Macroeconomics of Finance - Uniwersytet...

Macroeconomics for Finance

Lecture 11

Literature

• Mishkin F., 2016, The Economics of Money, Banking, and Financial Markets, Chapter 19: The International Financial System

• Calvo G., Reinhart C., 2002, Fear of floating, The Quarterly Journal of Economics, Vol. CXVII, Issue 2

• Gosh A., Gulde A., Wolf H., 2002, Exchange rate regimes: choices and consequences, MIT press, Chapter 3

Exchange rate regimes and internationalfinancial system – motivation• The exchange rate is an important asset price.

• Exchange rates have well-defined regimes which are chosen by the government and maintained by the central bank.

• Some economies fix their exchange rates, while others do not.

• Historically, countries have switched their exchange rate regimes frequently.

• Since it is evident that authorities care about the exchange rate, it is important to understand both the motivation and consequences of these choices (Rose, 2011)

• ”No single currency regime is right for all countries or at all times” (Frankel, 1999)

Foreign exchange intervention and the money supply

• Central banks regularly engage in international financial transactions called foreign exchange interventions, to influence exchange rates.

• A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base.

• A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base.

Reasons for official foreign interventions

• ”Wrong rate” argument – inefficient foreign exchange market may lead to exchange rate that does not fully reflect economics fundamentals; speculative bubbles.

• The information available to and used by market agents may be inaccurate or misleading, in comparison to the authorities’ information set.

• Exchange rate overshooting and cross-country policy interdependence (to offset temporary monetary disturbances).

• ”Adjustment argument” – to smooth the adjustment of exchange rates towards their long-run equilibrium value.

Foreign exchange intervention and the money supply

• Unsterilized foreign exchange intervention: a foreign exchange intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency.

• Sterilized foreign exchange intervention: a foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged.

Sterilized foreign exchange interventions

• Sterilized interventions can have effect on the exchange rate because of the change in the composition of assets through two possible channels:

• the portfolio balance channel – by changing the relative supplies of domestic and foreign bonds (with constant monetary base and no change in domestic interest rates, the spot exchange rate must shift in order to affect the domestic value of foreign bonds; ineffective in the case of perfect substitutes).

• the expectations (or signaling) channel – in response to sterilized intervention, agents may revise their expectations of the future exchange rate, altering the expected rate of depreciation and hence the return to foreign bond holdings.

Balance of payments

• How these transactions are measured?

• Balance of payment records all receipts and payments (private and public) that have a direct bearing on movement of funds between a nation and foreign countries.

Current account + capital account = net change in government internationalreserves

• Persistent current account deficits are a concern for several reasons:• It indicates that, at current exchange rates, foreign demand for domestic exports is far less

than domestic demand for foreign goods (domestic economy is not competetive).• A current account deficit means that foreigners’ claims on domestic assets is growing (these

claims will have to be paid back at some point).

Current account balance for the U.S.

IMF classification of exchange rate arrangements

Source: IMF, 2017

Exchange rate arrangements, 2008-2016(Percent of IMF members)

Source: IMF, 2017

Advantages and disadvantages of fixed exchange ratesAdvantages

• Complete control over stability of the exchange rate – eliminates risk and promotes investment and trade;

• Control over inflation by pegging the exchange rate to a low inflation currency;

• Provides ”nominal anchor” for the economy, stabilizes inflation expectations;

• Eliminates time-inconsistency problem of monetary policy.

Disadvantages

• Loss of independence of monetary policy;

• If the fixed exchange rate regime lacks credibility, it is vulnerable to speculative attacks;

• Uncertainty regarding the optimal exchange rate;

• An adequate quantity of international reserves are required.

Application: the 1992-1993 ERM crisis

• Reunification of Germany: inflationary pressures (increase in government deficit from 5% to 13.2%) and increase of interest rates by the Bundesbank.

• UK: recession; Bank of England unwilling to pursue a contractionary monetary policy

• Speculators expected depreciation of the pound: huge short position in pound

• Massive sell-off of pounds – Bank of England intervened; it raised interest rate from 10% to 15% during one day, but it was not enough

• On 16 September 1992 UK leaves ERM (Black Wednesday)

• On 17 September Italy leaves ERM.

• Speculative attacks forced devaluation of other currencies.

• On 1 August 1993: ERM bands widened to +/- 15%.

