Transcript April 22

Theory and Practice of International
Financial Management
Exchange Rate Intervention
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Exchange Rate Intervention
Why do governments attempt to fix exchange rates?
Why do governments attempt to fix prices?
1. They think ER volatility is destabilizing - that by
removing volatility they will be making people
better off.
2. Like any other price fix (i.e. U.S. sugar supports),
ER fixes are a political tool. They subsidize one
group at the expense of others.
3. To signal intentions.
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How to Fix Exchange Rates
How can a government fix an exchange rate?
The same way a government fixes any other price:
1. By controls (much like U.S. price controls in early
1970s). Make trade at a different price illegal.
2. By intervention in the market (much like sugar).
By committing to buy/sell at a certain price.
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1. Exchange Rate Controls
Recall our original supply-demand graph
for exchange rate determination…
$/Peso
Supply
s
Demand
Quantity of Pesos
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1. Exchange Rate Controls
If demand for Mexican pesos decreases...
$/Peso
Supply
s
Demand
Quantity of Pesos
5
1. Exchange Rate Controls
But the Mexican Banco Central makes exchanges of FX
illegal at any rate other than s...
$/Peso
Supply
s
Demand
Quantity of Pesos
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1. Exchange Rate Controls
Dollars will be rationed - there will be excess
supply of pesos (demand for $) at the fixed
exchange rate of s...
$/Peso
Supply
s
Demand
Quantity of Pesos
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1. Exchange Rate Controls
A black market will invariably emerge which trades
pesos at a discount relative to the fixed rate.
$/Peso
Supply
s
sb
Demand
Quantity of Pesos
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Example: The Uzbek Sum
In 1996, the Uzbek central bank fixed the exchange
rate at an overvalued level of $0.02 / Sum:
• Imports were cheap; exports expensive;
imports rose by 50% in 1996; exports were down.
• The central bank started running short of reserves.
• Daewoo and British American Tobacco
experienced delays in converting Sum revenues.
• Black market exchange rate began falling steadily.
• In October, the Central bank canceled all
conversion licenses and handed out dollar quotas.
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Example: The Uzbek Sum
• The government banned the use of dollars inside
Uzbekistan.
• Inflation soared.
• The black market rate fell to $0.0074 / Sum.
• Foreign investment inflows dried up - decreasing
Sum demand further.
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2. Exchange Rate Intervention
Central Bank Balance Sheet
(Domestic
DA
Assets/
C
(Currency)
R
(Reserves of
Commercial Banks)
Bonds)
(Foreign Assets
of Central Bank)
FACB
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2. Exchange Rate Intervention
Central Bank Balance Sheet
(Domestic
DA
Assets/
C
(Currency)
R
(Reserves of
Commercial Banks)
Bonds)
(Foreign Assets
of Central Bank)
FACB
H (High Powered Money)
Accounting Identity: DA + FACB = H
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2. Exchange Rate Intervention
To insure that the exchange rate remains at a constant
level, the central bank must purchase/sell FX to ensure
supply intersects demand at the appropriate price:
$/Peso
Supply
s
Demand
Quantity of Pesos
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2. Exchange Rate Intervention
Suppose the central bank is trying
to target an exchange rate of s.
$/Peso
Supply
s
Demand
Quantity of DM
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2. Exchange Rate Intervention
What happens if demand for
Pesos increases?
$/Peso
Supply
s
s
Demand
Quantity of Pesos
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2. Exchange Rate Intervention
Unless something is done, the
exchange rate will appreciate to s.
$/Peso
Supply
s
s
Demand
Quantity of Pesos
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What should the Central Bank Do?
3 Options:
1. Discourage capital inflows. Curb demand.
Example: Chile.
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Option 1. Discourage Inflows
Enact policies which curb demand for
peso (i.e. ‘Tobin Taxes’) and push
intersection back to original level.
$/Peso
Supply
s
s
Demand
Quantity of Pesos
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What should the Central Bank Do?
3 Options:
1. Discourage capital inflows. Curb demand.
Example: Chile.
2. Print Money: Unsterilized Intervention
Supply as many Pesos as the market wants at
the fixed exchange rate.
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Option 2: Unsterilized Intervention
Banco Central offers sufficient peso supply
in the FX market to meet demand at s
$/Peso
Supply
s
s
Demand
Quantity of Pesos
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Option 2: Unsterilized Intervention
What does this mean for the Central Bank’s
balance sheet? They supply Pesos for $.
Reserves of $ will increase:
D FACB > 0
Since the central bank is selling Pesos, the
supply of currency must increase too:
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Option 2: Unsterilized Intervention
What does this mean for the Central Bank’s
balance sheet? They supply Pesos for $.
