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International Money and FinanceChapter 1: The Foreign Exchange MarketOutline of Chapter 1What is Foreign Exchange?Understanding the Exchange RateDefinitionsHow exchange rates are quotedArbitrage opportunity and arbitrage closeThe factors that cause exchange rate fluctuations: short- and long-run.What is Foreign Exchange?Foreign Exchange: the act of trading one country’s currency for another country’s currency.We usually think of large commercial banks in financial centers, such as New York or London, that trade foreign-currency-denominated deposits with each other.Actual bank notes like dollar bills rarely physically cross international borders.Only tourism and illegal activities lead to movement of bank notes across borders.Foreign exchange dealing: 24-hour market The average amount of currency traded each business day is about $4 trillion.About 85% of foreign exchange transactions involve the U.S. dollar.39% of all transactions are euro and 19% of all transactions are Japanese ten foreign exchange markets by trading volume: the U.K. and the U.S. account for the half of total world tradingMost of the transactions are InterBank trading and speculation (rather than payments for goods and services).The biggest players in the foreign exchange markets are financial institutions such as banks, hedge funds, mutual funds, insurance companies, and central banks.The other major players are arbitrage firms and large import/export firms.DefinitionsExchange rate – is the price of one currency in terms of another currency.Example: $1.40 = 1 euroThis can be expressed as: Exchange rate $/€ =1.40 “the dollar price of euro”or:Exchange rate €/$ = 0.71 (= 1/1.40) “the euro price of dollar”Appreciation vs. DepreciationDepreciation: a fall in the exchange rate value of a currencyAppreciation: a rise in the exchange rate value of a currencyIn some cases the government directly controls the currency rates. In such cases, we talk about revalued and devalued currencies.When the government decides to raise the currency value it is revalued. When the government decides to lower the currency value it is devalued. Example: Before: Exchange rate €/$ = 0.71Now: Exchange rate €/$ = 0.67The euro price of dollar falls. Dollar depreciates.Percentage change in the value of dollar:%??€/$= (?.????.??)/?.??=??.????The dollar depreciates against the euro by 5.63%When the exchange rate changes, it affects the relative prices of imported and exported goods and services.If dollar depreciates, the U.S. products will become relatively cheaper to foreigners → ↑ U.S. exportsthe foreign products become relatively more expensive to Americans →↓ U.S. importsIf dollar appreciates, the U.S. products will become relatively more expensive to foreigners → ↓U.S. exportsthe foreign products become relatively cheaper to Americans → ↑U.S. importsDefinitions:Spot exchange transactions - involve the immediate exchange of currency, mostly involving bank deposits. This is the price of a currency for current delivery.Reading FT Dollar Spot RatesClosing mid-point: is calculated by taking average of Bid and Offer rates that is summing up Bid and Offer rates and dividing by 2. Change on day: the currency value change is measured in column two of the table, in some cases the currency is falling compared to the day before and in others the currency is increasing in value.Bid / Offer spread:Bid rate is the rate at which banks buy the currencyOffer rate is the rate at which they sellSpread is the difference between the buying and selling price of a currency.Notice that Bid/Offer rate shows only three last digits of the rate. Spread is the revenue for banks - what banks charge for their services when they deal with their customers. The spread is almost the same for a given currency across banks, but varies across currencies. Popular currencies have a very small spread, whereas other currencies may have a high spread. Factors that cause high spread: High inflation volatility high spreadHigh political risk high spreadLow turnover high spreadExample 1: How are Foreign Exchange Rates Quoted?S$/€ - Spot exchange rate (dollar per euro)Call a dealer at Citibank to get quotesCitibankBuy Sell1.20 1.22This means that the dealer at Citibank is ready to buy Euros for $1.20 and to sell Euros for $1.22. Note that the dealer will pay less for Euros than he/she is offering to sell Euros for. This is so that the bank can make money for each transaction. Assume that one trader Taka from Sumitomo bank calls Citibank and decides to buy Euros. He decides to buy 100,000 Euros at total cost of 122,000 dollars (at a price of 1.22 dollars per Euro). Transaction 1:TakaCitibankBuy €100,000+ $122,000- €100,000This transaction means that Citibank will gain $122,000, but has lost 100,000 Euros.Now Citibank’s books are unbalanced. They have taken a foreign exchange rate position. They have too little euros and too many dollars. This means that they would be happy to see the dollar gain value, but are vulnerable to the dollar losing value. To remedy this situation they would like to find someone that wants to buy dollars and sell euros. This activity is called “squaring off”Assume that Johan from Handelsbanken wants to buy dollars. Johan agrees to buy 120,000 dollars at a total cost of 100,000 Euros (or, in other words, he sells Euros at a per unit price of 1.20 dollars per Euro)Transaction 2.a:JohanCitibankSell €100,000+ €100,000- $120,000Note that Citibank sold Euros (in Transaction 1), and then bought Euros again (in Transaction 2), so that their foreign exchange position is back to the starting one “Squared off”In the process of “squaring off,” Citibank gains $2,000 (from the spread).Example 2: What happens if the currency transactions are not matched??From Transaction 1:TakaCitibankBuy €100,000+ $122,000 €100,000If the bank is worried about ending the day with a position on its books, then it will adjust the rates to make the transaction that it wants more attractive. At this point, Citibank has too few Euros (it will try to increase its Euro holding)To discourage people to buy Euros from the bank Citibank would raise its sell rateTo attract more people to sell Euro to Citibank, Citibank would raise its buy rateThus, both rates are raised!Many possible values of both rates are possible. One possible value would be:Buy Sell1.21 1.23Assume that now someone comes and sells Euros at the new quote. Assume that they sell 100,000 Euros to Citibank at a total price of $121,000 (a per unit cost of $1.21 per Euro). Thus, the entry in Citibank’s books would be slightly different from Example 1.Transaction 2.bCitibank + € 100,000 $ 121,000In this case, Citibank only gains $ 1,000.Square offTo make the inflows of a given currency equal to the outflows of that