USD/EUR Exchange Rate What is the right value? PPP? ( )

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1 Session 15. Exchange Rates Regimes. v Wrap-up on Exchange Rates v A Taxonomy of Exchange Rate Regimes v The Costs and Benefits of Fixed Exchange Rate Regimes v The EMS Crisis of 1992/93, the Great Recession and the Euro Crisis v The Difficulty Managing Flexible Exchange Rates. The Exchange Rate 1.75 USD/EUR Exchange Rate What is the right value? PPP? ( ) PPP M1 1978M5 1981M9 1985M1 1988M5 1991M9 1995M1 1998M5 2001M9 2005M1 2008M5 2011M9 In the past, Central Banks have intervened when the currency moved too far from its fundamental value as it happened in September 1985 (Plaza Accord), February 1987 (Louvre Accord) and the interventions of November But the recent need to rebalance the large US current account deficit has led to a persistent (and large) undervaluation of the USD. The current Euro crisis is bringing the exchange rate back to PPP. 1

2 Can the theory explain the data? The USD/EUR Exchange Rate What works: 1. Long term trend shows depreciating USD (because of higher inflation). 2. Some episodes of fast US growth and high interest rates (the early 80 s led to an appreciating USD. What cannot be explained: 1. The exchange rate is too volatile. 2. The link between interest rates and exchange rates is too weak. The spot rate is a better prediction than the interest rate differential. 3. Some short-term trends cannot be explained by any consistent economic theory. 4. There are too many episodes where the exchange rate appreciates (or depreciates) continuously over a long period of time. This is only possible if there is a continuous flow of news about monetary policy that always go in the same direction (very unlikely). Summary: What Do We Know about Exchange Rates? 1. In the long run, exchange rates are determined by arbitrage of tradable goods. There is a long-run equilibrium value of the nominal exchange rate implied by arbitrage and the actual nominal exchange rate fluctuates around it. 2. In the long run, we can describe movements in nominal exchange rates as reflecting differences in inflation rates (adjusted for productivity changes). 3. In the short run, we think of exchange rates as asset prices. Interest rate determine the evolution of nominal exchange rates in the short run. An unexpected increase in the interest rate, leads to immediate appreciation of the currency. Once the interest rate has gone up, higher interest rates predict depreciation of the currency. The reason is arbitrage. Make the distinction between an increase in interest rates vs. higher interest rates. 4. Empirically, nominal exchange rates are much more volatile than any of the macroeconomic fundamentals and even the overshooting result cannot explain why exchange rates are so volatile. 5. Be aware that the theories that explain exchange rate movements are much more ex-post rationalization than tested hypothesis. Only way to anticipate changes in the exchange rate is if you are good at guessing what the theory of the day will be. 2

3 News and Bubbles: The Exchange Rate November 15 th 2006, Financial Times, front page: Euro Tumbles French Premier Dominique de Villepin sent the Euro tumbling against the dollar after making a call for greater collaboration among Euro-zone authorities on managing the exchange rate Gavin Friend, strategist at Commerzbank, said that he was surprised at the currency s market reaction, given that there was little Mr Villepin could do about the strength of the Euro other than lobby the ECB Nov 10th Nov 13th Nov 14th Nov 15th Nov 16th Nov 17th Nov 29th Taxonomy of Exchange Rate Regimes Monetary policy regimes can be either with an explicit target (inflation, money, exchange rate) or without a pre-announced target (e.g. like in the US). We can also classify the regime by looking at the exchange rate arrangement. There is a wide variety of exchange rate regimes. Fixed (pegs) Exchange Rate Regimes (% in each category) Flexible Currency union, dollarization Currency board Horizontal peg Crawling peg Managed floating Freely floating 0 Peg Limited flexibility Managed floating Freely floating

