Transcript Chapter 15 Exchange-Rate Systems and currency crises

Exchange-Rate Systems
and Currency Crises
PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
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Exchange-Rate Practices
• Floating exchange-rate system
• Determined by market forces
• Float independently
• Float in unison with a group of other currencies
• Crawl according to a predetermined formula
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Exchange-Rate Practices
• Pegged exchange-rate system
• Fixed against some standard of value
• Anchor to a single currency
• Anchor to a basket of currencies
• Anchor to gold – not used since 1971
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Exchange-Rate Practices
• Members of the IMF
• Exchange rates should not be manipulated
• To prevent effective balance-of-payments
adjustments
• To gain unfair competitive advantage over other
members
• Members should act to counter short-term
disorderly conditions in exchange markets
• When members intervene in exchange markets
• Take into account the interests of other members
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TABLE 15.1 Exchange-rate arrangements of IMF members, 2008
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TABLE 15.2 Choosing an exchange-rate system
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Choosing an Exchange Rate System:
Constraints Imposed by Free Capital Flows
• Allowing free capital flows
• Constrains a country’s
• Choice of an exchange-rate system
• Ability to operate an independent monetary policy
• Impossible trinity
• A country can maintain only two of the
following three policies:
• Free capital flows
• A fixed exchange rate
• An independent monetary policy
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FIGURE 15.1
Countries can adopt only two of the following three policies: free capital flows, a fixed
exchange rate, and an independent monetary policy.
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Fixed Exchange-Rate System
• Fixed exchange rates
• Used primarily by small, developing nations
• Currencies are anchored to a key currency
• Key currency
• Widely traded on world money markets
• Demonstrated relatively stable values over time
• Widely accepted as a means of international
settlement
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TABLE 15.3 Key currencies: currency composition of official
foreign exchange reserves of the member countries
of the international monetary fund, 2008
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Fixed Exchange-Rate System
• Anchoring to a single currency
• Developing nations whose trade and financial
relations are mainly with a single industrialcountry partner
• Anchoring to the special drawing right (SDR)
• A basket of four currencies established by the
IMF
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Fixed Exchange-Rate System
• Anchoring to a basket of currencies
• Developing nations with more than one major
trading partner
• Currency basket
• Prescribed quantities of foreign currencies
• In proportion to the amount of trade done
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Fixed Exchange-Rate System
• Par value
• In terms of gold or other key currencies
• Official exchange rate
• Can be determined by comparing the par
values of two currencies
• Exchange-stabilization fund
• To defend the official rate
• Through purchases and sales of foreign
currencies
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FIGURE 15.2 Exchange-rate stabilization under a fixed
exchange-rate system
To defend the official exchange rate of $2.80 per pound, the central bank must supply all of the nation’s
currency that is demanded at the official rate and demand all of the nation’s currency that is supplied to it at
the official rate. To prevent a dollar depreciation, the central bank must purchase the excess supply of dollars
with an equivalent amount of pounds. To prevent a dollar appreciation, the central bank must purchase the
excess supply of pounds with an equivalent amount of dollars.
