Transcript 20081220101748113

1. Introduce exchange rates
2. Explain and evaluate the various kinds of
exchange rate systems that trading nations
use.
3. Examine the impact of Balance of Payments
outcome for the domestic economy.
4. Purchasing Power Parity
5. Asian Currency Crisis
We have considered the Balance of Payments and
the associated trade & financial flows.
These exchanges between nations are facilitated
by exchange rates that allow one currency to be
expressed in terms of another.
At a superficial level, we can view the exchange
rate as responding to changes in these flows – i.e.
the flows generate demand for & supply of these
currencies onto the foreign exchange market, thus
altering the exchange rate.
There are fundamental economic influences
that impact on the value of these exchange
rates.
For example, an increase in exports will
increase the demand for $A and (with all other
things constant) result in the value of the
exchange rate being bid up.
But what economic factors will provoke the
increase in exports?
Short Run (Speculative)
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Real interest rates
Expectations
Medium Run (Cyclical)
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Cyclical changes in economic Activity
Long Run (Structural)
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

Real income: increase imports
Employment
Productivity: lower costs increase exports
Inflation rates and relative price levels between countries
Consumer Preferences
Government Policy: trade and domestic
These factors affect the demand for and supply of an economy’s
currency and therefore the value of its exchange rate.
But an Exchange Rate is extremely volatile, especially in
the short run.
Can we specifically identify the factors that determine
the Exchange Rate?
Such information would be extremely useful to
businesses and macroeconomic policy makers for
forecasting Exchange Rate movement.
Can we posit a theory that helps our thinking about
Exchange Rate determination?
Currency is demanded and supplied not for its
own sake but to facilitate international trade.
The Exchange Rate is determined by the flow
of funds associated with this international
trade.
These flows constitute Demand for and Supply
of $A on FOREX market.
Demand for $A comes from credit items on
Balance of Payments (such as Merchandise
Exports).
Supply of $A comes from debit items on
Balance of Payments (such as Merchandise
Imports).
Direct Quote
(e.g. $A per $US, $A per £)
The exchange rate is expressed as the number of units
of a country’s currency required to buy a single unit of
some foreign currency.
Appreciation is a reduction in the number of units of
local currency required to buy a single unit of the
foreign currency. For example, $A1.60/$US appreciates
to $A1.50/$US.
Depreciation is an increase in the number of units of
local currency to buy one unit of foreign currency. For
example, $A1.50/$US depreciates to $A1.60/$US
Indirect Quote
(e.g. $US per $A)
The exchange rate is expressed as the foreign
currency price per unit of the local currency.
Reciprocal of a direct quote
For example, one $A is worth $US0.66 and then the
$A depreciates to $US0.625. Therefore, you get
less foreign currency for each $A (in other words,
one $A buys less foreign currency)
Indirect quote is also used in financial media
reports as it is conceptually easier to understand.
There are three main types:
1. Flexible exchange rate : value of currency
is determined by market forces
2. Fixed exchange rate: value of currency is
determined by Central Bank
3. Managed exchange rate: the central bank
intervenes in the FX market to smooth out
fluctuations but doesn’t seek to maintain
currency at predetermined level.
The type of exchange rate system an economy
adopts depends on a number of factors:
Size and openness of the economy
Political System
Degree of financial sector development
Capital Mobility
COUNTRY
CURRENCY
Australia
China
Hong Kong
India
Indonesia
Japan
Malaysia
New Zealand
Philippines
Singapore
South Korea
Taiwan
Thailand
Vietnam
Dollar
Yuan Renminbi
Dollar
Rupee
Rupiah
Yen
Ringgit
Dollar
Peso
Dollar
Won
Dollar
Baht
Dong
CURRENCY EXCHANGE RATE
CODE
SYSTEM
AUD
CNY
HKD
INR
IDR
JPY
MYR
NZD
PHP
SGD
KRW
TWD
THB
VND
Floating
Fixed
Fixed
Managed
Floating
Floating
Managed
Floating
Floating
Managed
Floating
Managed
Managed
Fixed
Changes in $US Exchange Rates for selected APEC
Countries
Source: Congressional Research Committee, East Asia’s Foreign Exchange
Rate Policies, April 10, 2008.
Market forces determine the value of a country’s
exchange rate.
Depreciation and Appreciation
Depreciation in the exchange rate is an increase in the number
of units of a country’s currency required to buy a single unit of
some foreign currency.
Direct Quote: $A1.50=$US1 depreciates to $A1.60=$US1; or
Indirect Quote: A$1=$US0.66 depreciates to $US0.625.
Appreciation is a reduction in the number of units of a country’s
currency required to buy a single unit of some foreign currency.
Direct Quote: $A1.50=$US1 appreciates to $A1.40=$US1; or
Indirect Quote: A$1=$US0.66 appreciates to $US0.68.
P¥/$
Depreciation
S0
S1
¥99
¥90
D0
Q$
Excess Supply of $A
A Current Account deficit causes excess supply of $A at the original
equilibrium exchange rate. A depreciation of the exchange rate from
¥99 to ¥90 occurs under a freely floating exchange rate system.
Monetary policy autonomy
If the Central Bank is not obliged to intervene in the currency
