Currency Policy and Currency Crises

1
Currency Policy and Currency Crises
2
Learning Objectives

1. Revise BOP
2. Forex Markets Fixed and Floating e-rates
3. Why care about e?
4. Current account Competitiveness
5. Capital account Interest rates
6. Currency Crises
7. Optimal Currency Areas

3
1. The Balance of Payments

• Record of a countrys economic transactions with
  the rest of the world.
• Rule receipt positive () , payment negative
  (-).
• If receipts gt payments surplus.
• If receipts lt payments deficit.
• At its most basic just an accounting system
• 2 main accounts current and capital.
• Different implications for the economy. The
  current account directly affects AD
• It is possible to have a current a/c deficit as
  long as there is a capital a/c surplus. Example,
  USA.

4
Balance of
Payments Current account Trade a/c Services
Freight Tourism Royalties Investment
income Direct investment income National
debt interest Transfers Balance on current
account Capital account Private capital Official
capital Government securities sold
abroad Banking transactions Balance on capital
account
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
5
(No Transcript)
6
2. Foreign Exchange Market

• Balance of payments and international
  transactions underlie the foreign exchange
  market.
• Different ways of quoting exchange rates
• Indirect quote (/).
• Direct quote (/).
• Define e as the price of a euro in i.e how many
  per
• There is a one to one correspondence between the
  components of the BOP and the supply and demand
  for euros
• Translate the accounts into economics
• Explain the behaviour of each of the bits

7

• Easier to if we think in terms of the Irish
• Any export will create an international demand
  for Irish pounds
• Foreigners need to buy Irish goods
• Imports create a supply of Irish pounds
• Irish people take to international markets
• Similarly foreign deposits in Ireland or Irish
  deposits aboard create a demand for or supply of
  
• Therefore BOP balance implies SD

8
Fixed vs Floating

• In a certain trivial sense the BOP always
  balances
• Supply equals demand
• Current account surplus is counteracted by cap
  deficit and/or changes in reserves
• US vs China
• For floating exchange rate this is achieved by
  the free market
• E rate is such that SD i.e. BOP0
• For fixed exchange rates the government makes up
  the difference

9
Floating Exchange Rate
The supply and demand for euro determines e.
Floating exchange rate.
S
e1
D
billions
10
Fixed Exchange Rates

• Governments may try to fix the exchange rate
  (why? See later)
• Requires supplying foreign currency to market
  when there is excess demand
• Requires buy foreign currency when there is
  excess supply
• Can influence the exchange rate via interest
  rates (EMS or dirty float)
• Mechanism by which an currency crisis can occur

11
Fixed e
By co-incidence it is at market eqm. Not likely
S
e
D
billions
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
12
Fixed e
Below market rate. CB print extra and buy
S
e
D
billions
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
13
Fixed e
E above market value. CB must buy with
S
e
D
billions
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
14
Irish Exchange rate Policy

• 1920-79 Sterling Link
• Currency Board
• Sensible strong currency, major trading partner
• Have British inflation and interest rates.
• 1979 break with sterling
• Seek lower inflation with Germany
• didnt work inflation diverged
• Interest rates converged only after 10 years
• Competitiveness declined

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
15
3. Why care about e?

• ?e affects the location of the AD curve.
• ?e ? ?X and ?M (see over)
• ? ?AD ? ?real GNP, employment, unemployment and
  inflation just as with any FP or MP
• Note that this effect works through the current
  account
• Thus e is another instrument of economic policy.
• See diagram
• Policy-maker can contrive to improve
  competitiveness by under-valuing e.
• Over-valued e can have a detrimental effect on
  key macroeconomic variables.
• A depreciation cause inflation in the log run
• This would be very useful for Ireland during the
  current crisis Think of Iceland

16

• X rises following a depreciation (e falls)
• Price in of goods produced in Ireland falls
• Example furry leprechaun 5
• e1.4
• 1 gets 1.4
• leprechaun costs 51.47
• Depreciation e1.2 implies 1 get 1.2
• Cost is 51.26
• Sales rise

17
LRAS
p
SRAS(pe)
AD1
AD0
Y
Y
18
4. Competitiveness

• First step in explaining why BOP flows occur
• Q Why do people trade goods services across
  borders?
• Explaining the current account
• A Prices
• Countries with cheaper prices will tend to have
  current account surpluses
• Extra demand for their currencies
• Appreciating currencies

19
Prices (Competitiveness)

• Look in detail at the link between prices and
  exchange rates and their joint effect on output
• PPP equal value for money for goods and
  services.
• Prices of similar goods expressed in a common
  currency should be the same.
• Based on arbitrage. Buy cheap, sell expensive to
  make profit.
• Actions should lead to a convergence of prices
• How expensive is Ireland?

