EC 380: Lecture 18

.title[
# EC 380: Lecture 18
]
.subtitle[
## Global Finance: Exchange Rate Policies
]
.author[
### Philip Economides
]
.date[
### Winter 2023
]

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# Prologue

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# Recap

<br>

* FX market mechanisms in the medium run driven by business cycles

* Short run variation in exchange rate attributed to monetary policy and speculation

* Parity relationships allow us to identify breakeven points at which investment decisions are made

### Today

* ExR Systems and single currency areas

---

# Topics

<br>

* Reasons for holding foreign reserves, main institutions

* Effect of `$\Delta S, \Delta D$` of foreign currency on home currency

* Identify short, medium and long term forces that affect currency value

* __Three rules of gold standard__

* Compare and contrast various exchange rate systems

* Price changes and real exchange rate interactions

* List conditions necessary to form single currency area

---

# Fixed Exchange Rates

Several possibilities for setting the value of the country’s currency.

One option is to keep the exchange rate constant, or __fixed__.

Also called .hi-pink[pegged exchange rate] systems.

Small countries often give up control over their currency and adopt the currency of another country, usually the dollar or the euro.

More commonly, the value of a nation’s money is set equal to a fixed amount of another country’s currency, or less commonly to a basket of several currencies.

If the exchange rate is not allowed to vary, then it is called a .hi-pink[hard peg].

---

# Fixed Exchange Rates

<br>

Fixed exchange rates that fluctuate within a set band are .hi-pink[soft pegs] and these, in turn, can take several forms depending on the amount of variation allowed.

<table class="table" style="font-size: 18px; margin-left: auto; margin-right: auto;">
 <thead>
  <tr>
   <th style="text-align:left;"> Currency Regime </th>
   <th style="text-align:right;"> Countries </th>
  </tr>
 </thead>
<tbody>
  <tr>
   <td style="text-align:left;"> Hard pegs </td>
   <td style="text-align:right;"> 24 </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Soft pegs </td>
   <td style="text-align:right;"> 88 </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Managed floating </td>
   <td style="text-align:right;"> 35 </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Independently floating </td>
   <td style="text-align:right;"> 30 </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Other </td>
   <td style="text-align:right;"> 13 </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Total </td>
   <td style="text-align:right;"> 190 </td>
  </tr>
</tbody>
</table>

---

# Gold Standard

<br>

Historically, fixed exchange rates were the norm, often within framework that defined the value of a country’s currency in terms of a .hi-pink[fixed amount of gold].

After WWII, many nations shifted away from gold and pegged the value of their currencies to the USD.

During 1970s, use of .hi-pink[flexible exchange rate systems] increased, mostly in high-income industrial economies.

Many developing countries adopted flexible systems in the 1980s and 1990s, easily managed with advent of the computer and internet.

---

# Gold Standard

<br>

There is no best exchange rate system.

Currently, less than half of the world’s nations have flexible exchange rates.

<br>

Abandoned nearly everywhere in 1930s during the Great Depression.

Restored in a modified form after WWII but has completely disappeared since the 1970s.

---

# Gold Standard

<br>

Economists overwhelmingly opposed to return of gold standard, first countries to end gold standard were first ones to escape .hi-pink[Great Depression].

After WWII, Western economies adopted a modified gold standard under the .hi-pink[Bretton-Woods exchange rate system] (1947–1971).

<br>

Abandoned in the early 1970s. Gold standards highlight a pure form of fixed exchange rate with a hard peg.

Under pure gold standard, nations keep .hi-pink[gold as international reserve].

---

# Gold Standard

Gold used to settle most international obligations, and nations must be prepared to trade it for their own currency whenever foreigners attempt to “redeem” the home currency.

In this sense, the nation’s money is backed by gold.

There are essentially .hi-pink[three rules] that countries must follow in order to maintain a gold exchange standard.

* Must fix value of their currency unit in terms of gold.

* Keep supply of domestic money fixed in some constant proportion to their supply of gold.

* Nations must stand ready and willing to provide gold in exchange for their home country currency

---

# Gold Standard

<br>

If a country _decided to print large quantities of money_ for which there is no gold backing.

* Purchases of domestically produced goods would rise.
 
* Would cause domestic prices to rise leading to foreign goods becoming more attractive.

--
 
As imports in the home country increase, foreigners accumulate an unwanted supply of the home country’s currency.

This is the point at which gold standard would begin to become unhinged.

