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INTERNATIONAL FINANCE

Week 9: Lecture 8 and 9

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LEARNING GOALS

• The effects of exchange rates on the macro economy and in particular to the economics of fixed versus floating exchange rate systems as part of the operation of macroeconomic policy in a country.

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Measuring the exchange rate Exchange rate prices are expressed in various ways:

• Spot Exchange Rate - the spot rate is the actual exchange rate for a currency at current market prices. This is determined by the FOREX market on a minute-by-minute base on the basis of the flow of supply and demand for any one particular currency.

• Forward Exchange Rate - a forward rate involves the delivery of currency at some time in the future at an agreed rate. Companies wanting to reduce the risk of exchange rate uncertainty by buying their currency ‘forward’ on the market often use this.

• Bi-lateral/Nominal Exchange Rate (the value of two currencies) - this is simply the rate at which one currency can be traded against another. Examples include: – Sterling/US Dollar, $/YEN or Sterling/Euro

• Real Exchange Rate - describes how many items of a good or service in one country can be traded for one of that good or service in another country. For example, a real exchange rate might state how many European bottles of wine can be exchanged for one US bottle of wine.. A rise in the real exchange rate implies a worsening of international competitiveness for a country.

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• In previous lectures we presented how currencies are exchanged and what seems to determine the exchange rate if the determination is left mainly to market forces .

• For better or worse many governments do not usually just let the private market set the exchange rate. To a certain extent governments have policies toward the foreign exchange market.

But what are the reasons that a government might

want to affect exchange rates?

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Reasons that Governments want to influence exchange rates.

1. Exchange rates if left to private market forces, sometimes fluctuate a lot. Also they may occasionally be influenced by bandwagons between investors or speculators ( gamblers). Exchange rates are very important prices – they can affect the entire range of a country’s international transactions. One objective for government policy is to reduce variability in exchange rates.

The bandwagon effect: some investors predict that the recent trend of the exchange rate will continue in the near future as well: the next minutes, hours, days, weeks. For instance currencies that have been appreciating are expected to continue to do so. The recent actual increase in the exchange rate value of a country’s currency leads some investors to expect further increases

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2. A government may want to keep the exchange rate value of its currency low preventing appreciation or encouraging depreciation. Why? This benefits certain activities or groups within the country, including the country’s exporters.

3. Or in a different setting a government may want to do the opposite: keep the exchange rate value of its currency high, preventing depreciation or encouraging appreciation. This can benefit other activities or groups-for instance buyers of imports. It also can be used as part of an effort to reduce domestic inflation by using the competitive pressure of low import prices.

4. In addition, the government policy may reflect other relatively noneconomic goals. The government may believe that it is defending national honor or encouraging national pride by maintaining a stable exchange rate or a strong currency internationally. Devaluation or depreciation may be feared as a confirmation of the weakness or inability of the government in selecting policies.

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Exchange rate systems• Free Floating Exchange Rate The value of a currency is

determined only by market demand and supply of the currency. Both trade flows and capital flows affect the exchange rate under a floating system. No target for the exchange rate is set by the GovernmentThere is no need for official intervention in the currency market by the central bank

• Managed Floating Exchange Rate The value of the currency is determined by market demand for and supply of the currency. However Central banks may try to calm down big changes in exchange rates on a day-to-day basis.Some currency market intervention might be considered as part of macro-economic demand management (e.g. a desire for a slightly lower currency to boost export demand or the desire for a strong currency to control inflationary pressures)

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• Semi Fixed Exchange Rates The exchange rate is given a specific target. The currency can move between permitted bands of fluctuation on a day-to-day basisExchange rate becomes a target of economic policy-making (interest rates are set to meet the exchange rate target). The Central Bank might have to intervene to maintain the value of the currency within the set targets if it moves outside the agreed range. Re-valuations are seen as a last resort

• Fully Fixed Exchange Rates The government makes a commitment to a fixed exchange rate. The exchange rate is pegged. There are no fluctuations from the central rate.This system achieves exchange rate stability but perhaps at the expense of domestic stability in the economy. A solution for the domestic stability is that a country can improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable.

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Two aspects: Rate flexibility and Restrictions on use

Government policies toward the foreign exchange market are of two types:

• (a) Those policies that are directly applied to the exchange rate it self.

• (b) Those policies that directly state who may use the foreign exchange market and for what purposes

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The first type of policy acts directly on price – the exchange rate – while the second type acts directly on quantity- by limiting some people’s ability to use the foreign exchange rate. Any one policy has impacts on both price and quantity in the market even though the policy directly acts on only one of these.

