Lecture 4

1. Lecture 4 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

2. Exchange Rate Determinationin the Short Run • Asset market approach • Focuses on short-run changes in the demands and supplies for assets denominated in different currencies • Incorporates a broader market approach that considers all financial assets (not just money) • Emphasizes short-run portfolio adjustments by international investors • Explains “overshooting”—the tendency for exchange rates to over-react to news or events.

3. Asset Market Approach • The spot exchange rate of a foreign currency (e) is raised on the short run by: • A rise in the foreign interest rate relative to our interest rate (if – i ) • A rise in the expected future spot exchange rate • Both events create an incentive to accumulate (increase demand) the currency, driving up the exchange rate.

4. Determinants of Returns • Recall that investors determine the total return on their investment in a bond denominated in a foreign currency as the sum of: • The basic return on the bond itself (interest, “coupon rate”, or yield), and • The expected gain or loss on the currency exchanges related to to the expected appreciation or depreciation of the currency.

5. Uncovered Interest Parity • Uncovered interest parity (whether exact or approximate) links together four variables: • The domestic interest rate • The foreign interest rate • The current spot exchange rate • The expected future spot rate

6. Short-runDeterminants of Exchange Rates Domestic Interest Rates

7. Process:Rise in Domestic Interest Rates • The domestic interest rate rises (foreign interest rate stays the same). • Some investors in the two countries will want the domestic investments because of the relatively higher returns. Portfolios adjust in the direction of the domestic-currency assets. • Foreign investors must buy domestic currency before they can buy these bonds. This creates an increase in demand for domestic currency. • Domestic investors will forego foreign bonds in favor of the domestic ones, thereby reducing the supply of domestic currency on the foreign exchange market. • The increase in demand and the reduction of supply for the domestic currency increases the current spot exchange rate for the domestic currency.

8. Short-runDeterminants of Exchange Rates Foreign Interest Rates

9. Process:Rise in Foreign Interest Rates • The foreign interest rate rises (domestic interest rate stays the same). • Some investors in the two countries will want the foreign investments because of the relatively higher returns. Portfolios adjust in the direction of the foreign-currency assets. • Domestic investors must buy foreign currency before they can buy these bonds. This creates an increase in demand for foreign currency. • Foreign investors will forego domestic bonds in favor of their own bonds, thereby reducing the supply of foreign currency on the foreign exchange market. • The increase in demand and the reduction of supply for the foreign currency increases the current spot exchange rate for the foreign currency.

10. Process: Interest Rates Change in Both Countries • What if interest rates change in both countries? (Exchange rates stay the same.) • Examine the net effect by looking at the interest rate differential i – if . • If the interest rate differential increases, then domestic rates have increased relative to foreign rates, and portfolios will adjust in favor of domestic-currency assets, and • The domestic currency will appreciate.

11. What causes interest rates to change? • The nominal interest rate i is:i = r + πe (Fisher Equation) where r is the real interest rate and πeis the expected inflation rate. • So nominal interest rates my change because: • People’s expectations of future inflation have changed, or • Real exchange rates have changed.

12. What causes interest rates change? • If the change in nominal interest rates is caused entirely by a change in inflationary expectations, real returns have not changed, and there is no reason for an asset shift toward assets denominated in the currency. The exchange rate will not change. • If the change in nominal rates is caused by a change in real interest rates, then real returns have changed, and investors will shift portfolios accordingly. The exchange rate will change.

13. Short-runDeterminants of Exchange Rates Expected Future Spot Exchange Rate

14. Process:Rise in Expected Exchange Rate • Domestic investors expect the future spot exchange rate to be higher than previously expected. (“Their expectations are adjusted upward.”) • They expect the foreign currency to appreciate more (equivalently, they expect the domestic currency to depreciate less). • If the interest-rate differential is the same, they expect a higher return on the exchange rate transaction “on the return trip” to the domestic currency. Thus they expect a higher total return based upon the appreciating currency. • Domestic investors adjust their portfolios toward the foreign-currency assets. • To do so, they must first buy the foreign currency to be able to buy the foreign-currency assets. • The demand for the foreign currency increases, and the spot exchange rate increases. (Foreign currency appreciates.)

15. What causes expectations changes? • Bandwagoning (Destabilizing) • Speculative bubbles • Belief in theories like PPP (Stabilizing) • News • Changes in gov’t policies • National or int’l economic news or data releases • Political news or events

16. Overshooting • Investors can react rationally to news in such a way as to drive the exchange rate past what they know to be it ultimate long-run equilibrium rate, and then slowly back to that rate later on. • That is, in the short run, the exchange rate actually overshoots its long-run value and then reverts back toward it.