currency, banks adjust their bid and offer rates. From this example, Citibank raises both bid and offer rates to “square” its exchange position in euro.What if Citibank raises the bid rate and lowers the offer rate?Lower profit, but more transactions. The bank will lose money.What if Citibank lowers the bid rate and raises the offer rate?Higher profit, but no transaction. This method means that the bank no longer trades.The only method that would “square off” the foreign exchange position is to raise both rates or lower both rates.Arbitrage vs. SpeculationArbitrage – creating a position to realize a riskless (sure) profit from market disequilibrium.No risk involvesOnly gainSpeculation – creating a position to realize a profit from his/her expectation.Risk-taking behaviorBetting on the actual future price > or < expected future price.Could either gain or loseHow can an arbitrage firm make money?To understand the idea of arbitrage profit opportunity in the foreign exchange market, let consider two examples.Two-point arbitrageThe simplest case – only two currenciesCitibankBank of AmericaBuy ?Sell ?Buy ?Sell ?1.54301.54401.54101.5420(1) Buy 1 million ? from Bank of America Pay $1,542,000(2) Sell 1 million ? to Citibank Receive $1,543,000Arbitrage profit = + $1,000As arbitrageurs buy and sell currency, banks will adjust their prices.From the example, an arbitrageur buys 1 million pounds from Bank of America and sell 1 million pound to Citibank.Citibank too many Pounds should lower both ratesBank of America too many Dollars should raise both ratesThree-point arbitrage (Triangular)For simplicity, we will ignore the bid/offer spread for right now. Suppose that the spot rates of U.S. dollar, British pound, and Swedish kronor are quoted in three locations as the following:$/?$/SKrSKr/?New York2.000.25--London2.00--10.00Stockholm--0.2510.00It seems as if no arbitrage activity can be done. But, a three-point arbitrage may still possible.To check for this possibility, first you need to find the implicit cross-rate in the missing market.\sThus, the rates of SKr/? in London and Stockholm are different from the NY implicit cross-rate.The way to make arbitrage profit is to buy the cheap currency. In NY, one ? only costs 8.00 SKr. We will start by buying ? in NY.Assume that a trader has $100.Buy ? in NY receive $100/2.00 = ?50Buy SKr in London ?50 × 10.00 = 500 SKrSell SKr in NY SKr500 × 0.25 = $125Arbitrage profit = $25Arbitrage profitAs in the previous case of the two-point arbitrage, the profit opportunity will disappear quickly.Buying ? will increase the value of ?.Selling SKr will decrease the value of SKr.All three currency rates will adjust to a new equilibrium.Fluctuations of the Exchange Rate:Two reasons for daily fluctuations:Inventory Control – effect on exchange rates when traders alter quotes to maintain a balance between amounts of currency bought and sold to “square off” at the end of a day.Explaining the Short-Run Fluctuations of the Exchange RateAsymmetric Information – causes exchange rates to change due to traders’ fear that they are quoting prices to someone who knows more about the current market conditions than they do.Order flow (which currency is requested become information). For example, if many people want to buy JPY from you three times in a day, then something might be happening, and you adjust the rates to this change.Inside information. It is not important whether you actually know something or just think you do. In either case, you are going to react by adjusting the rates.What causes the long-run fluctuations of the exchange rate?In the long run, economic factors affect the exchange rates.One of these factors is a change in demand for domestic goods relative to foreign goods will cause the movement in exchange rates.Trade Flow Model – Demand/Supply model to explain the long-run movement of exchange rate.Consider the market for British pound.Demand for pound: when U.S. importers want to buy U.K. goods, they will need to buy more ?.Supply of pound: when U.K. importers want to buy U.S. good, they will have to give up ? to get dollars.Equilibrium exchange rate: when supply = demand.Example 1: a change in DemandAssume that the U.S. taste for U.K. products increase. An increase in demand for U.K. products increases the demand for Pound shifts D for ? to the right.The new equilibrium point: BThe dollar price of British pound rises (Pound appreciates)The quantity of British pound traded increases.Example 2: a change in SupplyAssume that the U.K. taste for U.S. products increase. An increase in demand for U.S. products increases the supply of Pound shifts S of ? to the right.The new equilibrium point: BThe dollar price of British pound falls (Pound depreciates)The quantity of British pound traded increases.What is exchange rate index?Exchange rate index is a broad measure of the average value of a currency relative to several other major currencies.Ex. the U.S. dollar against the average value of 10 currencies.What is the trade-weighted exchange rate index?A weighted average of a currency’s value relative to other currencies based on the importance of each currency to international trade.That is, take into account of how much the U.S. trade with Canada and Mexico and then assign more weights to values of these currencies against the dollar.The exchange rate index of the U.S. dollarThe broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The major currency index is a weighted average of the foreign exchange values of the U.S. dollar against a subset of currencies in the broad index? SummaryThe foreign exchange market is a global market where foreign currency deposits are traded. Trading in actual currency notes is generally limited to tourism or illegal activities.The dollar/euro currency pair dominates foreign exchange trading volume, and the United Kingdom is the largest trading location.A spot exchange rate is the price of a currency in terms of another currency for current delivery. Banks buy (bid) foreign exchange at lower rate that they sell (offer), and the difference between the selling and buying rates is called the spread.Arbitrage realizes riskless profit from market disequilibrium by buying a currency in one market and selling it in another. Arbitrage ensures that exchange rates are transaction costs close in all markets.The factors that explain why exchange rates vary so much in the short run are inventory control and asymmetric information.In the long run, economic factors (e.g. demand/supply of foreign and domestic goods) affect the exchange rate movements. The Trade Flow model is useful for discussing fundamental changes in the foreign exchange rate.Exercises1. Suppose ?1 = $0.0077 in London, $1 = SF2.00 in New York, and SF1= ?65 in Paris.a. If you begin by holding 10,000 yen, how could you make a profit from these exchange rates?b. Find the arbitrage profit per yen initially traded. (Ignore transaction costs.)2. Suppose Sumitomo Bank quotes the ?