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The Spot Market for Foreign Exchange. Market Characteristics: An Interbank Market. The spot market is a market for immediate delivery 92 to 3 days). Primarily an interbank market, which is the trading of foreign-currency-denominated deposits between large banks.

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market characteristics an interbank market
Market Characteristics:An Interbank Market
  • The spot market is a market for immediate delivery 92 to 3 days).
  • Primarily an interbank market, which is the trading of foreign-currency-denominated deposits between large banks.
  • Approximately $US2 trillion daily in global transactions.
market quotes the wsj currency trading table
Market Quotes: The WSJ Currency Trading Table
  • Provides spot and forward rates. Forward rates are for forward contracts, or the future delivery of a currency.
  • US $ equivalent is the dollar price of a foreign currency (home currency price of a foreign currency).
  • Currency per US $ is the foreign currency price of one US dollar (foreign currency price of the home currency)
market quotes direct indirect quotes
Market Quotes:Direct - Indirect Quotes
  • The home currency price of a foreign currency is called ?
  • The foreign currency price of the home currency is called?
market quotes direct indirect quotes5
Market Quotes:Direct - Indirect Quotes
  • The home currency price of a foreign currency is called a direct quote.
  • The foreign currency price of the home currency is called?
market quotes direct indirect quotes6
Market Quotes:Direct - Indirect Quotes
  • The home currency price of a foreign currency is called a direct quote.
  • The foreign currency price of the home currency is an indirect quote.
  • Dollars & Yen? Dollars & pounds?
appreciating and depreciating currencies
Appreciating and Depreciating Currencies
  • A currency that has lost value relative to another currency is said to have ?
  • A currency that has gained value relative to another currency is said to have ?
appreciating and depreciating currencies8
Appreciating and Depreciating Currencies
  • A currency that has lost value relative to another currency is said to have depreciated.
  • A currency that has gained value relative to another currency is said to have appreciated.
  • These terms relate to the market process and are different from devaluation and revaluation.
appreciating and depreciating currencies9
Appreciating and Depreciating Currencies
  • We use the percentage change formula to calculate the amount of depreciation/appreciation.
  • Example, on Monday, the peso traded at 0.1021 $/P. On Tuesday the market closed at 0.1025 $/P.
  • The peso has appreciated, as it now takes more $ to purchase each peso.
appreciating and depreciating currencies10
Appreciating and Depreciating Currencies
  • Example, on Monday, the peso traded at 0.1021 $/P. On Tuesday the market closed at 0.1025 $/P.
  • The amount of appreciation is:

[(0.1025 - 0.1021)/0.1021] * 100 = 0.39%

bid ask spreads example from financial times
Bid - Ask Spreads:Example from Financial Times
  • The bid is the price the bank is willing to pay for the currency, e.g., 1.2002 $/€ is the bid on the euro in terms of the dollar.
  • The ask is what the bank is willing to sell the currency for, e.g. 1.2010 $/€, is the ask on the euro in terms of the dollar.
bid ask spread cost of transacting
Bid - Ask Spread:Cost of Transacting
  • The bid - ask spread of a currency reflects, in general, the cost of transacting in that currency.
  • It is calculated as the difference between the ask and the bid.
  • Example, 1.2020 - 1.2002 = 0.0018.
bid ask margin percent cost of transacting
Bid - Ask Margin:Percent Cost of Transacting
  • The bid - ask spread can be converted into a percent to compare the cost of transacting among a number of currencies.
  • The margin is calculated as the spread as a percent of the ask.
  • (Ask - Bid)/Ask * 100
  • Example, (1.2020 - 1.2002)/1.2020 * 100 = 0.15%.
cross rates unobserved rates
Cross-Rates: Unobserved Rates
  • A cross-rate is an unobserved rate that is calculated from two observed rates.
  • For example, the spot rate for the Canadian dollar is 0.70 $/C$, and the spot rate on the euro is 1.02 $/€. What is the Canadian dollar price of the euro (C$/€)?
cross rates unobserved rates15
Cross-Rates: Unobserved Rates
  • A cross-rate is an unobserved rate that is calculated from two observed rates.
  • For example, the spot rate for the Canadian dollar is 0.70 $/C$, and the spot rate on the euro is 1.02 $/€. What is the Canadian dollar price of the euro (C$/€)?
  • Note that ($/€)/($/C$) = ($/€)*(C$/$)=C$/€.
  • In this example, 1.02/0.70 = 1.457 C$/€.
arbitrage consistency of cross rates
Arbitrage:Consistency of Cross Rates
  • Arbitrage is the simultaneous buying and selling to profit (as opposed to speculation).
  • The ability of market participants to arbitrage guarantees that cross rates will be, in general, consistent.
  • If a cross rate is not consistent, the actions of currency traders (arbitrage) will bring the respective currencies in line.
spatial arbitrage
Spatial Arbitrage
  • Spatial Arbitrage refers to buying a currency in one market and selling it in another.
  • Price differences arise from geographical (spatial) dispersed markets.
  • Due to the low-cost rapid-information nature of the foreign exchange market, these prices differences are arbitraged away quickly.
triangular arbitrage
Triangular Arbitrage
  • Triangular arbitrage involves a third currency and/or market.
  • Arbitrage opportunities exist if an observed rate in another market is not consistent with a cross-rate (ignoring transaction costs).
triangular arbitrage an example
The British pound is trading for 1.455 ($/£) and the Thai baht for 0.024 ($/b) in New York, while the Thai baht is trading for 0.012 (£/b) in London.

