Transcript exchange rate

Dr Marek Porzycki
Chair for Economic Policy
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basic concepts
exchange rate regimes
evolution of the international currency system
Special Drawing Rights (SDR)
currency unions
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Currency
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synonym of money
system of monetary units in use in a country or an area
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Foreign exchange
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foreign currency (in: foreign exchange reserves)
market for trading currencies (in: FX market, i.e. global
decentralized market for the trading of currencies)
Exchange rate – value (price) of one currency
expressed in another currency
spot and forward exchange rate
buying and selling rate, mid-market rate
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Convertibility
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full convertibility
- currency of a country can be freely converted into foreign exchange at a
market-determined rate of exchange as determined by demand for and
supply of a currency
- no restrictions on currency trade on the foreign exchange market. E.g.
USD, EUR, PLN
- convertibility on current account- exports and imports of merchandise
(goods) and invisibles (e.g. services, intellectual property)
- capital account convertibility - in respect of capital flows (flows of
portfolio capital, direct investment flows, of borrowed funds, capital gains
like dividends and interests)
- advantages:
- greater trade and capital flows, better living standard,
- improved access to international financial markets and reduction in
cost of capital.
- greater confidence of global investors
- disadvantages: volatility of exchange rates, vulnerability to reversals in
capital flows (outflows of foreign capital – e.g., Asian crises in 1990s)
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Convertibility
partial convertibility – control on cross-border capital flows, some
restriction on currency conversion (permission of central bank). E.g.
CNY, INR
- transitional formula in India during the reforms in 1990s:
„Liberalised Exchange Rate Management” scheme in which 60% of
all receipts on current account (i.e., merchandise exports and
receipts from invisibles) could be converted freely into rupees at
market determined exchange rate quoted by authorised dealers,
while 40% of them was to be surrendered to Reserve Bank of India
at the officially fixed exchange rate, for meeting Government
needs for foreign exchange and for financing imports of essential
commodities.
no convertibility – currency conversion is generally banned, currency
is not traded on the FX market. E.g. Eastern Bloc currencies before
1989, Cuban „national” peso, North Korean won.
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appreciation / depreciation - an increase/loss (decrease) of value
(exchange rate) of a currency with respect to one or more foreign
reference currencies due to market forces,
Appreciation: if the Polish PLN appreciates relative to the euro, the
exchange rate falls: it takes fewer PLN to purchase 1 euro (1 EUR=
4.20 PLN → 1 EUR=4.10 PLN).
When the PLN appreciates relative to the Euro, the Polish economy
becomes less competitive. This may lead to larger imports of EURpriced goods and services from the euro area, and lower exports of
PLN-priced Polish goods and services.
Depreciation: if the Polish Zloty (PLN) depreciates relative to the
euro, the exchange rate (the PLN price of euros) rises: it takes more
PLN to purchase 1 euro (1 EUR=4.25 PLN → 1 EUR=4.40 PLN)
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Reasons for appreciation:
increased demand for that currency on world markets
High exports (the buyers of these exports need its currency to pay
for those exports)
increase of interest rates by country's central bank (people will want
that currency as deposits in it it attract a higher interest rate)
Increase of employment and per capita income in a country  the
demand for its goods and services increases, along with demand for
that country's currency in the local market
Loosening the fiscal policy by the government (borrowing money)
Effects of appreciation:
cheaper imports
lower inflation
Balance of trade deficit (because our currency is strong, our own
exported goods become more expensive for foreign customers)
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Reasons for depreciation:
inflationary pressure (inflation reduces the value of money)
collapse of confidence in an economy or financial sector (outflow of
capital)
lower growth and lower interest rates
current account deficit (a country imports more goods and services
than it exports)
price of commodities (If an economy depends on exports of raw
materials, a fall in the price of this raw material can cause a fall in
export revenue and a depreciation in the exchange rate. E.g. Russia
is suffering from a fall in price of oil).
speculation
Effects of depreciation:
Exports get cheaper, imports more expensive, demand for imports
will be reduced
inflation is likely to occur (in particular the „cost-push” inflation)
Improvement in the current account
devaluation vs. revaluation
- an official lowering (reduction) or increase of the value of a
country's currency within a fixed exchange rate system, by
which the monetary authority formally sets a new fixed rate
with respect to a foreign reference currency.
Devaluation – in order to reduce a country's trade deficit by
improving competitiveness of country’s commodities and
help to increase its export volume.
Sometimes devaluation is caused by impossibility of
maintaining a previous fixed exchange rate due to
downwards pressure on the currency.
Example: Argentinian peso in 2002
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Fixed exchange rate (currency peg) - rates are centrally determined (usually
by the central bank) and kept stable in relation to an anchor currency (e.g.
USD or EUR).
