Currency Policy and Currency Crises

1. Currency Policy and Currency Crises

2. Learning Objectives • Revise BOP • Forex Markets: Fixed and Floating e-rates • Why care about e? • Current account & Competitiveness • Capital account & Interest rates • Currency Crises • Optimal Currency Areas

3. 1. The 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. • At its most basic just an accounting system • 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.

5. 2. 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 €i.ehow many $ per € • There is a one to one correspondence between the components of the BOP and the supply and demand for euros • Translate the “accounts” into “economics” • Explain the behaviour of each of the bits

6. Easier to if we think in terms of the Irish £ • Any export will create an international demand for Irish pounds • Foreigners need £ to buy Irish goods • Imports create a supply of Irish pounds • Irish people take £ to international markets • Similarly foreign deposits in Ireland or Irish deposits aboard create a demand for or supply of £ • Therefore BOP balance implies S=D

7. Floating Exchange Rate The supply and demand for euro determines e. “Floating exchange rate.” S e1 D € billions

8. Fixed vs Floating • In a certain trivial sense the BOP always balances • Supply equals demand • Current account surplus is counteracted by cap deficit and/or changes in reserves of CB • US vs China • For floating exchange rate this is achieved by the free market • E rate is such that S=D i.e. BOP=0 • For fixed exchange rates the CB makes up the difference

9. Fixed Exchange Rates • 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

10. Fixed e By co-incidence it is at market eqm. Not likely S e* D € billions

11. Fixed e Below market rate. CB print extra € and buy $ S e* D € billions

12. Fixed e E above market value. CB must buy € with $ S e* D € billions

13. 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

14. 3. Why care about e? • 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 • This would be very useful for Ireland during the current crisis: Think of Iceland

15. 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

16. LRAS p SRAS(pe) AD1 AD0 Y* Y

17. 4. Competitiveness • First step in explaining why BOP flows occur • Q: Why do people trade goods & services across borders? • Explaining the current account • A: Prices • Countries with cheaper prices will tend to have current account surpluses • Extra demand for their currencies • Appreciating currencies

18. 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?

19. 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.

21. 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

22. 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

23. 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

24. 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. • Leads to currency crises when doesn’t work!

25. Ireland’s Competitiveness • How expensive is Ireland? • 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

27. 2000

28. 2004

29. 5. Capital A/c & 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.

30. 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

31. 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

32. 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

33. 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

34. 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

35. UIP & 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 interest rates tend not to diverge between countries. • So as EMU comes closer interest rates will converge • Eastern Europe now • Current crisis interest differentials reflect default risk

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

38.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

39. 6. Currency Crises • Current & capital account effects interact to generate currency crises • UIP & Competitiveness • 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.

40. EMS Crisis 1992 • Background to EMS • Objective was 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?

41. 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 • Crisis of 92 contains some parallels with current crisis and some differences.

42. 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)

43. Germany 1992 LRAS p SRAS(pe) A B AD1 AD0 Y* Y

44. UK Reaction • German action shifted UK AD curve to left via UIP • UK in recession (A to B) • Obvious that a simple way to boost economy was to restore competitiveness by devaluing the currency (B back to A) • Also could wait for automatic adjustment mechanism to work (B to C) • Improve competitiveness by reducing prices

45. Speculators aware of all this • UK government unlikely to wait for B to C • Expect that gov will boost AD by devaluation and/or reduction in interest rates • 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 (UIP) • Conspiracy: George Soros moves the market

46. UK 1992 LRAS SRAS(pe) p A B AD0 C AD1 Y* Y

47. 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 government

48. Stg/DM E above market value. CB must buy £ with DM S e* D £ billions

49. Structure of the Crisis • Economy in recession with fixed e rate • Tempting to use devaluation to boost AD (competiveness) • Knowledge of this possibility pushes up interest rates (UIP) • Higher interest rates make recession worse • Spirals out of control • Will stop when the CB runs out of foreign currency to keep e rate fixed

50. 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.