Exchange Rates and Exchange Rate Regimes

Exchange Rates and Exchange Rate Regimes Foreign Exchange Markets Bilateral Exchange Rates Foreign exchange is other currencies which must be used to buy goods, services or assets whose prices are denominated in other currencies. Foreign exchange markets are markets where currencies are exchanged. We measure the prices of foreign currencies by taking the bilateral exchange rates, eg. the US dollar-Australian dollar exchange rate. A bilateral rate is the rate at which one currency exchanges for another. These bilateral rates are what are needed to calculate the cost of goods and assets denominated in other currencies, and to measure changes in these rates. These prices are the most important prices in an economy. They define the purchasing power of domestic currency , and this in turn defines the international competitiveness of local production of goods and services, and the relative attractiveness of domestic and foreign financial assets. Quoting Bilateral Exchange Rates A bilateral exchange rate can be quoted in either of two ways: 1. English-speaking tradition (UK,US, Australia, etc) This expresses a bilateral exchange rate as the number of units of the foreign currency which exchange for a unit of the domestic currency, eg. US 0.75 for an Aus dollar 2. European tradition This expresses a bilateral exchange rate as the number of units of the domestic currency which exchange for a unit of the foreign currency, eg. Aus dollar 1.33 for a US dollar. Note that one of these methods of quotation is the inverse of the other, eg 1.33 =4/3= (¾)-1 or 0.75= ¾ = (4/3)-1. They convey precisely the same information. These alternative methods are available because the exchange rate is the price of one currency in terms of another. Example: The Australian Foreign Exchange market The Australian national currency is the Aus dollar, the AUD. The Aus dollar now floats freely against other currencies, with no interference from the Reserve Bank of Australia or the Australian government. [See RBA exchange rate statistics] In fact, according to the latest BIS statistics, the AUS dollar market is the seventh largest foreign exchange market in the world. The AUD/USD bilateral rate is the fourth most traded in the world, AUD/USD transactions accounting for around 40 per cent of all onshore foreign exchange transactions. Offshore trading of the AUD is now larger than onshore trading . Who Fixes Exchange Rates? The exchange rates of one currency are determined by the government of the country which manages this currency. Some countries fix their exchange rates vis-à-vis another country rigidly (eg the Chinese Renminbi is fixed vis-à-vis the US dollar) and others allow their currency to move freely in the foreign exchange market (eg Aus dollar), or adopt some intermediate position of managing the exchange rate while allowing it some movement in the markets. The International Monetary Fund There is a multilateral organisation with a role in this area, the IMF. The IMF oversees the world exchange rate system. Under its rules, all member countries have to maintain “current account convertibility”, i.e. they are not allowed to restrict foreign exchange payments on current account. In the days when all countries pegged their exchange rates, it played an important role in making short term loans to member countries to allow them to maintain their exchange rates. But in an era when most currencies float and others have some degree of flexibility, the IMF role is confined to making loans and giving advice to Developing Countries. Movements of Bilateral Exchange Rates Using the English-speaking tradition, we say that one currency devalues (or depreciates) against another currency if the number of units of the foreign currency which exchange for the first currency falls; for example, if the number of US dollars exchanges for an Australian dollar fall from, say, US 0.80 to US 0.70. We say that the currency appreciates if the number of units of the foreign currency which exchange for a unit of the first currency increase; for example, from, say, US 0.70 to US 0.75. Effective (Nominal) Exchange Rates For many purposes, we want a measure that reflects changes in the bilateral exchange rate of one country across several of its trading partners. The “effective” or “tradeweighted” exchange rate of one country visà-vis other currencies is an index that measures the average movement of one currency against other currencies. Trade-weighted Index In Australia, the Reserve Bank of Australia uses the following formula for the nominal effective exchange rate index: wi = e (t)w1x e (t)w2… x e (t)wn  TWI(t) = π ei(t) 1 2 n Here ei is the bilateral exchange rate with respect to one currency i and wi are the weights used to weight the movements of each currency. The weights are the shares of each major currency in the export and import trade of Australia (see RBA sheet in handout). n is the number of countries used in the calculation of the index. This formula gives us the (geometric) mean of the movements with respect to each of the currencies used in the calculation at time t. If this index rises (falls), it means that the currency of the home country is appreciating (depreciating) on average against