The Foreign Exchange Market 1

The Foreign Exchange Market 1

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70 3 Month Sep-99 Jul-99 M ay-99 Mar-99 Jan-99 Nov-98 Sep-98 Jul-98 May-98 Mar-98 Jan-98 Nov-97 Sep-97 Jul-97 M ay-97 Mar-97 Jan-97 Nov-96 Sep-96 Jul-96 May-96 Mar-96 Jan-96 Nov-95 Sep-95 Jul-95 M ay-95 M ar-95 Jan-95 Inde x Asian Currencies vs. U.S. Dollar 210 190 170 MYR/USD PHP/USD 150 SGD/USD 130 KRW/USD TWD/USD 110 THB/USD 90

The Foreign Exchange Market Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Appreciation 4. Depreciation Currency appreciates, country’s goods prices abroad and foreign goods prices in that country 1. Makes domestic businesses less competitive 2. Benefits domestic consumers 4 FX traded in over-the-counter market 1. Trade is in bank deposits denominated in different currencies

The Foreign Exchange Market Exchange rate Peso/ D S Supply of Dollars by people who want pesos Demand for Dollars by people who have pesos 5 Foreign exchange (dollars)

Currency Depreciation and Appreciation 6 Currency depreciation is an increase in the number of units of a particular currency needed to purchase one unit of foreign exchange Currency appreciation is a decrease in the number of units of a particular currency needed to purchase one unit of foreign exchange

Changes in the Equilibrium Exchange Rate Exchange rate Peso/ D Supply of Dollars S by people who S’ want pesos -depreciation Peso- appreciation Demand for Dollars by people who have pesos 7 Foreign exchange (dollars)

Exchange Rate Regimes Flexible Fixed – – (Floating) exchange rates. exchange rates. Currency Board Monetary Union Managed 8 Float (Dirty Float) exchange rates.

The Central Bank Can Intervene to Maintain Exchange Rates Exchange rate /pound 9 D’ D’’ S Foreign exchange (pounds)

7.4 9/2/2004 8/2/2004 7/2/2004 6/2/2004 5/2/2004 4/2/2004 3/2/2004 2/2/2004 3/2/2007 2/2/2007 1/2/2007 12/2/2006 11/2/2006 10/2/2006 9/2/2006 8/2/2006 7/2/2006 6/2/2006 5/2/2006 4/2/2006 3/2/2006 2/2/2006 1/2/2006 12/2/2005 11/2/2005 10/2/2005 9/2/2005 8/2/2005 7/2/2005 6/2/2005 5/2/2005 4/2/2005 3/2/2005 2/2/2005 1/2/2005 12/2/2004 11/2/2004 10/2/2004 10 1/2/2004 China Chinese Yuan to One U.S. Dollar 8.4 8.3 8.2 8.1 8 7.9 7.8 7.7 7.6 7.5

Currency Crisis Exchange rate Baht/ 52 D’ D S 25 11 Foreign exchange ( )

70 12 Month Sep-99 Jul-99 M ay-99 Mar-99 Jan-99 Nov-98 Sep-98 Jul-98 May-98 Mar-98 Jan-98 Nov-97 Sep-97 Jul-97 M ay-97 Mar-97 Jan-97 Nov-96 Sep-96 Jul-96 May-96 Mar-96 Jan-96 Nov-95 Sep-95 Jul-95 M ay-95 M ar-95 Jan-95 Inde x Asian Currencies vs. U.S. Dollar 210 190 170 MYR/USD PHP/USD 150 SGD/USD 130 KRW/USD TWD/USD 110 THB/USD 90

Law of One Price Example: American steel 100 per ton, Japanese steel 10,000 yen per ton If E 50 yen/ then prices are: In U.S. In Japan American Steel Japanese Steel 100 5000 yen 200 10,000 yen If E 100 yen/ then prices are: In U.S. In Japan 13 American Steel Japanese Steel 100 10,000 yen 100 10,000 yen Law of one price E 100 yen/

Purchasing Power Parity (PPP) PPP Domestic price level 10%, domestic currency 10% 1. Application of law of one price to price levels 2. Works in long run, not short run Problems with PPP 1. All goods not identical in both countries: Toyota vs Chevy 2. Many goods and services are not traded: e.g. haircuts 14

Big Mac Index 15

PPP: U.S. and U.K 16

Factors Affecting E in Long Run 17 Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E

Exchange Rates in the Short Run 18 An exchange rate is the price of domestic assets in terms of foreign assets Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other

