Figure: EUR-USD Exchange Rate - Uni Trier · Figure: EUR-USD Exchange Rate SuSe 2013 Monetary...

Figure: EUR-USD Exchange Rate

SuSe 2013 1 Monetary Policy and EMU: Open Economy Setting

Figure: EUR-USD Exchange Rate


Figure: Indirect Quotation and Price Quotation


Real Exchange Rates


where P is the domestic price level, P* is the foreign price level and E is the nominal exchange rate (expressed in foreign currency divided by domestic currency).

real exchange rate – price of domestic goods in terms of foreign goods.

SuSe 2013 Monetary Policy and EMU: Open Economy Setting 5

Interest Parity


Interest Parity


Interest Parity

Euro

US $ $

€

€ €

€


(Uncovered) Interest Parity


Purchasing Power Parity

The law of one price in the context of open economy –

two identical goods must sell for a price that is the same

when translated into a common currency: e.g.

E P = P* + C

where

P, P* – domestic price, foreign price,

E – price of the domestic currency (i.e $/€),

C – transaction cost.


Purchasing Power Parity (PPP)


Figure: Nominal and real exchange rates: Germany vs. UK, 1950–2010


The Balassa-Samuelson Effect

Average yearly inflation in Eurozone countries, 1999-2011 (%)


The Impossible Trinity

• Impossible trinity principle: only two of the three following features are compatible with each other:

• “The point is that you can’t have it all: A country must pick two out of three” Paul Krugman (1999)



There are examples for each side of the impossibility triangle:

- Full capital mobility, autonomous monetary policy, flexible exchange rate: Eurozone as a whole, USA, Japan, UK, Switzerland, Sweden:

• exchange rate can be quite volatile;

• ability to conduct short-run stabilization.



- Full capital mobility and fixed exchange rate: Exchange Rate Mechanism:

• shallow distinction between such a policy and euro membership.



- Fixed exchange rate, monetary policy autonomy, capital controls: many developing and emerging countries (e.g., Brazil, China):

• people try to evade the restrictions;

• negative effects on investment and growth.

• What happens when one tries to violate the impossible trinity? A currency crisis: sooner or later a speculative attack wipes out the fixed exchange rate arrangement.


Exchange Rate Regimes

- Free floating;

- Managed floating: central banks buy their own currency when they consider it too weak, and sell it when they see it as too strong, but they refrain from pursuing any particular exchange rate target;

- Fixed exchange rates or target zones: authorities declare an official parity vis-à-vis another currency or a basket of currencies, with margins of fluctuations around the central parity (i.e., target zone);

- Crawling pegs: central parity and band of fluctuation around it, which are allowed to slide regularly: they crawl. The rate of crawl is sometimes pre-announced, sometimes not;


Figure: Poland’s crawling band, May 1995–March 2000



- Currency boards: a tight version of fixed exchange rate regimes. The central bank may only issue domestic money when it acquires foreign exchange reserves. If it spends its foreign exchange reserves, the central bank must retire its own currency from circulation and the money supply shrinks;

- Dollarization/euroization and currency unions: a stricter regime is to fix the exchange rate irrevocably, by adopting a foreign currency, hence the term ‘dollarization’ (as in Ecuador, El Salvador, Panama, Liberia) or ‘euroization’ (as in Kosovo and Montenegro).



European Monetary System (EMS)

- 8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar (Exchange Rate Mechanism - ERM)

- ECU value was tied to a basket of specified amounts of European currencies

- Fluctuated within limits

- Led to foreign exchange crises involving speculative attack



Inflation during the ERM years:



French Franc/ DM during the ERM years:



• The 1990s was a decade of violent currency crises: Europe’s ERM was hit in 1992–93; Latin America followed in 1995–99; Southeast Asia’s turn in 1997–98; and Russia in 1998.

• These countries were operating one or another form of a peg, but countries like Hong Kong and Argentina, both with a currency board, escaped the apparently contagious wave.

• This has made popular the ‘two-corner’ view according to which the only safe regimes are the extremes ones, free floating or ‘hard pegs’.


The Monetary Model

• Links exchange rate movements to balance of payments equilibrium

• Dominant Theory of 1970s

• Still used for medium- to long-term forecasting.


