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ECONOMICS 3150B

Fall 2015Professor Lazar

Office: N205J, Schulichflazar@yorku.ca

736-5068

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Lecture 9: October 13Ch. 15, 16

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Fixed Exchange Rates: Policy Effectiveness

• B. of C. committed to maintaining value of exchange rate

• Consider case:

• If B. of C. commitment to fixed exchange rate credible [E*(e) – E*]/E* = 0

• B. of C. loses control over R – any attempt to change R with no change in values of other variables, will impact E*

• Covered interest rate parity model:– R(C) = R(US) + since B. of C. considered credible

– If R(C) – M determined by need to maintain R(C) = R(US) + and E* fixed

– Monetary policy loses effectiveness with fixed exchange rates

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Fixed Exchange Rates: Policy Effectiveness

• B. of C. committed to maintaining value of exchange rate

• Consider case: • Traditional D/S model

in D for C$, in S of C$– In absence of intervention, C$ depreciates in value (E)– To keep exchange rate constant, B. of C. either M R or intervenes

directly and buys C$ (sells foreign assets)

– Consider direct intervention: requirement for foreign asset reserves• Problem: can B. of C. persist in buying C$?

• Traders expect depreciation, so S of C$ compounds problem for B. of C.

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E

Q(C$)

D for C$: exports

S of C$: imports

Direct Intervention: Sell foreign assets

E0

SD

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Fixed Exchange Rates

• Speculative attacks– Reserves

– No-lose bets: short the exchange rate, short debt

– Soros and UK pounds in early 1990s

• Loans in foreign currency (US$, Euro, Yen)– Forced devaluation – domestic currency costs of loan interest and

principal payments increase

– Default – problems for domestic banks

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Flexible Exchange Rates

• Independent monetary policy – not constrained by need to keep exchange rate fixed at particular level– Fiscal policy ineffective

• Expansionary policy R E EX and IM aggregate demand

• Combination of higher interest rates and appreciation of C$ neutralize expansionary effects of fiscal policy

• Ignoring effects on P and repercussions on aggregate D

• Degree of independence– US M to stimulate economy and reduce UR (Canadian policy-makers

likely to have same objective)• US actions will lead to appreciation of C$ ( in US GDP Canadian CU;

and R(US) Canadian CA); which will reduce positive spillover effect from US

• Flexible rates will require B. of C. to follow lead of US Federal Reserve

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Flexible Exchange Rates

• Automatic stabilizer– Increase in rate of inflation in US

• R(C) = R(US) + [E*(e)-E*]/E* + • [E*(e)-E*]/E* = % E*(e) = %P(C) - %P(US)

• Assume %P(C) = %P(US) = % P(D) = initially %E*(e) = 0

• Now assume %P(US) %E*(e) < 0 E* (appreciation)

• P(C) = P(D)[P(US)E*]1- %P(C) = %P(D) + (1- )[%P(US) + %E*(e)]

• % P(C) = • If % P(US) %E* offsetting impact on %P(C)

– With fixed exchange rates• If % P(US) %P(C)

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Exchange Rate Crises

• Hot money – sudden changes in expectations result in sharp swings in exchange rates and/or interest rates

– Carry trade: borrow in low interest rate country and invest in high interest rate country with expectation of stable exchange rates

• Momentum – herd effects compound initial impacts

• Overshooting – exchange rates and/or interest rates move beyond reasonable levels of equilibrium (problem: determining equilibrium positions)

• Weak countries vulnerable – low reserves, absence of independent central bank, highly dependent on capital inflows, monetization of debt, TB deficit

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Dollarization

• Problems with flexible exchange rates– Effectiveness of

independent monetary policy

– Trade costs – Competitiveness – Demand for bail-outs– Instability of foreign

exchange markets: tendency to overshoot

– 78.5% appreciation in 5 years

• Problems with Dollarization– Loss of independent m.p.

– Loss of automatic stabilizer– Economic performance and

sovereignty

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Diversification

• Risk reduction– Same expected return, lower risk for portfolio– Higher expected return, same degree of risk– Risk aversion

• Risks:– Default – Price variability– Exchange rate– Imperfect information

• Insurance markets – financial and non-financial risks:– Spread risks: re-insurance, insurance pools– Pooling of risks: insurance pools– Derivatives

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Offshore Banking and Eurocurrencies

• Offshore banking– Business conducted by the foreign branches, subsidiaries of a bank

outside the home country of the bank

• Eurocurrencies– Bank deposits denominated in a currency other than the domestic

currency of the country in which the bank or its foreign operations reside• Offshore currencies

• Typical Eurocurrency deposit is non-negotiable time deposit with fixed term to maturity ranging from overnight to 5+ years

• US$ deposits in a bank in Canada (Canadian, US, other) – part of Eurodollars – Eurodollars: US $ deposits in banks outside US

• C$ deposits in a bank outside of Canada (Canadian, other)

– Eurobanks: banks that trade in market for Eurocurrencies – take deposits, make loans

• Most Eurocurrency trading occurs in non-European centers

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Eurocurrencies

• Euro-deposit rates – 3 months

08/26/09 08/24/08 07/14/08

U.S. 0.30% 5.48% 2.81%

Canada 0.50 4.83 3.20

Euro 0.84 4.65 4.90

Yen 0.28 0.97 0.87

Pound 0.52 6.49 5.65

Euro Deposit Rates Today

3-month rates:

US: 0.33%

Canada: 0.73%

Euro: -0.01%

Yen: 0.10%

Pound: 0.67%

Swiss Franc: -0.58%

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Rapid Growth of International Banking

• Reduction in trade costs growth in international trade– Hedging currency risks

• Liberalization of capital markets– Growth of MNEs – banks have followed corporate customers abroad

• Circumvent restrictive domestic government regulations on financial activity – reserve requirements, interest rate ceilings, deposit insurance

• Political factors – desire by some depositors to hold currencies outside jurisdiction of countries that issue them – freezing accounts

• Money laundering – drugs, arms sales, bribes, other criminal activities