Exchange Rate Regimes / Balance of Payments

2.
Exchange Rate Regimes and Balance of Payments

Rico von Wyss
International Financial Management New York, 09/12/11
Money
Storable Stable purchasing power Easy to handle
least-cost medium of exchange unit of account (numraire) transfer of purchasing power (lending and borrowing) Seigneurage Creditworthiness of the issuer
International Financial Management
Monetary Policy
M1 = m M 0 = m (D + G + RFX )
Money supply:
Monetary policy: Intervention in the foreign-exchange markets Open-market policies Reserve requirements Credit controls
Examples?
Agenda
Exchange Rate Regimes Balance of Payments
Bimetallism
Before 1875 Both, gold and silver coins were used as money Some countries were on the gold standard, some on the silver standard, some on both Both gold and silver coins were used as international means of payment the exchange rates among currencies were determined by either their gold or silver contents Greshams Law implies that it is the least valuable metal that tends to circulate
Classical Gold Standard
1875-1914 In most major countries: Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio Gold could be freely exported or imported The exchange rate between two countrys currencies would be determined by their relative gold contents Highly stable exchange rates fostered international trade and investments Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism Problems: The supply of new gold is so scarce that growth is hampered Any national government can abandon the standard.
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Interwar Period
1915-1944 Widespread depreciations of currencies To gain advantage in the world export market Exchange rates fluctuated Attempts were made to restore the gold standard, however Great depression Lack of political will to follow the rules of the game. Huge damage on international trade and investments
Bretton Woods System
1945-1972 Goal: Exchange rate stability Without gold standard creation of IMF and World Bank USD was pegged to gold at $35 per ounce other currencies were pegged to the USD Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary The Bretton Woods system was (a dollar-based) gold exchange standard
Flexible Exchange Rates
1973 present USD left the Bretton Woods system Flexible exchange rates were declared acceptable to the IMF members. Central banks were allowed to intervene in the exchange rate markets to dampen unwarranted volatilities Gold was abandoned as international reserve asset Emergency of a variety of parallel exchange rate regimes: Free Float Managed Float Pegged to another currency No national currency
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The Euro
A boost for European integration A second world currency beside the USD cost of monetary union: loss of national monetary and exchange rate policy independence The more trade-dependent and less diversified a countrys economy is the more prone to asymmetric shocks that countrys economy would be Greece (and other highly indebted countries) of the EMU cannot depreciate their currencies to become more competitive There is no more escape from debt
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Fixed versus Flexible Exchange Rate Regimes
Arguments for flexible exchange rates: Easier external adjustments. National policy autonomy Arguments against flexible exchange rates: Exchange rate uncertainty may hamper international trade Exchange rates may deviate from the relative strength of the underlying economy Fears of depreciation may become self-fulfilling prophecies No safeguards to prevent crises
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Agenda
Exchange Rate Regimes Balance of Payments
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Balance of Payments Accounting
The Balance of Payments is the statistical record of a countrys international transactions over a certain period of time presented in the form of double-entry bookkeeping It is about flows It is about sources (+) and uses (-)
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Balance of Payments
Current account exports and imports services income Unilateral income transfers Capital account and financial account) capital account financial account Private transactions Central bank transactions Statistical discrepancy
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The Balance of Payments Identity
CA + KFA + E&O = 0 where: CA = balance on current account KFA = balance on capital and financial account E&O = errors and omissions BoP always measures flows! To get an idea of the results of in- and outflows, one needs the net international investment (NII) account Source of CA deficits of surpluses: CA = Sp I p + Tx Cg I g
) (
NII reflects BoP statistics, however, there additional factors at work
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U.S. Balance of Payments Data 2010
Goods Services Goods and Services Labor Income Investment Income Income Unilateral Inc. Transfers Current Account Capital Account Financial Account Financial Account Net Errors and Omissions
Credit 1288.7 545.5 1834.2 3.1 659.4
Debit -1935.7 -394.2 -2329.9 -11.5 -488
Balance -647 151.3 -495.7 -8.4 171.4 163 -137.5 -470.2 -0.2 235.3 235.1 235.1
Source: BEA
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U.S. Current Account
Source: BEA
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Current Account Deficits
Bad!?! Is offset by a capital account surplus Imports exceed exports foreign investors have to finance the difference by net capital inflows depreciation pressure on the home currency (demand for FC to pay imports) offsetting effect in the capital account (demand for DC to pay securities) can be a sign of economic growth political activism: unemployment, tariffs and protectionism Sustainability? as long as capital inflows finance the deficit adjustments can be severe if the exchange rate is fixed: official reserves are used up
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Summary
Central banks control the supply of money and, therefore, influence exchange rates Chronology of exchange rate regimes: Bimetallism Classical gold standard Interwar period Bretton Woods system Today, there is a variety of parallel regimes BoP records all flows between one country and the rest of the world It links private and public consumption and investments to exchange rates
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Literature and Homework
Compulsory literature: Sercu (2009): chapter 2. Homeworks: Sercu (2009): p. 58-60, True-False Questions, Multiple-Choice Questions, Additional Quiz Questions 2, Applications 5, 9. Additional readings and sources: BEA (2011): U.S. International Transactions: Fourth Quarter and Year 2010 Eun/Resnick (2009): International Financial Management, McGraw-Hill, chapters 2, 3.
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2.

Exchange Rate Regimes and Balance of Payments

International Financial Management New York, 09/12/11

Storable Stable purchasing power Easy to handle

International Financial Management

International Financial Management