Exchange-Rate Policy & the Central Bank

1. Exchange-Rate Policy & the Central Bank Chapter 19

2. Exchange Rates are Volatile

4. Costs of Volatile Exchange Rates • Exchange rate volatility increases risk in international finance. Ex. Many developing economy corporates issue securities in US$. An exchange rate devaluation will make this more expensive to repay. • Exchange rate volatility increases risk in international trade. Ex. Some multinationals earn profits in foreign currency. A revaluation will reduce the domestic currency value of those profits. Ex. Changes in exchange rates will change the relative competiveness of exports and imports.

5. Exchange Rates • Exchange Rate: E- # of domestic currency units purchased for 1 US$. • An increase in E is a depreciation of domestic currency and a decrease in Eis an appreciation.

6. Interest Parity

7. Saving It is January 1st, and you have D$1000 to save for 1 year. You can put it into: • a domestic currency bank account at an interest rate i. • a foreign currency bank account at interest rate iF.

8. Payoff to strategy #2 • Strategy two has three parts. • Buy foreign exchange at spot rate Etto get {D$1000/Et} F dollars. • Put {D$1000/St} F dollars into F bank account. After 1 year get F$(1+iF)×{D$1000/Et } • Convert these funds into F$ at exchange rate prevailing at end of year.

9. Uncovered Interest Parity • If , deposit funds then deposit in F$ account. • If , deposit funds then deposit in D$ account. • Then in equilibrium

10. Interest Rate Parity • The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rates would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. • Approximately

11. Three Reasons UIRP might not hold • Future exchange rates are risky, uncovered interest parity does not account for risk. • Interest Parity Works for Forward Prices Forward Price for currency delivered at t+1 • Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons. • Currency controls

12. Midterm Exam • Tuesday, October 21, 2012, 1:30-1:50, LTG • Bring writing materials and calculator. • Coverage: Money, Central Banks, Interest Rates, Exchange Rates (through Thursday). • Semi-open book: Bring 1 A4 size piece of paper with handwritten notes on both sides.

13. Supply and Demand Model

14. Why do exchange rates change? • Relative values of two currency determined by supply and demand by traders of the two currencies. Unlike textbook, we will describe a model of domestic country’s forex market in which US$ is vehicle currency • Price of US$:E is the price of US$ in terms of DCU. Link

15. From Interest Parity • People trade currencies to engage in foreign trade and international investment. • Expected (Investment) Profit: • Of Domestic Investors in Foreign Economy • Of Foreign Investors in Domestic Economy

16. Supply and Demand in Forex Mkt E Excess Supply Supply E* Excess Demand Demand Forex Turnover

17. Equilibrium in the Forex Market • Gap between supply and demand of US$ is the Balance of Payments. • Two types of Forex Markets • Floating: Forces of supply and demand equilibrate markets. • Fixed: Gov’t/Central Bank buys excess foreign currency in market.

18. Difference w/ Textbook • Textbook version examines US dollar forex market from US perspectives. • We focus on market from more international perspective. • Supply of US $ liquidity in local forex market is not exogenous.

19. Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods E Supply Supply' ⓪ E* Domestic Currency Appreciates E** ① Demand

20. Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods E Domestic Currency Depreciates E** ① E* ⓪ Demand ' Supply Demand

21. Foreign Interest Rates Go UpRelative Demand for F$ Goes Up E ① E** Domestic Currency Depreciates E* ⓪ Supply' Demand ' Supply Demand

22. Why are exchange rates so volatile • Exchange rates are volatile because they are based on expectations. • Expectations of future exchange rates determine demand for forex today. • Waves of optimism and pessimism of future of currency affects currency today.

23. Expectation of Et+1Increases E 2 E** Domestic Currency Depreciates E** 1 Supply' Demand ' Supply Demand

24. D.C. Interest Rates Go UpRelative Demand for US$ Goes Down E Supply Supply' ⓪ Domestic Currency Appreciates E* E** Demand ① Demand '

25. Foreign Currency Purchase, D.C. Interest Rates Go Down. Relative Demand for US$ Goes Up E ① E** Domestic Currency Depreciates E* ⓪ Supply' Demand ' Supply Demand

26. Model of the Exchange Rate • Examine UIRP on a logarithmic scale

27. Monetary Policy Transmission Mechanism • A rise in policy interest rates will raise money market rates which will lead to forex appreciation. This will raise price of domestic export goods reducing demand. • A cut in policy rates will reduce money market rates leading to forex depreciation improving competitiveness of exports increasing demand. The impact of monetary policy will affect demand through an external channel in a way that parallels the effects through the internal channel.

