Week 2 Exchange Rate Systems

1. 2. 3. 4. Exchange Rate Systems History of Exchange Rate Systems The Role of Central Banks The Road to Monetary Integration in Europe

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1. Given great demand of cross-border trade and investment, how do we exchange currencies?

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Exchange rate systems

Pegged or fixed exchange rate systems

In pegged or fixed systems, governments maintain currency values at official exchange rates. Exchange rate changes are called devaluation (revaluation) when the currency falls (rises).

Floating exchange rate systems

Floating systems allow values to fluctuate according to supply and demand, without direct interference by government authorities. Exchange rate changes are called depreciation (appreciation) when the currency falls (rises).

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Exchange rate systems around the World

Pegged or fixed exchange rate systems Conventional fixed rate like Jordan and Saudi Arabia Target zones and crawling pegs like China Currency board like Hong Kong Floating exchange rate systems Independently floating like the U.S., Japan, and Australia Managed floating like Argentina and Brazil No separate legal tender Adopt the currency of another country. For example, Ecuador and Panama use the US dollar, and Kiribati uses the Australian dollar.

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Distribution and Trend in exchange rate systems

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What drives exchange rate in a freely floating system?

Exchange

rates are determined by demand and supply of a currency if there is excess demand for US$ by Australians, they will sell A$ and buy US$

E.g.

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Determinants of exchange rate in freely floating system

Differences Differences Differences Political

in income growth in inflation rate in real interest rate

and financial risks and central bank reputation

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Expectations

Currency risks in exchange rate systems

Statistical measures of currency risk Volatility and skewness

Currency risk in floating exchange rate systems High volatility based on historical data History provides data that indicates past currency volatility Currency risk in pegged exchange rate system Zero volatility based on historical data The true currency risk does not show up in day-to-day fluctuations of the exchange rate (latent risk)
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2. The history of exchange rate system

Major events in the history of FX rates

1946 Bretton Woods Conference IMF was created 1971 Exchange rate turmoil begins the modern era of floating exchange rates Jamaica Agreement (1976) European Monetary System (1979) 1991 Treaty of Maastricht Introduction of the euro (1999) Euro begins public circulation (2002)

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Recent currency crises

Mexican peso crisis of 1995 Asian contagion of 1997 Russian ruble crisis in 1998 Brazilian real crisis in 1998 Argentinian peso crisis of 2002

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Asian currency values: $/unit

(Dec 1996 = 1.00)

Thai baht

Korean won Indonesian rupiah

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Currency crises

Contributing factors in each crisis

- A fixed or pegged exchange rate system that overvalued the local currency - A large amount of foreign currency debt

Consequences of currency crises

- Currency crises have a pronounced negative short-term impact on the local economy - A market-based exchange rate can have an invigorating long-term impact on the local economy and on the local stock market

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The debate over IMF lending

Proponents of IMF lending policies believe

- Short term loans help countries overcome temporary financial crises

Critics of IMF lending believe

- Fiscal constraints and capital market liberalizations increase economic and financial risks - IMF loans can leave a legacy of debt that can last for decades - IMF loans are often spent trying to support an unsustainable exchange rate - IMF remedies benefit developed countries and not the country in crisis

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3. How are exchange rate systems controlled? --The role of central banks

The central bank

To understand how the exchange rate systems operate, you must first understand the functioning of central banks.
Assets
Official international reserves Domestic credit Government bonds Loans to domestic financial institutions Other Other

Liabilities
Deposits of private financial institution Currency in circulation

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The central banks balance sheet

Official international reserves Foreign exchange reserves (86%) Gold reserves (14%) Domestic credit The purchase or sales of government bonds by the central banks are used to influence the money supply Loans to domestic financial institutions are important in times of panic and financial crisis Deposits of private financial institution (bank reserves) Countries require their commercial banks to hold a certain percentage of the deposits the banks accept from the public Currency in circulation

The coins and bills are used by the public

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Questions:
Let us assume 1 A$= 1 US$ ---Reserve Bank of Australia buys A$5 billion Australian government bonds. What is the outcome on the Australian dollar? What about the impact on inflation in Australia?

--Reserve Bank of Australia buys US$5 billion US government bonds. What is the outcome on the Australian dollar? What about the impact on inflation in Australia?
--Reserve Bank of Australia buys US$5 billion US government bonds and sells A$5 billion Australian government bonds. What is the outcome on the Australian dollar? What about the impact on inflation in Australia?

Foreign exchange rate intervention

Central banks intervene in foreign exchange markets to affect exchange rates directly
By supplying domestic currency, central banks weaken the value of domestic currency. By demanding domestic currency, central banks strengthen the value of domestic currency.

Two methods of foreign exchange rate intervention Non-sterilized interventions (currency value and inflation) Sterilized interventions (currency value)

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4. The road to monetary integration in Europe

The desire of a stable currency system in Europe

The desire for currency stability in Europe is extremely strong

Western European countries are open to foreign trade and their trading partners are their neighboring countries Facilitate the operation of a common market for agricultural products Achieve the integral part of the wider drive toward economic, monetary, and political union among European countries

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The European Monetary System

From 1944 to 1973, stability was supplied by the Bretton Wood system of fixed exchange rates After the breakup of the Bretton Woods system, these western European countries established the European Monetary System in 1979 A grid of bilateral fixed central parities from which exchange rates can deviate by 2.25% on each side Interventions by central banks were compulsory whenever either bilateral margin was reached If the grid of bilateral fixed central parities can not be sustained, a new grid will be established

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Was the European Monetary System successful?

Day-to-day variability was down Large revaluations did occur due to a currency crisis from 1992-1993 Inflation and interest differentials narrowed Could have been due to hard currency policies Asymmetric adjustments Central role of Germany; others maintained stable rate of their currency around Germany

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The Maastricht Treaty and the Euro

In 1991, the European heads of state met in Maastricht in the Netherlands to map out the road to economic and monetary union with a single currency to be reached by 1999 Criteria Inflation within 1.5% of 3 best performing countries Interest rate on long-term government bonds within 2% of those of 3 best-performing countries A budget deficit to GDP <3% Government debt to GDP< 60% No devaluation within the ERM within past 2 years Three phases Restrictions of movement on capital removed (Jan. 1994) European Monetary Institute was created European Central Bank replaced European Monetary Institute in Jan. 1999
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Euro Zone (2013)

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Euro value from Jan. 1999 to Jan. 2008

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Pros and Cons of the monetary union

Potential pros: enhanced price transparency, lower transaction costs, no exchange rate uncertainty, enhanced competition could promote trade and economic growth Potential cons: loss of independent monetary policy. It is bad if country is in a bad stage and none of the other countries are. For example, Greece in global recession, 2010

Debates: research does not agree on whether or not the EU is particularly well suited to be a monetary union but in the end, the verdict is still out

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