Transcript International Monetary Policy

International Monetary Policy
Exchange Rates and Money
International Monetary Theory
• Given the large amount of economic activity that takes
place across borders, we need to consider the effects of
monetary policy on this activity
• Monetary policy principally affects international finance
through exchange rates
– When a central bank increases the money supply, a country’s
currency will depreciate, all else being equal
– Because of sticky prices and expectations, the exchange rate
will actually overshoot its long run value in response to monetary
policy.
• Monetary Policy may be guided by exchange rate targets
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Maintaining exchange rate stability
Fixed exchange rates
Currency Unions
Dollarization
Currency as an Asset
• An exchange rate is just the rate at which one currency trades for
another
• Exchange rates fluctuate based on the relative demand and supply
of one currency relative to another.
• These rates will move due to…
– Deviations from Purchasing Power Parity (Long Term Movements)
– Business Cycle Asymmetries (Medium Term)
– Interest Rate Differentials (Short Term)
• Monetary Policy principally affects exchange rates through the
interest rate channel.
• People choose to hold a currency for the same reason that they
choose to hold money.
– The choice of which currency to hold as money is subject to these same
motivations.
– On top of this, people can also choose to hold non-monetary assets in
foreign currency
The Demand for Foreign Currency: Asset Markets
• Changes in exchange rates affect the returns on foreign
currency deposits.
– An appreciation of the foreign currency causes the return on
foreign deposits to rise
– An appreciation of the domestic currency causes the return on
foreign deposits to fall
• Suppose that an American bond costs $100 to buy and will
pay annual interest of 6%
• Suppose that a British bond costs ₤50 to buy and will pay
annual interest of 4%
• Can we definitively say that the American bond yields the
higher return?
– NO! We need to have some measure of expected exchange rate
changes.
The Demand for Foreign Currency: Asset Markets
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American bond costs $100 and pays 6% interest
British bond costs ₤50 and pays 4% interest
Suppose the exchange rate is 2$/₤
Suppose that the expected exchange rate next year is 2.2$/₤
American Perspective
• American bond is worth $100 this year and $106 next year
• British bond is worth $100 this year and…
– ₤50*1.04 = ₤52  ₤52*2.2₤/$ = $114.4 next year!
British Perspective
• American bond is worth ₤50 this year and…
– $100*1.06 = $106  $106/2.2₤/$ = ₤48.2 next year
• British bond is worth ₤50 this year and ₤52 next year
The Exchange Rate Adjusted Rate of Return
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The return on foreign currency is a function of…
– the local interest rate
– Expected appreciations or depreciations in the foreign currency
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Exchange rate changes affect returns through two channels
– They change the baseline foreign value of the asset
– They change the foreign currency interest earned on that asset
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This second channel is generally much smaller than the first, so we ignore
it when defining the local return on foreign currency deposits:
RD , F  RF , F
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EDe / F  ED / F

ED / F
The domestic currency return on a foreign asset is equal to the foreign
currency return plus the expected percentage appreciation of the foreign
currency
Compute the US Dollar Return
RD , F  RF , F
EDe / F  ED / F

ED / F
• RUK,UK = 3%, E$/₤ = 2, Ee$/₤ = 2.1, RUS,UK = ?
– RUS,UK = 3% + (2.1 – 2)/2 = 3% + 5% = 8%
• REU,EU = 5%, E$/€ = 1, Ee$/€ = 0.95, RUS,EU = ?
– RUS,EU = 5% + (0.95 – 1)/1 = 5% - 5% = 0%
• RUS,EU = 10%, E$/€ = 1, Ee$/€ = 1.08, REU,EU = ?
– 10% = REU,EU + (1.08-1)/1
– REU,EU = 10% - 8% = 2%
Interest Rate Parity
RD , D  RD , F  RF , F
EDe / F  ED / F

ED / F
• Suppose that the US Dollar return on a British asset is 5%, while the US
Dollar return on an American asset is 3%
• The higher rate of return on British assets will induce investors to
purchase British assets in lieu of American assets
• Increased demand for British assets will drive up the current value
of the pound (E$/₤ will increase)
• This will continue until both the American and British assets offer
the same return when expressed in a common currency
Interest Rate Parity
Predict what will happen to the current value of the Dollar
• Mexican and US interest rates are both at 5%. New discoveries of
gold in Mexico make investors expect a 6% appreciation of the
peso.
• The interest rate on Australian assets is 4% above that on
American assets. People expect the Australian dollar to depreciate
by 7% against the US dollar.
• The expected depreciation of the dollar against the yen is 2%. The
U.S. central bank announces that it will cut interest rates to 3%.
The Central Bank of Japan offers a 1% interest rate on assets.
Questions on Interest Rate Parity
• The return on a Mexican bond is 7%. The return on an
equally risky British bond is 3%. The spot exchange rate
is 20 pesos per pound. The forward exchange rate is
20.8 pesos per pound. Does I.P. hold?