28. Exchange Rate Passthrough • Inflation targeting focuses on price stability in consumer goods. • In most small and medium economies, substantial share of imported goods in consumer goods. • Exchange rate depreciations make imported goods more expensive and can be inflationary. Raising interest rates in the face of depreciation will stabilize exchange rates and inflation. • Exchange rate depreciations make imported goods more expensive and can be inflationary. Raising interest rates in the face of depreciation will stabilize exchange rates and inflation.

29. Price Stability and Exchange Rates • Lower interest rates will be associated with weakening currencies on average … but… exchange rate movements are volatile and unpredictable. • Even central banks that target price stability intervene in forex markets to stabilize volatile exchange rates. • Is this consistent with inflation targeting nominal anchor?

30. T-Accounts: Unsterilized Intervention • UnSterilized Foreign Currency Purchase • UnSterilized Foreign Currency Sale

31. Forex Intervention • Unsterilized intervention –Gov’t uses open market operations to purchase (sell) foreign currency. Changes level of bank reserves, domestic liquidity, interest rates. • Sterilized interventions – Use domestic funds financed by bill issuance or long-term borrowing to purchase foreign currency.

32. Unsterilized Intervention Central Bank Buys Foreign Reserves & Increases Reserves Increases liquidity in interbank market and pushes down interest rates. . D iIBR i* i** Clearing Balances

33. Three Situations OK • Forex Intervention Aids Price Stability Goal: Large share of consumer goods are imported in Asian emerging markets and exchange rates factor into that price. • Forex Intervention Does Not Conflict with Inflation Target: When inflation is within the target range, exchange rate stability may work as an auxiliary goal.

34. Swiss Monetary Policy • Swiss Inflation Target: 0-2% • Peg: 1.2 SwF to 1 Euro. • Consistent?

35. Monetary Policy & Exchange Rates • The central impact of the foreign currency intervention is on domestic interest rates. • Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves. • Monetary policy that does not shift interest rates will not shift exchange rates.

36. What do you do if? • Forex Intervention Conflicts with the Target. • If inflation near top of the range, then forex intervention that weakens the currency will be inflationary and violate credibility of inflation target. • If inflation near bottom of the range, then forex intervention that strengthens the currency will violate target credibility

37. T-Accounts: Sterilized Intervention • Sterilized Foreign Currency Purchase/ Issue non-monetary liabilities • Sterilized Foreign Currency Sale/ Open Market Purchase

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

39. South Korean authorities are back in the local foreign-exchange market, checking the won’s gains after staying fairly quiet for several months, traders in Seoul say. The Bank of Korea is suspected to have bought dollars near the day’s low of 1,031.40 won and again towards the end of local trading hours, around the 1,040 won level, according to three Seoul-based currency traders. Two traders estimated the central bank may have bought more than $500 million worth of the U.S. currency to slow the Korean won’s gains Thursday. This would be the second day in a row that traders suspect the central bank has intervened to cool the won.  Link

41. Effectiveness of Sterilized Intervention • Sterilized Intervention may work by signaling future monetary policy intentions. • Sterilized purchase of foreign currency increases relative supply of domestic currency assets & puts downward pressure on exchange rates. • In developed financial markets, shift of relative assets would be too small to impact forex rates. • Evidence suggests that in some emerging markets, sterilization can have some effect on exchange rates.

42. Evidence from Latin American intervention Link • Regression of appreciation or first difference on forex intervention (share of GDP). Sterilized intervention can slow the rate of exchange rate movements but not overall changes!

43. Fixed Exchange Rate

44. Link Fixed Exchange Rates

45. Fixed Exchange Rate: Weakside Currency Target Gov’t Buys Excess Supply US$ E Supply ETGT Demand Forex Turnover

46. Fixed Exchange Rate: Strongside Currency Target E Supply ETGT Demand Gov’t Buys Excess DCU Forex Turnover

47. Exchange Rate Depreciation • Exchange Rate: S - # of domestic currency units purchased for 1 US$. • An increase in S is a depreciation and a decrease in S is an appreciation. • Depreciation Rate

48. If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then . If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high. i = iF Fixed Exchange Rate

50. Hong Kong’s Unique Monetary Institutions “Guide to Hong Kong Monetary and Banking Terms” by HKMA.seehttp://www.hkma.gov.hk