International Finance PDF

2. Models – When monetary policy meets exchange rate (What’s the link between monetary policy and exchange rate?) 2.1. Monetary policies and the exchange rate Recap. The Dornbusch-Fisher model All the adjustments are immediate, there is no dynamic....

2. Models – When monetary policy meets exchange rate (What’s the link between monetary policy and exchange rate?) 2.1. Monetary policies and the exchange rate Recap. The Dornbusch-Fisher model All the adjustments are immediate, there is no dynamic.  If US Ms increases, at the actual E, $ return on $ assets (R)decreases and $ depreciates (UIP)  If Euro Ms increases, at the actual E, $ returns on Euro assets decreases and $ appreciates (UIP) Money supply over the price equals to the money demand, that’s the equilibrium of the money market. Exchange rate corresponds to the price ratio (P/P*) that’s in the long run. As a result, we can 𝑀𝑠 𝑀𝑑 say that the exchange rate = 𝑀∗𝑠. We call that the monetary 𝑀∗𝑑 approach of the balance of payment (= MABoP). The exchange rate is only the consequence of monetary policy. If you assume PPP to hold: E = P /P* and money markets Ms/Md=P, you get the monetary approach of exchange rate E = (Ms/Md) / (Ms*/Md*). In the graph on the right, we represent the UIP and the monetary policy. Here, the idea is that the money market equilibrium gives me an equilibrium interest rate fixed on the money market thanks to which I can find an exchange rate. What’s happenings in the short run, if the monetary policy is tightened and if prices are fixed. My exchange rate will as a result appreciate if the monetary is tightened. Ec policy→ effects Temporary Permanent Summary  (Ee does not (Expect Affected) In the short run, the interest rate is determined by change) demand and supply of money. Through this effect on the interest rate, changes in the domestic/foreign Short run (P fixed) yes Yes money market spill over to the foreign exchange Long run (P No effects yes market. In the short run model of exchange rate adjusts) determination, an (de)increase in the domestic money supply causes an (ap)depreciation of the domestic currency. If you assume relative PPP to hold: 𝑑𝐸 = 𝜋 − 𝜋 ∗ and 𝐸 the UIP 𝑅 = 𝑅 ∗ + (𝐸 𝑒 − 𝐸 ) = 𝑅 ∗ + 𝑑𝐸. You get the Fisher’s rule 𝜋 − 𝜋 ∗ = 𝑅 − 𝑅 ∗ 35 In the long run, monetary policy is not efficient because of complete eviction of price adjustment. We have to forget the second column of the previous table. 36  2.2. Overshooting of the exchange rate Remember we made one assumption: “Exchange rate expectation is constant!”. Note that we have discussed only short run effects of a change in the money supply and that we have kept Ee constant. What happens in the long run?  Figure 14-9 Effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate An increase in Money supply in the US. Leads to no changes for the Money supply in Europe. There is a revision of expectations so UIP shifts downward as an appreciation of the US$ is expected. The long run model of the money market: The classical dichotomy: “Only real shocks affects real variables in the long run”. After an increase in Ms, prices will adjust (in the long run) such that Md = Ms. No real effect of monetary policy An increase in money supply in the short run and as a result, interest rates decrease and there is a depreciation of the exchange rate. If I am an well informed investor and that I see that impact, my expectation will change and as a result, I will have an immediate shifts of my expectations. Instead of remaining my expectations at the same level, I shift them and thus the UIP will shift upward. The impact of the policy will not be E1 but E2, so a higher point on the exchange rate. If expectations is changing, then instead of moving at E1, I will move to E2. We are still in the short run. In the long run, the price adjusts itself, we have a proportional shift back of the real balances and the real interest rates move back to the initial point but the expectations don’t change. Instead of coming back to E1, we are moving to E4. We shift our expectations permanently. Integrate the money market model in the asset approach (1) Ms increases, R decreases , real returns on assets decrease and thus E increases (UIP). (2) But the permanent change in the level of Ms causes that people expect a depreciation so Ee changes as well!! This strengthens the initial depreciation (3) and after a while P increases, Ms/P decreases, R increases (back to the old level), E decreases. (4) In the end: Ms increases has caused E increases. Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply. 37 By looking at the paths of the adjustments, we can observe that the nominal money supply is increasing. The nominal interest rate is going down and then, is increasing back. The overshooting is the fact that the exchange rate is overshooting in the short run because of the change in expectations. It indicates that exchange rates is a very volatile series. It implies huge variations and it’s a consequence of the Dornbusch-Fisher model. Expectations seem to be even more important than the realization of the variable. Overshooting means that the first reaction is stronger and go above the equilibrium. We have the initial jump and then the readjustment. In the Mundel-Fleming model since it is based on the backward, there is no overshooting. Take aways The long run consequences of a change in money market conditions differ from the short run consequences: (1) the nominal interest rate does not change after an increase in the level of the money supply (2) the aggregate price level changes after an increase in the level of the money supply (3) both the actual and the expected exchange rate change after a change in the money supply (4) differences in adjustment processes in different markets cause overshooting of E: the long run equilibrium of E is not immediately reached Results Exchange rate is very volatile, much more than real variables after a change in economic policy. Difficult to forecast it – See lecture 3 (???). If exchange rate is fixed, the adjustment is done via the prices – impossible to control both = impossible trinity issue. We had assumed that the exchange rate was fixed in the Dornbusch-Fisher. Under fixed exchange rate, we were translating the overshooting effect through changes in reserve. As a result, we would have a huge outsource of reserves and at some stage, we don’t have any more reserves. We can say that in those case, we are in a currency crisis. The impossible trinity: we have three possibilities and we can only control two of them at the same time. 38 39  2.3. Exercises 2.3.1. Exercise 1 Lot of erroneous statements are often made about monetary policies for open economies. Indicate if the following ones are correct. You will motivate your answer using the asset market approach and graphical argumentation. Comments: BoP = Trade balance + rF* + KA = CA a) Monetary restriction policies are more efficient when the exchange rate is flexible than fixed. It depends if we are in the long term or in the short term. Indeed, in the long term, it is not efficient because of the classical dichotomy. It is only a nominal shot and thus, we have the classical dichotomy. True, when it is fixed, it is not efficient since we cannot control monetary policies and thus, as a result, monetary restriction policies are more efficient when the exchange rate is flexible than fixed. In LR  Not efficient as classical dichotomy (shift back, no monetary policies efficient) In SR  Under fix E = cannot control many supply so not efficient. Under floating E = can control monetary policies. BoP = 0  change in reserve = 0  Can play on domestic credit b) A monetary expansion always impact the real and the nominal exchange rates in the long run. Wrong! Only the nominal one are affected when we look at the overshooting and because of the classical dichotomy which says that only the nominal variables is impacted in the long run. It is in the short run that the real interest rate is impacted (like we can see in the time paths) while in the long run it is the nominal one that is impacted. c) Nominal exchange rate is among the less volatile variables after a monetary shock. Wrong! It is the more volatile, like we can see in the overshooting effect (explanation of the overshooting effect if we had such question at the exam). We look at the nominal part of variables when we are in the short run and thus, since we are in a forward approach, when there is a change investors panics and their expectations for the nominal exchange rate vary a lot. As a result, we can say that the nominal exchange rate is among the most volatile variables after a monetary shock. d) An accompanying sterilization policy can always freeze the inflows or outflows of foreign reserves in the short-run. True, since a sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply. There is two problems; when we change the composition of the assets, we change the risk of the assets and thus we change the UIP and the positioning of the curve. In the long run, we cannot do sterilisation. Under fixed exchange rate, if we lose reserves, we have a contractions of the money supply because there is outsource of reserves pushing activities down. Through sterilisation, we are buying all currencies on foreign markets and thus we are freezing … Noticed, that it only happens on the short run. 2.3.2. Exercise 2 In 2013, growth has slowed down in all economies of the Euro area. Suppose that the European Central Bank (ECB) has thus decided to pursue an active permanent monetary policy. Assume furthermore that the world only consists of the Euro area and the United States, and that the Federal Reserve Bank is passive and doesn’t react on any way to the policy of the ECB. 40  a) Describe the potential policies of the ECB. Monetary expansionist policy  MP shifts to the right on the IS-MP graph  Money supply shifts to the right as a result on the graph of the money demand and supply  interest rate decreases since Eur return goes to the left  the exchange rate increases. b) Explain the asset-price approach and the short-run and long-run effects of the ECB’s policy on exchanges rates. Illustrate your answer with appropriate graphs and economic reasoning. Impact on the short run: money supply will increase and thus they will be more competitive. In the long run, we have a shift of the expectations and a price adjustment. All the real variables will come back to their initial point and thus, there will be no impact on the real variables. c) Explain the long-run consequences of this policy, assuming that PPP between the Euro area and the US holds. Illustrate your answer with appropriate graphs. If PPP holds we will keep competitiveness while if it doesn’t’ hold the price can adjust and thus the real exchange rate come back to the equilibrium and as a result, there is no more impact. d) Will the effect be different if PPP doesn’t hold? Explain. ??? 2.3.3. Exercise 3 41  2.4. Summary Last time we talk about overshooting in the Dornbusch-Fisher model. Exchange rate is a monetary component. We can extent that model by extending it to the good market. The good market gives us an aggregate demand and supply. Full employment  don’t have the capacity to absorb demand. Ms ↑  D ↑  push activity in the ST  …  shift back Ms stimulates activity in the ST but not in the long term because of the classical dichotomy. When we decide to increase money supply, the idea is to stimulate activity at least in the short run since it cannot have any impact in the long run because of the classical dichotomy. Expansionary monetary policy  put liquidity on the market through open market operations/ decrease IR / increase public spending (since financed by monetary policies)  two ways to finance a deficit (so when debt is increasing). ↑ deficit  ↑ debt It’s a flow (dt) it’s a stock The deficit at time t is usually called the primary balanced (dt) and it creates debt since the Dt = dt +(1+r)*Dt-1 (in nominal 𝐷𝑡 𝑑𝑡 𝐷𝑡−1 𝐷𝑡 terms) and 𝐺𝐷𝑃 = 𝐺𝐷𝑃 + (1 + 𝑟) 𝐺𝐷𝑃 (in real terms) where 𝐺𝐷𝑃 is the relative debt to GDP. 𝑡 𝑡 𝑡−1 𝑡 𝐺𝐷𝑃𝑡 = (1 + 𝑔) ∗ 𝐺𝐷𝑃𝑡−1 , where g is the output growth rate. We can rewrite the real terms equation to simplify it: 1+𝑟 𝐷 ̃𝑡 + ̃𝑡 = 𝑑 ̃. 𝐷 1+𝑔 𝑡−1 1+𝑟  debt depends on interest rate 1+𝑔 We can see that the dynamic of the debt depends on (1+r) and on (1+g) and thus if the interest rate is higher than the output growth rate then the debt will increase while if interest rate is lower than the output growth rate then the debt will automatically decrease:  r > g  Dt ↑  r < g  Dt ↓ Ex. If we want to run a business, we go to the bank and the bank will give a loan if the IR is lower than the growth rate. If IR is increasing that means that the debt will also increase. How can we finance the debt? (1) Domestic: We ask residents to pay for it (monetary policy). We issue money to compensate the debt. So we increase money and thus we increase inflation, we call that a monetary tax (inflation is a tax). One easy way to avoid tax is by increasing inflation. m ↑  π ↑ (2) Foreign: We can borrow on the financial market but there are two problems; the foreign currency (if it appreciates, … ) and the increase in interest rate. In order to stimulate my economy in the short run, I increase my money supply and thus, interest rates decrease and my exchange rate will increases (depreciation). The foreign debt will be higher since the interest rates have increased. In the long run, I will have a shift back but in terms of exchange rates, I will end up at point 1. We call that process, the overshooting. The exchange rate depreciates a lot in the short run but also in the long run. Interest rates at the end don’t change and monetary policy doesn’t change either while exchange rate changes. 