Exchange rates and exchange rate regimes International Finance

Lecture outline  The notion of the exchange rate  Types of exchange rate regimes  Types of exchange rate  The equilibrium on the currency market International Finance

Exchange rate  The price of one currency expressed in another currency  Direct quotation – the price of the foreign currency expressed in domestic currency  Indirect quotation the price of the domestic currency expressed in foreign currency International Finance

Types of ER regimes  Free floating/ Managed floating  Crawling band  Crawling peg  Fixed band  Fixed ER (hard peg)  Currency board  Monetary union International Finance

Free floating  A currency’s ER may fluctuate free versus other currencies ER  A currency’s exchange rate is determined by the demand and supply  Managed floating- central bank interventions  Examples  the majority of key currencies: EUR, USD, GBP, JPY, CHF International Finance

Crawling band  The ER fluctuates within a band around a central parity, the band is adjusted periodically at a preset rate  Examples  CLP (Chile), COP (Columbia), VEB (Venezuela) International Finance

Fixed band system  The ER may fluctuate within a fixed band around the central parity  Example:  ERM/ERM II- a system aimed at stabilizing the ER of euro area candidate countries International Finance

Crawling peg  The ER is fixed at a central parity, the parity is periodically adjusted at a preset rate  Example:  RMB (China) International Finance

Fixed ER (hard peg)  The ER is pegged to another currency, to a basket of currencies or to another value e.g. gold  Example:  RMB (China) till 2005 – currency pegged to USD International Finance

Currency board system  The ER is pegged to a foreign currency at a set and fixed exchange rate  The domestic monetary base issuance is 100% backed by reserves of the foreign anchor currency  Examples: LTL (Lithuania), EEK (Estonia)– pegged to EUR  HKD (Hong Kong), BMD (Bermuda) – pegged to USD International Finance

Monetary union  Two or more states using the same currency  Unilateral and multilateral monetary union  Unilateral - euroisation, dollarisation  Multilateral- EMU International Finance

„De iure” and „de facto” classification  Free floating- mostly developed economies  Peg to the EUR- 40 countries  Peg to the USD- 70 countries International Finance

Advantages and disatvantages of floating  Adjustment of the balance of payments +  Adjustment after shocks +  Volatility concerning foreign trade and investment –  The fear of floating – International Finance

Advantages and disatvantages of pegs  Stability concerning foreign trade and investment +  Possibility to „import” monetary stability + Higher risk of speculative attacks –  Constraint for the domestic economic policy-  The need of large reserves – International Finance

Impossible trinity International Finance

No single currency regime is right for all countries or at all times. J.A. Frankel International Finance

Exchange rate regime choices  Estonia  Argentina  China

Estonia  Currency board  ER pegged to DEM, since 1999 to EUR  Reasons for CB introduction in Estonia  Inflation up to 300% in the early 90-ties  Small open economy- outward oriented economic policy  Goal the join the EU (later the euro area) International Finance

Estonia- CPI Source: Estonian Central Bank International Finance

Argentina  Currency board  ER pegged to USD  Reasons for introduction:  Hyperinflation till 1990  Large macroeconomic imbalances International Finance

Argentina Results:  Monetary stability achieved  External shocks- liquidity crunch- late 90-ties  Overvalued peso due to wrong peg  Floating since 2002-extreme depreciation of the peso International Finance

China  Fixed ER  peg against the USD  Export oriented strategy  switching from the USD peg to a basket crawling peg  Reasons for switching  RMB undervalued  Large global imbalances International Finance

 Revaluation of the RMB  Gradual movement towards more flexible ER  Lifting capital controls Source: IMF International Finance

Types of exchange rate  Nominal and real ER  Nominal ER- the price of a currency expressed in a foreign currency  Real ER - the price of commodities of one country expressed in prices of foreign commodities -ratio of the domestic price level and the foreign price level International Finance

Types of ER  Billateral and effective  Billateral- the price of a currency expressed in a foreign currency  Effective- ER weighted with the shares of trade partners in the whole foreign trade International Finance

Equlibrium on the currency market  The state of equilibrium is reached when the supply of a foreign currency equals the demand for this currency  Appreciation / Depreciation  Revaluation / Devaluation International Finance

Depreciation and appreciation

Demand and supply on the FX market  Companies involved in foreign trade  Foreign investors  Central banks International Finance

A French investor buys Japanese stock International Finance

An American company buys products from the EU International Finance

Factors determining the exchange rate in the short term  Fundamental economic values  Trends  Events International Finance

Fundamental economic values  GDP growth rate  Interest rates  Prices International Finance

Growth rate International Finance

Interest rate International Finance

The interest rate parity theory  The FX market reaches equilibrium if the deposits in all currencies command the same expected rate of return  i USD =i EUR + (ER e EUR -E e USD )/E USD/EUR International Finance

The interest rate parity theory Example:  i USD =10%, i EUR = 6%  Expected 8% USD depreciation p.a.  the expected rate of return in EUR is 4% higher than in USD  higher demand for EUR  unequlibrium  ER changes International Finance

The interest rate parity theory  If i USD > i EUR   USD appreciates  If i USD < i EUR  USD depreciates International Finance

Prices International Finance

Trends  Inflationary path  Fiscal developments  Expectations  Example:  PLN - introduction of direct inflation targeting  appreciation of PLN International Finance

Events  Sudden decisions concerning economic policy  Market psychology  Example:  Hungarian ER regime switch  depreciation of HUF + market psychology  depreciation of all currencies in the region International Finance

Summing up  ER regime choice depends on the features of the economy  No ER regime is right for all countries or at all times  Impossible trinity International Finance

Summing up  Equlibrium in the short term depends on market participants actions  Fundamental values  Trends  Events International Finance

References  P. Krugman, M.Obstfeld, International economics: theory and policy. Part II, Pearson, Addison Wesley, Boston 2009  A. Budnikowski, Międzynarodowe stosunki gospodarcze, PWE, Warszawa 2004  J. Frankel, No single currency regime is right for all countries or at all times, Essays in International Finance, International Finance