MBASess7AExchRateSys09

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MBA Global Economy

Session 7A

Exchange rate Practices


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Session 7A-09 Professor Augustine H H Tan MBA Global Economy 2

Introduction Exchange-rate practices

Nature and operation of actual exchange-ratesystems

Economic factors that influence the choice ofalternative exchange-rate systems

Operation and effects of currency crises

Exchange Rate Unions & Common Currencies


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Fixed Vs Floating: Dog Wagging Tail or Tail Wagging Dog?

Collie


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Exchange-Rate Practices Floating or Fixed? IMF principles for member nations:

No manipulation to prevent effective balance-of-payments adjustments or unfair competitive gains

Act to counter short-term exchange market disorders When members intervene in markets, they should take

into account the interests of other members.

Exchange-rate practices of IMF members (Table 15.1)

Choosing an exchange-rate system (Table 15.2)


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Bretton Woods and After Postwar economic system negotiated at Bretton Woods

(1944) included adjustable pegged rates

In practice, countries were reluctant to adjust theirexchange rates, causing stresses that ended the system by1973

In 1973, the adjustable peg system was replaced with amanaged float system, which used governmentintervention in exchange markets to stay close to a targetexchange rate


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Fixed Exchange-Rate System Anchor to a single currency

Developing nations with a single industrial-country partner

Anchoring to a group or basket of currencies

Developing nations with more than one majortrading partner

Helps to average out fluctuations

Anchoring to the special drawing right (SDR)

Basket of four currencies (Table 15.4)

Increased stability


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Special Drawing Rights


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Fixed Exchange-Rate System Par value and official exchange rate

Governments assign their currencies a parvalue in terms of gold or other key currencies

Determining official exchange rate

Exchange-rate stabilization fund

Set up to defend the official rate

Purchases and sales of foreign currencies toiron out short-term fluctuations (Figure 15.2)

Fundamental disequilibrium


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Fixed Exchange-Rate System

Devaluation Home currencys exchange value depreciates,

counteracting a payments deficit

Revaluation

Home currencys exchange value appreciates,counteracting a payments surplus

Decisions to be made before implementation

Necessity of the step

Timing of adjustment Magnitude of adjustment

Advantages and disadvantages of fixed rates (Table15.5)


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Fixed Exchange Rates: Pros & Cons


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Bretton Woods System of Fixed Exchange Rates

Adjustable pegged exchange rates (1946-1973) Currencies tied to each other

Disequilibrium: Re-pegging up to 10 percent allowed

Par value fixed in terms of gold or the gold content of

the U.S. dollar in 1944 Band limits

Operational difficulties

Conflicting objectives

Magnitude of adjustments Difficulties in estimating equilibrium rates

Speculation


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Floating Exchange Rates Currency prices established in the foreign-

exchange market

Without restrictions imposed by governmentpolicies

Equilibrium exchange rate equates the demandfor and supply of the home currency


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Floating Exchange Rates Achieving market equilibrium

Example: Foreign-exchange market in Swissfrancs in the United States (Figure 15.3)

Market equilibrium will be established at apoint where the quantities of foreign exchangesupplied and demanded are equal


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Floating Exchange Rates


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Floating Exchange Rates Trade restrictions, jobs, and floating exchange

rates

Import restrictions will gradually shift jobsfrom other industries to the protected industry

No significant impact on aggregateemployment

Short-run employment gains in the protected

industry will be offset by long-run employmentlosses in other industries


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Floating Exchange Rates: Pros & Cons Advantages

Simplicity

Continuous adjustment in the balance of payments

Adverse effects of prolonged disequilibria are minimized

Partially insulates the home economy from external forces

Freedom to pursue policies that promote domestic balance Disadvantages

Unregulated market leads to wide fluctuations in currencyvalues

Prohibitively high cost of hedging

Flexibility to set independent policies leading to inflationarybias

Summarized in Table 15.5


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Managed Floating Rates Informal guidelines established by IMF (1973)

Based on two concerns Nations intervening in exchange markets

Clean float and dirty float

Disorderly markets with erratic fluctuations

Under managed floating, a nation: Can alter the degree of intervention

Can intervene to reduce short-term fluctuations:Leaning against the wind

Should not act aggressively with respect to theircurrency exchange rates

Can choose target rates and intervene to supportthem


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Managed Floating Rates: Short-run & Long-run