/$ exchange rate as 110.30–.40 and Nomura Bank quotes 110.40–.50. Is there an arbitrage opportunity? If so, explain how you would profit from these quotes. If not, explain why not.3. What is the cross-rate implied by the following quotes?a. C$/$ = 1.5613, $/€ =1.0008 b. ?/$ = 124.84, $/?=1.5720c. SF/$ = 1.4706, C$/$ = 1.56134. Suppose that the spot rates of the U.S. dollar, British pound, and Swedish kronor are quoted in three locations as the following: Is there an arbitrage opportunity? If so, explain how you, as a trader who have $1,000,000, would profit from these quotes. If not, explain why not. 5.Consider market for Japanese yen using the trade flow model. What would happen to the value of the Japanese yen (against the dollar), if Japanese people like American automobiles more than before. Explain graphically. Answers: First, sell yen for dollars in London. Then, use these dollars to buy Swiss francs in New York. Finally, exchange francs for yen in Paris.?10,000 = $77.00 (since ?1 = $.0077 in London) → $77 = SF154 (since $1 = SF2.00 in New York) → SF154 = ?10,010 (since SF1 = ?65 in Paris). Total arbitrage profit = 10,010 – 10,000 = ?10. To find the profit per yen, we divide 10/10,000 = ?.0012. There is no profit opportunity since the lowest price to buy dollars is 110.40 at Sumitomo and the highest price to sell dollars is 110.40 at Nomura. Since these prices are the same, then no profit can be made. It is important for students to realize that the bank’s selling rate is the customer’s buying rate and the bank’s buying rate is the customer’s selling rate.3. C$/€ = 1.5613 x 1.0008 = 1.5625, ?/? = 124.84 x 1.5720 = 196.2485, SF/C$ = 1.4706/1.5613 = 0.94194. The way to make arbitrage profit is to buy the cheap currency. In NY, one ? only costs 8.00 SKr. We will start by buying ? in NY. Assume that a trader has $1,000,000.Buy ? in NY receive $1,000,000/2.00 = ?500,000Buy SKr in London ?500,000 × 10.00 = 5,000,000 SKrSell SKr in NY SKr5,000,000 × 0.25 = $1,250,000Arbitrage profit = $250,000 5. Assume that Japanese people like American automobiles more than before. This increase in demand for the U.S. products will shift the supply of yen to the right. The dollar price of yen will fall (yen will depreciate) and the quantity of yen traded will increase.International Money and FinanceChapter 2: International Monetary ArrangementOutline of Chapter 2History of International Monetary ArrangementFloating vs. Fixed Exchange RateOptimum Currency AreasEuropean Monetary SystemHistory of International Monetary ArrangementGold Standard (1880-1914)Inter-war Period (1918-1939)Bretton Woods System (1944-1970)Transition Years (1971-1973)Floating Exchange Rates (1973-present)The Gold Standard (1880-1914)Metal-Based SystemGold Standard – currencies maintain a fixed price relative to gold. A gold standard is a commodity money standard. Thus, each currency is worth a fixed amount of gold, and the currency can be readily exchanged for gold at any point in time.During the gold standard period, one ounce of gold was worth $20.67 for the U.S. currency.Maintaining a gold standard requires a commitment from participating countries that issues currency to be willing to buy and sell gold to anyone at the fixed price.For example, 1499616801620$ fixed to gold exchange rate $ per ?? fixed to gold is also fixed?Suppose that$1 = ? ounce of gold?1 = 1 ounce of gold S$/? = 2 (one Pound is worth $2) This exchange rate would be perfectly fixed because there is a fixed amount of gold backing each currency.Why Gold? Gold was used as the commodity monetary standard because:It is a homogeneous commodityIt is easily storable, portable, and divisible into standardized units like ounces. It is based on a commodity with relatively fixed supply. Since gold is costly to produce, governments cannot easily increase its supply.The Gold Standard: Inflation depended on gold miningPrices may still rise and fall with swings in gold output and economic growth, but the tendency is to return to a long- run stable level.The supply of money is restricted by the supply of gold. Fixed supply of gold → long-run price stability.New discoveries of gold would generate jumps in the price level, but the period of the gold standard was marked by a fairly stable stock of gold.Find gold in the U.S. → ↑Money supply →↑prices in the U.S.Gold leaves the U.S. → ↓Money supply →↓prices in the U.S.People today often look back on the gold standard as a “golden era”The Interwar Period: 1918 - 1939World War I ended the gold standard.Both the patriotic response of each nation’s citizens and legal restrictions stopped gold from leaving the country. The exchange rates of most major countries floated (were allowed to vary).Much of Europe experienced rapid inflation during the war and in the period immediately following it, it was not possible to restore the gold standard at the old exchange values.In 1919, the United States returned to a gold standard.In 1925, England returned to a gold standard.England returned to the gold standard at the old pre-war value, even though things had become more expensive during war time. So, pound was overvalued!Overvalued pounds → ↓exports → trade deficits → gold left the country → deflation → people lost confidence and rushed to convert pounds into goldBy 1931, the pound was declared inconvertible because of a run on British gold reserves.Once a pound was no longer convertible into gold, attention centered on the U.S. dollar.By 1933, the United States abandoned the gold standard after a run on U.S. gold at the end of 1931. The Bretton Woods System (1944-1970):The Gold Exchange StandardAn international conference at Bretton Woods, New Hampshire, in 1944.There was a need for a system that fixed currencies relative to each other, but did not fix each currency in terms of gold.Each country fix the value of its currency in terms of an anchor currency, namely the dollar.The U.S. had to agree NOT to do any adjustment.To make sure that the anchor currency ($) did not move, this currency would be tied to gold in an indirect way. The $ would be valued at $1 = 1/35 of an ounce of gold. But this valuation would only be applicable to other Central Banks to buy. Thus, to us a dollar bill would not have any intrinsic value, but other central banks could ask for their dollar holdings be transformed into gold. This created pressure on the U.S. to not inflate their currency too much.The Bretton Woods System & IMFEach country’s central bank was committed to maintain its fixed exchange rate with $.The International Monetary Fund (IMF ) was created to monitor the operation of the system and provide