Transcript International Monetary System

Economics of International
Money & Finance
International Political Economy
Prof. Tyson Roberts
Goals
• Exchange rate policies
• International Monetary Systems
• Foundation for the “Unholy Trinity”
Exchange Rate
• Exchange rate: Price in own currency for one
unit of foreign currency
– Appreciation: currency stronger (fat?)
• Exchange rate goes down – price of foreign currency 
– Depreciation: currency weaker (thin?)
• Exchange rate goes up – price of foreign currency 
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Floating/Flexible Exchange Rate Regime
• Exchange rate determined by supply and
demand
– To buy goods from US, need USD. So high demand for
US goods => USD appreciate
– To invest in US, need USD. So high demand for US
financial assets => USD appreciate
– If the Fed increases money supply, more USD available
=> USD depreciate
4
American Market for Pesos
$ per peso
Sp
DP
Number of Pesos
5
American Market for Pesos
• Why would Americans want to buy pesos with
dollars?
– Travel to Mexico
– Buy Mexican imports
– Buy Mexican companies
– Deposit in Mexican banks
• Why would Mexicans want to sell pesos for
dollars?
Why is the supply curve upward sloped?
Why is the demand curve downward sloped?
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BoP Example
Suppose the BoP for the US & Mexico is 0
US invents a new camera people in Mexico want to buy
1. What foreign exchange transaction needs to
take place?
2. What happens to the current account in the
US? (Deficit, surplus, or no change?) In
Mexico?
3. What happens to the foreign currency
reserves in the US? In Mexico?
4. What happens to the exchange rate? (Which
appreciates? Which depreciates?)
Mexico buys cameras from US.
$ per
Peso
SP
DP
Number of Pesos bought & sold
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1. Mexico sells pesos for dollars (demand for $ increases, supply of pesos to
buy $ increases). Gives $ to camera shop in US for cameras.
$ per peso
SP
DP{
Number of Pesos bought & sold
10
2. Mexico’s current account down (deficit), US current account up (surplus)
3. Mexico foreign reserves down or US foreign reserves up (depends who sold $)
4. Peso depreciates (price of peso drops), dollar appreciates
$ per peso
Sp
DP
Number of Pesos bought & sold
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GDP impact
5. How does Mexico’s purchase of cameras
from the US affect Mexico’s Consumption?
Exports? Imports? What is the net effect on
GDP?
6. How does the US’s sale of cameras to Mexico
affect the US’s Consumption? Exports?
Imports? What is the net effect on GDP?
Macroeconomic Accounting in Closed
Economy
Y=C+I+G
• Income is earned from spending by
consumers, investors, and government
Macroeconomic Accounting in Closed
Economy
• S = Y – (G + C)
• SG = T - E
• Investment is financed from Savings, which is
income minus current spending (C + G)
• Government savings is Tax revenues minus
current Expenditures
Macroeconomic Accounting in Trading
Economy
• Y = C + I + G + (X – M)
– Exports are domestic production for foreigners in
exchange for income given to domestic residents
– Imports are foreign production for domestic
residents in exchange for income sent to foreigners
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Macroeconomic Accounting
• Y = C + I + G + (X – M)
• S = Y – (G + C)
• SG = T – E
5. How does Mexico’s purchase of cameras from
the US affect Mexico’s Consumption? Exports?
Imports? What is the net effect on GDP?
ANSWER: Mexico’s Consumption increases in
equal amount to the increase in imports => no
(direct) change in GDP.
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Macroeconomic Accounting
• Y = C + I + G + (X – M)
• S = Y – (G + C)
• SG = T – E
6. How does the US’s sale of cameras to Mexico
affect the US’s Consumption? Exports? Imports?
What is the net effect on GDP?
ANSWER: No (direct) change to US
Consumption, but Exports increases, so GDP
gains in amount of camera sales.
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So now either Mexico has fewer dollars or US has more
pesos. The peso is weaker and the dollar is stronger
7. How might the new exchange rate affect
trade? What would this do to the BoP and
the exchange rate?
8. Alternatively, how might the new exchange
rate affect investment flows? What would
this do to the BoP and the exchange rate?
9. Alternatively, what if Mexico doesn’t want
the exchange rate to change. How could it
stop it from changing?