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Fixed Exchange-Rate System
• Fundamental disequilibrium
• Long term, the official exchange rate and the
market exchange rate may move apart
• Reflecting changes in fundamental economic
conditions
• Income levels, tastes and preferences
• Technological factors
• Cost of defending the existing official rate may
become prohibitive
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Fixed Exchange-Rate System
• Balance-of-payments equilibrium
• By devaluing or revaluing its currency
• Currency devaluation
• To cause the home currency’s exchange value
to depreciate
• Counteracting a payments deficit
• Currency revaluation
• To cause the home currency’s exchange value
to appreciate
• Counteracting a payments surplus
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Fixed Exchange-Rate System
• Devaluation and revaluation
• Legal redefinition of a currency’s par value
under a system of fixed exchange rates
• Depreciation and appreciation
• Actual impact on the market exchange rate
caused by
• A redefinition of a par value
• Changes in an exchange rate
• Changes in the supply of or demand for foreign
exchange
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TABLE 15.4 Advantages and disadvantages of fixed
exchange rates and floating exchange rates
Advantages
Disadvantages
Fixed exchange
rates
Simplicity and clarity of exchangerate target
Automatic rule for the conduct of
monetary policy
Keeps inflation under control
Loss of independent monetary
policy
Vulnerable to speculative
attacks
Floating exchange
rates
Continuous adjustment in the
balance of payments
Operate under simplified institutional
arrangements
Allow governments to set
independent monetary and fiscal
policies
Conducive to price inflation
Disorderly exchange markets
can disrupt trade and
investment patterns
Encourage reckless financial
policies on the part of
government
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Fixed Exchange-Rate System
• Bretton Woods system, 1946-1973
• Semi-fixed exchange-rate system
• Adjustable pegged exchange rates
• Currencies were tied to each other
• Provide stable exchange rates for commercial and
financial transactions
• A nation could repeg its exchange rate via
devaluation or revaluation policies
• Use fiscal and monetary policies first to correct
payments imbalances
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Fixed Exchange-Rate System
• Bretton Woods system, 1946-1973
• Agree to defend existing par values
• Correct fundamental disequilibrium by
repegging their currencies
• Up to 10% without permission from the IMF
• By greater than 10% with the fund’s permission
• Par value set in terms of gold
• Or gold content of the U.S. dollar in 1944
• Market exchange rates were almost but not
completely fixed
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Fixed Exchange-Rate System
• Operational problems of the Bretton Woods
system
• Adjustments in prices and incomes often
conflicted with domestic-stabilization
objectives
• Currency devaluation was considered
undesirable
• Failure of domestic policies
• Loss of international prestige
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Fixed Exchange-Rate System
• Operational problems of the Bretton Woods
system
• Currency revaluations were unacceptable to
exporters
• Repegging exchange rates only as a last resort
• Sizable adjustments
• Difficult because of adjustable pegged rates
• Speculators
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TRADE
CONFLICTS
Is China a currency manipulator?
• China - manipulates the Yuan
• Yuan - significantly undervalued relative to the
dollar
• U.S. exports to China more expensive
• Harms U.S. production and employment
• Chinese goods cheaper for American
consumers – more imports
• Huge trade surplus with the United States
• Large accumulation of dollar reserves
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TRADE
CONFLICTS
Is China a currency manipulator?
• Little or no connection between the Yuan and
the health of U.S. manufacturing
• Transition away from manufacturing in the U.S.
is a long-term trend
• Goes far beyond competition from Chinese exports
• Jobs have been slashed: technological
improvements
• Each worker more productive
• U.S. – more competitive workers
• Reform its educational system
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TRADE
CONFLICTS
Is China a currency manipulator?
• Good economic rationale for China’s peg policy
• Effective monetary anchor for China’s internal
price level
• Positive results for the U.S. economy
• Large investments in U.S. debt - keep U.S. interest
rates low
• Increase the size of the economy
• Promotes a lower inflation rate in the United
States
• Foster economic stability
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Floating Exchange Rates
• Floating (flexible) exchange rates
• Currency prices established daily in the foreignexchange market
• Without restrictions imposed by government policy
• Equilibrium exchange rate
• Demand for and supply of the home currency
• Changes in the exchange rate
• Correct a payments imbalance
• Shifts in imports and exports of goods, services, and
short-term capital movements
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FIGURE 15.3 Market adjustment under floating exchange rates
Under a floating exchange-rate system, continuous changes in currency values restore payments equilibrium
at which the quantity supplied and quantity demanded of a currency are equal. Starting at equilibrium point
A, an increase in the demand for francs leads to a depreciation of the dollar against the franc; conversely, a
decrease in the demand for francs leads to an appreciation of the dollar against the franc.
