Exchange Rate Management

Exchange Rate Policy can be characterized along two dimensions Commitment Flexibility Currency Union (Euro) Hard Peg (Yuan) Target Zone (Bretton Woods)

Fixed Exchange Rates Time.1207 e 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 JanFebMarAprMay Flexibility

Fixed Exchange Rates Time.012 e 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 JanFebMarAprMay Flexibility

Fixed Exchange Rates Time e With an adjustable peg, the parity price is adjusted as circumstances warrant (monthly, weekly, etc). The Bretton Woods System was an adjustable peg JanFebMarAprMay Flexibility

Fixed Exchange Rates Time e 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 JanFebMarAprMay Flexibility

Target Zones Time e With a target zone, a currency’s price is held permanently between an upper and lower bound. The Bretton Woods system used 2% bands JanFebMarAprMay +2% -2% Flexibility

Floating Rates Floating rates allow the market to determine exchange values Floating rates allow the market to determine exchange values Managed (Dirty) Float: Central banks intervene periodically to correct fundamental misalignments (Russia, Singapore) Managed (Dirty) Float: Central banks intervene periodically to correct fundamental misalignments (Russia, Singapore) Pure Float: Central bank commits to zero currency interventions. (US, Europe) Pure Float: Central bank commits to zero currency interventions. (US, Europe) Flexibility

Commitment Policies can vary by the degree of commitment to the policy: Policies can vary by the degree of commitment to the policy: Fixed Exchange Rate: This is simply a policy decision of the government or central bank and can be easily reversed (China). 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) 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: foreign money replaces domestic money as official currency (Panama) Dollarization: foreign money replaces domestic money as official currency (Panama) Commitment

Exchange Rate Systems

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 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) Latvia: SDR (Euro, JPY, GBP, USD) Malta: Euro (67%), USD21%), GBP (12%) Malta: Euro (67%), USD21%), GBP (12%) Iceland: Euro + 6 other countries Iceland: Euro + 6 other countries Why peg to a basket? Why peg to a basket? Baskets or currency should exhibit less volatility that individual currencies. Baskets or currency should exhibit less volatility that individual currencies. The central bank has a wider choice for official reserves The central bank has a wider choice for official reserves

Currency Unions Currency unions are groups of countries who have agreed to share a common currency. They are usually share geographic borders and have highly integrated economic policies Currency unions are groups of countries who have agreed to share a common currency. They are usually share geographic borders and have highly integrated economic policies European Union (22 members in 2004): Euro European Union (22 members in 2004): Euro West African Economic and Monetary Union (7 countries): CFA Franc West African Economic and Monetary Union (7 countries): CFA Franc East Caribbean Monetary Union (8 countries): East Caribbean Dollar East Caribbean Monetary Union (8 countries): East Caribbean Dollar Gulf Cooperation Council Monetary Union Gulf Cooperation Council Monetary Union Unions Still in the Planning Stages Unions Still in the Planning Stages Central American Monetary Union Central American Monetary Union Asia Currency Union Asia Currency Union North American Monetary Union? North American Monetary Union?

Costs/Benefits of Fixed Exchange Rates Main Benefit Main Benefit Reduces uncertainty with regard to cross border trade in both goods and assets Reduces uncertainty with regard to cross border trade in both goods and assets Main Cost Main Cost Eliminates a country’s ability to use monetary policy for domestic objectives Eliminates a country’s ability to use monetary policy for domestic objectives

Internal vs. External Objectives Internal Objectives Internal Objectives Full Employment Full Employment High Output Growth High Output Growth Low Inflation Low Inflation External Objectives External Objectives Keep current account at “sustainable” levels. That is, current account deficits that are fully financed by willing capital inflows Keep current account at “sustainable” levels. That is, current account deficits that are fully financed by willing capital inflows

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

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) E 5,000,000 X 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

If we are going to analyze the policy options, we need a structured framework to proceed. Long Run PPP holds PPP holds Relative Prices are constant. Therefore, the real exchange rate equals one Relative Prices are constant. Therefore, the real exchange rate equals one The nominal exchange rate returns to its “fundamentals” The nominal exchange rate returns to its “fundamentals” Short Run Commodity prices are fixed (PPP fails) UIP and Currency markets determine exchange rates