short-term loans to countries experiencing temporary balance of payments difficulties.In the case of a fundamental disequilibrium, a country’s fixed exchange rate could be adjusted by applying for permission from the IMF. This exchange rate system is similar to the adjustable peg exchange rate system.How to Fix the Exchange Rate?During the Bretton Woods System, every currency fixed its value with the U.S. dollar.A shift in the supply or demand of a currency leads to an imbalance that the Central bank had to adjust by directly intervening in the foreign exchange market.Suppose that England agreed to fix its currency against the dollar at $2.0/pound.Now suppose that England would like to buy more U.S. products than before.To buy more American goods, the British would have to exchange pounds to get dollars.The supply of pound would increase and shift the supply of pound to the right.The dollar price of pound would fall.Pound would depreciate against the dollar.Central Bank InterventionAn increase in supply of pound would cause pound to depreciate.However, Bank of England has committed to fix the value of pound at the original level according to the Bretton Woods agreement.At $2.0/pound, there would be an excess supply of pound by the amount of Q3 – Q1.To maintain the fixed rate at $2.0/pound, the Bank of England will have to buy up pounds by the amount of the excess supply Q3 – Q1. Buying up pounds implies selling dollars from their vaults.If this disequilibrium persists for a long time, the Bank of England could run out of their dollar reserves and no longer be able to peg the rate at this level.In that case, the Bank of England can apply for permission from the IMF to devalue the pound to be in line with the market equilibrium rate.The Breakdown of the Bretton Woods SystemNote that the U.S. Federal Reserves Bank did not have to do anything in the exchange rate market. It was other central banks’ responsibility to fix their exchange rates with dollar.Bretton Woods system worked well until 1960, after the U.S. ran large chronic balance of payments deficits in the late1950s. The U.S. deficits became a concern in Europe and Japan (countries with surplus), since they had to accumulate more and more dollar reserves to peg their exchange rates with dollar. It became questionable whether the dollar was worth as much gold as it claimed. One of the options was to devalue the dollar in terms of gold.In 1971, President Nixon suspended convertibility of dollar into gold. He also imposed a 10 percent tariff on all foreign imports to pressure other countries to revalue their currencies against the dollar. Then, most major currencies begun to float against the dollar.In Dec. 1971, an international monetary conference (Smithsonian Agreement) was held to realign the exchange rates of major currencies.The dollar price of gold was raised to $38/ounce, but this was only symbolic because Nixon’s suspension remained.Speculators started to attack currencies that were “in trouble” such as the pound. Since England had trade and balance of payments deficits, speculators expected the pound to devalue. So, they tried to sell pounds.This created more pressure for the pound to devalue and made it even harder for Bank of England to fix the exchange rate. In June 1972, the pound began to float.Speculators moved on to the next troubled currencies.Finally, by March 1973, the Bretton Woods system was officially ended.Special Drawing Rights (SDR)This “currency” was issued by the International Monetary Fund (IMF), but never existed in physical form (no bank note or coins, just accounting numbers). SDR was created in 1969 to support the Bretton Woods system. SDR was used as an official reserve to support the domestic exchange rate in addition to gold. Since the supply of gold and US dollars was insufficient for the rapid growth of world trade, the SDR provided more liquidity to the world markets. After the end of Bretton Woods system, SDR has transformed its role to become international reserves and to settle international accounts between central banks.On May 19th, 2011 one SDR was worth $1.59. The value is computed by the weighted value of the Euro, the Japanese Yen, the Pound Sterling and the U.S. dollar.International Reserve CurrenciesThe U.S. dollar is still, by far, the dominant reserve currency.Why did we not see the German mark, Japanese yen, or Swiss franc emerge as the dominant reserve currency?The governments in these countries have resisted a greater international role for their monies.This is because any change in demand for their monies could interfere with their domestic monetary policy actions.The euro emerges as a dominant reserve currency, but still only accounts for 26.7 percent of total international reserves.Floating Exchange Rate: 1973-presentChoice of Exchange Rate SystemWho tends to fix?Small economyOpen economy (large amount of trades)Highly concentrated trade (peg with major trading partners)Harmonious inflation rates (similar monetary policy to a country that they peg to).Who tends to float?large economyClosed economy (relatively small amount of trades)Highly diversified trade (trade with many trading partners)Divergent inflation rates (remain independent monetary policy).Standard PegFix the domestic currency with a single foreign currency or a basket of major currencies.Benefits: limit exchange rate fluctuations (good for international trade)Drawbacks: limit ability to use domestic monetary policy (in emergency such as recession). Also, attract speculative attack on the currency.How to peg the exchange rate?Suppose Mexican peso is fixed to the U.S. dollar at $0.50 =1 peso. Then, there is an increase in demand for the U.S. products from Mexicans. So, the supply of peso increases.In floating, the peso would depreciate.However, with peg rate, the central bank of Mexico will have to do the official intervention to peg the rate.Buy pesosSell dollarsThus, dollar reserves go down.Speculative attacks on the peg After the persistent official interventions, the dollar reserves deplete.Speculators expect that one day the central bank of Mexico will run out of dollar reserves and the peso will fall in values.What would speculators do? Sell, sell, and sell peso (before it becomes less valuable).This will increase the supply of peso further and lead to greater surplus of peso.This is called “speculative attack.”To peg the rate at $0.50/peso, the central bank of Mexico has to buy up peso and sell dollars even more (as speculators continue to dump sell peso) and run out of dollar reserves quicker.Eventually, the central bank will run out of dollars and will have to allow the peso to devalue or float.This was what happened to Mexican peso. The case of Chinese yuanSuppose that yuan is fixed with the U.S. dollar at $0.125/yuan.Then, there