Transcript Pegged exchange rate

Lecture 11
Exchange Rates
13
Exchange Rates

Nominal Exchange Rate
 The
rate at which two currencies can be
traded for each other
Exchange Rates

Nominal Exchange Rates
 The
exchange rate between British and
Canadian currencies
0.4889 British pounds = $1 U.S.
 1.009 Canadian $s = $1 U.S.
 0.4889 British pounds = 1.009 Canadian $s
 0.4889/1.009 = 0.4845 pounds = 1 Canadian $
 British/Canadian exchange 0.4845 pounds per
Canadian dollar

Nominal Exchange Rates for the
U.S. Dollar
Major Currency Cross Rates
Currency
U.S. $
¥en
Euro
Can $
U.K. £
AU $
Swiss
Franc
Last Trade
N/A
8:46am ET
8:46am ET
8:46am ET
8:46am ET
8:46am ET
8:46am ET
1 U.S. $
=
1.000
111.690
0.680
1.006
0.489
1.136
1.125
1 ¥en
=
0.009
1.000
0.006
0.009
0.004
0.010
0.010
1 Euro
=
1.472
164.380
1.000
1.481
0.720
1.672
1.656
1 Can $
=
0.994
111.018
0.675
1.000
0.486
1.130
1.118
1 U.K. £
=
2.045
228.423
1.390
2.058
1.000
2.324
2.301
1 AU $
=
0.880
98.293
0.598
0.885
0.430
1.000
0.990
1 Swiss Franc
=
0.889
99.280
0.604
0.894
0.435
1.010
1.000
Fixed Exchange Rates

Economic Naturalist
 Should
China change the way it manages its
exchange rate?
U.S. Dollar to Chinese Yuan
11.4% Decline
in value
Exchange Rates

Appreciation
 An
increase in the value of a currency
relative to other currencies

Depreciation
 A decrease
in the value of a currency
relative to other currencies
Exchange Rates

Some Definitions
e
= nominal exchange rate
 e = the number of units of foreign currency
that the domestic currency will buy
 If e increases, it is an appreciation of the
domestic (base) currency.
 If e decreases, it is a depreciation of the
domestic (base) currency.
Exchange Rates
Flexible Exchange Rate
 Fixed Exchange Rates

The Supply and Demand for
Dollars in the Yen-Dollar Market
Yen/dollar exchange rate
The equilibrium exchange rate
(e*) or fundamental exchange rate
equates the quantity of dollars
supplied and demanded
Supply of dollars
e*
Demand for dollars
Quantity of dollars traded
The Determination of the
Exchange Rate in the Short
Run

Changes in the Supply of Dollars
 Factors
that increase the supply of dollars
An increase in the preference for Japanese goods
 An increase in U.S. real GDP
 An increase in the real interest rate on Japanese
assets

An Increase in the Supply of
Dollars Lowers the Value of the
Dollar
•Increase in demand for Japanese video games
Yen/dollar exchange rate
•Supply of dollars increases from S to S’
•The value of the dollar in terms of yen falls
•e* falls to e*’
S
S’
E
e*
e*’
F
D
Quantity of dollars traded
The Determination of the
Exchange Rate in the Short
Run

Changes in the Demand for Dollars
 Factors
that increase the demand for dollars
Increased preference for U.S. goods
 Increase in real GDP abroad
 An increase in the real interest rate on U.S. assets
 Thus a decrease in rates, decreases demand for
dollars

