Transcript Lecture Slides Chapter 15

Exchange-Rate Systems
and Currency Crises
Chapter 15
Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.
Exchange Rate Systems
1) fixed rate
a) also known as pegged exchange rate
b) anchored to the value of one other
currency or a group of currencies
2) floating rate
a) determined by market forces
b) float independently or with a group
of other currencies
IMF Principles
1) Member nations must avoid manipulating
exchange rates in order to impact balance of
payments
2) Members should intervene to counteract
disruptive short term exchange rate
movements
3) Members should take into account the
impact of intervention policies on other
members
Impossible Trinity
It is not possible for a country to maintain all
three of the following:
1) free capital flows
2) a fixed exchange rate
3) independent monetary authority
Impossible Trinity (continued)
A country can choose any two of the three:
Impossible Trinity (examples)
1) U.S. allows free flow of capital &
maintains monetary authority but does not
have a fixed exchange rate
2) Hong Kong has a fixed exchange rate &
allows free flow of capital but does not have
independent monetary authority
3) In the past, China had a fixed and
maintained monetary authority but did not
allow the free flow of capital
Fixed Exchange Rates
Fixed exchange rates are the norm for
developing economies. By tying their
currencies to a key currency – that of a
larger, more developed nation they promote
1) a means of international settlement
2) stabile prices for imports/exports
3) limits on inflationary pressure
Fixed Exchange Rates (continued)
Under a fixed exchange rate system
governments maintain
o par value for their currencies
o an official exchange rate determined by
comparing par values
o an exchange rate stabilization fund to buy
and sell foreign currencies in order to
preserve the official exchange rate
Preventing Depreciation
If the demand for
the euro
increased, the
value of the euro
would rise and
the value of the
dollar would fall.
In order to
maintain the fixed
exchange rate,
the U.S. would
use its reserve of
euros to buy
dollars.
P
Market for Euros
S1
S2
$1.70
$1.50
D2
D1
Q
Preventing Appreciation
If the supply of
the euro
increased, the
value of the euro
would fall and the
value of the
dollar would rise.
In order to
maintain the fixed
exchange rate,
the U.S. would
use dollars to buy
euros.
P
Market for Euros
S1
S2
$1.50
$1.25
D2
D1
Q
Devaluation & Revaluation
Devaluation
o legal reduction of a currency’s par value
o market impact termed depreciation
o counters a balance of payment deficit by making
exports less expensive
Revaluation
o legal increase of a currency’s par value
o market impact termed appreciation
o counters a balance of payment surplus by
making imports less expensive
Bretton Woods System
1) response to crises of Great Depression when
floating exchange rates had been unsuccessful
2) Bretton Woods created a semi-fixed system
known as adjustable pegged exchange rates
3) currencies values tied to each other
4) nations to use fiscal and monetary policies first
to address balance of payments disequilibria
5) last resort was to re-peg currencies; greater than
10% change required IMF permission
Floating Exchange Rates
o also known as flexible exchange rates
o equilibrium exchange rate determined by
demand for and supply of home currency
o changes in exchange rate correct
payments imbalance by changing the
effective cost of imports and exports
o will not fluctuate erratically unless there is
significant instability in financial markets
Depreciation & Exports
If real income in
the U.S.
increased, then
demand for
imports and
demand for the
euro would
increase. The
value of the euro
would rise and
the value of the
dollar would fall.
P
Market for Euros
S1
$1.70
$1.50
D2
D1
Q
Depreciation & Exports (cont.)
Since more dollars are required to purchase a euro,
the dollar has depreciated.
1) As a result, U.S. goods will become less
expensive to European citizens leading to more
exports from the U.S.
2) European goods will become more expensive to
U.S. citizens leading to fewer imports to the U.S.
$150 U.S. auto part
before $150 = 100 €
after $150 = 88.2 €
(150÷170)
100€ French wine
before 100 € = $150
after 100 € = $170
Appreciation & Imports
If real income in
the U.S. declined,
then demand for
imports and
demand for the
euro would also
decrease. The
value of the euro
would fall and the
value of the
dollar would rise.
P
Market for Euros
S1
$1.50
$1.25
D1
D2
Q
Appreciation & Imports (cont.)
Since fewer dollars are required to purchase a
euro, the dollar has appreciated.
