1. Forex Economics 285 Fall 2000

2. Exchange rates Current rate is ¥107 per US dollar –Depreciation of yen means more ¥ per $ At ¥107, an item costing ¥107,000 is US$1,000 At ¥214 that item costs only US$500 –Appreciation means fewer ¥ per $ In the mid-1980s, the rate was ¥240 The yen peaked at ¥80 in 1995

3. Impact of ¥ appreciation Query: what happens to Nissan’s exports? What brand TVs do Japanese buy? What happens to GDP? Y = C + I + G + X - M What happens to Japanese life insurers who bought US Treasuries & real estate? ¥240 x $50 bil = ¥12 trillion becomes ¥4 trillion

4. Pegs Fixed exchange rates Trade dollars (baht) at a fixed rate (B22.0=$1) Choice of pegs Single currency (e.g., US$) Basket (e.g., by % of trade against ¥, $, E) Government must be able to control Supply dollars to meet demand or Make holding baht more attractive to attract dollars / shift S&D If the rate is really fixed, where do you borrow? Query: can you have an independent monetary policy?

5. Dynamics Under a fixed rate –What happens with inflation? Example: Prices double B22 per shirt to B44 How does the price change in US$? What happens to exports? Imports? –What happens to reserves?

6. Exchange rate pressure How keep from running out of reserves –Raise interest rates? –Slow domestic demand? –Supply more dollars? Requires being able to borrow dollars But who will loan? The IMF!!

7. Thailand In July 1997 the Thai Baht fell 50% What happens to the number of baht a Thai bank would need to repay a US$ loan? Thai banks were rendered insolvent in one night! So should they use a crawling peg? Adjust for inflation? Adjust for shifts in ¥/$ rate, since Japan is a major market

8. Japan’s case Under the Dodge Plan, the yen was fixed in 1949 at ¥360 = $1 Modest inflation and rapid growth produced chronic trade deficits When Japan began running out of US$ they slowed domestic demand rather than depreciating their currency The tool? - raise interest rates!

9. But raise interest rates? Yes, because capital controls didn’t let people freely buy / sell yen So in the 1997 currency crisis, Malaysia imposed capital controls and avoided the full brunt of the crisis

10. How to use a hedge fund When you see a country in trouble: Borrow lots of baht Use it to buy US$ Wait! If you’re lucky The exchange rate collapses You buy back baht on the cheap Overnight profit $100 mil gives $50 mil profit

11. Liberalization However for Japan accession to the OECD in 1964 required that they gradually remove capital controls Process largely completed in 1980 Residual controls remained until 1998 –34 years, start to finish! –But what happened to the yen?

12. Response to US inflation Bretton Woods collapsed in 1971 ¥360 to ¥308 How respond? –Lower interest rates –Increase fiscal expenditures Tanaka Kakuei’s Rebuilding the Japanese Archipelago –Don’t “sterilize”

13. Bottom line Double-digit inflation in mid-1973 Then the oil crisis hit! Deep doo-doo