MGE 12.1

1

• Session 12 Exchange Rates and Speculative
  Attacks
• Goal Understanding what affects exchange
  rates, and how States can influence them
• Nominal and Real Exchange Rates
• The Market for Foreign Exchange
• Flexible, Fixed, and Black Market rates
• Currency Crises and Speculative Attacks
• Mexico 1994 the ERM Crisis 1992

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
2
China and the WTOGlobalization

• Economists usually argue that the free flow of
  goods, capital, and ideas is beneficial.
• Problems
• Assumes perfect markets
• Overlooks social tensions (Trade used to be in
  non-competing products)
• Three problems of Globalization
• Those who cannot move their capital are losers of
  the free trade
• Competition with different norms (No WTO rules on
  mode of production)
• Compensating losers makes for uncompetitivity

3
Nominal Exchange Rates

• Definition
• Amount of foreign currency that can be bought
  with one unit of domestic currency.
• Price of 1 unit of domestic currency in terms of
  foreign currency.
• Problem quoted differently in different sources
  

4
Selected Nominal Exchange Rates
Base Currency US Dollar, USD on Monday, October
6, 2003
5
Nominal exchange rate price of currency
Base Currency US Dollar, USD on Monday, October
6, 2003
You need 0.1451 USD to buy 1 Rand
1 USD buys 6.915 Rand
6
Nominal exchange rates vary over time
Base Currency US Dollar, USD on Sunday, October
7, 2001
Compare to Monday, October 6, 2003
You need 0.1451 USD to buy 1 Rand
1 USD buys 6.915 Rand
7
Exchange Rate movements

• When the exchange rate goes up (as we have
  defined it foreign units/domestic currency),
• the domestic currency is appreciating
• it takes more foreign currency to buy one unit of
  domestic currency (i.e. domestic currency is
  more expensive)
• 1 unit of domestic currency buys more units of
  foreign currency(i.e. domestic currency is worth
  more, is stronger)

8
Real Exchange Rates(or Terms of Trade)
9
Real Exchange Rates(or Terms of Trade)
Convert into common currency
Relative price of VW in Europe compared to US
10
Real Exchange Rates(or Terms of Trade)
Nominal exchange rate
Real exchange rate (terms of trade)
11
Purchasing Power Parity

• What would you have expected the real exchange
  rate to be?
• Whats the Real exchange rate ? relative price
  of goods in common currency
• Law of one price similar goods should have
  similar prices
• Why would PPP fail?

12
Why does PPP fail?

• Arbitrage costs
• Transport costs
• Regulations and taxes
• Low demand (scale economies)
• Many goods are not easily traded
• Tradable goods are not perfect substitutes
• Different tastes (ex Engine size in US versus
  Turbo Diesels in Europe)
• Different norms (ex security norms on cars)

13
The Big Mac Index
/
14
Inflation and Terms of Trade

• If 100 inflation, what happens to ToT?
• Nominal exchange rates do not tell you anything
  about inflation
• Inflation leads to loss in competitiveness
  (higher real exchange rate)
• However, normally devaluation/depreciation after
  inflation

44,620
2.72
15
Market for Foreign Exchange

• Real exchange rate (i.e. terms of trade)
  determine
• Quantity of imports we buy
• Quantity of exports we sell
• The higher the real exchange rate, the lower NX
  will be. (holding other factors constant)
• Currency is traded on FX market for 2 purposes
• Foreign Trade (X and IM)
• Capital Flows (buying of foreign assets, selling
  of domestic ones)

16
Foreign Exchange Market


Supply of domestic currency
Exchange rate

by domestic agents




Imports




Capital outflows



e


Demand for domestic currency
by foreign agents




Exports



Capital inflows



Number of units of

domestic currency traded


17
Shifting the Curves(Flexible Exchange Rates)


Ex EU goods improve in quality



Supply of domestic currency
Exchange rate

by domestic agents


e


Imports




Capital outflows

e


e


Demand for domestic currency
by foreign agents




Exports



Capital inflows



Number of units of

domestic currency traded


18
Fixed (pegged) Exchange Rates


Fixed (or pegged) exchange rate

Government fixes the desired exchange rate
Government fixes exchange rate



/Peso

S
(imports, Cap. outflows)

Pegged
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

19
Fixed (pegged) Exchange Rates


Fixed (or pegged) exchange rate

so when demand for domestic currency falls
Government fixes exchange rate



/Peso

S
(imports, Cap. outflows)

Pegged
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

20
Defending the Currency


Fixed (or pegged) exchange rate

government must defend it by boosting demand
Government fixes exchange rate



/Peso

S
(imports, Cap. outflows)

Pegged
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

21
How does Gvt defend the Currency?


Fixed (or pegged) exchange rate

by selling foreign reserves (i.e. buying
domestic currency)
Government fixes exchange rate

BOP deficit


Sell
/Peso

Foreign
S
(imports, Cap. outflows)

Reserves

Pegged
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

22
Black Market Rates?

Official and parallel exchange rates

1989

1990


Local currency / US
Official exchange rate

13.8

30.2

Parallel market exchange rate

107.8

121.2

Official rate is much higher than rate in the
street.
(i.e. get more local currency per dollar in the
street than at the airport)
23
Black Market Rates?

• Official rate is much higher than exchange rate
  in the street.
• i.e. get more local currency per dollar in the
  street than at the airport
• How is this possible?

