Economics 333

INTERNATIONAL ECONOMICS

Intersession 2016
 
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E.  Exchange Rate Systems

  • Should exchange rate be fixed or flexible?

1.  Choosing an exchange-rate system

a.  Exchange rate practices

(1) Floating exchange-rate system

  • Determined by market forces

(a)  Float independently

(b)  Float in unison with a group of other currencies

(c)  Crawl according to a predetermined formula

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(2)  Pegged exchange-rate system

  • Fixed against some standard of value

(a)  Anchor to a single currency

(b)  Anchor to a basket of currencies

(c)  Anchor to gold (not used since 1971)

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(3)  International Monetary Fund (IMF)

  • Exchange rates should not be manipulated to prevent balance-of-payments adjustments or gain unfair competitive advantage over other members

  • Members should act to counter short-term disorderly conditions in exchange markets

  • When members intervene, they must take into account the interests of other members

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(4)  Exchange rate arrangements of IMF members

  • No separate legal tender - 13

  • Currency board arrangements - 12

  • Conventional pegged (fixed) exchange rates - 59

  • Pegged exchange rates within horizontal bands - 1

  • Crawling pegged (band) exchange rates - 16

  • Managed floating exchange rates - 44

  • Independently floating exchange rates - 43

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b.  Factors affecting choice of an exchange-rate system

(1)  Size and openness of economy

  • Trade a large share of economy => cost of currency fluctuation high => fixed exchange rate

(2)  Inflation rate

  • Goods would be more expensive and less competitive with a fixed rate => flexible exchange rate

(3)  Labor market flexibility

  • Rigid wages => labor market can't help economy adjust to shocks => flexible exchange rate

(4)  Degree of financial development

  • Immature financial markets => could have big swings in currency => fixed exchange rate

(5)  Credibility of policymakers

  • Weak reputation for central bank => lack of confidence in ability to control inflation => fixed exchange rate

(6)  Capital mobility

  • Economy open to international capital flows => flexible exchange rate

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c.  Impossible trinity

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2.  Fixed exchange-rate systems

a.  Mechanics

  • Key currency - currency to which a country's currency is anchored

- Widely traded on world markets, relatively stable values over time, widely accepted as a means of international settlement

- U.S. dollar (62%), Euro (24%), Japanese yen (4%), British pound (4%), Canadian dollar (2%), Australian dollar (1%), other (3%)

- Helps facilitate international settlement of transactions

- Domestic-currency price of imports and exports stabilized

- Can reduce inflation in high-inflation countries by reducing inflationary expectations

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  • Could anchor to a basket of currencies

- Special drawing rights (SDRs) - bundle of U.S. dollar, Japanese yen, British pound, Euro, Chinese renminbi established by the IMF

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  • Par value - value of a currency in terms of gold or a key currency

- Official exchange rate (cross rate) determined by comparing par values

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  • Exchange-stabilization fund - fund of foreign currencies used to defend the official rate

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b.  Exchange-rate stabilization

(1)  Depreciation

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(2)  Appreciation

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c.  Devaluation and revaluation

  • Fundamental disequilibrium may develop where official exchange rate is far out of line with market exchange rate
  • Due to changes in fundamental economic conditions - income levels, tastes and preferences, technological factors
  • Cost of defending existing official rate may be prohibitive

- Devaluation - decrease the official value of a currency, counteracts a balance-of-payments deficit

- Revaluation - increase the official value of a currency, counteracts a balance-of-payments surplus

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3.  Floating exchange rates

  • Let market determine exchange rate

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a.  Pros

  • Simpler to implement
  • Continuous adjustment of balance of payments
  • Partially insulate home economy from external forces
  • Can have independent monetary and fiscal policies

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b.  Cons

  • Wide fluctuations in currency values can disrupt trade and investment
  • Inflationary bias
  • Could lead to lack of financial discipline by governments

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4.  Other exchange rate systems

a.  Managed floating rates

  • Allow market forces to determine exchange rate, but intervene to deal with erratic fluctuations

