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I. II. Chapter 13 Foreign Exchange Rates and Financial Crises Floating Exchange Rates A. Price and Quantity 1. Q = Quantity of Foreign Exchange (e.g., Yen) 2. e = exchange rate = Price (e.g. $/Yen ) 3. = 1/Price of $ 4. Appreciation/Depreciation B. Net Exports are Negatively Related to the Exchange Rate 1. Suppose e = 100Yen/$, P(Ford) = $20,000, P(Toyota) = Y2,000,000 => P(Toyota in US) = P(Ford in Japan) = 2. Suppose e = 200Yen/$, P(Ford) = $20,000, P(Toyota) = Y2,000,000 => P(Toyota in US) = P(Ford in Japan) = 3. Suppose e = 50Yen/$, P(Ford) = $20,000, P(Toyota) = Y2,000,000 => P(Toyota in US) = P(Ford in Japan) = C. Demand for Foreign Exchange: Buy Yen/Sell Dollars 1. Imports from Japan (Japan’s exports) 2. Capital Outflows from US to Japan (Capital Inflows into Japan) 3. Slopes downward D. Supply of Foreign Exchange: Sell Yen/Buy Dollars 1. US Exports to Japan (Japan’s Imports) 2. Capital Inflows to US from Japan (Japan’s Capital Outflows) 3. Slopes upward (maybe not in SR?) E. Market Clearing: D=S 1. Stylish Toyotas 2. Falling Demand for Commercial Aircraft (After 9/11/2001) 3. (Real) Interest Rates Rise in US 4. Confidence in $US declines (Those huge CA < 0 must end sometime!!!!) Fixed (Pegged) Exchange Rates A. D≠S 1. Target Value of Yen Below Market Equilibrium ($ Target Above) => Japan &/or US Central Banks Sell Yen/ Buy $ 2. Target Value of Yen Above Market Equilibrium ($ Target Below) => Japan &/or US Buy Yen/ Sell $ 3. Run out of Foreign Exchange? - Currency Crisis 4. Accumulate Huge Reserves of Foreign Exchange? - China & Japan B. How Else Do Gov’ts Influence Exchange Rates? 1. 2. 3. Interest rate policies Access to foreign exchange/Capital controls Other Macro Policies (e.g. Y up => Imports up => Depreciation; S & I) Egypt: 1999-2000 Official rate 3.4 Egyptian pounds (EGP)/$ Excess demand for $ Gov’t buying up pounds/selling $ For’n exchange reserves declined by 25% in a year Temporary? Oil prices at end of 1998 = $10/barrel Tourism way down after 1997 massacres Reality: Now 6.8 EGP/$ Reality: Egypt used a lot of foreign exchange to buy EGPs which depreciated in value C. Preventing Appreciation 1. Japan in 1970s; China today: Preserve “competitiveness,” i.e. keep their export prices low to foreigners 2. Sell Domestic Currency <=> Accumulate Foreign Reserves 3. If own Currency Appreciates Eventually, Suffer Loss on Foreign Reserves Example: Suppose China holds $2 trillion (T) in reserves denominated in $US which were accumulated when $1 = RMB 8.29, i.e. original total value = RMB16.58T Now (March, 2013) $1 = RMB 6.22 i.e. now total value = RMB12.44T. Loss = RMB 4.14T, or about 25 percent. 4. Or if Foreign Currency (in which reserves are held) depreciates relative to third currency, suffer losses in terms of third currency. Example: China is holding many of its reserves in $US. If the $US depreciates relative to the Euro, then China’s reserves are losing value when expressed in terms of Euros. D. Interest Rate Policy 1. “Tight” money => a. Short run: Raise domestic i => capital inflows => currency appreciate b. Long Run: Low inflation => currency appreciate 2. 3. May conflict with attempts to stimulate the Domestic Economy a. England: 1992 b. Countries hit with currency/financial crisis (Asia, 1997): IMF c. Generally, if a country uses monetary policy to defend exchange rate, it can’t use it for domestic stabilization Market rates rise with risk of default E. China and US arguments over currency: Summary as of March, 2013 1. China is keeping Yuan low by buying dollars/selling Yuan. Results: a. Chinese goods cheaper to US consumers => helps US consumers b. US goods more expensive => hurts US producers 2. China buys US bonds => lower interest rates for US borrowers 3. US has long term imbalance S < I (because of gov’t deficits & low personal saving) => capital inflows, and thus high value of $US is fault of US: NX = S-I 4. US has low interest rate policy which causes capital inflows to other countries and thus puts upward pressure on their currencies (note: opposite to 2.) 