So now either Mexico has fewer dollars or US has more
pesos. The peso is weaker and the dollar is stronger
7. How might the new exchange rate affect
trade? What would this do to the BoP and
the exchange rate?
ANSWER: Mexico will import less and/or export
more…
$ per peso
7. If Mexico has fewer dollars, it can buy fewer imports from US, which
means. Or, if US has more pesos, it can buy more exports from Mexico. It now
costs fewer $ to buy pesos, so slide down peso demand curve to higher
number of pesos demanded. It now costs more pesos to buy $, so slide down
peso supply curve to fewer pesos offered for dollars. The BoP returns to zero
(balanced) and new equilibrium price – peso depreciated.
Sp
DP
Number of Pesos bought & sold
So now either Mexico has fewer dollars or US has more
pesos. The peso is weaker and the dollar is stronger
7. How might the new exchange rate affect trade?
What would this do to the BoP and the
exchange rate?
ANSWER: Mexico will import less and/or export
more… Balance of Payments returns to balance.
Dollar remains stronger reflecting increase in
competitiveness from camera technology; Mexico
must have weaker currency to remain competitive.
So now either Mexico has fewer dollars or US has more
pesos. The peso is weaker and the dollar is stronger
8. Alternatively, how might the new exchange
rate affect investment flows? What would this
do to the BoP and the exchange rate?
ANSWER: The US will increase investment in
Mexico (maybe buy a Mexican company or lend
to Mexican government). This will add to
Mexico’s capital account, which will return the
BoP to 0. Dollar stronger at new equilibrium.
So now either Mexico has fewer dollars or US has more
pesos. The peso is weaker and the dollar is stronger
9. Alternatively, what if Mexico doesn’t want the
exchange rate to change. How could it stop it from
changing?
ANSWER:
1. Capital Controls (e.g., don’t let residents buy
cameras – hurts consumption, growth)
2. Currency Board/Monetary Policy
– Currency transactions (sell dollars from reserves to
buy pesos – could run out of dollars)
– Raise interest rates to encourage dollar-owners to
purchase pesos. But hurts investment, growth)
$ per peso
9. If peso doesn’t depreciate, there will be a BoP deficit because Mexican
buyers will not decrease demand for dollars and US buyers will not increase
demand for pesos. Mexicans will import more from the US than the US will
import from Mexico.
Sp
DP
BoP Deficit
Number of Pesos bought & sold
9. The Mexican government can use capital controls to stop peso sellers from
selling pesos for camera imports. (This may result in black market activity,
etc.)
$ per peso
Sp
DP
Number of Pesos bought & sold
$ per peso
9. … or, the Mexican government can raise demand for pesos by using dollar
currency reserves to buy pesos (which, over time, will burn through all of the
the governments dollar reserves), or by raising interest rates in Mexico (which
may lead to recession).
Sp
DP
Number of Pesos bought & sold
Foreign exchange markets between
countries are a mirror of one another
• An event that increases demand for dollars
will cause dollar to appreciate
– Dollars can buy pesos more cheaply
– Price of peso in dollars goes down
• The same event will cause an increase in
supply of pesos (to sell for dollars), which
causes the peso to depreciate
– Pesos buy dollars more dearly
– Price of dollars in pesos goes up
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Apple invents new iPhone
How will the exchange rate market in pesos respond?
$ per peso
Sp
DP
Number of Pesos
28
Apple invents new iPhone
Increase in supply of pesos in the foreign exchange market (Mexicans offer
up pesos for dollars to buy iPhones)
$ per peso
Sp
DP
Number of Pesos
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Increase in supply of pesos in the foreign exchange market reduces the
price in dollars for pesos (peso depreciates, dollar appreciates)
$ per peso
Sp
DP
Number of Pesos
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Increase in supply of pesos in the foreign exchange market reduces the
price for pesos (dollar appreciates), and increases number of pesos sold in
the foreign exchange market
$ per peso
Sp
DP
Number of Pesos
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Foreign exchange markets between
countries are a mirror of one another
• An event that increases demand for dollars
will cause dollar to appreciate
– Dollars can buy pesos more cheaply
– Price of peso in dollars goes down
• The same event will cause an increase in
supply of pesos (to sell for dollars), which
causes the peso to depreciate
– Pesos buy dollars more dearly
– Price of dollars in pesos goes up
32
Apple invents new iPhone
How will the exchange rate market in dollars respond?
