Understanding Foreign Exchange Interventions & Capital Controls

2. Foreign Exchange Intervention and the Monetary Base For-ex market intervention: central bank deliberate action to influence exchange rate. International reserves: central bank foreign currency assets for internat. transactions. To ↑/↓ for-ex value of $ Fed ↑/↓ demand for $ dollars by selling/buying foreign assets & buying/selling $. Such transactions also affect domestic monetary base. Unsterilized for-ex intervention when monetary base allowed to freely responds. Ex: To ↓ for-ex value of $ Fed buys $1B worth of foreign securities w/ check or cash. Because monetary base = currency in circulation + bank reserves, either transaction ↑ monetary base by the amount of foreign assets (international reserves) purchased. U. Ex: To ↑ for-ex value of $ Fed sells $1B worth of foreign securities & ↓ monetary base. Sterilized foreign exchange intervention keeps monetary base = w/ offsetting open market operations. Ex: Fed’s sale of $1B of foreign securities combined w/ open market purchase of $1B T-bills keeps monetary base the same.

3. For-Ex Intervention and Exchange Rate Sterilized For-ex Intervention affects neither monetary base (or domestic interest %) nor demand & supply for $ (or exchange rate). Only Unsterilized For-ex Intervention affects exchange rate. Raising Exchange Rate Lowering Exchange Rate Fed sells short-term ¥ government securities => US monetary base ↓ & interest % ↑. Demand for $ shifts right (D1→D2) & supply of $ shifts left (S2←S1). Equilibrium exchange rate ↑ (E1→E2). Fed buys short-term ¥ government securities => US monetary base ↑ & interest % ↓. Demand for $ shifts left & (D2←D1)supply of $ shifts right (S1→S2). Equilibrium exchange rate ↓ (E1→E2).

4. The Bank of Japan Counters the Rising Yen In late 2012, exchange rate dropped below ¥78 = $1. Bank of Japan acted to ↓ ¥ value. a. Is ¥ stronger if it takes more ¥ to buy $1? Why strong currency hurt exports? $ is weaker & ¥ is stronger if it takes fewer ¥ to buy $1. When ¥ ↑ Japanese exporters can ↑ $ prices (& ↓ sales) or keep $ prices = (& ↓ profits). b. What is monetary easing? Would Bank of Japan widen gap between ¥ & $ interest % to ↓ ¥? Use graph of market for ¥ in exchange for $. Monetary easing is expansionarymonetary policy ( ↓ interest %).↓ ¥ interest % ↑ demand for $ (= supply of ¥) & ↓ demand for ¥ (= supply of $) => ↓ S$/¥. c. Could Bank of Japan reduce value ¥ by buying $ assets, leaving interest rates =? If Bank of Japan uses sterilized intervention (combine open market sale in Japan w/ US T-bills purchases), Japanese interest rates remains = & value of ¥ remains =.

5. Foreign Exchange Interventions and the Exchange Rate Capital Controls Some currency crises in emerging market countries have been fueled in part by sharp capital inflows and capital outflows, leading some economists and policymakers to advocate restrictions on capital mobility. Capital controls are government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets. Capital controls have significant problems: • Government corruption is often a result of investors having to receive permission from the government to exchange domestic currency for foreign currency. • Multinational firms will have difficulty returning any profits they earn to their home countries if they can’t exchange domestic currency for foreign currency. • In practice, individuals and firms resort to a black market where currency traders are willing to illegally exchange domestic currency for foreign currency.

6. The Balance of Payments Measures flows of private & government funds between home & all foreign countries. Inflows/outflows from/to foreigners are receipts/payments, recorded as positive/negative. Purchases & sales of goods & services are in current account (includes trade balance). International lending or borrowing are in fin account (including official settlements). Current account balance + Fin account balance = 0. Large US current account deficits (partially due to global “saving glut” & high saving rates w/ limited investment opportunities abroad, foreign funds flowed into US ↑ $ => ↓/↑ US exports/imports further ↑ deficit) caused US to rely heavily on foreign borrowing. Fin account balance = capital inflows - capital outflows + net capital account transactions (mainly debt forgiveness & transfers of fin assets by migrants) Large statistical discrepancies ($80.6B capital inflow in 2011) reflect hidden capital flows (illegal activity, tax evasion or capital flight). Central banks hold official reserve assets(historically gold, now government securities, foreign bank deposits & SDRs) to settle BOP or conducting international monetary policy. Official settlements = net increase (domestic - foreign holdings) in official reserve assets. US BOP deficit paid from official reserves & ↑ in $ assets held by foreign central banks.

7. Foreign Exchange Regimes & International Fin System Exchange-rate regime: system for adjusting for-ex rates & flows of goods & capital. Fixed exchange rate system: for-ex rates determined & maintained by government. Gold standard (fixed exchange rate system) under which participating currencies convertible into agreed-upon amount of gold. Automatic price-specie-flow mechanism causes exchange rates to reflect underlying gold content of countries’ currencies. Example of a gold standard operation: ↑ in relative demand for US goods (vs French) puts upward pressure on exchange rate. Gold flows from France to US, ↓/↑ French/US monetary base, ↑ in US relative to French inflation makes French goods more attractive restoring trade balance & exchange rate. Under gold standard, unexpected & pronounced deflation (↑ real value of households’ & firms’ nominal debts causing fin distress for many econ sectors) caused recessions. W/ fixed exchange rates countries had little control over domestic monetary policies: Gold flows from international trade caused changes in monetary base. Gold discoveries & production also strongly influenced world money supply, making the situation worse.

