5.9 financial markets and central bank online test
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Week-11-pp.pptxWeek 11 Topic: Exchange Rate Policy and the Central Bank 2 Chapter 19 of main text: Stephen Cecchetti and Kermit Schoenholtz
Learning Objectives
This week material concludes last weeks discussion. At the end of the lesson, you are expected to critically engage in:
Explaining the links between exchange rates and monetary policy.
Describing the mechanics of exchange rate management.
Assessing the costs, benefits, and risks of fixed exchange rates.
Analysing how fixed exchange rate regimes work.
19-2
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Accessing cost and benefit of Fixed Exchange rate
The Danger of Speculative Attacks
Fixed exchange rates have benefits, but they are fragile and prone to a type of crisis called a speculative attack.
Suppose for some reason, financial market participants come to believe that the government will need to devalue its currency in the near future.
Investors are likely to attack the currency now and force an immediate devaluation.
19-3
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The Danger of Speculative Attacks
Causes of a speculative attack:
Fiscal policy:
If investors begin to think that at current levels, government spending must ultimately increase inflation, they will stop believing that officials can maintain the exchange rate at its fixed level.
Financial instability:
If a country’s banking system is insufficiently capitalized or otherwise unsound, a central bank may face pressure to relax monetary policy to avoid or contain a financial crisis.
If investors doubt that the central bank will keep interest rates high enough for a sufficient time to defend the currency peg, an attack may follow.
19-4
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Assessing the Costs and Benefits
Spontaneously:
If enough currency speculators simply decide that a central bank cannot maintain its exchange rate, they will attack.
Spontaneous speculative attacks are like bank runs; they can be contagious.
Many observers suspect that in today’s world, no central bank has the resources to withstand such an attack in the absence of capital controls
19-5
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The gold standard obligates the central bank to fix the price of gold.
Any political disruption in countries where gold is mined could have dramatic monetary policy effects.
The promise to convert dollars into gold means that international transactions must be settled in gold.
Under a gold standard, countries running current account deficient will be forced into deflation.
Economic historians believe that gold flows played a central role in spreading the Great Depression throughout the world.
The sooner a country left the gold standard and regained control of its monetary policy, the faster its economy recovered.
19-6
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Summarizing the Case for a Fixed Exchange Rate
Conditions under which adopting a fixed exchange rate makes sense for a country:
A poor reputation for controlling inflation on its own.
An economy that is well integrated with the one to whose currency the rate is fixed.
A high level of foreign exchange reserves.
A high degree of price and wage flexibility.
A robust banking system.
Fixed exchange rates are still risky to adopt and difficult to maintain.
19-7
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Exchange Rate Pegs and the Bretton Woods System
In 1944, a group of 44 countries agreed to form the Bretton Woods system.
It was a system of fixed exchange rates that offered more policy flexibility over the short term than had been possible under the gold standard.
The system lasted from 1945 to 1971.
Each country maintained an agreed-upon exchange rate with the U.S. dollar.
It pegged its exchange rate to the dollar.
19-8
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The dollar was what is known as a reserve currency.
The choice of the dollar was based on the facts that:
The U.S. was the biggest of the Allies in WWII, both economically and militarily.
Dollars were relatively abundant.
19-9
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Exchange Rate Pegs and the Bretton Woods System
Because other countries did not want to adopt U.S. monetary policy, their fixed exchange rates required complex capital controls.
Countries had to intervene regularly to maintain their exchange rates at the peg.
Adjustments were made to the exchange rate pegs, but only in response to perceived long-term imbalances.
19-10
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Exchange Rate Pegs and the Bretton Woods System
The system had some flexibility because of the International Monetary Fund (IMF).
They were created to manage the Bretton Woods System by making loans to countries in need of short-term financing to pay for an excess of imports over exports.
With a fixed exchange rate and the free movement of capital, countries could not have their own discretionary monetary policies.
19-11
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Exchange Rate Pegs and the Bretton Woods System
Because their exchange rate was fixed to the dollar, participating countries were forced to adopt policies that resulted in the same amount of inflation as in the U.S.
By 1971, the system had completely fallen apart.
The response of American officials has been to allow the dollar to float freely ever since.
Europeans took a different tack:
They maintained various fixed exchange rate mechanisms and gave up their ability to set interest rates.
19-12
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Exchange Rate Pegs and the Bretton Woods System
Monetary policy should be time consistent.
In 2010/11 investors were worried about a euro-area breakup and fled from the euro to the Swiss franc.
Given Switzerland’s size and location, the rise in the franc threatened to drive them from stable prices to deflation.
The Swiss National Bank had already lowered interest rates close to zero.
19-13
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To stop the runaway franc, the SNB promised to sell unlimited francs at a fixed rate of 1.20 Swiss francs per euro.
The move was controversial
In early 2015, the SNB gave up and let the franc float
Fixed exchange rate commitments typically fail when a central bank is trying to prevent the domestic currency from depreciating
In the absence of capital controls this cannot be maintained for long as it lacks time consistency
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In June 2014, China’s stockpile of foreign exchange reserves peaked at $4 trillion.
More than one-fourth of all currency reserves in the world.
The growth in China’s reserves reflected a combination of it fixed exchanged-rate regime and it sustained current account surpluses
China’s fixed exchange rate provided strong support for its export growth
19-15
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China promoted export-led growth by pegging their currency, the renminbi, to the U.S. dollar.
