Lecture 1 (a). The open economy. The international flows of capital and goods, balance of payments and exchange rates.

Transcription

1 Lecture 1 (a). The open economy. The international flows of capital and goods, balance of payments and exchange rates. Carlos Llano (P) & Nuria Gallego (TA) References: these slides have been developed based on the ones provided by Beatriz de Blas and Julián Moral (UAM), as well as the official materials from Mankiw, 2009 and Blanchard, 2007 books. I am grateful for that. 1

2 Outline 1. Introduction 2. Accounting framework: The Balance of Payment. 3. Exchange rates: definitions Nominal and real exchange rates. Cross Exchange Rates. Spot/Forward Exchange Rates. 4. The determination of Exchange rates The Uncovered Parity of Interest Rates (UPIR). The Demand and Supply of currencies. The Purchasing Power Parity (PPP) 5. Exchange Rates Regimes 2

3 1. INTRODUCTION 3

4 1. Introduction How deep the globalization process is? 4

5 1. Introduction Closed / Open: a relative concept EU = 10% Rest of the World: 5% Spain: 85% The world as a whole is a closed economy. But the economy of each country is increasingly open. Moreover, the regions within countries are even more open. 5

6 1. Introduction Region to Region (Nuts 2) A Spanish region trades 5 2 times more with itself than with any (non adjacent) Spanish region. A Spanish region trades 16 4 times more with another (non adjacent) Spanish region than with another (non adjacent) region from another European country.

7 1. Introduction Closed economy: no relationship with the rest of the world (RoW) Open economy: all types of operations between agents from 2 different countries (regions ) Trade in goods and services: Individuals can choose between domestic and foreign goods and services. Factors of production: International Labor movements: immigration. Capital movements: foreign direct investment (FDI) Transfers and intangible assets: International taxes, transfers and subsidies. Patents. 7

8 Trade/GDP ratio, selected countries, 2004 (Imports + Exports) as a % of GDP Luxembourg 275.5% Ireland Czech Republic Hungary Austria 97.1 Switzerland 85.1 Sweden 83.8 Korea, Republic of 83.7 Poland 80.0 Canada 73.1 Germany 71.1% Turkey 63.6 Mexico 61.2 Spain 55.6 United Kingdom 53.8 France 51.7 Italy 50.0 Australia 39.6 United States 25.4 Japan

9 Imports and Exports as a percentage of output: 2000 Percentage of GDP Canada France Germany Italy Japan U.K. U.S. Imports Exports 9

10 35,0% 30,0% 25,0% 20,0% 15,0% 10,0% 5,0% 0,0% International flows of goods: Spain Exportaciones e Importaciones de España (% PIB) X (% PIB) M (% PIB)

11 Trade balance (% GDP): Spain 2% 1% 0,5% 0,9% 0% 0,0% -1% -0,2% -2% -3% -1,9% -3,1% -2,5% -2,1% -2,4% -4% -4,0% -5% -6% -5,4%

12 DHL CONNECTEDNESS INDEX: Spain 12

13 2. THE BALANCE OF PAYMENTS (BOP) 13

14 Accounting frameworks and sources of statistics (Open Economy=Spain) International Operations Trade of goods Trade of services Transfers Foreign Investment in Spain Other Financial flows Source DG Customs (AEAT) i.e: Datacomex. Inst.Estudios Turíst. IGAE MINECO BoP= includes all operations. Residents vs nonresidents. Bank of Spain. Methodology=IMF Originally based on information captured through the capital control systems. All operations = National + International National Accounts Slightly different criteria. INE 14

15 The Balance of Payments (BoP) Definition: accounting framework that records all transactions between a country (region) and the rest of the world (as a whole): goods, services, transfers, capital, financial assets. Transactions are put into one of three accounts: Current account (CA): for exports and imports of goods and services; rents and transfers. Capital account (KA): capturing non market transactions, such as patents and long term transfers. Financial account (FA), for exports and imports of financial assets: bonds, stocks, money, factories, land, ownership of bank accounts, etc. 15