is an increase in demand for Chinese products from Americans. This implies an increase in demand for yuan. If floating, yuan would be appreciated.At $0.125, there is now excess demand for yuan.To peg the rate at $0.125, the People’s Bank of China will have to sell yuans and buy up dollars.Thus, dollar reserves increase.If this trade disequilibrium persists, China will accumulate more and more dollars and inject more and more yuan in the circulation.Can speculators cause yuan to crash?Answer: No. Why not: because China will never run out of yuan (they can print as many yuan as they want) and they will end up with huge amount of dollar reserves. China can continue to fix exchange rate at this level. Dollarization vs. Currency BoardWhen public questions the credibility of government in maintaining exchange rate stability, the country may adopt the extreme measure such as dollarization or the currency board.Dollarization – adopt someone else’s currency and completely give up your own currency.Ex. Ecuador and El Salvador have given up their currencies and use the U.S dollar to buy and sell things. All prices are in the U.S. dollar.Currency Board – fix the exchange rate with other country’s currency with 100% foreign reserve backing in the central bank. This is part of a written law that the government commits to fix the exchange rate.Ex. Hong Kong. For example, suppose the currency board exchange rate is 8HKD = 1USD, then 800 billion of HKD in the circulation will have $100 billion in reserves to back the currency (to replace at any point in time, if needed).Dollarization and Currency Board: Pros and ConsProsConsDollarizationStable currencyNo hyperinflationNo seigniorageNo monetary policyCurrency BoardNo exchange rate volatility, which is good for trade.No imprudent activity by the central bank No hyperinflationLess seigniorage as compared to a standard peg.Limit ability for the central bank to use monetary policy in the case of emergency such as an economic recession.Free Floating vs. Managed FloatFree floating – market mechanism determines the exchange rate, no intervention to set the exchange rate.Ex. the U.S., the U.K., Japan, EMU, Canada, ChileManaged float – appear as a floating exchange rate, but the central bank intervene at times with no preannounced path for the exchange rate. Ex. India, Brazil, Mexico, South Korea, Kenya, Iceland, South AfricaWhy floating?ProsConsCurrency crisis avoidance (smooth, automatic, and continuous adjustment toward equilibrium).Excessive exchange rate volatility (difficult for trade and investment)Monetary policy independenceTarget bandsThe rate is allowed to vary with the official set bands. Once it wanders too far, the central bank will intervene to put the rate back within the band.Ex. European Monetary System (EMS)This system has been more likely to have the drawbacks from both fixed and floating.Optimum Currency AreasOptimum currency area – The geographical area that would maximize economic benefits by keeping the exchange rate fixed within the area.For example, in Western Europe, a system of fixed exchange rates might be appropriate. (The Euro)One necessary criterion for an optimum currency area is that the region should have perfect mobility of the factors of production.If factors can freely and cheaply migrate from an area lacking jobs to an area where labor is in demand, then the mobility will restore equilibrium.The EUThe European Monetary System (EMS) was established in March 1979. Small exchange rate fluctuations among themselves, while allowing for large fluctuations against outside currencies (target band). The Maastricht Treaty was signed in December 1991Removed restrictions on European flows of capital. Coordinated monetary policies of the individual central banks. Fixed exchange rates among all member countries (Jan 1999).Synchronized their macroeconomic policies.One money requires one central bank. European Central Bank (ECB) began operations on June 1, 1998, in Frankfurt, Germany.Three member countries of the European Union that are eligible but not adopted the euro are Denmark, Sweden, and the United Kingdom. SummaryDuring the Gold Standard (1880 – 1914), currencies were convertible into gold at fixed exchange rates.The Bretton Woods system (1944 – 1970) was an adjustable peg system, with every country fixing their currencies to an anchor currency (the U.S. dollar) and the value of the anchor currency was fixed to gold. It is also called the “gold exchange standard” system.The International Monetary Fund (IMF) was created in 1944 to monitor the operations of the Bretton Woods system.The Bretton Woods system was ended in 1973. Since then the major developed nations began floating their exchange rates.Special Drawing Rights (SDR) is a special currency issued by the IMF to use as international reserves and settle international accounts.Reserve currencies serve as an international unit of account, a medium of exchange, and a store of value.The current exchange rate arrangement ranges from peg (such as dollarization, currency board, and standard peg) to floating (such as managed floating and free floating. Countries with floating exchange rate tend to have large, closed economies, with inflation rates that differ from those of their trading partners, and trade diversified across many countries.The optimum currency area is the geographical region that could gain economic efficiency by fixing exchange rates within a group and floating exchange rates with the rest of the world. An example of an optimum currency area arrangement is the euro.The European Monetary System (EMS) was established in March 1979 to maintain small exchange rate fluctuations amount member countries, while allow for floating against outside currencies. The EMS has evolved into a system with one currency, the euro, and one European central bank in 1999.ExercisesWhat type of exchange rate system was the gold standard? Explain how it operated?How does the gold standard eliminate the possibility of continuous balance of payments disequilibria?How did the Bretton Woods system differ from the gold standard? What was the primary purpose of the IMF under the Bretton Woods? Why did the Bretton Woods system finally collapse?What is seigniorage? Does the United States possess an unfair advantage in world commerce due to seigniorage?What is the difference between “dollarization” and a currency board?What is the difference between managed floating and free floating exchange rates?Discuss the common economic reasons for why a country should adopt a fixed exchange rate arrangement.Explain and graphically illustrate how speculators can attack a currency under the fixed exchange rate system. How can a target zone help create a more stable exchange rate? Explain.In what way is the European system