42 SR: Debt ↑  MS ↑  r ↓  E ↓ (depreciate) Unemployment ↓  foreign debt is higher LR: MS ↑  the price will adjust  shift back Monetary policy = no impact in the long run, only in the SR. - Interest rate will not change - Nominal exchange rate will change Monetary policy can as a result create permanent debt. In countries like Belgium, France, … the exchange rate is fixed and thus, there cannot be any overshooting effect, since we have an horizontal curve for the exchange rate. As a result, if UIP increases, there will be an outflow of reserves and thus those countries will lose reserves. We call that the shadow exchange rate. When our stock of reserves equal zero we are facing a currency crisis. Those kinds of crises can lead to the way out of EU of some countries. If the stock is exhausted, we arrive to particular cases of crisis. Without fixed ER it would have an outflow of reserves. When the stock of reserves = 0, we have what we call the currency crisis. There is no free lunch. Do we have enough reserves? The outflow of reserves will create tension in Europe. If we want to decrease debt  contractionary policy = ↓ activity Upper panel = external equilibrium (ex: IMF) Lower panel = internal equilibrium (ex: politicians) If you run an expansionary policy  ER depreciates How to solve the crisis in Europe? - Pass to a flexible ER - Or ↓ expansionary policies (teacher opinion) 43  2.5. Currency crises 2.5.1. What’s a currency or financial crisis? Ex. North European countries 92-3, Tequila crisis (Mexico) 94-5, Brazil 98-9 (fixed ER but in 98 ER exploded vis-à-vis US dollar), Argentina 01-9,... Currency crisis happens when there is a high volatility in the exchange rates. Currency crisis = exhaustion of reserves  Fixed exchange rates → devaluation (forced change in parity or abandonment of a pegged ER)  Floating exchange rate → high depreciation  The extreme case = insolvency (1) Banking crisis: Financial distress resulting from the erosion of most or all aggregate banking system capital. Ex. near-bankruptcy of the hedge fund LTCM (Long term Capital Management). It is when a bank has liquidity issues. If banks are investing in bad assets, the investment is going down to zero and it leads to insolvency. Bank panic means that investor have feelings that because of those bad investments, banks will not be able to cover everything and thus, consumers will take their money back from the bank. (2) Twin crisis: Banking + currency crisis Here, we have both crises at the same time. Currency crisis can mute into a banking crisis and we call that a twin crisis. It is what happens in 2008. In 2008: interbanking = impossible because of systemic crisis. (3) Financial crisis: Problem of illiquidity and insolvency among financial-market participant. (4) Global financial crisis 2.5.2. Is financial crises a growing problem? 1945-1971: Evaluate Bretton Woods There is an analysis proposed by Michael Bordeaux which says that we will analyses the occurrence of the appearance of crisis. He wanted to see if Bretton Wood has decreased or increased the probability of crisis. Bretton Woods system was very stable in terms of banking crisis like we can see in the table on the left. We are in a more rentable financial situation and a more instable financial system than before the Bretton Woods period. Higher probability of the occurrence of a crisis in the recent past.  Post Bretton Woods period = a lot of problem, crisis is not unfrequent. Explanations: There are two arguments; democratization (= lower panel matters to be elected) and high capital mobility (the world is globalized, capital inflows/outflows are moving very quickly). (1) Democratization has made it more difficult for governments to credibly commit to exchange rate stabilization. It is no more credible that all other goals of policy would be subordinate to the maintenance of a peg. (Eichengreen, 1996 and Jeanne, 1997). To be elected what’s matter is below the graph since we don’t care about exchange rate. 44  Democratization means that we have to be elected and that we are tempted to look at the goods market and to neglect the graph of the exchange rate with the UIP. (2) Moreover, there is a high capital mobility. There are two types of foreign capital investments: - FDI = physical investment (ex: buying a plant)  first type of foreign investment - Portfolio assets = buying foreign shares Which one is the most stable? Let’s imagine that we buy a plant like Arcelormittal and alternatively we can buy a part of the shares of the plant. It is easier to sell the shares on the market because shares are immediate on the market whereas for the plant we have to negotiate. FDI is fixed ≠ Portfolio assets. Investors prefer to invest in portfolio assets. Capital mobility is stabilizing. If r ↓  outflow of capitals In 1997, there was the Asian Crisis which was a sort of revolution in term of crisis. 