Special Topics in Economics Econ. 491 Chapter 5: Exchange Rate Policy

I. Foreign Exchange Market  Foreign Exchange Market: A market in which trading of currency and bank deposits denominated in particular currencies takes place.  There are 2 kinds of exchange rate transactions: 1. Spot Transactions: involve the immediate (two-day) exchange of bank deposits. 2. Forward Transactions: involve the exchange of bank deposits at some specified future date.

 There are 2 kinds of exchange rates: 1. Spot Exchange Rate: is the exchange rate for the spot transaction. 2. Forward Exchange Rate: is the exchange rate for the forward transaction.

How is Foreign Exchange Traded?  The foreign exchange market is organized as an over the counter market.  There are several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies.

II. The Demand & Supply in the Foreign Exchange Market  Simple standard demand & supply framework to analyze the foreign exchange market.

II.i Under Flexible Rate Regime  Demand for & supply of each currency in the foreign exchange market determine the exchange rate.

Case One: Consider R= 0.5  A shortage of foreign exchange would cause individuals to bid up its price as they offer to buy Euro denominated deposits in exchange for dollar-denominated ones. Case Two: Consider R= 1.5 Case Two: Consider R= 1.5 A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones. A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones. Result: The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign exchange market clears.

II.ii Under Fixed Rate Regime  The pegged or fixed exchange rate is a practice that works much like fixing the price of any good.  Demand & supply of foreign exchange still exist, but do not determine the exchange rate as they would in the flexible regime.  Central banks must stand ready to absorb any excess demand for or supply of a currency to maintain the pegged rate.  Central banks must step into the market, such action called a policy of intervention in the foreign exchange market.

 Case One: Suppose the US government decides to peg the exchange rate between dollars & Euros at 1.5  Case Two: Suppose the US government decides to peg the exchange rate between dollars & Euros at 0.5

Case One: Consider R= 1.5  The quantity supplied of euro exceeds the quantity demanded. Dollar denominated deposits are more attractive relative to the euro ones. Thus, surplus of euro in the foreign exchange market at (R=1.5) creates a tendency for the exchange rate to fall as individuals try to sell euro deposits in exchange for dollar ones.  As a result, US Fed steps in to buy up the surplus euro denominated deposits(individuals sell euro denominated deposits to the Fed in return for dollar ones at R=1.5).  The distance between points B and G at R=1.5 represents the level of required intervention.  What is the case of revaluation of the dollar?

Case Two: Consider R= 0.5 A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones. A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones. Result: The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign exchange market clears.

Case Two: Consider R= 0.5  The quantity demanded for euro exceeds the quantity supplied. Euro denominated deposits are more attractive relative to the Dollar ones. Thus, shortage of euro in the foreign exchange market at (R=0.5) creates a tendency for the exchange rate to increase as individuals try to buy euro deposits in exchange for dollar ones.  As a result, US Fed steps in to sell euro denominated deposits (from where Fed has them ) by buying dollar denominated deposits.  The distance between points H and C at R=0.5 represents the level of required intervention.  What is the case of devaluation of the dollar? Case Two: Consider R= 0.5 Case Two: Consider R= 0.5 A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones. A surplus of foreign exchange would cause the price to fall as individuals offered to sell Euro denominated deposits in exchange for dollar-denominated ones. Result: The price of mechanism equates the quantity demanded of each currency with the quantity supplied, thus the foreign exchange market clears.

III. Classification of Exchange Rate Arrangements  The existing literature on regime choices has usually used the International Monetary Fund’s classification of exchange rate regimes.  Prior to 1999, member countries of the IMF declared their exchange rate policies to the IMF according to their official or de jure exchange rate arrangements.  The former IMF classification identifies three major exchange rate arrangements: fixed policies, limited flexibility policies (fluctuated within a range), and more flexible policies (either managed or free float).

 However, the former IMF exchange rate classification does not distinguish between the announced exchange rate policy (de jure exchange rate) and the actual exchange rate policy (de facto exchange rate) undertaken by the country.  Another drawback of the pre-1999 classification is that it does not distinguish between the varieties of fixed exchange rate regimes.

 The new IMF classification distinguishes between various pegging policies and also distinguishes between eight categories ranging from hard peg regimes to free floating regimes: Exchange Rate RegimeDescription 1. No Separate Lender Tenderi.e., Formal dollarization 2. Currency Board Fixed to a specific foreign currency at a fixed rate 3. Conventional Fixed Pegs Fixed to a single currency or a basket of currencies as with band at most +/- 1% 4. Fixed Within Horizontal BandsFixed with bands at least +/- 1% 5. Crawling Pegs Fixed with central parity periodically adjusted in small amount at fixed rate or in response to changes in selective quantitative indicators 6. Crawling Bands Crawling peg associated with bands at least +/- 1% 7. Managed Floating Influencing the exchange rate without a specific target or pre- announced path of the exchange rate 8. Independently Floating Determining exchange rate through the market Table: The Revised IMF Classification of Exchange Rate Arrangements Source: IMF Exchange Rate Classification (1999)