1. 03.28.2001Lecture NotesFinance 3191 Finance 319 Lecture 03.28.01 Course Website http://www.citi.umich/u/galka/319 Galina Albert Schwartz Department of Finance University of Michigan Business School

2. 03.28.2001Lecture NotesFinance 3192 Lecture Summary u Exchange rate intervention, Levich, Ch. 17, pp.661 -671 –History: coordinated interventions, direct & indirect channels –Sterilized vs. unsterilazed, pp. 35 – 37, 203, 661 – 663 u Euro: –A summary of relevant considerations & –A forecast attempt u Euro: –Why is it still low? Inverse bubble? »Strategic players »Self-sustaining market beliefs u Could the Knowledge of History Help?

3. 03.28.2001Lecture NotesFinance 3193 Today’s Citation: Your Wake Up Call! “It is often said that men are ruled by their imaginations; but it would be truer to say they are governed by the weakness of their imaginations,” Walter Bagehot (1826–77), English economist, critic. The English Constitution, ch. 2 (1867). Historical Curiosity: See URL: Lombard Street. A Description of the Money Market Lombard Street. A Description of the Money Market, by Walter Bagehot Quiz: What is Bagehot rule? (p.

4. 03.28.2001Lecture NotesFinance 3194 Central Bank Intervention u In general, currently: –It is more difficult to intervene when market volume is high – It is more difficult to intervene when markets are more united (i.e. less segmented) u U.S. Foreign Exchange Intervention U.S. Foreign Exchange Intervention –How often? –How predictable? –How sizable?

5. 03.28.2001Lecture NotesFinance 3195 Costs and Benefits of Intervention –Costs of intervention »Speculation »Volatility increase »  Real costs for a taxpayer –Benefits of intervention »Volatility decrease »Signaling of Monetary Policy »Currency Stabilization

6. 03.28.2001Lecture NotesFinance 3196 Sterilized vs Unsterilized Intervention, pp. 661 - 663 –Sterilized Intervention -- leaves domestic monetary base unaffected –Unsterilized – Central Bank buys / sells its currency to reach exchange rate depreciation / appreciation –Sterilized – Unsterilized combined with adjustment of the domestic monetary base to its pre-sterilization level »Means of offsetting monetary base: Central Bank u buys / sells Bonds, u changes interest rates

7. 03.28.2001Lecture NotesFinance 3197 Coordinated Interventions: Examples u The Plaza-Louvre Intervention Accords, pp. 35 –37 u Joint efforts to appreciate Euro (fall 2000) –Case for intervention (example of EURO): too far from the fundamental level »US, Japan, ECB »Implementation strategy: were they really hesitant? »Success or failure?

8. 03.28.2001Lecture NotesFinance 3198 Euro: PAST, current & future u Levich, Ch. 2, pp. 70 -72 u European Monetary Union European Monetary Union –Past Verdict: »Too many conflicts of political / cultural interests »Too diverse economic interests, performance, traditions »Too little incentives for cross-subsidization Thus, more CONS than PROS: EMU will not be born, or it will dye fast

9. 03.28.2001Lecture NotesFinance 3199 Euro: past, CURRENT & future u European Monetary Union European Monetary Union –Current Trends »Euro is too low (relative to fundamental level) »How to explain this? u Past Verdict is correct? u Market Participants are biased? u Are they ALL wrong?

10. 03.28.2001Lecture NotesFinance 31910 Euro: past, current & FUTURE u European Monetary Union European Monetary Union u Expectations: –Too early to judge, but »Capital markets: more mature »Trade volume – increased »Non-participating countries are still reluctant to join. Reflective of –history & –common sense (but not always)

11. 03.28.2001Lecture NotesFinance 31911 Euro: past, current & FUTURE (cont.) u European Monetary Union European Monetary Union u Is Current Trend self- contradictory? u To some degree u Explanations of current trend: –Market makers interests participants

12. 03.28.2001Lecture NotesFinance 31912 Summary of Today’s Lecture: Euro u Euro: More gains than was expected: –Capital market developments –Transaction costs savings –Price stability: final and intermediate goods –As time passes return to national currencies gets less likely

13. 03.28.2001Lecture NotesFinance 31913 Summary of Today’s Lecture: Central Bank Intervention u Central Bank Intervention is costly (& inevitably wasteful) means to correct market imperfections. To succeed: »Central bank has to have some advantage: u in information, u in ability to coordinate (to internalize externality), u in scale of operations »This advantage diminishes as markets get more mature

14. 03.28.2001Lecture NotesFinance 31914 Next Time u Swap: another asymmetric instrument –To read: Levich, ch. 13