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Week 2 Exchange Rate Systems

1. Exchange Rate Systems

2. History of Exchange Rate Systems

3. The Role of Central Banks

4. 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 supplyand 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, Ecuadorand Panama use the US dollar, and Kiribati uses the Australiandollar.

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Distribution and Trend in exchange rate systems

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Exchange rates are determined by demand andsupply of a currency

E.g. if there is excess demand for US$ byAustralians, they will sell A$ and buy US$

What drives exchange rate in a freelyfloating system?

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Differences in income growth

Differences in inflation rate

Differences in real interest rate

Political and financial risks

Expectations and central bank reputation

Determinants of exchange rate in freelyfloating system

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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 dataHistory 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 ofthe exchange rate (latent risk)

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2. The history of exchange rate system

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Major events in the history of FX rates

1946 Bretton Woods Conference

IMF was created

1971 Exchange rate turmoilbegins the modern era offloating 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

Mexicanpeso crisis of 1995

Asiancontagion of 1997

Russianruble crisis in 1998 Brazilianreal crisis in 1998

Argentinianpeso crisis of 2002

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Asian currency values: $/unit(Dec 1996 = 1.00)

Koreanwon

Thai baht

Indonesianrupiah

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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-termimpact on the local economy

-A market-based exchange rate can have an invigoratinglong-term impact on the local economy and on the localstock 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 increaseeconomic 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

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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

Liabilities

Deposits of private financial institution

Currency in circulation

Other

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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 centralbanks are used to influence the money supply

Loans to domestic financial institutions are important intimes 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 thepublic

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 bondsand sells A$5 billion Australian government bonds. What is the

outcome on the Australian dollar? What about the impact on inflation

in Australia?

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Foreign exchange rate intervention

Central banks intervene in foreign exchange markets to affectexchange rates directly

By supplying domestic currency, central banks weaken thevalue of domestic currency.

By demanding domestic currency, central banks strengthen thevalue 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

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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 andtheir trading partners are their neighboring countries

Facilitate the operation of a common market for agriculturalproducts

Achieve the integral part of the wider drive toward economic,monetary, and political union among European countries

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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 oftheir currency around Germany

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The Maastricht Treaty and the EuroIn 1991, the European heads of state met in Maastricht in theNetherlands to map out the road to economic and monetary union

with a single currency to be reached by 1999Criteria

Inflation within 1.5% of 3 best performing countries

Interest rate on long-term government bonds within 2% ofthose of 3 best-performing countries

A budget deficit to GDP

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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 competitioncould promote trade and economic growth

Potential cons: loss of independent monetary policy. It is bad ifcountry 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 theEU is particularly well suited to be a monetary union but inthe end, the verdict is still out