market and high returns.

      • This leads to a capital inflow and a capital a/c surplus.

  • As long a (B) > (A) the exchange rate will appreciate.

  • United States in the 1990’s and 2000’s.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Prices 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?

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Absolute ppp

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Real exchange rate

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


The foreign exchange market and exchange rates

  • 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


The foreign exchange market and exchange rates

  • 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


Relative ppp

Relative PPP

  • Total differentiation of the absolute PPP equation gives:

  •  Pirl +  e =  Pw

  • Or irl + e = w

  • Inflation rates, adjusted for changes in the exchange rate, should be similar across countries.

  • Weak form of PPP.

    • Prices can be initially different, but change at the same rate over time.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Ppp as a economic theory under flexible exchange rates

PPP as a Economic Theory: Under Flexible Exchange Rates

  • PPP becomes a theory of exchange rates.

  •  e = w - irl

  • Inflation is the most important determinant of e. Country’s with high inflation rates will experience weak exchange rates and visa versa.

    • Why?

  • Very relevant in the case of large countries: USA, Japan and EMU.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Ppp as an economic theory under fixed exchange rates

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.

  • Used by small countries world-wide.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Ireland s competitiveness

Ireland’s Competitiveness

  • 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


The foreign exchange market and exchange rates

2000


The foreign exchange market and exchange rates

2004


Capital account

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


The foreign exchange market and exchange rates

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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

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)

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Implications

  • Difference between the future and current exchange rates equals the interest rate differential.

  • If ius < iezExpect € depreciation

  • If ius > iezExpect € 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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Dutch, German, and Irish Interest Rates converged as EMU approached and it was anticipated that E would be “irrevocably fixed”

Irl

NL

D


The foreign exchange market and exchange rates

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Currency crises

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

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

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Currency crisis of 1992 93

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)


The foreign exchange market and exchange rates

Germany 1992

LRAS

p

SRAS(pe)

AD1

AD0

Y*

Y


The foreign exchange market and exchange rates

UK 1992

LRAS

SRAS(pe)

p

AD0

AD1

Y*

Y


The foreign exchange market and exchange rates

  • 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


The foreign exchange market and exchange rates

Stg/DM

E above market value. CB must buy £ with DM

S

e*

D

£ billions

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The irish pound and the crisis of 1992 93

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Implications of the n o d evaluation s tance

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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

(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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The alternative to devaluation

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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

Ireland 1992

LRAS

SRAS(pe)

p

AD0

AD1

Y*

Y


Summary

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


The foreign exchange market and exchange rates

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Economic benefits

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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

  • 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.

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

  • 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?

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


Costs

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”

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


The foreign exchange market and exchange rates

  • 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

 Leddin and Walsh Macroeconomy of the Eurozone, 2003


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