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International Finance Part 1 Fundamentals of International Finance Lecture n° 4 Exchange rate management 1 Exchange rate management Introduction Goals of the chapter : Ask whether a flexible exchange rate system is desirable, Discuss the argument for greater exchange rate fixity Flexible exchange rate system Implies a minimum of insitutional design Carry weaknesses linked to this minimal framework : • Uncertainty • Lack of discipline • Problems of volatility and misalignments Case for more managed exchange rates Then leads to problems of speculative attacks if monetary policy is inconsistent with fixed exchange rate target. 2 Exchange rate management The case for flexible exchange rates - Arguments Defined as « Rates of foreign exchange that are determined daily in the markets for foreign exchange by forces of demand and supply… » Avoid the intervention of the government and the possible run out of reserves Automatically adjusts the BOP disequilibria Speculators facilitate and smooth the adjustment of the exchange rate, having a stabilising effect Confer monetary autonomy to a country Provide insulation from external shocks via exchange rates adjustements, upward or downward. 3 Exchange rate management The case for flexible exchange rates - Challenges However, the argument for flexible exchange rates have been seriously challenged to several extents. Floating rates since 1973 have exhibited high volatility and spent long periods away from their long-run fundamental equilibrium level (misalignement) Domestic price of foreign exchange Supply of foreign exchange Seq Demand for foreign exchange Q of foreign exchange 4 Exchange rate management The case for flexible exchange rates - Challenges Exchange rate determination models do not seem to prove empirically that fundamentals drive the exchange rate. Studies showed that same current account imbalances persisted after the adoption of floating exchange rates in 1970 ’s and 1980 ’s. Changes in prices caused by depreciation may not alter demand for the product (ex. Switzerland, Germany, Japan), in particular for high quality goods with few substitutes. Monetary autonomy ? UK example in 1979-1981 where monetary tightness rise interest rates, causing a huge capital inflow, leading to exchange rate appreciation, affecting badly the tradeable sectors.-> few autonomy. 5 Exchange rate management The case for flexible exchange rates - Challenges Insulation from external shocks? Full insulation : idea abandoned. Still a question on whether flexible rates better insulate the domestic economy. Via, p.ex., appreciation of the rate in case of rise of foreign demand for domestic exports, and vice versa. Empirical results are mixed. Overall : several exaggerated benefits for flexible exchange rates. 6 Exchange rate management The benefits of greater exchange rate fixity Four arguments in favour of some degree of exchange rate intervention : The discipline argument : helps to promote lower inflation. The need to reduce exchange rate volatility : more uncertainty can reduce the volume of trade. The desire to eliminate misalignments : long period of over- and undervaluation - like displayed in the floating rates period - results in various cost for the real sector. The benefits of a single currency 7 Exchange rate management Exchange rate fixity : The Discipline argument (1) Flexible rates tend to promote inflation (evidence is mixed and theoretically unlikely) (2) Fixed exchange rate force countries to contain inflation : one of the core arguments in favour of EMS. Consider 2 countries : • UK : high inflation, and current account deficit • Germany : low inflation, and current account surplus • In theory : leads to a tendency of appreciation of the DM : Bundesbank should sell DM against foreign currencies, expanding the monetary base, and reducing pressure on S. • UK : should disinflate, buy Pounds against foreign currencies to reduce pressure of depreciation. 8 Exchange rate management The Discipline argument Asymmetry : Germany could sterilise (and avoid a price rise) by selling bonds against DM, reducing back the monetary base. UK cannot sterilise much, soon running out of reserves. -> this asymmetry leads to a disinflationary bias. And, the credibility bonus brought by the exchange rate target reduces the costs of disinflation in terms of unemployment : agents easily observe the exchange rate target and believe that inflation will fall -> they adapt their wage bargaining behaviour. Exchange rate targets are more efficient (credible) disinflation tools than monetary growth targets. 9 Exchange rate management Exchange rate fixity : The Volatility argument Need to reduce exchange rate volatility : more uncertainty can reduce the volume of trade. Foreign direct and long-run foreign investment might also decline in greater exchange rate uncertainty. Sudden changes in the value of reserve currencies can be problematic. However, possible recourse to the forward market, but: only existing for large currencies, can be expensive. 10 Exchange rate management Exchange rate fixity : The Misalignment argument Floating rates have a tendency for persistent departures from long-run equilibrium Long period of overvaluation and undervaluation cause changes in the price of tradeables goods relative to non tradeables. • Example : persistent overvaluation, causing industries to become uncompetitive, but capital and labour are not easily convertible into other, non tradeable sectors • -> overvaluation usually leads to unemployment and underutilisation of resources, and ultimately, to desindustrialisation. Also : effect of misalignment on long-term debt accumulated in foreign currencies : can significantly change the return of project financed by borrowed currencies. 11 Exchange rate management Exchange rate fixity : The Single Currency Benefits of a single currency within any country are : simplification of the profit-maximising computations of producers and traders facilitated competition among competitors of the country promotion of the integration of the economy into a connected series of markets for the factors of production If single currency among different countries : accrued benefits due to the suppression of the transaction costs of exchanging currencies. If exchange rate management : part of these listed benefits could be achieved, compared to a fixed rate regime. 12 Single Currency Costs of a single currency Costs : of a single currency across different countries: loss of the exchange rate loss of the monetary policy Loss of exchange rate : Eliminate the possibility of using the exchange rate as a policy instrument to rectify external equilibria. • Example : External shock of price fall in steel leads Belgium (large exporter) to a deficit on its current account. • Belgium should either deflate (allowing prices to fall) or let the currency depreciate (or devalue if fixed exchange rate) in order to restore equilibrium. • If prices are sticky and cannot fall to restore competitiveness, deflation (i rises, M falls) will create unemployement. 13 Single Currency Costs of a single currency - loss of exchange rate Example : • If Belgium is in a monetary union : no depreciation is allowed, the economy will go into recession. • Belgium has no longer a BOP problem, but has a regional problem within EMU. Three factors mitigating the costs : Factor mobility Openness of the economy Product diversification 14 Single Currency Costs of a single currency - Mitigation factors Factor mobility The greater the mobility of capital and labour, the lower the cost of joining a monetary union. Example : asymmetric demand shock : rise of D in region A, drop in region B. If prices are sticky downwards, region B will have unemployement, and inflationnary pressures in region A. Solution : move unemployed workers from region B to region A. 15 Single Currency Costs of a single currency - Mitigation factors Openness of the economy The loss of exchange is less costly if the economy is more open. Reason : exchange rate changes are less effective at improving competitiveness because money illusion is reduced. In fixed exchange rates, devaluation increase competitiveness via the drop real wages following the increase in prices of imported goods. In open economies, workers anticipate this change and will adjust their demand of wage increase to offset the effect. Product diversity A demand disturbance in one product is less likely to affect significantly the exchange rate, if the diversfication is large. 16 Single Currency Costs of a single currency - Loss of monetary policy Costs : of a single currency across different countries: loss of the exchange rate loss of the monetary policy Loss of monetary policy : Eliminate the ability to conduct an individual monetary policy, since monetary policy is directed from the centre rather than from individual countries. Many believe that the more similar inflation rates countries have, the more appropriate candidates they are for a monetary union. More generally : the closer degree of policy integration at macro level, the more easy it is to form a monatery union. 17 Single Currency Criteria for countries to benefit from a single currency Similar policy goals Similar macroeconomic performance Close inflation rates Conduction a lot a of trade transactions between one another. 18