1. Exchange-Rate Systems and Currency Crises
Chapter 15
Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

2. Exchange Rate Systems
1) fixed rate a) also known as pegged exchange rate b) anchored to the value of one other currency or a group of currencies
2) floating rate a) determined by market forces b) float independently or with a group
of other currencies

3. IMF Principles
1) Member nations must avoid manipulating exchange rates in order to impact balance of payments
2) Members should intervene to counteract disruptive short term exchange rate movements
3) Members should take into account the impact of intervention policies on other members

4. Impossible Trinity
It is not possible for a country to maintain all three of the following:
free capital flows
a fixed exchange rate
independent monetary authority

5. Impossible Trinity (continued)
A country can choose any two of the three:

6. Impossible Trinity (examples)
1) U.S. allows free flow of capital & maintains monetary authority but does not have a fixed exchange rate
2) Hong Kong has a fixed exchange rate & allows free flow of capital but does not have independent monetary authority
3) In the past, China had a fixed and maintained monetary authority but did not allow the free flow of capital

7. Fixed Exchange Rates a means of international settlement
Fixed exchange rates are the norm for developing economies. By tying their currencies to a key currency – that of a larger, more developed nation they promote
a means of international settlement
stabile prices for imports/exports
limits on inflationary pressure

8. Fixed Exchange Rates (continued)
Under a fixed exchange rate system governments maintain
par value for their currencies
an official exchange rate determined by comparing par values
an exchange rate stabilization fund to buy and sell foreign currencies in order to preserve the official exchange rate

9. Preventing Depreciation
If the demand for the euro increased, the value of the euro would rise and the value of the dollar would fall.
In order to maintain the fixed exchange rate, the U.S. would use its reserve of euros to buy dollars.
Market for Euros D1 S1 P D2 S2
$1.70
$1.50 Q

10. Preventing Appreciation
If the supply of the euro increased, the value of the euro would fall and the value of the dollar would rise.
In order to maintain the fixed exchange rate, the U.S. would use dollars to buy euros.
Market for Euros D1 S1 P D2 S2
$1.50
$1.25 Q

11. Devaluation & Revaluation
legal reduction of a currency’s par value
market impact termed depreciation
counters a balance of payment deficit by making exports less expensive
Revaluation
legal increase of a currency’s par value
market impact termed appreciation
counters a balance of payment surplus by making imports less expensive

12. Bretton Woods System
response to crises of Great Depression when floating exchange rates had been unsuccessful
Bretton Woods created a semi-fixed system known as adjustable pegged exchange rates
currencies values tied to each other
nations to use fiscal and monetary policies first to address balance of payments disequilibria
last resort was to re-peg currencies; greater than 10% change required IMF permission

13. Floating Exchange Rates
also known as flexible exchange rates
equilibrium exchange rate determined by demand for and supply of home currency
changes in exchange rate correct payments imbalance by changing the effective cost of imports and exports
will not fluctuate erratically unless there is significant instability in financial markets

14. Depreciation & Exports
Market for Euros D1 S1
If real income in the U.S. increased, then demand for imports and demand for the euro would increase. The value of the euro would rise and the value of the dollar would fall. P D2
$1.70
$1.50 Q

15. Depreciation & Exports (cont.)
Since more dollars are required to purchase a euro, the dollar has depreciated.
As a result, U.S. goods will become less expensive to European citizens leading to more exports from the U.S.
European goods will become more expensive to U.S. citizens leading to fewer imports to the U.S.
$150 U.S. auto part
before $150 = 100 €
after $150 = 88.2 €
(150÷170)
100€ French wine
before 100 € = $150
after 100 € = $170

16. Appreciation & Imports
If real income in the U.S. declined, then demand for imports and demand for the euro would also decrease. The value of the euro would fall and the value of the dollar would rise.
Market for Euros P S1
$1.50
$1.25 D1 D2 Q

