LECTURE XIV. 31 July Tuesday, July 31, 12

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1 LECTURE XIV 31 July 2012

2 TOPIC 16 Exchange Rates and Policy

3 BIG PICTURE What are different common exchange rate systems? How can exchange rates be manipulated to affect a country s real variables? What is the connection between the foreign exchange market and other domestic markets studied so far? What is the impossible trinity? Why is it impossible?

4 EXCHANGE RATE SYSTEMS

5 SYSTEMS OF EXCHANGE Why would countries want to manipulate their exchange rates? We know that exchange rates have impacts on real variables, such as trade In general there are two types of exchange rate systems: Flexible exchange rate: Demand and supply determine exchange rates, and there is no government intervention to manipulate the price (what we looked at in topic 15) Fixed exchange rate: Governments determine exchange rates and make adjustments to domestic variables to achieve those rates

6 FLEXIBLE EXCHANGE RATE What are disadvantages to having a constantly fluctuating exchange rate? Uncertainty and diminished trade: long-term trade agreements and contracts more difficult with constantly changing prices (exchange rate) of outputs and inputs Terms of trade changes: exchange rate changes imply frequent changes in terms of trade Instability: A country high dependent on trade (recall many countries in Africa with <70% of GDP made up by trade) will suffer frequent cycles with constantly changing prices and trade flows

7 DETERMINANTS OF EXCHANGE RATES Mentioned supply () and demand (NX) last class, but break this down by isolating determinants of and NX: 1. Tastes and preferences for goods (NX) 2. Relative income changes ( and NX) 3. Relative prices (domestic) (NX) - recall PPP does not hold in reality so changes in prices not necessarily reflected in exchange rates 4. Relative Interest rates () 5. Speculation (on future value of currency) 6. Trade barriers (NX) Which of these can be impacted by government? Government can impact relative prices (inflation), relative interest rates (monetary policy), and trade barriers

8 FIXED EXCHANGE RATES Basically, a country can peg their currency to another; i.e. China pegged their currency at ~6 Yuan for 1 USD How do we control the exchange rate? Trade policies: by controlling imports or exports (demand) or financial flows (supply) directly Exchange controls: the government can unilaterally control all foreign exchange or close capital markets (Chile in the 90s) Domestic macroeconomic adjustment: change fiscal or monetary policy to increase or decrease demand goods (change trade) Currency intervention: suppose demand shifts right, then government expands supply by increasing the supply of currency directly (will off set increase in exchange rates)

9 FIXED EXCHANGE RATES What are disadvantages of this system? Monetary policy tools are tied up trying to control exchange rate so cannot smooth business cycles The supply of currency cannot be freely changed (see above) Prices cannot freely adjust to meet changes in demand and supply because they are tied to international markets

10 HISTORICAL USE Flexible exchange rate regimes are more common now, but fixed defined two major eras: Gold Standard: international agreement to maintain relationship between money and gold stocks so money indirectly related to each other through old stock System collapsed because of currency devaluation in an attempt to boost exports Bretton Woods: international agreement to keep currency pegged to US dollar or gold within a small band System collapsed in 1971 after Nixon announced the US would drop the gold standard (previously pegged to $35/oz. of gold) Since then the system has used a managed exchange rate float: currency that is allowed to change as a result of supply and demand but is managed by governments by buying and selling currency. What are benefits and issues with this system?

11 EXCHANGE RATES AND POLICY

12 LINKING MARKETS We know that domestic factors can impact the foreign exchange market. How do interest rates impact it? Consider a German interest rate of 2%. If domestic interest is 1%? Foreign assets are relatively attractive. If domestic interest increase to 5%, what will happen to? Foreigners will be more interested in domestic assets and Americans less interested in foreign assets so will fall So as interest rates rise, falls

13 LINKING MARKETS: So can express the as a function of the interest rate (recall it can be negative) Domestic Interest Rate Where can we get interest rates from? Money market or loanable funds market Recall that loanable funds market is more closely tied to our variables of interest

14 LINKING MARKETS: LOANABLE FUNDS Recall that supply for loanable funds is a function of national savings S = Y - C - G or S = Y - C - T - (G - T) with taxes Interest Rates Demand in a closed is simply investment I; in an open economy? Investment demand is domestic and foreign so I + Supply Demand Loanable Funds (Remember last class we claimed S = I + in an open economy)

15 LINKING MARKETS: EXCHANGE RATES Exchange market we derived last time Notice that the is inelastic so we can take it straight from the - IR relationship Now we have a formal connection between interest rates and exchange rates Real Exchange Rate Supply of dollars, Demand for dollars Net quantity of US exchanged

16 LINKED MARKETS Interest Rates Domestic Interest Rate Supply IR* Demand Loanable Funds Interest rates taken from loanable funds Pins down the Real Exchange Rate * Supply of dollars, pins down the exchange rate RER* Demand for dollars Net quantity of US exchanged

