PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 28 International Dimensions of Monetary Policy

Copyright © 2004 South-Western. All rights reserved.28–2 Fundamental Issues 1.What are the pros and cons of fixed versus floating exchange rates? 2.What is the monetary approach to exchange rate determination? 3.What is the portfolio approach to exchange rate determination? 4.How effective are foreign-exchange-market interventions?

Copyright © 2004 South-Western. All rights reserved.28–3 Fixed versus Floating Exchange Rates An Argument for Fixed Exchange Rates  Hedging:  Adopting strategies intended to offset the risk arising from exchange rate variations.  Hedging against foreign exchange risks is not costless can entail taking potentially risky positions that increase exposure of other kinds of risk if market conditions change unexpectedly.  Fixing exchange rates:  Eliminates hedging costs.  Rate variability is greatly diminished when exchange rates are fixed.  Defeats the exchange rates’ “shock absorber” effect.

Copyright © 2004 South-Western. All rights reserved.28–4 Monetary Union Optimal currency area:  A region within which fixed exchange rates can be maintained without inhibiting prompt internal adjustments of employment and output to changes in international market conditions. Reasons favoring a monetary union:  Reduced hedging and conversion costs.  Increased mobility.

Copyright © 2004 South-Western. All rights reserved.28–5 Monetary Union? (cont’d) Reasons against a monetary union  Residents are sufficiently averse to giving up sovereignty.  National governments would lose seigniorage revenues that they could not recoup via other sources of taxation.  The countries fear that the loss of currency competition could remove restraints on inflationary policymaking.

Copyright © 2004 South-Western. All rights reserved.28–6 Average Annual Rates of Seigniorage Relative to Gross Domestic Product and Government Expenditures Table 28–1 Seigniorage as a Seigniorage asPercentage of a PercentageGovernment Countryof GDPSpending New Zealand Denmark United States Kuwait United Kingdom France Germany Japan Kenya Sri Lanka Korea India Spain Colombia Uganda Brazil Costa Rica Mexico Bolivia Iran Nicaragua Yugoslavia Israel SOURCE: Reid Click, “Seigniorage in a Cross- Section of Countries,” Journal of Money, Credit, and Banking 30 (May 1998): 154–171.

Copyright © 2004 South-Western. All rights reserved.28–7 Foreign-Exchange-Market Interventions Foreign-exchange-market intervention:  A central bank purchase or sale of foreign-currency reserves in an effort to alter the value of its nation’s currency. Domestic credit:  A central bank’s holdings of domestic securities.

Copyright © 2004 South-Western. All rights reserved.28–8 Intervening in the Foreign Exchange Market to Peg the Exchange Rate Figure 28–1

Copyright © 2004 South-Western. All rights reserved.28–9 A Simplified Central Bank Balance Sheet Figure 28–2

Copyright © 2004 South-Western. All rights reserved.28–10 Foreign Exchange Sterilization:  A central bank action to prevent variations in its foreign exchange reserves from affecting the monetary base. Monetary approach:  A theory of exchange rate determination that predicts that the fundamental determination of a nation’s exchange rate is the quantity of money supplied by its central bank.

Copyright © 2004 South-Western. All rights reserved.28–11 The Monetary Approach to Exchange Rate Determination

Copyright © 2004 South-Western. All rights reserved.28–12 Effects of a Sterilized Foreign-Exchange- Market Intervention under the Monetary Approach to Exchange Rate Determination Figure 28–3

Copyright © 2004 South-Western. All rights reserved.28–13 The Portfolio Approach to Evaluating the Effects of Foreign-Exchange-Market Interventions Portfolio approach:  A theory of exchange rate determination that predicts that a nation’s exchange rate adjusts to ensure that its residents are satisfied with their allocation of wealth among holdings of domestic money, domestic bonds, and foreign bonds.  The portfolio approach to exchange rate determination:

Copyright © 2004 South-Western. All rights reserved.28–14 The Portfolio Approach to Evaluating the Effects of Foreign-Exchange-Market Interventions (cont’d) Portfolio-balance effect:  A fundamental prediction of the portfolio approach to exchange rate determination, in which changes in central bank holdings of domestic and foreign bonds alter the equilibrium prices at which traders are willing to hold these bonds, inducing a change in the exchange rate.

Copyright © 2004 South-Western. All rights reserved.28–15 The Portfolio Approach to Evaluating the Effects of Foreign-Exchange-Market Interventions (cont’d) Announcement effect:  A change in the exchange rate resulting from an anticipation of near-term changes in foreign- exchange-market conditions signaled by an intervention by a central bank.

Copyright © 2004 South-Western. All rights reserved.28–16 Evidence on the Effects of Foreign- Exchange-Market Interventions Short-run effects of interventions:  Announcements of coordinated multinational interventions have the most short-run effects. The big foreign-exchange-market interventions of the 1980s Long-term effects of interventions:  Were sporadic and highly variable.  Added to market instability.  Exposed interveners to increase risk.

Copyright © 2004 South-Western. All rights reserved.28–17 Combined U.S., German, and Japanese Interventions, February 1985– August 1989 Figure 28–4 SOURCES: Michael Bordo and Anna Schwartz, “What Has Foreign Exchange Market Intervention since the Plaza Agreement Accomplished?” Open Economies Review 2 (1991): 39–64.

Copyright © 2004 South-Western. All rights reserved.28–18 Falling Inflation Rates and Debt-Equity Ratios in Selected Nations Figure 28–5 SOURCES: Dale Gray and Mark Stone, “Corporate Balance Sheets and Macroeconomic Policy,” Finance and Development, World Bank, September 1999, pp. 56–59; Stijn Claessens, Simeon Djankov, and Larry Lang, “East Asian Corporates: Growth, Financing, and Risks,” World Bank, October 27, 1999; International Monetary Fund, World Economic Outlook, various issues.