20
Absolute PPP

• Pirl ?? e Pw
• Prices, adjusted for the exchange rate, should be
  the same in different countries.
• Example Levi Jeans,
• Pirl 10 in Dublin,
• Pus 20 in New York.
• If e / 2 then PPP holds.
• If e ? 2, PPP does not hold.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
21
(No Transcript)
22
Real Exchange Rate

• Compare price levels of different countries
• In a common currency (usually US)
• Related to the concept of purchasing power parity
  (PPP)
• Law of one price
• Simple example is the Hamburger index
• What is the US price of a Big Mac in various
  countries
• PIRL PIRLe
• Is PIRL gtPUS

23

• What does this tell you?
• competitiveness
• Are one countrys goods cheaper than anothers?
• Do for all goods in a basket and calculate the
  ratio
• i.e. CPI or GDP or wages
• Look at R for Ireland over time
• Level doesnt tell much
• Trend does

24

• What is the effect of an increase in real e rate?
• competitiveness
• Our goods more expensive
• Their goods relatively cheaper
• Expect exports to fall and imports to rise
• Better off?
• What causes R to change
• e changes
• Prices change i.e. inflation can erode
  competitiveness
• productivity

25
PPP as an Economic Theory Under Fixed Exchange
Rates

• PPP becomes a theory of inflation.
• ?irl ?w - ? e
• If e is fixed, ?irl is determined by ?w.
• Ireland is a price taker on international
  markets.
• One of the main reasons for fixed e
• EMS EMU.
• Leads to currency crises when doesnt work!

26
Irelands Competitiveness

• How expensive is Ireland?
• Big mac index
• Economist magazine
• Balassa-Samuelson theory
• Expect richer countries to be more expensive
• Deviation from PPP because of non-tradable
• Susan O'Carroll thesis
• Real Effective E-rate
• Current situation
• Euro appreciated
• High but falling(?) costs

27
(No Transcript)
28
2000
29
2004
30
4. Capital Flows and Interest Rates

• Interest rates can be used to influence capital
  flows and therefore defend a currency.
• ieuro gt ius Capital inflow ? ? e
• ieuro lt ius Capital outflow ? ? e
• Usually used to prevent depreciation of the
  exchange rate.

31
Capital Account

• So far have paid most attention to current
  account
• Competitiveness affects current account and AD
• Historically this was the most important part of
  BOP
• Nowadays capital flows account for most BOP flows
• Recent phenomenon
• Capital controls were the norm until 1980

32
Interest Rate Parity

• Capital account is driven by differences in
  interest rates
• A comparison of domestic and foreign interest
  rates must allow for the expected change in the
  exchange rate.
• Compare a domestic (Eurozone) and a foreign (US)
  investment.
• Domestic investment (1 iez)
• 1,000(1 0.1) 1,100

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
33
Foreign Investment

• 1st January Convert into using the spot
  exchange rate et.
• Invest in the USA. Total return (1 ius).
• 31st December Convert the total return back
  into . (1/ee t1). Note it is the expected e as
  the exchange rate 12 months from now is unknown.
• US return measured in Euro is
• (1 ius)et/ee t1.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
34
Two Parts to the Foreign Investment

• 1. Interest rate.
• 2. Gain or loss on the foreign exchange market.
• Arbitrage should now ensure
• (1 iez) (1 ius)et/ee t1
• Rearrange
• (ee t1 - et)/et (ius - iez)/(1 iez)

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
35
Implications

• Difference between the future and current
  exchange rates equals the interest rate
  differential.
• If ius lt iez Expect depreciation
• If ius gt iez Expect appreciation
• The interest rate differential gives an
  indication of how the market expects the exchange
  rate to move.
• This is key to understanding currency crises

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
36
Implication Fixed e

• UIP gives another rationale for fixed exchange
  rates
• Interest rate will track that of the larger
  country
• With a single currency in the Eurozone, it is not
  possible for interest rates to diverge between
  countries.
• So as EMU comes closer interest rates will
  converge
• Eastern Europe now

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
37
Dutch, German, and Irish Interest Rates converged
as EMU approached and it was anticipated that E
would be irrevocably fixed
Irl
NL
D
38
(No Transcript)
39
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
40
Currency Crises

• UIP Competitiveness help explain how currency
  crises arise.
• Basic story
• Country in a recession with fixed e rate
• Markets expect that gov will devalue to boost AD
• Expectation of devaluation leads to higher
  interest rates
• Makes recession worse
• Speculators try to sell their holdings of the
  domestic currency
• Self fulfilling prophecy
• Devaluation usually but not always occurs.