• The return on a German bond is 5%. The current
exchange rate is 1.5 dollars per euro. The forward
exchange rate is 1.8 dollars per euro. What U.S. interest
rate would satisfy I.P.?
• The return on a German bond is 8%. The return on a
French bond is 4%. What does I.P. suggest is the
expected appreciation of the French currency?
The Local Currency Return on Foreign Assets
Spot Exchange Rate
(Eh/f)
Rh,fe
Home Currency Return on Foreign Assets = Rh, f  R f , f 
Ehe/ f  Eh / f
Eh / f
The Equilibrium Exchange Rate
Spot Exchange Rate
(Eh/f)
Rh,h
Home assets have a higher return on
foreign assets – the foreign currency
will depreciate today, leading to a
higher expected appreciation of the
foreign currency
Foreign assets have a higher
return than home assets.
Investors will bid up the price of
foreign currency, thereby
increasing the expected
appreciation of the home currency
Eh/fHigh
Eh/f*
Eh/fLow
Rh,fe
Rh,h = Rh,f
Rates of Return in home currency
Exchange Rates and I.P.
• In the short run, the exchange rate between currencies are
determined by two factors:
– The interest rates that can be earned on deposits in each currency
– The expected future exchange rate (appreciation or depreciation)
• With open capital markets and low transactions costs, interest rate
parity suggests that the common currency return on assets must be
the same across countries
• Otherwise, investors would flock to the highest return assets, driving
up the price of that country’s current currency.
• A rise in the current exchange rate is also a decrease in the
expected appreciation of that currency. This lowers the expected
common currency return until I.P. holds.
• We have taken interest rates and expectations as given.
• We now need to look closely at how interest rates and expectations
are formed.
Money and Exchange Rates
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Interest rates within a country are primarily affected by the domestic money
market
– Less true for small countries, where the policies of a large neighboring country
can have profound effects on the domestic market.
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We know that interest rate differentials can lead to exchange rate changes –
interest rate parity.
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Suppose the Federal Reserve increased the U.S. money supply.
In the short run (fixed prices), this would lower U.S. interest rates
What would happen to the value of the dollar against the British pound
assuming the Bank of England did not pursue a similar policy and that
interest rate parity initially holds?
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Relatively lower U.S. interest rates (in dollars) suggest that American
investors will demand British assets.
To get these assets, they will bid up the current value of the pound against
the dollar.
This will continue until the expected appreciation of the pound falls enough
to offset the lower domestic currency interest rate in the U.S.
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Money and Exchange Rates in the Long Run
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In the short run, prices are sticky and monetary policy can have real effects.
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In the long run, the economy is running at full employment, with real interest
rates and output determined solely by the economy’s fundamentals (capital,
labor, technology, property rights, etc.)
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In the long run, any increase in the money supply will be met with a
proportionate increase in the price level.
– People expect prices to rise in the future.
– Higher prices in the future suggest a lower future value for the exchange rate.
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An increase in the money supply will therefore have two effects on
exchange rates in the short run:
– Domestic interest rates fall
– With higher price expectations, the expected future exchange rate also falls.
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Lower current interest rates and lower expected exchange rates causes the
currency to fall considerably in the short run.
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In the long run, prices rise, pushing domestic interest rates up. This will
lead to an appreciation of the currency
– However, the currency will not recover its full value since expectations do not
change.
Monetary Policy and Interest Rates: Long Run
R
Ms2
Ms1
1. The Central Bank increases the
money supply. With sticky short
run prices, the interest rate falls.
1
2. In the long run, the price level
will rise in proportion to the
increase in the nominal money
supply. Higher prices induce an
increase in money demand,
bringing interest rates back to
R1
R1
2
R2
Md2
Md1
M1
M2
M
Exchange Rate Overshooting
Rh,h
Eh/f
1
1. The home money supply rises, causing
home interest rates to fall in the short
run.
2. In anticipation of higher future prices in
home, people expect the home
currency to depreciate against foreign.
This raises the expected home
currency return on foreign assets.
3
Eh/f2
3
3. Eventually, prices in the home country
rise. As these prices rise, the home
interest rate goes up (real money
supply falls).
1,2
Eh/f3
Eh/f1
2
Rh,fe
Rh,h = Rh,f
Home Currency Returns
Exchange Rate Overshooting
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Since expectations adjust immediately, but prices change only gradually,
exchange rates tend to fluctuate wildly in response to changes in monetary
policy.
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Expansionary monetary policy has two effects on the exchange rate market:
– Lowers domestic interest rates
– Increases the expected appreciation of foreign currency.
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Lower domestic interest rates induce investors to buy into foreign assets,
causing an appreciation of the foreign currency.