17. Overshooting Sequence • There is a one-time (unexpected) increase of the money stock by 10%. • If PPP and the monetary approach are correct, this should mean that in the long run prices and the exchange rate should rise by 10%. • But prices are sticky, meaning that in the short run domestic prices do not rise relative to foreign prices. • Because prices do not rise, the nominal money supply increase amounts to a real money supply increase, and real interest rates fall. • With lower domestic interest rates, the interest rate differential shifts in favor of foreign-currency assets. The demand for foreign currency assets and foreign currency increases. • Because of PPP, investors also expect future spot exchange rates to rise as well. So investors seek the higher returns resulting from both the interest rate differential and the expect higher future spot exchange rates. • This (5 and 6) results in the current spot exchange rate rising by more than 10%. • As prices adjust and uncovered interest parity is restored, the exchange rate shifts back toward its longer-run equilibrium value.

18. Overshooting: Graphic 10% higher Original rs Time Time t0 when money supply unexpectedly rises by 10%

19. Short-term Prediction • In recent studies, like that by Frankel and Rose (1995), it appears that elaborate structural models are unable to predict any better than a naïve model. That is to say that structural economic models are useless for predicting short-run changes in exchange rates. • A naïve model is one in which the prediction is that the next period’s rate will be the same as the current period’s rate. (The current period’s rate is the best predictor of next period’s rate.) This is a random walk model.

20. Short-term Prediction (Continued) • Why are the results so poor? • Exchange rates react very strongly to news. • News, by definition, is random and unexpected. (Defies prediction) • Overshooting • Speculative Bubbles • Self-fulfilling expectations? • Trading based upon “technical models”

21. Reasons for Policies • Stabilization—reduce the variability in the exchange rates to encourage trade. • A government may want to keep the exchange value of its currency low to encourage exports and discourage imports. • In potentially inflationary periods, a government may want to keep the exchange value of its currency high to encourage imports and provide price competition designed to keep domestic prices in check. • A strong currency or steady exchange rate may be considered as a point of national pride.

22. Government Policies • Governments may adopt policies toward the foreign exchange market in two forms: • Policies toward the exchange rates themselves, and • Policies toward who is allowed to use the market, and for what purposes.

23. Policies Toward Exchange Rates • Choice of regime: • Flexible exchange rates • Pure float • Dirty/managed float • Fixed exchange rates • Degree and types of intervention

24. Polices that Restrict Access • No restrictions • Everyone is free to use the foreign exchange market. The country’s currency is fully convertible into foreign currency for all uses. • Exchange Controls • Restrictions on the use of foreign exchange. • Extreme forms include requiring that all foreign payments be turned over to the government. If anyone wants/needs “hard currency” they have to make a request to a gov’t authority. • Some controls involve allowing access to foreign exchange markets for some kinds of transactions but not others.

25. Capital Controls • One example of exchange controls is for the gov’t to allow use of foreign exchange for import-export, but not for payments related to financial activities. • Thus the currency is convertible for “current transactions” but not for “capital/financial” transactions. • There may be limits on int’l financial transactions, or special approvals required. • Hence these are referred to as capital controls.

26. Exchange Rate Regimes • We will discuss the various types of regimes in the discussion that follows: • Floating (Flexible) Exchange Rate • Pure (clean) float • Managed (dirty) float • Fixed Exchange Rate • Pegged exchange rate • Adjustable peg • Crawling peg • In reality, there is a spectrum of possibilities ranging from pure float to permanent fix.

27. Floating Exchange Rate • Pure or clean float: the government allows the market to determine the exchange rate. The exchange rate is allowed to go to its equilibrium, driven by private supply and demand, at all times. • Official intervention is the act of the monetary authority of a country entering the foreign exchange market with the intention of affecting supply and demand, and thus affecting the equilibrium value of the exchange rate—driving the rate to a different value that would occur by private supply and demand.

28. Floating Exchange Rate (Continued) • A managed or dirty float is an approach in which the government generally allows the exchange rates to float, but periodically chooses to intervene to influence the market rate. • Most governments adopting a floating exchange rate system do intervene and attempt to manage their rates to some extent. • Often such intervention (these days) is intended to stabilize the currency, reducing volatility or dampening short-run erratic movements in the exchange rate. Thus they “lean against the wind”.

29. Fixed Exchange Rates • Under a fixed exchange rate regime, the government sets the exchange rate it wants. • Some flexibility is allowed within a narrow trading range, called a band. • The official, chosen fixed rate is called the par value or central value.

30. Fixed Exchange Rates (Continued) • Design of a fixed exchange rate system requires answers to the following questions: • To what do you fix the value of the currency? • When or how often do you change the fixed value? • How do you defend the fixed value against market pressures?

31. Fixing the Value of the Currency • Fix to gold • This was the way it was done a century ago. • When all currencies are tied to the same commodity, they are all effectively tied to each other. • Fix to a “basket” of commodities (a commodity price index). • Fix to another currency—from WWII until 1970 the U.S. fixed its currency to gold and most other nations fixed their currency to the U.S. dollar. • Fix to a “basket” of currencies—takes advantage of averaging to reduce volatility and to insulate the currency.