/Peso

S
(imports, Cap. outflows)

Official
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

24
Black Market Rates?

• Hurts exporters
• Must sell exports at official rate (change USD at
  official rate)
• ? exports look expensive to rest of the world
  (official rate is strong)
• Usually buy imports at black market rate
• ? imports are expensive (black rate reflects weak
  domestic currency)
• Why buy imports at black market rate?
• Insufficient foreign exchange at official rate
• Or opportunity cost of official-rate dollars that
  could be sold on black market
• Incentives for corruption to get official rate
  dollars

25
Currency Crises (1) Inability to defend a peg

• Example Mexico, 1994
• Early 1990s Mexico on the rise
• Single digit inflation (1993)
• NAFTA (1/94)
• Euphoria for newly emerging economies
• ? Confidence in Mexican economy
• ? Foreign investment surges

26
The Mexican Crisis
27
The Mexican Crisis

• Inability to defend a peg (Example Mexico,
  1994)
• 1994 Mexico in Political Crisis
• Revolt in Chiapas
• Assassination of Colosio (opposition candidate)
• Loose of competitiveness, current account
  deficits growing, fragile banking sector
• ? Confidence in Mexican economy plummets
• ? Foreign investors start pulling out

28
The Mexican Crisis
29
Central Bank defends the Peso
30
Central Bank defends the Peso(1) foreign
investors not renewing investments


/Peso

BOP
S
(imports, Cap. outflows)

deficit

Pegged
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

31
Central Bank defends the Peso(2) domestic
capital flight
BOP
deficit

/Peso

S
(imports, Cap. outflows)

Pegged
rate

D
(exports, Cap. inflows)

Domestic Currency
exchanged

32
22 Dec CB runs out of foreign reserves
33
Effect on GDP
34
Currency Crises (2) Speculative Attacks

• e.g. European Monetary System crisis, 1992
• 1979 EMS Managed float
• /- 2.5 bands around official central value
• Central bank intervention required if either band
  is reached.

35
EMS D
F
M

IRTY
LOAT
ECHANISM



Exchange rate

S

of domestic
currency

Official
Rate

D

for domestic
currency

As soon as exchange rates attained either of
these bands, central banks intervened.
36
EMS Crisis 1992

• German Unification
• Fear of inflation ? tighten monetary policy
  (.75 to 8.75!)
• Other countries in recession so do not want to
  follow suit.

37
Higher German Interest Rates
GERMANY
UK
Interest
Interest
S
S
o

o

rate
rate




World interest rate
r
r
o

o

I
I
I
I
o

o

Initial point
38
Higher German Interest Rates
GERMANY
UK
S
Interest
Interest
S
S
o

o

rate
rate




World interest rate
r
r
o

o

I
I
I
I
o

o

Interest
rate

Tighter monetary policy
r
o

L
Real
M

Balances

P

39
Reaction in rest of Europe
GERMANY
UK
S
S
S
Interest
Interest
S
S
o

o

rate
rate




World interest rate
r
r
o

o

I
I
I
I
o

o

Interest
rate

Tighter monetary policy
r
o

L
Real
M

Balances

P

40
High German Interest Rates
e(DM/)

e(/DM)

S(DM)

()

S


Official

Rate


D(DM)


D()





German market

UK market

41
Black September 1992
42
The Swedish Crisis

S
(imports, Cap. outflows)

Krona/

Pegged
rate

D
(exports, Cap. inflows)

Krona exchanged on

FX market

(1) Loss of confidence ? capital outflows
43
The Swedish Crisis

S
(imports, Cap. outflows)

Krona/

Pegged
rate

D
(exports, Cap. inflows)

Krona exchanged on

FX market

(2) Central bank intervenes to defend the peg
44
The Swedish Crisis

S
(imports, Cap. outflows)

Krona/

Pegged
rate

D
(exports, Cap. inflows)

Krona exchanged on

FX market

(3) Worry that Central bank cannot defend the peg
forever ? capital outflows
45
The Swedish Crisis

S
(imports, Cap. outflows)

Krona/

Pegged
rate

D
(exports, Cap. inflows)

Krona exchanged on

FX market

(4) Eventually, CB runs out of reserve (or
courage) ? devaluation
46
Speculative attacks

• Identify currency in trouble
• Borrow money in the attacked currency (10
  million Kr)
• Convert immediately to dollars (10 million )
• When attacked currency devaluates, repay loan
  (11 million Kr 5.5 million )

47
Speculative attacks

• Identify currency in trouble

48
Speculative attacks

S
(imports, Cap. outflows)


Krona/



10 million Kr

Pegged

rate



D
(exports, Cap. inflows)

Krona exchanged on

FX market

• Borrow money in the attacked currency (10
  million Kr)
• Convert immediately to dollars (10 million )

49
Speculative attacks

S
(imports, Cap. outflows)


Krona/




Pegged

rate



D
(exports, Cap. inflows)

Krona exchanged on

FX market

• When attacked currency devaluates, repay loan
  (11 million Kr 5.5 million )

50
How to prevent speculative attacks?

• Increase interest rates to reduce profits
  (Sweden 500 interest rate to defend the Krona)
  
• Benefit interest costs are greater than gains
  from devaluation
• Cost restrictive monetary policy leads to a
  recession
• Foreign exchange controls
• Benefit no outflows of capital, so price cannot
  fall
• Cost can compromise future foreign capital
  inflows
• Tobin Tax? (presentations)