Expected Returns and Interest Parity Re for Deposits Francois iD (Eet 1 – Et)/Et Al iD Euro Deposits iF iF – (Eet 1 – Et)/Et Relative Re iD – iF (Eet 1 – Et)/Et iD – iF (Eet 1 – Et)/Et Interest Parity Condition: and Euro deposits perfect substitutes iD iF – (Eet 1 – Et)/Et Example: 19 if iD 10% and expected appreciation of , (Eet 1– Et)/Et, 5% iF 15%

Deriving RF Curve Assume iF 10%, Eet 1 1 euro/ Point A: Et 0.95, RF .10 – (1 – 0.95)/0.95 .048 4.8% B: Et 1.00, RF .10 – (1 – 1.0)/1.0 .100 10.0% C: Et 1.05, RF .10 – (1 – 1.05)/1.05 .148 14.8% RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF Deriving RD Curve Points B, D, E, RD 10%: so curve is vertical Equilibrium RD RF at E* If Et E*, RF RD, sell , Et If Et E*, RF RD, buy , Et 20

Equilibrium in the Foreign Exchange Market 21

Shifts in RF RF curve shifts right when 1. iF : because RF at each Et 2. Eet 1 : because expected appreciation of F at each Et and RF Occurs Eet 1 iF: 1) Domestic P , 2) Trade Barriers 3) Imports , 4) Exports , 5) Productivity 22

Shifts in RD RD shifts right when 1. iD ; because RD at each Et Assumes that domestic e unchanged, so domestic real rate 23

Foreign Exchange I Exchange rate—price of one currency in terms of another Foreign exchange market—the financial market where exchange rates are determined Spot transaction—immediate (two-day) exchange of bank deposits – Forward transaction—the exchange of bank deposits at some specified future date – 24 Spot exchange rate Forward exchange rate

Foreign Exchange II 25 Appreciation—a currency rises in value relative to another currency Depreciation—a currency falls in value relative to another currency When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa Over-the-counter market mainly banks

Exchange Rates in the Long Run Law of one price Theory – – – 26 of Purchasing Power Parity Assumes all goods are identical in both countries Trade barriers and transportation costs are low Many goods and services are not traded across borders

Factors that Affect Exchange Rates in the Long Run Relative Trade price levels barriers Preferences for domestic versus foreign goods Productivity 27

Factors that Shift RF and RD 28

Response to i Because e 1. e , Eet 1 , expected appreciation of F , RF shifts out to right 2. iD , RD shifts to right However because e iD , real rate , Eet 1 more than iD RF out RD out and Et 29

Response to Ms 1. Ms , P , Eet 1 expected appreciation of F , RF shifts right 2. Ms , iD , RD shifts left Go to point 2 and Et 30 3. In the long run, iD returns to old level, RD shifts back, go to point 3 and get Exchange Rate Overshooting

Why Exchange Rate Volatility? 1. Expectations of Eet 1 fluctuate 2. Exchange rate overshooting 31

The Dollar and Interest Rates 1. 2. 32 Value of and real rates rise and fall together, as theory predicts No association between and nominal rates: falls in late 70s as nominal rate rises

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Chapter 18 The International Financial System

Unsterilized Foreign Exchange Intervention Federal Reserve System Assets Foreign Assets (International Reserves) 39 Federal Reserve System Liabilities - 1B Currency in circulation Assets - 1B Foreign Assets (International Reserves) Liabilities - 1B Deposits with the Fed - 1B (reserves) A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base

Unsterilized Intervention An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency 40

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Sterilized Foreign Exchange Intervention Federal Reserve System Assets Liabilities Foreign Assets (International Reserves) - 1B (reserves) Government Bonds 1B 42 Monetary Base 0 To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation There is no effect on the monetary base and no effect on the exchange rate

Balance of Payments Current Account – 43 International transactions that involve currently produced goods and services Trade Balance Capital Account – Net receipts from capital transactions Sum of these two is the official reserve transactions balance

Monetary Policy Strategy: The International Experience

Role of a Nominal Anchor Ties Down Expectations Helps Avoid Time-Consistency Problem 1. Arises from pursuit of short-term goals which lead to bad long-term outcomes 2. Time-consistency resides more in political process 3. Nominal anchor limits political pressure for time-consistency 45

Exchange-Rate Targeting Advantages 1. Fixes for internationally traded goods 2. Anchors expectations 3. Automatic rule, avoids time-consistency 4. Easy to understand: “sound currency” as rallying cry 5. Helps economic integration 6. Successful in reducing France, UK, Mexico 46