other currencies. Real Effective Exchange Rates Foreign exchange transactions depend, however, not only on what happens to the exchange rate but also on whether prices are rising or falling in the home country relative to a foreign country. Consequently, we can adjust this formula to allow for the differences in the rate of increase of prices among trading partners. This gives us an index of the real effective exchange rate. It is given by the formula E(t) = [Ih(t) /Ip(t)] •TWI(t) Here, Ih and Ip are the rates of inflation in the home country and the average rate of inflation among the trading partners. Thus, this index at time t rises (fall) if the rate of inflation in the home country is higher than among the trading partners or if the TWI rises (falls). If the index rises (falls), we say there has been a real effective exchange rate appreciation (depreciation). This means that the country is becoming less (or more) competitive with overseas markets. [See RBA table of real effective exchange rates] Index calculations Both the effective exchange rate and the real effective exchange for a currency are useful measures, each designed to measure one aspect of currency movements. For Australia, the Reserve Bank of Australia makes estimates of the (nominal) effective exchange rate and the real effective exchange rate, and the Commonwealth Treasury makes estimates of the real effective exchange rate, using different indices of price movements. In other countries the IMF and other organisations measure effective and real effective exchange rates for other currencies in a similar way. Today a number of financial institutions also calculate indices of effective exchange rates [See BIS figures] Exchange Rate Volatility Bilateral exchange rates tend to be volatile, especially for emerging market countries. Volatility is usually measured by the standard deviation of the movements each day or each week of one currency vis-à-vis another, say the US dollar, over some period. [See handouts for Asian currencies during and after the period of the Asian Crisis] A number of currencies have been subject to crises in recent years, eg. Mexico (1994), east Asia (1997), Russia (1998), Turkey (2001). Purchasing Power Parity Exchange Rates What determines exchange rates in the longer run? One hypothesis is that market exchange rates will tend, in the longer run, to reflect the fundamentals of the price levels in the countries concerned. If one country has a higher inflation rate than its trading partners, it currency will tend to depreciate. This is known as the Purchasing Power Parity Hypothesis. It is an application of the Law of One Price – exchange rates are such, under this hypothesis, that a single price holds in the market for each traded commodity. Example 1: the Big Mac Index of PPP The Economist produces a Big Mac Index of the PPP of currencies. The Big Mac is chosen as a representative good because it is a good which is virtually identical in all countries in which it is sold, which is almost all countries in the world. Suppose, the price of a Big Mac is in Australia A$ 3.00, and in the US, US $ 2.00. Then the Big Mac PPP of the AUS $ is 2/3 or 66 US cents to the A$. If this were the exchange rate, A$3.0x(2/3) = US$2.0 i.e the Law of One Price would hold for Big Macs. Example 2: The CommSec iPod Index From 2007, CommSec has calculated a similar one good index, but this time using the price of iPods in different countries. The current price of an iPod in Australia is, in terms of US dollars, US $172.36. the price in the US is US $149.00. If this reflected purchasing power parity, one would expect a a bilateral AUD/USD exchange rate of 86.44 US cents to the Aus dollar. At this rate, the Aus dollar is undervalued, despite its recent rise. [see CommSec handout] The Purchasing Power parity Hypothesis In fact, of course, many goods are traded between any two countries. We can calculate the PPP exchange rate using a bundle of goods. The IMF does this for most countries that have their own currency. With these PPP exchange rates we can test whether the PPP hypothesis holds, i.e. does the nominal effective exchange move to reflect, in the longer run, price levels in the trading countries. The empirical evidence suggests that the nominal effective exchange rates of countries do tend to adjust towards their PPP’s, but PPP is not a complete explanation of the movements of nominal exchange rates. Other factors influence exchange rates. In an age of high capital mobility, interest rate differentials have become important. Exchange Rate Regimes Different countries manage their exchange rates in different ways. We can think of exchange rate regimes being arrayed on a continuum, from those which are fixed rigidly to those which are allowed to vary freely according to market conditions. It is useful to think of three broad categories: Hard fixes, i.e. a fixed rate that is hard to change: -common currency, monetary union, currency board - all involving the abandonment of national monetary sovereignty Intermediate Completely freely floating, i.e. no government intervention In fact, there are many different possible exchange rate arrangements. IMF Classification The International Monetary Fund (IMF) uses a classification