Under a managed float Market intervention is used to stabilize

exchange rates in the short run

In the long run, a managed float allows marketforces to determine exchange rates

Example: Theory of a managed float in atwo-country framework (Figure 15.4)


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Trend & Fluctuation


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Exchange-Rate Stabilization and Monetary Policy

Stabilization requires the central bank to adopt: An expansionary monetary policy to offset

currency appreciation

A contractionary monetary policy to offsetcurrency depreciation

Example: Exchange-rate stabilization andmonetary policy (Figure 15.5)

Long-run effectiveness of using monetarypolicy to stabilize the exchange value of thecurrency is limited


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Is Exchange-Rate Stabilization Effective?

Volatility of foreign-exchange markets Intervention by central banks

Intervention supported by central bank interestrate changes

Coordinated intervention

Proponents of intervention:

Useful when the exchange rate is under

speculative attack

May be helpful in coordinating private-sector expectations


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The Crawling Peg Small, frequent changes in the par value of currency

Correct balance-of-payments disequilibria

Used primarily by nations having high inflation rates

Proponents

Flexibility of floating rates with stability of fixed rates

More responsive to changing competitive conditions

Avoids changes that are frequently wide of the mark

Frustrates speculators with their irregularity

IMF view

Hard to apply this system to industrialized nationswhose currencies serve as a source of internationalliquidity


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Currency Crises

Currency crises or speculative attack A weak currency experiences heavy selling pressure

Indications of selling pressure include:

Sizable losses in the foreign reserves held by a

countrys central bank Depreciating exchange rates in the forward market

Widespread flight out of domestic currency intoforeign currency or into goods

Examples of currency crises (Table 15.6)


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Currency Crises Crisis ends when selling pressure stops

Ways to end pressure

Devalue the currency

Adopt a floating exchange rate

Currency crashes: Crises that end in devaluations oraccelerated depreciations

Avoiding a currency crash

Impose restrictions on the ability of people to buy

and sell foreign currency Obtain a loan to bolster the foreign reserves

Restore confidence in the existing exchange rate


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Currency Crises: Causes

Budget deficits financed by inflation Over-borrowing short-term from abroad

Weak financial systems

Mismanaged banks are guaranteed bail-outs

Faltering economy, raising doubts about the course ofmonetary policy (pressure for inflationary stimulus)

Political crises and uncertainty

External shocks

Contagion: tom-yam effect Fixed exchange rate regimes are particularly vulnerable


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Currency Crises: Speculative Attack

Southeast Asian currency decline led by the ThaiBaht

Resistance offered to the depreciationpressure and raising interest rates to make the

Baht attractive Abandoning the dollar peg in July 1997

Long-term effects of abandoning the fixed rate


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Currency Crises: Capital Controls

Government-imposed barriers To foreign savers investing in domestic assets

To domestic savers investing in foreign assets

Also known as exchange controls


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Capital Controls: Advantages

Government can influence its paymentsposition

Encourage or discourage certain transactionsby offering different rates for foreign currency

for different purposes Can give domestic monetary and fiscal

policies greater freedom in their stabilization

roles


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Capital Controls: Disadvantages

Disadvantages of capital outflows Outflows may increase since confidence in the

government is weakened

Restrictions often result in evasion

False sense of security for officials

Controls on capital inflows often receive moresupport


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Should Foreign-Exchange Transactions Be Taxed?

Proponents Tax would give traders an incentive to look at

long-term economic trends

Increased cost of transactions

Dampen excess volatility

Drawbacks

Difficult to determine excesses

Burden on countries that are quite rationallyborrowing overseas

Difficult to implement


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Currency Boards Currency boards

Issues notes and coins convertible into a foreign anchorcurrency at a fixed exchange rate

Backing of the domestic currency must be at least 100percent: Monetary policy on autopilot

Benefits of a currency board system (next slide)

Concerns

Prevents a country from pursuing a discretionarymonetary policy

Susceptible to financial panics - lacks a lender of lastresort

Creates a colonial relationship with the anchorcurrency


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Currency Board - Argentina

Shift to fixed exchange rate and currency boardfollowing hyperinflation in 1970s and 80s

Economy hit during the late 1990s

Appreciation of the dollar

Rising U.S. interest rates

Falling commodity prices on world markets

The depreciation of Brazils real

Borrow to finance deficits

Defaults ended convertibility of pesos intodollars


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Dollarization

Usage of the U.S. dollar alongside or instead ofthe local currency

Partial dollarization and full dollarization

Why Dollarize?

