Government Policies toward the Foreign Exchange Market

Members
Adnan

Renwarin Arina Nindya Kirana Azcarlo van Raalten Dera Karunia Pratama M Rella Pasca Prasasti Yolanda Sriepambajeng P

Chapters
1. 2. 3. 4. 5. 6.

Exchange Rate Definitions Floating Exchange Rate System Fixed Exchange Rate System Defense Through Official Intervention Exchange Control International Currency Experience

Exchange Rate Definitions

1. 2.

3.

Value of a countrys currency in terms of some other countrys currency The exchange rate is the price of one currency stated in terms of a second currency (James Gerber, 2008: 209) Price for which the currency of a country can be exchanged for another country's currency

Floating Exchange Rate

System

in which a currency's value is determined solely by the interplay of the market forces of demand and supply for example by the interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of transactions clearing, hedging, arbitrage and speculation.

Fixed Exchange Rate

An

exchange rate between currencies that is set by the governments involved rather than being allowed to fluctuate freely with market forces. Some flexibility is permitted within a range, called a band. To implement fixed exchange rate government faces 3 major question :

1. 2. 3.

What the things should fix to? When to change fixed exchange rate? How does government defending fixed exchange rate?

What to fix to
Country can choose to fix the value of its currency to some other currency, after the end of world war II many countries fixed their currency to U.S. dollar And also they could fixed their currency to basket currency.

When to change the fixed rate?

Pegged

exchange rate Adjustable peg Crawling peg

Defending fixed exchange rate

Intervention, buying or selling in the foreign exchange market to influence the equilibrium spot exchange rate. Exchange controls imposed by the govt restrict demand and/or supply. Set domestic interest rates so as to influence shortterm capital flows, thus influencing the exchange rate by changing the supply and demand in the market. Macroeconomic adjustments (changes in fiscal or monetary policy) to influence supply and demand in the foreign exchange market.

Defending against depreciation

Defending against appreciation

Consider now the case in which the pressure from private supply and demand in the foreign exchange market is attempting to drive the exchange rate, the relativly strong demand for locals is generally related to relatively strong demand by foreigners for the countrys goods, services and financial asset. This result in an official statements balance surplus if the countrys monetary authority intervenes to defend the fixed rate. The intervention provides the local currency for the foreignersnto but more from the country than they are selling to the country ( for goods, services, and nonoffical financial assets ). Defending against appreciation The rate of C$ tends to go below the band BoC buys US$ and sells C$ The strong private demand for C$ is due to exports and capital imports BOC increases its holdings of US$ reserves and foreign countries increase their holdings of C$ reserves (surplus) What does the BoC do with the US$? increase its holdings of official reserve assets Sterilization remove the additional C$ from the economy, otherwise a monetary expansion will follow

Intervention to Defend a Fixed Rate: Preventing Appreciation of the Countrys Currency :

Temporary Disequilibrium

We build a bisector reproduction model with classical features in which the capitalists aim at maximizing accumulation of their profits. At variance with gravitation models, it is assumed that they invest their profits in their own industry. Their plans are based on actual productions and expected prices. Effective prices and effective allocations of resources are determined by a market-clearing mechanism. A simple law on the formation of expectations allows us to define the dynamics of disequilibria, which let appear endogenous self-sustained fluctuations, around a long-run path. The long-run rate of growth and the amplitude of the fluctuations depend on the initial conditions. Intervention (financing temporary BOP deficits and surpluses) is better than letting the exchange rate float Net gain to the world from the intervention BOC supplied C$ at 1.60 when importers would have had to pay 1.80

BOC bought C$ at 1.60 from people who would have sold for 1.40

Gain is measured by areas ACD and DBE Speculators must not be able to do arbitrage Officials must correctly predict the future demand and supply for foreign exchange

A Successful Financing of Temporary Deficits and Surpluses at a Fixed Exchange Rate :

Disequilibrium that is not temporary

Monetary authority is continuously losing reserves if it defends against depreciation Speculators may bet on a future devaluation and sell domestic currency and buy foreign currency further increasing the imbalance (Mexico) If defending an appreciation (due an ongoing BOP surplus), the monetary authority builds up foreign currency reserves (China?) The rates of return on these foreign currency assets is not high (government bonds, etc.) The value of these reserves will decrease if eventually the domestic currency appreciates

EXCHANGE CONTROL
What

is Exchang Control?

Exchange rate control are closely analogous to quantitave restriction (quotas) on import.

EXCHANGE CONTROL (cont)

There are two other effect and cost of actual exchang control regime First, in practice, government usually dont hold public foreign currency auctions. Second, annother effect of exchange control, effort to evade them is predictable.

