FIN 40500: International

Finance
Exchange Rate Management

Exchange Rate Policy can be characterized
along two dimensions
C
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m
m
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Flexibility
Currency
Union (Euro)
Hard Peg
(China)
Pure Float
(USA)
.1265
With a hard peg, a currencys price is held
permanently at a fixed level. For example, the
Chinese Yuan.
Jan Feb Mar Apr May
Flexibility
$1 = 7.90Yuan
e
.012
With a soft peg, a currencys price is returned
to the predefined parity at regular intervals
(monthly, weekly, etc). For example, the
Algerian Dinar.
Jan Feb Mar Apr May
Flexibility
$1 = 76 Dinar
e
With an adjustable peg, the parity price is
adjusted as circumstances warrant (monthly,
weekly, etc). The Bretton Woods System was
an adjustable peg
Jan Feb Mar Apr May
Flexibility
e
With a crawling peg, a currencys price is held
permanently at a fixed level, but that parity level
has prescheduled changes For example, the
Mexican Peso followed a crawling peg in the
1990s
Jan Feb Mar Apr May
Flexibility
e
With a target zone, a currencys price
is held permanently between an upper
and lower bound. The Bretton Woods
system used 2% bands
Jan Feb Mar Apr May
+2%
-2%
Flexibility
e
Flexibility
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
Jan-71 Jan-75 Jan-79 Jan-83 Jan-87
The Plaza Accord
(1985) purposely
devalued the dollar
against the Yen and
Deutschmark by
51%
The Louvre Accord
(1987) ended the
dollar devaluation
policy of the plaza
accord
USD/JPY
From 1971 until 1987 the US followed a policy
of managed floating (market based exchange
rate with periodic re-alignments). A pure
float would have no such re-alignments.
Fixed Exchange Rate: This is simply a policy
decision of the government or central bank
and can be easily reversed (China).

Currency Boards: A currency board is a
monetary authority separate from (or in
replacement of) a countrys central bank
whose sole responsibility is maintaining
convertibility of the countrys currency. (Hong
Kong)

Dollarization/Currency Union: foreign money
replaces domestic money as official currency
(Panama)
C
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Policies can also vary by the degree of commitment to the
policy
Exchange Rate Systems
5%
20%
24%
14%
10%
6%
21%
Pure Float
Managed Float
Crawling Peg or
Band
Target Zone
Pure Peg
Currency Board
Dollarization
Currency Baskets
Some countries choose to peg to a basket of currencies rather
that a single currency. This basket will have a price equal to a
weighted average of the individual currencies
Latvia: SDR (Euro, JPY, GBP, USD)
Malta: Euro (67%), USD21%), GBP (12%)
Iceland: Euro + 6 other countries
Why peg to a basket?
Baskets of currency should exhibit less volatility that individual
currencies.
The central bank has a wider choice of options for official
reserves
Costs/Benefits of Fixed Exchange
Rates
Main Benefit
Reduces uncertainty with regard to cross border
trade in both goods and assets
Main Cost
Eliminates a countrys ability to use monetary
policy for domestic objectives
Full Employment
High Output Growth
Low Inflation
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000


Currently, the reserve ratio is 65% (6.5M/10M)
Suppose that the US decides to peg to the Euro at a price of $1.30 per
Euro Our ability to maintain the peg depends on our foreign
exchange reserves.
If we are going to analyze the policy options, we need a
structured framework to proceed.
Long Run
PPP holds
Relative prices are
constant. Therefore,
the real exchange rate
equals one
The nominal exchange
rate returns to its
fundamentals
Short Run
Commodity prices are
fixed (PPP fails)
UIP and Currency
markets determine
exchange rates
Using PPP and the two Money Market equilibrium conditions, we
get the fundamentals for a currency
Domestic Money Market
PPP
( )
*
*
* *
1
y
M
i P + =
( )
y
M
i P + = 1
*
eP P =
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1
1
i
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Y
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M
M
e
Foreign Money Market
This should give us the long run trend
The US is pegging at $1.30/Euro. This explicitly defines a
monetary policy!
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= =
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*
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1
1
30 . 1
i
i
Y
Y
M
M
e
Now, solve for M
( )
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=
i
i
Y
Y
M M
1
1
30 . 1
*
*
*
We now have the US monetary policy rule
Suppose that US economic growth is 4% per year
while Europe is 1% per year.
To maintain the peg, the US would have to
increase the US money supply by 3% relative to
Europe
This is actually better expressed in percentage terms
( ) ( ) i i Y Y M M + A A + A = A
* * *
% % % %
Note: All else equal, money growth rates should be the
same.
Mama knows best!
If Billy jumped off the
Brooklyn Bridge,
would you do it to?
Suppose that Europe was following an irresponsible monetary
policy (excessive money growth). If the US was pegging to the
Euro, we would be forced into the same irresponsible behavior!
( )
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M M
1
1
30 . 1
*
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*
Jan Feb Mar Apr May
You need to choose a currency regime that is
compatible in the long run with your economic
fundamentals
Mexicos crawling peg to the US was due to its high inflation rate
relative to the US (high inflation is a result of low economic growth
and high money growth
e
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

