javier lozano 1 advanced applied macroeconomics economics of the exchange rate javier lozano...
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1Javier LozanoJavier Lozano
Advanced Applied MacroeconomicsAdvanced Applied Macroeconomics
Economics of the Exchange RateEconomics of the Exchange Rate
Javier Lozano
Universitat de les Illes Balears
Master and PhD programs in Tourism and Environmental Economics
University of the Balearic Islands
2Javier LozanoJavier Lozano
Learning objectives
• We shall study several topics on international macroeconomics.– How is the exchange rate determined?– Classification of exchange rate regimes– Main criteria for adoption of exchange rate regimes– Relationship between fiscal policy, monetary policy and ER– Sustainability of current account imbalances– Real world topics:
• EMS crisis (1992-1995)• Mexican crisis (1994)• Asian crisis (1997)• Argentina’s crisis (2001)• Current international imbalances
• Combination of macro theory, data analysis and readings.
3Javier LozanoJavier Lozano
Today’s session
• Basic definitions and motivation
• The Uncovered Interest Parity (UIP)
• Relationship between monetary policy and exchange rate
5Javier LozanoJavier Lozano
Definitions
• Exchange rate: relative price of two currencies. Relative value of assets denominated in different currencies
• $/€ €/$
• Flexible/fixed exchange rates
• Depreciation/appreciation
• Devaluation/revaluation
6Javier LozanoJavier Lozano
Motivation
• ERs play a key role in international transactions:– Goods & services: relative prices
(competitiveness)– Assets: rates of return
• ER is one of the main policy variables for open economies– Important for unemployment– Important for inflation
• International tourism
7Javier LozanoJavier Lozano
• Short-run: UIP
• Long-run: Purchasing Power Parity (PPP)
• Long-run: beyond PPP
Models of ER determination
9Javier LozanoJavier Lozano
Uncovered Interest Parity
Main determinants of ER in the short-run
International transactions
Goods and services (current account)
Assets (capital account)
Asset approach to ER determination
10Javier LozanoJavier Lozano
Uncovered Interest Parity
• With no restrictions to capital flows, two assets of the same liquidity and risk should yield the same return even if they are denominated in different currencies
t
te
t
E
EERR
€,/$
€,/$1€,/$€$
11Javier LozanoJavier Lozano
Uncovered Interest Parity
t
et
E
ERR
€,/$
1€,/$€$ 11
Every investor is willing to hold € deposits instead of $ deposits
$ depreciates against € (€ appreciates relative to $)
Equality is restored
12Javier LozanoJavier Lozano
Uncovered Interest Parity
t
te
t
E
EERR
€,/$
€,/$1€,/$€$
approximation
t
et
E
ERR
€,/$
1€,/$€$ 11 exact condition
13Javier LozanoJavier Lozano
Interest Rates in US and Mexico
0
10
20
30
40
50
60
70
80
90
100
USMexico
Source: IFS
14Javier LozanoJavier Lozano
Interest Rates in US and Argentina
0
10
20
30
40
50
60
70
80
Q41994
Q41995
Q41996
Q41997
Q41998
Q41999
Q42000
Q42001
Q42002
Q42003
USArgentina
Source: IFS
15Javier LozanoJavier Lozano
UIP: Graphical Representation
Rates of return in $ terms
E$/€
E2$/€
E1$/€
E3$/€
R$
Return on $ deposits (in $ terms)
Expected return on € deposits (in $ terms)
t
te
t
E
EER
€,/$
€,/$1€,/$€
16Javier LozanoJavier Lozano
UIP: Changes in own interest rate
Rates of return in $ terms
E$/€
E1$/€
R1$ R2
$
E2$/€
Increases in own interest rate tend to appreciate our
currency
17Javier LozanoJavier Lozano
UIP: Changes in foreign interest rate
Rates of return in $ terms
E$/€
R$
E1$/€
Increases in foreign interest
rate tend to depreciate our
currency
E2$/€
18Javier LozanoJavier Lozano
UIP: Changes in future ER expectations
Rates of return in $ terms
E$/€
R$
E1$/€
Increases in expected future
ER tend to depreciate our
currency
E2$/€
19Javier LozanoJavier Lozano
What determines previous changes? (looking ahead)
• What does determine interest rates?– We will mainly focus on monetary policy
• What does determine expected future ER? – Long-run model of ER determination (PPP)– Sustainability of current account deficits– Same UIP
20Javier LozanoJavier Lozano
UIP: modified version with risk premium
• Previous discussion have neglected differences in risk (perfect substitutability)
• Differences in risk comparing two individual assets
• Differences in risk comparing two countries:
-Polítical risk
-Sovereign risk The risk that a host government may unilaterally repudiate its foreign obligations or may prevent local firms from honoring their foreign obligations. Sovereign risk is often regarded as a subset of political risk.
