International Macroeconommics

Transcription

1 International Macroeconommics Chapter 4: Exchange Rate Regimes and the Department of Economics, UCDavis

2 Outline Exchange Rate Regimes 1 Exchange Rate Regimes 2 3

3 Outline Exchange Rate Regimes 1 Exchange Rate Regimes 2 3

4 Exchange rate regime: Different Patterns of exchange rate behavior. Two major types: Floating/Flexible exchange rate regime A government allows market forces in the foreign exchange market to determine the exchange rate. Exchange rate fluctuates in a wide range Fixed/Pegged exchange rate regime A government intervenes in the foreign exchange market to make the equilibrium value of the exchange rate equal some desired value. Exchange rate fluctuates in a a very narrow range (or not at all) against some base currency.

5 In practice, annual variation of exchange rate within 2% is categorized as fixed exchange rate regime. Band a tiny variation around the fixed exchange rate level is allowed Denmark krone/euro, 2% variation around 7.44 is allowed. Crawl not target at the level of exchange rate, but the rate of change of exchange rate. currency steadily appreciates/depreciates at a constant rate. Crawling peg: a simple trend Crawling band: a tiny variation about the trend is allowed.

6 Currency union A single central bank for the member nations. European Union; Eastern Caribbean Currency Union; CFA Franc Zones; CFP Franc Zones. Dollarization Adopt the currency of another country. Popular choices: US dollar, New zealand dollars, Australian dollars. nation is two small to operate its own monetary system. poor record of managing its own monetary affairs.

7

8 Outline Exchange Rate Regimes 1 Exchange Rate Regimes 2 3

9 Study the polar cases: tight fixing and free floating Free floating: theories of exchange rate determination, the overshooting theory. Tight fixing: theories of exchange rate determination are still useful to understand the fixed exchange rate.

10 How does a country fix its exchange rate against some base currency? The central bank maintains a commitment to always be willing to trade national currency for foreign currency with anyone at the official rate. This means the central bank must satisfy the extra demand of foreign currency (home currency overvalued) or take the extra supply of foreign currency (home currency undervalued).

11 Ē kr/euro = 7.44 Suppose there is extra demand of e(extra supply of krone). buy eusing krone at 7.44 krone per euro from the central bank. Central bank sells e, take krone as payment. Krone in circulation decreases, money supply decreases in Denmark. Must have enough eto satisfy the extra demand. Enough holdings of foreign reserves.

12 Ē kr/euro = 7.44 Suppose there is extra supply of e(extra supply of krone). sell eto get krone at 7.44 krone per euro from the central bank. Central bank buys e, pays krone. Krone in circulation increases, money supply increases in Denmark. Central bank accumulates e. Foreign reserves increases.

13 Outline Exchange Rate Regimes 1 Exchange Rate Regimes 2 3

14 Central bank loses control over money supply by fix its exchange rate at a certain level. Apply our model to the fixed exchange rate. i kr = i euro + E e kr/euro E kr/euro E kr/euro Under fixed exchange rate, E e kr/euro E kr/euro E kr/euro = 0 i kr = i euro Denmark pegs its currency to the euro. Its interest rate should be the same as the euro interest rate. This means that monetary policy is out of the question. During recession, expansionary monetary policy increases money supply thus decreases nominal interest rate. A low nominal interest rate stimulate investment thus help the economy recover. Under fixed exchange rate, this can not be achieved.

15 Suppose Denmark increases nominal money supply to decrease nominal interest rate. As nominal money supply in Denmark increases, nominal intereat rate in krone drops. This implies a lower return to krone assets than to euro assets at the fixed exchange rate between krone and euruo. Trades sell krone to Denmark central bank to get euro at the fixed rate. This means that the central bank is selling euro and taking krone as payment. Money supply decreases. As money supply decreases, nominal interest rate in krone increases. Until money supply and nominal interest rate both back to the initial level. Returns to krone assets are equal to returns to euro assets at the fixed rate. No more arbitrage transactions.

16 A way to avoid losing monetary policy autonomy under fixed exchange rate regime is capital control. legally prevent traders from taking advantage of the arbitrage opportunities involving cross-border trades in assets Conclusions: among the following three objectives: (1) exchange rate stability (fixed exchange rate) (2) monetary policy autony (set own monetary policy independently) (3) capital mobility (no capital controls) only two are possible at one time. Called the tri-lemma.

17