International Finance Chapter 5

How do developing countries typically manage to keep currencies pegged at values that are too high?

By imposing exchange controls. The central bank of the developing country strictly controls financial transactions involving foreign currencies.

Do you believe its monetary union will be beneficial for Europe?

Economic benefits have already been documented, including those of price convergence, lower costs of capital, and increased trade. *However*, the high unemployment rates and debt crises in some countries are causing strain within Europe.

What was the EMS?

European Monetary System (1979-1999) - a target zone system with exchange rates maintained between bands of 2.25% around central rates.

What are potential benefits of a pegged currency system?

Some believe it brings more discipline and stability and controls inflation. They are believed to eliminate the uncertainty that comes with floating exchange rates. *though they may show considerable latent variability and devaluation risk*

What is likely to happen if a central bank suddenly prints a large amount of new money?

The result would likely only be *higher inflation* since additional supply of money is unlikely to make people consume more or work harder

Describe two channels through which foreign exchange interventions may affect the value of the exchange rate.

There is a direct and an indirect channel. *With the direct channel,* effects from foreign exchange interventions are minimal because of how large trading volumes are. Still, there may be short-term effects, like on the money supply. *The indirect channel* shows how an intervention can alter peoples' expectations and affect their investments, helping to push the exchange rate in the direction the central bank desires.

How can you quantify currency risk in a floating exchange rate system?

Volatility is an adequate indicator of risk and can be assessed using historical information. The higher the volatility, historically, the riskier are positions in this currency.

What is the effect of a foreign exchange intervention on the money supply? *How can a central bank offset this effect and still hope to influence the exchange rate?*

When a central bank buys (sells) foreign currency, its international reserves increase (decrease), and the money supply increases (decreases) simultaneously. *there is no consensus on how effective sterilized interventions are in affecting the level and volatility of exchange rates* BUT the central bank can do several things to counteract the effects of the intervention including *signaling its opinion on the fundamental value of the exchange rate through an intervention that consequently affect market expectations*

devaluation

a change in a fixed exchange rate that increases the domestic currency price of foreign currency and thus decreases the value of the domestic currency

What is basket currency?

a composite currency consisting of various units of other currencies *examples: European Currency Unit in the EMS and the Special Drawing Right of the IMF*

Soft Peg

a currency whose value relative to other currencies is set by the government; a currency in a *fixed exchange rate system*

In pegged exchange rate systems, countries imposing capital controls sometimes *force their importers and exporters to hedge*. - Assuming that forward contracts are to be used, and an exporter has future foreign currency receivables, what will the government force him to do?

a forced hedge would require the exporter to sell the foreign currency forward for the local currency (*immediate positive demand for local currency*

foreign exchange reserves

all the foreign currency denominated assets the central bank holds (mostly consists of foreign government bonds)

What is likely to be the most credible exchange rate system?

among *fixed exchange rate systems*, a monetary union with a common currency is likely the most credible exchange rate system because of its price transparency, no exchange rate uncertainty, and lower transaction costs. *HOWEVER* they are still not entirely credible as seen with the tensions in Europe that could lead to the breakup of the euro.

What is an *optimum currency* area?

an area that balances the microeconomic benefits of a perfect exchange rate certainty against the costs of macroeconomic adjustment problems. *suitable for a single currency and monetary union*

Target Zones

an exchange rate system in which the exchange rate can fluctuate within a fixed band of values

How effective are non-sterilized and sterilized interventions?

coordinated efforts & efforts consistent with market fundamentals are *more effective* *still not effective in the long-run* and there is conflicting evidence on *whether or not the intervention is profitable*

lead operation

domestic importers prepay for goods to beat an increase in cost when devaluation goes into effect

Currency Board

exchange rate system in which the monetary base of the domestic currency is *100% backed by a foreign reserve currency* and is fully convertible into the reserve currency at a fixed rate and on demand

exchange rate risk can be hedged using...

forward contracts

Why might it be hard to quantify currency risk in a target zone system or a pegged exchange rate system?

historical volatility is not accurate enough with the peg and target zone. The true currency risk does not show up in day-to-day fluctuations of the exchange rate. *It is hard to quantify this "latent volatility"*

the monetary authorities in the countries with weaker currencies have *three basic defense mechanisms available*:

interventions interest rate increases capital controls

an unwelcome side effect of non-sterilized interventions

its effect on money supply (higher money supply = higher inflation)

What are official international reserves of the central bank?

official reserves consist of *three components*: foreign exchange reserves, gold reserves, and IMF-related reserve assets, with the first being by far the most important component.

lag operation

postpones the inflow of foreign currency to increase the value of their receivables

optimum currency area *pros*

sharing a currency across a border *enhances price transparency, lowers transaction costs, removes exchange rate uncertainty for investors/firms, and enhances competition*

In 1999/2000, Zimbabwe's Central Bank stabilized the Zim at Z$38/USD. In response, an illegal market developed wherein the Zim traded at Z$44/USD. *Are you surprised at the rumors that claim corporations were "hoarding" USD200 million?* Explain.

the existence of an illegal market indicates that the *Zim is incorrectly valued* at Z$38/USD. It is not surprising that people would hoard foreign exchange until the Zim is valued correctly. *US dollars are a better store of value than the Zim until it is de-valued*.