A Tightening of Monetary
Policy Strengthens the Dollar
• Tighter monetary policy raises the domestic
real interest rate
• Foreign demand for U.S. assets increase
• The demand for dollars rises
Yen/dollar exchange rate
S'
F
e*'
E
e*
S
• The increased demand for U.S.
assets by American Savers
decreases the supply of dollars
• Exchange rate appreciates from
e* to e*’
D'
D
Quantity of dollars traded
Foreign Exchange Market
Equilibrium (example)
• The dollar price of the English
pound is measured on the vertical
price of
axis. The horizontal axis indicates Dollar
foreign exchange
(for pounds)
the flow of pounds in exchange
for dollars.
• The demand and supply of pounds
are in equilibrium at the exchange
rate of $1.50 = 1 English pound.
• At this price, quantity demanded
$1.80
equals quantity supplied.
• A higher price of pounds (like
$1.50
$1.80 = 1 pound), would lead to
an excess supply of pounds ...
$1.20
causing the dollar price of the
pound to fall (depreciate).
• A lower price of pounds (like
$1.20 = 1 pound), would lead to
an excess demand for pounds …
causing the dollar price of the
pound to rise (appreciate).
S(sales to
foreigners)
Excess supply
of pounds
e
Excess demand
for pounds
D(purchases from
foreigners)
Q
Quantity of
foreign exchange
(pounds)
Foreign Exchange Market Equilibrium
• Other things constant, if incomes
increase in the United States, U.S.
imports of foreign goods and
services will grow.
• The increase in imports will
increase the demand for pounds
(in the foreign exchange market)
causing the dollar price of the
pound to rise from $1.50 to $1.80.
Dollar price of
foreign exchange
(for pounds)
S(sales to
foreigners)
$1.80
$1.50
b
a
D2
D1
Q1 Q2
Quantity of
foreign exchange
(pounds)
Inflation with Flexible Exchange Rates
S2
• If prices were stable in England
while the price level in the U.S.
increased by 50 percent …the
U.S. demand for British goods
(and pounds) would increase …
as U.S. exports to Britain would
be relatively more expensive they
would decline and thereby cause
the supply of pounds to fall.
• These forces would cause the
dollar to depreciate relative to
the pound.
Dollar price of
foreign exchange
(for pounds)
S1
$2.25
b
$1.50
a
D2
D1
Q1
Quantity of
foreign exchange
(pounds)
Fixed Exchange Rates

How to Fix an Exchange Rate
 The
government will peg its currency to a
major currency or to a “basket” of currencies.
 The government may have to devalue or
revalue its currency.
Fixed Exchange Rates

Devaluation
 A reduction
in the official value of a currency
(in a fixed-exchange-rate system)

Revaluation
 An
increase in the official value of a currency
(in a fixed-exchange-rate system)
Fixed Exchange Rates

Overvalued Exchange Rate
 An
exchange rate that has an officially fixed
value greater than its fundamental value

Undervalued Exchange Rate
 An
exchange rate that has an officially fixed
value less than its fundamental value
An Overvalued Exchange Rate
Dollar/peso exchange rate
• The peso’s official value is greater than the
fundamental value; the peso is overvalued
• To maintain the value, the government must
purchase a quantity of pesos (A-B)
Supply of pesos
0.125 dollar/
peso
A
B
Official value
Market equilibrium
value
0.10 dollar/
peso
Demand for pesos
Quantity of pesos traded
Fixed Exchange Rates

How to Fix an Exchange Rate
 Responses



 To
to an overvalued currency
Devalue the currency
Impose trade barriers
Purchase the currency
purchase its own currency, a country must hold
international reserves. International Reserves
 Foreign currency assets held by a government for the
purpose of purchasing the domestic currency in the
foreign exchange market.
Fixed Exchange Rates

Speculative Attack
 A massive
selling of domestic currency assets
by financial investors
A Speculative Attack on the Peso
• Peso overvalued at 0.125
• Central bank buys pesos
• Investors launch a speculative attack -- sell
peso dominated assets
Dollar/peso exchange rate
S
S’
0.125 dollar/
peso
A
B
C
Official value
• Supply of pesos increases
• Central bank must purchase
more pesos
0.10 dollar/
peso
D
Quantity of pesos traded
Fixed Exchange Rates

Balance-of-Payments Deficit
 The
net decline in a country's stock of
international reserves over a year
Fixed Exchange Rates

Balance-of-Payment Surplus
 The
net increase in a country's stock of
international reserves over a year
Fixed Exchange Rates

Example
 Latinia’s
balance-of-payments deficit
Demand = 25,000 - 50,000e
 Supply = 17,600 - 24,000e
 Official value of the peso = 0.125 dollars

