FIN 40500: International Finance

FIN 40500: International Finance Exchange Rate Management

Exchange Rate Policy can be characterized along two dimensions Currency Union (Euro) Commitment Hard Peg (China) Pure Float (USA) Flexibility

With a hard peg,a currency’s price is held permanently at a fixed level. For example, the Chinese Yuan. Flexibility .1265 $1 = 7.90Yuan Jan Feb Mar Apr May

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. Flexibility $1 = 76 Dinar .012 Jan Feb Mar Apr May

With an adjustable peg,the parity price is adjusted as circumstances warrant (monthly, weekly, etc). The Bretton Woods System was an adjustable peg Flexibility Jan Feb Mar Apr May

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 Flexibility Jan Feb Mar Apr May

With a target zone,a currency’s price is held permanently between an upper and lower bound. The Bretton Woods system used 2% bands Flexibility +2% -2% Jan Feb Mar Apr May

From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”). A pure float would have no such re-alignments. Flexibility USD/JPY The Plaza Accord (1985)purposely devalued the dollar against the Yen and Deutschmark by 51% The Louvre Accord (1987)ended the dollar devaluation policy of the plaza accord

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

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

Suppose that the US decides to peg to the Euro at a price of $1.30 per Euro – Our ability to maintain the peg depends on our foreign exchange reserves. LiabilitiesAssets $ 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)

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

Foreign Money Market Domestic Money Market Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency PPP This should give us the long run trend

The US is pegging at $1.30/Euro. This explicitly defines a monetary policy! Now, solve for M We now have the US monetary policy rule

This is actually better expressed in percentage terms… Note: All else equal, money growth rates should be the same. 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

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!

You need to choose a currency regime that is compatible in the long run with your economic fundamentals Jan Feb Mar Apr May 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

Suppose the Federal Reserve conducts an open market purchase of $1,000,000 in Treasuries to increase the money supply, what will the short run impact be? LiabilitiesAssets $ 10,000,000 (Currency) E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) + $1,000,000 E 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 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

The Fed Conducts an open market purchase of Dollars LiabilitiesAssets $ 10,000,000 (Currency) E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) + $1,000,000 E 5,000,000 - $1,000,000X 1.30 $/E $ 6,500,000 $ 3,500,000 (T-Bills) $10,000,000 + $1,000,000 (T-Bills) - $1,000,000 (Euros) The reserve ratio drops to 55% (5.5M/10M) Note: The money supply returns to $10M

Suppose that the US Government runs a deficit (either spending increases or tax cuts) to stimulate the economy • Increased spending increases the trade deficit • Higher government debt raises the interest rate (this attracts foreign capital) Can this policy be maintained under a currency peg system?

If capital mobility is sufficiently high, the increase in domestic interest rated creates sufficient capital inflow to finance the trade deficit. The dollar begins to appreciate The balance of payments surplus forces the dollar to appreciate in the short run.

The Fed Conducts an open market sale of Dollars to maintain the peg with the Euro LiabilitiesAssets $ 10,000,000 (Currency) E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) + $1,000,000 E 5,000,000 X 1.30 $/E $ 6,500,000 $ 3,500,000 (T-Bills) $10,000,000 +$1,000,000 (Euros) The reserve ratio rises to 68% (7.5M/11M)

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 The balance of payments surplus forces the dollar to depreciate in the short run.

The Fed Conducts an open market purchase of Dollars to maintain the peg with the Euro LiabilitiesAssets $ 10,000,000 (Currency) E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) - $1,000,000 E 5,000,000 X 1.30 $/E $ 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. Can the Fed avoid this monetary contraction?

The Fed Conducts an open market purchase of Treasuries to “Sterilize” the currency intervention LiabilitiesAssets $ 10,000,000 (Currency) E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) • $1,000,000 + $1,000,000 E 5,000,000 X 1.30 $/E $ 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)

Suppose that foreign investors view US debt as too risky? Financial flows reverse, the US runs a BOP deficit requiring a purchase of dollars Reversal of capital flows causes the dollar to begin to depreciate. The US must correct this by buying dollars. Note: This would contract the money supply – raising interest rates and lowering output.

The Fed Conducts an open market purchase of dollars to stabilize the exchange rate LiabilitiesAssets $ 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 (Euros) The reserve ratio falls to 61% (5.5M/9M)

Suppose that foreign investors view US debt as too risky? Financial flows reverse, the US runs a BOP deficit. Alternatively, if capital is mobile enough, the government could “bail out” the private companies – replacing private debt with public debt This is risky…total indebtedness increase!!

Foreign Reserves are dangerously low! What can we do? LiabilitiesAssets $ 6,100,000 (Currency) E 1,000,000 (Euro) E 1,000,000 (ECB Bonds) E 2,000,000 X 1.30 $/E $ 2,600,000 $ 3,500,000 (T-Bills) $6,100,000 The reserve ratio is at 42% (2.6M/6.1M) • 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 devaluation would also improve the Fed’s reserve position

A devaluation from $1.30 to $1.50 helps LiabilitiesAssets $ 6,100,000 (Currency) E 1,000,000 (Euro) E 1,000,000 (ECB Bonds) E 2,000,000 X 1.50 $/E $ 3,000,000 $ 3,500,000 (T-Bills) $6,500,000 The reserve ratio is at 49% (3M/6.1M)

Speculation and “Peso Problems” • 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. • 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 • A country can maintain an appreciating currency forever • Currency pegs are not terribly successful during tough times • 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)

Pearls of wisdom from “The Karate Kid” “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?”

Committed Floater Committed Pegger Uncertain Pegger

FIN 40500: International Finance