exchange rate management. exchange rate policy can be characterized along two dimensions commitment...

Exchange Rate Exchange Rate ManagementManagement

Exchange Rate Policy can be Exchange Rate Policy can be characterized along two characterized along two dimensionsdimensions

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Flexibility

Currency Union (Euro)

Hard Peg (Yuan)

Target Zone (Bretton Woods)

Fixed Exchange RatesFixed Exchange Rates

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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

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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

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

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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

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Target ZonesTarget Zones

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

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+2%

-2%

Flexibility

Floating RatesFloating Rates

Floating rates allow the market to Floating rates allow the market to determine exchange valuesdetermine exchange values Managed (Dirty) Float: Central banks Managed (Dirty) Float: Central banks

intervene periodically to correct intervene periodically to correct fundamental misalignments (Russia, fundamental misalignments (Russia, Singapore)Singapore)

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

Flexibility

CommitmentCommitment Policies can vary by the degree of Policies can vary by the degree of

commitment to the policy:commitment to the policy: Fixed Exchange Rate: This is simply a policy Fixed Exchange Rate: This is simply a policy

decision of the government or central bank decision of the government or central bank and can be easily reversed (China).and can be easily reversed (China).

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

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

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Exchange Rate SystemsExchange Rate Systems

24%

14%

10%

6% 21%

5%

20%

Pure Float

Managed Float

Crawling Peg orBandTarget Zone

Pure Peg

Currency Board

Dollarization

Currency BasketsCurrency Baskets

Some countries choose to peg to a “basket” of Some countries choose to peg to a “basket” of currencies rather that a single currency. This currencies rather that a single currency. This basket will have a price equal to a weighted basket will have a price equal to a weighted average of the individual currenciesaverage of the individual currencies Latvia: SDR (Euro, JPY, GBP, USD)Latvia: SDR (Euro, JPY, GBP, USD) Malta: Euro (67%), USD21%), GBP (12%)Malta: Euro (67%), USD21%), GBP (12%) Iceland: Euro + 6 other countriesIceland: Euro + 6 other countries

Why peg to a basket?Why peg to a basket? Baskets or currency should exhibit less volatility that Baskets or currency should exhibit less volatility that

individual currencies.individual currencies. The central bank has a wider choice for official reservesThe central bank has a wider choice for official reserves

Currency UnionsCurrency Unions Currency unions are groups of countries who have agreed Currency unions are groups of countries who have agreed

to share a common currency. They are usually share to share a common currency. They are usually share geographic borders and have highly integrated economic geographic borders and have highly integrated economic policiespolicies European Union (22 members in 2004): EuroEuropean Union (22 members in 2004): Euro West African Economic and Monetary Union (7 West African Economic and Monetary Union (7

countries): CFA Franccountries): CFA Franc East Caribbean Monetary Union (8 countries): East East Caribbean Monetary Union (8 countries): East

Caribbean DollarCaribbean Dollar Gulf Cooperation Council Monetary Union Gulf Cooperation Council Monetary Union

Unions Still in the Planning StagesUnions Still in the Planning Stages Central American Monetary UnionCentral American Monetary Union Asia Currency UnionAsia Currency Union North American Monetary Union?North American Monetary Union?

Costs/Benefits of Fixed Costs/Benefits of Fixed Exchange RatesExchange Rates

Main BenefitMain Benefit Reduces uncertainty with regard to Reduces uncertainty with regard to

cross border trade in both goods and cross border trade in both goods and assetsassets

Main CostMain Cost Eliminates a country’s ability to use Eliminates a country’s ability to use

monetary policy for domestic monetary policy for domestic objectivesobjectives

Internal vs. External Internal vs. External ObjectivesObjectives

Internal ObjectivesInternal Objectives Full EmploymentFull Employment High Output GrowthHigh Output Growth Low InflationLow Inflation