Does an arbitrage opportunity exist?

Triangular Arbitrage: An Example
triangular arbitrage an example20
The British pound is trading for 1.455 ($/£) and the Thai baht for 0.024 ($/b) in New York, while the Thai baht is trading for 0.012 (£/b) in London.

The cross-rate in New York is:

0.024/1.455 = 0.016 (£/b)

Hence, an arbitrage opportunity exists.

Triangular Arbitrage: An Example
triangular arbitrage an example21
The British pound is trading for 1.455 ($/£) and the Thai baht for 0.024 ($/b) in New York, while the Thai baht is trading for 0.012 (£/b) in London.

The cross-rate in New York is:

0.024/1.455 = 0.016 (£/b)

Hence, an arbitrage opportunity exists.

How do you exploit it?

Triangular Arbitrage: An Example
example continued
Example Continued
  • “Buy low, sell high.”
  • A trader with $1, could buy £0.687 in New York.
  • The £0.687 would purchase b57.274 in London.
  • The b57.274 purchases $1.375 in New York, or 37.5% profit on the transaction.
real exchange rates real measures
Real Exchange RatesReal Measures
  • Nominal variables, such as exchange rates, do not consider changes in prices over time.
  • Real variables, on the other hand, include price changes.
  • A real exchange rate, therefore, accounts for relative price changes.
real exchange rates
Real Exchange Rates
  • A nominal exchange rate indicates the purchasing power of one nation’s currency over the currency of another nation.
  • Real exchange rates indicate the purchasing power of a nation’s residents for foreign goods and services relative to their purchasing power for domestic goods and services.
  • A real exchange rate is an index. Hence, we compare its value for one period against its value in another period.
real exchange rates an example
Real Exchange RatesAn Example
  • In 2000 the spot rate between the dollar and the pound was 1 USD = 0.6873 GSB (£/$).
  • Yesterday the rate was 1 USD = 0.5100 GBP.
  • Hence, the pound appreciated relative to the dollar by 26 percent {[(0.5100-0.6873)/0.6873]*100}.
  • Based on this alone, the purchasing power of US residents for British goods and services (relative to US goods and services) fell by 26 percent.
example continued27
Example: Continued
  • Suppose in 2000 the British CPI was 156.4 and the US CPI was 154.7. In early 2006, the CPI’s were 170.5 and 172.7 respectively.
  • Based on this, British prices rose 9.0 percent while US prices rose 11.6 percent, a 2.6 difference.
  • Since the prices of British goods and services rose slower than the prices of US goods and services, there was an increase in purchasing power of British goods and services relative to the purchasing power of US goods and services.
combining the two effects
Combining the Two Effects
  • A real exchange rate combines these two effects - the fall in purchasing power of US residents due to the nominal appreciation of the pound and the gain in relative purchasing power due to British prices rising at a slower rate than US prices.
  • To construct a real exchange rate, the spot rate, as it is quoted here, is multiplied by the ratio of the US CPI to the UK CPI.