16 The Balance of Payments (BoP) Spain (BdE): Current Account (CA) + Capital Account (KA):

17 Spain (BdE): Financial Account (FA)

18 The Balance of Payments (BoP) The current account (CA) is one of the main parts of the BOP, which records flows of real resources between countries. The operations recorded in the CA are: Market flows of goods and services: Goods: Services: tourism, transport, communications, insurances, others. Market flows of factor services: Related to Labor (international wages); Related to Capital (interest rates and dividends); Related to Land (rents). Non market flows = transfers. Unilateral flows without real compensation. i.e.: remittances from immigrants; public transfers (EU, International Organization: IMF, WB, OCDE), etc) 18

19 The Balance of Payments (BoP) Capital Account (KA): Capital Transfers with No impact on the National Income (EU Cohesion Funds; foreign debt forgiveness) Buys/shells of intangible assets (patents, brand names, property and intellectual rights)... The balance of the CA and the KA are interpreted jointly. In Macro II we won t make the difference. Credit (Ingresos) > Debit (Pagos) : Positive CCAA balance (Surplus) Credit (Ingresos) < Debit (Pagos) : Negative CCAA balance (Deficit).

20 FA: Financial Account The FA register all transactions of assets (real and financial) between nationals and foreigners. All the operations are registered in net terms (inflowsoutflows; + creation liquidation of claims) using the following terminology: Variación Neta de Pasivos (Credit; Liabilities [with the rest of world]; VNP) Variación Neta de Activos (Debit; Assets [in the rest of world]; VNA) Therefore, the FA Balance = VNP VNA The main rubrics within the FA are: Direct Investments: real state (houses, buildings,..), companies (M&A). Portfolio Investments: equity, bonds, Other Investments: credits, deposits, Reserves Assets (always VNA): monetary gold, SDRs, reserve position in the IMF, foreign exchange, and other claims. Errors and Omissions.

21 FA: Financial Account Rubrics Credit (Liabilities; VNP) Debit (Assets; VNA) Direct Investments: houses, buildings, companies Portfolio Investments: equity, bonds, Other Investments: Credits, Deposits, Net Investment in national assets by foreigners. Idem Net credits given by foreign banks to residents. Net deposits by foreigners in national institutions (Banks). Net Investment in foreign assets by nationals. Idem Net credits given by national banks to foreigners. Net deposits by nationals in foreign Banks. Reserves Assets Inflows (+) Outflows ( ) Errors and Omissions Imports of Capital We increase our position as net international debtors Exports of Capital We increase our position as net international lenders

22 The BoP: How to register operations? We keep track of real flows (goods, services ) and the assets flows (ownership). Every international transactions implies two BOP entries, one as a credit and one as a debit. Every international transactions should be recorded in the BOP of the two countries implied in the operation, although in the inverse way. Therefore: For each country, the overall Balance of all the Accounts is null. BCA+BKA+BFA=0. For the World as a whole, the overall Balance of all the Accounts is also null. BoP Spain +BoP US + =0. 22

23 The BoP: How to register operations? A transaction resulting in a payment of assets to foreigners (outflow of currency) is recorded as a debit in the corresponding balance, and it is offset by an equivalent record in another account (usually in the FA) with the opposite sign (or with the same sign as credit ). Example: Spain buys a car (100$) from the USA: 1. Record for the car as an Spanish import (+ 100$ debit CA). 2. Record for payment in the Reserve Assets Account ( debit FA). A transaction resulting in a receipt of assets from foreigners (inflow of currency) is recorded as a credit in the corresponding balance, and it is offset by an equivalent record in another account (usually in the FA) with the opposite sign (or with the same sign as debit ). Example: Spain sells tourist services (500$) to Japanese citizens: 1. Record for tourism as an Spanish export (+ 500$ credit CA). 2. Record for the payment in the Reserve Assets Account (+ debit FA). 23

24 Interpreting the balance of all accounts together BCA+BKA+BFA=0 BCA+BKA+BFA( RA) = RA The Reserve Assets can be isolated. The net position of a country in the RA will mirror the balance of the rest of the international flows. BCA+BKA= BFA The Balance of the BCA+BKA has a reflect on the BFA. Therefore: A surplus in the (BCA+BKA) implies a deficit in the BFA. A Deficit in BFA implies that [(VNP VNA)<0], that is: Net capital outflows >0 X K >IM K The country is increasing its Net position as International Lender Ex: Germany, China or Japan. 24

