FIN 40500: International Finance Exchange Rate Management

FIN 40500: International Finance

Exchange Rate Management

Exchange Rate Policy can be characterized along two dimensions

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Flexibility

Currency Union (Euro)

Hard Peg (China)

Pure Float (USA)

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With a hard peg, a currency’s price is held permanently at a fixed level. For example, the Chinese Yuan.

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Flexibility

$1 = 7.90Yuan

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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.

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Flexibility

$1 = 76 Dinare

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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Flexibility

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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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Flexibility

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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%

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Flexibility

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Jan-71 Jan-75 Jan-79 Jan-83 Jan-87

The Plaza Accord (1985) purposely devalued the dollar against the Yen and Deutschmark by 51%

The Louvre Accord (1987) ended the dollar devaluation policy of the plaza accord

USD/JPY

From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”). A pure float would have no such re-alignments.

Fixed Exchange Rate: This is simply a policy decision of the government or central bank and can be easily reversed (China).

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

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

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tPolicies can also vary by the degree of commitment to the policy

Exchange Rate Systems

5%

20%

24%

14%

10%

6% 21%

Pure Float

Managed Float

Crawling Peg orBandTarget Zone

Pure Peg

Currency Board

Dollarization

Currency Baskets Some countries choose to peg to a “basket” of currencies rather

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

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

currencies. The central bank has a wider choice of options for official

reserves

Costs/Benefits of Fixed Exchange Rates Main Benefit

Reduces uncertainty with regard to cross border trade in both goods and assets

Main Cost Eliminates a country’s ability to use monetary

policy for domestic objectives Full Employment High Output Growth Low Inflation

Liabilities Assets$ 10,000,000 (Currency) E 2,000,000 (Euro)

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

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 – Our ability to maintain the peg depends on our foreign exchange reserves.

If we are going to analyze the policy options, we need a

structured framework to proceed.

Long Run PPP holds Relative prices are

constant. Therefore, the real exchange rate equals one

The nominal exchange rate returns to its “fundamentals”

Short Run Commodity prices are

fixed (PPP fails) UIP and Currency

markets determine exchange rates

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

Domestic Money Market

PPP

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*** 1y

MiP

y

MiP 1

*ePP

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* 1

1

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Y

Y

M

Me

Foreign Money Market

This should give us the long run trend

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

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i

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Y

M

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Now, solve for M

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YMM

1

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We now have the US monetary policy rule

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

This is actually better expressed in percentage terms…

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Note: All else equal, money growth rates should be the same.

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

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

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

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

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

Suppose the Federal Reserve conducts an open market purchase of $1,000,000 in Treasuries to increase the money supply, what will the short run impact be?

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LM

0BOP

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

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


E 3,000,000 (ECB Bonds)

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

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

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

The Fed Conducts an open market purchase of Dollars

Suppose that the US Government runs a deficit (either spending increases or tax cuts) to stimulate the economy Increased spending increases the trade deficit Higher government debt raises the interest rate (this

attracts foreign capital)

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Can this policy be maintained under a currency peg system?

If capital mobility is sufficiently high, the increase in domestic interest rated creates sufficient capital inflow to finance the trade deficit. The dollar begins to appreciate

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KFACABOP

0BOP

The balance of payments surplus forces the dollar to appreciate in the short run.


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

X 1.30 $/E $ 6,500,000

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

+$1,000,000 (Euros)

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

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KFACABOP

0BOP

The balance of payments surplus forces the dollar to depreciate in the short run.

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


E 3,000,000 (ECB Bonds)

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

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

-$1,000,000 (Euros)

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

Fed avoid this monetary contraction?

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


E 3,000,000 (ECB Bonds)

- $1,000,000+ $1,000,000 E 5,000,000

X 1.30 $/E $ 6,500,000

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

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

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

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

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

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Reversal of capital flows causes the dollar to begin to depreciate. The US must correct this by buying dollars.

Note: This would contract the money supply – raising interest rates and lowering output.


E 3,000,000 (ECB Bonds)

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

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

-$1,000,000 (Euros)

The reserve ratio falls to 61% (5.5M/9M)

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

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

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Alternatively, if capital is mobile enough, the government could “bail out” the private companies – replacing private debt with public debt

This is risky…total indebtedness increase!!


E 1,000,000 (ECB Bonds)E 2,000,000

X 1.30 $/E $ 2,600,000

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

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

Foreign Reserves are dangerously low! What can we do?

The Fed could fix this problem by devaluing the dollar (i.e. raising the dollar price of Euro)

The drop in value would hopefully stop the selling The devaluation would also improve the Fed’s reserve position


E 1,000,000 (ECB Bonds)E 2,000,000

X 1.50 $/E $ 3,000,000

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

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

A devaluation from $1.30 to $1.50 helps

Speculation and “Peso Problems” Even a strong currency can become the

victim of a speculative attack. If the market believes that a currency might

devalue in the future, they will sell that country’s currency and assets.

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

Short Run Management Currency Pegs work well as long as times are

good A country can maintain an appreciating currency

forever Currency pegs are not terribly successful during

tough times You can’t maintain a depreciating currency forever –

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

economic conditions worse (tight 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 FloaterCommitted Pegger

Uncertain Pegger

Documents

FIN 40500: International Finance Exchange Rate Management