(£/$) x (US CPI/UK CPI)

combining the two effects29
Combining the Two Effects
  • 2000 Real Rate = 0.6873 x (154.7/156.4) = 0.6798
  • 2007 Real Rate = 0.51 x (172.7/170.5) = 0.52.
  • The real appreciation of the pound was only 24 percent.
conclusion
Conclusion
  • The nominal exchange rate change resulted in a 26 percent fall in the purchasing power of US residents for UK goods and services.
  • The difference in price changes resulted in a 2.6 percent gain in purchasing power of UK goods and services relative to US goods and services for US residents.
  • Consequently, the 26 percent rise was offset by the 2.6 gain, resulting in an overall 24 percent loss in purchasing power.
effective exchange rate

Effective Exchange Rate

A measure of the general value of a currency.

effective exchange rate32
Effective Exchange Rate
  • On any given day, a currency may appreciate in value relative to some currencies while depreciating in value against others.
  • An effective exchange rate is a measure of the weighted-average value of a currency relative to a select group of currencies.
  • Thus, it is a guide to the general value of the currency.
weighted average value
Weighted Average Value
  • To construct an EER, we must first pick a set of currencies we are most interested in.
  • Next, we must assign relative weights. In the following example, we weight the currency according to the country’s importance as a trading partner.
weights
Weights
  • Suppose that of all the trade of the US with Canada, Mexico, and the UK, Canada accounts for 50 percent, Mexico for 30 percent, and the UK for 20 percent.
  • These constitute our weights (0.50, 0.30, and 0.20).
  • Now consider the following exchange rate data.
calculating the eer
Calculating the EER
  • The EER is calculating by summing the weighted values of the current period rate relative to the base year rate.
  • The weighted-average value is calculated as:

(weight i)(current exchange value i)/(base exchange value i)

where i represents each individual country included in the weighted average.

calculating the eer37
Calculating the EER
  • Commonly this sum is multiplied by 100 to express the EER on a 100 basis.
  • Hence, an EER is an index.
  • As we shall see next, the base-year value of the index is 100.
  • The index, therefore, is useful is showing changes in the weighted average value from one period to another.
example
Example
  • Let last year be the base year.
  • The effective exchange rate last year was:

[(1.52/1.52)*0.50 + (10.19/10.19)*0.30

+ (0.61/.61)*0.20]*100

= 100.

  • As with any index measure, the base year value is 100.
example39
Example
  • Today’s value of the EER is:

(1.44/1.52)*0.50 + (9.56/10.19)*0.30

+ (0.62/0.61)*0.20

  • or (0.958) 95.8
  • The dollar, therefore, has experienced a 4.2 percent depreciation in weighted value.
effective exchange measures
Effective Exchange Measures
  • There are a number of effective exchange measures available in the popular press. Some common measures are:
  • Bank of England Index: The Economist.
  • J.P. Morgan: The Wall Street Journal and the Financial Times.
purchasing power parity absolute or the law of one price
Purchasing Power ParityAbsolute or the Law of One Price
  • Suppose The Economist magazine sells for £2.50 in the UK and $3.95 in the US.
  • Arbitrage, therefore, should guarantee that the exchange rate between the dollar and the pound be s = 3.95/2.50 = 1.580 ($/£).
  • In words, the dollar price of The Economist in the UK should equal the dollar price of the Economist in the US (ignoring transportation costs).
absolute ppp
Absolute PPP
  • Absolute PPP is expressed as P = P*×S, where P is the domestic price, P* is the foreign price, and S is the spot rate, expressed as domestic to foreign currency units.
  • Often it is rearranged as: S = P/P*.
absolute ppp as a guide to exchange values
Absolute PPP as a Guide to Exchange Values
  • Suppose the actual spot rate pertaining to the previous example is 1.7743 whereas PPP says the rate should be 1.580.
  • A difference exists so we can conclude (for instructional purposes) that the pound is overvalued relative to the dollar.
  • In percentage terms (1.580 - 1.7743) /1.7743 x 100 = -11 percent.
relative ppp a weaker version
Relative PPP - A Weaker Version
  • Rearrange APPP to S = P/P*.
  • Divide one period equation by another period, e.g., S1/S0= (P1/P0)/(P*1/P*0)
  • Rearrange as: S1 = S0(P1/P0)/(P*1/P*0)
  • Can be used as a “model” of exchange rate movements.
  • Note that the emphasis is on exchange rate movements, not levels, though it may appear otherwise.
example47
Example
  • Suppose the exchange rate between the dollar and the pound was 1.58 in 2000 and is 1.77 today. Further, the UK CPI was 110 and is now 115, while the US CPI was 108 and is now 111.
  • Plugging this into the formula we have
  • st = (1.58) [(111/108)/(115/110)] = 1.55
  • Hence the £ is overvalued (14%).
another expression
Another Expression

In words, domestic inflation less foreign inflation should equal the change in the spot rate.