of central banks similar to the Federal Reserve SystemAnswersUnder a gold standard, each currency is defined in terms of its gold value and therefore all currencies are linked together in a system of “pegged” exchange rates. All currencies are convertible into gold. Possible answers:Under a gold standard, each currency is defined in terms of its gold value and therefore all currencies are linked together in a system of “pegged” exchange rates. All currencies are convertible into gold. The Bretton Woods system was essentially a pegged exchange rate system. It allowed for changes in exchange rates when economic circumstances required such changes. They system can be considered an “adjustable peg.” The system may also be thought as a “gold exchange standard” because the key currency, the dollar, was convertible into gold for official holders of dollars, and other currencies were convertible into dollars.The Bretton Woods system required each country to fix a parity value of its currency in terms of dollar. Countries were expected to maintain their exchange rates by buying and selling their own currencies. The IMF was created to aid countries with temporary BOP deficits. Countries were to change the pegged value of a currency only when BOP disequilibria were viewed as permanent. Individual country policies in the early 1970s demanded more flexibility in exchange rates than was permissible under the Bretton Woods. This lack of flexibility led to the ultimate breakdown of the agreement.Seigniorage is the difference between the cost of printing a currency and its purchasing power value. The seigniorage returns from being the dominant reserve currency producer is small. One reason is that foreign holdings of actual currency are small relative to foreign holdings of dollar-denominated interest-bearing securities and deposits. The United States earns no seigniorage return from interest-bearing bank deposits.Currency board (peg): the country’s currency is fixed with the other currency with 100% backing of foreign reserves in central bank. A monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.Dollarization (peg): the country adopts someone else’s currency. The currency of another country circulates as the sole legal tender, or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union. Adopting such regimes implies the complete surrender of the monetary authorities' control over domestic monetary policy. In this case, the country decides to adopt another currency than its own (note it does not have to be the dollar that is adopted).The difference between the managed float and free floating rates is whether or not the government tries to influence the rates. The floating rates protect a country’s monetary policy, but as the market participants determine the rates there might be large fluctuations in the exchange rate. The central bank intervenes in foreign exchange market from time to time in managed float to reach unspecified desired exchange rate levels. In free floating, there is no intervention by the central bank. A country should adopt the fixed exchange rate if it is: small size, open economy, having harmonious inflation rate with the country it pegs to, having concentrated trade with the country it pegs to, and having greater domestic money shocks relative to foreign shocks.Speculators can attack a currency under the fixed exchange rate when the currency has been pressured to depreciate. The attempt to peg the exchange rate would cause foreign reserve depletion. Speculators anticipate that the central bank will eventually run out of foreign reserves and have to let the currency devalued. At this point, they would get rid of their domestic currency holdings which generate greater pressure of devaluation. The central bank will run out of reserves faster.Target zones limit how high and low a currency can go. The exchange rate floats in between the target rates, but is not allowed to float above or below. Therefore the size of the fluctuations in a currency lower than it would if the exchange rate was allowed to float freely.The European Central Bank dictates the money supply growth to the individual central banks that belong to the Euro zone. For example, Bank of Italy (the central bank of Italy) cannot set its own money supply growth, but has to follow directives from the European Central Bank. This is similar to the way the Board of Governors of the Federal Reserve in Washington D.C. dictate the actions of the Federal Reserve Bank system. For example, the Atlanta Federal Reserve cannot set its own money supply growth.International Money and FinanceChapter 3: The Balance of PaymentsOutline of This ChapterWhat is the balance of payments (BOP)?Current account and capital accountExamples of international transactions and how to enter them into the BOP.The balance of payment equilibrium.The U.S. trade deficit and foreign debt.What is the Balance of Payments?The balance of payments records a country’s trade in goods, services, and financial assets with the rest of the world.It is an accounting statement based on double-entry bookkeeping.Every transaction is entered on both sides of the balance sheet: a credit and a debit.If all transactions are included, the sum of all credits must equal to the sum of all debits (total receipts = total payments)The balance of payment always balances!!!Credit – entries that bring foreign exchange into the countryDebit – entries that foreign exchanges leave the country.If the BOP always balances, then why we talk about the U.S. trade deficit?For each particular section of the BOP, there could be an imbalance.When credits > debits → a surplusWhen credits < debits → a deficitThus, there can be a deficit or surplus in any of the following:merchandise trade (goods), services trade, foreign investment income, unilateral transfers, private investment, the flow of gold and money between central banks and treasuries, or any combination of these or other international transactionsThe statement that a country has a deficit or surplus in its “balance of payments” must refer to some particular class of transactions.TerminologyCurrent account – sometime called “balance of trade”. It measures the value of trade from:Good imports and good exports +Service imports and service exports +Net receipts of investment income +Unilateral transfersCurrent AccountNet receipts of investment income = net factor income from abroad. Foreign payments to capital, labor, and land owned by domestic firmsDomestic payments to capital, labor, and land owned by foreign firmsUnilateral transfer – ex. gifts, pensions, and foreign aid. Trade balance = exports – imports TB > 0 → Exports > Imports → trade surplusTB < 0 → Exports < Imports → trade deficitTB = 0 → Exports = Imports → balanced tradeCapital account – purchases