25 Spain (BdE): BOP recent evolution

26

27 Let s assume E($/ )= 1 An example A Spanish citizen purchases abroad 2 cars paying $ 1,000. Half of this amount is paid immediately with currency, and the other half is financed (3 months credit). Foreign tourists in Spain spent $ 1,000. A Dutch bank gives a credit $ 5000 worth to a Spanish company. A Spanish company sells clothes to France for A Spanish investor buys equity of a German bank for 50,000. Half of the operation is financed by a French bank granting a loan to Spanish investor. The other half is paid with cash.

28 3. EXCHANGE RATES: 3.1. NOMINAL AND REAL EXCHANGES RATES. 28

29 Definition of exchange rates Def. of exchange rate: price of one currency in terms of another. The conventional way of reporting this is home currency per foreign (indirect or inverse exchange rate). In Europe: per foreign currency. Example: today E($/ )= It takes about U.S. $ to buy one euro (E $/ ) We receive about U.S. $ per 1 euro (E $/ ) This is the convention in economics, the most used in markets and the one that will be used in this course. Sometimes you will see direct exchange rates as how much local currency do I have to pay for 1 unit of foreign currency ( /$): ie: 1/1.33 $/ = /$. 29

30 Definition of exchange rates Exchange rate (E foreign/domestic) The price of a unit of domestic currency in terms of foreign currency for immediate purchase To be completely accurate this measure is In general, we will use the term exchange rate to mean the spot bilateral nominal exchange rate. A nominal rate (refers to the relative values of currencies) A spot rate (refers to a trade at this instant) A bilateral rate (one currency versus another) There are other exchange rates which refer to real values, trades at future times, or multiple currencies. 30

31 Definition of exchange rates Appreciation: a rise in the value of a currency relative to other currencies in the foreign exchange market. Being in Spain: an E($/ ) from 1.2 to 1.3 implies: the number of that we pay for each $. the number of $ that we receive for each. Thus, the Euro ( ) appreciates against the dollar ($), or equivalently, the dollar ($) depreciates against the Euro ( ). Journalistic jargon: the Euro ( ) becomes stronger while the dollar ($) weakens. Effects: With 1 I can buy now more products in USA. With 1$ Americans can buy less Spanish products. Thus, it is expected that: National exports lose competitiveness while Americans increase it. Therefore, with normal elasticities: CA Deficit. 31

32 Definition of exchange rates Depreciation: a fall in the value of a currency relative to other currencies in the foreign exchange market. Being in Spain: an E($/ ) from 1.2 to 1 implies: the number of $ that we pay for each. the number of that we receive for each $. Thus, the Euro ( ) depreciates against the dollar ($), or equivalently, the dollar ($) appreciates against the Euro ( ). Journalistic jargon: the Euro ( ) becomes weaker while the dollar ($) is strengthened. Effects: With 1 I can buy now less products in USA. With 1$ Americans can buy more Spanish products. Thus, it is expected that: National exports become more competitive while Americans decrease it. Therefore, with normal elasticities: CA Surplus. 32

33 Definition of exchange rates 33

34 Does an increase in the nominal exchange rate (E= $/ ) necessarily implies that the Spaniards could buy more American products with their? Real Exchange Rates: The price of a Spanish good (Oranges) translated into the price of an American good (computer) It is the exchange relation between domestic/foreign products: Computer price (1PC/$) =P*= $/1 PC Price 1kg orange = P = 10 /1 kg Oranges Spot nominal exchange rate in the EU = E 0 $/ = 1 $/1 1$ 10 10$ * EP 0 1 1_ kg _ oranges 1_ kg _ oranges computer _ USA * P 1,000$ 1,000$ 1_ kg _ oranges 1_ computer _ USA 1_ computer _ USA 34