Implies that the higher inflation country should see its currency depreciate.

the macdougall diagram of international investment flows
The MacDougall Diagramof International Investment Flows

Model for understanding the interaction of supply of and demand for investment capital in different countries.

Provides us with a benchmark for interpreting cross-border capital movements.

Simple but quite useful - will be revisited later in course.

optimal international investment

Optimal International Investment

x-axis measures total capital available for investment in a country

O

Capital

optimal international investment53

y-axis reflects the prevailing rate of return per unit of capital (i.e. per $) available in a country.

r

(rate of

return)

Optimal International Investment

O

Capital

optimal international investment54

Then draw a line which reflects the prevailing rate of return in an economy, depending on the total stock of capital.

r

(rate of

return)

Optimal International Investment

O

Capital

optimal international investment57

If a country only has one unit of capital, the rate of return must be high.

r

(rate of

return)

Optimal International Investment

Lots of land, lots of workers, little equipment, few factories.

O

Capital

optimal international investment58

r

(rate of

return)

Optimal International Investment

As more capital is around competing, land becomes scarce and workers become expensive.

O

Capital

optimal international investment59

r

(rate of

return)

Optimal International Investment

If k is the total stock of capital in a particular country

O

Capital

k

optimal international investment60

r

(rate of

return)

Optimal International Investment

Then r0 is the prevailing interest rate in the economy.

r0

O

Capital

k

optimal international investment61

r

(rate of

return)

Optimal International Investment

The shaded area then represents the economy’s gross domestic product (GDP).

r0

O

Capital

k

optimal international investment62

Now consider a second country with a different (better) schedule of return possibilities...

r

(rate of

return)

Optimal International Investment

O

Capital

k

optimal international investment63

Now consider a second country with a different (better) schedule of return possibilities...

r

(rate of

return)

Optimal International Investment

O

Capital

k

optimal international investment67

r

(rate of

return)

Optimal International Investment

Denoting variables of this second (call it ‘foreign’) country with asterisk.

r0*

O*

k*

Capital

slide71

How far over do we bring it?

r

(rate of

return)

r0*

r0

O

O*

Capital

k

k*

slide72

Until the length of the horizontal axis represents the total quantity of capital in the two economies...

r

(rate of

return)

r0*

r0

O

O*

Capital

k

k*

slide73

So that the length from 0 to k0 is the amount of capital in the domestic economy...

r

(rate of

return)

r0*

r0

O

O*

Capital

k0

slide74

So that the length from 0* to k0 is the amount of capital in the foreign economy...

r

(rate of

return)

r0*

r0

O

O*

Capital

k0

slide75

Now what happens if both countries allow capital to flow freely between them?

r

(rate of

return)

r0*

r0

O

O*

Capital

k0

slide77

Whereas capital in the foreign country is earning a higher return of r0*

r

(rate of

return)

r0*

r0

O

O*

Capital

k0

slide78

So owners of capital in the home country will begin to move capital overseas...

r

(rate of

return)

r0*

r0

O

O*

Capital

k0

slide79

Shifting k to the left

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide80

Increasing the supply of capital in the foreign country

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide81

Decreasing the supply of capital in the home country

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide82

Increasing interest rates in the home country

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide83

And decreasing the returns to capital in the foreign country

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide84

When will the flows of capital from the home to the foreign country cease?

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide85

When incentives to transfer capital no longer exist...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide86

When rates of return to capital are equated: when r1 = r1*

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide87

This concept is know as:

Real Interest Parity

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide89

The foreign country’s GDP increases from this...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide90

to this.

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide91

The home country loses some GDP...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide92

The home country loses some GDP...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide93

But total world production has now increased by this amount.

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide94

For use of the home country’s capital, the foreign country pays r1* times the amount borrowed.

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide95

GNP (which equals GDP + Overseas Income) is therefore...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide96

So the home country GNP increases by...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

slide97

Similarly, after paying the interest bill, the foreign GNP increases by...

r

(rate of

return)

r0*

r1*

r1

r0

O

O*

Capital

k1

k0

why does capital flow
Why Does Capital Flow?

