Download KC3002 International Finance /International Macroeconomics

KC3002 International Finance
/International Macroeconomics
Spring 2016
Lecture 7 Fixed Exchange Rates
Hideyuki IWAMURA
Faculty of International Studies
1
Exchange rate regimes
What are the costs and benefits of fixed rates?
2
Yen return on dollar assets
under a fixed rate
Under fixed rates, the expected rate of yen return on
dollar assets is equal to the dollar interest rate.
R
∗e
=
i∗
This is because under fixed rates, people never expect
the dollar to depreciate or appreciate, that is, the
expected rate of dollar’s appreciation is zero.
R
∗e
=
i
∗
+
E1e − E0
E0
=
i
∗
A fixed rate implies expected
appreciation is zero.
3
Fixing the exchange rate : case 1
Suppose the yen is fixed to the dollar, at ¥100/$,
the yen interest rate is equal to the dollar interest rate, 0.02,
and the FX market is in equilibrium.
The Bank of Japan(BOJ) raises the interest rate by 0.01.
Yen assets become more profitable and people try to sell
dollar assets and buy yen assets.
Supply of the dollar pressures the exchange rate to fall.
The BOJ can buy as many dollars as they want to sell at
the official price and keep the exchange rate from falling.
4
Fixing the exchange rate : case 1
Any purchase of dollars by BOJ automatically results
in an increase in Japan’s money supply.
If BOJ buys dollars, it must pay for the dollars with new
printed yens. Therefore, Japan’s money supply increases.
The increase in money supply lowers the yen interest rate.
When the yen interest rate is finally pulled back down to
the dollar interest rate, people are indifferent between
yen and dollar assets.
No pressure on the exchange rate to change,
and the fixed rate is successfully maintained.
5
Fixing the exchange rate : case 2
Suppose the yen is fixed to the dollar, 100 yens per dollar,
and the yen interest rate is equal to the dollar interest rate.
The Fed raises the interest rate.
Dollar assets become more profitable and people try to
sell yen assets and buy dollar assets.
Demand for the dollar pressures the exchange rate to rise.
The BOJ can sell as many dollars as they want to buy at
the official price, and keep the exchange rate from rising.
6
Fixing the exchange rate : case 2
Any sale of dollars by BOJ automatically results in a
decrease in Japan’s money supply.
If BOJ sells dollars, the yens paid by the buyers will no longer
be in circulation. Therefore, Japan’s money supply decreases.
The decrease in money supply raises the yen interest rate.
When the yen interest rate is finally pushed up to the
dollar interest rate, people are indifferent between yen
and dollar assets.
No pressure on the exchange rate to change,
and the fixed rate is successfully maintained.
7
Monetary policy autonomy
Under fixed rates, the BOJ has to adjust its money supply
in order to keep the yen interest rate equal to the dollar
interest rate.
Case 1 : When reducing the money supply and raising
the interest rate above the dollar interest rate, it must
finally withdraw the money and pull the interest rate
back to the US level.
Case 2 : When the dollar interest rises above the yen
interest rate, the BOJ must decrease the money supply
and push the yen interest rate up to the US level.
Under fixed rates, the BOJ cannot affect its money supply
in its own will, independently of the US interest rate.
Fixed rates imply the country’s loss of autonomy in monetary
policy.
8
Expansionary monetary policy
under a fixed rate
i
i
LM 0
LM1
1
IS0
2
0.02
500
1. An increase in the money
supply shifts LM right.
This lowers the interest rate
and threatens the exchange
rate to rise.
Y
100
E0
2. The BOJ must hastily reverse
itself and decrease the money
supply in order to raise the
interest rate and keep the
exchange rate fixed.
9
Expansionary monetary policy
under a fixed rate
An increase in the money supply lowers the interest rate
and raises the output.
A fall in the interest rate makes dollar assets more
attractive, forcing the yen to depreciate.
To keep the yen from depreciating, the BOJ sells dollars
and decreases the money supply so that the interest rate
continues to be equal to the dollar interest rate, 0.02.
After all, the interest rate and exchange rate stay
unchanged, and thus output stays constant.
Under a fixed rate, monetary policy is impossible to
undertake.