35 The real exchange rates What will be the effect if the euro depreciates against the $ (E goes from 1$/ to 0,5 $/ )? Now, the exchange relation between products varies: PC price in $ = P*= $/1 PC Price for 1kg of oranges in = P= 10 /1 kg oranges E 1 $/ = 0,5 $/1 0.5$ 10 5$ * EP 0 1 1_ kg _ oranges 1_ kg _ oranges computer _ USA * P 1,000$ 1,000$ 1_ kg _ oranges 1_ computer _ USA 1_ computer _ USA 35

36 Definition of real exchange rates (Mankiw) The real exchange rate ε the lowercase Greek letter epsilon = real exchange rate, the relative price of domestic goods in terms of foreign goods (e.g. price of a Japanese Big Mac per price of a Big Mac in Madrid) 36

37 ε in the real world & our model In the real world: ε is the relative price of a basket of domestic goods in terms of a basket of foreign goods In our macro model: There s just one good, output. So ε is the relative price of one country s output in terms of the other country s output If: P = GDP deflactor in Spain. P* = GDP deflactor in US. E = nominal exchange rate $/. Then: The price of Spanish goods in $ is = EP The real Exch. rate is = EP * P Note: real exchange rates are index numbers. They are not traded in markets. 37

38 The real exchange rate and competitiveness The real exchange rate measures the degree of competitiveness of a country in the international trade. (a real appreciation of domestic goods), implies: Our goods are relatively more expensive abroad, That is, we become less competitive (a real depreciation of domestic goods), implies: Foreign goods are relatively more expensive abroad, Keeping everything else constant, consumption of home goods increases Our goods are more competitive 38

39 Question: 1. Does the real exchange rate $/ explains the whole competitiveness of Spanish products and the whole evolution of the Current Account? 2. Knowing that Spain and France have the same currency ( ), are their Current Accounts equally affected by a depreciation of the Mexican Peso? 3. What would be the answer if Spain does not trade at all with USA but just with the EU? Answer: the real effective exchange rate 39

40 The real effective exchange rate The effective exchange rate is an Index number that captures a weighted average of the main real exchange rates that are relevant for an specific country (group of countries, group of sectors, ). Is the best measure for the overall trade competitiveness of a country. The weights can be different variables such as: X, IM, X+ IM, etc. ITC Spain Xin _$ Min _$ Xin _ Min _ Xin _ Min _ $/ * / * / * Total _ X M Total _ X M Total _ X M 40

41 The real effective exchange rate for US (75 98) 1,12 1,04 0,96 Índice (199=1,0) 0,88 0,80 0,72 0,64 0,56 41

42 The evolution of the Spanish ITC exterior/estadisticas informes/pages/indice de tendencia de competitividad.aspx 42

43 The evolution of the Spanish ITC exterior/estadisticas informes/pages/indice de tendencia de competitividad.aspx 43

44 3.2. Cross Exchange Rates What is the implicit exchange rate between 2 currencies depending on the exchange rate of each one of them with a third one? 44

45 3.2. Cross Exchange Rates Ex: compute the cross exchange rate between the Euro and the Yen (given their exchange with the $): E March 04: $/ : 1,22 Yen/ : 126,970 If 1 = 126,970 Yens 1 $ = x Yens Since 1 $= 1/1,22 = 0,818 then 1$.. x = 126,970 * 0,818 = 103,886 Yens E February 05: $/ : 1,304 ; Yen/ : 137,0 If 1 = 137,0 Yens 1 $ = x Yens Since 1 $= 1/1,304 = 0,766 Then 1$.. x = 137,0 * 0,766 = 104,942 Yens Result: In March 04: 1$=103,886 Yens Yen/$= 103,886 In Feb 05: 1$=104,942 Yens Yen/$= 104,942 Aprec/Deprec= between both dates there is a E (yen/$): The Yen depreciates and the $ appreciates. The depreciation rate for the Yen is= ((104,9 103,8)/103,8)*100= 1,1% 45