The risk that political and/or governmental actions may unfavorably influence the value of an investment
21Javier LozanoJavier Lozano
UIP: modified version with risk premium
RPE
EERR
tP
tPe
tPP
$,/
$,/1$,/$
Consider P/$
22Javier LozanoJavier Lozano
Interest rates in US and Argentina
0
10
20
30
40
50
60
70
80Q
4 19
94
Q3
1995
Q2
1996
Q1
1997
Q4
1997
Q3
1998
Q2
1999
Q1
2000
Q4
2000
Q3
2001
Q2
2002
Q1
2003
Q4
2003
USArgentina (P)Argentina ($)
Source: IFS
RPE
EERR
tP
tPe
tPP
$,/
$,/1$,/$
RPRRP $
23Javier LozanoJavier Lozano
UIP: Changes in Risk Premium
EP/$
RP
E1P/$
Increase in risk premium tend to depreciate our
currencyE2
P/$
RPE
EER
t
te
t
€,/$
€,/$1€,/$€
25Javier LozanoJavier Lozano
Monetary Policy and the ER
• Monetary Policy
• Short run relationship between MP and ER
• Expected ER and expected interest rates
• Long run relationship between MP and ER– Money supply and prices– Prices and ER (PPP)
• Fiscal policy, monetary policy and the ER
27Javier LozanoJavier Lozano
What is money?
• Characteristics of money– Medium of exchange (liquidity)– Unit of account– Store of value
• Monetary assets– Currency (coins and notes)– Bank deposits on which checks may be written
M1
28Javier LozanoJavier Lozano
Money Market
• Money supply: determined by central bank
• Money demand: Md=P.L(R,Y)
• Money market equilibrium: – Ms=P.L(R,Y) (nominal terms)– Ms/P=L(R,Y) (real terms)
29Javier LozanoJavier Lozano
Money market equilibrium
Nominal interest rate
Real money supply and demand
Ms/P
L(R,Y)
R
30Javier LozanoJavier Lozano
Monetary Policy in Action: Expansionary MP
Nominal interest rate
Real money supply and demand
Ms1/P
L(R,Y)
R1
Ms2/P
Ms
R2
Assume:
-fix Y
-fix P(short term)
31Javier LozanoJavier Lozano
Monertary Policy in Action: Contractionary MP
Nominal interest rate
Real money supply and demand
Ms1/P
L(R,Y)
R1
Ms2/P
M
s
R2
Assume:
-fix Y
-fix P(short term)
32Javier LozanoJavier Lozano
Monetary Policy: Summary
• Expansionary (easy, loose) MP:– Increase of Ms (increase of Ms growth rate)– Decrease of R (of short term nominal interest
rate)
• Contractionary (tight) MP:– Reduction of Ms (reduction of Ms growth rate)– Increase of R (of short term nominal interest
rate)
33Javier LozanoJavier Lozano
Monetary Policy: Short and Long Run Effects
• We define:– Short run: fixed (sticky) prices– Long run: flexible prices
• Effects of monetary policy:– Short run: mostly on real output and
employment. Less in prices– Long run: no effect on output and employment.
Proportional variation in price level (money neutrality)
34Javier LozanoJavier Lozano
Monetary Policy: Short and Long Run Effects
P
Y
AD
AS (short run)
AS (long run)
easytight
Y
36Javier LozanoJavier Lozano
MP & ER in the short run: assumptions
• Fixed price (definition of short run)
• Fixed output (not necessary)
37Javier LozanoJavier Lozano
MP & ER in the short run: graphical rep.
