International Macro ECN 160B
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Lecture notes 160B revised 052707 Lecture 8 Currency Union Topics 1 European Monetary system background EMS 2 European Monetary Union EMU 3 Currency boards and dollarizations 1 Background European Monetary System EMS exchange rate bands After Bretton Woods Break up several European countries attempt various mechanisms to x their exchange rates to each other In 1979 eight European countries created a formal system of mutually xed exchange rates called the European Moneta system EMS g The xed their exchange rates relative to each other oating jointly against the dollar The bilateral exchange rates were not held exactly xed but were allowed to uctuate within bands of an assigned par value with each of the other currencies Called margins When first set up each bilateral rate was only allowed to deviate from this by 225 above or below If the French franc depreciates to its lower limit relative to the DM it is obligated to sell DM reserves to make Franc appreciate German central bank is obligated to loan DM to France Initially had capital controls that limited the ability of private citizens to trade in foreign currencies Prevent speculators from starting a currency crisis These restrictions were relaxed in 1987 This regime was subiect to speculative attacks and currency crises which almost destroyed the regime in 1992 We will discuss this historical case later if we have time 2 European Monetary Union a Introduction On January 1 2002 12 European countries nalized their monetary union This meant that they had a common central bank in Frankfurt in Germany at which all 12 countries had to agree on a common monetary policy Why did these countries take this step We look below at the various costs and bene ts of a monetary union also called a currency union b Theory Gains from monetary union Lower 39 L and quot costs of crossborder trade Transaction costs of exchanging currency Imagine if every time someone bought agricultural products from California they had to convert to dollars from California pesos Uncertain is even a bigger issue Example if electronics store risky to order shipment of Japanese TVs if not sure what the price will be when they are delivered Investment Even worse for making longterm investment where payoff is far in future Not like uncertainty Same as for xed rates Note size of all these gains depend on extent of trade Another issue Is irrevocable In EMS as long as there is some chance E parities can be realligned invites speculative attacks to undermine the system The way to maintain xed e is by selling reserves of foreign currencies and buying own currency from anyone who wishes to sell it at the official rate If run out of reserves must give up and let value of currency fall So speculators can make money borrow bunch of FF go to central bank and sell for large DM FF overvalued when reserves of DM depleted bank allows value of FF to fall then sell back your DM for large number of FF Repay loan and have pro t Eliminate this possibility if is only one currency 0 Theory Costs of monetary union Main cost is cant use independent moneta policy as with xed exchange rate regime But lets see how costly this cost is what depends on Consider a recession in Spain alone high unemployment and falling output Previously Spain could use its monetary policy increase money supply to lower interest rates cheaper to borrow to buy car or build new factories so stimulate demand for investment projects and consumption This increased demand causes factories to produce more and hire more workers So raise GDP and lower unemployment But now Spain cant do this on own ECB decides on common monetary policy to suit diverse interests of all the EU 11 Are some features that determine size of this cost 1 Symme of shocks If rest of EMU countries all experiencing same shock fall in tastes for all European goods In that case monetary union as a whole could increase money supply to restore fullemployment output But suppose Spain is the only one Then stuck This is a question of how asymmetric the shock is If is asymmetric hits one country more than others so would want to use a country speci c policy if could Shocks will tend to more symmetric if the national economies are more similar producing same sorts of things in similar ways 2 Integrated factors markets Ifunemployed workers in Spain can move to Denmark if there are more jobs there then this helps alleviate stress of asymmetric shocks 3 Fiscal Federalism Also if there is a mechanism whereby if Spain is hurt by a shock income would be transferred from Denmark to Spain to compensate for lost welfare of higher unemployment Example would be a federal system of taxation and welfare payments Collect more taxes from where income is higher and pay more to where income is lower similar economies Seems that costs are low and bene ts high if economies are highly integrated high level of trade in goods ow of labor integrated scal administration If these things true say is an optimal currency area costs are lower than gains d Evidence We can compare to US which is a functioning common currency area 1 Extent of trade If trade more the gains of lower transaction costs will be big Most European countries trade 1020 percent of their GDP with other European countries This is larger than trade between Europe and the US But not as large as trade between regions within the US However there is a trend of increasing trade between