---

# Gold Standard

<br>

If gold supplies low relative to supply of domestic currency, gold reserves will begin to run out at some point.

This spells crisis and a .hi-pink[possible end to the gold standard].

Under a .hi-pink[fixed exchange rate system], the national supply and demand for foreign currencies may vary but the nominal exchange rate cannot.

It is the responsibility of the monetary authorities to keep the exchange rate fixed.

---

# Topics

<br>

* Reasons for holding foreign reserves, main institutions

* Effect of `$\Delta S, \Delta D$` of foreign currency on home currency

* Identify short, medium and long term forces that affect currency value

* Three rules of gold standard

* __Compare and contrast various exchange rate systems__

* Price changes and real exchange rate interactions

* List conditions necessary to form single currency area

---

# Fixed ExR Policy Action

Suppose US & UK both on gold standard and the US demand for GBP `$\uparrow$`.

---

# Fixed ExR Policy Action

Policymakers must counter weakening dollar and keep `$R_{\text{USD per GBP}}$` fixed.

---

# Fixed ExR Policy Action

<br>

There are two possibilities for the home country as it sells its gold reserves.

* Demand for gold satisfied and pressure on its currency eases

* Begins to run out of gold (coffers too light).

<br>

If the latter happens, the home country may be forced into a devaluation that is accomplished by changing the gold price of its currency.

---

# Fixed ExR Policy Action

<br>

.hi-pink[Pegged exchange rate systems] operate similarly to gold standard except that instead of gold, another currency is used to “anchor” home currency.

* Exposed to policies of external third party.

* Thailand pegged its currency to USD for many years.

* If Japan and China devalue against the dollar, also devalued against Thai currency, and Thai exports suddenly less competitive.

The simplest way to avoid is peg to a group of currencies. Reduces the importance of any single country’s currency.

---

# Fixed ExR Policy Action

<br>

Countries that use a .hi-pink[crawling peg] may peg to a single currency or a basket of currencies, but they regularly adjust the exchange rate.

The changes in the peg may occur on a daily basis by a predetermined amount.

May prevent some country-specific problems with a fixed rate but difficult to manage and has been associated with numerous exchange rate crises.

---

# Topics

<br>

* Reasons for holding foreign reserves, main institutions

* Effect of `$\Delta S, \Delta D$` of foreign currency on home currency

* Identify short, medium and long term forces that affect currency value

* Three rules of gold standard

* Compare and contrast various exchange rate systems

* __Price changes and real exchange rate interactions__

* List conditions necessary to form single currency area

---

# Real Exchange Rate

<br>

ExR used so far does not really tell us what a foreign currency is worth.

We still do not know the .hi-pink[purchasing power] of our domestic money when it is converted to a foreign currency.

Suppose USD–Malaysian ringgit exchange rate is 0.25 USD per ringgit, constant over the year.

Suppose Malaysian inflation is __4%__ and US inflation __1%__.

After one year, 4 ringgits that cost one dollar will buy __3% less in Malaysia than the dollar buys in the United States__.

---

# Real Exchange Rate

Higher inflation in Malaysia erodes the value more rapidly than at home.

Converted to ringgits, .hi-pink[real purchasing power] of the dollar has declined even though the exchange rate is still 0.25 USD per ringgit.

For foreign exchange participants, key item of interest is .hi-pink[purchasing power] upon conversion, not nominal units of a foreign currency.

US importer deciding between Malaysian and Chinese textiles does not really care if she gets four ringgits per dollar or eight Chinese yuan per dollar.

_Volume of textiles that can be purchased in Malaysia with four ringgits and in China with eight yuan is the only thing that matters._

---

# Real Exchange Rate

<br>

Consider a US vendor deciding whether to stock Italian or locally-produced cheese.

Suppose a wheel of Italian cheese costs __300 EUR__ and American cheese (same quality) costs __250 USD__.

Suppose that the nominal exchange rate is __1.25 USD per euro__ so that __250 USD__ is equivalent to __200 EUR__.

Italian cheese costs 50% more than American cheese, .hi-pink[real ExR] is __1.5 wheels__ of American cheese per wheel of Italian cheese.

