Powerpoint class 5 International Macroeconomics

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Exchange rates (2)
Thomas Lagoarde-Segot, PhD, HDR
THE INTERNATIONAL FINANCIAL SYSTEM
1. Foreign exchange market interventions
1.1 The dirty floating regime
1.2 Unsterilized market interventions
1.3 Sterilized market interventions
2. The international monetary system
2.1 	A brief history
2.2 First generation crises
2.2 Second generation crises
2.3 Third generation crises
2
So far, we have assumed that exchange rates are determined by market forces
But the reality is a ‘dirty floating’ regime: Central Banks frequently purchase or sell currencies in the forex market in order to influence exchange rates.
Ex: strategies include leaning against the wind(reverse the market trend), leaning with the wind (smooth the market trend), anti-volatility operations (decrease uncertainty)
Central Bank interventions can be coordinated (implying at least two Central Banks) or unilateral; secret or public (announced or not, confirmed or not
Ex: Asian Central Banks (Japan, China, India) frequently buy US dollars to prevent a depreciation of the dollar. The latter should occur given the US trade deficit, but would have a negative impact on these countries’ current account (by making their goods more expensive in the US market). This policy is tacitly encouraged by US authorities as these purchases fund the US Federal deficit. China owns about 1 trillion US$ (10%) of US Treasury bonds. 
The dirty floating regime
Assets
Liabilities
Foreignassets(FA)
Gold
Foreignexchangereserves
Domesticassets(DA)
Treasurybills
Loansto commercialbanks
Monetarybase (M)
Currencyin circulation
Commercialbanks’reserves
Stylized balance sheet of a Central Bank:
 In order to reverse a depreciation, the Central Bank sells foreign exchange reserves (ΔFA<0) to purchase 1 billion of euros
 As a consequence, the amount of euros in circulation decreases (M<0) and the Central Bank’s balance sheet shrinks by 1 billion euros
 
Unsterilized foreign exchange market interventions
Assets
Liabilities
Foreignassets(FA)
Gold
Foreignexchangereserves
Domesticassets(DA)
Treasurybills
Loansto commercialbanks
Monetarybase (M)
Currencyin circulation
Commercialbanks’reserves
 In order to reverse an appreciation, the Central Bank purchases foreign exchange reserves (ΔFA>0) by selling 1 billion of euro-denominated assets
 As a consequence, the amount of euros in circulation increases (M>0)
 The Central Bank’s balance sheet expands by 1 billion euros
 
Unsterilized foreign exchange market interventions
Stylized balance sheet of a Central Bank:
Assume the Central Bank purchases foreign assets and sells euros. As a result, money supply increases. Three things happen:
Investors expect an increase in the price level in the Eurozone; which decreases the expected exchange rate of the euro Eet+1. This increases the relative expected return of dollar investment and shifts the demand of euro-denominated assets to the left 
Prices being rigid in the short run, the increase in money supply leads to an increase in the demand for money and leads to lower interest rates. Lower interest rates further reduce the demand for euro-denominated assets 
In the long run, the interest rate goes back toward its initial level which leads to a small increase in the exchange rate
Consequences of an unsterilized intervention
D1
E1*
E2*
D2
Exchange rate
EURUSD
Supply of euro-denominated assets
Quantity of euro-denominated assets
Consequences of an unsterilized intervention
D3
E3*
Assets
Liabilities
Foreignassets(FA)
Gold
Foreignexchangereserves
Domesticassets(DA)
Treasurybills
Loansto commercialbanks
Monetarybase (M)
Currencyin circulation
Commercialbanks’reserves
 The Central Bank sells foreign exchange reserves (ΔFA<0) and purchase 1 billion of euros
 The Central Bank simultaneously purchases 1 billion of domestic assets (ΔDA>0), 
 The monetary base is unchanged: the intervention is sterilized
 
Sterilized foreign exchange market interventions
Stylized balance sheet of a Central Bank:
In a sterilized intervention, the Central Bank’s intervention has no impact on the money supply nor on the interest rate. 
Therefore, the relative return of euro-denominated assets is left unchanged and the demand curve does not shift
Central banks often use sterilized interventions to send a signal to market operators regarding its expected value for the exchange rate 
 
Consequences of a sterilized intervention
 Titre du document - page 10
https://www.newyorkfed.org/markets/OMO_transaction_data.html#tabs-3
https://snbchf.com/monetary-fiscal-policy/history-boj-interventions/
THE INTERNATIONAL FINANCIAL SYSTEM
1. Foreign exchange market interventions
1.1 The dirty floating regime
1.2 Unsterilized market interventions
1.3 Sterilized market interventions
2. The international monetary system
2.1 	A brief history
2.2 First generation crises
2.2 Second generation crises
2.3 Third generation crises
11
A brief history
The international financial system governs international monetary relations. There are two main categories of exchange rate regimes: fixed exchange rate and floating exchange rates. 
In a fixed exchange rate regime, the value of a given currency is indexed on the value of another currency (the anchor currency) so that the exchange rate is held constant
In a floating exchange rate regime, the value of a given currency floats against the other currencies 
A dirty floating regime is a floating exchange rate regime where central banks intervene by purchasing/selling currencies – this is the current arrangement
 