Exchange-Rate Targeting Disadvantages 1. Loss of independent monetary policy Problems after German reunification: UK, French monetary policy too tight 2. Open to speculative attacks Europe, Sept. 1992; Mexico: 1994; Asia: 1997 3. Successful speculative attack disastrous for emerging market countries because it leads to financial crisis 4. Weakened accountability: lose exchange-rate signal 47

Currency Boards vs. Dollarization Currency Boards 1. Domestic currency exchanged at fixed rate for foreign currency automatically 2. Fixed exchange rate with very strong commitment mechanism and no discretion 3. Usual disadvantages of fixed exchange rate 4. Still subject to speculative attack 5. Lose ability to have lender of last resort Dollarization 1. Even stronger commitment mechanism 2. No possibility of speculative attack 3. Usual disadvantages of fixed exchange rtae 4. Lose seignorage 48

Summary: Advantages and Disadvantages of Different Monetary Policy Strategies 49

Summary: Advantages and Disadvantages of Different Monetary Policy Strategies 50

Monetary Targeting Canada 1. Targets M1 till 1982, then abandons it 2. 1988: declining targets, M2 as guide United Kingdom 1. Targets M3 and later M0 2. Problems of M as monetary indicator Japan 1. Forecasts M2 CDs 2. Innovation and deregulation makes less useful as monetary indicator 3. High money growth 1987-1989: “bubble economy,” then tight money policy Germany and Switzerland 1. Not monetarist rigid rule 2. Targets using M0 and M3: changes over time 3. Allows growth outside target for 2-3 years, but then reverses overshoots 4. Key elements: flexibility, transparency, and accountability 51

Monetary Targeting Advantages 1. Able to cope with domestic considerations 2. Signals are immediate 3. Immediate accountability of central bank Disadvantages 1. Big if: all advantages require reliable relationship between goal and targeted aggregate 2. In many countries, weak relationship between goal and Maggregate Poor communications device and accountability 52

Inflation Targeting Five Elements 1. Public announcement of medium-term štarget 2. Institutional commitment to price stability 3. Information inclusive strategy 4. Increased transparency through public communication 5. Increased accountability 53

Inflation Targeting in New Zealand, Canada, and the UK 54

Inflation Targeting Advantages 1. Allows focus on domestic considerations 2. Not dependent on reliable relationship between Maggregate and inflation 3. Readily understood by public 4. Reduce political pressures for time-consistent policy 5. Focus on transparency and communication 6. Increased accountability of central bank 7. Performance good: and e , and stays low in business cycle upturn 55

Inflation Targeting Disadvantages 1. Delayed signalling 2. Too much rigidity 3. Potential for increased output fluctuations 4. Low economic growth Nominal GDP Targeting 1. Close to inflation targeting with concern about output fluctuations 2. Problem of announcing specific target for real GDP growth 3. Harder for public to understand 56

Monetary Policy with an Implicit Nominal Anchor Forward-Looking and Preemptive to Deal With Long Lags Advantages 1. Focus on domestic considerations 2. Has worked very well in the U.S. 3. If It Ain’t Broke Why Fix It? Disadvantages 1. Lack of transparency and accountability 2. Dependence on personalities 3. Inconsistent with democratic principles 57

Comparing Expected Returns I Dollar assets pay an interest rate of i D and do not have any capital gain Foreign assets have an interest rate of i F and there is no capital gain To compare the expected returns on dollar assets and foreign assets the returns must be converted into the currency unit used Et the spot exchange rate Et 1 the exchange rate for the next period e Et 1 - Et the expected rate of appreciation for the dollar Et 58

Comparing Expected Returns II The expected return on dollar assets R D in terms of foreign currency is the sum of the interest rate on dollar assets plus the expected appreciation of the dollar R D Ete 1 Et in term of euros i Et D The expected return on foreign assets R F is i F Ete 1 Et Relative R i i Et D D F As the relative expected return on dollar assets increases, foreigners will want to hold more dollar assets 59

Comparing Expected Returns III The expected return on foreign assets R F in terms of dollars is the interest rate on foreign assets i F plus the expected appreciation of the foreign currency, equal to minus the expected appreciation of the dollar e Et 1 Et R in terms of dollars i Et F F The expected return on the dollar assets R D is i D e e Et 1 Et Et 1 Et D F Relative R i (i ) i i Et Et D D F Which is the same as previously Relative expected return on dollar assets is the same whether it is calculated in terms of euros or in terms of dollars As the relative expected return on dollar assets increases, both foreigners and 60 domestic residents will want to hold more dollar assets

Interest Parity Condition D F i i 61 e t 1 E Et Et Capital mobility with similar risk and liquidity the assets are perfect substitutes The domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency Expected returns are the same on both domestic and foreign assets An equilibrium condition