46 3.3. Spot vs Forward Exchange Rates 46

47 spot / forward 47

48 4. THE DETERMINATION OF EXCHANGE RATES UNCOVERED INTEREST RATE PARITY (UIRP) 48

49 4.3. Exchange rates risk and coverage Why do agents chose between Money / Assets? Liquidity / Profitability. We just want money for transactions The rest of our wealth will be in profitable assets. What type of assets? Domestic assets: Spanish bonds (in ). Foreign assets : American bonds (in $). Spanish Bonds i t = nominal interest rate (1+i t ) = return to be obtained in 1 year, paid in. American Bond To buy them we need $. How many $? It depends on the current nominal exchange rate $/ (E t ) = $/1. i* t = is the interest rate to be paid by American bonds after 1 year (payable in $) (E t )(1+i* t ) = return (in $) for each invested today in American bonds 49

50 4.3. Exchange rates risk and coverage How many we will obtain after 1 year from our American bonds? American Bonds E e t+1 = expected exchange rate for the next year (E t )(1+i* t )(1/E e t+1 ) = expected return per each invested Year t Year t+1 Spanish bonds 1 (1+i t ) $ E t (1 i* ) t 1 E e t 1 American bonds $ E t E (1 i * ) $ t t 50

51 4.3. Uncovered interest rate parity (UIRP) Let s assume the following hypothesis: Perfect capital mobility between countries. Agents just look for the best bit (highest profitability). There is no transaction costs. There is no risk-aversion. There is no country-risk premium. What type of assets? The Uncovered interest rate parity (UIRP) is the relation between i, i*, E, E e that assures that agents are indifferent between holding domestic bonds (Spanish) or foreign ones (Americans). 1 i t Return in in t+1 to be paid by a Spanish bond E (1 i * )( ) t t E 1 e t 1 Return in in t+1 expected to be paid by an American bond 51

52 t t t e E E E 1 Expected rate of appreciation of the domestic currency ) )( * (1 1 1 t e t t t E E i i ] ) / ( 1 ) * (1 1 1 t t t e t t E E E i i t t t e t t E E E i i 1 * 4.3. Uncovered interest rate parity (UIRP) 52

53 53

54 4. EXCHANGE RATE DETERMINATION: 4.2. THE DEMAND AND SUPPLY OF CURRENCIES 54

55 4. The exchange rate determination: the traditional or flow approach 1. The exchange rate is a price between 2 currencies (domestic/foreign). 2. The equilibrium price and the quantity of these 2 currencies would be determined by the Demand and Supply of such currencies. 3. What is behind this Demand and Supply? Ex: Nominal Exchange Rates EU USA: E($/ ) The Demand for Euros (local currency) = Supply of Dollars (foreign currency) The Supply for Euros (local currency) = Demand of Dollars (foreign currency) Who Demand Euros in exchange for Dollars? Those needing Euros for buying European goods, services or assets. Who Supply Euros in exchange for Dollars? Those needing Dollars for buying American goods, services or assets. 55

56 The Demand of euros (Supply of $) $/ The lower the Exchange rate (cheaper ), the larger the amount of Euros that is demanded in exchange of dollars ( XN) 1,3 1,2 Demand for euros = Supply of $ Q 0 Q 1 Quantity of euros Quantity of dollars 56

57 The Supply of euros (the demand of $) $/ With higher Exchange Rates (stronger euro) the Supply of euros in exchange for Dollars increases Euros Supply = Dollars demand 1,3 1,2 Q 0 Q 1 Quantity of euros Quantity of dollars 57

58 The Equilibrium Exchange Rate $/ S (= D $ )= f [Y(+), P(+), P*(-), r(-), r*(+)] S (D $ )= [ IM; X k ] Euros Supply = $ demand 1,3 D (= S $ )= f [Y*(+), P(-), P*(+), r(+), r*(-)] D (S $ )= [ X; IM k ] Euros Demand = $ Supply Q 0 Quantity of euros Quantity of dollars 58

59 Euros Demand = Dollars Supply Therefore: D = f (Y*, P, P*, r, r*) = S $ Y* (+): Y* X D P (-): P ( P/P*) X D P* (+): P* ( P/P*) X D r (+): r (r>r*) European bonds become more attractive Net capital inflow D r* (-): r* (r*>r) American bonds become more attractive Net capital outflow D 59