5. China restricts access to foreign capital markets by its citizens. If allowed capital outflows, Yuan might be even lower. International Lending and Foreign Exchange Crises Why does international lending occur? Is it desirable? Why do “financial crises” sometimes occur? I. Theoretical Rationale A. If the return on capital (MPK) is higher in country A than country B, 1. Total world income (output) will be increased by shifting investment from B to A 2. Individual investors will find it profitable to invest (more) in A than B, i.e. when the market is working well, funds are “automatically” channeled to the investments offering the highest rates of return. B. International lending may be desirable for both countries (lenders and borrowers), depending on: 1. The terms of the loan 2. The actual outcome of the use of the loan (Increase K? Beer party?) 3. The market working well (taxes, regulations, monopoly, corruption) II. Historical Sketch A. 19th Century - 1950 1. Large Capital Flows from (more developed) Europe to (developing) countries in N and S America, Australia 2. Mostly, worked well: Financing railroads, canals, etc. 3. But sometimes defaults: a. Eight US states defaulted on loans for canals and cotton plantations during Panic of 1837 b. Massive defaults by developing countries during 1930s B. 1974-1982 Surge in International Lending to Developing Countries 1. Oil Exporters had huge current account surpluses balanced by capital account deficits (ie they put their money in foreign (US and Europe) banks) 2. Real rates of interest in US/Europe were low (negative, often), among pessimistic expectations about MPK in developed countries 3. LDCs objected to FDI (“Imperialism”) but accepted loans, often by corrupt or inept (or both) governments 4. Banks “herded:” Everyone else is doing it so we should too. C. 1. 2. 3. 4. 1980s Debt Crisis High interest rates in US (Volcker disinflation) LDCs burdened by high oil import costs Plunging (other) commodity prices Widespread defaults: Negotiations; repay 30 cents on the dollar D. 1. 2. 3. 1990-2000s Resumption of International Investment More Asian More FDI Capital Flows from China to USA III. A. 1. 2. 3. 4. 5. International Financial Crises The Scenario “Fixed” Exchange Rate Market Equilibrium Value Falls Below Target Rate Country “Defends” Currency, but Uses up Foreign Exchange Reserves Speculators Bet Against Currency Speculators are Right (Poof!) B. 1. 2. policy 3. 4. 5. England: 1992 After German unification, interest rates rise on the Continent England remains in recession and tries to pursue expansionary monetary John Major declares England will never devalue England devalues Who is John Major? C. Mexico, 1994-1995 1. Early 1990s: Mexico is the darling of international investors (NAFTA, etc.) Growth=3-9%/yr - huge capital inflows cause high value of peso. 2. Political unrest increases the perceived risk of investment - inflows diminish / outflows increase. 3. Mexico declares it will never devalue - and uses up its for’n exchange reserves trying to defend the peso. 4. Mexico devalues. 5. Government is on the verge of default on debt. 6. US/IMF bailout restores confidence and economy recovers. Note: What incentives does a promise of bailouts create for risk taking? Moral Hazard D. Asia 1997-98 1. E. Asia is the darling of international investors (Asian “Miracle”, etc.) - huge capital inflows cause high value of currencies. 2. Capital inflows are often short term bank deposits, which are lent to bankers’ brother, uncle, and favorite politician - “crony capitalism”. 3. Bad news hits - investors try to withdraw their money, ie capital outflows. 4. Thailand declares it will never devalue the baht, and .... 5. Thailand devalues, .... E. Lessons 1. There is no such thing as a “fixed exchange rate,” unless strong supporting institutions/policies. a. If you wait long enough... b. Bank regulation/Supervision 2. Short term capital flows are “hot” money. 3. Capital Controls a. Restrictions on capital outflows => b. Incentive for inflows?