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Floating Exchange Rates
• Economic downturns
• Labor unions lobby for import restrictions
• To save jobs for domestic workers
• Implementation of import restrictions
• Help one industry
• Shift jobs from other industries in the economy to
the protected industry
• No significant impact on aggregate employment
• Short-term employment gains in the protected
industry
• Offset by long-term employment losses in other
industries
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Floating Exchange Rates
• Arguments for floating exchange rates
• Simplicity
• Respond quickly to changing supply and demand
conditions
• Clear the market of shortages or surpluses of a
given currency
• Simplified institutional arrangements that are
relatively easy to enact
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Floating Exchange Rates
• Arguments for floating exchange rates
• Continuous adjustment in the balance of
payments
• Partially insulate the home economy from
external forces
• Nations have greater freedom to pursue
policies that promote domestic balance
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Floating Exchange Rates
• Arguments against floating exchange rates
• An unregulated market may lead to wide
fluctuations in currency values
• Discourage foreign trade and investment
• Inflationary bias
• Monetary authorities may lack financial discipline
• Greater freedom for domestic financial
management
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Managed Floating Rates
• Managed floating system
• Informal guidelines established by IMF for
coordination of national exchange-rate policies
• Nations might intervene in the exchange markets to
avoid exchange-rate alterations that would weaken
their competitive position
• Concern that floats over time might lead to
disorderly markets with erratic fluctuations in
exchange rates
• A nation can alter the degree to which it
intervenes in the foreign-exchange market
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Managed Floating Rates
• Leaning against the wind
• Intervene to reduce short-term fluctuations in
exchange rates
• Without attempting to adhere to any particular
rate over the long term
• Target exchange rates
• To reflect long-term economic forces that
underlie exchange-rate movements
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Managed Floating Rates
• Managed floating rates
• Market intervention - used to stabilize
exchange rates in the short term
• Allows market forces to determine exchange
rates in the long term
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FIGURE 15.4 Managed floating exchange rates
Under this system, central bank intervention is used to stabilize exchange rates in the short
term; in the long term, market forces are permitted to determine exchange rates.
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Managed Floating Rates
• Monetary policy
• To stabilize a currency’s exchange value
• Expansionary monetary policy
• Increase the money supply
• To offset currency appreciation
• Contractionary monetary policy
• Decrease the money supply
• To offset currency depreciation
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FIGURE 15.5 Exchange-rate stabilization and monetary policy
In the absence of international policy coordination, stabilizing a currency’s exchange value
requires a central bank to initiate (a) an expansionary monetary policy to offset an
appreciation of its currency, and (b) a contractionary monetary policy to offset a depreciation
of its currency.
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Managed Floating Rates
• Official foreign-exchange intervention
• May be useful when the exchange rate is under
speculative attack
• May be helpful in coordinating private-sector
expectations
• Some support for the short-term effectiveness
• No support for the long-term intervention
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The Crawling Peg
• The crawling-peg system
• Small, frequent changes in the par value of its
currency
• To correct balance-of-payments disequilibrium
• The process of exchange-rate adjustment
• Continuous for all practical purposes
• Used by nations with high inflation rates
• Combines the flexibility of floating rates with
the stability usually associated with fixed rates
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Currency Crises
• Currency crisis, speculative attack
• A weak currency experiences heavy selling
pressure
• Sizable losses in the foreign reserves held by a
country’s central bank
• Depreciating exchange rates in the forward market
• Widespread flight out of domestic currency
• Into foreign currency
• Into goods that people think will retain value
• Can decrease GDP growth by 6%
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TABLE 15.5 Examples of currency crises
Mexico, December 1994–1995. Mexico’s central bank maintained the value of the peso
within a band that depreciated four percent a year against the U.S. dollar. In order to
reduce interest rates on its debt, the Mexican government in April 1994 began issuing debt
linked to the dollar. The amount of this debt soon exceeded the central bank’s falling
foreign-exchange reserves. Unrest in the province of Chiapas led to a speculative attack on
the peso. Although the government devalued the peso by 15 percent by widening the
band, the crisis continued. The government then let the peso float; it depreciated from
3.46 per dollar before the crisis to more than 7 per dollar. To end the crisis, Mexico
received pledges for $49 billion in loans from the U.S. government and the IMF. Mexico’s
economy suffered a depression and banking problem that led to government rescues.
Russia, 1998. The Russian government was paying high interest rates on its short-term
debt. Falling prices for oil, a major export, and a weak economy also contributed to
speculative attacks against the ruble, which had an official crawling band with the U.S.
dollar. Although the IMF approved loans for Russia of about $11 billion and the Russian
government widened the band for the ruble by 35 percent, the crisis continued. This crisis
led to the floating of the ruble and its depreciation against the dollar by about 20 percent.