market to fix exchange rates, each country’s Monetary Policy is
more autonomous relative to international circumstances. The
money supply can be dedicated solely to addressing domestic
economic problems, particularly inflation. For example, a country
does not have to import an inflation rate established abroad. (e.g.
in the late 1960s many countries felt that they were importing US
inflation)
Symmetry
Under a system of floating exchange rates, one country no longer
is able to set world monetary conditions by itself. At the same
time, any country has the same opportunity as others to influence
its exchange rate against foreign currencies. Exchange rates would
be determined symmetrically by the foreign exchange market, not
government decisions.
Exchange Rates as Automatic Stabilisers
Even in the absence of active monetary policy, the swift
adjustment of market-determined exchange rates help
countries maintain internal and external balance in the
face of aggregate demand.
For example, as output falls, domestic demand falls
which reduces transaction demand for money. The
home interest rate declines to keep the money market
in equilibrium.
This fall in home interest rates causes the domestic
currency to depreciate in the foreign exchange market.
This can increase the demand for exports and GDP.
Discipline: Central Banks are freed from the obligation to fix
exchange rates so might embark on overexpansionary fiscal or
monetary policy (particularly near election time).
Destabilising speculation and money market disturbances:
speculation on changes in exchange rates could lead to
instability in foreign exchange markets. This instability, in turn,
might have negative effects on countries’ internal and external
balances.
Further, disturbances to the home money market could be
more disruptive under a floating than a fixed rate. For example,
a rise in money demand works like a fall in money supply currency appreciates and output falls. Under a fixed rate, the
central bank would simply purchase foreign exchange and
expand the money supply.
However, destabilising speculators who persisted in selling
currency after it had depreciated below its long run value
(or buying after it had appreciated above its long run
value) would lose money over the long term.
Injury to international trade and investment: floating rates
make relative international prices more unpredictable. This
can harm international trade and investment. For example,
importers are more uncertain of what they will pay;
exporters are uncertain of what they will receive.
Supporters of floats argue traders can use the forward
exchange market, sceptics reply that forward markets are
expensive to use and cannot cover all exchange-rate risks.
Illusion of greater autonomy: floating exchange
rates can contribute to inflation.
A currency depreciation that raised import
prices might induce workers to demand higher
wages. Higher wages fuel price level rises and
further inflation.
In addition, currency depreciation would raise
price of imported goods used in production of
domestic output.
Disadvantages of floating exchange rates:
Uncertainty and diminished trade
uncertainty on prices due to movements in the
exchange rate
Terms of trade (declining terms of trade if you are a
commodity exporter).
Instability in the macroeconomic environment:
shifts in net exports brought about by changes in the
exchange rate. Appreciation of the dollar lowers
exports and increases imports.
Nations have often fixed or pegged the
exchange rate at a certain value to overcome
the disadvantages from floating exchange rates.
The value decided upon is the par value
associated with another currency or commodity.
Provide stability but government must intervene
in the foreign exchange market by using its
stock of currency (domestic and international) to
manipulate the market process.
Fixed exchange rates require adequate
reserves held by the central bank to
accommodate periodic balance of payments
deficits
Stabilisation funds
supplies of both foreign and domestic monies and
gold held with the central bank or treasury for the
purpose of intervention in the foreign exchange
market to maintain the par value of the exchange rate
IMF credit
To maintain a fixed exchange rate a country may enact
protectionist trade policies to increase net exports.
Imports: outflow of domestic currency, depreciation
Exports: inflow of foreign currency, appreciation
Exchange controls: rationing
restricting imports to the amount of foreign exchange
earned by exports
the deficit would cause changes in domestic prices and
incomes, shifting the demand and the supply of currency
into equilibrium.
P¥/$
Depreciation
S0
S1
¥99
D1
¥90
D0
Excess Supply of $A
Q$
Under a Gold or fixed exchange rate system, the government would need to
buy the excess quantity of $A (increase demand for $A and, conversely,
supply more Japanese Yen) in the foreign exchange market to maintain the
exchange rate value at ¥99.
Devaluation and revaluation of an economy’s
currency value refers to the deliberate
alteration of the par value of a currency
against a particular standard.
This is decided by the central government in
an attempt to address problems stemming
from an over-valued or under-valued
currency and its consequences for domestic
economic activity (such as economic growth,
aggregate demand, employment and
inflation).
Need adequate foreign reserves
If constantly run Current Account deficits and are not