+ $1,000,000 (T-Bills)

The reserve ratio drops to 59% (6.5M/11M)
Suppose the Federal Reserve conducts an open market purchase of
$1,000,000 in Treasuries to increase the money supply, what will the short
run impact be?
i
i
y
IS
LM
0 = BOP
The increase in money increases income (this worsens the trade
balance as imports increase) and lowers domestic interest rates (this
worsens the capital account by cutting off foreign investment)
With a BOP deficit, Federal Reserve must use Euro
reserves to buy dollars in order to maintain the peg
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
- $1,000,000 X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+ $1,000,000 (T-Bills)
- $1,000,000 (Euros)


The reserve ratio drops to 55% (5.5M/10M)
Note: The money supply returns to $10M
The Fed Conducts an open market purchase of Dollars
Suppose that the US Government runs a deficit
(either spending increases or tax cuts) to
stimulate the economy
Increased spending increases the trade deficit
Higher government debt raises the interest rate (this
attracts foreign capital)


i
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y
IS
LM
Can this policy be maintained
under a currency peg system?
If capital mobility is sufficiently high, the increase in domestic interest
rated creates sufficient capital inflow to finance the trade deficit. The
dollar begins to appreciate
i
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y
IS
LM
KFA CA BOP + =
0 = BOP
The balance of payments surplus forces the dollar to appreciate in
the short run.
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

+$1,000,000 (Euros)


The reserve ratio rises to 68% (7.5M/11M)
The Fed Conducts an open market sale of Dollars to maintain
the peg with the Euro
i
i
y
IS
LM
KFA CA BOP + =
0 = BOP
The balance of payments surplus forces the dollar to depreciate in
the short run.
With low capital mobility, high US interest rates are unable to attract
sufficient financing for the trade deficit. A BOP deficit causes the
dollar to depreciate
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

-$1,000,000 (Euros)


The reserve ratio falls to 61% (5.5M/9M)
The purchase of dollars contracts the money supply. Can the
Fed avoid this monetary contraction?
The Fed Conducts an open market purchase of Dollars to
maintain the peg with the Euro
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

-$1,000,000 (Euros)
+$1,000,000 (T-Bills)

The reserve ratio falls to 55% (5.5M/10M)
The Fed Conducts an open market purchase of Treasuries to
Sterilize the currency intervention
Suppose that foreign investors view US debt as too risky?
Financial flows reverse, the US runs a BOP deficit requiring
a purchase of dollars
i
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y
IS
LM
Reversal of capital flows causes
the dollar to begin to depreciate.
The US must correct this by
buying dollars.
Note: This would contract the money supply raising interest rates and
lowering output.
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

-$1,000,000 (Euros)


The reserve ratio falls to 61% (5.5M/9M)

The Fed Conducts an open market purchase of dollars to
stabilize the exchange rate
Suppose that foreign investors view US debt as too risky?
Financial flows reverse, the US runs a BOP deficit.
i
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y
IS
LM
Alternatively, if capital is mobile
enough, the government could
bail out the private companies
replacing private debt with
public debt
This is riskytotal indebtedness increase!!
Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.30 $/E
$ 2,600,000
$ 3,500,000 (T-Bills)
$6,100,000

The reserve ratio is at 42% (2.6M/6.1M)
Foreign Reserves are dangerously low! What can we do?
The Fed could fix this problem by devaluing the dollar (i.e. raising the
dollar price of Euro)
The drop in value would hopefully stop the selling
The devaluation would also improve the Feds reserve position
Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.50 $/E
$ 3,000,000
$ 3,500,000 (T-Bills)
$6,500,000


The reserve ratio is at 49% (3M/6.1M)
A devaluation from $1.30 to $1.50 helps
Speculation and Peso Problems
Even a strong currency can become the
victim of a speculative attack.
If the market believes that a currency might
devalue in the future, they will sell that
countrys currency and assets.
The resulting balance of payments deficit
forces the country to devalue (self fulfilling
prophesy)
Short Run Management
Currency Pegs work well as long as times are
good
A country can maintain an appreciating currency
forever
Currency pegs are not terribly successful during
tough times
You cant maintain a depreciating currency forever
and markets know this!
A peg forces you to follow policies that tend to make
economic conditions worse (tight money, balanced
government budgets)

Daniel-san, must talk. Man walk on road. Walk left side, safe. Walk right
side, safe. Walk down middle, sooner or later, get squished just like
grape. Same here. You karate do "yes," or karate do "no." You karate do
"guess so," just like grape. Understand?
Pearls of wisdom from The Karate
Kid
Committed Floater
Committed Pegger
Uncertain Pegger