Russia then went into recession and experienced a burst of inflation. Many banks became
insolvent. The government defaulted on its ruble-denominated debt and imposed a
moratorium on private-sector payments of foreign debt.
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TABLE 15.5 Examples of currency crises
Turkey, 2001. The Turkish lira had an IMF-designed official crawling peg against the U.S.
dollar. In November 2000, rumors about a criminal investigation into ten government-run
banks led to a speculative attack on the lira. Interbank interest rates rose to 2,000 percent.
The central bank then intervened. Eight banks became insolvent and were taken over by
the government. The central bank’s intervention had violated Turkey’s agreement with the
IMF, yet the IMF lent Turkey $10 billion. In February 2001, a public dispute between the
president and prime minister caused investors to lose confidence in the stability of Turkey’s
coalition government. Interbank interest rates rose to 7,500 percent. Thus, the government
let the lira float. The lira depreciated from 668,000 per dollar before the crisis to 1.6 million
per dollar by October 2001. The economy of Turkey stagnated and inflation skyrocketed to
60 percent.
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Currency Crises
• End a currency crisis - end the selling pressure
• Devalue - establish a new exchange rate at a
sufficiently depreciated level
• Adopt a floating exchange rate
• Impose restrictions on the ability of people to
buy and sell foreign currency
• Obtain a loan to bolster the foreign reserves of
the monetary authority
• Restore confidence in existing exchange rate
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Currency Crises
• Sources of currency crises
•
•
•
•
•
•
•
•
Currency speculators
Budget deficits financed by inflation
Weak financial systems
Recently deregulated financial systems
A weak economy
Political factors
External factors
Choice of an exchange-rate system
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Capital Controls
• Capital controls, exchange controls
• Government-imposed barriers
• To foreign savers investing in domestic assets
• To domestic savers investing in foreign assets
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Capital Controls
• Capital controls, exchange controls
• Advantages
• Government can influence its payments position
• Regulating the amount of foreign exchange allocated to
imports or capital outflows
• Government - encourage or discourage certain
transactions
• 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
• Controls on capital outflows – problems:
• Capital outflows may further increase after the
controls are implemented
• Result in evasion
• Provide government officials the false sense of
security that they do not have to reform their
financial systems to ameliorate the crisis
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Capital Controls
• Controls on capital inflows
• Support
• If speculative capital cannot enter a country, then it
cannot suddenly leave and create a crisis
• Problems
• Can prevent funds that would be used to finance
productive investment opportunities from entering
• Are seldom effective because the private sector
finds ways to evade them and move funds into the
country
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Capital Controls
• Taxing foreign-exchange transactions
• A tax would increase the cost of these
transactions
• Discourage massive responses to minor changes
• Dampen volatility in exchange rates
• Drawbacks:
• We do not know how much volatility is excessive or
irrational
• A tax could impose a burden on countries that are
quite rationally borrowing overseas
• Would be difficult to implement
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Increasing the Credibility of Fixed Exchange
Rates
• Currency board
• Monetary authority that issues notes and coins
convertible into a foreign anchor currency at a
fixed exchange rate
• Can operate in place of a central bank or as a
parallel issuer alongside an existing central
bank
• Takes over the role of a central bank in
strengthening the currency of a developing
country
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Increasing the Credibility of Fixed Exchange
Rates
• Currency board
• Has no discretionary powers
• Sole function: to exchange its notes and coins for
the anchor at a fixed rate
• The government can finance its spending only
by taxing or borrowing
• Not by printing money and thereby creating
inflation
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Increasing the Credibility of Fixed Exchange
Rates
• Currency board
• Monetary policy on autopilot
• When the anchor currency flows in
• The board issues more domestic currency
• Interest rates fall
• When the anchor currency flows out
• Interest rates rise
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Increasing the Credibility of Fixed Exchange
Rates
• Major benefits of the currency-board system:
• Making a nation’s currency and exchange-rate
regimes more rule-bound and predictable
• Placing an upper bound on the nation’s base
money supply
• Arresting any tendencies in an economy toward
inflation
• Forcing the government to restrict its
borrowing to what foreign and domestic
lenders are willing to lend it at market interest
rates
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Increasing the Credibility of Fixed Exchange
Rates