41
EMS Crisis 1992

• Background to EMS
• Objective is to stabilise exchange rates.
• Reduce e uncertainty and thereby encourage
  international trade.
• Key point is that for the system to work, there
  must be similar inflation, interest rates and
  growth rates.
• In turn, this requires policy co-ordination
  (fiscal, monetary policies)
• Why?

42
EMS until 1992

• Seen as step on way to EMU
• Not fixed
• Limit movement to band of /- 2.25 around
  central rate
• Possible to adjust central rate
• 1979-87 numerous realignments mostly involving
  an appreciation of the DM. Ir devalued twice.
  March 1983 and August 1986.
• Usual reason no co-ordination of fiscal and
  monetary policies.
• 1987-92 no realignments. System was a success.
  Look forward to EMU.
• All ended with the currency crisis of September
  1992.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
43
Currency Crisis of 1992-93

• German unification in 1990 lead to huge budget
  deficit.
• Could not be financed by increasing taxes
• AD shifts right.
• Bundesbank raises interest rates to combat
  inflation
• ?i (by 3).
• AD shift to left
• Because of fixed exchange rates, the increase in
  interest rates was transmitted to rest of Europe
• The FP was not
• Everyone elses AD shifts left.
• Europe has recession (worse for UK)

44
Germany 1992
LRAS
p
SRAS(pe)
AD1
AD0
Y
Y
45
UK 1992
LRAS
SRAS(pe)
p
AD0
AD1
Y
Y
46

• However, the UK was in recession, needed lower
  not higher i.
• Speculators took view that DM/Stg e was not
  sustainable.
• Expect that gov will boost AD by devaluation
  and/or reduction in interest rates
• Attacked the currency.
• Try to sell stg and buy DM
• Situation becomes self re-enforcing
• As speculators fear a devaluation, sell stg
  (supply increases)
• CB has to use up more reserves
• Anticipation of devaluation pushes up int rates
  making recession worse, making devaluation more
  likely
• Conspiracy George Soros moves the market
• Black Wednesday.
• Bank of England spends 10b of reserves and then
  gives up
• Stg withdrawn from ERM.
• Immediately depreciated to low level.
• Speculators made a killing.
• Economy rebounds as AD pushed up
• Political death of gov

47
Stg/DM
E above market value. CB must buy with DM
S
e
D
billions
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
48
The Irish Pound and the Crisis of 1992-93

• Example of SOE
• Sterlings dropped EMS in September and the
  currency depreciated by 15
• Market attacked Irish Pound
• Likely that Irish pound was likely to be devalued
  to avoid competitive loss (AD curve shifts left)
• strangle Celtic tiger at birth
• U still high (12) so not credible to keep e
  overvalued
• Hence, funds flowed out of Ireland in
  anticipation of a devaluation of the Irish pound.
  
• Despite this severe misalignment, the government
  decided on this occasion to resist devaluation.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
49
(No Transcript)
50
Implications of the No Devaluation Stance

• If continued lead to recession
• e was overvalued
• i high in anticipation of devaluation
• Both shift AD to left
• The Central Banks external reserves fell from
  3.05 billion at the end of August to 1.07
  billion at the end of September, despite
  significant foreign borrowing.
• Short-term interest rates were raised to
  unprecedented heights to defend the currency from
  speculative attacks.
• One-month inter-bank interest rates peaked at 57
  per cent on 12 January 1993.
• Overnight interest rates on the Euro-Irish pound
  market rose to 1,000 per cent.
• The combination of an overvalued currency and
  penal interest rates was seriously damaging the
  Irish economy.
• Eventually had to devalue

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
51
(Wrong)Arguments against Devaluation

