Transcript Chapter 12

Chapter 12
International Financial Markets
and Foreign Exchange Policy
Major World Currencies
• The “Big Three” currencies are the dollar,
the euro, and the yen.
• Active foreign exchange (forex) futures
markets also exist for the British pound,
Swiss franc, Canadian dollar, Australian
dollar, and Mexican peso
• Cash forex markets exist for all currencies,
but are unregulated markets among
bankers instead of organized exchanges.
Trade-weighted indexes of the
value of the dollar
• The Fed prepares several indexes of the tradeweighted average of the dollar. The major
distinctions are:
• Nominal or real
• Major-country index or broad index
• The real index accounts for differential rates of
inflation. This is particularly important for
countries where the inflation rate is very rapid.
For the major-country index, it does not make
much difference.
Purchasing Power Parity
• In equilibrium, the value of the dollar would be
at a level where the trade-weighted average cost
of a market basket of traded goods is the same
in the U.S. and the average of other economies.
The same concept would hold for all currencies.
• Some components of costs are difficult to
measure. However, a useful approximation can
be obtained from average wage rates in
manufacturing. The BLS prepares such tables.
Difficulties in Predicting Foreign
Exchange Rates
• Predicting forex rates is even more difficult
than predicting interest rates and stock
prices for several reasons.
• Expectations play an even more important
role
• Central banks may intervene
• Values may remain far away from
economic equilibrium for many years or
even decades
Strategies for Fluctuating Forex
Rates
• In the short run, foreign currency exposure
can be hedged. This isn’t costless, but it
does define and limit the risk
• In the long run, major trends in forex will
help managers determine whether
expansion should be made in the U.S. or
abroad. In that sense, an understanding
of the underlying trends determining forex
rates is useful.
Determinants of Forex Rates
• The principal factor has been and still
remains the relative rates of inflation. If,
for example, inflation averages 7% per
year in Country A and 2% per year in
Country B, in the long run, the currency of
B will depreciate about 5% per year
relative to A
Impact of the Trade Balance on
Rates
• Except for the U.S., the value of the
currency will be correlated with the size of
the current account balance. A surplus will
boost the value of the currency; a deficit
will reduce it. This doesn’t hold for the
U.S. because the world is on a de facto
dollar standard.
Financial Determinants of Forex
Rates
• It is often claimed that high interest rates
will boost the value of the currency.
Actually, though, it is the expected rate of
return on a weighted average of all assets
that is the relevant variable. This includes
short-term money market assets, bonds,
stocks, and the rate of return on physical
assets, or profits. Tax rates are also
important, as is the free flow of capital.
Financial Determinants of Forex
Rates, Slide 2
• High nominal rates will not attract more
foreign capital if they are due to higher
inflation. The real rate must have also
risen.
• If the stock market rises sharply, the value
of the currency may increase even if real
interest rates remain at low levels.
Expectations and Political
Considerations
• It used to be said that “money moves to the
right”. Obviously foreign capital flees situations
where revolutions or economic unrest are
expected.
• In general, investors look for a pro-growth
atmosphere regardless of the particular party in
power. Credibility of the central bank to keep
inflation low and stable is always important. In
this sense, large deficits are worrisome only if
they are funded by monetizing the debt.
The Dollar Bubble of the 1980s
• The overvalued dollar was due primarily to
the unprecedented 10% real rate of
interest on U.S. Treasury bonds.
• In addition, the stock market was rising
rapidly, profit margins were increasing, tax
rates were cut, and the government was
considered pro-business.
• When real interest rates returned to
normal, the dollar returned to normal.
The Overvalued Japanese Yen
• The Japanese yen remained severely
overvalued from the late 1980s until the late
1990s, yet interest rates fell to zero, the stock
market plunged 75%, and the economy entered
an extended recession. Obviously financial
factors did not keep the value of the yen high.
• In this case, Japan refused to allow imports to
rise very much, and restricted inflows of foreign
capital. Hence the current account balance
remained in surplus. The Japanese ministers
thought they were helping the economy, but in
fact they were harming it.
The J-Curve Effect
• The J-curve effect means that for a while,
an increase (say) in the value of the
currency is accompanied by an increase in
the current account surplus, instead of the
decline that would be expected. The
situation usually is reversed after about a
year, but in the interim, the normal
stabilizing mechanism does not work.
The J-Curve Effect, Slide 2
• The J-curve effect usually occurs because of the
leads and lags in ordering, and habit persistence
means it takes people a while to change their
purchasing patterns.
• However, if a stronger currency leads to lower
import prices, lower costs of production, and
hence higher exports, the J-curve effect could
continue indefinitely. That appears to be what
happened in Japan.
Which is Better: Fixed or Flexible
Exchange Rates?
• There are advantages and disadvantages
to both.
• Fixed rates reduce the cost of doing
business and permit better planning for
capital expenditures. Imagine how difficult
it would be to do business in the U.S. if, for
example, New York, Florida, Texas, and
Ohio all had different currency values.
Fixed or Flexible, Slide 2
• The key here, of course, is that all states
in the U.S. have a common currency.
• If countries do not have a common
currency, they are likely to have different
rates of inflation. Thus if fixed rates
remain in place under that circumstance,
eventually there will have to be a major
devaluation, which could cause a severe
recession in one or more countries.
Fixed or Flexible, Slide 3
• The collapse of the Korean won, Thai baht,
Indonesian rupee, and Malaysian ringgit in the
late 1990s indicates what happens when
countries remain on fixed exchange rates with
the dollar but have a higher rate of inflation than
the U.S.
• From an economic viewpoint, the optimal
solution would be a single world currency. The
Europeans have moved in that direction. So far,
though, the political realities dictate that there
will be many different currencies indefinitely.
Optimal Trade and Forex Policies
• If all major countries followed these rules,
world real growth would be maximized,
and the resulting trade surpluses or
deficits in individual countries would be
irrelevant.
• 1. Keep the value of the dollar and other
key currencies near their trade-weighted
purchasing power parity equivalent.
Optimal Policies, Slide 2
• Balance the budget at full employment and
maintain a credible monetary policy
• Reduce tax rates that will encourage
saving and investment within the confines
of the above condition.
• Continue to advocate free trade practices
around the world.