• Major benefits of the currency-board system:
• Engendering confidence in the soundness of
the nation’s money
• Assuring citizens and foreign investors that the
domestic currency can always be exchanged for
some other strong currency
• Creating confidence and promoting trade,
investment, and economic growth
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Increasing the Credibility of Fixed Exchange
Rates
• Objections to the currency-board system:
• Prevents a country from pursuing a
discretionary monetary policy
• Reduces its economic independence
• Susceptible to financial panics
• It lacks a lender of last resort
• Creates a colonial relation with the anchor
currency
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55
Increasing the Credibility of Fixed Exchange
Rates
• Dollarization
• When residents of a foreign country use the
U.S. dollar alongside or instead of the domestic
currency
• Full dollarization
• Elimination of the domestic currency and its
complete replacement with the U.S. dollar
• U.S. Virgin Islands, Marshall Islands, Puerto
Rico, Guam, Ecuador, other Latin American
countries
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56
Increasing the Credibility of Fixed Exchange
Rates
• Benefits of dollarization
• Credibility and policy discipline
• Avoid the capital outflows that often precede
or accompany an embattled currency situation
• Decrease in transaction costs
• Lower rate of inflation
• Tied to inflation rate of the issuing country
• Greater openness
• Balance-of-payments crises are minimized
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57
Increasing the Credibility of Fixed Exchange
Rates
• Effects of dollarization for the foreign country
• Monetary policy of the Federal Reserve
• Federal Reserve
• Not a lender of last resort for the foreign nation
• The country
• No seigniorage from its monetary system
• State expenditures are not affected
• Can establish its own trade policies
• Constraint on fiscal policy:
• Cannot print more domestic currency to finance budget
deficits
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58
Increasing the Credibility of Fixed Exchange
Rates
• Effects of dollarization for the U.S.
• For each dollar sent abroad, Americans enjoy a
one-time increase in the amount of goods and
services they are able to consume
• The U.S. gets an interest-free loan from the
foreign country
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59
Increasing the Credibility of Fixed Exchange
Rates
• Effects of dollarization for the U.S.
• Might hinder the formulation and execution of
monetary policy by the Federal Reserve
• Could result in more pressure on the Federal
Reserve to conduct policy according to the
interests of the foreign country
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60
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• General factors causing economic crises
•
•
•
•
•
•
An overshooting of markets
Excessive leveraging of debt
Credit booms
Miscalculations of risk
Rapid outflows of capital from a country
Unsustainable macroeconomic policies
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61
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• Global economic crisis of 2007–2009
• Bursting of the U.S. housing market bubble
• Increase in foreclosures
• Global financial and economic crisis
• The U.S. - major center of the financial world
• Main guarantor - international financial system
• Provider of dollars: currency reserves,
international medium of exchange
• Financial capital - moves around the world
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62
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• Spreading of the financial crisis
• Industrial countries
• Emerging market
• Developing economies
• Economies deteriorated
•
•
•
•
Investors pulled capital from countries
Plunging values of stocks, domestic currencies
Slumping exports and commodity prices
Recession or slow economic growth
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63
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• Global crisis played out at two levels
• Among the industrialized nations of the world
• Losses from subprime mortgage debt, excessive
leveraging of investments, and inadequate capital
backing financial institutions
• Among emerging market and other economies
• Innocent bystanders to the crisis - weak economies
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64
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• Cope with the global financial crisis
• Control the contagion
• Minimize losses to society
• Restore confidence in financial institutions and
instruments
• Lubricate the wheels of the economy
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65
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• Measures
• Injecting capital
• Loans or stock purchases
• Prevent bankruptcy of financial institutions
• Increasing deposit insurance limits
• To limit withdrawals from banks
• Purchasing toxic debt of financial institutions
on the verge of failure
• So that they would start lending again
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66
TRADE
CONFLICTS
The global economic crisis of
2007–2009
• Measures
• Coordinating interest-rate reductions by central
banks
• To inject liquidity into the economy
• Enacting stimulative fiscal policies
• To bolster sagging aggregate demand
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67