Pesos per $
S$
D$
Number of Dollars
33
Apple invents new iPhone
Increase demand for dollars in the foreign exchange market (Mexicans
offer up pesos for dollars to buy iPhones)
Pesos per $
S$
D$
Number of Dollars
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Increase in demand for dollars in the foreign exchange market increases
the price in pesos for dollars (peso depreciates, dollar appreciates) and
increases number of dollars bought in the foreign exchange market
Pesos per $
S$
D$
Number of Dollars
35
Foreign exchange markets between
countries are a mirror of one another
• An event that decreases demand for dollars
will cause peso to appreciate
– Pesos can buy dollars more cheaply
– Price of dollars in pesos goes down
• The same event will cause a decrease in
supply of pesos (to sell for dollars), which
causes the dollar to depreciate
– Dollars buy pesos more dearly
– Price of pesos in dollars goes up
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US reduces interest rates
How will the exchange rate market in pesos respond?
$ per peso
Sp
DP
Number of Pesos
37
US reduces interest rates
Supply of pesos falls (fewer peso holders offer pesos for dollars)
$ per peso
Sp
DP
Number of Pesos
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$ per peso
US reduces interest rates
Supply of pesos falls (fewer peso holders offer pesos for dollars)
Dollar depreciates (more dollars needed to buy pesos), peso appreciates
(fewer pesos needed to buy dollars). Fewer pesos exchanged for dollars.
Sp
DP
Number of Pesos
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US reduces interest rates
How will the exchange rate market in dollars respond?
Pesos per $
S$
D$
Number of Dollars
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US reduces interest rates
Demand for dollars falls
Pesos per $
S$
D$
Number of Dollars
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US reduces interest rates
Price of dollars in pesos falls (peso appreciates, dollar depreciates)
Fewer pesos exchanged for dollars.
Pesos per $
S$
D$
Number of Dollars
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Swiss Franc example
• What was the nature of the Swiss franc crisis
in 2011, according to the podcast?
Swiss Franc example
• What was the nature of the Swiss franc crisis
in 2011, according to the podcast?
• Euro crisis increased demand for Swiss franc
(safe), which strengthened franc
• Strong Swiss franc undermined export
industries in Switzerland
Swiss Franc example
• How did Switzerland address crisis?
Swiss Franc example
• How did Switzerland address crisis?
• Made commitment to buy sufficient Euros to
keep Swiss franc below a certain value
(currency board approach)
• When they abandoned this pledge, value of
Swiss franc rose
• Attempted to keep Swiss devalued by further
lowering negative interest rate
Fixed exchange rate regime
• Exchange rate determined by the government
• Revaluation: Increase official value of own
currency
– Market equivalent: appreciation
• Devaluation: Decrease official value of own
currency
– Market equivalent: depreciation
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Fixed exchange rate methods
• Intervention in foreign exchange market
(Currency Board)
– Sell foreign currency to prop up own currency
(increase supply of foreign currency, reduce supply of
own currency)
– “Overvaluation”
• Problem 1: Can run out of foreign currency
• Problem 2: Exports become less competitive
• Problem 3: Expectations that peg will fail reduces demand
for currency, increasing downward pressure
– Commonly cited example: Argentina “dollarization”
48
Fixed exchange rate methods
• Intervention in foreign exchange market
(Currency Board)
– Buy foreign currency to devalue own currency
(reduce supply of foreign currency, increase
supply of own currency)
• Problem 1: what to do with foreign currency?
• Problem 2: Reduced investment & consumption in own
country
– Commonly cited example: China
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Fixed (pegged) exchange rate methods
• Capital controls
– Restrict how much money can be exchanged to
maintain peg
• Problem 1: Market distortions, black market
• Problem 2: Deters investment
• Problem 3: Reduced exports (if overvalued) or reduced
consumption (if undervalued)
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Balance of Payments (BoP)
Current account
• Current account balance =
Current receipts – Current Expenditures
• Current account includes
– Goods & services (i.e., TRADE)
– Income receipts (interest & dividends)
– Transfers (foreign aid, remittances)
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Balance of Payments (BoP)
Capital account
• Capital Account Balance =
Capital Inflows – Capital Outflows
• Capital includes
– FDI (managerial control)
– Indirect investment (shares & bonds without
control)
– Cross-national checking accounts
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Balance of Payments (BoP)
Financial
• In the three-account system,
– Capital account includes non-financial & nonproduced assets & fixed assets (debt forgiveness,
gifts, payment for land, etc.)
