Contents of the course

1
International Finance
Part 1 Fundamentals of International Finance
- Lecture n 4 Exchange rate management
2
Exchange rate management

• Introduction
• Goals of the chapter
• Ask whether a flexible exchange rate system is
  desirable,
• Discuss the argument for greater exchange rate
  fixity
• Flexible exchange rate system
• Implies a minimum of insitutional design
• Carry weaknesses linked to this minimal framework
  
• Uncertainty
• Lack of discipline
• Problems of volatility and misalignments
• Case for more managed exchange rates
• Then leads to problems of speculative attacks if
  monetary policy is inconsistent with fixed
  exchange rate target.

3
Exchange rate management

• The case for flexible exchange rates - Arguments
• Defined as
•  Rates of foreign exchange that are determined
  daily in the markets for foreign exchange by
  forces of demand and supply 
• Avoid the intervention of the government and the
  possible run out of reserves
• Automatically adjusts the BOP disequilibria
• Speculators facilitate and smooth the adjustment
  of the exchange rate, having a stabilising effect
• Confer monetary autonomy to a country
• Provide insulation from external shocks via
  exchange rates adjustements, upward or downward.

4
Exchange rate management

• The case for flexible exchange rates - Challenges
• However, the argument for flexible exchange rates
  have been seriously challenged to several
  extents.
• Floating rates since 1973 have exhibited high
  volatility and spent long periods away from their
  long-run fundamental equilibrium level
  (misalignement)

Domestic price of foreign exchange
Supply of foreign exchange (brought by X) D of
domestic curr.
Seq
Deficit M gt X
Demand for foreign exchange(brought by M) S of
domestic curr.
X
M
Q of foreign exchange
5
Exchange rate management

• The case for flexible exchange rates - Challenges
• Exchange rate determination models do not seem to
  prove empirically that fundamentals drive the
  exchange rate.
• Studies showed that same current account
  imbalances persisted after the adoption of
  floating exchange rates in 1970 s and 1980 s.
• Changes in prices caused by depreciation may not
  alter demand for the product (ex. Switzerland,
  Germany, Japan), in particular for high quality
  goods with few substitutes.
• Monetary autonomy ? UK example in 1979-1981 where
  monetary tightness rise interest rates, causing a
  huge capital inflow, leading to exchange rate
  appreciation, affecting badly the tradeable
  sectors.-gt few autonomy.

6
Exchange rate management

• The case for flexible exchange rates - Challenges
• Insulation from external shocks?
• Full insulation idea abandoned.
• Still a question on whether flexible rates better
  insulate the domestic economy. Via, p.ex.,
  appreciation of the rate in case of rise of
  foreign demand for domestic exports, and vice
  versa.
• Empirical results are mixed.
• Overall several exaggerated benefits for
  flexible exchange rates.

7
Exchange rate management

• The benefits of greater exchange rate fixity
• Four arguments in favour of some degree of
  exchange rate intervention
• The discipline argument helps to promote lower
  inflation.
• The need to reduce exchange rate volatility
  more uncertainty can reduce the volume of trade.
• The desire to eliminate misalignments long
  period of over- and undervaluation - like
  displayed in the floating rates period - results
  in various cost for the real sector.
• The benefits of a single currency

8
Exchange rate management

• Exchange rate fixity The Discipline argument
• (1) Flexible rates tend to promote inflation
  (evidence is mixed and theoretically unlikely)
• (2) Fixed exchange rate force countries to
  contain inflation one of the core arguments in
  favour of EMS.
• Consider 2 countries
• UK high inflation, and current account deficit
• Germany low inflation, and current account
  surplus
• In theory leads to a tendency of appreciation
  of the DM Bundesbank should sell DM against
  foreign currencies, expanding the monetary base,
  and reducing pressure on S.
• UK should disinflate, buy Pounds against
  foreign currencies to reduce pressure of
  depreciation.

9
Exchange rate management

• The Discipline argument
• Asymmetry Germany could sterilise (and avoid a
  price rise) by selling bonds against DM, reducing
  back the monetary base. UK cannot sterilise much,
  soon running out of reserves. -gt this asymmetry
  leads to a disinflationary bias.
• And, the credibility bonus brought by the
  exchange rate target reduces the costs of
  disinflation in terms of unemployment agents
  easily observe the exchange rate target and
  believe that inflation will fall -gt they adapt
  their wage bargaining behaviour.
• Exchange rate targets are more efficient
  (credible) disinflation tools than monetary
  growth targets.