  • Clean float - no intervention at all

  • Dirty float - interference in the market

  • Leaning against the wind - intervene to reduce short-term fluctuations

  • Some countries intervene to achieve a target exchange rate

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  • Use of monetary policy

- Expansionary monetary policy => increase money supply, decrease interest rates, offset currency appreciation

- Contractionary monetary policy => decrease money supply, increase interest rates, offset currency depreciation

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  • Expansionary monetary policy could be inflationary in the long run, which offsets short-run benefits

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b.  Crawling peg

  • Small, frequent changes in par value of currency - virtually continuous

  • Used when inflation is high

  • Flexibility of floating rates with stability of fixed rates

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5.  Currency manipulation and currency wars

  • Artificially lowering a country's exchange rate to make exports cheaper

  • Difficult to differentiate between manipulation and expansionary monetary policy

- Expansionary monetary policy => low interest rates, weak currency

  • U.S. complaints about China

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6.  Currency crises

  • Weak currency experiences heavy selling pressure

Ex. - Mexico (1994 - 1995), East Asia (1997 - 1998), Russia (1998), Turkey (2001)

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a.  End of crisis

  • Devaluation (currency crash)

  • Floating exchange rate adopted

  • Restrictions on ability to buy and sell foreign currency

  • Loans to bolster foreign reserves

  • Restore confidence in existing exchange rate

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b.  Sources of currency crises

  • Currency speculators

  • Budget deficits financed by inflation

  • Weak financial systems

  • Recently deregulated financial systems

  • Weak economy

  • Political factors

  • External factors

  • Choice of an exchange rate system (fixed exchange rates)

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7.  Capital controls (exchange controls)

  • Government-imposed barriers to the free flow of capital

- On foreign savers investing in domestic assets

- On domestic savers investing in foreign assets

- Controls on international transactions

- Government allocate foreign exchange

- Government sets prices

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a. Benefits

  • Government can influence its payments position

  • Government can encourage or discourage certain transactions

  • More freedom for fiscal and monetary policies

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b.  Problems

  • Outflows may increase after controls are implemented - lack of confidence

  • Evasion possible

  • Officials may feel no need to reform financial systems

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8.  Increasing the credibility of fixed exchange rates

a.  Currency board

  • Monetary authority that issues notes and coins convertible into a foreign anchor currency at a fixed exchange rate

  • Takes over role of a central bank in strengthening the currency of a developing country

  • Has no discretionary powers

  • Can't print currency to finance budget deficits

  • Monetary policy on autopilot

- Anchor currency flows in => issue more domestic currency => interest rates fall

- Anchor currency flows out => withdraw domestic currency => interest rates rise

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(1)  Benefits

  • Currency and exchange rate regimes more rule-bound and predictable

  • Upper bound placed on nation's money supply

  • Tendency towards inflation curtailed

  • Financial discipline needed on budget

  • Confidence in soundness of a country's money - currency can always be exchanged for stronger currency

  • Creating confidence => trade, investment, growth

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(2)  Problems

  • No discretionary monetary policy - reduces economic independence

  • Susceptible to financial panics - no lender of last resort

  • Creates colonial relationship with anchor currency

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b.  Dollarization

  • Use U.S. dollars alongside or instead of (full dollarization) domestic currency

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(1)  Benefits

  • Credibility and policy discipline

  • Avoid capital outflows

  • Decrease in transactions costs

  • Lower rate of inflation (same as U.S.)

  • Greater openness

  • Balance-of-payments crises are minimized

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(2)  Effects on foreign country

  • No monetary policy - affected by Federal Reserve action

  • Fed not the lender of last resort for this country

  • Loss of seigniorage (income from securities) if securities have to be sold to get U.S. dollars

  • Expenditures and trade policies not affected

  • Cannot print more domestic currency to finance budget deficits

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(3)  Effects on U.S.

  • One time increase in goods and services as dollars are accumulated

  • Interest free loan if country holds dollars instead of Treasury securities

  • Might hinder Federal Reserve monetary policy

  • Pressure to conduct policy according to interests of foreign country