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8/12/2019 Fins3616 - Lec - Week 2
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Week 2 Exchange Rate Systems
1. Exchange Rate Systems
2. History of Exchange Rate Systems
3. The Role of Central Banks
4. The Road to Monetary Integration in
Europe
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1. Given great demand of cross-border trade and investment,how do we exchange currencies?
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Exchange rate systems
Pegged or fixed exchange rate systems In pegged or fixed systems, governments maintain currency
values at official exchange rates.
Exchange rate changes are called devaluation (revaluation)when the currency falls (rises).
Floating exchange rate systems
Floating systems allow values to fluctuate according to supplyand demand, without direct interference by government
authorities. Exchange rate changes are called depreciation (appreciation)
when the currency falls (rises).
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Exchange rate systems around the World
Pegged or fixed exchange rate systems
Conventional fixed rate like Jordan and Saudi Arabia Target zones and crawling pegs like China
Currency board like Hong Kong
Floating exchange rate systems
Independently floating like the U.S., Japan, and Australia
Managed floating like Argentina and Brazil
No separate legal tender
Adopt the currency of another country. For example, Ecuadorand Panama use the US dollar, and Kiribati uses the Australiandollar.
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Distribution and Trend in exchange rate systems
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Exchange rates are determined by demand andsupply of a currency
E.g. if there is excess demand for US$ byAustralians, they will sell A$ and buy US$
What drives exchange rate in a freelyfloating system?
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Differences in income growth
Differences in inflation rate
Differences in real interest rate
Political and financial risks
Expectations and central bank reputation
Determinants of exchange rate in freelyfloating system
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Currency risks in exchange rate systems
Statistical measures of currency risk
Volatility and skewness
Currency risk in floating exchange rate systems
High volatility based on historical dataHistory provides data that indicates past currency volatility
Currency risk in pegged exchange rate system
Zero volatility based on historical data
The true currency risk does not show up in day-to-day fluctuations ofthe exchange rate (latent risk)
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2. The history of exchange rate system
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Major events in the history of FX rates
1946 Bretton Woods Conference
IMF was created
1971 Exchange rate turmoilbegins the modern era offloating exchange rates
Jamaica Agreement (1976)European Monetary System (1979)
1991 Treaty of Maastricht
Introduction of the euro (1999)
Euro begins public circulation (2002)
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Recent currency crises
Mexicanpeso crisis of 1995
Asiancontagion of 1997
Russianruble crisis in 1998 Brazilianreal crisis in 1998
Argentinianpeso crisis of 2002
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Asian currency values: $/unit(Dec 1996 = 1.00)
Koreanwon
Thai baht
Indonesianrupiah
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Currency crises
Contributing factors in each crisis-A fixed or pegged exchange rate system that overvalued
the local currency
-A large amount of foreign currency debt
Consequences of currency crises
- Currency crises have a pronounced negative short-termimpact on the local economy
-A market-based exchange rate can have an invigoratinglong-term impact on the local economy and on the localstock market
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The debate over IMF lending
Proponents of IMF lending policies believe- Short term loans help countries overcome temporary financial
crises
Critics of IMF lending believe
- Fiscal constraints and capital market liberalizations increaseeconomic and financial risks
- IMF loans can leave a legacy of debt that can last for decades
- IMF loans are often spent trying to support an unsustainable
exchange rate- IMF remedies benefit developed countries and not the country
in crisis
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3. How are exchange rate systems controlled?--The role of central banks
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The central bank
To understand how the exchange rate systems operate, you must
first understand the functioning of central banks.
Assets
Official international reserves
Domestic credit
Government bonds
Loans to domestic financial institutions
Other
Liabilities
Deposits of private financial institution
Currency in circulation
Other
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The central banks balance sheet
Official international reserves
Foreign exchange reserves (86%)
Gold reserves (14%)
Domestic credit
The purchase or sales of government bonds by the centralbanks are used to influence the money supply
Loans to domestic financial institutions are important intimes of panic and financial crisis
Deposits of private financial institution (bank reserves)
Countries require their commercial banks to hold a certain
percentage of the deposits the banks accept from thepublic
Currency in circulation
The coins and bills are used by the public
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Questions:
Let us assume 1 A$= 1 US$
---Reserve Bank of Australia buys A$5 billion Australian government
bonds. What is the outcome on the Australian dollar? What about the
impact on inflation in Australia?
--Reserve Bank of Australia buys US$5 billion US government
bonds. What is the outcome on the Australian dollar? What
about the impact on inflation in Australia?
--Reserve Bank of Australia buys US$5 billion US government bondsand sells A$5 billion Australian government bonds. What is the
outcome on the Australian dollar? What about the impact on inflation
in Australia?
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Foreign exchange rate intervention
Central banks intervene in foreign exchange markets to affectexchange rates directly
By supplying domestic currency, central banks weaken thevalue of domestic currency.
By demanding domestic currency, central banks strengthen thevalue of domestic currency.
Two methods of foreign exchange rate intervention
Non-sterilized interventions (currency value and inflation) Sterilized interventions (currency value)
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4. The road to monetary integration in Europe
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The desire of a stable currency system in Europe
The desire for currency stability in Europe is extremely strong
Western European countries are open to foreign trade andtheir trading partners are their neighboring countries
Facilitate the operation of a common market for agriculturalproducts
Achieve the integral part of the wider drive toward economic,monetary, and political union among European countries
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Was the European Monetary System successful?
Day-to-day variability was down
Large revaluations did occur due to a currency crisis
from 1992-1993
Inflation and interest differentials narrowed
Could have been due to hard currency policies
Asymmetric adjustments
Central role of Germany; others maintained stable rate oftheir currency around Germany
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The Maastricht Treaty and the EuroIn 1991, the European heads of state met in Maastricht in theNetherlands to map out the road to economic and monetary union
with a single currency to be reached by 1999Criteria
Inflation within 1.5% of 3 best performing countries
Interest rate on long-term government bonds within 2% ofthose of 3 best-performing countries
A budget deficit to GDP
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Euro Zone (2013)
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Euro value from Jan. 1999 to Jan. 2008
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Pros and Cons of the monetary union
Potential pros: enhanced price transparency, lower transaction
costs, no exchange rate uncertainty, enhanced competitioncould promote trade and economic growth
Potential cons: loss of independent monetary policy. It is bad ifcountry is in a bad stage and none of the other countries are.
For example, Greece in global recession, 2010
Debates: research does not agree on whether or not theEU is particularly well suited to be a monetary union but inthe end, the verdict is still out