and sales of financial assets (ex. buying private or government bonds, stocks, and bank deposits) and direct investment (ex. purchase of a plant in another country).The domestic-owned assets abroad (1)+ The foreign-owned assets at home (2)Capital AccountPurchases of U.S. assets by foreigners ? Capital InflowU.S. residents purchases foreign financial assets ? Capital OutflowCapital account surplus → Net capital inflow→ the home country received more capital transfers than it made→ Net borrower (issuing IOUs to lenders)Capital account deficit → Net capital outflow→ the home country make capital transfers than it received→ Net lender (acquiring IOUs from borrowers)Official transactions Any intervention in the foreign exchange market done by official government sources.U.S. government assets abroadForeign government assets in the U.S.Private transactions Direct investment: private sector invests in foreign firmsSecurity purchases: purchases and sells stocks and bondsBank claims and liabilities: bank loans and deposits abroadOfficial Settlement Balance – change in U.S. official reserves assets abroad plus change in foreign official assets in the U.S. It measures the net change in foreign exchange reserves and official government borrowing.It can serve as a measure for potential foreign exchange pressure on a dollar.Current Account (CA) and Capital Account (KA)Since the Balance of Payments always balance, BOP = CA + KA = 0CA + KA = 0Current account surplus ? Capital account deficitCurrent account deficit ? Capital account surplusStatistical Discrepancy (SD)Because not all international transactions are properly recorded, the statistical discrepancy (errors) will be added.CA + KA + SD = 0SD = ? (CA + KA)How to enter transactions into the BOP?The Current Account EntriesDebit (-) → cause outflow of money Credit (+) → bring in moneyTrade in goods:Import (-) (-) U.S. farmer purchases German tractor.Export (+)(+) India stores buy Apple iPodsTrade in services:Import (-) (-) An American takes a cruise on a Norwegian cruise line.Export (+)(+) A Brazilian company hires U.S. consulting firm.The Current Account EntriesInvestment income receipts and paymentsInterest, dividend, and other income paid (-)(-) The U.S. subsidiary of a Japanese company pays dividends to its parent company in JapanInterest, dividend, and other income receipts (+)(+) A Canadian company pays salaries to its executives stationed in New York.Unilateral TransfersRemittances by foreigners in the U.S., pension paid and aid offered by the U.S. to its citizens living abroad (-)Remittances by Americans working abroad, pension paid and aid offered by foreigners to the U.S. (+)The Capital Account EntriesDirect investment (factories, machines) Purchases of U.S. physical capital by foreigners (+) (+) Ford Motor Company sells its factory to British investors.Purchases of foreign physical capital by U.S. residents (-)(-) Ford Motor Company builds a factory in Mexico.Portfolio Investment (stocks, bonds, CDs) Purchases of U.S. securities by foreigners (+) (+) A London-based insurance company buys U.S. corporate bonds.Purchases of foreign securities by U.S. residents (-) (-) An American buys shares of a European company stock in London Stock Exchange.Other investments – loans and currencyIncrease in loans and trade credits to U.S. residents by foreigners (+)(+) A Canadian firm receives a payment for exports from the U.S. firm.Increases in loans and trade credits to foreigners by U.S. residents (-)(-) A U.S. firm deposits $1 million in a bank account in London.Official Reserve AssetsIncreases in dollar reserves held by foreign central banks (+)Increases in holdings of foreign currency reserves by the Fed (-)Examples of BOP Entries French retailer buys $50,000 wheat from farmer Joe in Idaho, and pays with a 90-day note.$50,000 exports (+ in merchandise trade)$50,000 90-day note (- in private capital account because it is a loan that Joe lends to the French retailer)U.S. resident receives $10,000 in interest from a German bond and is deposited in German bank account.$10,000 investment income (+ in investment income for the current account)$10,000 bank deposits in Germany (- in private capital account because it is a portfolio investment)U.S. government donates $100,000 in wheat to Nicaragua.$100,000 wheat shipped (+ as exports in merchandise trade)$100,000 donation (- in the unilateral transfer because it is aid offered to foreigner by the U.S.)U.S. tourist travels to Germany, spend $5,000 on an “Oktober Fest” package deal, and pays a German travel company.$5,000 Germany trip by American tourist (- as import of services)$5,000 payments for the trip to German company (+ in private capital account because it is a payment of trade credit to foreigners by U.S. resident)The U.S. BOP from these examplesCredit (+)Debit (-)Trade of Merchandises(1) 50,000(3) 100,000Trade of Services(4) 5,000Investment Income(2) 10,000Unilateral Transfer(3) 100,000CA: Current Account+ 55,000Private Capital(4) 5,00050,00010,000Official CapitalKA: Capital Account- 55,000BOP: Balance of Payment0U.S. Trade DeficitThe current account deficits have been persistent since 1980.Some explanations for large U.S. trade deficitUnfair tradeThe U.S. is open to trade and thus importing a lot. Other countries are closed so that they don’t buy enough from the U.S.Twin deficitBecause our government runs budget deficit, so we would have trade deficit.Investment Demand ShiftPeople like to invest in the U.S. much more than before.Unfair TradeAccording to this claim, to explain what happen to the U.S. trade deficit since 1982, two things must happen:Foreign countries must have suddenly increased their trade protection in 1982.All countries must have decided to protect themselves against the U.S. at the same time.Neither of the above statements was true.In fact, many countries reduced trade protection and opened their economies.There was no coordinated protection against the U.S. Thus, it is unlikely that this popular claim is an explanation for the U.S. trade deficit.Twin Deficit:Let Y be Gross Domestic Product (GDP)Y = C + I + G + (X – M)Y = domestic output or incomeC = consumptionI = private investmentG = government spendingX = exports M = imports(X – M) = net exports or the trade balanceY – C – I – G = (X – M) Y – T – C – I + T – G = (X – M)(Y – T – C) – I + (T – G) = (X – M)Private saving = (Y – T – C) = income-after-tax minus consumption spendingPublic saving = (T – G) = tax revenues minus spendingIf the LHS of the equation is negative, the RHS of the equation will also be negative.Trade deficit comes from the negative value of the LHS of the equationNegative RHS → (X – M) < 0 → X < MT – G (public saving)T > G → budget surplusT < G → budget deficit (Y – T – C) – I (private saving (S) minus domestic investment)S > I → positive net private savingS < I → overinvestment How does trade deficit arise from government budget deficit?If the government spending exceeds tax revenue, thenT – G < 0 → government will have to borrow money to finance its spending by issuing bonds (T-bills)Interest rate in the U.S. will rise. Suppose that ↑ ius > iJAPANJapanese would like to invest in the U.S. (buy T-bills), which will increase demand for the U.S. dollar.