External ObjectivesExternal Objectives Keep current account at “sustainable” Keep current account at “sustainable”

levels. That is, current account levels. That is, current account deficits that are fully financed by deficits that are fully financed by willing capital inflowswilling capital inflows

Fixed Exchange Rates & Fixed Exchange Rates & Monetary PolicyMonetary Policy

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

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

E 3,000,000 (ECB E 3,000,000 (ECB Bonds)Bonds)

E 5,000,000E 5,000,000X 1.30 $/EX 1.30 $/E$ 6,500,000$ 6,500,000$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

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

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

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

Long RunLong Run PPP holds PPP holds Relative Prices are Relative Prices are

constant. Therefore, constant. Therefore, the real exchange the real exchange rate equals onerate equals one

The nominal The nominal exchange rate exchange rate returns to its returns to its “fundamentals”“fundamentals”

Short Run Short Run Commodity prices Commodity prices

are fixed (PPP fails)are fixed (PPP fails) UIP and Currency UIP and Currency

markets determine markets determine exchange ratesexchange rates

Exchange Rate Exchange Rate FundamentalsFundamentals

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

Y*= M*(1+i*)P*

Y= M (1+i)P

Domestic Money Market Foreign Money Market

PPP

P = eP*

YM (1+i) =

Y*eM*(1+i*)

Currency FundamentalsCurrency Fundamentals Taking the previous expression and solving for Taking the previous expression and solving for

the exchange rate, we getthe exchange rate, we get

YYMM (1+i)(1+i)

== Y*Y*M*M* (1+i*)(1+i*)ee

Relative Money Stocks

Relative Output

Relative Interest Rates

Long Run Exchange Rate Long Run Exchange Rate ManagementManagement

YYMM (1+i)(1+i)

== Y*Y*M*M* (1+i*)(1+i*)ee

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

YYMM (1+i)(1+i)

== Y*Y*M*M* (1+i*)(1+i*)1.301.30

Y*Y*(1+i*)(1+i*)

== YY1.3M*1.3M* (1+i)(1+i)MM

Long Run Exchange Rate Long Run Exchange Rate ManagementManagement

Y*Y*(1+i*)(1+i*)

== YY1.3M*1.3M* (1+i)(1+i)MM

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



E 5,000,000E 5,000,000X 1.30 $/EX 1.30 $/E$ 6,500,000$ 6,500,000$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

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

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)

+ $300,000 (Currency)

+ $300,000 (T-Bills)

Y*Y*(1+i*)(1+i*)

== YY1.3M*1.3M* (1+i)(1+i)MM

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

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!

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

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 ManagementShort Run Management

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



+ $1,000,000+ $1,000,000 E 5,000,000E 5,000,000X 1.30 $/EX 1.30 $/E$ 6,500,000$ 6,500,000$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

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

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

The Fed Conducts an open market purchase of T-Bills

A Monetary ExpansionA Monetary Expansion

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

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



+ $1,000,000+ $1,000,000 E 5,000,000E 5,000,000- - $1,000,000$1,000,000 X 1.30 $/EX 1.30 $/E

$ 6,500,000$ 6,500,000$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000+ $1,000,000 (T-Bills)+ $1,000,000 (T-Bills) - $1,000,000 (Euros)- $1,000,000 (Euros)

The reserve ratio drops to 55% (5.5M/10M)The reserve ratio drops to 55% (5.5M/10M)Note: The money supply returns to $10MNote: The money supply returns to $10M

The Fed Conducts an open market purchase of Dollars

Fixed Exchange Rates & Fixed Exchange Rates & Money SupplyMoney Supply

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

Fixed Exchange Rates and Fixed Exchange Rates and Fiscal PolicyFiscal Policy

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

deficitdeficit Higher government debt raises the Higher government debt raises the

interest rate (this attracts foreign interest rate (this attracts foreign capital)capital)