4 Currency boards A currency board operates in the following way: The Parliament fixes the exchange rate at some level, say, 1 peso for 1 dollar and instructs the currency board to increase money supply (monetary base) only in the case that the dollar reserves of the board increase by the equivalent amount. If the foreign exchange reserves increase by $1,000 then the board has to increase money supply by 1,000 pesos. The currency board is a very credible institution and may help a country reduce significantly its inflation rate. The drawbacks are that this arrangement leaves no flexibility in the hands of the monetary authority. Country Start date Inflation before Inflation in 1998 Argentina 4/ Estonia 6/ Lithuania 4/ Bulgaria 7/ Exchange Rate Regime: Fixed or flexible? Costs of fixed exchange rates and currency unions Loss of monetary policy as a stabilization tool Benefits of fixed exchange rates and currency unions 1. Credibility 2. Increased trade and capital flows (because of reduced exchange rate uncertainty) Costs are high when: 1. Business cycles are not aligned. 2. Fiscal policy cannot be used for stabilization purposes. 3. Low flexibility in the economy Benefits are high when: 1. Establishing credibility is difficult. 2. Countries are integrated with large potential for trade and capital flows. 4

5 % of GDP The difficulty of managing fixed exchange rates: The EMS Crisis of 1992/93 The European Monetary System (EMS) was established in 1979 as a system of fixed exchange rates. Countries were committed to keep their currencies within a small band (2.25% or 6%) around a fixed central parity In the period the credibility of the EMS was low because of continuous realignments of the central parity In the years , there were fewer realignments and the system gained credibility After 1991, the process of German unification lead to economic tensions that caused the break up of the EMS. Several countries leave the discipline of fixed exchange rates, others devalue and stay within the system (after broadening the bands to 15%) The EMS Crisis of 1992/93 In the period increases in government spending in Germany without comparable increases in taxes caused a large government deficit. The government increased the amount of funds borrowed in financial markets. The increase in government borrowing in Germany was not accommodated by expansionary monetary policy and led to an increase in the interest rate. In addition, the German central bank increased interest rates further in 1992 to reduce inflation. To defend its currency, other members of the EMS, such as Italy, had to increase interest rates to avoid capital outflows and devaluation of the Lira Government Balance (Germany) Short-term interest rates 7.8 Italy 5.8 Germany

6 The EMS Crisis of 1992/93 1 Expansionary fiscal policy in Germany has to be matched by contractionary monetary policy in Italy 2 Contractionary monetary policy in Germany (aimed at reducing inflation) leads to higher interest rates and forces the Bank of Italy to further raise interest rates Germany Italy r 2 LM r 2 1 LM 1 IS IS Y Y The EMS Crisis of 1992/93 July 16, 1992: Bundesbank announces a 0.75 percentage point rise in its discount rate to a record 8.75 per cent. The mark begins a relentless rise against other European currencies. September 5-6: EU finance ministers meet in England and stress that they have no plans for ERM realignment. September 8. The first attack: The first attack is against Finland and Sweden. The Finnish central bank gives in immediately and lets the markka float. The currency depreciates by 13%. Sweden fights back increasing interest rates to 24% and later to 75%. September 10: The second attack: Attack on the Italian lira. For three days the Bank of Italy intervenes on the foreign exchange market to support the exchange rate, but on September 13, the currency is devalued by 7%. At the same time, the British Prime Minister rules out devaluation within ERM as "a betrayal of our future". September 16: "Black Wednesday". Markets attack the pound, lira (again) and peseta, forcing them below ERM floors. Central banks intervene and Britain announces unprecedented two-stage rise in interest rate from 10 to 15%. Later it suspends the pound from ERM. The next day the lira is also suspended from the ERM. Both currencies depreciate by 15%. September 17-18: Speculation against the krona and the Irish punt: Sweden announces it will maintain 500% interest rate to defend the krona, while the Irish bank raises overnight rates to 300%. Spain devalues by 5%. September 20: French voters narrowly approve Maastricht but result does not prevent more attacks on weak ERM currencies. September 23-28: Attack on the French franc and continued pressure on the peseta and the punt. Spain and Ireland introduce capital controls.the toll is: Britain and Italy are out of the ERM. Spain has devalued. The other countries have incurred reserve losses and periods of high interest rates. November 1992: new attacks lead to devaluation of the peseta, the escudo and the krona. July 1993: Renewed attacks on the French franc. In August the bands in the ERM are increased from 2.25% to 15%, which is equivalent to introducing floating exchange rates. 6