Exchange Rate Fundamentals Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency Y* = M*(1+i*) P* Y = M(1+i) P Domestic Money MarketForeign Money Market PPP P = eP* Y M(1+i) = Y* eM*(1+i*)

Currency Fundamentals Taking the previous expression and solving for the exchange rate, we get Taking the previous expression and solving for the exchange rate, we get Y M (1+i) = Y* M*(1+i*) e Relative Money Stocks Relative Output Relative Interest Rates

Long Run Exchange Rate Management Y M (1+i) = Y* M*(1+i*) e The US is pegging at $1.30/Euro. This explicitly defines a monetary policy! Y M (1+i) = Y* M*(1+i*) 1.30 Y* (1+i*) = Y 1.3M* (1+i) M

Long Run Exchange Rate Management Y* (1+i*) = Y 1.3M* (1+i) M 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

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) E 5,000,000 X 1.30 $/E $ 6,500,000 $ 3,500,000 (T-Bills) $10,000,000 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* (1+i*) = Y 1.3M* (1+i) M 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!

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

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) + $1,000,000E 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) The Fed Conducts an open market purchase of T-Bills

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

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) + $1,000,000E 5,000,000 - $1,000,000 X 1.30 $/E $ 6,500,000 $ 6,500,000 $ 3,500,000 (T-Bills) $10,000,000 + $1,000,000 (T-Bills) - $1,000,000 (Euros) - $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

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

Fixed Exchange Rates and Fiscal Policy Suppose that the US Government runs a deficit (either spending increases or tax cuts) to stimulate the economy Suppose that the US Government runs a deficit (either spending increases or tax cuts) to stimulate the economy Increased spending increases the trade deficit Increased spending increases the trade deficit Higher government debt raises the interest rate (this attracts foreign capital) Higher government debt raises the interest rate (this attracts foreign capital)

Case #1: High Capital Mobility The increase in domestic interest rated creates sufficient capital inflow to finance the trade deficit. The dollar begins to appreciate The increase in domestic interest rated creates sufficient capital inflow to finance the trade deficit. The dollar begins to appreciate Trade Balance Interest Rate BOP Deficit BOP Surplus BOP = 0

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) + $1,000,000E 5,000,000 X 1.30 $/E X 1.30 $/E $ 6,500,000 $ 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

Case #2: Low Capital Mobility 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 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 Trade Balance Interest Rate BOP Deficit BOP Surplus BOP = 0

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) - $1,000,000E 5,000,000 X 1.30 $/E X 1.30 $/E $ 6,500,000 $ 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 The Fed Conducts an open market purchase of Dollars to maintain the peg with the Euro

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

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) - $1,000,000 + $1,000,000E 5,000,000 X 1.30 $/E X 1.30 $/E $ 6,500,000 $ 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

Fixed Exchange Rates BOP shocks Suppose that foreign investors view US debt as too risky? Suppose that foreign investors view US debt as too risky? Financial flows reverse, the US runs a BOP deficit requiring a purchase of dollars Financial flows reverse, the US runs a BOP deficit requiring a purchase of dollars Trade Balance Interest Rate BOP = 0

Liabilities Assets $ 10,000,000 (Currency)E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) - $1,000,000E 5,000,000 X 1.30 $/E X 1.30 $/E $ 6,500,000 $ 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 money supply contracts The Fed Conducts an open market purchase of dollars to stabilize the exchange rate

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

Liabilities Assets $ 6,100,000 (Currency)E 1,000,000 (Euro) E 1,000,000 (ECB Bonds) E 2,000,000 X 1.30 $/E X 1.30 $/E $ 2,600,000 $ 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!

Liabilities Assets $ 6,100,000 (Currency)E 1,000,000 (Euro) E 1,000,000 (ECB Bonds) E 2,000,000 X 1.50 $/E X 1.50 $/E $ 3,000,000 $ 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. 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. 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) 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 Currency Pegs work well as long as times are good A country can maintain an appreciating currency forever A country can maintain an appreciating currency forever Currency pegs are not terribly successful during tough times Currency pegs are not terribly successful during tough times You can’t maintain a depreciating currency forever – and markets know this! 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) 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 Floater Committed Pegger Uncertain Pegger