60 Euros Supply = Dollars Demand Therefore: S = f (Y, P, P*, r, r*) = D $ Y (+): Y M S P (+): P ( P/P*) M S P* (-): P* ( P/P*) M S r (-): r (r>r*) European bonds become more attractive Net capital inflows S r* (+): r* (r*>r) American bonds become more attractive S 60

61 What variables affect exchange rates equilibrium? Shock Effect over: Y S Y* D P D ; S P* D ; S r (+ atrac. Bonds ) D ; (- atrac. Bonds $) S r* S (+ atrac. Bonds $) ; D (- atrac. Bonds ) 61

62 An increase in Y* $/ S = D $ 1,35 1,3 D = S $ Q o Q Q d 62

63 An increase in P* ( P/P*) $/ S = D $ 1,38 1,3 D = S $ Q o Q Q d 63

64 4. EXCHANGE RATE DETERMINATION: 4.3. THE PURCHASING POWER PARITY 64

65 Purchasing Power Parity (PPP) In the short term, exchange rate variations are explained by the needs arising from currency flows and capital goods (X, IM, X k, IM K ). In the long run, empirical studies show that variations in the exchange rate does not respond to the interest differential. Among the theories used to explain the evolution of the exchange rate in the long run, is the theory of purchasing power parity (PPP). This is a very simple theory that takes as its starting point the law of one price (LPU). The law of one price: In conditions of free competition and absence of transport costs and trade barriers, the same good should have a single price in any country. If there are differences in prices, arbitrage would take place. Through the "arbitrage", the game of supply and demand would balance prices, through the exchange rate market: byers should demand the currency from the country where the product is cheaper. 65

66 Purchasing Power Parity (PPP) i.e. ipod (80 gb) price at El Corte Inglés Madrid= 379 ipod price in Nueva York = 349$ If the E($/ ) = 1,3 How many Euros does an ipod in New York cost? 349$ / 1,3 = 268,46 Thus, an ipod is 110,54 euros more expensive in Madrid than in Nueva York. What is the E($/ )* that satisfies that the price of the ipod will be equal in Madrid (euros) and NY (dollars)? P($) = E($/ ) x P( ) E($/ ) = P($) / P( ) E($/ ) = 349 $ / 379 = 0,921 $/ In order to assure that an agent is indifferent between buying an ipod in New York and Madrid, and given the current prices in both locations, E($/ ) should be = 0,921 instead of 1,3. Therefore, according to the UPL, the euro is currently overvalued. 66

67 Purchasing Power Parity (PPP) The PPP assumes that the UPL is true for all goods and services The PPP suggests that the E between the currencies of two countries = ratio of their price levels. Only then the purchasing power of the currencies of both countries is the same. The Absolute PPP: E ($/ ) = P * / P P = P * are the price indices (internal and external). i.e.: If P * = 150 and P = 125 the exchange rate that satisfies the PPP is: E ($/ ) = 150/125 =

68 Purchasing Power Parity (PPP) PPP: e P = P* Cost of a basket of domestic goods, in foreign currency. e = P*/ P Cost of a basket of domestic goods, in domestic currency. Cost of a basket of foreign goods, in foreign currency. If e = P*/P, then e P P * P * P P P * 1 68

69 Purchasing Power Parity (PPP) The Relative PPP : prices and exchange rates vary in a proportion that keeps constant the evolution of the purchasing power of the currencies of the 2 countries. Exact expression: Approximate expression: An increase in the foreign inflation rate increases the purchasing power of our currency, and therefore it induces a nominal appreciation of our currency against the foreign currency. Inversely, an increase in the domestic inflation rate reduces the purchasing power of our currency and induces a nominal depreciation of our currency. 69

70 Does PPP hold in the real world? No, for two reasons: 1. International arbitrage is not always possible. Non traded goods Transportation costs 2. Different countries goods may be not perfect substitutes. Nonetheless, PPP is a useful theory: It s simple & intuitive In the real world, nominal exchange rates tend toward their PPP values over the long run. 70