Starting in mid-2005, Chinese policymakers began adjusting the dollar peg, allowing the renminbi to appreciate over the next decade by more than 25 percent versus the dollar.
When a country runs a current account surplus, it also runs a capital account deficit.
It is either making loans to foreigners or buying their assets.
19-16
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As of September 2018, China owned about $1.33 trillion of Treasury and agency debt.
Chinese firms have also increased their direct investment abroad.
From July 2014 until January 2017, unprecedented capital outflows triggered a plunge in China’s reserves.
In 2017, a partial restoration of capital controls, combined with the perception that policymakers were aiming to limit devaluation, helped steady both the value of currency and the level of reserves.
19-17
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19-18
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Hard Pegs: Currency Boards and Dollarization
In a hard-peg system, the central bank guarantees convertibility of domestic currency into the foreign currency to which it is pegged.
Only two exchange rate regimes can be considered hard pegs:
Currency boards
Dollarization or euroization.
19-19
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With a currency board, the central bank commits to holding enough foreign currency assets to back domestic currency liabilities at a fixed rate.
With dollarization (euroization), one country formally adopts the currency of another country for use in all its financial transactions.
19-20
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Hard Pegs: Currency Boards and Dollarization
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Somewhere between 10 and 20 currency boards operate in the world today.
The Hong Kong Monetary Authority (HKMA) operates a system whose sole objective is to maintain a fixed exchange rate of 7.8 Hong Kong dollars to one U.S dollar.
The rules of the currency board provide that the HKMA can increase the size of Hong Kong’s monetary base only if it can accumulate additional dollar reserves.
19-21
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Hard Pegs: Currency Boards and Dollarization
With a currency board, the central bank’s only job is to maintain the exchange rate.
While that means that policymakers cannot adjust monetary policy in response to domestic economic shocks, the system does have it advantages.
It allows for the control of inflation, which is very important in an inflation prone economy.
19-22
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Hard Pegs: Currency Boards and Dollarization
Currency Boards and the Argentinean Experience
Currency boards do have their problems.
The central bank loses its role as the lender of last resort to the domestic banking system.
The Banco Central de la Republica Argentina solved this problems by establishing standby letters of credit from large U.S. banks.
Lending was limited to the amount of dollar credit that foreign banks were willing to extend.
19-23
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In 2001, the Argentinean currency board collapsed and authorities were forced to allow the peso to float.
The peso was pegged to the U.S. dollar, even though Argentina’s economy doesn’t have much to do with the U.S. economy.
When the dollar appreciated, the peso appreciated.
The overvalued peso priced Argentinean exporters out of their markets severely damaging their economy.
19-24
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Currency Boards and the Argentinean Experience
Fiscal policy was the other problem.
While the Argentinean economy grew at a healthy rate, government spending rose even faster.
The more the government borrowed, the more wary lenders became of continuing to lend.
Politicians spent until they simply ran out of money.
When politicians began printing their own money, the claim that Argentinean inflation would roughly mirror U.S. inflation was no longer credible and the currency board collapsed.
19-25
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Currency Boards and the Argentinean Experience
Dollarization in Ecuador
Some countries just give up and adopt the currency of another country for all their transactions, completely eliminating their own monetary policy.
In 1865, Monaco adopted the French franc and uses the euro today.
19-26
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Dollarization in Ecuador
In 1999, Ecuador experienced severe financial crisis.
In 2000, Ecuador officially gave up its currency.
Within 6 months, the central bank had bought back all the sucres in circulation.
Almost immediately,
Interest rates dropped
The banking system reestablished itself
Inflation fell dramatically
Growth resumed
19-27
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In a small emerging-market country, there are many reasons why a country would give up their currency.
With no exchange rate, there is no risk of an exchange rate crisis.
Using dollars or euros or yen can help a country to become integrated into world market, increasing trade and investment.
By rejecting the possibility of inflationary finance, a country can reduce the risk premium it must pay on loans and generally strengthen its financial institutions.
19-28
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Dollarization in Ecuador
There are costs to dollarization as well.
There is a loss of revenue that comes from issuing currency:
What is called seignorage.
Dollarization effectively eliminates the central bank as the lender of last resort as they cannot print their own money.
There is a loss of autonomous monetary or exchange rate policy.
Any country that adopts the dollar as its currency gets U.S. monetary policy, like it or not.
19-29
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Dollarization in Ecuador
Dollarization is not the same as a monetary union.
The decision by European countries to adopt a common currency, the euro, was fundamentally different from a country's decision to adopt the dollar.
When the FOMC makes its decisions, the affairs of Ecuador and El Salvador carry no weight.
All European countries participating in the monetary union take part in monetary policy decisions.
A monetary union is shared governance; euroization is not.
19-30
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Dollarization in Ecuador
Balance-of-payment (BoP) crises – sudden stops of caital flow reversals – compel countries to restore their external balance between exports and imports or shift export surpluses rapidly.
If one country is importing more than it is exporting from another country, it must find a way to finance that difference.
When a country can no longer finance a current account deficit, it must adjust quickly, often resulting in recession.
A capital flow reversal compels a shift to a current account surplus and causes an even deeper recession.
1-31
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