7 The EMS Crisis of 1992/93 The increase in government spending in Germany and the contractionary monetary policy of 1992 led to increases in interest rates that spread to all members of the European Monetary System and to a fall in the growth rate of real GDP (given that those interest rates were too high for their economic conditions). Growth of Real GDP Italy Germany The EMS Crisis of 1992/93: The Lesson Fixed exchange rates are not always a good idea. One policy does not fit all. Correct but do no forget: This was a one-time event the degree of asymmetry among EMU countries is small Monetary Policy and Exchange Rate Policy are not a magic recipe for growth. Countries that devalued in 1992/93 (UK, Spain or Italy) did not do much better than those that stayed within the system (Netherlands or France) Italy France Netherlands Spain UK 7

8 The Great Recession and Euro Crisis: the conventional wisdom Some Euro countries (Ireland, Spain, Greece) had high inflation in the years that preceded the crisis. Because they could not control their economy through monetary policy this led to an appreciation of the real exchange rate and a loss of competitiveness. The lack of monetary policy control was partially responsible for the real estate bubble (Ireland, Spain). Once the crisis starts, Euro members cannot devalue and they have to suffer a long and deep crisis. The UK economy had the advantage of being outside of the Euro area so it managed to isolate itself better from the crisis and it has been able to find an easier way out of the crisis. The Euro Crisis: the Facts Unit Labor Costs (1999=100) France Germany Greece Ireland Italy Netherlands Portugal Spain 8

9 The Euro Crisis: the Facts The Euro Crisis: the Facts 170 Volume of Exports of Goods and Services (1998=100) France Spain United Kingdom 9

10 The Euro Crisis: the Facts Growth of Real GDP Spain UK The Euro Crisis: the Facts Nominal Exchange Rate (EUR/GBP) 10

11 The Euro Crisis: the Facts Real GDP (Index 2008Q1=100) Spain UK The Euro Crisis: the Facts Gross Government Debt (% of GDP) Spain UK 11

12 The Great Recession and Euro Crisis: A different and more subtle reading The creation of the Euro led to strong economic booms in countries with traditionally weaker credibility. These booms were possible by large capital flows from the rest of the Euro area. Out of the countries who were saving, Germany is an outlier. After a very difficult decade (the 90s, post-german reunification) Germany went into a process of internal devaluation by controlling wages and unit labor costs. This led to a very large increase in exports which was not matched by an increase in spending. The resulting saving went to the deficit countries. Germany benefitted from a stable exchange rate that allowed decreasing wages not to be compensated by a strong currency. The imbalances turned out to be unsustainable as financial markets did not price risk properly. A reversal of these imbalances (similar to the one we are seeing in the world economy) is forcing a crisis in all countries, particularly in the ones with a deficit. The difficulties of managing flexible exchange rates Despite the success in controlling inflation, the Central Bank of Brazil has struggled with persistent inflationary expectations that forces them to keep interest rates high. This leads to increasing capital flows that can add to the inflationary pressures and appreciate the currency (which might lead to more capital flows). Interest Rate (Selic) (%) Today

13 r 1 Decreased Spending in the US leads to a recession US Currency Wars 2010/11 2 The Federal Reserve implements aggressive monetary policy (increase in M / decrease in r) which affects the World interest rate. 3 Lower interest rates in the US forces investors to look for investment opportunities in emerging markets where growth is healthy. This leads to capital inflows into these markets and exchange rate appreciation. 4 The only way to avoid a strong appreciation of their currencies is by central banks (in emerging markets) to also implement expansionary monetary policy but this might lead to risk of inflation. LM r Brazil LM IS IS Y Y Session 15. Summary v One mechanism to gain credibility and restrict monetary policy is by fixing the exchange rate. v Fixed exchange rates, however, can impose large costs by taking away the ability of monetary policy to smooth business cycle fluctuations and by exposing the countries to shifts in investors expectations. In assessing the stability of the regime, evaluate the vulnerabilities of the country to capital flow reversals, its policies, synchronization with the reserve country, the evolution of the real exchange rate and the current account deficit. v The benefits of fixed exchange rates or currency unions is that they can increase economic integration by encouraging trade and capital flows. 13

14 Appendix. European Monetary Union: The Timetable Timetable 1979: EMS (pre EMU); 1991 Maastricht Treaty (conditions for joining) 1998: Decision to go ahead. 11 countries join (Greece added in 2001) January 1999: Official launch of the new currency January 2002: Bank notes and coins introduced January 2007: Slovenia joins January 2008: Cyprus and Malta join January 2009: Slovakia joins January 2011: Estonia joins 14