of exchange rate arrangements. [see IMF hand-out] These are arrayed from hard to soft. Choice of Regime There is a big debate about which type of exchange rate regime is best. A rigidly fixed exchange rate has the advantage of fixity in the short term but it has some long term disadvantages: A rate pegged in terms of one currency leads to effective exchange rate changes if the currency to which it is pegged changes in world markets eg before the Asian Crisis, the US dollar was depreciating in world currency markets vis-à-vis the Japanese yen and German DM, which caused the effective rates of those Asian currencies pegged to the US dollar to appreciate, at a time when there balance of payments positions were worsening Pegged rates are prone to crises when investors and speculators lose confidence in the future of the currency as market fundamentals change Choice of Regime Cont’d  The macro-economy managers of the country concerned lose one instrument of monetary policy (the exchange rate itself). Foreign exchange markets must then be managed in by other instruments, such as interest rates, exchange rate quantitative controls. The Macro-economic Trilemma There are three common objectives of macro-economic policy in an economy To retain an independent monetary policy, i.e. to raise or lower domestic interest rates to control the economy To maintain stable exchange rates To maintain freedom to convert one currencies into others However, it is not possible to achieve all three simultaneously. This is know as the Macroeconomic Trilemma. For example, a hard fixed exchange rate achieve the second and perhaps the third but not the first. A floating currency achieves the third and perhaps, in association with monetary policy, the second but not the first. There is now a perception among exchange market experts that the only sustainable regimes are those at the very hard and very soft extremes, i.e. hard pegs or freely floating exchange rate regimes. This is know as the “bipolar view” of exchange rate regimes. However, there is still no agreement on this issue. Dollarisation One exchange rate regime choice is for a country to officially adopt the currency of another country as the legal tender circulating in that country. An increasing number of countries, mainly small and island economies, are doing this. In fact, in 2005, 14 independent countries and 15 territories officially use a foreign currency as their predominant currency (Xenias,2006). 13 of these use the US dollar. The EU Euro is another choice, but a number of other currencies are also used. The US International Monetary Stability Act To protect the independence of its monetary policy at a time when more countries were dollarising, the US government passed the International Monetary Stability Act in 1999. This Act states that the US is not obliged to act as a lender of last resort to countries that have officially dollarised or to consider their economic and financial conditions when setting US monetary policy, or to supervise their financial institutions. Questions of the Day 1. 2. Which country or countries use the A$ as their currency? What is the currency used in Timor-Leste (East Timor)? Currency Unions Another exchange rate choice is a monetary union. A monetary union is an agreement among a group of countries to share a common currency and to have a common central bank with powers to issue notes and coins and to determine the monetary policies of the countries concerned. Three examples of monetary unions: the European Monetary Union. This uses the Euro( with 12 countries), the Eastern Caribbean Currency Union. This has 6 countries and uses the East Caribbean dollar (that is pegged to the US dollar), and the two CFA (Colonies Française d’Afrique) Frank Zones in West and Central Africa (with 14 countries) - the West African Economic and Monetary Union and the Central African Economic and Monetary Union, which use the CFA Frank that is now pegged to the Euro. Optimal Currency Unions Bob Mundell developed a theory of optimal currency areas. According to this theory, the extent to which a set of countries can be considered candidates for a monetary union depends on the symmetry/asymmetry of the shocks to their economies and on the extent of factor mobility between them. If shocks are symmetrical of if factors are highly mobile, there is little need for an independent monetary policies and the costs of a monetary union will be small. However, this theory is not appropriate in an era of floating exchange rates and inflation-targeting monetary policies. Now the crucial issue is how would monetary union and the loss of independent monetary policies affect the macro-economies. The Single World Currency Movement The number of countries which do not have their own currency is increasing as the number of countries that have adopted another country’s currency or joined a monetary union have both increased in recent years; according to the IMF, 41 countries did not have their own currency as at 31 July 2006. Some macroeconomists and some foreign exchange market experts believe that the optimal foreign exchange market regime is a single global currency with a single global central bank. One such group is the Single Global Currency Association.