$ will appreciate as Japanese trade ? for $.U.S. exports become more expensive →↓ XU.S. imports become cheaper → ↑ M(↓X - ↑M) ↓ Trade deficitInvestment Demand ShiftAn increase in investment demand could come from 1980s deregulations and 1990s IT boom. These events have increased demand for investment capital and driven the interest rate in the U.S. upward.Interest rate in the U.S. will rise. Suppose that ↑ ius > iJAPANJapanese would like to invest in the U.S., which will increase demand for the U.S. dollar.$ will appreciate as Japanese trade ? for $.U.S. exports become more expensive →↓ XU.S. imports become cheaper → ↑ M(↓X - ↑M) ↓ Balance of Payments Equilibrium (or Disequilibrium)Countries can have an equilibrium balance on the current account that is positive, negative, or zero, depending on what circumstances are sustainable over time.Ex. the U.S. equilibrium could be with the current account deficit, if the rest of the world is willing to accumulate U.S. assets over time. This involves a U.S. capital account surplus.What happens if there is a disequilibrium in the balance of payments?Under floating exchange rate: the exchange rate will adjust to restore the BOP equilibrium.Under fixed exchange rate: the central bank must finance the trade imbalance by international reserve flows (there will be reserve assets losses from deficit countries and reserve accumulation by surplus countries). Or, countries may use trade restrictions on imports, exports, and/or restrictions on capital flows.SummaryThe balance of payments records a country’s international transactions: payments and receipts that cross the country’s border.The balance of payments uses the double-entry bookkeeping method. Each transaction has a debit and a credit entry.If the value of the credit items on a particular balance of payments account exceeds (is less than) that of the debit items, a surplus (deficit) exists.The current account is the sum of the merchandise, services, investment income, and unilateral transfers accounts.The balance of trade is the merchandise exports minus the merchandise imports.Current account deficits are offset by capital account surpluses.The official settlements balance is equal to changes in financial assets held by foreign monetary agencies and official reserve asset transactions.An increase (decrease) in the U.S.-owned deposit in foreign bank is a debit (credit) to the U.S. capital. While an increase (decrease) in foreign-owned deposit in the U.S. bank is a credit (debit) to the U.S. capital.The United States became a net international debtor in 1986.With floating exchange rates, the equilibrium in the balance of payments can be restored by exchange rate changesWith fixed exchange rate, the balance of payments will not be automatically restored. Thus, central banks must either intervene to finance current account deficits or impose trade restrictions to restore the equilibrium. Deficits are not necessarily bad, nor are surpluses necessarily good.ExercisesExplain the principles of double-entry bookkeeping in the Balance of Payments. In terms of international transactions, what do we count as a debit and a credit?Classify the following transactions and enter them into the U.S. balance of payments:An American tourist travels to Frankfurt and spends $1,000 on hotel, bratwurst, and beer. He pays with a check drawn on a Tulsa, Oklahoma, bank.Mercedes-Benz in Germany sells $400,000 of its cars to a U.S. distributor, allowing for 90-day trade credit until payment is due.Herr Schmidt in Germany receives a $100 check, drawn on a U.S. bank, from his grandson in New York as a birthday gift.A resident in Sun City, Arizona, receives a $2,000 dividend check from a German company. The check is from a German bankThe U.S. government donates $100,000 worth of wheat to Germany.What is the current account balance in the question 2?If a country has a current account deficit, will it be a net lender or borrower to the rest of the world? Should the country be concerned about its current account deficit? Discuss.What is the balance of payments disequilibrium? Can a country run a balance of payments deficit indefinitely? Explain how balance of payments disequilibria can be automatic self-correcting.Answers:Double-entry bookkeeping implies that every transaction is entered on both sides of the balance sheet: a credit and a debit. Credit records entries that bring foreign exchange into a country and debit records entries that lead to foreign exchange leaving the country. Suppose we record the sale of a machine from a U.S. manufacturer to a French importer and the manufacturer allows the buyer 90 days credit to pay. The machinery export is recorded as a credit in the merchandise account, whereas the credit extended to the foreigner is a debit to the capital account.CreditDebitMerchandise100,000 (e)400,000 (b)Service1,000 (a)Investment Income2,000 (d)Unilateral Transfers100 (c)100,000 (e)Official CapitalPrivate Capital1,000 (a)2,000 (d)400,000 (b)100 (c)Total503,100503,100Credits are $102,000 and Debits are $501,100, making the current account balance -$399,100.A current account deficit implies that a country must borrow from aboard to finance the deficit, and thus is a net borrower. Current account deficits are not necessarily bad. The crucial question is how efficiently a net borrowing-country can use these resources today such that there is greater wealth in the future.A balance-of-payment disequilibrium is a condition in which exports do not equal imports, or credits differ from debits on some particular subaccount. For example, a balance-of-trade disequilibrium implies that merchandise exports do not match merchandise imports in value. The time that a country can run a deficit is limited by the amount of international reserves. The lower the official reserve assets, the less likely that a country can keep running deficits. With flexible exchange rates, any balance-of-payments problems are corrected automatically through adjusting exchange rates. If the exchange rate remains fixed, eventually the country must run out of reserves by trying to support a continuing deficit, and at that time the balance-of-payment disequilibrium would end by exchange rate change. Therefore, balance-of-payment disequilibria tend to be self-correcting. ................
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