• There was no guarantee that the devaluation would
  be accepted by the markets. There would be no
  significant inflow of funds and interest rates
  would not fall.
• The currency was not overvalued.
• Speculators could not be allowed to destroy the
  ERM, which was regarded as the stepping stone to
  EMU.
• It was the governments desire to break our
  dependence on the UK and become a hard-core EMS
  country.
• Devaluation was ineffective as it resulted in
  only a short-term competitive gain.
• The rise in prices could lead to higher wage
  demands resulting in a wage-price spiral.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
52
The Alternative to Devaluation

• The over-valuation of the sterling/Irish pound
  exchange rate results in a loss of
  competitiveness relative to the UK and this
  reduces Irish exports and increases imports.
• This shifts the aggregate demand (AD) curve down
  to the left.
• Real wages increase because the inflation rate
  falls while the nominal wage remains unchanged.
• If workers were to accept a cut wages nominal
  wages so as to restore the original real wage,
  the aggregate supply (AS) curve would move down
  to the right.
• The economy would return to the natural real
  growth rate.
• Same argument as with any recessionary shock
• Workers are not any worse off because the
  original real wage has been restored.
• Devaluation is easier to implement

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
53
Ireland 1992
LRAS
SRAS(pe)
p
AD0
AD1
Y
Y
54
Summary

• All crises have a common structure
• Start with a problem in the real economy
• Asymmetric shock
• AD is low, recession or danger of one
• e is fixed but over-valued (current deficit)
• Reasonable to expect it to fall in a free market
• Self re-enforcing process of capital flows
• UIP causes i to rise (making recession worse)
• Cap outflows
• Downward pressure on e
• Eventually reserves depleted an e rate cannot be
  maintained
• Conspiracy?
• Market size

55
EMU

• EMU is fixed e rate regime
• But more difficult to leave so more credible
• Economic Single market in persons, goods,
  services and capital.
• Single currency and CB.
• European Central Bank (ECB) responsible for
  monetary policy (money supply, interest rates,
  inflation).
• Liberalisation of all capital (money, equity)
  markets and transactions.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
56
Economic Benefits

• Price transparency.
• Should lead to a convergence of prices in
  Eurozone.
• Indirect taxes still a serious problem.
• Elimination of exchange rate transaction costs.
• Savings of about 0.5 of GDP.
• Reduction in exchange rate uncertainty.
• Should stimulate trade and investment.
• But little evidence to support this view. Trade
  between USA and Japan has grown dramatically even
  though the exchange rate is flexible.
• 80 of Irish trade is outside the Eurozone.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
57

• Scale economies.
• Firms spread plants around Europe to hedge
  against currency movements. Now build plants to
  reap economies of scale.
• Lead to regional specialisation and an efficiency
  gain.
• Low inflation.
• In effect, Irish inflation is determined by the
  German rate.
• Argued that this is better than an anti-inflation
  policy based on internal rules (doing it for
  ourselves).
• Note that Ireland had achieved a low inflation
  rate prior to EMU entry.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
58
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
59

• Low interest rates.
• Given the single currency, there can be only one
  interest rate in the Eurozone.
• The current rate represents a significant fall
  for high interest rate countries like Ireland,
  Spain, Portugal and Italy.
• In 2002, real interest rates are negative in
  several Eurozone countries.
• Represents a transfer of resources from savers to
  borrowers.
• Also major implications for macroeconomy bubble?

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
60
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
61
Costs

• Problem of adjustment within a monetary union.
• With any fixed e regime
• Economy cannot have currency crisis but can
  suffer asymmetric shocks.
• Think of the 1992 crisis if had EMU at the time
• German interest rates would have spread to rest
  of Europe causing recession
• No currency crisis but still a recession
• No opportunity to use MP
• No opportunity to use e rate
• Little opportunity to use FP (Stability and
  Growth pact)
• Rely on the self adjustment mechanism
  flexibilty

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
62

• EMU results in a loss of economic independence.
• No longer have control over interest rates or the
  exchange rate.
• Fiscal policy is constrained by the Growth and
  Stability Pact.
• Burden of adjustment switches from monetary and
  fiscal policy to the wage adjustment effect
• But the labour market is much less flexible than
  the money market.
• Result is that the economy may be slow to adjust.
• Obviously relevant to the current situation
• Currency crisis in absence of EMU
• Shorter recession

? Leddin and Walsh Macroeconomy of the Eurozone,
2003