10
Exchange rate management

• Exchange rate fixity The Volatility argument
• Need to reduce exchange rate volatility more
  uncertainty can reduce the volume of trade.
• Foreign direct and long-run foreign investment
  might also decline in greater exchange rate
  uncertainty.
• Sudden changes in the value of reserve currencies
  can be problematic.
• However, possible recourse to the forward market,
  but
• only existing for large currencies,
• can be expensive.

11
Exchange rate management

• Exchange rate fixity The Misalignment argument
• Floating rates have a tendency for persistent
  departures from long-run equilibrium
• Long period of overvaluation and undervaluation
  cause changes in the price of tradeables goods
  relative to non tradeables.
• Example persistent overvaluation, causing
  industries to become uncompetitive, but capital
  and labour are not easily convertible into other,
  non tradeable sectors
• -gt overvaluation usually leads to unemployment
  and underutilisation of resources, and
  ultimately, to desindustrialisation.
• Also effect of misalignment on long-term debt
  accumulated in foreign currencies can
  significantly change the return of project
  financed by borrowed currencies.

12
Exchange rate management

• Exchange rate fixity The Single Currency
• Benefits of a single currency within any country
  are
• simplification of the profit-maximising
  computations of producers and traders
• facilitated competition among competitors of the
  country
• promotion of the integration of the economy into
  a connected series of markets for the factors of
  production
• If single currency among different countries
  accrued benefits due to the suppression of the
  transaction costs of exchanging currencies.
• If exchange rate management part of these
  listed benefits could be achieved, compared to a
  fixed rate regime.

13
Single Currency

• Costs of a single currency
• Costs of a single currency across different
  countries
• loss of the exchange rate
• loss of the monetary policy
• Loss of exchange rate
• Eliminate the possibility of using the exchange
  rate as a policy instrument to rectify external
  equilibria.
• Example External shock of price fall in steel
  leads Belgium (large exporter) to a deficit on
  its current account.
• Belgium should either deflate (allowing prices to
  fall) or let the currency depreciate (or devalue
  if fixed exchange rate) in order to restore
  equilibrium.
• If prices are sticky and cannot fall to restore
  competitiveness, deflation (i rises, M falls)
  will create unemployement.

14
Single Currency

• Costs of a single currency - loss of exchange
  rate
• Example
• If Belgium is in a monetary union no
  depreciation is allowed, the economy will go into
  recession.
• Belgium has no longer a BOP problem, but has a
  regional problem within EMU.
• Three factors mitigating the costs
• Factor mobility
• Openness of the economy
• Product diversification

15
Single Currency

• Costs of a single currency - Mitigation factors
• Factor mobility
• The greater the mobility of capital and labour,
  the lower the cost of joining a monetary union.
• Example asymmetric demand shock rise of D in
  region A, drop in region B. If prices are sticky
  downwards, region B will have unemployement, and
  inflationnary pressures in region A.
• Solution move unemployed workers from region B
  to region A.

16
Single Currency

• Costs of a single currency - Mitigation factors
• Openness of the economy
• The loss of exchange is less costly if the
  economy is more open.
• Reason exchange rate changes are less effective
  at improving competitiveness because money
  illusion is reduced.
• In fixed exchange rates, devaluation increase
  competitiveness via the drop real wages following
  the increase in prices of imported goods.
• In open economies, workers anticipate this change
  and will adjust their demand of wage increase to
  offset the effect.
• Product diversity
• A demand disturbance in one product is less
  likely to affect significantly the exchange rate,
  if the diversfication is large.

17
Single Currency

• Costs of a single currency - Loss of monetary
  policy
• Costs of a single currency across different
  countries
• loss of the exchange rate
• loss of the monetary policy
• Loss of monetary policy
• Eliminate the ability to conduct an individual
  monetary policy, since monetary policy is
  directed from the centre rather than from
  individual countries.
• Many believe that the more similar inflation
  rates countries have, the more appropriate
  candidates they are for a monetary union.
• More generally the closer degree of policy
  integration at macro level, the more easy it is
  to form a monatery union.

18
Single Currency

• Criteria for countries to benefit from a single
  currency
• Similar policy goals
• Similar macroeconomic performance
• Close inflation rates
• Conduction a lot a of trade transactions between
  one another.