European 2 Symme of Shocks Studies have tended to nd that shocks are more asymmetric in Europe Partly due to fact that Northern Europe tends to produce more goods that require capital and skilled labor than do southern European countries Right now Ireland is in boom and France OK but Germany on verge of recession Output fell last quarter one more and will be recession But can also see some asvmmetric shocks in US Consider Recession in 199091 Hit Californian harder and longer than most of rest of country because was partly due to cutback in defense spending and many defense contractors were based in California 3 Integration of Labor markets Labor mobili is low in Europe despite fact that have removed passport checks within Europe Main reason is that countries have distinct cultures making people less willing to relocate to nd employment Further even within each European country there is less mobility than in the US One study showed that in 1986 3 of US citizens changed state of residency while in Germany only 11 changed from one German region to another German region Italy was 06 Labor mobili is an important means for US regions to adjust to asymmetric shocks When California went through bigger recession there was out ow of migration say to Oregon and Washington where unemployment was lower 4 Fiscal Federalism Not highly developed in Europe individual governments have not given up their separate authority over taxing and spending Is highly developed scal federal svstern in US national income tax and welfare system This transfers much income to areas hit by asymmetric shock For example for every dollar California lost in income relative to rest of country 25 cents less was paid to the federal government and 10 cents more was received from the federal government So offset perhaps 35 percent of an asymmetric output shock Conclusion not optimal cur area costs gt bene ts So why move forward e Political bene ts of EMU 1 Joint decision making NonGerman countries want In EMS Germany is the leader in deciding monetary policy and other countries are followers But if have one common central bank deciding monetary policy Germans will just be one among many members others will also have a voice in deciding policy What then is in it for Germany why join 2 Next step toward political Integration Seen as a necessary step toward political integration allowing more influence in international affairs Something Germany has a hard time doing now because of its history 3 Prevent political opposition to free trade Are large gains to free trade in goods If allow uctuations in exchange rate to hurt export sectors on one country or another will be an organized political force to demand protectionism and undo free trade in goods Recall outcry after UK and Italy leave EMS Raises question of whether US is really an optimal currency area Have mechanisms to help deal with asymmetric shocks like California recession in early 1990s But wonder if California would have been better of if had had own currency Could have used monetary policy to make California Peso depreciat California goods cheaper improve California CA component of AD raise California output level toward full employment 3 Curren Boards and Dollarization a Currency Boards As a way to prevent currency crises a number of developing countries have pursed more extreme forms of xed exchange rate regimes On example is a currency board It is related to a monetary union De nitinn39 Currency board 39 quot similar to a central bank that is responsible for maintaining the xed exchange rate A notable feature is that it is required to hold sufficient reserves to back 100 of money base in the economy The board is prohibited from acguiring any domestic assets no home bonds Must hold only foreign reserve assets Assets l Liabilities Foreign assets 1500 l Currency in circulation 1500 Domestic assets 0 l The currency board maintains a xed exchange rate as seen before for other regimes by being willing to execute any trades for domestic currency at official exchange rate But because the board has full reserve backing it is impossible to run out of reserves People could take the whole domestic money supply to the central bank to convert into foreign currency before the currency board would run out of reserves This should make the country immune from speculative attacks you can t break the bank The hope is that speculators should see this and won t try to launch an attack I the first place In most cases of currency boards there is not even a central bank The only role of the board is to execute trades automatically that public initiates Like a vending machine Implications Of cially removes monetary policy from hands of politicians They implicitly adopt the monetary policy of the other country They can t increase the money supply without tending to lower the value of currency and the public will return money supply to the board If the other country increases its money supply then the board will nd itself buying foreign currency and issuing more home currency As a result the country adopting the currency board loses all control over its monetary policy According to our theories this is true for xed exchange rate regimes of any kind But it is explicit here Also the legislation of no home assets in the central bank balance sheet prevents any attempt to sterilize exchange operations and attempt monetary policy But this may be an advantage if the foreign country has a better reputation for low money growth