Fixed Exchange Rates

Example
 Latinia’s

Fundamental value


balance-of-payments deficit
25,000 - 50,000e = 17,600 + 24,000e
Solving for e:
7,400 = 74,000e
 e = 0.10

Fixed Exchange Rates

Example
 As
the official rate -- 0.125
 D = 25,000 - 50,000(0.125) = 18,750
 S = 17,600 - 24,000 (0.125) = 20,600
 Excess supply = 1,850 pesos
 Balance of payments deficit = 1,850 pesos
 1,850 x 0.125 = $231.25
A Tightening of Monetary Policy
Eliminates an Overvaluation
•Pesos overvalued at 0.125
•Tightening monetary policy increases D to D’
and the supply will fall S to S'.
•Official value = fundamental value
Dollar/peso exchange rate
S'
S
F
0.125 dollar/
peso
0.10 dollar/
peso
Official value
E
D'
D
Quantity of pesos traded
Fixed Exchange Rates

Observation
 If
monetary policy is used to set the
fundamental value of the exchange rate equal
to the official value, it is no longer available for
stabilizing the domestic economy.
Fixed Exchange Rates

Observation
 The
conflict monetary policymakers face,
between stabilizing the exchange rate and
stabilizing the domestic economy, is most
severe when the exchange rate is under a
speculative attack.
Should Exchange Rates
Be Fixed or Flexible?

Monetary Policy
 Flexible
exchange rates can strengthen the
impact of monetary policy.
 Fixed exchange rates prevent the use of
monetary policy to stabilize the economy.
Should Exchange Rates
Be Fixed or Flexible?

Trade and Economic Integration
 Fixed
exchange rate proponents argue that
fixed rates promote international trade.
 The risk of a speculative attack may make the
country less attractive to investors and trade.
Fixed Rate, Unified Currency Regime

Some examples of fixed rate, unified currency
systems:



the U.S., Panama, Ecuador, El Salvador,
and Hong Kong all of which use currencies that are
unified with the U.S. dollar
the 12 countries of the European Monetary Union, all of
which use the euro, which is managed by the European
Central Bank
Countries such as El Salvador & Hong Kong, that
link their currency to the dollar at a fixed rate, are
no longer in a position to conduct monetary
policy. They merely accept the monetary policy
of the Federal Reserve.

The same can be said for the 12 countries of the
European Monetary Union that accept the monetary
policy of the European Central Bank.
Pegged Exchange Rate Regimes


Pegged exchange rate system:
a system where the country commits to
using monetary and fiscal policy to
maintain the exchange-rate value of the
domestic currency at a fixed rate or within
a narrow band relative to another
currency (or bundle of currencies).
Unlike the case of a currency board,
however, countries with a pegged
exchange rate continue to conduct
monetary policy.
When Pegged Regimes
Lead to Problems

A nation can either:
 follow
an independent monetary
policy, allowing its exchange rate to
fluctuate, or,
 tie its monetary policy to the
maintenance of the fixed exchange
rate.

It cannot, however:
 maintain
currency convertibility at a
fixed exchange rate while following a
monetary policy more expansionary
than that of the country to which its
currency is tied.
When Pegged Regimes
Lead to Problems


Attempts to peg rates and follow a
monetary policy that is too expansionary
have led to several recent financial
crises—a situation where falling foreign
reserves eventually force the country to
forego the pegged rate.
The experiences of Mexico in 19891994 and of Brazil, Thailand, South
Korea, Indonesia, and Malaysia in 19971998 illustrate this point very clearly.
Balance of Payments
Revisited
Balance of Payments

Balance of payments:
accounts that summarize the transactions
of a country’s citizens, businesses, and
governments with foreigners

Any transaction that creates a demand for
foreign currency (and a supply of the domestic
currency) in the foreign exchange market is
recorded as a debit item.
Example: Imports

Transactions that create a supply of foreign
currency (and demand for the domestic currency)
on the foreign exchange market are recorded
as a credit item.
Example: Exports
Balance of Payments

Under a pure flexible rate system,
the foreign exchange market will
bring the quantity demanded and
the quantity supplied into balance,
and as a result, it will also bring the
total debits into balance with the
total credits.
Balance of Payments

Current account transactions:
all payments (and gifts) related to the
purchase or sale of goods and services and
income flows during the current period

Four categories of current account
transactions:
 Merchandise
trade
(import and export of goods)
 Service
trade
(import and export of services)
 Income
from investments
 Unilateral transfers
(gifts to and from foreigners)
Balance of Payments

Capital account transactions:
transactions that involve changes in the
ownership of real and financial assets

The capital account includes both
 direct
investments by foreigners in
the U.S. and by Americans abroad, and,
 loans to and from foreigners.