0
incr
easi
ng
Ms2/P
E2$/€
Ms/P, L
Ms1/P
L
E$/€
E1$/€
Rates of return in $ terms
Expansionary MP causes ER
depreciation
38Javier LozanoJavier Lozano
MP & ER in the short run: graphical rep.
0
incr
easi
ng
Ms3/P
E3$/€
Ms/P, L
Ms1/P
L
E$/€
E1$/€
Rates of return in $ terms
Contractionary MP causes ER appreciation
39Javier LozanoJavier Lozano
MP & ER in the short run: impossible trinity
• It is not possible to meet the following three policy targets simultaneously:– Free capital mobility– Fixed exchange rate– Independent monetary policy
40Javier LozanoJavier Lozano
MP & ER in the short run: impossible trinity
• With free capital mobility (UIP holds) it is not possible to set RP (Ms) and EP/€ independently.
• Either:
– Set capital controls
– Let the ER change
– Subordinate MP to ER policy
Ms/P
EP/$
0
incr
easi
ng
Ms/P, L
L
EP/$
Ra. of ret. in Pesos
41Javier LozanoJavier Lozano
MP & ER in the short run: impossible trinity
Ms/P
EP/$
0
incr
easi
ng
Ms/P, L
L
EP/$
Ra. of ret. in Pesos
•Suppose we face an increase in risk premium or in foreign interest rate or depreciation
expectations emerge (fixed ER regime loses credibility)
•Fixed ER policy may be in conflict with other targets:
–Help economic recovery–Avoid high fiscal deficit
•Why want to keep ER fixed? (see later)
–Fight inflation (in case fall in foreign interest rates)
42Javier LozanoJavier Lozano
MP & ER in the s/r: complementary point of view
• Apart from Ms and R, the central bank has an apparently different instrument to control ER level: direct intervention in ER markets
If Mexican CB wants peso appreciation (wants to avoid
peso depreciation)
If Mexican CB wants peso depreciation (wants to avoid
peso appreciation)
buys pesos =sells $ assets
sells pesos=buys $ assets
Limited by $ reserves
Technically unlimited
(K&O, pp. 470-474)
43Javier LozanoJavier Lozano
MP & ER in the s/r: complementary point of view
• Are we really speaking about a different instrument?
buy pesos Ms RP Ep/$
UIP
sell pesos Ms RP Ep/$
(K&O, pp. 470-474)
44Javier LozanoJavier Lozano
MP & ER in the s/r: complementary point of view
• In principle it is possible to avoid effects of foreign exchange market intervention on monetary policy through the so called sterilized foreign-exchange interventionsterilized foreign-exchange intervention– This amounts to say that there is no “impossible
trinity”– In practice sterilization is not effective as a tool
for independent management of monetary policy and exchange rate policy
(K&O, pp. 470-474)
45Javier LozanoJavier Lozano
Interest Rates in US & Argentina and Foreign Exchange Reserves
0
10
20
30
40
50
60
70
80
0
5000
10000
15000
20000
25000
R$
Rp
Argentina'sforeignexchangereserves
Source: IFS
46Javier LozanoJavier Lozano
Interest Rates in US & Mexico and Foreign Exchange Reserves
0
10
20
30
40
50
60
70
80
90
100Q
1 19
90
Q2
1990
Q3
1990
Q4
1990
Q1
1991
Q2
1991
Q3
1991
Q4
1991
Q1
1992
Q2
1992
Q3
1992
Q4
1992
Q1
1993
Q2
1993
Q3
1993
Q4
1993
Q1
1994
Q2
1994
Q3
1994
Q4
1994
Q1
1995
Q2
1995
Q3
1995
Q4
1995
0
2
4
6
8
10
12
14
16
18
20
R$
Rp
mexican foreignexchange reserves
Source: IFS
48Javier LozanoJavier Lozano
Expected ER and Expected Interest Rate
• Relationship between MP and ER is more complex than explained before.
• Important assumption made before: expected ER independent from monetary policy.
• In fact, the expected ER depends on MP. For instance, expected ER depends on expected interest rates differentials (expected monetary policies)
49Javier LozanoJavier Lozano
Expected ER and Expected Interest Rate
et
t
tt E
R
RE 1€,/$
$,
€,€,/$ 1
1
ete
t
ete
t ER
RE 2€,/$
1$,
1€,1€,/$ 1
1
ete
tt
ett
t ERR
RRE 2€,/$
1$,$,
1€,€,€,/$ 11
11
50Javier LozanoJavier Lozano
Expected ER and Expected Interest Rate
• Effects of interest rates changes on ER depend on whether they are interpreted as permanent or temporary
• Statements by monetary authorities are signals of future interest rates and therefore affect ER.