Advantages and disadvantages of floatingexchange rates

Advantages

• Monetary policy independence, central bank is free to respond to economic shocks;

• Changes in nominal exchange rate act as automatic stabilizers and are able to absorb foreign and domestic shocks;

• Large foreign exchange reserves are not required;

Disadvantages

• Little or no control over the value of the currency – difficulties in planning and pricing, higher transaction costs

The policy trilemma

• A country cannot pursue the following three policies at the same time (the policy trilemma, the impossible trinity):

1. free capital mobility,

2. a fixed exchange rate,

3. an independent monetary policy.

Fixed Exchange Rate

Free Capital

Mobility

Independent

Monetary Policy

Option 2

(Hong Kong)

Option 3

(China)

Option 1

(United States)

Application: How Did China Accumulate $4 Trillion of International Reserves?

• By 2014, China had accumulated $4 trillion in international reserves.

• In 1994 China pegged its exchange rate to the U.S. dollar at a fixed rate of 12 cents to the renminbi.

• Fast productivity growth and low inflation rate (combined with fixed exchange rate) caused undervaluation of renminbi.

• To keep the renminbi from appreciating, the Chinese central bank engaged in massive purchases of U.S. dollar assets to maintain the fixed relationship between the Chinese renminbi and the U.S. dollar.

• Chinese government is one of the largest holders of U.S. government bonds.

Foreign ownership of U.S. debt

Source: Labonte, Nagel, 2016, Foreign holdings of federal debt, Congressional Research Service

Other de facto classifications

Source: Eichengreen and Razo-Garcia, 2011

Classification de jure vs. classification de facto

Source: Gosh A., Gulde A.M., Wolf H., Exchange Rate Regimes: Classification and Consequences, MIT Press 2003.

Fear of floating• Calvo G., Reinhart C., 2002, Fear of floating, The Quarterly Journal of

Economics, Vol. CXVII, Issue 2.

• In 1990s many emerging market countries have suffered severe financial crises (crises in Asia, Russia, Brazil, Turkey). Many observers blamed soft pegs for these crises.

• It seemed that countries tended to move toward corner solutions – either hard pegs or free floating (bipolar view, hypothesis of vanishing intermediate regimes).

• Calvo and Reinhart analysed 39 countries in a period from January 1970 to November 1999.

• They found that in many emerging market countries officially declaring floating exchange rate regime policy interventions were used to dumpen exchange rate fluctuations.

Fear of floating

• In many cases the authorities were trying to stabilize the exchange rate through both direct intervention in the foreign exchange rate market and open market operations.

• Possible reasons for fear of floating:• liability dollarization,

• high pass-through from exchange rates to prices,

• lack of credibility and inflation targeting,

• protection of domestic industries.

Fear of floating

Source: Calvo G., Reinhart C., 2002, Fear of floating, The Quarterly Journal of Economics, Vol. CXVII, Issue 2

Fear of floating

Source: Levy-Yeyati E., Sturzenegger F., Classifying exchange rate regimes: Deeds vs. words, European Economic Review49, 2005

Fear of pegging• Fear of pegging denotes the situation, in which a country is announcing a pegged

exchange rate regime while in practice implementing frequent changes in parity.In other words, it is the situation when the regime is de jure more fixed than de facto.

• Reasons of fear of pegging:• openness of capital markets magnifies any weakness in a policymakers’ commitment to a

fixed exchange rate (Obstfeld and Rogoff, 1995);• official commitment to a fixed exchange rate regime is an investment in credibility and

that investment is lost if the policymaker changes his statement; as a consequence, it could be more advantageous to slightly modify the exchange rate target rather than changing the announced (von Hagen and Zhou, 2009);

• institutional underdevelopments and imperfect credibility of central banks, making the adoption of more flexible regimes impossible (Fear of pegging was a common phenomenon in the mid-1990s, when several EU accession countries with a fixed peg were confronted with challenges which required a higher degree of flexibility but the central banks had not yet build up sufficient credibility to adopt more flexible regimes).

Fear of pegging

Source: Levy-Yeyati E., Sturzenegger F., Classifying exchange rate regimes: Deeds vs. words, European Economic Review49, 2005

The theory of exchange rate regimes

Gosh A., Gulde A., Wolf H., 2002, Exchange rate regimes: choices and consequences, MIT press, Chapter 3.