Reserves of $ will increase:
D FACB > 0
Since the central bank is selling Pesos, the
supply of currency must increase too:
FACB + DA = H
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What should the Central Bank Do?
3 Options:
1. Discourage capital inflows. Curb demand.
Example: Chile.
2. Print Money: Unsterilized Intervention
Supply as many Pesos as the market wants at
the fixed exchange rate.
Expanded monetary base will result in
inflation.
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What should the Central Bank Do?
3 Options:
1. Discourage capital inflows. Curb demand.
Example: Chile.
2. Print Money: Unsterilized Intervention
Supply as many Pesos as the market wants at
the fixed exchange rate.
Expanded monetary base will result in
inflation, leading to RER appreciation:
P*
e =s
P
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What Should the Central Bank Do?
3. Sterilized Intervention:
a. Supply currency in FX market to maintain
exchange rate:
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What Should the Central Bank Do?
3. Sterilized Intervention:
a. Supply currency in FX market to maintain
exchange rate:
FACB + DA = H
b. Then sell bonds in Money Market to reduce
monetary base (‘sterilizing the inflows’):
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What Should the Central Bank Do?
3. Sterilized Intervention:
a. Supply currency in FX market to maintain
exchange rate:
FACB + DA = H
b. Then sell bonds in Money Market to reduce
monetary base (‘sterilizing the inflows’):
FACB + DA = H
Benefits: Less inflationary impact and RER appreciation.
Costs: To sell bonds, may need to raise interest rates.
Can cause further capital inflows and economic
slowdown. May need corresponding fiscal adjustment.
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Example: Norwegian Krone
In late 1996, the Norwegian Krone appreciated by 3.5%:
• Booming North Sea oil production and rising price of
oil had resulted in jump in current account surplus
(7.7% of GDP) for the world’s 2nd largest oil exporter.
• Jump in exports put pressure on Krone to appreciate.
• To maintain competitiveness of non-oil exporters,
central bank wanted to maintain a ‘stable krone.’
• Norges Bank intervened heavily in foreign
exchange markets, selling 20 billion Kroner in the
first week of 1997.
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Example: Norwegian Krone
• Although Norway no longer has any long-term state
debt, to reduce inflationary pressure, Norway
sterilized inflows with short-term borrowing and
conservative spending.
• Tight fiscal policies allowed Norges Bank to actually
reduce interest rates.
• Upon announcing a recent interest rate cut,
Finance Minister Jens Stoltenberg said,
“We’ve achieved international credibility by
maintaining tight fiscal policy, and showing we have
no intention of fueling the economy with oil funds.”
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Relationship to Balance of Payments
Remember:
Current Account + Capital Account = Changes in Reserves
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Relationship to Balance of Payments
Remember:
Current Account + Capital Account = Changes in Reserves
+
+
If demand for pesos by
purchasers of Mexican
assets and exports...
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Relationship to Balance of Payments
Remember:
Current Account + Capital Account = Changes in Reserves
+
-
If demand for pesos by
purchasers of Mexican
assets and exports...
+
-
>
...is greater than supply
of pesos by importers of
U.S. exports and assets
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Relationship to Balance of Payments
Remember:
Current Account + Capital Account = Changes in Reserves
+
-
+
If demand for pesos by
purchasers of Mexican
assets and exports...
-
>
+
...is greater than supply
of pesos by importers of
U.S. exports and assets
Either prices, returns, and exchange
rates will adjust to equate the two or
Banco Central’s reserves will grow.
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Key Points
1. Influencing an exchange rate is exactly like any other
price - a government must be able to alter supply and
demand.
2. A government has two options:
a. Make trade at other levels illegal.
b. Commit to buy or sell at a given price.
3. A government is better off if demand for currency is
greater than supply vs. the opposite.
Why? Because the government can increase supply
limitlessly, but cannot increase demand limitlessly (it
can print its own currency but not FX).
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Key Points
4. If demand is less than supply, the government will only be
able to increase demand by using limited reserves of
foreign exchange.
Unless something changes, it will run out and either must
make exchange at other rates illegal or allow adjustment.
5. If demand is greater than supply, and the government does
not restrict demand, it has two options: sterilized and
unsterilized intervention.
6. With unsterilized intervention, the government simply
prints money to meet demand - leading to inflation.
7. With sterilized intervention, the central bank removes the
new currency from circulation by selling bonds - creating
a decline in high-powered money with a decline in
domestic assets - leading to less inflation.
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