and low inflation Import that reputation Another cost Lose seigpiorage revenues income generated from printing money Any revenue from seigniorage and the inflation tax goes to the other country the one that issues the currency b Examples of currency boards Argentina was a US dollar currency board 19912001 This was seen as a way to ght hyperin ation Previously when the government declared its intention to cut money growth to decrease in ation people would not believe it because of a lack of credibility So Argentina passed a national law requiring the central bank to keep 100 backing with dollars Means cannot have money supply growth unless US does So will have same in ation as US Estonia and Latvia when got independence from Soviet Union these countries had no track record in running a central bank so they hoped to establish reputations as low in ation countries Estonia become a DM currency board Latvia a US dollar currency board Now both are Euro currency boards Hong Kong inherited status as a British pound currency board from its days as British Colony It allowed colonial power to run its monetary policy It switched in 1970s from a pound currency board to the US dollar c Dollarization A country can go a step beyond a currency board and simply adopt the other country s currency as its own national currency Unof cial Dollarization To some degree this happens unof cially in many countries when people concerned that their national currency will lose value because of high in ation choose to hold their wealth in the form of dollars even though their government has its own distinct of cial currency This can take several stages asset substitution people hold foreigp deposits and bonds as stores of value urrency substitution people hold foreigp currency notes as a means of payment unit of account domestic goods are priced in terms of the foreign currency to save on costs of changing domestic currency prices under high rates of in ation This practice is widespread the Federal Reserve estimates that 5570 of dollar currency notes are held outside the US As much as 10 of the dollars in the world are located in Russia Also popular in Latin America This practice sometimes exists for the DM as in the Balkans but it is less popular than the dollar Perhaps this will change once euro notes are available especially in Russia The yen does not seem to be used very much in this way Full of cial dollarization This occurs when foreign currency has exclusive status as full legal tender Not only is foreign currency legal for use in contracts between private parties but the government uses it in payments If domestic currency exists it is confined to a secondary role such as being issued only in coins having small value Mainly small countries Currently there are 29 countries with full dollarization 15 of these are territories that are not independent such as the US Virgin Islands Most of the other countries are extremely small such as East Timor and Mocronesia The largest dollarized coun is Panama Works like being a monetary union but you have no voice in setting of monetary policy If there is a rise in money demand in the country the only way to increase money holdings is to decrease spending if Panama imports 6 billion worth of goods and assets and sells 7 billion worth then Panama has accumulated 1 billion dollars In other words to accumulate more dollars the country needs to run a surplus on its official settlements balance current account plus private portion of the capital account Dollarizing entails some costs for the dollarizing coun l loose seigniorage from issuing money 2 no bank supervision no central bank to supervise the private banking system 3 no lender of last resort for banks in trouble 4 no independent monetag as with any xed exchange rate regime Although there is a gain for the US in extra seigniorage it gets there may also be some sts for the U S 1 Pressure to alter monetary policy to 39 the needs of the other country 2 If the country abandons system they could dump dollars on financial markets Lecture notes 160B revised 4302 Lecture 2 Exchange Rates and the Foreign Exchange Market chapter 13 Topics Exchange Rates Foreign exchange market Asset approach to exchange rates Interest Rate Parity Conditions 1 De nitions a De ne Exchange Rates Def of exchange rate price of one currency in terms of another The conventional way of reporting this in economics is home currency per foreign In the US this is per foreign currency For example currently it would take about 090 to buy one European euro Esem This is the convention in economics and will be used in this class Sometimes you will hear quoted the other way around o en called European terms ie 111 euro b Exchange rates are important for trade because they allow you to compare the cost of imports to that of domestic goods in common terms There was a period when Americans were going to Germany to buy Mercedes and bring them home rather than buying them in the US Example Consider the Mercedes suppose the going price is 60 thousand euros in Germany and 60 thousand dollars in the US Would people ock to Germany Depends on the exchange rate comparing and euro is like comparing apples and oranges Suppose the euro exchange rate is 090 So the 60 thousand euros equals 60 thousand euros 090 euro 54 thousand At this exchange rate looks like its cheaper to buy the car in Germany How know using the rate not upside down Look at units have euro want dollars so multiply by euro and euro cancels