• An increase in interest rate could trigger an ER depreciation if the increase is lower than expected (if monetary policy is less tight than expected)
52Javier LozanoJavier Lozano
Monetary Policy and ER in the long run
monetary policy prices exchange
rate
53Javier LozanoJavier Lozano
Monetary Policy and ER in the long run
• First it is important to remember that domestic and foreign prices, as well as nominal ER interplay in the determination of a country’s price-competitiveness
• The real exchange rate is a synthetic indicator of price-competitiveness:
q$/€=(E$/€xPEU)/PUS
• In principle real appreciation is “bad” for growth and employment (real depreciation “good” for growth and employment) (we will qualify this statement later)
54Javier LozanoJavier Lozano
Monetary Policy and the ERLong Run Relationship Money Supply and Prices
55Javier LozanoJavier Lozano
MP and ER in l/r: Money Supply & Prices
• We can reasonably assume that in the long run increases in money supply have no positive effect on real variables, only on prices Ms P
• This implies that money growth (in excess of real economic growth) will eventually end up in inflation
56Javier LozanoJavier Lozano
MP and ER in l/r: Money Supply & Prices
Relationship between money growth rate and inflation for some selected Latinamerican countries (1980-1990)
0%
200%
400%
600%
800%
1000%
1200%
1400%
1600%
0% 200% 400% 600% 800% 1000% 1200%
average annual money growth rate
ann
ual
infl
atio
n r
ate
Bolivia
Peru
Argentina
Brazil
MexVen
ParChile
Source: IFS
58Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER
• Law of one price (LOOP): prices of the same good sold in two different countries should be equal when they are expressed in the same currency Pi
US= PiEUxE$/€
• Purchasing Power Parity (PPP): given a basket of goods (let us say the basket used to calculate the CPI) sold in two different countries, the price of this basket, expressed in the same currency, should be equal PUS= PEUxE$/€
59Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER
•Absolute PPP:EU
US
P
PE €/$
•Relative PPP: EUUSt
tt
E
EE
1€,/$
1€,/$€,/$
(can be derived mathematically) Imply q does
not change!
60Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER
Countries: Austria, Australia, Belgium, Germany, Italy, Spain, United Kingdom, Greece, Kenya, Mexico, Zimbabwe, Bolivia, Brazil, Argentina, Chile, Colombia, Tanzania, Cameroon, South Africa
-20
-10
0
10
20
30
40
50
60
70
80
-20 -10 0 10 20 30 40 50 60 70 80
inflation minus US inflation in 1999
annual exchange r
ate
deprecia
tion/a
pprecia
tion a
gain
st
$
in 1
999
45º line
Source: WDI
PPP does not hold in the short run...
61Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER...but it may be a reasonable rule of thumb for long term movements of nominal ER... (see
comments on p. 93 in O&R paper)
-20
80
180
280
380
480
580
680
780
880
-20 80 180 280 380 480 580 680 780 880
average annual inflation during 82-99 minus US average annual inflation during same period
aver
age
annu
al E
R d
ep/a
p du
ring
82-
99
Countries: Austria, Australia, Belgium, Germany, Italy, Spain, United Kingdom, Greece, Kenya, Mexico, Zimbabwe, Bolivia, Brazil, Argentina, Chile, Colombia, Tanzania, Cameroon, South Africa
Source: WDI
45º line
62Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER...albeit not in all cases even in the long run.
yen/$ real exchange rate (1949=100)
0
20
40
60
80
100
120
140
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
Source: IFS
63Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER
• Reasons for deviations from the PPP are different in the short and in the long run.
• Short run: nominal factors (price stickiness or price inertia)
• Long run: real factors
64Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER
• An economy with high inflation adopts a fixed ER to support antiinflationary policy (reason seen later). Given price inertia, domestic inflation keeps at a higher level than foreign inflation. This results in real appreciation.