10
Policy trilemma
A country cannot simultaneously
1. allow capital mobility
2. maintain fixed exchange rates
3. pursue an autonomous monetary policy
A country can pursue an autonomous monetary policy
under fixed rates, if it restricts cross-border lending and
borrowing. 【2 & 3】 → Capital control
A country can pursue an autonomous monetary policy
under free capital mobility, if it allows the exchange rate
to move freely. 【1 & 3】 → Floating exchange rates
11
Expansionary fiscal policy
under a fixed rate
i
i
IS0
1
IS1
LM 0
2
LM1
0.02
500
600
1. Expansionary fiscal policy
shifts IS right.
This raises the interest rate
and threatens the exchange
rate to fall.
Y
100
E0
2. The BOJ must purchase dollars,
increase the money supply,
shift LM right in order to lower
the interest rate and keep the
exchange rate fixed.
12
Expansionary fiscal policy
under a fixed rate
An increase in government purchases increases output,
which in turn raises the interest rate and appreciates the yen.
To keep the yen from appreciating, the BOJ purchases dollars
and increases the money supply.
The expansion in the money supply also raises output.
Under a fixed rate, an increase in the money supply has a
larger impact on output than it does under a floating rate.
13
Expansionary fiscal policy
under a fixed rate
Government purchases ↑
Goods market
Rise in aggregate demand
→ GDP ↑
Money market
Rise in money demand
→ Interest rate ↑
FX market
Rise in return on yen assets
→ Exchange rate ↓
Goods market
Fall in aggregate demand
→ GDP ↓
Under a floating rate, the first
increase in GDP is partly offset
by a subsequent rise in the
interest rate and yen’s
appreciation.
Under a fixed rate, the BOJ
increases the money supply
and keeps the interest rate and
the exchange rate constant.
Thus the first increase in GDP is
never offset.
14
Devaluation（切り下げ）
Devaluation occurs when the central bank raises the
domestic currency price of the foreign currency.
Devaluation makes the domestic goods relatively cheaper
and raises aggregate demand, thus increasing output.
When people expect a devaluation in the near future, it can
sometimes spark a sharp fall in official foreign reserves –
balance of payments crisis.
15
Costs of fixing : Trilemma
Shambaugh(2004) compared co-movements between the
interest rates for all pairs of countries under three alternative
regimes (a), (b), and (c).
(a) Open and Pegged: Open capital markets with fixed
exchange rates. Changes in the country’s interest rate
must be equal to changes in the interest rate of the base
country to which it is pegging.
(b) Open and Not Pegged: Open capital markets with
floating exchange rates.
(c) Closed: Closed capital markets.
Shambaugh(2004), “The Effect of Fixed Exchange Rates on Monetary
Policy,” Quarterly Journal of Economics, 119(1).
16
Costs of fixing : Trilemma
Feenstra & Taylor(2014), p.728.
17
Costs of fixing : Output volatility
An increase in the base country interest rate should cause
output to fall in a country which pegs its exchange rate to the
base country, because the pegging country has to tighten its
monetary policy and raise its interest rate to match the base
interest rate.
Di Giovanni and Shambaugh(2008) examined how the GDP
growth in pegging country is related with one percent
increase in base country interest rates.
Di Giovanni and Shambaugh(2008), “The Impact of Foreign Interest Rates
on the Economy: The Role of the Exchange Rate Regime,” Journal of
International Economics, 74(2).
18
Costs of fixing : Output volatility
Feenstra & Taylor(2014), p.730.
19
Benefits of fixing
Shambaugh and Klein(2006) compared bilateral trade
volumes for all pairs under (a), (b), and (c) with the
benchmark level of trade under a floating regime.
(a) The two countries are using a common currency.
(b) The two countries are linked by a direct exchange rate
peg. (A’s currency is pegged to B’s.)
(c) The two countries are linked by an indirect exchange rate
peg. (A’s currency and B’s currency are pegged to C’s.)
(d) The two countries are not linked by any type of peg.
Klein and Shambaugh(2006), “Fixed Exchange Rates and Trade,” Journal
of International Economics, 70(2).
20
Benefits of fixing
Feenstra & Taylor(2014), p.726.
21
Final Exam
The final exam will be held 13:35 to 14:55 on July 22.
You can withdraw anytime provided that you’re sure you
finished the exam.
The exam covers all the materials, though National
Income Accounting, Open-economy IS-LM Model, and
Fixed Exchange Rates are mainly focused on.
This is a closed book exam.
You are allowed to use a simple calculator.
10 multiple-choice questions, 2 computational questions,
and 2 essay/graphing questions.
The model answers will be posted on my website.
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