In order to maintain the exchange rate, the central bank buys and sells its own
currency (interventions) on the foreign exchange market in return for the
currency to which it is pegged (more vulnerable)
In order to maintain the rate, the central bank must keep a high level of
foreign exchange reserves. This is a reserved amount of foreign currency held
by the central bank that it can use to release (or absorb) extra funds into (or
out of) the market.
currency board – currency reserves in the anchor currency need to cover all
local currency cash and reserves held with central bank (all M0 monetary
aggregate). New money in local currency can be issued only in return for
anchor currency.
a further step: currency substitution- citizens of a country officially or
unofficially use a foreign country's currency as legal tender for conducting
transactions.
dollarization (El Salvador, Ecuador, Panama), euroization (Kosovo,
Montenegro)
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Fixed exchange rate (currency peg) Advantages:
avoids currency fluctuations – decrease of costs of
international trade
stability encourages investment
keeps inflation low
Disadvantages:
less flexibility – it is difficult to respond to temporary shocks
(e.g. on the oil market)
„joining at the wrong rate” – it is difficult to set the right level
for fixing the exchange rate. If the rate is too high, it will make
exports uncompetitive. If it is too low, it could cause inflation.
current account imbalances
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Flexible (floating) exchange rate – exchange rate results from
supply and demand on the foreign exchange market
Advantages:
No need for management of exchange rates
No need for frequent central bank intervention, lower foreign
exchange reserves needed
Automatic adjustment of the balance of payments - Any balance of
payments disequilibrium will tend to be rectified by a change in the
exchange rate
Greater insulation from other countries’ economic problems
Disadvantages
Higher volatility in exchange rates
Speculation which can be destabilising for the economy
Uncertainty for trade (exports and imports)  can be reduced by
hedging the foreign exchange risk on the forward market
risk of inflation
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hybrid regimes, e.g.:
managed float - exchange rate fluctuates from day to day,
but central bank attempts to influence it by buying or selling
its currency
pegged float - a central bank keeps the rate from deviating
too far from a target band or value (e.g. ERM II),
crawling peg - a part of fixed exchange rate regimes that
allows depreciation or appreciation in an exchange rate
gradually, frequent but moderate exchange rate changes
exchange rate floor or ceiling
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Constraints on monetary policy resulting from a fixed
exchange rate. It is impossible to maintain
simultaneously:
fixed exchange rate,
free flow of capital
independent monetary policy
Examples:
China until mid-2015 (tightly managed float similar to a
currency peg, capital controls, some degree of
independence in monetary policy)
Bulgaria (currency peg, free flow of capital under EU
law, no independent monetary policy)
Poland (floating exchange rate, free flow of capital
under EU law, independent monetary policy)
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‘gold standard’ until WWI – effectively a system of fixed exchange rates with
gold as a measure of reference
Advantage: it prevented inflation, stabilized world trade; disadvantage:
danger of deflation crisis; it restricted monetary policy
Bretton Woods system (after WWII)
system of fixed exchange rates: currencies were pegged to USD; USD was
linked to gold ($35 = 1 oz.), convertibility of USD to gold
USD became international reserve currency
IMF (goal: to bridge temporary imbalances of payments) and World Bank
(International Bank for Reconstruction and Development)
Crisis of the Bretton Woods system: growing dollar overhang—the difference
between the amount of dollars in international circulation and the value of
the gold backing held by the U.S.- as a result of increased U.S. investment
abroad and military spending (1960s).
1971: United States unilaterally terminated the convertibility of the US dollar
to gold
Since 1970s – a system of flexible exchange rates, with several mutual or
regional arrangements
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an accounting unit created by the IMF in 1969 to facilitate
management of foreign exchange reserves and international
settlements
represents a claim on currency held as reserves by IMF member
states
value based on a weighted basket of 5 currencies (EUR, USD, JPY,
GBP, CNY). CNY was added to the basket from 1.10.2016.
allocated by the IMF Board of Governors to IMF Member States
(current total allocation at ca. 204 bn SDRs, average rate 1 SDR =
1,50 USD)
used as supplementary foreign exchange reserve asset (relatively
minor importance) and unit of account
XDRs are allocated to countries by the IMF. Private parties do not
hold or use them.
a 2009 proposal by Zhou Xiaochuan, chairman of the People’s Bank
of China, to increase the role of SDR as global reserve currency
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use of the same currency in more than one
country
usually result from a formal arrangement
(treaty) but may also result from de-facto
usage of a currency of another country (see
also  dollarization/euroization)
need for a common monetary policy (see 
optimum currency area), loss of monetary
sovereignty
historical: Latin Monetary Union (1865-1914/1927),
Scandinavian Monetary Union (1873-1914)
 existing:
- West African and Central African CFA Franc zones (CFA
Franc, pegged to EUR)
- East Carribean Currency Union (East Caribbean dollar,
pegged to USD)
- Singapore-Brunei currency interchangeability agreement
- Common Monetary Area, South Africa (South African rand)
- Economic and Monetary Union (euro area) [see  further
courses]
 planned:
- initiative of the Gulf Cooperation Council (currency:
Khaleeji)
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Additional (facultative):
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F. Mishkin, The Economics of Money, Banking, and Financial
Markets, Pearson, 10th ed. 2013, p. 506-513
Ch. Proctor, Mann on the Legal Aspect of Money, 7th ed.
2012: Chapter 33, Other Forms of Monetary Organization, pp.
861-891
Zhou Xiaochuan, Reform the International Monetary System,
March 2009,
http://www.pbc.gov.cn/publish/english/956/2009/2009122
9104425550619706/20091229104425550619706_.html