• Given a fixed ER, domestic agents expect devaluation. These expectations accelerate domestic inflation. If government do not devaluate, a real appreciation will take place (see Obstfeld and Rogoff’s paper, page 83)
• In these cases real appreciation is “bad” for the economy because of loss of price-competitiveness
Some Cases of Short Run Deviations from PPP (case of real appreciation)
65Javier LozanoJavier Lozano
MP and ER in l/r: Prices & ER
• Changes in world preferences that increase demand for products your country produces.
• Increases in the quality of your products.• Shift in sectoral specialization to sectors of higher
world demand.• These cases imply a “good” real appreciation:
the goods & services you produce are more expensive (relative to those of foreign competition) because they are more valued.
• (more of this in K&O pp. 396-412)
Some reasons for Long Run Deviations from PPP (case of real appreciation)
67Javier LozanoJavier Lozano
Fiscal Policy, Monetary Policy and the ER
• Historically in many cases (e.g. Latin America during the 80’s) monetary policy has been subordinated to the finance of public expenditure (fiscal deficit monetization). Monetization leads to high inflation (see slide 56) and high depreciation rates of the currency.
• A country that wants to maintain a fixed ER should avoid suspicions of future monetization (low deficits+CB independence) that could trigger devaluation expectations. This is specially true if the country has bad reputation because of past monetization.
68Javier LozanoJavier Lozano
Sustainability of current account deficitshttp://www.stern.nyu.edu/globalmacro/
Macro resources
Lectures in macroeconomics
Chapter 1 and 3
69Javier LozanoJavier Lozano
Sustainability of current account deficits
• Again, what determines future (expected) ER?– Future expected interest rates differentials– Inflation differentials– Current account imbalances
• How log can a country have a current account deficit (and of which magnitude)? What are the determinants of CA sustainability?
70Javier LozanoJavier Lozano
-10
-5
0
5
10
15
ArgentinaMexicoThailand
CA
def
icit
as
% o
f G
DP
Source: WDI
Sustainability of current account deficits
Mexican crisis
Argentinian crisisAsian
crisis
Relevant question since most ER crisis are preceded by large CA deficits and result in sharp CA corrections, suggesting that those
CA deficits were not sustainable.
71Javier LozanoJavier Lozano
Sustainability of current account deficits
Argentina
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
1997 1998 1999 2000 2001 2002 2003
-50
0
50
100
150
200
250
CA as % of GDP(left axis)
ER change in %(right axis)
Moreover, this sharp CA correction goes hand in hand with sharp currency depreciation
72Javier LozanoJavier Lozano
Sustainability of current account deficits
Mexico
-8
-7
-6
-5
-4
-3
-2
-1
0
1989 1990 1991 1992 1993 1994 1995
0
10
20
30
40
50
60
70
80
90
100
CA as % of GDP(left axis)
ER change in %(right axis)
73Javier LozanoJavier Lozano
Sustainability of current account deficits
Thailand
-10
-5
0
5
10
15
1992 1993 1994 1995 1996 1997 1998
-1
4
9
14
19
24
29
34
CA as % ofGDP (left axis)
ER change in% (right axis)
74Javier LozanoJavier Lozano
Sustainability of CA deficits: some national accounts identities
• GDP=C+I+G+NX
• GNP=C+I+G+NX+NFIA (1)
• CA=NX+NFIA– Brazil in 1986:
• NX=$8.3b
• CA=-$5.3b
• NFIA=-$13.6b
• GNP=S+C+T (2)
• (1)+(2)CA=(S-I)+(T-G) (3)(net flows of
assets from/to abroad)
75Javier LozanoJavier Lozano
Sustainability of CA deficits: asset transactions with ROW
CA=(S-I)+(T-G)>0lend CA=(S-I)+(T-G)<0borrow
GNP>C+I+G
You earn more income than you expend (you lend excess
income abroad)
You earn less income than you expend (you borrow
from abroad)
From (1)
GNP<C+I+G
A CA deficit implies an increasing foreign debt whereas a CA surplus implies a fall in foreign debt
76Javier LozanoJavier Lozano
Sustainability of current account deficits
• Previous slides suggest the following interpretation: an excessive dependence on foreign borrowing (high and persistent CA deficit) may undermine foreign investor’s confidence (higher risk of default). This tends to reduce capital inflows and causes a combination of higher interest rates to curb the fall in capital inflows and pressures of ER depreciation/devaluation (because lower demand of domestic assets, among other reasons). This situation may become unbearable and end up in a sharp CA correction and strong ER depreciation/devaluation.