• (a) the first policy allows the governments to choose between floating and fixed exchange rates.

• (b) the second policy allows governments to choose between restriction in access to the FEM and no restriction. No restriction is the case where everyone is free to use the foreign exchange market: the country’s currency is fully convertible into foreign currency for all uses, for both trade in goods and services (current account transactions) and international financial activities. The other choice of this policy is the exchange control: the government places some restrictions on use of foreign exchange market. In the most extreme form of exchange control anyone who wants to obtain foreign exchange must request it from the authority which then determines whether to approve the request.

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Common forms of exchange control is when government :• Permits use of the FEM for all payments for exports and imports of

goods and services (so currency is convertible for current account transactions)

• Imposes some form of capital controls, by placing limits or requiring approvals for payments related to some international financial activities.

• Also another less extreme form of restriction is limits on the use of FEM for transactions related to large imports of consumer luxury goods.

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Distinguish between a fixed and a managed floating exchange rate system

When a country uses a floating exchange rate system:

* The value of the currency is determined purely by demand and supply of the currency. .* Trade flows and capital flows affect the exchange rate under a floating system. . * There is no target for the exchange rate and no intervention in the market by the central bank.

This policy choice results in a clean float in which governments make no direct attempts to influence foreign currency values.

Floating exchange rates

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The Bank of England has not intervened to influence the pound’s value since it became independent in September 1992 when sterling exit the Exchange Rate Mechanism (ERM).

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• Even when the country’s exchange rate policy is to permit flexibility by floating the rate, the government often is not willing to simply let the rate go whether private supply and demand drive it. In contrast the government often tries to have a direct impact on the rate through official intervention. By this we mean that the monetary authority enters the FEM to buy or sell foreign currency in exchange for domestic currency. Through this intervention the government hopes to change the deal of supply and demand. This policy approach – an exchange rate that is generally floating (or flexible) but with the government willing to intervene to attempt to influence the market rate - is called managed float or a dirty float.

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• Often the government is attempting to ‘act’ against the wind so as to control movements in the floating rate.

For example if the exchange rate value of the country’s currency is rising and that of the foreign currency falling then the authorities intervene to buy foreign currency and sell domestic currency. They hope that the intervention and the extra supply of domestic currency can slow or stop their own currency’s rise in value or likewise that the demand for foreign currency can slow or stop its decline.

However most governments that choose a floating

exchange rate policy also do manage or ‘dirty’ the float to

some extent.

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Characteristics of Managed floating exchange rate:When a country uses a managed floating exchange rate system:

• The value of a currency from day to day is determined by market demand for and supply of the currency .* Some currency market intervention might be considered as part of demand management (e.g. a desire for a slightly lower currency value to increase export demand) . * Intervention can either be explicit (direct) i.e. a central bank buys foreign currency when it wants the domestic currency to depreciate* Or Intervention might come from changes in policy interest rates so as to affect the net flows of short term banking money (so- called “hot money”)* Verbal intervention is when a central bank tries to send a signal to the currency markets that it wishes the currency to move in a certain direction and that it stands by ready to engage in official market intervention if this does not happen.

• In 2012 a growing number of countries are moving towards managed or “dirty” floating systems. Brazil, Japan, Switzerland and Norway have all intervened in the currency markets in recent months. Brazil in particular has claimed that developed nations are seeking to undervalue their currencies to create a competitive advantage in the world economy and stimulate their economies. For this reason they have introduced extra taxes on the interest paid on foreign deposits in their banking system. 17

Chara Charalambous - CDA COLLEGE

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• If the government chooses the policy of a fixed exchange rate then the government sets the exchange rate that it wants. Often some flexibility is permitted within a range called band around the chosen fixed rate which is called the par value or central value. However the flexibility is generally more limited than would occur if the government instead permitted a floating rate.

• In the case of fixed exchange rate the government faces three major questions:

To what does the government fix the value of its currency? When or how often does the country change the value of its fixed

rate? How does the government defend the fixed value against any

market pressures pushing toward some other exchange value?

Fixed Exchange rate

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What to fix to?• A fixed rate means that the value of the country’s currency is

fixed to something else. A century ago this something was gold: several countries were fixing the value of their currency to specific amount of gold then the exchange rates between the currencies were fixed at the rates resulting by their gold values. So currencies were tied to the same thing- gold- and then tied to each other. In principle any other commodity or group of commodities could serve the same purpose as gold did.

• The country could choose to fix the value of its currency to some other currency rather than to a commodity.

Since the World War II many countries have often fixed the value of their currency to the US dollar. Any other currency can serve the same purpose.