Under a pure flexible-rate system, official
reserve transactions are zero; therefore:
a
current-account deficit implies
a capital-account surplus.
 a current-account surplus implies
a capital-account deficit.
U.S. Balance of Payments, 2003*
Debits
Current account:
1. U.S. merchandise exports
2. U.S. merchandise imports
3. Balance of merchandise trade (1 + 2)
4. U.S. service exports
5. U.S. service imports
6. Balance on service trade (4 + 5)
7. Balance on goods and services (3 + 6)
8. Income receipts of Americans from abroad
9. Income receipts of foreigners in the U.S.
10. Net income receipts (8 + 9)
Balance
Credits
+ 713.1
- 1260.7
- 547.6
+ 307.4
- 256.3
+ 51.1
- 496.5
+ 294.4
- 261.1
12. Balance on current account (7 + 10 + 11)
Continued on next page …
33.3
- 67.4
11. Net unilateral transfers
Source: http://www.economagic.com/.
deficit (-) / surplus (+)
* Figures are in Billions of Dollars
- 530.6
U.S. Balance of Payments, 2003*
Debits
Balance
Credits
Current account:
12. Balance on current account (7 + 10 + 11)
Capital account:
13. Foreign investment in the U.S. (capital inflow)
14. U.S. investment abroad (capital outflow)
15. Balance on capital account (13 + 14)
Official Reserve Transactions:
16. U.S. official reserve assets
17. Foreign official assets in the U.S.
18. Balance, Official Reserve Account (16 + 17)
- 530.6
+ 580.6
-297.1
+ 283.5
-1.5
+ 248.6
+ 247.1
0.0
17. Total (12 + 15 + 18)
Source: http://www.economagic.com/.
deficit (-) / surplus (+)
* Figures are in Billions of Dollars
Capital Flows and
the Current Account
Leading Trading Partners of the U.S.
Current Account as % of GDP
surplus (+) or deficit (-)
+2
0
-2
-4
1973
1978
1983
1988
1993
1998
2003
1998
2003
Net Foreign Investment as % of GDP
surplus (+) or deficit (-)
+4
+2
0
-2
1973


1978
1983
1988
1993
Under a flexible exchange rate system the inflow and outflow
of capital will exert a major impact on the current account and
trade balances.
The figures for the U.S. (above) illustrate this linkage.
Are Trade Deficits Bad?
An inflow of capital implies a trade
(current account) deficit; an outflow
of capital implies a trade (current
account) surplus.
 While the term “deficit” generally has
negative connotations, this is not
necessarily true for a trade deficit.

 If
a nation’s investment environment is
attractive, it is likely to result in a net
inflow of capital, which will tend to
cause a trade deficit.
 Similarly, rapid economic growth will
tend to stimulate imports, which is
likely to result in a trade deficit.
Trade Deficits: Points to Ponder



Although they often cause trade (and
current account) deficits, both rapid
growth and a healthy investment
environment are signs of a strong
economy, not a weak one.
A trade deficit (or surplus) is an aggregate
that reflects the voluntary choices of
individuals and businesses. In contrast
with a budget deficit, no legal entity is
responsible for the trade deficit.
The trade deficits of the U.S. during the
1980s and 90s were largely the result of
rapid growth and a favorable investment
climate.
Should Trade Between
Countries Balance?

Political leaders often imply that
U.S. exports to a country, China or
Japan for example, should be
approximately equal to our imports
from that country.
 This

is a fallacious view.
Under a flexible exchange rate
system, overall purchases from
foreigners will balance with overall
sales to foreigners, but there is no
reason why bilateral trade between
any two countries will balance.