According to the optimal investment analysis...

Whenever returns are different in two countries.

According to the Balance of Payments Equation...

It doesn’t have much choice.

That is, it must flow into any country that is importing more than it is exporting.

How do we reconcile these two perspectives?

With changes in prices, returns, and exchange rates.

slide99

Key Points

1. MacDougall diagram can account for international investment in a frictionless world.

2. It produces Real Interest Parity, which says that when international capital markets are frictionless, real returns are equated across countries.

3. Capital will flow from capital-rich countries with ordinary returns to capital-poor countries with attractive possibilities.

4. MacDougall analysis can account for shocks to capital stock and technological shifts.

5. From a GNP standpoint, all countries benefit from international capital mobility.

slide100

Key Points

6. MacDougall analysis is highly simplified - only a benchmark from which to proceed.

7. Later in course we will introduce frictions (i.e. risk, taxes, government intervention, etc.).

8. The Balance of Payments equation tells us that goods and capital must flow together… or differences must be offset by government intervention (resulting in changes in reserve levels).

9. Not always clear whether goods drive capital or capital drives goods (i.e. are residents of one country demanding too much consumption or are foreigners too eager to invest).

10. Adjustments in prices, exchange rates, and returns will be important for balancing the balance of payments.

example us capital inflows sony and ford 1997 1998
Example: US Capital Inflows, Sony, and Ford (1997-1998)

January 1997:

- Yen/$ exchange rate reaches 115 - a 45-month high.

- DJIA finishes 1996 up 26%, fueled by near-record $142 billion US capital account inflows.

- Sony announces they will halt production of Playstation home-video game in the U.S. and shift it back to Japan.

example us capital inflows sony and ford 1997 1998103
Example: US Capital Inflows, Sony, and Ford (1997-1998)

January 1997:

- Yen/$ exchange rate reaches 115 - a 45-month high.

- DJIA finishes 1996 up 26%, fueled by near-record $142 billion US capital account inflows.

- Sony announces they will halt production of Playstation home-video game in the U.S. and shift it back to Japan.

January 1998:

- Yen/$ exchange rate reaches 133.6 - a 5.5 year high.

- US capital account expands to $157 billion as weak Asian currencies prompt a flight to dollar deposits.

- Ford announces plans to build autos in Japan for export.

central bank functions
Central Bank Functions
  • Fiscal Agents
  • Bankers’ Bank
  • Lenders of Last Resort
  • Macroeconomic and Monetary Policy Makers
    • Exchange market intervention
    • Monetary policy
the monetary base
The Monetary Base
  • A nation’s monetary base can be measured by viewing either the assets or liabilities of the central bank.
  • The assets are domestic credit (DC) and foreign exchange reserves (FER).
  • The liabilities are currency in circulation (C) and total reserves of member banks (TR).
simplified balance sheet of the central bank
Simplified Balance Sheet of the Central Bank

Assets

Liabilities

Currency

(C)

Domestic Credit

(DC)

Foreign Exchange

Reserves (FER)

Total Reserves

(TR)

Monetary Base

(MB)

Monetary Base

(MB)

money stock
Money Stock
  • There are a number of measures of a nation’s money stock (M).
  • The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.
money multiplier
Money Multiplier
  • Most nations require that a fraction of transactions deposits be held as reserves.
  • The required fraction is determined by the reserve requirement (rr).
  • This fraction determines the maximum change in the money stock that can result from a change in total reserves.
money multiplier109
Money Multiplier
  • Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only.
  • In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement,

m = 1/rr.

relating the monetary base and the money stock
Relating the Monetary Base and the Money Stock
  • Under the assumptions above, we can write the money stock as the monetary base times the money multiplier.

M = mMB = m(DC + FER) = m(C + TR).

  • Focusing only on the asset measure of the monetary base, the change in the money stock is expressed as

M = m(DC + FER).

example boj intervention
Example - BOJ Intervention
  • Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system.
  • This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.
boj balance sheet
BOJ Balance Sheet

Assets

Liabilities

C

DC

FER

TR

-¥1 million

-¥1 million

MB

MB

-¥1 million

-¥1 million

boj intervention
BOJ Intervention
  • Because the monetary base declined, so will the money stock.
  • Suppose the reserve requirement is 10 percent. The change in the money stock is

M = m(DC + FER),

M = (1/.10)(-¥1 million) = -¥10 million.

slide114

Exchange Rate Intervention

Why do governments attempt to fix exchange rates?