• Output is determined by a Lucas-type supply function:

where y is the log of output, π is the inflation rate, πe is the private sector’s expectation of the inflation rate, and θ is a positive constant. η denotes a stochastic shock with mean zero and variance σ2

η observed after the private sector sets wages, but before the central bank decides on monetary policy.

Workers demand nominal wage increases sufficient to cover expected inflation. Employment is determined by realized real wages. If inflation turns out to be unexpectedlyhigh, real wages are eroded, making it profitable for firms to increase employment and output.


• The real rate of growth of money demand depends positively on the long-run real growth of output and negatively on expected inflation.

• The long-run real growth of output is constant and normalized to zero ( ).

• Money demand is subject to a shock, ε, observed after the central bank choosesits monetary policy.

• Money market equilibrium is thus given by:

where α is the income elasticity of money demand and 0 ≤ 𝜗 < 1 is the elasticitywith respect to expected inflation.

• If than expression for inflation is:


• For simplicity the banking sector is ignored, so that the money supply consists of central bank domestic credit and international reserves:

• Under fixed exchange rates, the central bank chooses Δdc while the change in reserves is endogenous.

• Under floating rates, the central bank again chooses Δdc, but does not holdreserves (Δr=0) and the nominal exchange rate is endogenous.

• We assume purchasing power parity:

where π* is the foreign inflation rate, which is assumed to be lower than the domestic inflation rate, and for simplicity is set to zero.


• The central bank is assumed to have two objectives: stabilizing output around some desired level 𝑦, and keeping inflation low. The central bank’s objective function may be written as:

where A denotes the relative weight placed on output (or, more generally, on the incentive to generate inflation surprises).

• As the natural level of output is normalized to zero, 𝑦 >0, implies that the central bank is aiming for a level of output above the economy’s natural level. Thus, the central bank is tempted to generate surprise inflation.


Pegged exchange rate regime• PPP condition implies that, as long as the exchange rate remains fixed, inflation

must equal the foreign rate of inflation: π= π*=0.

• Since monetary policy can affect neither inflation nor the level of output, the central bank has no incentive to expand the money supply, hence domestic credit is constant and the expected inflation rate under rational expectations is zero.

• Monetary shocks are passively absorbed by the change in reserves, ∆𝑟 = −𝜀, as long as the shock is not so large as to deplete the central bank’s stock of foreign reserves and force a devaluation.

• The low inflation comes at the cost of greater real volatility as the lack of an activist monetary policy implies that the productivity shock cannot be offset:

𝑦 = 𝜂


Pegged exchange rate regime cont.

• Substituting into loss function and taking expected value yields:


Floating exchange rate regime

• Under a regime of floating exchange rates, reserves are constant. Substituting equations for output and inflation into the CB loss function and solving for the optimal reaction of the central bank yields:

• Substituting the above equation into the inflation equation yields:


Floating exchange rate regime cont.

• Since the private sector has observed neither η nor ε at the time expectations areformed, it must use their unconditional means (zero) in forming its expectations, which yields:

• Output y is independent of 𝑦:


Floating exchange rate regime cont.

• While the central bank is unable to systematically fool the private sector, it cannot credibly commit itself to not trying to do so. This imparts an inflationary bias to the economy:

• The ex ante loss under a floating exchange rate is than equal:


Comparison of Regimes

• Let’s assume that 𝑦=0, so that the central bank has no incentive to create surprise inflation. Then

𝐿𝐹𝑖𝑥 > 𝐿𝐹𝑙𝑡 if

• Suppose further that there are only real productivity shocks and no (unanticipated) monetary shocks, so that 𝜎𝜀

2=0. In this case the expected loss under the pegged regime is greater, and hence the floating regime is preferable. On the other hand, if there are only monetary shocks and no real productivity shocks, then 𝐿𝐹𝑖𝑥 < 𝐿𝐹𝑙𝑡. Hence the pegged regime is preferable.


Comparison of Regimes• If there are no shocks in the economy (η=0, ε=0), the output is the same under the two

regimes:

• It follows that welfare under the floating regime is lower. The inability of the central bank to precommit to low inflation in the floating exchange rate regime creates both the expectation, and, ex post, the realization of higher inflation. However, since this inflation is anticipated, it provides no benefit in terms of generating higher employment and output.

• In countries with histories of high inflation a pegged exchange rate may be useful in enhancing the central bank’s anti-inflationary credibility. On the other hand, a country with history of sound macroeconomic policies, but subject to substantial real shocks, may prefer a floating exchange rate regime.

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