Fixing the Exchange Rate

1
Fixing the Exchange Rate

• Chapter Three
• Shapiro

2
Why fix exchange rates

• reduce uncertainty
• increase world-wide liquidity
• reduce costs of international trade

3
Gold Standard The Original Fixed Rate

• Countries fix parity price of gold
• They allow arbitrage between two markets
• parity price of gold at Central Bank
• free market price of gold
• De facto single currency the ounce of gold
• many units of account
• periodic falling off of the gold standard
• Balance of Payments deficits settled with gold

4
Arbitrage
Pg
S2
S1
Par
Pg
D2
D1
Qg
5
The Act of Arbitrage

• Two markets for gold
• official government market
• external markets
• Parity Price greater than market price
• governments price (parity) the high price
• external markets price the low price
• trader buys low sells high
• buys externally
• sells to government

6
The Effects of Arbitrage

• External market gold supplies decrease
• holders of gold will sell first to the government
• arbitrageurs will buy up stocks and sell to the
  government
• excess supply will dry up bringing market price
  to equal the parity price
• Government gold supplies will increase
• increases the money supply
• decrease the value of money (inflation)

7
Gold Standard (monetary effects)

• Gold backs all money
• prices move relative to
• excess demand for gold (economic growth)
• deflation
• excess supply of gold (new gold finds)
• inflation
• Central banks have no independent policy

8
Gold Standard Central Bank
Liabilities
Assets

• Gold
• 30 40
• T-bills
• 60 70

• currency

9
Gold standard exchange rates

• All currencies fixed to gold
• Gold is the de facto currency
• single world wide currency
• all international trade is denominated in gold
• No price uncertainty
• No need to hedge exchange rate volatility

10
Gold Standard Central Bank
Liabilities
Assets

• Gold
• T-bills
• gold increases due to BOT surplus

• cash
• currency
• Money supply increases

11
BOT Surplus

• gold is paid to pay for excess of exports to
  imports
• gold coming into the central bank increases money
  supply
• inflation in the economy
• your goods now more expensive in foreign markets
• foreign goods less expensive to you

12
Off the Gold standard

• When CBs can execute a monetary policy
• discipline of the gold standard is gone
• after WWII governments ran inflationary policies
• interest rate policies
• employment policies
• inflation sometimes running at 200 or more
• Exchange rates fluctuate
• creating uncertainty for trade

13
Managed Exchange rate regimes

• Pegging exchange rates
• pegged to another currency
• pegged to a basket
• Currency boards
• Monetary unification

14
Pegging Exchange Rates (Denmark)

• Denmark pegs to the Euro

15
Means to manage exchange rates

• Currency Boards
• Central Bank Intervention
• devalutaion/revaluation
• Joint Intervention

16
Argentine Currency Board
Liabilities
Assets

• gold, silver
• dollar assets
• (T-bills) 80
• some foreign exchanger

• Peso cash currency
• Commercial Bank reserves

17
Trade-offs in a managed exchange rate

• reduced volatility
• loss of sovereignty
• monetary policy
• fiscal policy
• regulatory policy

18
Fixed vs Flexible

• fixed rates reduce volatility
• fixed rates require
• disciplined monetary policies
• disciplined fiscal policies
• fixed rates require large foreign exchange
  reserves
• fixed rates impede relative price adjustments

19
Floating exchange rates

• Advantages
• Purchasing power parity allowed to hold
• Trend line reflects relative inflation
• International prices adjust automatically
• Prices more transparent
• Allows an independent monetary policy
• Disadvantages
• Exchange rate volatility increases
• Higher costs due to need to hedge volatility

20
Fixed exchange rates

• Advantages
• reduces uncertainty (volatility) over the short
  run
• increase world-wide liquidity
• reduce costs of international trade
• Disadvantages
• Externally mandated discipline
• Monetary policy
• Fiscal policy
• Impede relative price adjustments

21
The impact of a devaluation

• Brazilian Stock market take a hit
• Government borrowing in dollars
• have to pay back in higher valued currency
• often leading to re-negotiation of terms
• operating exposure
• (change in real exchange rate)
• on exporters
• on importers

22
Trade-offs in a managed exchange rate

• reduced volatility
• loss of sovereignty
• monetary policy
• fiscal policy
• regulatory policy

23
Euro

• convergence criteria
• nominal inflation no more than 1.5 above
• avg of 3 members with lowest in previous year
• long-term interest no more than 2.0 above
• avg of 3 members with lowest in previous year
• fiscal deficit no more than 3 of GDP
• debt no more than 60 of GDP
• strong independent European Central Bank

24
Countries in the Euro

• Belgium (franc)
• Germany (deutschemark)
• Spain (peseta)
• France (franc)
• Ireland (punt)
• Luxembourg (franc)

• Italy (lira)
• Netherlands (guilder)
• Austrian (shilling)
• Portugal (escudo)
• Finland (markka)

25
Countries out of the Euro

• Denmark (krone)
• Greece (drachma)
• Sweden (krona)
• United Kingdom (pound)
• These currencies are pegged to the Euro