Introductory Macroeconomics Lecture 20: Exchange Rates II 2024 PDF

Introductory Macroeconomics Lecture 20: Exchange Rates II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Exchange Rates II (1) monetary policy and the exchange rate (2) fixed exchange rate regime...

Introductory Macroeconomics Lecture 20: Exchange Rates II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Exchange Rates II (1) monetary policy and the exchange rate (2) fixed exchange rate regimes (3) speculative attacks (4) the policy ’trilemma’ BOFAH Chapter 17 2 Monetary Policy and the Exchange Rate 3  (1) Monetary Policy and the Exchange Rate Recall the closed-economy AD-AS model from Lectures 11-12. Central bank changes demand using changes in real interest rate r What about in the open economy? Changes in r also affect demand through the exchange rate channel – increase in r increases demand for local currency assets and decreases supply of local currency assets appreciates the exchange rate, reduces net exports – decrease in r decreases demand for local currency assets and increases supply of local currency assets depreciates the exchange rate, increases net exports 4  Monetary Policy and the Exchange Rate Increase in real interest rate r shifts out demand for local currency and shifts in supply of local currency, appreciating the exchange rate (and reducing net exports). 5  Monetary Policy and the Exchange Rate Effects of monetary policy are amplified by exchange rate channel – usual closed-economy effects of changes in r on domestic demand – plus changes in net exports via exchange rate channel Seems that monetary policy is more effective in an open economy? – Not so fast! – This assumes the exchange rate can change i.e., exchange rates are flexible 6  Exchange Rate Regimes: Australia Various nominal exchange rates — fixed or ’hard peg’ to 1972, ’crawling peg’ against a basket of currencies to 1983, and then floating since 1983. 7  Australia’s trade portfolio Australian trade was heavily tilted toward the UK. After World War II, Australia began ramping up trade with other countries, especially its local regional partners in Asia. 8  What if Exchange Rate is Fixed? Rather than letting nominal exchange rate be determined by market forces, central bank may fix at a target level – either against some major currency – or against a commodity, like gold Fixing the exchange rate may reduce the amount of volatility in the macroeconomy driven by ’excessive’ exchange rate fluctuations But fixing the exchange rate constrains monetary policy 9 Fixed Exchange Rate Regimes 10 (2) Exchange Rates Can be Too Low 11  Fixed Exchange Rates Key concern: exchange rate may be fixed or ’pegged’ at a level that is too high or too low relative to ’fundamentals’ – exchange rate is undervalued if Epeg < Efun – exchange rate is overvalued if Epeg > Efun To maintain peg, central bank must be willing and able to buy/sell its currency to soak up excess demand/supply To make such transactions, central bank draws on its international reserves, its holdings of other major currencies, gold etc. 12  International Reserves Exchange rate undervalued ⇒ excess demand for the currency. CB sells its currency, building up its international reserves Exchange rate overvalued ⇒ excess supply of the currency. CB buys back its currency, depleting its international reserves Ability to defend an overvalued exchange rate therefore limited by stock of international reserves. Can run out, or be about to! 13  Undervalued Exchange Rate Exchange rate pegged at level Epeg below value Efun where supply equals demand. There is excess demand in amount ab. To maintain the peg, central bank (CB) must sell this amount, thereby building up its international reserves. 14  Overvalued Exchange Rate Exchange rate pegged at level Epeg exceeding fundamental value Efun where supply equals demand. There is excess demand in amount ab. To maintain the peg, central bank (CB) must buy back this amount, depleting its international reserves. 15  Unsustainable Pegs Central banks do not have unlimited international reserves Can maintain peg in face of transient shocks to demand or supply But maintaining an overvalued exchange rate for a long time will eventually drain reserves, forcing a devaluation And expectations of a future devaluation can cause crisis right now In short, unsustainable pegs invite speculative attacks 16 Speculative Attacks 17  (3) Speculative Attacks A speculative attack is a massive selling of domestic currency assets Investors sell domestic currency assets if they expect devaluation Such selling requires central bank to deplete international reserves But depleting international reserves makes it more likely central bank will have to actually devalue Devaluations can be the result of a ’self-fulfilling prophecy’ (See Appendix for Case Study: Thailand) 18 Speculative Attacks and Exchange Rate Collapses With extra selling pressure from speculative attach, central bank has to buy ab and ab′. If this depletes reserves, exchange rate will fall by more, from Epeg to Efun ′. 