The International Financial System and Monetary Policy

1. The International Financial System and Monetary Policy Chapter 22

2. Fixed Exchange Rates and Feedback • Hong Kong has a de facto interest rate target equal to US interest rates (minus expected appreciation rate). • This means that there is no direct feedback between HK inflation and HK interest rates. • Credibility tends to be pro-cyclical. • When economy is booming there are sometimes expectations of future appreciation, interest rates fall. • When economy is slumping there are sometimes expectations of future depreciation, interest rates rise.

3. Zero Interest Rate Lower Bound • There is a lower bound on the interest rate in money markets equal to zero since there is always an asset available that pays at least a zero interest rate (i.e. currency) savers will not accept negative interest rates on their deposits. • Demand curve for money becomes horizontal at zero. • Savers will hold as much money as is supplied at zero interest rate.

4. Increase in Money Demand(Money Target) MS i MD’ MD M

5. Japanese Interest Rate

6. Monetary Policy • Beyond some point, monetary policy will cease to have an effect on the economy. • To stimulate economy, Japan has adopted a zero interest policy in the call money rate and additionally a quantitative easing policy to buy stocks and foreign exchange to stimulate economy through other channels. • By increasing the money supply, the central bank hopes to increase inflationary expectations and reduce real interest rates. (it = 0 = rt + πt+1)

7. Japanese Money Supply

8. Monetary Policy in China Features • Chinese currency, Renminbi, has long had a fixed exchange rate with the US dollar. • Since May, 2005 RMB allowed to float within a very narrow range • China maintains currency controls, so interest rates in China differ from US. • If Chinese savers could get a better return on their investments in the US, they are forbidden by law from

9. China’s Exchange Rate • Chinese exports have been increasing rapidly. Foreign purchasers want Renminbi to buy Chinese goods. This would put upward pressure on Renminbi exchange rate. To keep foreign exchange rate stable, the central bank sells RMB and buys HK$.

10. Foreign Reserves in China

11. Sterilized Intervention • Sterilized intervention occurs when the central bank engages in a foreign exchange market intervention combined with an offsetting open market operation which leaves the monetary base unchanged. • When the government conducts a foreign currency intervention but maintains a fixed interest rate target, defensive transactions will automatically sterilize. • Sterilized interventions will not affect the domestic interest rate. However, they may create a very liquid currency market which temporarily affects the exchange rate. • Most empirical studies find that sterilized interventions have little effect on exchange rates in even the medium run.

12. Sterilized Foreign Currency Purchase/Open Market Sale Sterilized Foreign Currency Sale/Open Market Purchase T-Accounts: Sterilized Intervention

13. Rapid Money Growth (in 5 years money supply has tripled)

14. Money Base growth has been relatively slow. Money multiplier has been increasing.

15. Central Bank and Interest Rates • Central Bank operates a discount window and lends money directly to banks in the interbank market. • Central bank maintains interbank lending rate target • People’s Bank of China also directly sets base deposit rate and base lending rate of the big 4 banks.

16. Interest Rates have been very stable

17. Increase in Money Demand/ Interest Rate Target i MS MS’ i* MD’ MD M

18. Interest Rate Policy • Central Bank has increased money supply in response to increased money demand at given interest rates. Not an attempt to push down interest rates. • Central bank does not raise interest rate to stabilize the economy. • Possible reason: Banks aren’t effective at allocating credit. Raising interest rates may have adverse selection effects.

19. Exchange Rates • Currency board/Convertibility Undertaking in Hong Kong is a systematic monetary policy which targets a particular level of the exchange rate at a permanent level. • Monetary policy of many neighboring economies often are targeted toward changing the exchange rate. • Reason: Prices of goods in domestic currencies are sticky, so changes in the exchange rate will (in the short run) change the relative prices of domestic exports and foreign imports.

20. Terms • Depreciation: A reduction in the value of exchange rate under a monetary policy in which exchange rate is not the target. • Appreciation: An increase in the value of exchange rate. • Devaluation: A reduction in the value of exchange rate under a fixed exchange rate regime. • Revaluation: An increase in the value of the exchange rate.

21. Uncovered Interest Parity • The central equation for thinking about the exchange rate will be uncovered interest parity. • Define the domestic currency returns from investing in foreign bonds as • Uncovered Interest Parity indicates that • UIP is 1 equation and 4 variables. It can only determine the exchange rate if we take the others as given.

22. Exchange Market 1+R 1+RF EX EX* Return

23. Exchange Market • We have treated domestic and foreign interest rates as well as the future exchange rates as exogenous. We can examine the effects of changes in each of these on the current exchange rate. • Because we are treating the future exchange rate as a given, we can only consider the effects of temporary changes in interest rates (because we are by definition analyzing temporary changes in the economy).

24. FAQ • Q: Why is the domestic currency returns from investing in foreign currency bonds increasing in the exchange rate? • A: The greater is the current exchange rate, the more foreign currency you can buy with each unit of domestic currency. Holding the future exchange rate constant, this will be associated with higher returns.

25. Equilibrium Interest Rate • If exchange rate is above EX*, investors can gain more funds if they buy foreign currency bonds. In order to buy foreign currency bonds, they must sell their domestic currency to buy foreign currency. This will drive down the price of domestic currency. • If exchange rate is below EX*, investors will sell foreign currency driving up the price of domestic currency.

26. Rise in Foreign Interest Rates 1+RF EX EX* EX** Return

27. Rise in Domestic Interest Rates 1+i EX 1+RF EX** EX* Return

28. Foreign Exchange Rate Intervention • Purchase of Foreign Currency increases the monetary base. • An increase in the monetary base (combined with the money multiplier) will increase the money supply. • An increase in the money supply will (with fixed money demand) lead to a decline in domestic interest rates. • A decline in the interest rate leads to a decline in equilibrium exchange rates. • Putting more domestic currency on the market reduces the value of the domestic currency.

29. History of Exchange Rate Regimes • Prior to World War I: Metal Standard • Interwar Period: Return to Gold Standard with less credibility. • 1945:1971 Bretton Woods System. Most economy’s fix the exchange rate relative to the US$. • 1979: European Monetary System. European economies link their exchange rates relative to one another. In 1998, a new currency the Euro was created.

30. Fixed Exchange Rate Regimes • When central banks choose a monetary policy of a fixed exchange rate, they must engage in foreign currency interventions to maintain that level. • When foreign interest rates rise, the central bank must sell foreign currency to reduce the domestic monetary base. • This will raise domestic interest rates and keep the exchange rate stable. • Convertibility Undertaking in HK makes this automatic.

31. Rise in Foreign Interest Rates/Exchange Rate Target 1+RF EX EX* Return

32. Foreign Reserves • To depreciate the exchange rate using foreign exchange market intervention the central bank must buy foreign currency with domestic currency. Central bank has an infinite amount of domestic currency. • To appreciate the exchange rate using foreign exchange market intervention the central bank must sell foreign currency to buy domestic currency. Central bank has a finite amount of foreign currency. • It may be impossible to buy enough domestic currency to stabilize the exchange rates if they run out of foreign reserves. • Stabilizing the exchange rate may destabilize the interest rates.