How can a central bank peg the value of its currency relative to another currency?

the government must make a market in the two currencies. *if there is excess supply of the foreign currency that would drive down the domestic currency price of the foreign currency, the government must buy the private excess supply of foreign currency and deliver domestic currency to those demanding it*

Dollarization

the phenomenon in which use of a foreign currency drives out the domestic currency as a means of payment and as a savings vehicle *allows countries to exactly match monetary and exchange-rate policies of the US but comes with loss of sovereignty* - Zimbabwe & Ecuador dollarized

Do you think the Euro will survive?

the weak countries are not powerful enough to leave and develop their own currency, so the breakdown of the Euro would likely be due to *the strong countries deciding they cannot afford to continue bailing out the weak countries* - things would have to get very bad for this to happen

What does a fixed exchange rate do

undervalues the foreign currency overvalues the domestic currency *developing countries do this*

optimum currency area *cons*

when sharing a currency across a border, there is a *loss of independent monetary policies for participating countries* - so if a country experiences an adverse shock, it can no longer save itself from a recession with monetary policies

How can a central bank create money?

*2 ways*: 1. *by literally printing money* (the central bank has the only authorized printing press in the country) 2. *by increasing the reserve accounts financial institutions hold with it* (and then that credit can be used to lend money to individuals and businesses, essentially creating money)

The Impossible Trinity - *examples of pairs*

*Domestic Monetary Autonomy & a Fixed Exchange Rate*: China and major industrial countries under Bretton Woods (give up free flow of capital) *Domestic Monetary Autonomy & Perfect Mobility*: United States, Japan (give up a fixed exchange rate) *Perfect Mobility & Domestic Monetary Autonomy*: Individual European Union Member States (give up independent monetary policy)

What is the result of setting pegs above and below market rate?

*Peg > Market Rate*: there is an excess supply of domestic currency, everyone wants to sell it and buy foreign currency to invest abroad *Peg < Market Rate*: quantity demanded of domestic currency exceeds quantity supplied

What are the benefits and costs of a unified currency area (monetary union)?

*benefits*: enhanced price transparency, lower transaction costs, no exchange rate uncertainty, enhanced competition (promotes economic growth) *costs*: even a monetary union can be broken apart, as seen in the euro and related asymmetric shocks. Labor mobility is limited and there is the loss of independent monetary policy

Developing countries keep currencies pegged at values that are too high. *Who benefits from this? Who is hurt by an overvalued currency?*

*benefits:* importers and those investing abroad by subsidizing buyers of foreign currency (increases the purchasing power of the political elite) *hurts*: exporters and foreign buyers of domestic assets by taxing sellers of foreign exchange

What was the Bretton Woods currency system?

*between 1944 and 1971*. The participating countries agreed to an exchange rate regime that linked their exchange rates to the dollar. The dollar had a fixed gold parity ($35 per ounce) but the system broken when President Nixon abandoned the US commitment to exchange dollars for gold in August 1971.

what are the costs and benefits of a fixed rate regime?

*costs*: if a country with a fixed exchange rate runs higher inflation than its trading partners, it loses competitiveness. Very short durations and devaluations *benefits*: they effectively lower exchange rate volatility

how can central banks defend their currency - for example, if the currency is within a target zone or pegged at a particular value?

*interventions* but it may result in lower money supply, reduced liquidity, and higher interest rates. *interest rate increases* but same as above. *capital controls to limit foreign exchange transactions*

pegged exchange rate system

*latent volatility* (not observable through historical exchange rate movements)

What is the difference between a sterilized and non-sterilized intervention?

*non-sterilized intervention*: to lower the yen price of the dollar, the Fed pays the bank by creating $50 million of base money, increasing the demand for yen and increasing the supply of dollars to the foreign exchange market *AN UNWELCOME SIDE EFFECT: higher money suppy* *sterilized interventions* offset open market transactions to restore the monetary base to its original size

What is the difference between a target zone and a crawling peg?

*target zone*: currency is allowed to fluctuate in a certain percentage around a central value. *crawling peg*: the fixed rate is adjusted over time

benefits of a crawling peg country

*the fixed rate is adjusted over time* the "crawl of the rate/band prevents the country from losing too much competitiveness when its inflation rate is higher than that of the benchmark country

How do central banks defend pegs or target zones?

- intervening through open market operations - raising interest rates - capital controls

What did the Maastricht Treaty try to accomplish?

1991 - mapped out the road to economic and monetary union within the European Union to be finalized by 1999. It established the euro and created a European central bank. Not all EU countries participate

Pegged Currency

A currency based on the fixed exchange rate of another country's currency.

floating currencies

A currency whose value is determined by market forces (supply and demand)

Describe the impossible trinity

In a standard open economy, there is an *intrinsic incompatibility* between *perfect mobility* (no capital controls, full financial integration), *a fixed exchange rate* (exchange rate stability), and *domestic monetary autonomy* (monetary independence). *Only two of these three policies are possible*

Target Zone System

Less historical volatility than floating rate systems - the underlying risk can be big due to *devaluations/revaluations*