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1/31/2010
To Fix or Float?
Economics of currency regimes
Choosing an exchange rate regime
• Is there an optimal exchange rate regime?
• The choice of exchange rate system affects:
–E i th (b th d d d l id )
Economic growth (both on demand and supply‐side)
– Inflation
– Trade balance
– Susceptibility to and ability to absorb external economic
shocks
• Si 1992 th UK h h fl ti h
Since 1992 the UK has chosen a floating exchange rate t
system
– Value of currency determined by the market
– No official intervention by the Bank of England
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Key drivers of the currency’s value
• Macroeconomic performance
– Inflation in one country relative to another
International trade performance (net balance of trade)
–I t ti lt d f ( tb l ft d )
– Government finances
• Interest rate differentials between countries
• Net capital flows between countries
– Foreign direct investment
– Net flows of money into property, bonds, equities
• Perceptions of currency traders in the market
• Is the currency at its equilibrium level
Exchange rate systems – the options
• Countries can choose their exchange rate system:
• (1) Free‐floating exchange rate
• (2) Managed floating system
• (3) Semi‐fixed exchange rate system
• (4) Fully‐fixed exchange rate system
• (5) Monetary Union with other countries
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Floating exchange rates
• The value of the currency is determined purely by
market demand and supply
No official target for the exchange rate
• N ffi i l t t f th h t
• There is no need for intervention in the currency market
by the central bank
• Sterling has floated freely on the foreign exchange
markets since the UK suspended membership of the
ERM in September 1992
ERM i S t b 1992
Sterling against the US dollar
GBP/USD
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Sterling against the Euro
Pence per Euro1
Managed floating exchange rates
• Currency is usually determined by market forces
• Some market intervention might be considered as part of
macroeconomic demand management
g
– E.g. intervention by Bank of Japan to influence the Yen a few years ago
– Swiss Central Bank intervened in 2009 to prevent Swiss franc appreciation
• Interest rates may be changed to affect the market value of the
currency by influencing hot‐money flows
• No attempt is made to influence the long‐term external value of
the currency
the currency
• There are limits to the effectiveness of intervention in markets
because of the power of speculators
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Semi-fixed exchange rates
• The exchange rate is given a specific target
• The currency can move between permitted bands of fluctuation
on a day‐to‐day basis
y y
• Exchange rate becomes a target of monetary policy
• The central bank must intervene to maintain the value of the
currency within the set targets if it moves outside the agreed
range
• Re‐valuations of the currency are seen as a last resort or when
intervention is proving ineffective
intervention is proving ineffective
• Examples include currencies of countries that plan to join the
Euro (they join a system known as ERM‐mark II)
Pegging to the Euro
Pegging to the Euro - Estonia and Latvia
Local exchange rates to the Euro, daily value
15.95 15.95
15.90 15.90
15.85 Estonian currency 15.85
15.80 15.80
15.75 15.75
EUR/EEK
15.70 15.70
15.65 15.65
15.60 15.60
15.55 15.55
15.50 15.50
15.45 15.45
0.725 0.725
Latvian currency
0.700 0.700
0.675 0.675
0.650 0.650
L
EUR/LVL
0.625
0 625 0.625
0 625
0.600 0.600
0.575 0.575
0.550 0.550
0.525 0.525
0.500 0.500
97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Reuters EcoWin
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Fully-pegged exchange rates
• Commitment to a fixed exchange rate
• The exchange rate is pegged
• There are no daily fluctuations from the agreed central
rate
• Occasional realignments
– Revaluation
– Devaluation
Some recent currency intervention stories
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Currencies in the news
Choosing a currency regime has consequences
• Countries have always faced constraints in choosing
their exchange rate regime.
Any country can have only two out of the following
• Any country can have only two out of the following
three:
1. An independent monetary policy
2. A fixed exchange rate
3. An open capital account
• As international financial markets have developed,
As international financial markets have developed,
there has been a general movement to flexible
exchange rates supported by credible domestic
monetary policies.
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Case for floating exchange rate systems
• Less need for currency reserves for use in intervention
– Fixed exchange rates can become vulnerable to speculative attack
• Useful instrument of macroeconomic adjustment
e.g. a lower currency can stimulate aggregate demand
– e g a lower currency can stimulate aggregate demand
– Sterling’s depreciation in 2008‐09 may have helped limit the scale of the
recession
– Appreciation against the US dollar in 2007 was helpful when world oil
prices (based in $s) were very high
• Provides partial “automatic correction” for a trade deficit by changing the
relative prices of exports and imports
( y) yp y
• Freedom (autonomy) for domestic monetary policy
– Allows countries greater freedom to set interest rates for domestic
economic aims
– It gives policy‐makers another tool of policy which can be useful especially
if other instruments of policy are not working as well as hoped
Sterling and UK Economic Growth
Percentage change on quarter
Index e
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Sterling and the trade balance
Sterling index
x
Quarterly balance £ (billions)
(
billions
How might a change in the currency affect inflation?
Index
Percent
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Case for fixed exchanges
• Stability and certainty ‐ helpful for trade and capital investment
• Some flexibility (i.e. the occasional devaluation or revaluation of
the currency – known as “realignment”)
y g )
• Reductions in costs of currency hedging for businesses
• Fixed rate provides a discipline on domestic producers to keep
costs & prices down and to become more productive
• Reinforces gains in comparative advantage:
– If one country has a fixed rate with another, then differences
in relative costs will quite easily be reflected in changes in the
i l i ill i il b fl di h i h
rate of growth of exports and imports
Benefits of a cheaper currency
• Competitive boost to export sector and industries facing import
competition
– Improved profitability of exporting
– Relative price of imports rises
Relative price of imports rises
– Impact depends on overseas Ped for UK X and domestic Ped for M
– And whether export industries have sufficient capacity / flexibility
• Increase in the value of investment income from overseas assets
• Higher value of subsidies from overseas e.g. Farm income payments are
made in Euros
• Possible multiplier and accelerator effects
• Helps to rebalance the economy (i.e. Shift away from reliance on
domestic consumption)
• Currency depreciation acts as a partial automatic‐stabiliser for economy
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Risks from a falling currency
• Inflationary effects from higher import prices (cost‐push)
– Higher import prices for raw materials, food, energy
– Imported capital technology becomes more expensive
– g
Possible second round effects on wages
– Weaker currency increases import prices and thus worsens terms of trade
• Weak currency may deter foreign investors
– Harder for the government to find foreign purchasers of sovereign debt
– May require higher bond yields – increases cost of servicing debt
– Greater risk of capital flight
• Risks for those who have borrowed in a foreign currency
– Good example here are consumers in countries such as Hungary and Latvia
Low elasticity of demand may limit the impact of currency depreciation
• L l ti it f d d li it th i t f d i ti
on the trade balance and export volumes
• Currency devaluation does not turn around what might be long term
supply‐side weaknesses in the economy
Russian rouble against the US dollar
USD/RUB
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A controversial exchange rate! The Yuan v the dollar
USD/CNY
Blog articles on currencies
• Blog articles on exchange rates
• Blog articles on sterling
• Blog articles on the US dollar
• Blog articles on devaluation
• Blog articles on the Euro
• Blog articles on the Yuan
• Blog articles on the balance of payments
Blog articles on the balance of payments
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