The Gold Standard
Between 1873 and 1914, the international economy was under the Gold Standard: currencies were directly convertible into Gold according to a fixed parity
For instance, 1 French franc was worth 0.29032 grams of fine gold, 1 British pound was worth 7.32 grams of fine gold. 1 British pound was worth 25.21 (7.32/0.29032) French francs.
Anchoring the various currencies on the value of gold led to a very stable fixed exchange rate regime 
The Gold Standard also required that each country adjust its domestic money supply in direct relation to the amount of gold it held.
When gold production was lower than economic growth rate, money supply increased too slowly, leading to a period of deflation (1870-1880). Reciprocally when new gold mines were discovered (for instance in South Africa on 1890), money supply increased too fast, leading to global inflation
 
 Titre du document - page 14
Assume the United Kingdom ran a trade deficit with the United States.
As a result, gold would flow from the UK to the US (gold financed trade imbalances).
Each country’s domestic money supply was tied into the amount of gold it held, thus the U.S. money supply would rise.
The increase money supply would increase prices in the United States, which in turn would make U.S. goods less attractive to the UK.
The net result was that the trade surplus of the US would decrease and the trade deficit of the UK would decrease.
The Gold Standard
The Bretton Woods system
In 1944, delegates of the Allied forces met in Bretton Woods and agreed on the creation of a fixed exchange rate regime, which was maintained from 1945 to 1971:
 The system rested on the gold convertibility of the US dollar (35 US dollars sold for 1 ounce of gold)
 The exchange rates of the other currencies were to be maintained around an official rate (called parity). 
To do so, non-US Central Banks bought and sold assets labelled in US dollars
 Countries with persisting trade/public deficits could obtain conditional loans from the International Monetary Fund (IMF), or devaluate their currency
 
D2
E1par
E1
Exchange rate
Supply of domestic currency
Expected return
Fixed exchange rate intervention: the Central Bank purchases domestic assets
D1
D1
E1par
E1
Exchange rate
Supply
of domestic currency
Expected return
D2
Fixed exchange rate intervention: the Central Bank sells domestic assets
 Titre du document - page 18
The Japanese yen/USD exchange rate under Bretton Woods
 In the 1960s, US governments adopted expansionary monetary policies
President Lyndon Johnson tries to finance both his “Great Society” programs at home and the American war in Vietnam; This produced a large US Federal budget deficit, which, coupled with easy monetary policy, resulted in (i) high inflation in the United States and (ii) an increase in U.S. spending for cheaper imports
 It appeared that the US dollar was overvalued. Unfortunately the system did not allow for a devaluation of US dollar
 The system collapsed in 1971: the price of gold increased from 35 to 42 US dollars. In 1973, the IMF member states agreed to switch to a floating exchange rate regime. 
 
The Bretton Woods system
 Titre du document - page 20
https://fred.stlouisfed.org/series/DEXJPUS
The Japanese yen/USD exchange rate since Bretton Woods
 In March 1979, 8 EEC member countries (Germany, France, Italy, the Netherlands, Belgium, Luxembourg, Denmark, Ireland) decided to fix their exchange rates and to let it float against the US dollar 
They were joined by Spain in 1989, Great Britain in 1990 and Portugal in 1992.
 The exchange rates of these currencies were allowed to fluctuate +/- 2.25%. For instance, in case the French Franc lost too much value against the Deutschmark:
 The Banque de France purchased French francs and sold Deutschmarks, decreasing its own foreign reserves 
 The Bundesbank sold Deutschmarks and purchased French francs, increasing its own foreign reserves
 This was hence a symmetrical system resting on coordinated interventions of European Central Banks 
 
 
The European Monetary System (EMS)
 In 1990, the Bundesbank faced inflationist pressures following the German reunification
It response was to increase its basis interest rate by 10%. This induced a strong appreciation of the Deutschmark
 The system required that other countries increased their interest rates, but their domestic contexts spite were very different from the German context 
 The British authorities which were facing a recession refused to increase their interest rate. Reciprocally, the Bundesbank refused to decrease its interest rates 
 The EMS collapsed following a series of speculative attacks against the British pound, the Spanish peseta and the Spanish lira and the French franc. Britain left the system and fluctuations margin were extended to +/- 15%
 
The European Monetary System (EMS)
 Titre du document - page 23
https://www.youtube.com/watch?v=K_oET45GzMI
Assignment