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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. 22