1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich

2 Lecture 9: October 13 Ch. 15, 16

3 Fixed Exchange Rates: Policy Effectiveness B. of C. committed to maintaining value of exchange rate Consider case:  If B. of C. commitment to fixed exchange rate credible  [E*(e) – E*]/E* = 0 B. of C. loses control over R – any attempt to change R with no change in values of other variables, will impact E* Covered interest rate parity model: –R(C) = R(US) +  since B. of C. considered credible –If   R(C)  –M determined by need to maintain R(C) = R(US) +  and E* fixed –Monetary policy loses effectiveness with fixed exchange rates

4 Fixed Exchange Rates: Policy Effectiveness B. of C. committed to maintaining value of exchange rate Consider case:  Traditional D/S model  in D for C$,  in S of C$ –In absence of intervention, C$ depreciates in value (E  ) –To keep exchange rate constant, B. of C. either  M   R or intervenes directly and buys C$ (sells foreign assets) –Consider direct intervention: requirement for foreign asset reserves Problem: can B. of C. persist in buying C$? Traders expect depreciation, so  S of C$  compounds problem for B. of C.

5 E Q(C$) D for C$: exports S of C$: imports Direct Intervention: Sell foreign assets E0E0 SD

6 Fixed Exchange Rates Speculative attacks –Reserves –No-lose bets: short the exchange rate, short debt –Soros and UK pounds in early 1990s Loans in foreign currency (US$, Euro, Yen) –Forced devaluation – domestic currency costs of loan interest and principal payments increase –Default – problems for domestic banks

7 Flexible Exchange Rates Independent monetary policy – not constrained by need to keep exchange rate fixed at particular level –Fiscal policy ineffective Expansionary policy  R   E  EX and  IM   aggregate demand Combination of higher interest rates and appreciation of C$ neutralize expansionary effects of fiscal policy Ignoring effects on P and repercussions on aggregate D Degree of independence –US  M to stimulate economy and reduce UR (Canadian policy-makers likely to have same objective) US actions will lead to appreciation of C$ (  in US GDP   Canadian CU; and  R(US)   Canadian CA); which will reduce positive spillover effect from US Flexible rates will require B. of C. to follow lead of US Federal Reserve

8 Flexible Exchange Rates Automatic stabilizer –Increase in rate of inflation in US R(C) = R(US) + [E*(e)-E*]/E* +  [E*(e)-E*]/E* = %  E*(e) = %  P(C) - %  P(US) Assume %  P(C) = %  P(US) = %  P(D) =  initially  %  E*(e) = 0 Now assume %  P(US)   %  E*(e) < 0  E*  (appreciation) P(C) = P(D) [P(US)E*] 1-  %  P(C) = %  P(D) + (1- )[%  P(US) + %  E*(e)] %  P(C) =  If %  P(US)   %  E*   offsetting impact on %  P(C) –With fixed exchange rates If %  P(US)   %  P(C) 

9 Exchange Rate Crises Hot money – sudden changes in expectations result in sharp swings in exchange rates and/or interest rates –Carry trade: borrow in low interest rate country and invest in high interest rate country with expectation of stable exchange rates Momentum – herd effects compound initial impacts Overshooting – exchange rates and/or interest rates move beyond reasonable levels of equilibrium (problem: determining equilibrium positions) Weak countries vulnerable – low reserves, absence of independent central bank, highly dependent on capital inflows, monetization of debt, TB deficit

10 Dollarization Problems with flexible exchange rates –Effectiveness of independent monetary policy –Trade costs –Competitiveness –Demand for bail-outs –Instability of foreign exchange markets: tendency to overshoot –78.5% appreciation in 5 years Problems with Dollarization –Loss of independent m.p. –Loss of automatic stabilizer –Economic performance and sovereignty

11 Diversification Risk reduction –Same expected return, lower risk for portfolio –Higher expected return, same degree of risk –Risk aversion Risks: –Default –Price variability –Exchange rate –Imperfect information Insurance markets – financial and non-financial risks: –Spread risks: re-insurance, insurance pools –Pooling of risks: insurance pools –Derivatives

12 Offshore Banking and Eurocurrencies Offshore banking –Business conducted by the foreign branches, subsidiaries of a bank outside the home country of the bank Eurocurrencies –Bank deposits denominated in a currency other than the domestic currency of the country in which the bank or its foreign operations reside Offshore currencies Typical Eurocurrency deposit is non-negotiable time deposit with fixed term to maturity ranging from overnight to 5+ years US$ deposits in a bank in Canada (Canadian, US, other) – part of Eurodollars – Eurodollars: US $ deposits in banks outside US C$ deposits in a bank outside of Canada (Canadian, other) –Eurobanks: banks that trade in market for Eurocurrencies – take deposits, make loans Most Eurocurrency trading occurs in non-European centers

13 Eurocurrencies Euro-deposit rates – 3 months 08/26/0908/24/0807/14/08 U.S.0.30%5.48%2.81% Canada Euro Yen Pound

Euro Deposit Rates Today 3-month rates: US: 0.33% Canada: 0.73% Euro: -0.01% Yen: 0.10% Pound: 0.67% Swiss Franc: -0.58% 14

15 Rapid Growth of International Banking Reduction in trade costs  growth in international trade –Hedging currency risks Liberalization of capital markets –Growth of MNEs – banks have followed corporate customers abroad Circumvent restrictive domestic government regulations on financial activity – reserve requirements, interest rate ceilings, deposit insurance Political factors – desire by some depositors to hold currencies outside jurisdiction of countries that issue them – freezing accounts Money laundering – drugs, arms sales, bribes, other criminal activities