Case #1: High Capital Case #1: High Capital MobilityMobility

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

Trade Balance

Interest Rate

BOP Deficit

BOP Surplus BOP = 0



+ $1,000,000+ $1,000,000 E 5,000,000E 5,000,000 X 1.30 $/EX 1.30 $/E $ 6,500,000$ 6,500,000

$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

+$1,000,000 (Euros)+$1,000,000 (Euros)

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

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

Case #2: Low Capital MobilityCase #2: Low Capital Mobility

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

Trade Balance

Interest Rate

BOP Deficit

BOP Surplus

BOP = 0



- $1,000,000- $1,000,000 E 5,000,000E 5,000,000 X 1.30 $/EX 1.30 $/E $ 6,500,000$ 6,500,000

$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

-$1,000,000 (Euros)-$1,000,000 (Euros)

The reserve ratio falls to 61% (5.5M/9M)The reserve ratio falls to 61% (5.5M/9M)The purchase of dollars contracts the money supply

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

SterilizationSterilization

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


E 3,000,000 (ECB Bonds)E 3,000,000 (ECB Bonds)- $1,000,000$1,000,000+ $1,000,000+ $1,000,000 E 5,000,000E 5,000,000

X 1.30 $/EX 1.30 $/E $ 6,500,000$ 6,500,000$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

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

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

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

Fixed Exchange Rates BOP Fixed Exchange Rates BOP shocksshocks

Suppose that foreign investors view US debt as Suppose that foreign investors view US debt as too risky?too risky? Financial flows reverse, the US runs a BOP deficit Financial flows reverse, the US runs a BOP deficit

requiring a purchase of dollarsrequiring a purchase of dollars

Trade Balance

Interest Rate

BOP = 0



- $1,000,000$1,000,000 E 5,000,000E 5,000,000 X 1.30 $/EX 1.30 $/E $ 6,500,000$ 6,500,000

$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$10,000,000$10,000,000

-$1,000,000 (Euros)-$1,000,000 (Euros)

The reserve ratio falls to 61% (5.5M/9M)The reserve ratio falls to 61% (5.5M/9M)The money supply contractsThe money supply contracts

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

DevaluationsDevaluations

Suppose that, due to repeated attempts to Suppose that, due to repeated attempts to defend the dollar, Fed reserves of Euro are defend the dollar, Fed reserves of Euro are running low. The Fed could fix this problem by running low. The Fed could fix this problem by devaluing the dollar (i.e. raising the dollar devaluing the dollar (i.e. raising the dollar price of Euro)price of Euro) The drop in value would hopefully stop the selling The drop in value would hopefully stop the selling The devaluation would also improve the Fed’s The devaluation would also improve the Fed’s

reserve positionreserve position



E 2,000,000E 2,000,000 X 1.30 $/EX 1.30 $/E $ 2,600,000$ 2,600,000

$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$6,100,000$6,100,000

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

Foreign Reserves are dangerously low!



E 2,000,000E 2,000,000 X 1.50 $/EX 1.50 $/E $ 3,000,000$ 3,000,000

$ 3,500,000 (T-Bills)$ 3,500,000 (T-Bills)$6,500,000$6,500,000

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

A devaluation from $1.30 to $1.50 helps

Speculation and “Peso Speculation and “Peso Problems”Problems”

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

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

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

Short Run ManagementShort Run Management

Currency Pegs work well as long as Currency Pegs work well as long as times are goodtimes are good A country can maintain an appreciating A country can maintain an appreciating

currency forevercurrency forever Currency pegs are not terribly Currency pegs are not terribly

successful during tough timessuccessful during tough times You can’t maintain a depreciating currency You can’t maintain a depreciating currency

forever – and markets know this!forever – and markets know this! A peg forces you to follow policies that tend A peg forces you to follow policies that tend

to make economic conditions worse (tight to make economic conditions worse (tight money, balanced government budgets)money, balanced government budgets)

“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?”

Pearls of wisdom from “The Karate Kid”

Committed Floater

Committed Pegger

Uncertain Pegger

exchange rate management. exchange rate policy can be characterized along two dimensions commitment...

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