9. Exchange Rate Determination and Policy
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Transcript of 9. Exchange Rate Determination and Policy
7/27/2019 9. Exchange Rate Determination and Policy
http://slidepdf.com/reader/full/9-exchange-rate-determination-and-policy 1/33
Exchange Rate Determination
and Policy
Colin F. Bullock
7/27/2019 9. Exchange Rate Determination and Policy
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Learning Objectives
• PPP and long run exchange ratedetermination.
• The market for domestic assets and exchange
rate determination in the short run.• The Mundell-Fleming Model and monetary,
fiscal and trade policy under fixed and floating
exchange rates.• Fixed vs floating exchange rates in small open
economies.
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Introduction
• Exchange rates are the rate at which one country’s currencytrades for another country’s currency.
• The exchange rate may either be expressed as units of foreign currency per unit of local currency (US$/J$) or units
of local currency per unit of foreign currency.• An increase in US$/J$ is an appreciation of the Jamaica
dollar and an increase in J$/US$ is a depreciation of theJamaica dollar.
• The spot market is for settlement in two days while the
forward market may be for settlement for longer periods,usually over thirty days.
• Depreciation makes exports cheaper abroad and importsmore expensive at home. Appreciation does the opposite.
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Exchange Rates in the Long Run
• The Law of one price: for two countriesproducing an identical commodity with notrade restrictions and transport costs, the
exchange rate ensures that price is the samein both countries.
• Purchasing Power Parity (PPP): An applicationof the law of one price to the general pricelevel (the cost of an identical basket of goods)in two countries.
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Limitations of PPP
• Product differentiation; goods not identical.
• Transport costs are not likely to be minimal
•
Countries use tariffs and quotas to restricttrade.
• The general price level includes many non-
traded goods that do not influence theexchange rate.
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Exchange Determinants in the Long
Run
• A factor that increases the demand for domesticgoods relative to foreign goods will appreciatethe exchange rate (and vice versa).
• A rise in the country’s price level relative to othercountries depreciates the currency.
• Increased restrictions on trade cause anappreciation of the currency.
• Increased preference for a country’s productsappreciates the currency.
• Increased productivity appreciates the country’scurrency.
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Summary of Long Range Influences on
the Exchange Rate
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Short Run Influence of the Market for
Domestic assets
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Impact of Increased Domestic Interest
Rate
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Impact of Increased Foreign Interest
Rate
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Impact of Expected Increase in
Exchange Rate
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Mishkin Summary of Influences I
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Mishkin Summary II
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Domestic vs Real Interest rates
• Recall the Fisher equation:
in = ir + ∏e
•
If the increase in the nominal interest rate isdue to an increase in the real interest rate, it
appreciates the domestic currency.
• If it is due to an increase in the expected rate
of inflation, it depreciates the domestic
currency.
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Money Supply and Expected Inflation
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The Mundell-Fleming Model of the
Small Open Economy
• r = r* (Domestic interest rate = world interest
rate)
• IS Curve: Y = C(Y-T) + I(r*) + G + NX(e)
• LM Curve: M/P = L (r*,Y)
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Derivation of the IS Curve
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Derivation of the LM Curve
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Mundell-Fleming Equilibrium
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Fiscal Policy Under Floating Exchange
Rates
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Monetary Policy Under Floating
Exchange Rates
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Trade Policy Under Floating Exchange
Rates
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Fixed Exchange Rate Governs the
Money Supply
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Fiscal Expansion Under Fixed Exchange
Rates
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Monetary Expansion Under Fixed
Exchange Rates
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Trade Restrictions Under Fixed
Exchange rates
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Mundell-Fleming Policy Effects
Summary
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Fixed Exchange Rates for Developing
Countries?FOR Against
Facilitates price stability Prices stability depends on the true market
exchange rate and not merely the official
exchange rate.
Stability reduces uncertainty and
encourages investment.
There is a loss of independent exchange
rate policy.Avoids independent monetary policy
that a small country may not be able to
manage.
There is a loss of independent monetary
policy.
Discourages irresponsible fiscal and
monetary policy that is inconsistent with
exchange rate stability.
Policy is entirely dependent on fiscal policy
which may be driven into deficits by shocks.
A disincentive for political
irresponsibility.
Structural inflationary impulses may cause
a loss of competitiveness.
Encourages hard work and productivity
in the absence of inflationary gains.
May require costly exchange control to
defend exchange rate
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Floating Exchange Rates for
Developing Countries?For Against
Allows independent exchange rate policy Facilitates exchange rate instability and
price uncertainty.
Allows independent monetary policy. Independent monetary policy is likely to
be irresponsible and inflationary.
Policy is more flexible in the face of
shocks.
Flexibility allows for postponement of
difficult decisions in the face of shocks.
Policy can more easily retain price
competitiveness.
Exchange rate policy cannot sustain
enhanced competitiveness in face of high
import price dependence.
There is greater capacity to avoid the
development of parallel fx markets.
On-going exchange rate depreciation may
encourage dollarization and loss of
monetary policy.
The budget may be balanced over time
rather than constantly.
The facilitation of fiscal deficits may
become endemic through the build-up of
external debt.
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From Peg to Float in Jamaica
• Jamaica entered independence with an exchangerate fixed to the British pound (1:1).
• In the late 1960s, the “peg” was switched to the
United States Dollar at (J$0.7 = $US$1).• Foreign exchange pressures in the 1970s and
1980s elicited a variety of foreign exchangesystems with devaluation to J$6 = US$1.
• With very negative NIR, minimal gross reservesand an active // market, Jamaica liberalized its fx.system between Sept 1990 and Sept 1991.
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Performance Under Managed Float
• Liberalization in less than ideal circumstancesre tightness of macroeconomic policy andfinancial sector regulation.
• This facilitated exchange rate slippage, tripledigit inflation and loose financial institutionmanagement culminating in crisis.
•
Beneficial results in NIR moving from negativeto positive and the elimination of the parallelmarket in foreign exchange.
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Should Jamaica Return to a Peg?•
Concern about slippage in exchange rate over time and impacton inflation and uncertainty.
• Negative comparisons with Barbados and other fixed exchange
rate economies.
• Perspectives on the ineffectiveness of depreciation in fostering
competitiveness.
• In reality, Jamaica lost capacity to fix due to inappropriate fiscal
policy and low productivity which is what drives depreciation.
• These factors will create problems in peg or float.
• Barbados retained peg because of more effective fiscal policy
and even now has competitiveness issues.
• Floating has benefitted NIR and fx. market and success of fix or
float depends on effective fiscal policy.
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Readings
• Mishkin Ch. 17
• Mankiw (7th ed.), Macroeconomics Ch. 12
• Ghatak and Sanchez-Fung Ch. 10
• Articles by Hon. Edward Seaga and Colin
Bullock in Mona School of Business Review
Vol. I, #1.