out and you le with units in dollars c Note the way we conventionally de ne the exchange rate can also make it confusing to talk about changes in the exchange rate which we call appreciations and depreciations 39 quot increase in value of the given currech relative to another Say the euro rate changed from 090 to 080 we say the dollar appreciated relative to the euro Or we could sav the euro 39 39 39 relative to the dollar Note that this can be confusing Given how we de ne the exchange rate as home currency per foreign if this gets lower it means that it takes less home currency units to buy a foreign currency unit and this means the home currency is worth more Hence a appreciation of the home currency 2 Features of foreign exchange market a Actors 1 39 39 banks handle most of the e market quot involve a company having its commercial bank debit its account change into foreign currency and pay a business partner by depositing in its foreign bank Not usually direct exchange of currency and coins Interbank trading bank gathers requests of its customers and enters foreign exchange market to execute trade as a unit so are very large transactions Entering market is a matter of checking the postings on a computer network the rates at which other banks are willing to trade currency then call on phone and nalize a price 2 corporations sometimes corporations enter e market directly Increasingly common and corporations have plants abroad or buy components from abroad 3 Nonbank nancial institutions There has been much deregulation of nancial markets so nancial institutions other than banks can compete with banks in providing services in e market One example is pension funds 4 Central banks Learned in BOP accounts that central banks sometimes intervene in the for 39gn exchange market to increase or decrease the supply of their currency or purposefully affect the exchange rate Size of of cial foreign exchange interventions are relatively small because there is so much private money involved Is a question if central bank is a big enough player to affect things b Characteristics Volume is enormous over a trillion dollars a day GDP is under 10 tril in the whole year of 1994 Central bank Banks dealing in e market tend to be concentrated in certain key nancial cities know which biggest London largest but also NY Tokyo Frankfurt and Singapore Highly integrated globally when one major market is closed usually another is open so people can trade around the clock moving from one center to another Y quot means exchange rate quotes in different centers must be the same Is 39 by arbitrage de ned as making a riskless pro t on a nancial trade If NY offer more euros for a lower price of euros higher price of 5 Ewen is low than Frankfurt then people will take their 5 sell in NY for bunch of euros then sell these in Frankfurt for dollars again and end up with more dollars than they started Possibility for you to make riskless pro t No because shortlived The increased demand for euros in NY would drive up the price of euros in terms of this is an exchange rate depreciation for the 5 There are computers monitoring such openings and ready to take advantage of them So gaps close up very quickly Vehicle currency Most foreign exchange transactions are between banks and take place in E even if want to change Swedish kroner for Polish Zloty not dollars Easier to change kroner rst to and then to Zlotys Since US is so important in world economy there are many people willing to trade dollars for kroner and Zloty for dollars to take the opposite sides of your trade rather than the opposite side of a direct kroner for Zloty trade Euro and Yen are also used as vehicles but less so at current time 0 Spot and forward rates The exchange transactions talked about so far take place on the spot Spot rate exchange rate for currency transactions that take place basically immediately In practice can t be right away because it typically takes two days for the checks to clear used to make the payments Forward exchange rates Can also arrange currency trade for some date in future Is one way of hedging against risk of e changes Suppose Best Buy electronics is expecting a shipment of Sony TVs in a month for which it needs to pay yen Could wait until the shipment to buy the yen to pay Sony but not know what will happen to value of that yen in meantime If yen appreciates a lot the price store has to pay to get the TVs could change a lot To avoid this risk the store can arrange for currency trade ahead of time to be executed later at a set exchange rate This rate is the forward rate Swaps another possibility is to combine a spot with a forward arrangement ie A spot sale then arrange a repurchase in the future at a set rate Why do this Say our electronics store sold some computers in Japan and got yen know will need them again in a month to buy Sony TVs but not want to hang on the money in yen over the month want to hold it in dollars for domestic expenses Might be lower brokers fees if arrange both transactions at one time Futures like a forward arrangement except you can sell the contract to someone else Currency exchange occurs when contract comes due and is delivered to whoever is holding the contract in the end Useful if your opinions about the exchange rate change Some people just trade these contracts to make a pro t because expect the value of the contract to change as expectations for exchange rate movements change This is an example of currency speculation ie if