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• A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.

• It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

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• Or a country could choose to fix the value of its currency not to one other currency but to the average value of a number of other currencies – a basket of other currencies. Why? The logic is the same as that of diversifying a portfolio – not putting all your eggs in one basket. If a country fixes to one single other currency then it will move in the same level as the other currency and this will be a disadvantage in cases were the other currency experience extreme changes against any third countries currencies.

• Therefore fixing to a basket of currencies the effect of extreme changes is controlled since the average value is kept steady.

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What basket of currencies might the country fixed to?

• There is one ready made basket – the special drawing right (SDR) - a basket of the four major currencies in the world (US dollar, Euro, Japanese Yen and British pound). Or a country can create its own basket and include the currencies of its major trading partners. No country today fixes its currency to gold or any other commodity but it fixes the exchange rate value of its currency to one or more other currencies.

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When to Change the Rate?• When a country has chosen to fix its exchange rate and

chosen to what to fix to faces the question of when to change the fixed rate.

• Why might a government want to change the exchange value of its currency? Most probably nothing is fixed forever. It might do so in order to promote, for example, greater export volume. A fixed exchange rate system does not imply that the rate will stay at that same level all the time. The government may decide to change the rate because of adverse effects on the economy. For example, if the currency is overvalued exporting industries will become less internationally competitive, affecting international trade and the balance of payments, and the government might take action to devalue the exchange rate.

• On this basis we often use the term pegged exchange rate in place of fixed exchange rate, and it indicates that the government has some ability to move the peg value. (Peg=attach, fix, tight, connect)

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• A devaluation of a currency occurs under a fixed exchange rate system when there is on purpose (intentional,planned) action taken by a government to decrease its value in the forex market.

OR• Alternatively a revaluation occurs under a fixed

exchange rate system when there is on purpose action taken by the government to increase the value of the currency in the forex market.

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What is a pegged exchange rate? • The term pegged exchange rate refers to setting a targeted value for a

country’s foreign exchange. A pegged, rate is a rate the government (or central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

If, for example, it is determined that the value of a single unit of local

currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and finally, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

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• The government sets the price of the exchange rate at the par value it considers the most appropriate for the country and also sets a band around the par value so as the exchange rate can move without facing the problem to change all the time the pegged rate value.

• Governments attempt to keep the value fixed for relatively long periods of time to reduce trade uncertainties.

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What must the Central Bank do to maintain- devaluate the value of the domestic currency at the desired rate?

Just like any other product, the value of a currency goes up and down based on supply & demand. So basically, a country can devalue its own currency by selling/releasing more of it into the world. It can do this in many ways, including just printing cash and dumping it onto the foreign exchange market. It can allow more imports into the country or put taxes on exports, forcing consumers to purchase foreign products with their cash - hence increasing the supply of their currency abroad. It can do any number of things to increase the amount of its currency abroad and devalue it.

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What must the Central Bank do to maintain- revaluate the value of the domestic currency at the desired rate?

If a government wants its currency to be increased in value buys its own currency from the foreign exchange market, at the high price it wants to reach its currency, by selling its reserves of foreign currency. In this way the government is removing domestic currency from the economy. This will tend to reduce the domestic money supply and so the price of the currency will go up. If the government wants to reverse this effect of low supply of domestic currency takes another action called sterilization to restore the domestic money back into the economy.

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• The government may change the pegged rate if a substantial disequilibrium in the country’s international position develops (e.g., demand for the currency is too weak to maintain the desired value). This approach is called adjustable peg.

• Also a country might choose a different way to peg its currency, the crawling peg. A crawling peg can be changed often (monthly, say) according to a set of indicators or the judgment of the country’s monetary authority.

• Indicators:– The difference of inflation rates: the difference

between the country’s inflation rate and the inflation rate of the country whose currency it pegs to.

– Growth of the country’s money supply indicates the inflation pressure.

• e.t.c

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‘Defending a Fixed Exchange Rate’ or in other words ‘How the Central Bank

manipulates the value of the currency’?• The third major question faces a country that has chosen

a fixed exchange rate is how to defend its fixed rate. The pressures of private or nonofficial supply and demand in the FEM may sometimes drive the exchange rate toward values that are not within the band. The government then must use some means to defend the pegged rate – to keep the actual exchange rate within the band.

• There are four basic ways that a government uses to defend the fixed rate that it has been announced.

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Ways that a government uses to manipulate exchange rate

1. To buy or sell foreign currencies in exchange for domestic currency (in order to influence the existing exchange rate). Therefore a government must have foreign exchange reserves.