At the same time, people expect that looser money in the domestic country
will eventually lead to a weaker currency in that country. They expect the
currency to depreciate in the future too.
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As a result, the short-run response of the exchange rate to monetary policy
is very large.
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In the long run, the domestic interest rate effect goes away because prices
rise to offset the increase in the money supply.
The long-run response of the exchange rate to monetary policy is smaller
than the short run effect.
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Exchange Rate Overshooting
Exchange Rate Volatility
Changes in price
levels are less
volatile, suggesting
that price levels
change slowly.
Exchange rates are
influenced by
interest rates and
expectations, which
may change rapidly,
making exchange
rates volatile.
Fixing the Exchange Rate
• If a central bank wants to pursue a fixed exchange rate, they must
work within the foreign exchange market
• Suppose the Fed wanted to maintain a fixed exchange rate of 1.2
$/€.
– The Fed must be willing to buy or sell as many dollars or euros as the
market will bear at this fixed exchange rate.
– If they do not meet the market’s excess supply or demand at the desired
fixed rate, the exchange rate will change.
– Even if the government mandates and sets an “official” exchange rate,
the market will set the “practical” or black-market rate based on
equilibrium in the asset market (interest rate parity).
• To maintain a fixed exchange rate, the central bank must ensure that
the asset market is in equilibrium at that fixed exchange rate.
Fixing the Exchange Rate
• The asset market is in equilibrium when interest rate parity holds:
– R$,US = R€,EU + (Ee$/€ - E$/€)/E$/€
– To simplify notation: RUS = REU + (Ee – E)/E
• The Fed sets a fixed exchange rate of E = E0.
• Assume that this fixed exchange rate is credible, such that people
expect the exchange rate to be E0 in the future as well.
• The interest rate parity condition is now…
– RUS = REU + (E0 – E0)/E0
– RUS = REU
• If you are going to maintain a fixed exchange rate with a foreign
currency, then equilibrium in the asset market is only achieved when
your interest rate equals the interest rate in the foreign country.
Devaluing the Currency
• Sometimes governments decide to change the fixed exchange rate
– A Devaluation lowers the currency’s fixed value (Eh/f rises)
– A Revaluation raises the currency’s fixed value (Eh/f falls)
• If a country devalues its currency, there is an increase in output
– The Central Bank devalues the currency by purchasing foreign assets,
leading to an increase in the money supply.
– With the weaker currency, exports are cheaper and imports are more
expensive.
– This leads to increased demand and a rise in output.
– In the long run, the devaluation of the country’s currency will just lead to
a price increase proportionate to how much the money supply went up.
– Countries that consistently devalue their currencies also see consistent
inflation.
Balance of Payments Crises
• So far, we have been assuming that the government’s commitment
to a fixed exchange rate is credible
– Investors believe that the exchange rate is truly fixed; they expect that
the exchange rate in the future will be the same as the exchange rate
today.
• What if expectations change?
• Suppose a country is facing serious unemployment problems and
running a fixed exchange rate regime.
• There is mounting pressure on this country to devalue its currency,
since this will lead to a (short-run) increase in output and
employment.
• What happens if investors expect the government to devalue the
currency in the future (i.e. Ee is larger than E)?
• What does the government have to do to maintain the current
Exchange rate?
Balance of Payments Crises
E$/€
E>E0
E = E0
RUS,1
RUS,2
Investors expect the dollar to be
devalued, so the expected future
rate rises from E0 to E1. This
shifts the expected dollar return
on an EU bond up.
The relatively higher return on EU
bonds creates an excess demand
for euros. To maintain the fixed
exchange rate, the Fed must offer
to buy dollars and sell EU assets.
This lowers the U.S. money
supply and raises U.S. interest
rates
REU + (E1-E)/E
REU + (E0-E)/E
The adjustment by the Fed is contingent on them having
enough reserves of EU assets to satisfy the excess demand
for euros. What if they don’t? Then they must devalue the
dollar!
Returns
Balance of Payments Crises
• The expectation of an impending devaluation will lead to a capital
flight
– The expected return on foreign assets increases when people expect
the domestic currency to be devalued.
– Investors rush to convert their wealth from the domestic asset to the
foreign asset
– To maintain the fixed exchange rate, the domestic central bank must
sell foreign assets to private investors in exchange for domestic
currency/assets.
• Why do people change their expectations about a currency’s
stability?
– A central bank that is financing a federal government’s budget deficit 
The CB drains its reserves by lending to the gov’t.
– Sluggish growth in the domestic economy  the temptation to devalue
increases.
– Contagion from other countries  If neighboring countries have
devalued their currencies, the domestic currency is under increasing
pressure to devalue or suffer large losses in export revenues.
– Pure speculation  If enough people believe in an impending
devaluation and there is a large degree of “hot” money (short-term
capital), then a currency crises may become a self-fulfilling prophecy.