• Therefore CA deficit may not be sustainable. This sustainability depends on the causes of CA deficit as well as on other aspects related to the country’s characteristics.
77Javier LozanoJavier Lozano
Sustainability of CA deficits: causes of CA deficit
• Increase in national investment– Similar to a firm, it is normal and a good option for a country to
borrow from abroad in order to finance a boom in investment. Returns from investment in the form of economic growth should allow the country to repay the debt (to increase exports in the future and generate the CA surplus needed for repayment) In this case the CA deficit is sustainable (e.g. US situation during second half of 90s)
– However, there could be exceptions to this general rule:• When investments are made in sectors that do not generate
exports, for instance, real state sector (residential and commercial building).
• When most of investments are of low profitability• In the case of the Asian crisis you can find both situations
78Javier LozanoJavier Lozano
Sustainability of CA deficits: causes of CA deficit
• Increase in public budget deficit– To borrow abroad for financing public budget deficit is
not necessarily a bad idea, it depends on public expenditure allocation. If public expenditure generates economic growth (for instance, expenditure in infrastructures) then no problem.
– However, historically this has not been the case. Many experiences of CA deficits caused by public budget deficits where public expenditure has not been growth-enhancing. E.g., case of many developing countries during 70s that end up in Debt Crisis of the 80s; US current situation (military expenditure).
79Javier LozanoJavier Lozano
Sustainability of CA deficits: causes of CA deficit
• Decrease in private domestic saving– Again, a CA deficit whose main cause is a fall
in private savings does not need to be worrisome. It may reflect increase in consumption fueled by expectations of future higher income (usual in economic expansion).
– However expectations may be overoptimistic. In this case the country may have problems for debt repayment and if foreign investors suspect this, they will stop financing CA deficit.
80Javier LozanoJavier Lozano
Sustainability of CA deficits: other important factors
• A country’s economic openness, measured as Exports/GDP may be important for CA deficit sustainability since a country’s ability to service its external debt depends on its ability to obtain foreign currency receipts through exports. Low openness could be bad for sustainability of CA deficit.
81Javier LozanoJavier Lozano
Sustainability of CA deficits: other important factors
• Composition of capital inflows– Foreign Direct Investment (FDI) vs. short-term
speculative capital flows (hot money)
– Official public institutions vs. private investors
– Currency composition of foreign liabilities • If most domestic agent’s foreign liabilities are denominated
in foreign currency then ER crisis (ER devaluation) may be very harmful for the real economy since domestic agents get revenues in local currency
82Javier LozanoJavier Lozano
US CA deficit: situation
-6,00%
-5,00%
-4,00%
-3,00%
-2,00%
-1,00%
0,00%
1,00%
-30,00%
-25,00%
-20,00%
-15,00%
-10,00%
-5,00%
0,00%
currentaccount (leftaxis)
net foreignliabilities(right axis)
Source: IFS(All data as share of US GDP)
83Javier LozanoJavier Lozano
US CA deficit: situation
-6,00%
-3,00%
0,00%
3,00%
6,00%
9,00%
12,00%
15,00%
18,00%
21,00%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
currentaccount
publicbudget
privatesavingminusinvestmentinvestment
privatesaving
Source: IFS(All data as share of US GDP)
84Javier LozanoJavier Lozano
US CA deficit: situation• Huge capital inflows relative to US economy and to global
markets...• ...but very low US interest rates! Why do investors want to
invest so much in US economy?!– Very low risk of default (sound economy)– $ is the most widely used currency for international transactions
(high liquidity)– High productivity growth in US makes FDI and equity
investment in US very profitable (OK for late 90s, not for now; currently there are net FDI outflows; most of capital inflows buy Treasury bonds)
– According to many analysts, the main reason behind this situation is Asian (especially China’s) export-led growth strategy.