suddenly looks like will appreciate a contract specifying dollars be delivered for a given amount of yen looks more pro table and price of contact will go up Options Call option have the right to buy an amount of currency at a speci ed e rate any time before a speci ed date Put option right to sell Like futures options can themselves be bought and sold 3 Asset annroach t0 39 rates a Preview Theories of exchange rate determination Now we come to the question of how does the foreign exchange market determine what the exchange rate will be There two main theories we well study here 1 The asset approach 7 which is based upon interest rate parity 2 The monetary approach 7 which is based upon purchasing power parity Each of these tells a logical but somewhat different story of how the e is determined A general theme in the next couple lectures will be to discuss these stories the empirical evidence on how well each explains e movements and how the two theories perhaps could be integrated together Asset Approach First we discuss the asset approach Recall that most foreign exchange holdings are in form of bank deposits which is a type of asset and these can be analyzed as any other asset b Determinants of demand for assets 1 Expected Rate of return What are the determinants of the demand for a nancial asset like a bank account The main determinant is the rate of return that is paid In the case of your saving account in dollars you care about the interest rate In the case of a Stock you care about the dividend and the capital gain Suppose you pay 100 for a share of Ford and you get a dividend payment of 5 and resell it for 105 So you made a total of 10 off of the asset divided by the initial 100 investment the implies a rate of return of 10 So to re ne this a bit note that we may not know ahead of time what resale value will be So when you make a decision now about buying an asset you must base it on the expectation of what the return will be In addition to the return some savers care about two other features risk and liguidi 2 risk uncertain about rate of return Even if a stock has a higher expected payoff than a saving account the fact that the payoff is uncertain means it may be less desirable because people not like risk 3 liquiditv how easy it is to convert the asset to cash if you want to buy a different one or use your savings for consumption c Foreigp currency assets What is the expected return for the large bank accounts typically used in foreign exchange market transactions The typically do pay an interest rate An additional feature with an account in a foreign currency is that changes in the exchange rate while holding the currency also affect the value of the asset when you switch it back to domestic currency terms So when you are deciding whether to hold your assets in accounts or euro accounts you need to consider the interest rates on each deposit option and the expected change in the exchange rate in the meantime Example where interest parity holds Lets say you have a 100 and need to decide whether hold in or er39uo account I Define R3 interest on a account 10 Rem Interest on a euro account 5 Is euro better I Represent the current spot exchange rate as Eseuro and suppose this starts at 0900 So convert 100 into 111 euro Get 5 interest so have 117 euro at end of year But then you need to convert these back to in the end Represent the expectation for the future spot exchange rate as Eeseum and suppose this is 0945 So when you are ready to convert back to these euro are worth more than they used to be 117 euro are worth 110 5 account EURO account 100 Eseuro 090 a 111 euro 1 R10 Rem5 1 L058 e Eeseuro 945 e 117 euro 4 Interest parity condition a There is a simple rule to shorten this calculation Write total return on EURO asset as consisting of two parts the EURO interest rate plus the percent appreciation of the EURO currency this is Total return on EURO deposit Rpmm Ee mm Ew FUROV Ew mm In the example above this exactly equals the return on the deposit so In equilibrium Total return on deposit Total return on EURO deposit in terms RX RFIIRO Bet EURO EV FIIRO EV FITRO Rw Rpmm expected APPreciation of EURO The idea is that the German interest rate might be lower than the interest rate but the total return will be increased by an expected appreciation of the EURO currency while holding the EURO deposit in that currency This equation is called the uncovered interest rate parity condition b Eguilibrium in the Foreign Exchange Market We will take this interest rate parity condition to be a description of guilibrium in the foreigp exchange market Given a certain interest rate on deposits R3 and a certain interest rate on EURO deposits REURO and given certain expectations about the future exchange rate ExEURO then the interest parity condition tells us what the current spot exchange rate has to be in order for there to be no excess demand or supply in the foreign exchange market Equilibrating process For example suppose a case where the total return on EURO assets are less than on assets given the current spot exchange rate and given our expectation for the future spot exchange rate In this case holding EURO assets is less attractive than holding assets and people will try to sell their EURO and buy 5 This excess supply of EURO will immediately bid down the current value of EURO and bid up the value of 5 in other words the current spot exchange rate ESEURO will fall
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