receiving foreign currency then this will be a problem.
If market decides a devaluation is coming, foreign reserves
drop sharply due to private capital flows abroad (capital
flight). Self fulfilling currency crisis can occur when an
economy is vulnerable to speculation.
Domestic macroeconomic adjustments
use fiscal and monetary policies to adjust GDP to a level
consistent with the fixed exchange rate. But to maintain
exchange rates might mean domestic economic activity is
not able to be effectively controlled.
In other circumstance, the exchange rate collapse
may be the result of inconsistent government
policies. For example, the central bank may be buying
bonds from the domestic government to allow the
government to continue running fiscal deficits.
Central bank purchases may eventually run down
reserves to the point where exchange rate cannot be
supported.
Also, the Central Bank may loan to uncreditworthy
domestic banks to prevent domestic financial
collapse. In the process, reserves are run down so the
Central Bank loses ability to support the exchange
rate.
An exchange rate system where central banks
buy and sell foreign exchange to smooth out
short-run or day-to-day fluctuations in rates.
Exchange rates are allowed to float or
fluctuate in response to more fundamental
changes in a nation’s exports and imports.
Encourages international trade and finance,
while allowing for trend or long-term
exchange rate flexibility to correct
fundamental payments disequilibria.
Liquidity and Special Drawing Rights
Special Drawing Rights are bookkeeping entries at the
IMF, available to IMF members in proportion to their
IMF quotas, that may be used to settle payments
deficits or satisfy reserve needs in place of foreign
exchange or gold.
Arguments for Managed Float
Trade growth
Managing turbulence (Australia’s ‘managed float’ had
the ability to depreciate, thus weathered the Asian
currency crisis)
Arguments against a Managed Float
Volatility and adjustment
Reinforcement of inflation
A Current Account deficit results from domestic
consumers buying more imports than foreign
consumers buying exports.
This causes an oversupply of domestic currency in the
foreign exchange market.
Under a freely-floating exchange rate system, this
oversupply results in a decrease in the price of the
domestic currency’s value against other currencies.
This is a depreciation.
Currency depreciation generally improves a nation’s
competitiveness.
A depreciation makes exports cheaper and imports
dearer in foreign currency terms.
This can have the effect of automatically correcting a
Current Account deficit (by increasing demand for
exports and decreasing demand for imports).
The ability of a currency depreciation to correct a
Current Account deficit depends on a number of
factors.
J-curve effect
Represents a time lag between a depreciation and an
improvement in an economy’s trade balance.
Exchange Rate Pass-through
How much of a depreciation is passed through to a
change in prices of goods and services.
A depreciation can:
Improve trade balance if economy has excess
capacity.
Reduce domestic performance if economy operating
at full capacity because resources are taken away
from domestic production and used for export
production.
So, currency depreciation not good for an economy
operating at maximum capacity.
Under a fixed exchange rate system, the central
government must meet the excess supply of currency
brought about by a Current Account deficit by buying
it on the foreign exchange market to maintain the
pre-determined exchange rate value. It deals in the
foreign exchange market by selling foreign currency.
A nation finances a Current Account deficit out of its
international reserves or by attracting investment or
borrowing from other nations.
The capacity of a deficit nation to cover excess outpayments over in-payments is limited by its stocks of
international reserves and willingness of other
nations to invest in, or lend to the deficit nation.
Flexible exchange rates automatically adjust
so as to eliminate balance of payments
deficits or surpluses.
This involves automatic adjustment
depending on demand and supply for
domestic currency on the foreign exchange
market.
Law of One Price
Identical goods sold in different countries must sell for the same price
when their prices are expressed in terms of the same currency.
So, prices of goods and services in an economy can influence the value of
an economy’s exchange rate.
This law applies only in competitive markets free of transport costs and
official barriers to trade.
It implies that the dollar price of good i is the same wherever it is sold:
PiA = (E$A/¥) x (PiJ)
where:
PiA is the dollar price of good i when sold in Australia
PiJ is the corresponding Yen price in Japan
E$A/¥ is the Dollar/Yen exchange rate (i.e. direct quote from the
perspective of the Australian currency)
Example
If the Dollar/Pound exchange rate is $A1.50 per
Pound, a sweater that sells for ¥30 in Tokyo must sell
for $A1.50 x ¥30 = $A45 in Sydney.
The theory of Purchasing Power Parity (PPP) explains
movements in the exchange rate between two
countries’ currencies by changes in the countries’
price levels. It differs to the Law of One Price by
examining general price levels in 2 different
economies.
Theory of Purchasing Power Parity (PPP)
The exchange rate between two counties’
currencies equals the ratio of the counties’ price
levels.
 It compares average prices across countries.
 It predicts a $A/¥ exchange rate of:

E$A/¥ = PA/PJ
where:
PA is the Dollar price of a reference commodity
basket sold in Australia.
PY is the Yen price of the same basket in Japan
The Relationship Between PPP and the Law of
One Price
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The law of one price applies to individual
commodities, while PPP applies to the general
price level.
If the law of one price holds true for every
commodity, PPP must hold automatically for the
same reference baskets across countries.
Proponents of the PPP theory argue that its
validity does not require the law of one price to
hold exactly.

Absolute PPP and Relative PPP

Absolute PPP
 States that exchange rates equal relative price levels.

Relative PPP
 States that the percentage change in the exchange rate
between two currencies over any period equals the
difference between the percentage changes in national
price levels.
 Relative PPP between Australia and Japan would be:
(E$A/¥,t - E$A/¥, t –1)/E$A/¥, t –1 = A, t - J, t
where:
t = inflation rate
Holding constant other determinants, low
interest rates lead to reduced demand for an
economy’s currency and to exchange rate
depreciation for that economy;
High interest rates result in appreciation.
The relative interest rate is the nominal rate
adjusted for inflation.
If domestic inflation exceeds foreign inflation,
then the purchasing power of the domestic
currency falls relative to the foreign currency.
There is proportional depreciation.
For example, if inflation in Australia exceeds
Japan’s inflation by 2% per year, the
purchasing power of the $A falls 2% relative
to the yen. The foreign exchange value of the
$A should therefore depreciate 2% per year.
Market fundamentals influence flows of exports
and imports: bilateral trade relationships;
consumer tastes; investment profitability;
product availability; productivity changes; trade
policy.
In the short-run however, market expectations
influence exchange rate movements. Future
expectations of rapid domestic growth, falling
domestic interest rates and high domestic
inflation rates tend to cause the domestic
currency to depreciate.
When exchange rates respond immediately to
market forces, they are subject to
expectations; that is, rather than reflecting
existing market fundamentals, rates can move
in anticipation of future changes.
Factor
Change
Impact
Expected domestic price level (relative to foreign nations)
Increase
Decrease
Depreciation
Appreciation
Expected domestic interest rate (relative to foreign
nations)
Increase
Decrease
Appreciation
Depreciation
Expected domestic trade barriers (relative to foreign
nations)
Increase
Decrease
Appreciation
Depreciation
Expected domestic import demand
Increase
Decrease
Depreciation
Appreciation
Expected domestic export demand
Increase
Decrease
Appreciation
Depreciation
Expected domestic productivity (relative to foreign
nations)
Increase
Decrease
Appreciation
Depreciation
Demonstrate how future expectations of the $A
depreciating can be self-fulfilling.
Importers stock up on foreign currency, yet
holders of foreign currency (including
importers of Australian products domestic
goods) will restrict supply of foreign currency
as its price relative to the $A is expected to
rise.
Therefore price of foreign currency rises
Forecasts used by exporters, importers, investors, bankers and
foreign-exchange dealers. Useful in practice e.g. Multi-National
Corporations need to know what currency to make bank deposits
in.
3 types:
1. Judgmental forecasts: examine data of individual nations and
includes economic, social and political factors. Involves
subjectivity.
2.
Technical forecasts: uses historic exchange-rate data to estimate
future values. Only works if market follows a consistent pattern
and more reliable in the short-term.
3.
Fundamental analysis: uses computer based econometric models.
Consider economic variables likely to affect a currency’s value.
Most forecasters use a combination of the three.
Problems
 Too much foreign debt financing
unproductive activity
 Debt default
 Reduced foreign investment
 Depreciating exchange rate values
 High inflation in affected countries
 Reduced asset values and declining wealth
 Fall in Aggregate Expenditure and GDP
 Growth in unemployment
Government response to protect exchange
rate values :
Buy domestic currency; and
 Raise interest rates
 Increased liquidity provided by IMF
 Expansionary Fiscal Policy

Contributing Factors
 Insufficient financial sector management
 Inadequate financial regulation
 Overvalued exchange rates
 Currency speculation
 Poor political management
Countries most affected:
 Indonesia, South Korea and Thailand
Response
Floating
Build
of many Asian currencies
up of foreign currency reserves
Regional
Free Trade Agreements (instead of
uncontrolled globalisation)
Improved
corporate governance
Financial
market reform
Greater
financial regulation
General
economic structural reform