32. Fixing to a Basket of Currencies • The Special Drawing Right (SDR) is one possibility for a fix. • It is a basket of the four major currencies of the world. • It is a reserve asset created by the International Monetary Fund (IMF) • As of 2002, the value of one SDR was: • US$0.577 • 0.426 euros • 21 Japanese yen • British £0.0984

33. Pegs • Permanent fix? • Pegged exchange rate—implies that the government probably will exercise its right, at some point(s), to “move” the peg. • Adjustable peg—implies that the gov’t will adjust the level of the peg as required in the face of substantial fundamental changes in the country’s international position.

34. Pegs (Continued) • Crawling peg • The exchange rate is changed often, but only by official revaluation. • Best of both worlds? Allows some degree of stability and control, as well as some degree of flexibility. • The peg move according to some set of indicators, or according to the gov’t monetary authority. • Central bankers set the rate much as the Fed changes the discount rate.

35. Four ways to Defend the Fix • Intervention, buying or selling in the foreign exchange market to influence the equilibrium spot exchange rate. • Exchange controls imposed by the gov’t restrict demand and/or supply. • Set domestic interest rates so as to influence short-term capital flows, thus influencing the exchange rate by changing the supply and demand in the market. • Macroeconomic adjustments (changes in fiscal or monetary policy) to influence supply and demand in the foreign exchange market.

36. Surrender • Of course the country can always give up and • Devalue or revalue its currency • Switch to a floating exchange rate and allow the exchange rate to go to the market equilibrium rate.

37. Defending the Fix--Intervention • Consider a country that is attempting to maintain a fixed rate of 25 pesos to the US dollar, with a band of ±4% (±1 peso). • The market is pushing the exchange rate above the top of its band (i.e., to 28 pesos per dollar). • The monetary authority in the country must enter the market and sell dollars and buy their own pesos.

38. Defending a Fixed Rate

39. Where does it get the dollars? • If it holds U.S. Treasury bonds as reserves, it sells the bonds on the international market in return for U.S. dollars. • If it holds assets denominated in, say, yen, it sells those assets for yen, and then trades the yen for dollars. • It may borrow the dollars from the IMF if it has a reserve position with the IMF. • It could sell gold or any other asset to raise dollars, or another currency tradable for dollars.

40. Swap Lines • The country may be able to borrow the dollars directly from the U.S. Federal Reserve. • It may have an agreement with the Fed to “swap” each other’s currencies on demand within certain parameters. • (The monetary authority may also borrow from private sources.)

41. Reserve Currency • Because the U.S. dollar is held by monetary authorities in most countries, the U.S. can effectively borrow by issuing bonds and notes and selling them to another monetary authority. This makes the financing of deficits: • Particularly easy • Less burden on the domestic economy

42. Sterilized Money? • If the monetary authority engages in exchange market intervention AND separately takes other actions (makes other transactions, etc.) to insulate the domestic economy from the foreign exchange transaction, this is called a sterilized intervention and the secondary domestic market transaction is called a sterilization. • An intervention may be sterilized or unsterilized.

43. Temporary Imbalances

44. Financing Temporary Imbalances • The monetary authority makes offsetting transactions during the periods of deficits and surpluses. • The monetary authority must ensure that private speculators do not see or cannot take advantage of the swings. • The monetary authority must forecast correctly and time its interventions well.

45. Financing Permanent Imbalances • What if the disequilibrium in the foreign exchange market is fundamental ? • Consider a case in which the country is facing continuing downward pressure on its currency. • The monetary authority must continually intervene to sell foreign currency to maintain its fix. • Eventually, the country will run out of reserves to sell and also run out of credit on which to borrow reserves. • Ultimately, it must devalue its currency.

46. And worse… • If private investors catch on, seeing the reserve losses in the monetary authority, speculation regarding a devaluation will ensue. • Speculators will sell domestic currency, requiring more intervention—they make things worse. • The monetary authority runs out of reserves or must devalue sooner.

47. Exchange Control Policies • According to the IMF, in 2001, about 78 developing countries had comprehensive exchange controls in place. • The controls included requirements related to • Export proceeds • Restrictions on payments for both current and capital transactions • About 40 countries had controls on capital transactions.

48. Exchange Controls (Continued) • Many countries: • Had persistent BOP deficits • Were defending a fixed exchange rate • Attempting to maintain that fix by restricting their residents’ ability to buy imports, travel abroad, or invest abroad. • Exchange controls operate similar to quotas, limiting imports by limiting the access to the currency with which to buy the imports.

49. Exchange Controls (Continued) • Besides the direct welfare costs to society, exchange controls have other effects: • Governments usually allocate the right to buy foreign currency according to complicated rules. • This creates high administrative costs and high private resource costs in dealing with the rules. • Governments also often allocate according to political pressures and not according to economic priorities, leading to economic inefficiencies.

50. Exchange Controls (Continued) • Additional costs (continued) • Predictably, people attempt to circumvent the controls. This leads to • Parallel or “black” markets • Government corruption and bribery