19  Constraints on Monetary Policy Alternative to devaluing currency would be changing r In the face of selling pressure could increase r to increase demand for domestic currency assets But if r is having to change to take pressure off the fixed exchange rate, can no longer use r to stabilise the domestic economy (unemployment, inflation, etc) More generally, r is constrained by needs of the fixed exchange rate. 20  Constraints on Monetary Policy The central bank increases r to maintain an overvalued peg. The increase in r shifts the supply curve to the left and the demand curve to the right. 21 The Policy ’Trilemma’ 22  (4) Policy Trilemma A central bank’s ’policy trilemma’ is that it can choose to pursue only two of the following three goals simultaneously: (i) independent monetary policy (setting r as needed) (ii) fixed exchange rate (iii) free international capital flows (no ’capital controls’) 23  Policy Trilemma Monetary policy can choose side a, b, or c. In Australia before 1983 we had side a, then since 1983 we have had side b. 24  Policy Trilemma (a) Fixed exchange rate and free capital flows (but not an independent monetary policy) e.g., raising r to maintain overvalued fixed exchange rate makes stabilisation of domestic economy difficult (b) Independent monetary policy and free capital flows (but not the fixed exchange rate) e.g., lowering r to stabilise economy undermines fixed exchange rate (c) Fixed exchange rate and independent monetary policy (but no free capital flows) e.g., capital controls used to break link between exchange rate and demand/supply of domestic currency assets 25  Learning Outcomes 1 Understand and explain the exchange rate channel of monetary policy. Understand and explain why this channel amplifies the effects of monetary policy. 2 Understand and explain how a central bank uses international reserves to support a fixed exchange rate system. 3 Understand and explain the difference between maintaining an overvalued and undervalued peg, along with key risks associated with these pegs. 4 Understand and explain the mechanisms of a speculative attack. 5 Understand and explain the ’policy trilemma’. 26  New Formula(s) and Notation None! 27  Next Lecture Balance of Payments I – Saving, investment, and the trade balance – Current account vs. Capital account – International capital flows BOFAH Chapter 18 28  Appendix Case Study: Thailand 29  East Asian Crisis of 1997-98 East Asian countries enjoyed rapid economic growth until 1997 – In many of these countries, exchange rate pegged to USD for years. – Capital inflows lent to families, friends, and politically well-connected parties. – Defaults/low returns caused foreign investors to sell, shifting out currency supply, putting downward pressure on the exchange rate. – Central banks raised real interest rates to mitigate likelihood of devaluation, but inadvertently causing domestic recession. – Currencies eventually allowed to devalue to moderate recessions. Plunging exchange rates between 1996-1997: Indonesia (-59%), Korea (-58%), Malyasia (-31%), Phillipines (-30%), Thailand (-24%), and Taiwan (-17%) 30  Case Study: Thailand Pre-1997, Thai baht was pegged to the US dollar at a rate of 25 baht to 1 USD. 31  Case Study: Thailand Thai central bank supported the peg by maintaining high real interest rates. (It must manufacture demand for its own currency by selling its foreign reserves.) 32  Case Study: Thailand Investors borrow funds where interest rate comparatively low (i.e., the US) and purchase assets in Asia at high rates. If the exchange rate remains stable, investor makes a 10% return! If currency devalues, investor may not be able to pay back the debt (e.g., 50% devaluation means the asset is only worth $500,000). 33  Case Study: Thailand The artificially high real interest rate attracted excessive foreign investment into Thailand, causing an asset bubble. 34  Case Study: Thailand Investors realised the baht’s peg was not sustainable, leading to a speculative attack. With dwindling foreign reserves, the Thai central bank was forced to float the Baht, causing a sharp devaluation. This lead to a collapse in value of baht-denominated assets, which cascaded into region-wide economic crisis. 35