Chapter 2: The balance of payments and the foreign exchange market

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1 Chapter 2: The balance of payments and the foreign exchange market 1- Exchange rates and international transactions Currency Overview Asia 10:46 a.m. EDT 03/22/11 Last (bid) Prior Day Australian Dollar (in dollars) Hong Kong Dollar Indian Rupee Indonesian Rupiah Japanese Yen Malaysian Ringgit Singapore Dollar South Korean Won Taiwanese Dollar Thai Baht Late Monday in New York. Europe & Others 11:05 a.m. EDT 03/22/11 Last (bid) Prior Day Euro (in dollars) Czech Republic Koruna Denmark Krone Norwegian Krone Polish Zloty Russian Ruble Swedish Krona Swiss Franc U.K. Pound (in dollars) Egyptian Pound Israeli Shekel South African Rand Late Monday in New York. Americas 11:12 a.m. EDT 03/22/11 Last (bid) Prior Day Argentine Peso Brazilian Real Canadian Dollar Mexican Peso Late Monday in New York. -1-

2 Key Currency Cross Rates: 10:34 a.m. EDT 03/22/11 Dollar Euro Pound SFranc Peso Yen CdnDlr Canada Japan Mexico Switzerland U.K Euro U.S (Source: Thomson Reuters) The real euro/dollar exchange rate, denoted q, is the euro price of the American basket relative to that of the euro area: q = (E x P $ )/P (2-1) The nominal effective exchange rate: n NEER i = ω j.e ji j=1,j i (2-2a) where, NEER i = (nominal) effective exchange rate of currency i, E ji = nominal exchange rate of currency i with respect to currency j, ω j = weight given to currency j in the construction of the index; by definition the sum of weights equals one. The real effective exchange rate: n REER i = ω j.q ji j=1,j i (2-2b) where, NEER i = (nominal) effective exchange rate of currency i, q ji = real exchange rate of currency i with respect to currency j, ω j = weight given to currency j in the construction of the index; by definition the sum of weights equals one. -2-

3 Graph 1: Government debt, deficits and sovereign credit premia (Source: BIS, Quarterly review, March 2011) Graph 2: Implied forward interest rates (Source: BIS, Quarterly review, March 2011) -3-

4 Graph 3: International debt securities issuance (in billions of US dollars) (Source: BIS, Quarterly review, March 2011) Graph 4: Expectations for inflation, monetary policy and NEER (emerging countries) (Source: BIS, Quarterly review, March 2011) -4-

5 Currency Futures, Tuesday, March 30, 2010 March 22 10:29:32 GMT All quotes are in Greenwich Mean Time Euro CME Session Previous day Month Open High Low Last Time Sett Chg Volume Sett. OpenInt Cash Mar 22, 10 : June Mar 22, 10 : Sept Mar 21, 16 : Dec Mar 21, 16 : Mar Mar 21, 16 : June Mar 21, 16 : Sept Mar 21, 16 : The balance of payments as the net demand for foreign currency Table 2-1: Comparing euro rates of return on dollar and euro deposits Dollar Expected rate of euro interest rate depreciation against dollar Euro interest rate Rate of return difference between euro and dollar deposits Case R R $ (E e /$ - E /$ )/E /$ R - R $ - (E e /$ - E /$ )/E /$ The uncovered interest parity condition between dollar and euro deposits shows that the equality between the two assets expected rates of return measured in euros: R = R $ + (E e - E)/E (2.5) Table 2-2: Today s euro/dollar exchange rate and the expected euro return of dollar deposit when E e = per dollar Euro exchange rate, direct Interest rate on dollar Expected rate of depreciation of euro Expected euro return on dollar deposits terms deposits against dollar Case E R $ ( E)/E R $ + ( E)/E

6 Figure 2-2: Relation between current exchange rate and expected euro return in dollar deposits 0,82 0,8 Today's euro/dollar exchange rate 0,78 0,76 0,74 0,72 0,7 0,68-0,029-0,005 0,02 0,047 0,075 Expected euro return in dollar deposits The covered interest parity condition can be written R = R $ + (F E)/E (2-7) with F the one-year forward price of dollars in terms of euros. -6-

7 4. Exchange rates regimes De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks Data as of April 31, 2008 The classification system is based on the members' actual, de facto arrangements as identified by IMF staff, which may differ from their officially announced arrangements. The scheme ranks exchange rate arrangements on the basis of their degree of flexibility and the existence of formal or informal commitments to exchange rate paths. It distinguishes among different forms of exchange rate arrangements, in addition to arrangements with no separate legal tender, to help assess the implications of the choice of exchange rate arrangement for the degree of independence of monetary policy. The system presents members' exchange rate regimes against alternative monetary policy frameworks in order to highlight the role of the exchange rate in braod economic policy and to illustrate that different exchange rate arrangements can be consistent with similar monetary frameworks. The following explains the categoreis. Exchange rate anchor The monetary authority stands ready to buy or sell foreign exchange at given quoted rates to maintain the exchange rate at its predetermined level or within a range (the exchange rate serves as the nominal anchor or intermediate target of monetary policy). These regimes cover exchange rate regimes with no separate legal tender, currency board arrangements, fixed pegs with or without bands, and crawling pegs with or without bands. Monetary aggregate target The monetary authority uses its instruments to achieve a target growth rate for a monetary aggregate, such as reserve money, M1, or M2, and the targeted aggregate becomes the nominal anchor or intermediate target of monetary policy. Inflation targeting framework This involves the public announcement of medium-term numerical targets for inflation, with an institutional commitment by the monetary authority to achieve these targets. Additional key features include increased communication with the public and the markets about the plans and objectives of monetary policymakers and increased accountability of the central bank for its inflation objectives. Monetary policy decisions are guided by the deviation of forecasts of future inflation from the announced inflation target, with the inflation forecast acting (implicitly or explicitly) as the intermediate target of monetary policy. Other The country has no explicitly stated nominal anchor, but rather monitors various indicators in conducting monetary policy. This is also used when no relevant information on the country is available

8 4,5 4 3,5 3 2,5 2 1,5 1 0,5 0 The exchange rate of the Deutschemark againt the US dollar and the French Franc USD 1 = DEM FRF 100 = DEM... Source: Bundesbank (Exchange rates on the Frankfurt exchange)

9 The annual rate of appreciation of the Deutschemark against the US dollar and the French Franc USD 1 = DEM FRF 100 = DEM Source: Bundesbank (Exchange rates on the Frankfurt exchange) -9-

10 -10- Source: European Central Bank

11 (Source : WEO, October 2010) -11-

12 (Source: OECD, March 2011) -12-

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