Why do governments attempt to fix prices?

1. They think ER volatility is destabilizing - that by removing volatility they will be making people better off.

2. Like any other price fix (i.e. U.S. sugar supports), ER fixes are a political tool. They subsidize one group at the expense of others.

3. To signal intentions.

slide115

How to Fix Exchange Rates

How can a government fix an exchange rate?

The same way a government fixes any other price:

1. By controls (much like U.S. price controls in early 1970s). Make trade at a different price illegal.

2. By intervention in the market (much like sugar). By committing to buy/sell at a certain price.

slide116

1. Exchange Rate Controls

Recall our original supply-demand graph for exchange rate determination…

$/Peso

Supply

s

Demand

Quantity of Pesos

slide117

1. Exchange Rate Controls

If demand for Argentine pesos decreases...

$/Peso

Supply

s

Demand

Quantity of Pesos

slide118

1. Exchange Rate Controls

But the Argentine Banco Central makes exchanges of FX illegal at any rate other than s...

$/Peso

Supply

s

Demand

Quantity of Pesos

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1. Exchange Rate Controls

Dollars will be rationed - there will be excess supply of pesos (demand for $) at the fixed exchange rate of s...

$/Peso

Supply

s

Demand

Quantity of Pesos

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1. Exchange Rate Controls

A black market will invariably emerge which trades pesos at a discount relative to the fixed rate.

$/Peso

Supply

s

sb

Demand

Quantity of Pesos

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Example: The Uzbek Sum

  • In 1996, the Uzbek central bank fixed the exchange rate at an overvalued level of $0.02 / Sum:
  • Imports were cheap; exports expensive; imports rose by 50% in 1996; exports were down.
  • The central bank started running short of reserves.
  • Daewoo and British American Tobacco experienced delays in converting Sum revenues.
  • Black market exchange rate began falling steadily.
  • In October, the Central bank canceled all conversion licenses and handed out dollar quotas.
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Example: The Uzbek Sum

  • The government banned the use of dollars inside Uzbekistan.
  • Inflation soared.
  • The black market rate fell to $0.0074 / Sum.
  • Foreign investment inflows dried up - decreasing Sum demand further.
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2. Exchange Rate Intervention

Central Bank Balance Sheet

C (Currency)

R (Reserves of Commercial Banks)

(Domestic DA Assets/Bonds)

(Foreign Assets FACB of Central Bank)

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2. Exchange Rate Intervention

Central Bank Balance Sheet

C (Currency)

R (Reserves of Commercial Banks)

(Domestic DA Assets/Bonds)

(Foreign Assets FACB

of Central Bank)

H (High Powered Money)

Accounting Identity: DA + FACB = H

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2. Exchange Rate Intervention

To insure that the exchange rate remains at a constant level, the central bank must purchase/sell FX to ensure supply intersects demand at the appropriate price:

$/Peso

Supply

s

Demand

Quantity of Pesos

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2. Exchange Rate Intervention

Suppose the central bank is trying to target an exchange rate of s.

$/Peso

Supply

s

Demand

Quantity of DM

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2. Exchange Rate Intervention

What happens if demand for Pesos increases?

$/Peso

Supply

s

s

Demand

Quantity of Pesos

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2. Exchange Rate Intervention

Unless something is done, the exchange rate will appreciate to s.

$/Peso

Supply

s

s

Demand

Quantity of Pesos

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What should the Central Bank Do?

3 Options:

1. Discourage capital inflows. Curb demand. Example: Chile.

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Option 1. Discourage Inflows

Enact policies which curb demand for peso (i.e. ‘Tobin Taxes’) and push intersection back to original level.

$/Peso

Supply

s

s

Demand

Quantity of Pesos

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Option 2: Unsterilized Intervention

Banco Central offers sufficient peso supply in the FX market to meet demand at s

$/Peso

Supply

s

s

Demand

Quantity of Pesos

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Option 2: Unsterilized Intervention

What does this mean for the Central Bank’s balance sheet? They supply Pesos for $. Reserves of $ will increase:

D FACB > 0

Since the central bank is selling Pesos, the supply of currency must increase too: