Transcript Document

The Foreign Exchange Market and
Exchange Rates
• Balance of Payments:
– Record of a country’s economic transactions with the
rest of the world.
• Rule: receipt = positive (+) , payment = negative
(-).
– If receipts > payments = surplus.
– If receipts < payments = deficit.
• 2 main accounts: current and capital.
– Different implications for the economy. The current
account directly affects AD
– It is possible to have a current a/c deficit as long as
there is a capital a/c surplus. Example, USA.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Balance of Payments
Current account
Trade a/c
Services
Freight
Tourism
Royalties
Investment income
Direct investment income
National debt interest
Transfers
Balance on current account
Capital account
Private capital
Official capital
Government securities sold abroad
Banking transactions
Balance on capital account
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
-2000
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BOP
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curre
overa
Foreign Exchange Market
• Balance of payments and international transactions
underlie the foreign exchange market.
• Different ways of quoting exchange rates:
– Indirect quote = ($/€).
– Direct quote = (€/$).
• Define e as the price of a euro in $
– i.e how many $ per €
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Foreign Exchange Market
S
e1
The supply
and demand
for euro on
the FEM
determines
e. “Floating
exchange
rate.”
D
€ billions
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Fixed vs Floating
• In a certain trivial sense the BOP always balances
– Supply equals demand
• For floating exchange rate this is achieved by the
free market
– For fixed exchange rates the government makes up the
difference
• Current account surplus is counteracted by cap
deficit and/or changes in reserves
– US vs China
Fixed Erates
• Governments may try to fix the exchange
rate (why? See later)
– Requires supplying foreign currency to market
when there is excess demand
– Requires buy foreign currency when there is
excess supply
– Can influence the exchange rate via interest
rates (EMS or dirty float)
• Mechanism by which an currency crisis can
occur
Fixed e
S
By coincidence it
is at market
eqm. Not
likely
e*
D
€ billions
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Fixed e
S
Below
market rate.
CB print
extra € and
buy $
e*
D
€ billions
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Fixed e
S
e*
E above
market
value. CB
must buy €
with $
D
€ billions
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Irish Exchange rate Policy
• 1920-79: Sterling Link
– Currency Board
– Sensible: strong currency, major trading partner
– Have British inflation and interest rates.
• 1979: break with sterling
–
–
–
–
Seek lower inflation with Germany
didn’t work: inflation diverged
Interest rates converged only after 10 years
Competitiveness declined
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Effect of e on AD
• e affects the location of the AD curve.
– e  X and M (see over)
•  AD  real GNP, employment, unemployment and
inflation just as with any FP or MP
• Note that this effect works through the current account
• Thus e is another instrument of economic policy.
– See diagram
– Policy-maker can contrive to improve competitiveness by undervaluing e.
– Over-valued e can have a detrimental effect on key
macroeconomic variables.
• A depreciation cause inflation in the log run
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
• X rises following a depreciation (e falls)
–
–
–
–
–
–
–
–
Price in $ of goods produced in Ireland falls
Example: furry leprechaun €5
e=1.4
1€ gets $1.4
leprechaun costs $5*1.4=$7
Depreciation e=1.2 implies €1 get $1.2
Cost is $5*1.2=6
Sales rise
LRAS
p
SRAS(pe)
AD1
AD0
Y*
Y
Determinants of Exchange Rates
• At most fundamental level:
– BOP determines Supply and demand for euro (€)
– foreign exchange market determines e.
– Receipts (e.g. Exports): Demand for Euro.
– Payments (e.g. Imports): Supply of Euro.
• Factors that influence the supply and demand
include:
– Interest Rates (UIP)
– Prices (Competitiveness)
– Growth:.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Prices
• Relative inflation rates.
–  p  X and M
– Demand curve to the left,
– Supply curve to the right.
• Result is e depreciation.
• Countries with high inflation rates tend to
have weak exchange rates.
• PPP theory (see later)
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Interest Rates
• Interest rates can be used to influence
capital flows and therefore defend a
currency.
• ieuro > ius Capital inflow   e
• ieuro < ius Capital outflow   e
• Usually used to prevent depreciation of the
exchange rate.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Output
• Two effects:
– Economic growth leads to an increase in imports
(via MPM), a current a/c deficit and
depreciation.
– Economic growth is reflected in high company
profits, a rising stock market and high returns.
• This leads to a capital inflow and a capital a/c
surplus.
• As long a (B) > (A) the exchange rate will
appreciate.
• United States in the 1990’s and 2000’s.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Prices (Competitiveness)
• Look in detail at the link between prices and
exchange rates and their joint effect on output
• PPP: equal value for money for goods and
services.
– Prices of similar goods expressed in a common
currency should be the same.
– Based on arbitrage. Buy cheap, sell expensive to make
profit.
– Actions should lead to a convergence of prices
• How expensive is Ireland?
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Absolute PPP
• Pirl  e = Pw
• Prices, adjusted for the exchange rate,
should be the same in different countries.
• Example: Levi Jeans,
• Pirl = €10 in Dublin,
• Pus = $20 in New York.
• If e = $/€ = 2 then PPP holds.
• If e  2, PPP does not hold.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Real Exchange Rate
• Compare price levels of different countries
– In a common currency (usually US$)
• Related to the concept of purchasing power
parity (PPP)
– Law of one price
• Simple example is the Hamburger index
– What is the US$ price of a Big Mac in various
countries
– $PIRL=€ PIRL*e
– Is $PIRL >$PUS
• What does this tell you?
– “competitiveness”
– Are one country’s goods cheaper than
another’s?
• Do for all goods in a basket and calculate
the ratio
– i.e. CPI or GDP or wages
$PIRL
PIRL
R

$PUS e * PUS
• Look at R for Ireland over time
– Level doesn’t tell much
– Trend does
• What is the effect of an increase in real e
rate?
–
–
–
–
–
competitiveness
Our goods more expensive
Their goods relatively cheaper
Expect exports to fall and imports to rise
Better off?
• What causes R to change
– e changes
– Prices change i.e. inflation can erode
competitiveness
– productivity
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Competitiveness
250.000
200.000
150.000
NEER
REER
100.000
50.000
0.000
Relative PPP
• Total differentiation of the absolute PPP equation
gives:
•  Pirl +  e =  Pw
• Or pirl + e = pw
• Inflation rates, adjusted for changes in the
exchange rate, should be similar across countries.
• Weak form of PPP.
– Prices can be initially different, but change at the same
rate over time.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
PPP as a Economic Theory: Under
Flexible Exchange Rates
• PPP becomes a theory of exchange rates.
•  e = pw - pirl
• Inflation is the most important determinant of e.
Country’s with high inflation rates will experience
weak exchange rates and visa versa.
– Why?
• Very relevant in the case of large countries: USA,
Japan and EMU.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
PPP as an Economic Theory: Under
Fixed Exchange Rates
•
•
•
•
PPP becomes a theory of inflation.
pirl = pw -  e
If e is fixed, pirl is determined by pw.
Ireland is a price taker on international
markets.
• One of the main reasons for fixed e
– EMS & EMU.
• Used by small countries world-wide.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Ireland’s Competitiveness
• Big mac index
– Economist magazine
• Balassa-Samuelson theory
– Expect richer countries to be more expensive
– Deviation from PPP because of “non-tradable”
– Susan O'Carroll thesis
• Real Effective E-rate
• Current situation
– Euro appreciated
– High but falling(?) costs
2000
2004
Capital Account
• So far have paid most attention to current
account
– Competitiveness affects current account and
AD
• Historically this was the most important
part of BOP
– Nowadays capital flows account for most BOP
flows
– Recent phenomenon
– Capital controls were the norm until 1980
Interest Rate Parity
•
•
•
•
•
Capital account is driven by differences in
interest rates
A comparison of domestic and foreign
interest rates must allow for the expected
change in the exchange rate.
Compare a domestic (Eurozone) and a
foreign (US) investment.
Domestic investment: (1 + iez)
€1,000(1 + 0.1) = €1,100
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Foreign Investment
•
•
•
•
•
1st January: Convert € into $ using the spot
exchange rate et.
Invest $ in the USA. Total return (1 + ius).
31st December: Convert the total $ return back into
€. (1/ee t+1). Note it is the expected e as the
exchange rate 12 months from now is unknown.
US return measured in Euro is:
(1 + ius)et/ee t+1.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Two Parts to the Foreign
Investment
•
•
•
•
•
•
1. Interest rate.
2. Gain or loss on the foreign exchange
market.
Arbitrage should now ensure:
(1 + iez) = (1 + ius)et/ee t+1
Rearrange:
(ee t+1 - et)/et = (ius - iez)/(1 + iez)
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Implications
•
•
•
•
•
Difference between the future and current
exchange rates equals the interest rate
differential.
If ius < iez
Expect € depreciation
If ius > iez
Expect € appreciation
The interest rate differential gives an
indication of how the market expects the
exchange rate to move.
This is key to understanding currency crises
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Implication:
Fixed e
•
•
•
UIP gives another rationale for fixed exchange
rates
• Interest rate will track that of the larger country
With a single currency in the Eurozone, it is not
possible for interest rates to diverge between
countries.
So as EMU comes closer interest rates will
converge
• Eastern Europe now
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Dutch, German, and Irish Interest Rates
converged as EMU approached and it was
anticipated that E would be “irrevocably fixed”
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16
14
12
10
8
6
4
2
0
Irl
NL
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
D
Interest Rates
20.000
18.000
16.000
14.000
12.000
Germany
10.000
Ireland
8.000
6.000
4.000
2.000
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70
0.000
Nominal interest rates
Austria
30
Belgium
Finland
25
France
20
Germany
15
Ireland
10
Italy
1999 Q1
Q3
Q2
1994 Q1
Q4
Q3
Q2
1989 Q1
Q4
Q3
Q2
1984 Q1
Q4
Q3
Q2
1979 Q1
0
Q4
5
Luxembo
urg
Netherlan
ds
Portugal
Spain
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Currency Crises
• UIP & Competitiveness help explain how
currency crises arise.
• Basic story
–
–
–
–
–
Country in a recession with fixed e rate
Markets expect that gov will devalue to boost AD
Expectation of devaluation leads to higher interest rates
Makes recession worse
Speculators try to sell their holdings of the domestic
currency
– Self fulfilling prophecy
– Devaluation usually but not always occurs.
EMS Crisis 1992
• Background to EMS
– Objective is to stabilise exchange rates.
– Reduce e uncertainty and thereby encourage
international trade.
– Key point is that for the system to work, there
must be similar inflation, interest rates and
growth rates.
– In turn, this requires policy co-ordination:
(fiscal, monetary policies)
– Why?
EMS until 1992
• Seen as step on way to EMU
– Not fixed
– Limit movement to band of +/- 2.25% around central rate
– Possible to adjust central rate
• 1979-87: numerous realignments mostly involving an
appreciation of the DM. Ir£ devalued twice. March 1983
and August 1986.
– Usual reason: no co-ordination of fiscal and monetary policies.
• 1987-92: no realignments. System was a success. Look
forward to EMU.
• All ended with the currency crisis of September 1992.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Currency Crisis of 1992-93
• German unification in 1990 lead to huge budget
deficit.
– Could not be financed by increasing taxes
– AD shifts right.
• Bundesbank raises interest rates to combat
inflation
– i (by 3%).
– AD shift to left
• Because of fixed exchange rates, the increase in
interest rates was transmitted to rest of Europe
– The FP was not
– Everyone else’s AD shifts left.
• Europe has recession (worse for UK)
Germany 1992
LRAS
p
SRAS(pe)
AD1
AD0
Y*
Y
UK 1992
LRAS
p
SRAS(pe)
AD0
AD1
Y*
Y
• However, the UK was in recession, needed lower not
higher i.
• Speculators took view that DM/Stg£ e was not sustainable.
– Expect that gov will boost AD by devaluation and/or reduction in
interest rates
– Attacked the currency.
– Try to sell stg and buy DM
• Situation becomes self re-enforcing
– As speculators fear a devaluation, sell stg (supply increases)
– CB has to use up more reserves
– Anticipation of devaluation pushes up int rates making recession
worse, making devaluation more likely
– Conspiracy: George Soros moves the market
• Black Wednesday.
–
–
–
–
–
–
Bank of England spends £10b of reserves and then gives up
Stg£ withdrawn from ERM.
Immediately depreciated to low level.
Speculators made a killing.
Economy rebounds as AD pushed up
Political death of gov
Stg/DM
S
e*
E above
market
value. CB
must buy £
with DM
D
£ billions
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
The Irish Pound and the Crisis
of 1992-93
• Example of SOE
• Sterling’s dropped EMS in September and the
currency depreciated by 15%
• Market attacked Irish Pound
– Likely that Irish pound was likely to be devalued to avoid
competitive loss (AD curve shifts left)
– strangle Celtic tiger at birth
– U still high (12%) so not credible to keep e overvalued
– Hence, funds flowed out of Ireland in anticipation of a
devaluation of the Irish pound.
• Despite this severe misalignment, the government
decided on this occasion to resist devaluation.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
19
92
M
19 5
92
M
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92
M
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92
M
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92
M
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M
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92
M
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93
M
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93
M
9
%
Irish and German interest rates during the currency crisis
45
40
35
30
25
20
15
10
5
0
Implications of the No
Devaluation Stance
• If continued lead to recession
– e was overvalued
– i high in anticipation of devaluation
– Both shift AD to left
• The Central Bank’s external reserves fell from £3.05 billion at the end
of August to £1.07 billion at the end of September, despite significant
foreign borrowing.
• Short-term interest rates were raised to unprecedented heights to
defend the currency from speculative attacks.
– One-month inter-bank interest rates peaked at 57 per cent on 12 January
1993.
– Overnight interest rates on the Euro-Irish pound market rose to 1,000 per
cent.
• The combination of an overvalued currency and penal interest rates
was seriously damaging the Irish economy.
• Eventually had to devalue
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
(Wrong)
Arguments against Devaluation
• There was no guarantee that the devaluation would be
accepted by the markets. There would be no significant
inflow of funds and interest rates would not fall.
• The currency was not overvalued.
• Speculators could not be allowed to destroy the ERM,
which was regarded as the stepping stone to EMU.
• It was the government’s desire to break our dependence on
the UK and become a hard-core EMS country.
• Devaluation was ineffective as it resulted in only a shortterm competitive gain.
• The rise in prices could lead to higher wage demands
resulting in a wage-price spiral.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
The Alternative to Devaluation
• The over-valuation of the sterling/Irish pound exchange
rate results in a loss of competitiveness relative to the UK
and this reduces Irish exports and increases imports.
– This shifts the aggregate demand (AD) curve down to the left.
– Real wages increase because the inflation rate falls while the
nominal wage remains unchanged.
• If workers were to accept a cut wages nominal wages so
as to restore the original real wage, the aggregate supply
(AS) curve would move down to the right.
– The economy would return to the natural real growth rate.
– Same argument as with any recessionary shock
– Workers are not any worse off because the original real wage has
been restored.
• Devaluation is easier to implement
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Ireland 1992
LRAS
p
SRAS(pe)
AD0
AD1
Y*
Y
Summary
• All crises have a common structure
• Start with a problem in the real economy
–
–
–
–
Asymmetric shock
AD is low, recession or danger of one
e is fixed but over-valued (current deficit)
Reasonable to expect it to fall in a free market
• Self re-enforcing process of capital flows
–
–
–
–
UIP causes i to rise (making recession worse)
Cap outflows
Downward pressure on e
Eventually reserves depleted an e rate cannot be
maintained
• Conspiracy?
– Market size
EMU
• EMU is fixed e rate regime
– But more: difficult to leave so more credible
• Economic: Single market in persons,
goods, services and capital.
• Single currency and CB.
– European Central Bank (ECB) responsible for
monetary policy (money supply, interest rates,
inflation).
– Liberalisation of all capital (money, equity)
markets and transactions.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Economic Benefits
• Price transparency.
– Should lead to a convergence of prices in Eurozone.
– Indirect taxes still a serious problem.
• Elimination of exchange rate transaction costs.
– Savings of about 0.5% of GDP.
• Reduction in exchange rate uncertainty.
– Should stimulate trade and investment.
– But little evidence to support this view. Trade between
USA and Japan has grown dramatically even though the
exchange rate is flexible.
– 80 % of Irish trade is outside the Eurozone.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
• Scale economies.
– Firms spread plants around Europe to hedge against
currency movements. Now build plants to reap
economies of scale.
– Lead to regional specialisation and an efficiency gain.
• Low inflation.
– In effect, Irish inflation is determined by the German
rate.
– Argued that this is better than an anti-inflation policy
based on internal rules (doing it for ourselves).
– Note that Ireland had achieved a low inflation rate prior
to EMU entry.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Inflation in the Eurozone Countries
1979 - 2001
AUSTRIA
23.0
BELGIUM
FINLAND
FRANCE
GERMANY
IRELAND
ITALY
18.0
LUXEMBOURG
NETHERLANDS
PORTUGAL
%
13.0
EMU entry
criteria:
inflation rate of
less than 2.7%
SPAIN
8.0
3.0
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
-2.0
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
• Low interest rates.
– Given the single currency, there can be only one interest rate in
the Eurozone.
– The current rate represents a significant fall for high interest rate
countries like Ireland, Spain, Portugal and Italy.
– In 2002, real interest rates are negative in several Eurozone
countries.
– Represents a transfer of resources from savers to borrowers.
– Also major implications for macroeconomy: bubble?
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Nominal Interest Rates in the Eurozone Countries
1979 - 2002
25.0
Austria
Belgium
Finland
France
Germany
20.0
Greece
Ireland
Italy
Luxembourg
Netherlands
15.0
Portugal
%
Spain
10.0
5.0
0.0
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Costs
• Problem of adjustment within a
monetary union.
– With any fixed e regime
– Economy cannot have currency crisis but can suffer
asymmetric shocks.
• Think of the 1992 crisis if had EMU at the time
– German interest rates would have spread to rest of
Europe causing recession
– No currency crisis but still a recession
– No opportunity to use MP
– No opportunity to use e rate
– Little opportunity to use FP (Stability and Growth pact)
– Rely on the self adjustment mechanism: “flexibilty”
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
• EMU results in a loss of economic independence.
– No longer have control over interest rates or the
exchange rate.
– Fiscal policy is constrained by the Growth and
Stability Pact.
• Burden of adjustment switches from monetary and
fiscal policy to the “wage adjustment” effect
– But the labour market is much less flexible than the
money market.
– Result is that the economy may be slow to adjust.
• Obviously relevant to the current situation
– Currency crisis in absence of EMU
– Shorter recession
 Leddin and Walsh Macroeconomy of the Eurozone, 2003