---

# Real Exchange Rate

<br>

Algebra:

`$$\text{Real ExR} \\
=[(\text{R} \times \text{Foreign Price})]/ (\text{Domestic Price})\\
=[(1.25 \text{ per EUR}) \times (300\text{ EUR per wheel})]/( 250 \text{ USD per wheel})\\
=\frac{(375 \text{ USD per wheel of Italian Cheese})}{(250 \text{ USD per wheel of American cheese})}\\
= 1.5 \text{ wheels of American cheese per wheel of Italian cheese}$$`

Local supply is cheaper, when establishing .hi-pink[Real ExR].

---

# Real Exchange Rate

<br>

`$$R_r = R_n (P^*/P)$$`

The real rate equals the nominal rate when the price levels (purchasing powers) are the same in both countries.

For example, consider the current EUR-USD exchange rate, along with their price levels: `$R_r = (1 \text{ USD per EUR}) \times (109.1/108.5)$`

Even though we express parity in EUR to USD, .hi-pink[real exchange rates] suggest USD denominated goods are cheaper due to lower inflation environment.

---

# Choosing Exchange Rate System

<br>

Economic research has focused on performance characteristics of systems under different economic conditions and institutional arrangements.

Researchers have become more concerned with understanding how varying degrees of .hi-pink[flexibility] might best serve the interests of individual countries.

How do different systems influence core elements of a country’s macroeconomy?

---

# Choosing Exchange Rate System

<br>

.hi-pink[Traditional view]: Countries with fixed exchange rate systems were better at controlling inflation but paid a price in the form of slower economic growth.

Governments have to be very careful about issuing new money. Exchange rate policy that limits the supply of money would also help avoid inflation.

Limits placed on ability to manipulate money supply also remove an important monetary policy tool tused to manage economic growth.

---

# Choosing Exchange Rate System

<br>

.hi-pink[Research has failed to demonstrate a strong relationship between the type of exchange rate system and either inflation or economic growth.]

Before 90s, countries .hi-pink[pegged exchange rates] associated with lower inflation, but during the 90s the differences disappeared.

Countries with .hi-pink[flexible rates] have higher average rates of economic growth, but result depends on classification of the fastest growing Asian economies.

When they omit countries who manage flexible rates, no significant difference in growth between countries with relatively fixed and relatively flexible rates.

---

# Choosing Exchange Rate System

Neither fixed nor flexible rates offer superior protection against a currency crisis.

_No particular system_ seems to rank above any other in its ability to provide superior macroeconomic performance.

If the goal set to minimize negative shocks to an economy, then .hi-pink[source of the shock] determines which system should be adopted.

If originates in monetary sector (printing new money), fixed rate is better since it imposes discipline on the central bank.

If originates in the external environment (oil shock), relatively more flexibility enables the country to adapt more easily.

---

# Topics

<br>

* Reasons for holding foreign reserves, main institutions

* Effect of `$\Delta S, \Delta D$` of foreign currency on home currency

* Identify short, medium and long term forces that affect currency value

* Three rules of gold standar

* Compare and contrast various exchange rate systems

* Price changes and real exchange rate interactions

* __List conditions necessary to form single currency area__

---

# Single Currency Areas

<br>

Jan-1999, 11 members of EU .hi-pink[adopted euro] as their official currency.

As the EU added new members, several chose to use the euro, and as of 2016, .hi-pink[19 of 28 members] had replaced their national currencies with the euro.

Shared vision developed economic interdependence and prevent future war.

Nation’s currency is one of its strongest symbols of national sovereignty, remarkable set of events.

---

# Single Currency Areas

<br>

Four potential reasons why countries might want to share a common currency.

* Eliminates need to convert money, reduces transaction costs. Some gain in efficiency.

* Eliminates price fluctuations caused by changes in the exchange rate.

* Can help increase political trust between countries seeking to increase their integration.

Nations that give up their national money do not do so without cost.

---

# Single Currency Areas

Adoption of a .hi-pink[common currency] also means that the country no longer has its own .hi-pink[money supply as a tool] for managing its economic growth.

* If control money supply, can influence growth of economy in the short run thru change in money supply.

* Hard for monetary policy of single currency to implement interest rates that suit every member state perfectly.

* Countries give up their ability to alter their exchange rates.

* Expected to implement policies aimed at pushing down prices and wages inside their countries and do not have the option to devalue currencies to make goods cheaper.

---

# Single Currency Areas

<br>

* Business cycle must be synchronized

* High degree of labor and capital mobility between the member countries

* Regional policies capable of addressing the imbalances that may develop

* Nations involved must be seeking a level of integration that goes beyond simple free trade

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