8. Did the Gold Standard Make the Great Depression Worse? When Great Depression began in 1929, governments under pressure to abandon gold standard. It collapsed by late 1930s. To remain on gold standard, central banks often had to take actions that contracted production & employment rather than expanding it. Fed attempted to stem gold outflows by ↑ discount % & making fin investments in US more attractive to foreign investors. Higher interest % were opposite of lower % needed to stimulate economy. Devastating econ performance of countries that stayed on gold standard the longest is the key reason policymakers did not try to bring back gold standard.

9. Adapting Fixed Exchange Rates: The Bretton Woods System Countries pledged to trade currencies at fixed rates against $ & hence among them (& US pledged to convert $ into gold at $35 per ounce if foreign central banks requested it to - $ was international reserve currency) lasted 1945-1971. Central bank intervened in for-ex market to maintained fixed exchange rates by trading its own currency. Ability of country w/ BOP deficit to buy its own currency (to ↑ its value versus $) limited by its international reserves. After exhausting international reserves central bank had to implement restrictive economic policies (e.g. ↑ interest %) . IMF established by Bretton Woods to administer a system of fixed exchange rates & serves as a lender of last resort to countries undergoing balance-of-payments problems. Headquartered in DC grew from 29 member countries in 1945 to 188 in 2012. IMF encourages econ policies consistent w/ stable exchange rate, gathers international econ & fin data to monitor member countries. No longer maintains fixed exchange rates, but it has grown as an international lender of last resort. Currency overvalued/undervalued versus $ could devalue/revalue w/ IMF agreement. In practice governments did it only in response to severe imbalances in for-ex . Investors believing government was unable to maintain exchange rate, profit by selling/buying weak/strong currency in speculative attacks forcing devaluation or revaluation when central bank was unable or unwilling to defend exchange rate.

10. The Speculative Attacks On British Pound Equilibrium exchange rate E1 < fixed exchange rate £ = $2.80. To defend overvalued £ Bank of England had to buy surplus pounds (Q2 – Q1) w/ international reserves. Speculators convinced that £ would devalue caused supply of pounds to shift (S1→S2) ↑ overvaluation. On Deutsche Mark & Collapse of Bretton Woods Bundesbank tried to maintain low inflation w/ undervalued Deutsche mark. Defending fixed exchange rate was inflationary because buying $ ↑ monetary base. Revaluation would avoid inflation but would undermine the Bretton Woods. Speculators bought DM w/ $, expecting ↑ in DM. On May 5, 1971, Bundesbank purchased > $1B but stop for inflation fear. DM began to float, its value determined solely by demand and supply.

11. Central Bank Interventions after Bretton Woods Flexible exchange rate system: currency value determined in for-ex market. Central banks may intervene if currency is significantly under or overvalued. Managed (dirty) float regime: central banks occasionally intervene. Central banks lose some control over money supply when intervene for-ex market. To ↑ exchange rate or depreciate home currency, central bank sells international reserves & buys home currency => ↓ monetary base. The Case of $ $ still represents majority of international reserves today & unlikely to lose dominance. Many believe US will suffer if $ loses its reserve currency status: • US households & businesses might be unable to trade & borrow in $ around the world (which ↓ transactions costs & exposure to exchange rate risk). • Foreigners’ willingness to hold $ is windfall (foreigners providing interest-free loan). • $’s reserve currency status makes foreigners more willing to hold Treasuries ↓ COC. • NY’s role as leading international financial capital might be jeopardized.

12. Fixed Exchange Rates in Europe Fixed exchange rates reduce costs of uncertainty about exchange rates. Commitment to fixed exchange rate is implicit commitment to controlling inflation. Members of European Monetary System agreed to limit currency fluctuations against each other & to maintain currency values w/i range set by European Currency Unit. In 1989 ECB (main objective inflation) formed to conduct monetary policy & control €. In 1992 European Community countries moved toward European Monetary Union & fixed their exchange rates by using euro as common currency. In 1999 11 countries met budget deficit, inflation & interest % conditions for € (no currency conversion, exchange rate risk & econ of scale ↑ production efficiency). EC countries much < harmonized, > econ, politically & culturally diverse than US. With € Greece can ↑ competitiveness by ↓ real exchange rate through internal devaluation by deflation. However, ↓ wages & prices would led to political unrest. Drachma depreciation ↑ export competitiveness, but heavy losses fore bank deposits. Potential sovereign debt default would cause spending ↓ & tax ↓ => depression. Harder to borrowing from foreign lenders objecting to drachmas. Leaving the euro would make people in Greece worse off in the short run, but it would raise its competitiveness with foreign firms in the long run.

13. Currency Pegging Keep exchange rate fixed versus another currency for fixed exchange rate advantages (↓ exchange rate risk, inflation control & protecting foreign currencies loan takers). Problems if equilibrium & pegged exchange rate significantly ≠. During 1990s East Asian currency crisis overvalued currencies couldn’t defend speculative attacks. In 1994, Chinese pegged yuan at 8.28 yuan to $1. Many argued yuan undervalued. Between July 2005 & July 2008 China allowed yuan to ↑ against $ before returning to hard peg at about 6.83 yuan to $. In mid-2010, President Obama argued “market-determined exchange rates are essential to global economic activity.”Chinese central bank allowed yuan to change based on movements in other currencies. Through late 2010, value of yuan ↑ slowly against $.