International Currency Experience

There

are 4 International Currency that had been experienced by countries :

The Gold Standard Era (1870 1914) Interwar Instability (1918 1939) The Bretton Woods Era (1944 1971) The Current System: Limited Anarchy

History of Gold Standard

Gold Standard, in economics, monetary system wherein all forms of legal tender may be converted, on demand, into fixed quantities of fine gold, as defined by law. Until the 19th century, most countries of the world maintained a bimetallic (gold silver) monetary system. The widespread adoption of the gold standard during the second half of the 19th century was largely a result of the Industrial Revolution, which brought about a vast increase in the production of goods and widened the basis of world trade. The countries that adopted the gold standard had three principal aims: to facilitate the settlement of international commercial and financial transactions; to establish stability in foreign exchange rates; and to maintain domestic monetary stability. They believed these aims could best be accomplished by having a single standard of universal validity and relative stability; hence the gold standard is sometimes called the single gold standard.

History of Gold Standard

The first country to go on the gold standard was Britain, in 1816. The United States made the change in 1873, and most other countries followed suit by 1900. With some exceptions, the prevalence of the gold standard lasted until the economic crisis of 1929 and the ensuing depression. Between 1931 and 1934, the governments of virtually all countries found it expedient or necessary to abandon the gold standard. This policy was partly motivated by the belief that the exports of a country could be stimulated by devaluating its currency in terms of foreign exchange. In time, however, the advantage thus gained was offset as other countries also abandoned the gold standard. In the U.S., a policy of devaluation of the currency was initiated by President Franklin D. Roosevelt. Shortly after his inauguration in April 1933, the U.S. went off the full gold standard in favor of the modified gold bullion standard.

Definition

The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold.
There are distinct kinds of gold standard. First, the gold specie standard is a system in which the monetary unit is associated with circulating gold coins, or with the unit of value defined in terms of one particular circulating gold coin in conjunction with subsidiary coinage made from a less valuable metal. Similarly, the gold exchange standard typically does not involve the circulation of gold coins, instead using notes or coins made of silver or other metals, but where the authorities guarantee a fixed exchange rate with another country that is on the gold standard. This creates a de facto gold standard, in that the value of the silver coins has a fixed external value in terms of gold that is independent of the inherent silver value. Finally, the gold bullion standard is a system in which gold coins do not circulate, but in which the authorities have agreed to sell gold bullion on demand at a fixed price in exchange for the circulating currency.

How the Gold Standard Worked

The gold standard was a domestic standard regulating the quantity and growth rate of a countrys MONEY SUPPLY. Because new production of gold would add only a small fraction to the accumulated stock, and because the authorities guaranteed free convertibility of gold into non gold money, the gold standard ensured that the money supply, and hence the price level, would not vary much. But periodic surges in the worlds gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run. The gold standard was also an international standard determining the value of a countrys currency in terms of other countries currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were necessarily fixed. For example, the United States fixed the price of gold at $20.67 per ounce, and Britain fixed the price at 3 17s. 10 per ounce. Therefore, the exchange rate between dollars and poundsthe par exchange ratenecessarily equaled $4.867 per pound.

Interwar Instability

If the gold standard era before 1914 has been viewed as the classic example of international monetary soundness, the interwar period has played the part of a nightmare, which postwar officials have been determined to avoid repeating. Payments, balances, and exchanges, gyrated chaotically in response to World War I, and The Great Depression.
After World War I, the European countries had to struggle with a legacy of inflation and political instability. Their currencies had become inconvertible during the war, since their rates of inflation were much higher than that experienced in the United States, the new financial leader. It appears to have caused considerable unemployment and stagnation in the traded goods industries, as theories predicted.

Interwar Instability (cont)

Money became totally worthless; by late 1923 not even a wheel barrowful of paper money could buy a week's groceries. The mark had to be reissued in a new series equal to the prewar dollar value, with old marks forever unredeemable. On September 19, 1931, Britain abandoned the gold standard it had championed, letting the pound sink to its equilibrium market value. Between early 1933 and early 1934, the United States followed suit and let the dollar drop all gold value

What lessons do the interwar experience hold for postwar policymakers?

During

World War II expert opinion seemed to be that the interwar experience called for a compromise between fixed and flexible exchange rates, with emphasis on fixity.

The Bretton Woods Era 1994-1971

Bretton

Woods was established with the intention of aiding governments in exercising their powers of inflationary finance. only there were enough reserves to tide countries over temporary disequilibrium, and if only countries followed policies that made all disequilibriums temporary, then we could capture those welfare gains from successful stabilization

If

Its central feature was the adjustable peg , which called for a fixed exchange rate and temporary financing out of internatioal reserves unless a country's balanced of payments was seen to be in " fundamental disequilibrium".

The current system: Limited Anarchy

Since

the early 1970's, a growing number of countris , including many major industrialized countries, have floating or relatively flexible exchange rates, but government authorities often attempt to have an impact though intervention or some other form of management of the floating or flexible exchange rates.

A noteworthy feature of the experience since 1973 is the extent of official resistance to floating. Some of this resistance is seen in the management of the floating . Some of this resistance is seen in the management of the float. For instance , the government of japan has tried to hold down the dollar value of the yen, apparently to prevent a loss in the international price competitiveness of japanese product. In the process, the japanese central bank has bought huge number of dollars .

The current international monetary system , perhaps its best to describe it as a nonsystem-countries can choose almost any exchange rate policies they want and change them whenever they want. The policies of various countries in mid-2007 are shown in figure 6.9.