Demand and Supply for Domestic Assets Demand – – Relative expected return At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher Supply – – 62 The amount of bank deposits, bonds, and equities in the U.S. Vertical supply curve

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Exchange Rate Overshooting Monetary Neutrality – The exchange rate falls by more in the short run than in the long run – 67 In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level Helps to explain why exchange rates exhibit so much volatility

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The Dollar and Interest Rates While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced 69

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Exchange Rate Regimes Fixed exchange rate regime – Floating exchange rate regime – Value of a currency is allowed to fluctuate against all other currencies Managed float regime (dirty float) – 71 Value of a currency is pegged relative to the value of one other currency (anchor currency) Attempt to influence exchange rates by buying and selling currencies

Past Exchange Rate Regimes Gold standard – – – Bretton Woods System – – 72 Fixed exchange rates No control over monetary policy Influenced heavily by production of gold and gold discoveries Fixed exchange rates using U.S. dollar as reserve currency International Monetary Fund (IMF)

Past Exchange Rate Regimes (cont’d) Bretton Woods System (cont’d) – – World Bank General Agreement on Tariffs and Trade (GATT) European Monetary System – 73 World Trade Organization Exchange rate mechanism

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How a Fixed Exchange Rate Regime Works 76 When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result, it loses international reserves When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves

How Bretton Woods Worked 77 Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments) Loans from IMF to cover loss in international reserves IMF encourages contractionary monetary policies Devaluation only if IMF loans are not sufficient No tools for surplus countries U.S. could not devalue currency

Managed Float Hybrid of fixed and flexible – – 78 Small daily changes in response to market Interventions to prevent large fluctuations Appreciation hurts exporters and employment Depreciation hurts imports and stimulates inflation Special drawing rights as substitute for gold

European Monetary System 79 8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar ECU value was tied to a basket of specified amounts of European currencies Fluctuated within limits Led to foreign exchange crises involving speculative attack

Capital Controls Outflows – – – – Inflows – 80 Promote financial instability by forcing a devaluation Controls are seldom effective and may increase capital flight Lead to corruption Lose opportunity to improve the economy Lead to a lending boom and excessive risk taking by financial intermediaries

Capital Controls (cont’d) Inflows (cont’d) – – – 81 Controls may block funds for productions uses Produce substantial distortion and misallocation Lead to corruption Strong case for improving bank regulation and supervision

The IMF: Lender of Last Resort Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in this function May The be able to prevent contagion safety net may lead to excessive risk taking (moral hazard problem) 82

How Should the IMF Operate? May not be tough enough Austerity programs focus on tight macroeconomic policies rather than financial reform Too slow, which worsens crisis and increases costs 83

Direct Effects of the Foreign Exchange Market on the Money Supply Intervention in the foreign exchange market affects the monetary base U.S. dollar has been a reserve currency: monetary base and money supply is less affected by foreign exchange market 84

Balance-of-Payments Considerations Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong U.S. deficits mean surpluses in other countries large increases in their international reserve holdings world inflation 85

Exchange Rate Considerations A contractionary monetary policy will raise the domestic interest rate and strengthen the currency An expansionary monetary policy will lower interest rates and weaken currency 86

Advantages of Exchange-Rate Targeting Contributes to keeping inflation under control Automatic rule for conduct of monetary policy Simplicity 87 and clarity

Disadvantages of Exchange-Rate Targeting Cannot respond to domestic shocks and shocks to anchor country are transmitted Open to speculative attacks on currency Weakens the accountability of policymakers as the exchange rate loses value as signal 88

Exchange-Rate Targeting for Industrialized Countries Domestic monetary and political institutions are not conducive to good policy making Other important benefits such as integration 89

Exchange-Rate Targeting for Emerging Market Countries Political and monetary institutions are weak Stabilization 90 policy of last resort

Currency Boards 91 Solution to lack of transparency and commitment to target Domestic currency is backed 100% by a foreign currency Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate Money supply can expand only when foreign currency is exchanged for domestic currency

Currency Boards (cont’d) 92 Stronger commitment by central bank Loss of independent monetary policy and increased exposure to shock from anchor country Loss of ability to create money and act as lender of last resort

Dollarization 93 Another solution to lack of transparency and commitment Adoption of another country’s money Even stronger commitment mechanism Completely avoids possibility of speculative attack on domestic currency Lost of independent monetary policy and increased exposure to shocks from anchor country

Dollarization (cont’d) 94 Inability to create money and act as lender of last resort Loss of seignorage

Appendix Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book. They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future. 95