2.5.3. Sources of the currency crises A good manager is someone who tries to balance between the internal and the external goals (= connect the two goals). Macroeconomic policy: Inadequate policies lead to a fall in the reserves, and at some stage the defense of the currency (to respect the external balance) is impossible. Ex. Expansionary monetary policy → pressure for a future devaluation of the currency (as E should ). These are the 1st generation crisis models. The first generation crisis model (= bad management)  be in line with macroeconomics goals. But also, it exists non fundamental based currency crises (2nd generation crises model)  bad luck. New factors of the second generation crisis (1) Self-full-filling prophesies: If you think too much that you are sick, then you’ll become sick. That’s the placebo effect while these prophesies are the anti-placebo effect. A speculative attacks can occur even with good macro- fundamentals. Ex. Sorros’ attack of the British pounds  In 1992, in the UK (at the post-Thatcher time), there was no major disequilibrium. The prime minister decided to attack the British pounds and announced it at the TV news. The day after that the market collapses. Let’s imagine we are a fund manager in London and when we come back home, we heard that on the TV. We will either follow (because of asymmetric information, Sorros is more clever than me and he has more information than me) or we won’t follow, we will have to find argument for our boss in order to justify our decision. We call that the animal spirit (René Girard) which says that Human Being are animals and prefer to die in group instead of surviving alone. We call that the behavioral finance (Richard Thaler), which says that investors are buffalo that prefer to pass away in groups than to survive alone. There are other explanations like the game theory which is the idea of the prisoner dilemma (denounce our friend or not  multiple equilibrium, we don’t know which one is better and it depends on sunspots equilibrium). The idea of the sunspots (Montesquieu), at his time, the economy was based on agriculture and the growth of the economy was depending on good agriculture producers and … The first one was depending on the weather and thus, if we could predict the weather, we could predict if the production will be high or low. (2) The moral hazard: if X has discovered the pill that cure cirrhosis, what would be the consequences? The result will be an increase of alcohol consumption. You’ll start to drink too much because you know that the pills will cure you. Metzler  in which case should we help or not a country? There is no answer. 45 (3) Contagion: Propagation of shocks in excess to that which can be explained by fundamentals. Channels of transmission (ex: trade) are multiple and not staple. Ex. Asian Flue: The shart depreciation of the Thailand Bath has led investors to withdraw their investment from the Whole Asia. Idea the same causes can lead to the same consequences. 2.5.4. How to cure a financial crisis? It depends of course on the factor at its origins. (1) Improve macro-fundamental: Cut budget spending (to avoid the overvaluation), devaluate (in order to gain competitiveness, while stabilizing inflation), moderate wage increase and monetary expansion  Austerity package. It is sometimes difficult to apply because of domestic trouble (see Argentine, 2001). (2) If contagion, or self-fulfilling speculative attacks, a credible announcement should be done by international authorities.  There is a need for international help (IFS). (3) Loans to smooth the Austerity package (IMF and World Bank). (4) Regulation and supervision role (BIS). (5) Lender as last resort. The problem is that by boing so, moral hazard is favored. As the international financial system would prevent a global crisis, government, banks have no incentive to run "correct" policies. It could lead to an increase in risky investment, or populist economic policies. 2.5.5. Brazil 98 currency crisis 2.5.5.1. Brazil from 1994 to 1998 In 1994, (1) High level of inflation 3.000% a year on average early 90 (despite previous stabilization plans Bresser Plan, 06/1987, Summer Plan, 01/1989). An inflation rate of 3000% means that you lose a lot of purchasing power. (2) Tequila Crisis in Mexico → speculation attack in Brazil → no more confidence in the cruzeiro (3) Political corruption: 1992, President Fernando Color has been destituted. That leads to the Real Plan but what is that? It is a stabilization program to restore confidence in the currency and control inflation. What does it imply? (1) Cuts in current government spending (since it increases money supply). (2) Limit monetary growth: Wage and prices are fixed for a certain period of time. (3) The cruzeiro real ceased to exist and is replaced by the Real, which is pegged to the US$ (dollarization). The primary balance is the deficit in the public sector and was around 3.4% and has been cut to 0.4%. the consequence is that crisis decreases.at the same time, there is a little decrease in GDP and there is a loss of competitiveness because 46