– Financial account includes financial assets (FDI,
bonds, payment for real estate, etc.)
• We’ll use the two-account system in class
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BoP adjustment under flexible
exchange rate regime
• Adjustment is automatic (via market)
• If BoP surplus, (i.e., exports > imports and/or
inflows > outflows)
Supply of foreign currency  => home currency
appreciates
 Exports , imports , inflows , outflows 
 Supply of foreign currency  => home currency
depreciates
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Adjustment under fixed exchange rate
regime
• Currency Board Interventions
– Interest rates (increase to revalue, decrease to
devalue)
– Buy (to devalue) or sell (to revalue) foreign
currency with home currency
– Borrow or receive transfers from foreign
government (to revalue)
• Capital Controls
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International Monetary System
1st Age of Globalization: Gold Standard
• Fixed exchange rate: pegged to gold
• Balance of Payment surplus in form of gold
reserves
• Automatic (market) adjustment mechanism:
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Automatic (market) adjustment
mechanism under Gold Standard
•
•
•
•
•
•
•
•
•
BoP deficit =>
Gold shortage =>
High interest rates (to attract gold/currency) =>
Less domestic borrowing for local investment =>
Fewer jobs=>
Lower wages =>
Lower prices for domestic produced goods =>
Increased exports, decrease imports =>
BoP balance
57
International Monetary System
1st Age of Globalization: Gold Standard
• Fixed exchange rate: pegged to gold
• Balance of Payment surplus in form of gold
reserves
• Automatic (market) adjustment mechanism:
• No monetary policy autonomy
– Interest rates dictated by market
– Central bank goal is to hold gold, not to create
jobs or tame inflation
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WWI & Interwar
• WWI & early 1920s
– Gold standard suspended, replaced with exchange
controls
– Paper money printed to finance government,
hyperinflation in parts of Europe
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• Mid-1920s
– USD & British pound reserve currencies
– Trade credit readily available => global trade
growth
– International capital flows => deficit countries
such as Germany over-consume
• 1928: US concerned about financial market
exuberance
• Fed hiked interest rates => foreign central banks
followed (to fixed exchange rates) => Great
Depression
• Germany responds to capital flight with exchange
controls, freeze loans from UK banks
• Investors withdraw from UK banks
• Value of British pounds falls
1930s: Chaotic floating exchange rate system
• British pound & USD no longer trusted as
reserve currencies
• Larger countries devalued currencies to
increase exports (competitive devaluation)
• Chaotic liquidation of foreign exchange
reserves made credit scarce, interest rates
• Disorderly exchange rates disrupted trade
• Recession, war loans, etc. => WW2
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Bretton Woods
• http://www.youtube.com/watch?v=GVytOtfPZ
e8
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Bretton Woods system
• Goal: stable exchange rates AND domestic
economic autonomy
• Components:
– Exchange rate “flexibility” (adjustable peg to gold –
NOT a “flexible exchange rate” policy)
– Capital controls (currency exchange restrictions)
– Stabilization fund (all members contribute, can
borrow during BoP deficits)
– IMF (to monitor members’ policies & BoP, decide
when devaluation warranted, and manage fund)
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What should the following events do to the US
exchange rate (stronger vs. weaker)?
1.
2.
3.
4.
5.
6.
7.
Interest rate on US Treasury bonds goes up
Interest rate on Greek sovereign debt goes up
S&P says Europe is likely to default on its loans
Unemployment benefits for US workers cut off
US Trade deficit with China increases
Chinese government buys US Treasury bonds
Japan buys American movie studio
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Takeaways
• Various international monetary systems are
available
– Gold Standard: Fixed, market-maintained, stateenforced
– Bretton Woods: (Adjustable) Fix, maintained by
states & IMF
– Float: Market-determined
– (Managed) Float: Market-determined,
government-influenced
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Takeaways
• Each international monetary system has its
pros and cons
– Gold Standard: Exchange rate stability, capital
freedom, price instability, economic volatility
– Bretton Woods: Exchange rate stability, some
capital restrictions, liquidity problem
– Float: Exchange rate volatility, capital freedom