Transcript Exchange Rate Policy I. Foreign Exchange Market

Special Topics in Economics
Econ. 491
Chapter 2:
Exchange Rate Policy
I. Foreign Exchange Market
 Foreign Exchange Market:
A market in which trading of currency and bank
deposits denominated in particular currencies takes
place.
 There are 2 kinds of exchange rate transactions:
1. Spot Transactions: involve the immediate (two-day)
exchange of bank deposits.
2. Forward Transactions: involve the exchange of
bank deposits at some specified future date.
 There are 2 kinds of exchange rates:
1. Spot Exchange Rate: is the exchange rate for the spot
transaction.
2. Forward Exchange Rate: is the exchange rate for the
forward transaction.
How is Foreign Exchange Traded?
 The foreign exchange market is organized as
an over the counter market.
 There are several hundred dealers (mostly
banks) stand ready to buy and sell deposits
denominated in foreign currencies.
II. The Demand & Supply in the Foreign
Exchange Market
 Simple standard demand & supply framework to
analyze the foreign exchange market.
II.i Under Flexible Rate Regime
 Demand for & supply of each currency in the foreign
exchange market determine the exchange rate .
Case One: Consider R= 0.5
 A shortage of foreign exchange would cause individuals
to bid up its price as they offer to buy Euro denominated
deposits in exchange for dollar-denominated ones.
Case Two: Consider R= 1.5
• A surplus of foreign exchange would cause the price to
fall as individuals offered to sell Euro denominated
deposits in exchange for dollar-denominated ones.
Result: The price of mechanism equates the quantity demanded of
each currency with the quantity supplied, thus the foreign
exchange market clears.
II.ii Under Fixed Rate Regime
 The pegged or fixed exchange rate is a practice that
works much like fixing the price of any good.
 Demand & supply of foreign exchange still exist, but
do not determine the exchange rate as they would in the
flexible regime.
 Central banks must stand ready to absorb any excess
demand for or supply of a currency to maintain the
pegged rate.
 Central banks must step into the market , such action
called a policy of intervention in the foreign exchange
market.
 Case One: Suppose the US government decides to peg
the exchange rate between dollars & Euros at 1.5
 Case Two: Suppose the US government decides to peg
the exchange rate between dollars & Euros at 0.5
Case One: Consider R= 1.5
 The quantity supplied of euro exceeds the quantity
demanded. Dollar denominated deposits are more
attractive relative to the euro ones. Thus, surplus of euro
in the foreign exchange market at (R=1.5) creates a
tendency for the exchange rate to fall as individuals try
to sell euro deposits in exchange for dollar ones.
 As a result, US Fed steps in to buy up the surplus euro
denominated deposits(individuals sell euro denominated
deposits to the Fed in return for dollar ones at R=1.5).
 The distance between points B and G at R=1.5
represents the level of required intervention.
 What is the case of revaluation of the dollar?
Case Two: Consider R= 0.5
• A surplus of foreign exchange would cause the price to
fall as individuals offered to sell Euro denominated
deposits in exchange for dollar-denominated ones.
Result: The price of mechanism equates the quantity demanded of
each currency with the quantity supplied, thus the foreign
exchange market clears.
Case Two: Consider R= 0.5
 The quantity demanded for euro exceeds the quantity
supplied. Euro denominated deposits are more attractive
relative to the Dollar ones. Thus, shortage of euro in the
foreign exchange market at (R=0.5) creates a tendency
for the exchange rate to increase as individuals try to
buy euro deposits in exchange for dollar ones.
 As a result, US Fed steps in to sell euro denominated
deposits (from where Fed has them ) by buying dollar
denominated deposits.
 The distance between points H and C at R=0.5
represents the level of required intervention.
 What is the case of devaluation of the dollar?
III. Classification of Exchange Rate
Arrangements
 The existing literature on regime choices has usually
used the International Monetary Fund’s classification
of exchange rate regimes.
 Prior to 1999, member countries of the IMF declared
their exchange rate policies to the IMF according to
their official or de jure exchange rate arrangements.
 The former IMF classification identifies three major
exchange rate arrangements: fixed policies, limited
flexibility policies (fluctuated within a range), and
more flexible policies (either managed or free float).
 However, the former IMF exchange rate classification
does not distinguish between the announced exchange
rate policy (de jure exchange rate) and the actual
exchange rate policy (de facto exchange rate)
undertaken by the country.
 Another drawback of the pre-1999 classification is
that it does not distinguish between the varieties of
fixed exchange rate regimes.
 The new IMF classification distinguishes between
various pegging policies and also distinguishes
between eight categories ranging from hard peg
regimes to free floating regimes:
Exchange Rate Regime
Description
1. No Separate Lender Tender
i.e., Formal dollarization
2. Currency Board
Fixed to a specific foreign currency at a fixed rate
3. Conventional Fixed Pegs
Fixed to a single currency or a basket of currencies as with band at
most +/- 1%
4. Fixed Within Horizontal Bands
Fixed with bands at least +/- 1%
5. Crawling Pegs
Fixed with central parity periodically adjusted in small amount at fixed
rate or in response to changes in selective quantitative indicators
6. Crawling Bands
Crawling peg associated with bands at least +/- 1%
7. Managed Floating
Influencing the exchange rate without a specific target or preannounced path of the exchange rate
8. Independently Floating
Determining exchange rate through the market
•Table: The Revised IMF Classification of Exchange Rate Arrangements
•Source: IMF Exchange Rate Classification (1999)