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3 Fixed Exchange Rates: Policy Effectiveness B. of C. committed to maintaining value of exchange rate Consider case: If B. of C. commitment to fixed exchange rate credible [E*(e) – E*]/E* = 0 B. of C. loses control over R – any attempt to change R with no change in values of other variables, will impact E* Covered interest rate parity model: –R(C) = R(US) + since B. of C. considered credible –If R(C) –M determined by need to maintain R(C) = R(US) + and E* fixed –Monetary policy loses effectiveness with fixed exchange rates
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Lecture 10: February 10Ch. 20, 21
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Fixed Exchange Rates: Policy Effectiveness
• B. of C. committed to maintaining value of exchange rate• Consider case:
• If B. of C. commitment to fixed exchange rate credible [E*(e) – E*]/E* = 0
• B. of C. loses control over R – any attempt to change R with no change in values of other variables, will impact E*
• Covered interest rate parity model:– R(C) = R(US) + since B. of C. considered credible– If R(C) – M determined by need to maintain R(C) = R(US) + and E* fixed – Monetary policy loses effectiveness with fixed exchange rates
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Fixed Exchange Rates: Policy Effectiveness
• B. of C. committed to maintaining value of exchange rate• Consider case: • Traditional D/S model
in D for C$, in S of C$– In absence of intervention, C$ depreciates in value (E)– To keep exchange rate constant, B. of C. either M R or intervenes
directly and buys C$ (sells foreign assets)– Consider direct intervention: requirement for foreign asset reserves
• Problem: can B. of C. persist in buying C$? • Traders expect depreciation, so S of C$ compounds problem for B. of C.
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E
Q(C$)
D for C$: exports
S of C$: imports
Direct Intervention: Sell foreign assets
E0
SD
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Fixed Exchange Rates
• Speculative attacks– Reserves– No-lose bets: short the exchange rate, short debt– Soros and UK pounds in early 1990s
• Loans in foreign currency (US$, Euro, Yen)– Forced devaluation – domestic currency costs of loan interest and
principal payments increase– Default – problems for domestic banks
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Flexible Exchange Rates
• Independent monetary policy – not constrained by need to keep exchange rate fixed at particular level– Fiscal policy ineffective
• Expansionary policy R E EX and IM aggregate demand• Combination of higher interest rates and appreciation of C$ neutralize
expansionary effects of fiscal policy• Ignoring effects on P and repercussions on aggregate D
• Degree of independence– US M to stimulate economy and reduce UR (Canadian policy-makers
likely to have same objective)• US actions will lead to appreciation of C$ ( in US GDP Canadian CU;
and R(US) Canadian CA); which will reduce positive spillover effect from US
• Flexible rates will require B. of C. to follow lead of US Federal Reserve
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Flexible Exchange Rates
• Automatic stabilizer– Increase in rate of inflation in US
• R(C) = R(US) + [E*(e)-E*]/E* + • [E*(e)-E*]/E* = % E*(e) = %P(C) - %P(US)• Assume %P(C) = %P(US) = % P(D) = initially %E*(e) = 0• Now assume %P(US) %E*(e) < 0 E* (appreciation)
• P(C) = P(D)[P(US)E*]1- %P(C) = %P(D) + (1- )[%P(US) + %E*(e)]
• % P(C) = • If % P(US) %E* offsetting impact on %P(C)
– With fixed exchange rates• If % P(US) %P(C)
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Dollarization
• Problems with flexible exchange rates– Effectiveness of
independent monetary policy
– Trade costs – Competitiveness – Demand for bail-outs– Instability of foreign
exchange markets: tendency to overshoot
– 78.5% appreciation in 5 years
• Problems with Dollarization– Loss of independent m.p.– Loss of automatic stabilizer– Economic performance and
sovereignty
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Diversification
• Risk reduction– Same expected return, lower risk for portfolio– Higher expected return, same degree of risk– Risk aversion
• Risks:– Default – Price variability– Exchange rate– Imperfect information
• Insurance markets – financial and non-financial risks:– Spread risks: re-insurance, insurance pools– Pooling of risks: insurance pools– Derivatives
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Offshore Banking and Eurocurrencies• Offshore banking
– Business conducted by the foreign branches, subsidiaries of a bank outside the home country of the bank
• Eurocurrencies– Bank deposits denominated in a currency other than the domestic
currency of the country in which the bank or its foreign operations reside• Offshore currencies• Typical Eurocurrency deposit is non-negotiable time deposit with fixed term to
maturity ranging from overnight to 5+ years • US$ deposits in a bank in Canada (Canadian, US, other) – part of Eurodollars
– Eurodollars: US $ deposits in banks outside US • C$ deposits in a bank outside of Canada (Canadian, other)
– Eurobanks: banks that trade in market for Eurocurrencies – take deposits, make loans
• Most Eurocurrency trading occurs in non-European centers
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Eurocurrencies
• Euro-deposit rates – 3 months
08/26/09 08/24/08 07/14/08
U.S. 0.30% 5.48% 2.81%
Canada 0.50 4.83 3.20
Euro 0.84 4.65 4.90
Yen 0.28 0.97 0.87
Pound 0.52 6.49 5.65
Euro Deposit Rates Today
3-month rates:US: 0.35%Canada: 1.35%Euro: 1.33%Yen: 0.10%Pound: 0.96%
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Rapid Growth of International Banking
• Reduction in trade costs growth in international trade– Hedging currency risks
• Liberalization of capital markets– Growth of MNEs – banks have followed corporate customers abroad
• Circumvent restrictive domestic government regulations on financial activity – reserve requirements, interest rate ceilings, deposit insurance
• Political factors – desire by some depositors to hold currencies outside jurisdiction of countries that issue them – freezing accounts
• Money laundering – drugs, arms sales, bribes, other criminal activities
