Professional Documents
Culture Documents
2nd edition
MACROECONOMICS
Copyright 2005 John Wiley & Sons, Inc. All rights reserved.
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Key Concepts
Covered Interest Parity
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Currency Crisis
Sudden and dramatic currency depreciation,
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Malaysia E xchange rate against U S dollar (1996=100) Thailand E xchange rate against U S dollar (1996=100) S outh K orea E xchange rate against U S D ollar (1996=100)
Source: EcoWin
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Fiscal deficit Nominal exchange rate constant Short term interest rate must fall Expected inflation must rise
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iJ
Short term interest rate falls Expected future exchange rate falls (inflation)
S*(0)
iUS + [Se(1)-S(0)]/S(0)
Rate of Return
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iJ
To maintain S(0), interest rates must increase (consistent with inflation story)
S*(0)
iUS + [Se(1)-S(0)]/S(0)
Rate of Return
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Fiscal deficit Nominal exchange rate constant Short term interest rate must fall Expected inflation must rise Offer higher interest rates Buy domestic currency
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Vicious circle
Fiscal Deficit and Monetization
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End game
Government eventually runs out of reserves
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Exchange rate mechanism Fixed exchange rates among European economies Implied same inflation and interest rate among member countries If rate is stable, no attack If currency is vulnerable, sell off
Self-fulfilling equilibria
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Tradeoff
Low and Stable Inflation
Fixed Rate
No Fixed Rate
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Snowball effect
Slow Growt h Incentive to abandon fixed rate Investors sell currency Interest rate must rise
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Capital inflows to Asian countries Countries become net borrowers (capital account surplus)
Capital account deficit Downward pressure on exchange rate
Capital outflow
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Debt Dependence
Emerging economies rely on foreign-
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Member quota
Emergency lending service
Wednesday August 4, 2004 1 SDR = 1.456 USD 1 USD = 0.686811 SDR SDR Interest Rate = 1.91%
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Risk diversification
Improving government policy Increasing efficiency of financial sector
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controls may also turn out to be an important setback not only to that countrys [Malaysia] recovery and potentially to its future development, but also to other emerging market economies
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especially short-term credit flows, can be dangerous for countries with weak or inconsistent macro-economic policies or inadequately capitalized and regulated financial systems
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80%
40%
20%
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Fixed Rate
Exchange rate fixed at constant level
Advantages
Provides a nominal anchor Encourages trade and investment Avoids speculative bubbles Reduces risk premium
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Floating Rate
Let nominal exchange rate adjust to market
Independent monetary policy Automatic adjustment to trade shocks Seignorage Avoid speculative attacks
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Intermediate Regime
Float, but within boundaries
Exchange Rate
Time
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Hard Peg
Fix one bilateral nominal exchange rate Dollarize (Ecuador)
Abandon own currency and use another nations currency No more seignorage! Central bank holds interest-bearing foreign assets Will exchange domestic currency for foreign currency at a fixed exchange rate, backed by assets
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Currency Board
Role of Central Bank
Exchange domestic currency for foreign reserves at fixed rate of exchange Can never produce fiat money Cannot issue liquidity of domestic banks
falls
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Argentina
Public sector financing requirements (Billions of US$) 2001 2002 Uses 20.1 18.8 Fiscal Deficit 6.9 0.0 Primary Surplus 4.1 10.4 (T G) Interest 11.0 10.4 Amortizations 12.2 17.8 (existing bonds/loans) Other 1.0 1.0 Sources Initial Cash IFIs
Voluntary Market
End Cash
18.8 4.3 7. 0 (International Financial Institutions, IMF) 7.5 (Financial markets) 0.0
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Argentina
$150 billion in external debt
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10%
15%
20%
0%
5%
3Ja n01 31 -J an -0 1 28 -F eb -0 1 28 -M ar -0 1 25 -A pr -0 1 23 -M ay -0 1 20 -J un -0 1 18 -J ul -0 1 15 -A ug -0 1
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Why go Euro?
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The euro
Optimal Currency Area
Degree of trade between countries Similarity of economic shocks Labor market mobility Nature and amount of fiscal transfers
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Convergence Criteria
Inflation
Rate cannot be more than 1.5% above average inflation rate of three lowest Member states
Cant exceed 3% of GDP Cant exceed 60% of GDP Rate cannot be more than 2% higher than the average of the three states with the lowest inflation rates No currency fluctuations outside the normal EMS margins for two years
Public Debt
Interest Rate
Currency
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Benefits
Reduce business costs for intra-EU trading
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Source: EcoWin
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DM/Dollar Intervention
2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Source: EcoWin
21.2 34.8 28.1 157.7 39.7 61.0 286.9 106.2 31.8 0.6 8.5 29.8 60.5 0.3
3.2 5.6 1.4 11.4 1.4 1.2 9.4 10.2 2.7 6.5 1.4 0.9 0.7 1.2
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Summary
Currency crises