85Javier LozanoJavier Lozano
US CA deficit: situation. Asian export-led strategy• Policy consisting of keeping your currency at a low value (with
respect to $) to boost exports and to help growth, industrialization and employment
• This policy requires that the Asian CB buys $ to support a high value of $ relative to their local currencies (another reason for buying $ is to build foreign exchange reserves to avoid another Asian Crisis)
• For Asian countries this policy has two disadvantages and one risk :– It implies to imitate US monetary policy, that has been until now
quite expansionary. This is causing inflationary pressures in Asian countries.
– For most of Asian countries (except for Japan) domestic interest rates are higher than in US so for Asian central banks buying $ assets instead of assets denominated in local currency has an opportunity cost.
– Asian CB are taking the risk of capital losses if $ depreciates
86Javier LozanoJavier Lozano
US CA deficit: sustainability• Is this situation stable?• Dooley, Folkerts-Landau and Garber say yes because the
situation is in the interest of both Asian countries and the US:– China needs to follow this policy in order to industrialize the
country and reallocate underemployed from rural and public sector. Inconveniences stated before are minor.
– Other Asian countries (South Korea, India...) will not let their currencies appreciate against China’s currency.
– US obtains cheap (low interests) financing. Inconveniences (low price-competitiveness against Asian imports) are minor.
– For them this is the birth of BWII
87Javier LozanoJavier Lozano
US CA deficit: sustainability• Roubini, Setser and The Economist say no.• Main reason is based on the classical prisoners’ dilemma:
– If all Asian CB keep on buying $, the $ will not appreciate so Asian CB will not experience capital losses. Then each Asian CB has incentives to keep on buying $ as long as the others do the same.
– However, if you as a CB expect for this situation to be unsustainable (that is, you expect for the $ to depreciate a lot) then you have strong incentives to be the first to sell your $ before the $ depreciation takes place (if you sell too late, you will have to sell too cheap)
– Given that this “Asian cartel” is not a formal one, there are not institutions to solve this coordination problem, so these free-riding incentives will make the situation collapse sooner or later, specially because growth in external US debt increases risks of $ depreciation.
88Javier LozanoJavier Lozano
US CA deficit: sustainability• Finally, which are the threats for the global
economy that stem from this situation?– € appreciation against $ probably exacerbated by
Asian fixed ER against $ (bad for EU price-competitiveness; good for EU antiinflationary policy because oil not so expensive)
– A sharp fall in US capital inflows may increase US interest rates and consequently ROW interest rates.
– The increase in interest rates may slow US and ROW economic growth.
– Since ROW has many $ assets, sharp $ depreciation will reduce ROW wealth and then consumption and growth.
90Javier LozanoJavier Lozano
Reasons for choosing a fixed ER1. To reduce ER volatility: ER volatility increase
uncertainty in international transactions. This discourages trade and long-term investment (e.g., European Monetary Union)
2. To help antiinflationary policy through two channels:2.1. Discipline: let us consider a country with high inflation
fueled by loose monetary policy (may be because of monetization). A fixed ER puts a constraint on undisciplined monetary policy (because of UIP arguments and/or because of PPP arguments)
2.2. Credibility: let us consider a country that truly wants to stop inflation through monetary policy tightening. In this case, the short-term effects on growth and employment of antiinflationary monetary policy will be more harmful the lower is the credibility of the announced policy.
91Javier LozanoJavier Lozano
c
c= short-run Phillips curve if
anttinflationary MP credible
Reasons for choosing a fixed ER (Credibility)
Unemployment
Inflationa= long-run Phillips
curve
U*
Current inflation
a
b= short-run Phillips curve if
anttinflationary MP not credible
b
recession
Targeted inflation
92Javier LozanoJavier Lozano
Reasons for choosing a fixed ER (Credibility)
• To peg the ER to a currency of a country of low inflation may help to reduce inflationary expectations and this way to reduce negative effects of antiinflationary monetary policy. (ER acts as a nominal anchor)
• ER pegging is not the only device for making antiinflationary policy credible. Another way is CB independence.
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Inconveniences of fixed ER
• Finally, an important disadvantage of fixed ER is that you lose monetary policy for stabilization policy.
• This is important if you suffer from asymmetric shocks. For instance, suppose that you have pegged your currency to $. Then you experience a negative shock but the US not. You would like to loose your MP but since the US does not like and you have to mimic US MP, then you cannot.