Credibility and policy discipline

Avoiding capital outflows that often precede oraccompany an embattled currency situation

Decrease in transaction costs Lower inflation

Greater openness


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Dollarization Effects of Dollarization Ecuador

Accepting the monetary policy of the Federal Reserve

Risk that business cycles might not coincide

Federal Reserve is not their lender of last resort

Loss of seigniorage

Freedom to decide how to spend its tax dollars

Ecuador could establish its own tariffs, subsidies,and trade policies

Constraint: No recourse to printing local currency


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Dollarization Implications of Dollarization for the U.S.

For each dollar sent abroad, Americans enjoy a one-timeincrease in the amount of goods and services they areable to consume

Effect of opting to hold dollars rather than debt:

An interest-free loan from Ecuador

Use of U.S. currency abroad might hinder theformulation and execution of monetary policy

More pressure on the Federal Reserve to conduct policyaccording to the interests of Ecuador


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INTERVENTION IN THE FOREIGNEXCHANGE MARKET

Pegging the Exchange Rate with Monetary Policy

A country may be willing to sacrifice domesticmonetary policy for a fixed exchange rate

Suppose two countries are very closely relatedand there is extensive trade between them

There is a high correlation between changes inthe GDPs of the two countries with onecountrys being substantially larger than the

other

Session 7A-09 46Professor Augustine H H Tan MBA Global Economy


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This may lead to the smaller country fixing its

exchange rate to the larger country in nominalterms

The smaller countrys monetary policy may haveto be sacrificed to keep the exchange rate fixed

as the smaller country may not be able toinfluence the domestic economy with monetarypolicy

A recession in the larger country would mostlikely lead to a recession in the smaller country



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Passively following the monetary policy of the

larger country may be the most sensible policyfor small country

There would not be much of a loss in doing so,and exchange rate stability is maintained

It may require occasional intervention in theforeign exchange market to maintain the fixedexchange rate, but whether the intervention is

sterilized or not is irrelevant



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The smaller country will have a growth

rate of the money supply and an inflationrate that is nearly identical to that of thelarger country

Intervention is simply a way for theexchange rate to be made sufficientlystable in the short run



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CURRENCY UNIONS If maintaining a fixed rate is such a headache,

why not do away with the problem? If two countries really want to keep exchange rate

stability between them, it might be more logical tomerge two currencies into one

This is called a currency union

There are a number of benefits and costsassociated with this decision

While the factors are relatively straightforward,the weights of these factors are not



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CURRENCY UNIONS Before the creation of the Euro, Austria had

pegged its currency to Germany The first benefit from creating a common

currency is monetary efficiency gains, the gainsderived from not having to change currencies

when conducting trade between the countries

This would a considerable savings when twocountries trade heavily between themselves

The largest loss to both countries would be theloss of autonomous monetary policy



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CURRENCY UNIONS At some point in time, the joint monetary policy

for the two countries would be less than optimalfor each individual country

With a currency union, there would be aneconomic stability lossdue to the currency union

because of the inability of a country to conductan independent monetary policy

Whether or not a currency union is a good idea

depends on the magnitude of the monetaryefficiency gains versus the potential losses interms of economic stability



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CURRENCY UNIONS The greater the amount of trade between the

countries, the larger the monetary efficiencygains will be if the countries move to a commoncurrency

The difficulty is that economists cannot precisely

determining how much trade is required betweenthe countries to make a union profitable

This rule remains a useful generalization

There is not a precise cutoff point where acurrency union is a good idea



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CURRENCY UNIONS Common currency will ease transaction of capital

flows across countries and increase theefficiency of the financial markets in bothcountries

Similarly, would be easier to make direct

investments (FDI) if currency did not have to beconverted across borders and would eliminatesome uncertainty with respect to the return onthe investment

