Currency Exchange Rates: Fixed vs Floating

• Valuta is a country's money, and the exchange rate is the price of one country's money in relation to the price of another country's money.
• For Norway, the exchange rate is the value of foreign currency in relation to NOK, where E = 10.
• The krone exchange rate is the value of NOK in relation to foreign currency, where 1/E = 0.10.

Fixed vs. Floating Exchange Rate

• A regulated market involves the central bank buying and selling kroner/currency to achieve a specific exchange rate.
• Devaluation is the reduction of this fixed exchange rate.
• Revaluation is the increase of this fixed exchange rate.
• A free market determines the exchange rate based on supply and demand, which can fluctuate greatly.
• Depreciation occurs when a currency becomes less valuable due to market reasons.
• Appreciation occurs when a currency becomes more valuable due to market reasons.

Supply and Demand

• Currency is demanded/supplied by those involved in export/import, investments/loans, and speculation.
• Speculation trading can be very large compared to the other elements.

Fixed Exchange Rate

• Fixed exchange rates provide stability for businesses but can result in volatile exchange rates if floating.
• A "wrong" exchange rate can face speculation, such as Soros in 1992.
• Fixed exchange rates can lead to a loss of control over interest rates if there are free capital movements, potentially leading to all capital flowing to the country with the highest interest rate.

Historical Context

• Until 1971, the Bretton Woods system had fixed exchange rates with the dollar convertible to gold.
• After 1971, many attempts were made to establish fixed exchange rates within Europe, with free movement against other major currencies.
• "The Snake" and the EMU were among these attempts, but the band for floating eventually became out of sync with what the rate should be.
• Speculative waves in 1992 demonstrated the vulnerability of fixed exchange rates.
• The Euro in 1999/2002 tried to make fixed exchange rates between European countries impossible to break out of, but its success is questionable.

Norwegian Exchange Rate Regimes

• From 1816-1842: Floating exchange rates in Norway
• From 1842-1914: Silver and gold standards were implemented, where Norges Bank was obligated to exchange kroner for silver/gold at a fixed rate
• From 1914-1920: A floating krone rate during WWI and its aftermath.
• From 1920-1928: The floating krone rate was managed toward gold parity
• From 1928-1931: The currency was tied to gold, against pre-war levels
• From 1931-1933: Floating krone rates
• From 1933-1946: The krone was fixed against the pound and dollar
• From 1946-1971: The krone was fixed under the Bretton Woods system
• In 1971: A floating krone rate lasted for 5 months.
• From 1971-1972: The krone was fixed under the Smithsonian Agreement
• From 1972-1978: The krone was fixed under a Agreement in Europe
• From 1978-1990: The krone was fixed against a currency basket
• From 1990-1992: The krone was fixed against the ECU
• From 1992-March 2001: A floating krone had a goal of stable krone rates against European currencies
• From March 2001-present: A floating krone has a goal of 2.5% annual inflation

Exchange Rate Theory

• The market focus on exchange rate markets can understate the role of speculative actions.
• Economists' exchange rate theories are not sufficient to predict or explain short-term exchange rate movements.
• Two central premises for exchange rate theory:
  • Interest rate parity
  • Purchasing power parity

Interest Rate Parity and Real Exchange Rate

• Interest rate parity applies in the short term (uncovered).

Real Exchange Rate

• It's a measure of competitiveness, while other measures focus on wage differences between countries.
• The question is whether one should aim for the best possible competitiveness.
• Competitiveness/real exchange rate can improve/worsen with changes in national prices and/or exchange rates.
• There is a difference between external devaluation versus internal devaluation.

Purchasing Power Parity

• Purchasing power parity applies in the long term.

• Real exchange rate is

  • ε = E PF/P,

• Real exchange rate is 1 indicating absolute purchasing power parity.

• Real exchange rate is a fixed number indicating relative purchasing power parity.

• Purchasing power parity suggests that no country can be uncompetitive forever, as market forces will equalize the price of macro goods across different countries.

Macroeconomics

• A country with an uncompetitive macro good buys macro goods from abroad/sells little to abroad, leading people to buy foreign currency/sell domestic currency, which causes the domestic currency to fall, strengthening competitiveness.

"Naive" Analysis

• Higher interest rates in Norway lead to a stronger NOK due to capital inflows.
• The expectation of a long-term level for the krone exchange rate (e.g., 8.20) means that if the rate becomes 7.50, a fall is expected.
• Eventually, the interest rate difference is negated by the expectation of a fall in NOK, stopping capital inflows.
• A country will eventually achieve a competitive exchange rate in the long run.

Oil and Currency

• Oil prices significantly impact the Norwegian krone due to the following:
  • Low oil prices lead to low Norwegian exports.
  • Low activity in the public sector due to a lack of funds.
  • Low interest rates to stimulate the economy.
• All parties in the currency market are aware of these factors, so the weakening of NOK occurs immediately.