71 The BigMac Index The Economist 71

72 5. THE EXCHANGE RATES REGIMES 72

73 Exchange rate regimes According to the IMF, each country can choose freely among a variety of exchange rate regimes. These regimes reflect policy choices made by governments, and their causes and consequences will be a major focus of our study. For most purposes, two general categories are sufficient: Fixed exchange rate regimes Floating exchange rate regimes Note This is a coarse classification Finer distinctions are possible (see later). It is not always possible to rely on what governments announce as their exchange rate regime. It is more reliable to look at how the exchange rate actually behaves (see later). 73

74 Exchange rate regimes Fixed exchange rates Those in which a country s exchange rate fluctuates in a narrow range (or not at all) against some base currency over a sustained period, usually a year or longer. A country s exchange rate can remain rigidly fixed for long periods only if the government intervenes in the foreign exchange market in one or both countries. Floating (or flexible) exchange rates Those in which a country s exchange rate fluctuates in a wider range, and the government makes no attempt to fix it against any base currency. Appreciations and depreciations may occur from year to year, each month, by the day, or every minute. 74

75 Exchange rate regimes: examples 1 CAN YOU IDENTIFY FIXED AND FLOATING? Selected developed countries Scale x2 75

76 Exchange rate regimes: examples 1 CAN YOU IDENTIFY FIXED AND FLOATING? Selected developing countries Asia Scale x3 Latin America Scale x10 76

77 Exchange rate regimes of the World Both fixed and floating regimes are widely in use: so we need to understand both types of regimes How do they work? Why are they chosen? Note: fixed category includes many countries that use a currency other than their own (e.g., eurozone and dollarized economies) 77

78 Dollarized economies 78

79 Pros and cons of fixed exchange rates Pros Control of imported inflation: prices of imported goods and services become cheaper, allowing for a reduction in domestic inflation No exchange risk no uncertainty for firms Requires a responsible macroeconomic policy: no public deficit Cons No control of monetary policy If our inflation is higher than foreign, it worsens our current account (continuous real appreciation) Requires enough reserves of foreign currency 79

80 Fixed ER: Central Bank intervention if D What happen if D? The exchange rate tends to increase, and the local currency (euro) tends to appreciate against the foreign one. In a Fixed Exchange Rate Regime, the Central Bank operates by eliminating the excess of demand of euros How? It buys foreign currency (dollars) in exchange of the domestic one (euros) Therefore, the Reserve of Assets (currencies) increases. 80

81 Fixed ER: Central Bank intervention if D $/ S = D $ The CB sells euros, buys dollar Parity:1,3 D = S $ D = S $ Q o Q d Euros quantity 81

82 Fixed ER: Central Bank intervention if S What happen if S? The exchange rate tends to decrease, and the local currency (euro) tends to depreciate against the foreign one. In a Fixed Exchange Rate Regime, the Central Bank operates by eliminating the excess of supply of euros How? It buys euros in exchange of dollars (it sells dollars) Therefore, the Reserve of Assets (currencies) decreases. 82

83 Fixed ER: Central Bank intervention if S $/ S = D $ S = D $ Paridad:1,3 The CB buys euros, sells dollars D = O $ Q d Q o Quantity ofeuros 83

84 Mixed Exchange Rates Sometimes, the Exchange rate can vary within two bands. Fluctuation within the bands is free. Any variation in the Demand or Supply of the domestic/foreign currency that takes the E outside the bands, will motivate the immediate intervention of the Central Bank, which will push the currency inside the bands again. As always, the intervention of the CB would be by selling/buying currencies in the market, with the corresponding effect over the Reserve of Assets. 84

85 Mixed ExR: Ajustment after an D below the upper band $/ S = D $ The euro appreciates up to 1,31 and the CB do not act 1,35 1,31 Paridad:1,3 1,25 Exces of demand D = S $ D = S $ Q o Q Q d Quantity of euros 85

86 Mixed ExR: Ajustment after an D above the upper band $/ S = D $ The CB operates selling and buying $; the E will come bak again into the bands (1,35) 1,35 Paridad:1,3 D = S $ 1,25 Exces of demand D = S $ Q o Q Q d Quantity of euros 86