17. Appreciation & Imports (cont.)
Since fewer dollars are required to purchase a euro, the dollar has appreciated.
As a result, U.S. goods will become more expensive to European citizens leading to fewer exports from the U.S.
European goods will become less expensive to U.S. citizens leading to more imports to the U.S.
$150 U.S. auto part
before $150 = 100 €
after $150 = 120 €
(150/125)
100€ French wine
before 100 € = $150
after 100 € = $125

18. Arguments on Floating Exchange
Advantages Disadvantages
Fixed • simplicity and clarity of • loss of independent
exchange-rate target monetary policy
  • automatic rule for • vulnerable to
monetary policy speculative attacks
• controls inflation
Floating • continuous adjustment • conducive to
in balance of payments inflation
• simplified institutional • disorderly markets
arrangements can disrupt trade and investment patterns
  • independent monetary • reckless financial
and fiscal policies policies by government

19. Managed Floating System
intervention to stabilize rates in short run with market forces determining rates in long run
informal guidelines established by IMF
clean float – free-market forces of supply and demand determine equilibrium
dirty float – central banks intervene to promote depreciation of their currencies
leaning against the wind – intervention to reduce fluctuations in the short run only

20. Managed Float Example
permanent change in demand to D1 – exchange rate allowed to increase
temporary increase in demand - central bank sells francs while demand is D1 until return to D0

21. Monetary Policy if demand for pounds decreases
Fed increase MS lowering rates
decreasing demand for dollars
if demand for pounds increases
Fed decrease MS raising rates
increasing demand for dollars

22. Crawling Peg
uses small, frequent changes in par value to correct balance of payments disequilibria
primarily nations with high inflation
differs from adjustable pegged rates under which par values change infrequently
crawling peg is appropriate for developing nations but not for industrialized nations whose currencies provide international liquidity

23. Currency Crises also known as speculative attacks
weak currency depreciates significantly as a result of selling
can substantially reduce economic growth
usually ended by official devaluation or adoption of a floating rate
extreme cases => currency crashes

24. Causes of Currency Crises
speculation
deficit financed by inflation
weak financial systems
recent deregulation of financial markets
weak economic performance
political factors
external factors such as interest rates
choice of exchange rate system

25. Capital Controls also known as exchange controls
barriers to foreign savers investing in domestic assets
pro: government can control its balance of payments position and possibly prevent speculative attacks
con: weakened confidence in the government may actually cause an increase in capital outflows

26. Question of Foreign Exchange Tax
volatile capital movements lead to severe repercussions across economies
a tax on inflows or outflows would reduce the number of transaction based on short term speculation
such a tax would still allow market forces to influence investment and exchange rates over the long term
how much volatility is acceptable

27. Currency Board
monetary authority that issues notes convertible into a foreign anchor currency at a fixed rate
anchor currency chosen for stability and acceptability
government finance only by taxation and borrowing – not by printing money
implies elimination of discretionary monetary policy by domestic government

28. Case Study – Hong Kong
Hong Kong adopted a currency board system in 1983
U.S.$ = 7.75 to 7.85 HK$
reversed lack of confidence in the economy despite anticipation of control shifting from the U.K. to China
contributed to significant economic growth in Hong Kong; per capita real GDP of $37,300 ranks 13th of 216 nations

29. Case Study – Argentina
adopted currency board in 1991 to limit inflation
1 U.S.$ = 1 Argentine Peso
issues: dollar appreciated, U.S. interest rates rose, domestic commodity prices fell, and Brazil’s currency depreciated
U.S. fiscal & monetary policy ill suited to conditions in Argentina
results: deficits, borrowing, default and economic chaos

30. Dollarization
partial dollarization indicates use of the U.S. dollar alongside domestic currency
full dollarization indicates use of the dollar and elimination of domestic currency
benefits:
lower inflation
decreased transactions costs
greater openness

31. Effects of Dollarization
U.S. monetary policy would not necessarily be appropriate for a foreign economy
Federal Reserve is not the lender of last resort for that economy
loss of seigniorage which is the income that would have been derived from interest bearing foreign reserves