2. The government can impose some form of exchange control by harmonizing demand or supply in the market. A way is to use trade controls such as tariffs or quotas to attempt to achieve this result.

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3. The government can change domestic interest rates to influence short-term capital flows of ‘hot money’ and consequently influencing the exchange rate, as it is changing the supply and demand position in the market.

What is ‘hot money’?Answer: Money that flows regularly between financial markets as investors

attempt to ensure they get the highest short-term interest rates possible. Hot money will flow from low interest rate yielding countries into higher interest rates countries by investors looking to make the highest return. These financial transfers could affect the exchange rate if the sum is high enough and can therefore impact the balance of payments.

How can higher (i) rates keep the currency value up?Answer: As soon as the institution reduces interest rates or another

institution offers higher rates, investors with "hot money" withdraw their funds and move them to another institution with higher rates. Investors will purchase the nation’s currency to make short-term investments in the country because they will give them higher return, bidding in this way the value of the currency upward.

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4. The government can also make long-term adjustments of its macroeconomic policies (monetary and/or fiscal policy). In this way it can adjust export abilities or the demand for imports or change the direction of international capital flows.

Taxation of foreign deposits in banks cut the profit from the ‘hot money’ inflows. Foreigners will move their investments causing the currency to be devaluate (reduce in value). The devaluation of currency affects trade: exports are profited.

Why does inflation put downward pressure on a country’s exchange rate?

Non-inflating countries are unwilling to pay more and more to buy an inflating country’s goods and services. Reduced demand for the inflating currency will make it depreciate.

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A fifth way is to give up rather than to defend: Following this option the country can change its fixed rate (devaluating or revaluing its currency) or switch / change to a floating exchange rate (in this case the currency will immediately depreciate or appreciate)

The four first ways displayed above are not excluding each other but in fact a country can use several methods at the same time. For example changing interest rates to influence short-term capital flows relates to overall macroeconomic management.

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Figure 1:

At the equilibrium exchange rate is $A1.00 = $US0.50. The equilibrium quantity supplied and demanded is Q1 Australian dollars.

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Figure 2 : A currency appreciation

If the demand increases for Australian dollars.

If the supply decreases for Australian dollars.

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Figure 3 : A currency depreciation

If the demand decreases for Australian dollars.

If the supply increases for Australian dollars.

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• Competitive devaluations

Competitive devaluations occur when a country intentionally intervenes in foreign exchange markets to drive down the value of their currency to provide a competitive boost to demand and jobs in their export industries.

For nations with persistent trade deficits and rising unemployment a competitive devaluation of the exchange rate can become an attractive option - but there are risks. One is that devaluing an exchange rate can be seen by other countries as a form of trade (or crisis) protectionism that invites some form of penalizing action. Cutting the exchange rate makes it harder for other countries to export their goods and services.

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Comparison between Flexible and Fixed Exchange Rate Systems

Flexible exchange rate

exchange rate is determined by demand for and supply of foreign currency

Fixed exchange rate

the government fixes the foreign exchange rate by buying and selling of foreign exchange

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Flexible exchange rate

• depreciation or appreciation of a currency is determined by the market forces

• speculation in foreign exchange market is common

Fixed exchange rate

• devaluation or revaluation of a currency is determined by the government

• speculation occurs when there is rumour about the change in government policy

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Flexible exchange rate

• self-adjusting mechanism operates to eliminate external disequilibrium by change in foreign exchange rate

Fixed exchange rate

• self-adjusting mechanism operates through the change in money supply, domestic interest rate and domestic price

In a heavily managed float the exchange rate may show little flexibility – it is almost pegged, even though this is not the way that the government describes its choice.

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Appendix: The European Exchange Rate Mechanism

• The European Exchange Rate Mechanism (ERM) was a system introduced by the European Community in March 1979, as part of the European Monetary System (EMS), to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the euro, which took place on 1 January 1999.

• After the adoption of the euro, policy changed to linking currencies of countries outside the Eurozone to the euro (having the common currency as a central point). The goal was to improve stability of those currencies, as well as to gain an evaluation mechanism for potential Eurozone members. This mechanism is known as ERM2

Pound sterling’s forced withdrawal from the ERM

• The United Kingdom entered the ERM in October 1990, but was forced to exit the programme within two years after the pound sterling came under major pressure from currency speculators. The resulting crash of 16 September 1992 was subsequently named "Black Wednesday". There has been some revision of attitude towards this event given the UK's strong economic performance after 1992, with some commentators naming it "White Wednesday

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