The Monetary Model

The Monetary model rests on three assumptions: 1. the aggregate supply curve is vertical

2. the demand for real money balances is a stable function of only a few domestic macroeconomic variables – using the Cambridge quantity equation in equilibrium,

where y is real national income 3. PPP obtains at all times.

kPyMM ds 0k


Figure: Aggregate demand with the quantity equation


The Monetary Model: Disturbance: M0

s increases to M1s


The Monetary Model: Equilibrium

which is solved for S as:

The exchange rate is the ratio of the money stock to the demand, measured at the foreign price level.

ykSPkPyMs *

ykPMS s *

0/


The Monetary Model

Home currency will depreciate (S will increase) whenever:

– Home money stock increases

– Home real income decreases

– Foreign price level falls.


Figure: Income increase under floating exchange rates


Figure:Foreign price increase under floating exchange rates


The Monetary Model: Two-country model of a floating exchange rate

The foreign-country version of the quantity equation:

– foreign demand for money, proportional to foreign nominal

income

**** yPkM d

****

00// yPkkPyMM ss


The Monetary Model: Two-country model of a floating exchange rate

Under PPP,

Solving for S,

– the exchange rate equals the ratio of the relative money stocks to the relative real demands.

***

00// ykkSyMM ss

**

*

/

/

ykky

MMS

SPP */


The Monetary Model: Fixed Exchange Rates

• Money stock endogenous, since monetary policy is needed to defend the fixed exchange rate

• Money stock contains FX component which increases (decreases) when there is excess demand (supply) for domestic currency, hence, domestic credit is the monetary policy instrument – not the money supply as a whole

• Endogenous: P, FX

• Exogenous: y, P*, DC.

• FX+DC=Ms


Figure: Domestic credit and money stock

000 DCFXMs

DC0

FX0

Ms0

DC1

Ms1

FX2


Figure: Domestic credit increase under fixed rates


Money Supply Increase

If reserves =

Money stock:

Under a fixed exchange rate regime, the policy variable for the

money supply is domestic credit, DC0

000 DCFXMs

0FX


Money Supply Increase

If the exchange rate is pegged at , under PPP,

• The foreign currency reserves must be equal to the gap between

• given demand for domestic money

• supply generated by the local banking system.

*

0PSP

0

*

0 DCFXMyPSkM sd

0

*

0 DCyPSkFX

0S


Conclusions regarding fixed exchange rates

• In a fixed exchange rate system, the (change in the) stock of reserves simply fills the gap between the demand for money and the domestically generated supply (DC)

• Domestic credit expansion changes nothing, except composition of money stock: increase (decrease) in DC is offset by fall (rise) in reserves, hence, post-expansion money stock is:

Ms1 = FX1+DC1


Q. What happens if authorities prevent money stock returning to its previous level by further increases in DC?

• Sterilization can only work in the short run, if at all. Pushing the Ms curve back out simply repeats the same process of balance of payments deficit followed by reserve loss

• The longer the policy is sustained, the greater the domestic credit component of Ms and the smaller the reserve backing

• At some point, fall in reserves leads to collapse of fixed exchange rate as speculators sell currency.


Change in real income under fixed exchange rate

• Initial situation: Ms0 = P0 = 1 → ky0 = 1, since Ms

0 = kP0y0

• Now y changes, so the above equation no longer holds, and the link between the second and third graphs broken!

• Disturbance: shift in AS-curve

P

S

P

Yr

Ms

FX

AS0

Ms0

Ms0

Ms1

FX+DC0

FX1 FX0 Yr0

DC0

P1

P0

P = SP0*

P1

P0=1

AS1

Yr1

Ms1

SuSe 2013

Devaluation under fixed exchange rates


Conclusions regarding devaluation

• Devaluation raises domestic competitiveness creating temporary balance of payments surplus and consequent reserve increase, until money stock increases in same proportion as devaluation

• Final outcome: higher domestic price level with cheaper domestic currency means real exchange rate (competitiveness) unchanged, balance of payments back in balance

• Only change: one-off increase in reserves.


Interest rates in the monetary model

Interest rate increase under floating exchange rates

Figure: EUR-USD Exchange Rate - Uni Trier · Figure: EUR-USD Exchange Rate SuSe 2013 Monetary...

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