1) As a result, U.S. goods will become more
expensive to European citizens leading to fewer
exports from the U.S.
2) European goods will become less expensive to
U.S. citizens leading to more imports to the U.S.
$150 U.S. auto part
before $150 = 100 €
after $150 = 120 €
(150/125)
100€ French wine
before 100 € = $150
after 100 € = $125
Arguments on Floating Exchange
Advantages
Fixed
• simplicity and clarity of
exchange-rate target
• automatic rule for
monetary policy
• controls inflation
Floating • continuous adjustment
in balance of payments
• simplified institutional
arrangements
Disadvantages
• loss of independent
monetary policy
• vulnerable to
speculative attacks
• conducive to
inflation
• disorderly markets
can disrupt trade and
investment patterns
• independent monetary • reckless financial
and fiscal policies
policies by government
Managed Floating System
o intervention to stabilize rates in short run with
market forces determining rates in long run
o informal guidelines established by IMF
o clean float – free-market forces of supply and
demand determine equilibrium
o dirty float – central banks intervene to promote
depreciation of their currencies
o leaning against the wind – intervention to reduce
fluctuations in the short run only
Managed Float Example
permanent change in demand temporary increase in demand to D1 – exchange rate allowed central bank sells francs while
demand is D1 until return to D0
to increase
Monetary Policy
if demand for pounds decreases if demand for pounds increases
Fed increase MS lowering rates Fed decrease MS raising rates
increasing demand for dollars
decreasing demand for dollars
Crawling Peg
o uses small, frequent changes in par value
to correct balance of payments disequilibria
o primarily nations with high inflation
o differs from adjustable pegged rates under
which par values change infrequently
o crawling peg is appropriate for developing
nations but not for industrialized nations
whose currencies provide international
liquidity
Currency Crises
o also known as speculative attacks
o weak currency depreciates significantly as
a result of selling
o can substantially reduce economic growth
o usually ended by official devaluation or
adoption of a floating rate
o extreme cases => currency crashes
Causes of Currency Crises
1)
2)
3)
4)
5)
6)
7)
8)
speculation
deficit financed by inflation
weak financial systems
recent deregulation of financial markets
weak economic performance
political factors
external factors such as interest rates
choice of exchange rate system
Capital Controls
1) also known as exchange controls
2) barriers to foreign savers investing in
domestic assets
3) pro: government can control its balance of
payments position and possibly prevent
speculative attacks
4) con: weakened confidence in the
government may actually cause an
increase in capital outflows
Question of Foreign Exchange Tax
1) volatile capital movements lead to severe
repercussions across economies
2) a tax on inflows or outflows would reduce
the number of transaction based on short
term speculation
3) such a tax would still allow market forces
to influence investment and exchange
rates over the long term
4) how much volatility is acceptable
Currency Board
1) monetary authority that issues notes
convertible into a foreign anchor currency
at a fixed rate
2) anchor currency chosen for stability and
acceptability
3) government finance only by taxation and
borrowing – not by printing money
4) implies elimination of discretionary
monetary policy by domestic government
Case Study – Hong Kong
1) Hong Kong adopted a currency board
system in 1983
2) U.S.$ = 7.75 to 7.85 HK$
3) reversed lack of confidence in the
economy despite anticipation of control
shifting from the U.K. to China
4) contributed to significant economic growth
in Hong Kong; per capita real GDP of
$37,300 ranks 13th of 216 nations
Case Study – Argentina
1) adopted currency board in 1991 to limit
inflation
2) 1 U.S.$ = 1 Argentine Peso
3) issues: dollar appreciated, U.S. interest
rates rose, domestic commodity prices
fell, and Brazil’s currency depreciated
4) U.S. fiscal & monetary policy ill suited to
conditions in Argentina
5) results: deficits, borrowing, default and
economic chaos
Dollarization
1) partial dollarization indicates use of the
U.S. dollar alongside domestic currency
2) full dollarization indicates use of the dollar
and elimination of domestic currency
3) benefits:
a) lower inflation
b) decreased transactions costs
c) greater openness
Effects of Dollarization
o U.S. monetary policy would not
necessarily be appropriate for a foreign
economy
o Federal Reserve is not the lender of last
resort for that economy
o loss of seigniorage which is the income
that would have been derived from
interest bearing foreign reserves