17 SHIFTING EQUILIBRIUM 1 Interest Rates Domestic Interest Rate Supply 1 1 IR* new IR* Demand 2 Loanable Funds Suppose there is an expansionary monetary policy; what moves first? 1. Supply for investment increases and interest rates fall Real Exchange Rate * Supply of dollars, new * 2. Increases 3. RER falls So expansionary policy has called US dollar to depreciate 3 RER* new RER* Demand for dollars Net quantity of US exchanged

18 SHIFTING EQUILIBRIUM 2 Interest Rates Domestic Interest Rate 1 1 new IR* IR* Supply Demand Loanable Funds Suppose there is a budget deficit so national savings falls 1. Decreases supply of loanable funds so IR increases 2. Higher IR decreases the Real Exchange Rate 2 new * * Supply of dollars, 3. Lower raises RER (and decreases NX) 3 So crowding out has also decreased GDP by decreasing net exports 3 new RER* RER* Demand for dollars (NX) Net quantity of US exchanged

19 SHIFTING EQUILIBRIUM 3 Interest Rates Domestic Interest Rate Supply IR* Demand Suppose the government implements a tariff Loanable Funds At a given exchange rate, demand for imports (M) falls because they are more expensive so demand for NX (= X - M) falls (shifts right) Real Exchange Rate * Supply of dollars, RER increases making imports more attractive Increase in RER balances change in demand so there is no change in NX or 2 new RER* RER* 1 Demand for dollars So if the is inelastic in real life, changes in trade policies should not impact the Net quantity of US exchanged

20 SHIFTING EQUILIBRIUM 4 Interest Rates 1 Supply Domestic Interest Rate 1 new IR* 1 IR* Demand Suppose we have capital flight: large and sudden reduction in the demand for assets in a country (war? financial instability?) For a given interest rate now the is higher (why?) CONCURRENTLY, demand for loanable funds increases (remember D = + I and is getting less negative or more positive with less foreign investment in the US) so interest rates increase; intuition: there is higher demand domestically to purchase funds for investment and move it out of the country so demand for assets decreases but demand for loans increases Lower increases the RER and NX increases Loanable Funds Real Exchange Rate 2 RER* new RER* * 3 new * Supply of dollars, Demand for dollars Some claim China does the opposite, invest a lot in US capital to artificially decrease NX (for the US) - do this exercise yourself Net quantity of US exchanged

21 THE TRILEMMA: IMPOSSIBLE TRINITY

22 THE TRILEMMA We have established the connection between various parts of our economy, specifically we see monetary policies (ex. 1), capital (ex. 4), and exchange rates (every example...) are interdependent Leads us to the impossible trinity / trilemma: a country can only have 2 of the following at a given time 1. A fixed exchange rate 2. Free capital flows 3. An independent monetary policy Why are any of these attractive? 1 and 3 mentioned previously Free capital flows improve production efficiency and opens up foreign investment possibilities China has 1 and 3; US 2 and 3; Argentina 1 and 2

23 THE TRILEMMA Interest Rates Domestic Interest Rate Supply IR* Demand Loanable Funds A fixed exchange rate implies keeping RER constant Free capital flows allows the to move wildly (with the market) Independent monetary policy implies IR should be able to move freely with policy not foreign markets Real Exchange Rate RER* * Supply of dollars, Demand for dollars Net quantity of US exchanged

24 THE TRILEMMA 1 Interest Rates Domestic Interest Rate with fixed Supply IR* new IR* Demand Loanable Funds We have a recession and want a fixed exchange rate * new * An expansionary monetary policy will shift the RER (which we don t want) Can increase interest rates again (to old levels) but then we have no independent monetary policy Real Exchange Rate Supply of dollars, Or fix capital flows, which converts eliminates responsiveness to interest rates So we can only have two of three RER* new RER* Demand for dollars Net quantity of US exchanged

25 THE TRILEMMA 2 Interest Rates Supply IR* Demand Loanable Funds Suppose we want a fixed RER and we become wealthier NX decreases (shifts left) which decreases RER The government can shift left to achieve the old RER (note that the is not being chosen freely) How? By force... or Perhaps by using a contractionary monetary policy (so lose independent monetary policy) Could also coordinate with foreign banks to buy more US bonds so line shifts left (again lose free capital flow) Real Exchange Rate RER* new RER* * Supply of dollars, Demand for dollars Net quantity of US exchanged

26 REVIEW Because exchange rates are tied with real parts of the economy, countries have interests in managing exchange rate policies Generally, exchange rates can be fixed or move flexibly Exchange rates are tied to the rest of the economy through, which is in turn tied to domestic interest rates Ultimately, because of the interdependence of these elements of the economy, countries face a choice of an independent monetary policy, free capital flows, and a fixed exchange rate

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