Investors in both countries would be more likelyto invest across borders



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CURRENCY UNIONS There are several factors that influence the

economic stability losses each country mightincur

If labor can and does move across borders whenone country has a recession, the effects to the

recession are reduced It would not be necessary for the country

experiencing the recession to pursue

expansionary monetary and fiscal policies inorder to stimulate domestic demand



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CURRENCY UNIONS If the two countries have similar average rates

of inflation, there is less chance that a jointmonetary policy would be undesirable in eithercountry

If the taxation and spending systems of the

two countries were somewhat integrated, acommon fiscal policy, economic stabilitylosses would be diminished

The economic stability losses will be smallerthe higher the correlation of GDP between thetwo countries



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OPTIONS FOR INTERNATIONALMONETARY REFORM

Businesses dislike floating exchange

rates since volatility increases risk In the short run, they can choose between

taking risk or protection through hedging

but neither are costless The current system forces businesses to

implicitly forecast exchange rates whether

they want to or not



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OPTIONS FOR INTERNATIONALMONETARY REFORM

Volatile exchange rates make international trade

and investment more risky and activities thatentail more risk command a higher rate of return

Since volatile exchange rates make internationaltrade and investment more risky, fluctuatingexchange rates also implicitly make internationaltrade more costly

Thus volatile exchange rates lower the total

volume of international trade and investment


OPTIONS FOR INTERNATIONAL


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MONETARY REFORM Governments have similar views to business

Overvalued currency can hurt the tradable goodssector and undervalued currency can create aboom that cannot be sustained

A collapse in the currency can cause a

macroeconomic crisis

Though the current system is disliked, there havebeen no serious multilateral moves toward a

more stable system There are good reasons for the current lack of

motivation for a new system




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MONETARY REFORMAn Exchange Rate Map

Rules

Cooperation

Discretion

Noncooperation

Gold Standard

United States

Bretton Woods




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MONETARY REFORM Any new international monetary system would

presumably include a movement toward morestable exchange rates and would include at leastone of two things, more rules or morecooperation

The most likely move is toward more cooperation G-7 countries, a group of the seven largest

industrial countries, made such moves in the late1970s and the 1980s

Countries tried to achieve more exchange ratestability by increasing the level of cooperation




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MONETARY REFORM There were few, if any, rules

There was more cooperation, but since itbasically was voluntary cooperation theseagreements invariably failed

In terms of a workable internationalmonetary system, this arrangement doesnot seem to be very promising

Countries do not seem inclined to go backto a system with a lot of relatively rigidrules




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MONETARY REFORM Countries tend to focus on their internal balance

first and consider external balance and theexchange rate only after the fact

Thus any move toward more cooperation isunlikely

The current system is messy with costs for boththe private and the public sector

But given the preferences of most governments

for autonomy in fiscal and monetary policy, itmay be all that is feasible at this point



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European Monetary Union (EMU)

Lowers the costs of goods and services

Facilitate a comparison of prices within the EU

Promotes more uniform prices


Economic Costs and Benefits of a Common Currency


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When Italy adopted the euro as its currency:

Gave up option of changing its exchange rateto improve competitiveness of its exporters

Lira converted to euro at too high a rate,

resulting in uncompetitiveness? Effects of euro strengthening against the

dollar:

Italian firms lost competitiveness in U.S.markets

Realization of the downside of joining theeuro club


Euro Gained in Value


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A region that has a single official currency

Advantages and disadvantages (Table 8.2)

Various reactions to economic shocks:

Mobility of labor

Flexibility of prices and wages

Automatic mechanism for transferring fiscalresources to the affected country

To improve success chances, countries should have:

Similar business cycles Similar economic structures

Affect all the participating countries in the samemanner


Optimum Currency Area


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Session 7A-09

Professor Augustine H H Tan MBA

Global Economy 67


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Advantages of forming a EMU:

Improves economic efficiency

Facilitates genuine comparison of prices

Elimination of exchange-rate risk

Stimulates competition

Facilitates broadening and deepening offinancial markets

Disadvantage of the EMU: Loss in use of monetary policy and exchange

rate as a tool in adjusting to economicdisturbances


Europe as a Suboptimal Currency Area


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Difficulty in determining interest rates due to wide

difference in economic growth rates among EMUcountries

Avoidance of excessive budget deficits

Structural reform in European countries


Challenges for the EMU

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