Topic 16 Exchange Rates and Policy Kailin Clarke University of Minnesota April 26 2012 Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 1 24 Outline We will talk about Exchange Rate Systems Flexible Fixed Managed Exchange Rate Float How foreign exchange market is tied to the domestic loanable funds market The Impossible Trinity 3 conditions of government policy that cannot all hold at the same time Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 2 24 Exchange Rate Systems There are two kinds of exchange rate systems 1 Flexible Exchange Rates In this system demand and supply determines the exchange rate and the government does not intervene 2 Fixed Exchange Rates Under this system the government determines the exchange rates and then makes the necessary adjustments in the economy to maintain those rates For example The Hong Kong dollar is pegged to the US with 7 75 HK 1US Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 3 24 Exchange Rate Systems What are these government policies required to maintain fixed exchange rates Fixed Exchange Rate Controls 1 Trade Policies The government can control the flow of trade and finance directly by controlling imports exports and or financial flows 2 Exchange Controls and Rationing The government becomes the sole foreign exchange market It can then open or shut down the market as need be in order to control prices 3 Domestic Macroeconomic Adjustments Changing fiscal or monetary policy to increase or decrease the demand for goods 4 Currency Intervention Suppose the demand for the currency increases the government will increase the supply of the currency to offset demand Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 4 24 Exchange Rate Systems Disadvantages of Flexible Exchange Rates 1 Uncertainty and diminished trade When agents sign contracts to trade across borders they can t perfectly predict exchange rates and this introduces an element of uncertainty in the transaction 2 Terms of trade change A change in the exchange rate could lead to the worsening in terms of trade fluctuation in the international business environment 3 Domestic Instability If a country is highly dependent on trade then wide fluctuations in currency may cause a lot of business cycle fluctuations Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 5 24 Exchange Rate Systems Disadvantages of Fixed Exchange Rates 1 No automatic adjustments in trade balance Suppose there is a trade deficit more imports than exports people want to hold more foreign currency which pushes up the price of the foreign currency in terms of the domestic currency This makes foreign goods more expensive compared to domestic goods People start demanding fewer foreign goods and the trade deficit decreases But of course if the exchange rate is fixed then this corrective system won t work 2 Reduction in freedom over monetary and fiscal policy Suppose the government decides to use expansionary monetary policy injecting more money in the economy or fiscal policy decreasing taxes Domestic prices go up Exchange rates are fixed domestic goods become more expensive compared to foreign goods and exports go down trade deficit Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 6 24 Exchange Rate Systems The two systems outlined above are the extreme ends of the system Most governments use some sort of mix of the two Current system is usually Managed Exchange Rate Float Under this system the currency is allowed to change float as a result of changes in demand and supply but is managed by the governments via buying and selling of currency Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 7 24 Exchange Rates and Policy Now we want to start thinking in a little more detail about how the foreign exchange market is linked to the domestic market For this we need to link the following Domestic interest rates and investment both foreign and domestic Are NCOs linked to interest rates at home and in the world Should be Savings and Investment in the domestic market Market for Loanable Funds RER and foreign exchange Two of these markets we are already familiar with To build the story we need one final piece Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 8 24 Market 1 NCO Domestic Interest Rate and NCO Let s fix foreign interest rates at some constant say 2 Would we expect more NCO when domestic interest rates are 1 or when they are 5 When domestic interest rate is 1 investors want to invest abroad so NCO is high When domestic intest rate is 5 investors want to keep money inside the economy and NCO is low So graphically Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 9 24 Market 2 Market for Loanable Funds The supply of loanable funds is National Savings S Y C G Higher interest rates means higher savings The demand for loanable funds in the closed economy was just the I investment demand of firms The demand for loanable funds in the open economy is I NCO Higher domestic interest rates discourages domestic investment as well as NCO Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 10 24 Market 3 Foreign Exchange Market And finally recall from last time the Foreign Exchange Market Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 11 24 Equilibrium We want to look at a situation where all these markets clear Let s define an Equilibrium as a RER and an interest rate at which 1 2 The market for loanable funds clears S I NCO The foreign exchange market clears Remember that the supply in the foreign exchange market is the NCO which depends on interest rates Now let s see what this equilibrium looks like Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 12 24 Equilibrium Graph Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 13 24 Exchange Rates and Policy Expansionary Monetary Policy Suppose the government uses expansionary monetary policy Recall that under such a policy the supply of loanable funds expands i e Supply curve shifts to the right The quantity of LF increases and the interest rates decrease Graphically Kailin Clarke U of M Topic 16 Exchange Rates and Policy April 26 2012 14 24 Exchange Rates and Policy Expansionary Monetary Policy The increase in the interest rate leads to a decrease in the NCO Kailin Clarke U of M Topic 16 Exchange Rates and Policy April
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