Economic Analysis of Floating Exchange Rate Systems

Transcription

1 Economic Analysis of Floating Rat Systms Th businss sction of any nwspapr will hav a tabl of spot s. Ths ar th s at which a prson could hav bought othr currncis or forign, such as th English Pound, Frnch Franc, or th nw Europan Euro. Th prics of forign currncis can b dtrmind in two major typs of systms. In th Unitd Stats, th dollar s s ar dtrmind by th marktplac, i.., by supply and dmand. This typ of systm is calld a floating systm. In othr countris, govrnmnts st th pric of thir currncis with rspct to othr countris. Thy thn buy or sll forign at th prics thy v st. This is calld a fixd systm. Th conomic ffcts of ths two systms can b vry diffrnt. Howvr, in ithr systm th undrlying forcs influncing th valu of a country s currncy rmain th sam. Du to possibl confusion of bing abl to quot diffrnt currncis in trms of ach othr,.g., $/ or /$, w nd to xplicitly dfin an. An is, thrfor, th domstic cost of a unit of forign. For xampl, from th US prspctiv th pric of th English Pound would b dnominatd as th numbr of US dollars pr pound, or $/. As notd abov, th in a floating systm is dtrmind by markt forcs. Our dfinition of th dfins th markt as th markt for forign. In this markt w hav dmandrs and supplirs of forign currncis willing to pay and accpt dollars in rturn for ths currncis. W will in turn discuss th dmand and supply of forign. Dmand Th dmand for forign is a drivd dmand. With th xcption of currncy collctors, th dmand for forign is du to popl s dsir to us it in th purchas of forign goods or financial assts. dmand is, thrfor, highly snsitiv to changs in ths dsirs. In ordr to undrstand changs in th dmand for forign, w will nd to discuss its undrlying forcs. Ths ar th dmand for forign goods and srvics and th dmand for forign financial assts. Th supply of forign has at its roots th sam concptual basis as dmand, only it is from th forign prspctiv. currncy is supplid to th forign markt whn forignrs thir currncy for dollars in ordr to buy US goods or financial assts. Equivalntly, th supply of forign is nothing mor than a mirror imag of th forign dmand for US currncy. This is shown in Figur 1 by labling th supply curv as th supply for forign (Sfx) or as th dmand for dollars (D$). Using th sam logic, th domstic dmand for forign 1

2 is th mirror of th supply of dollars to th forign markt. Again in Figur 1, th dmand for forign (Dfx) is th sam as th supply of dollars (S$). On qustion which might aris is which forign markt. Nw York, London, Frankfort and Tokyo ar major financial cntrs with larg forign markts. Th answr as to which markt is all of thm. Th first rul of businss is to buy low and sll high. Should s b diffrnt across diffrnt financial cntrs, thn th opportunity for arbitrag profits occurs. Currncy dalrs will buy low in on cntr and sll high in anothr, driving s into quality across th diffrnt markts. $/ Figur 1 For xampl, should th Swiss Franc b at a lowr pric (in trms of $) in London and at a highr pric in Nw York, thn th dalrs will incras th dmand for th Swiss Franc in London, driving up its pric, and incras its supply in Nw York, driving down its pric thr. This continus until th pric is th sam in both placs. Th major qustions to b addrssd ar how ar s dtrmind and what ar th forcs which influnc thm. In Figur 1, th quilibrium () is th on whr th quantity dmandd is qual to th quantity supplid for forign. As with most markts, th pric changs in ordr to quilib th markt. Whn quantity dmandd xcds quantity supplid, thn th will ris. If th quantity supplid is gratr thn quantity dmandd, th falls. What dos it man whn th riss or falls? As w hav dfind th ($/ ), whn th riss, th valu of th dollar dcrass or dprciats. It now taks mor dollars to buy an English pound than it did bfor th chang in th $/ Figur 2 Shortag. Fwr forign goods can now b purchasd for a givn numbr of dollars. Th rvrs is also tru. As th falls, th dollar cost of forign falls, incrasing th dollar s valu. This is trmd an apprciation of th dollar. Mor forign 2

3 goods can now b purchasd. Should markt forcs lad to a chang in ithr th supply or dmand for forign thn th will chang accordingly to r-quilib th markt. Figur 3 Tim Trnd Short run fluctuations In Figur 2, dmand incrass from D to D. At th initial, th incras in dmand lads to a shortag of forign. Domstic dmandrs bid up its pric and th riss to, which as bfor this rprsnts a wakning or dprciation of th dollar. Th major qustion to b addrssd is what ar ths markt forcs which lad to changs in th dmand and supply of forign. Ths will b discussd in ordr of th tim frams in which thy occur. Figur 3 rprsnts th movmnt of s ovr tim. It shows th day-to-day fluctuations (th jaggd movmnts), as wll as th longr-trm trnd (th smooth upward sloping curv). W nd to b abl to xplain both of ths charactristics. Th day-to-day volatility is xplaind in trms of th short run. Th trnd is bst xplaind in th long and mdium runs. Long-Run Effcts - Law of On Pric Th basic notion is that s ar snsitiv to diffrntial inflation s across countris. Should th domstic inflation ris at a gratr than our trading partnrs, thn at a givn, th pric of domstic goods will b rising rlativ to forign goods. This will, in turn, incras th dmand for forign goods (imports ar now chapr in domstic currncy trms) and dcras th dmand for domstic xports (domstic xports ar now mor xpnsiv in forign currncy trms). This rsults in an incras in th dmand for forign, as wll as a dcras in th supply of forign. It is lft to th studnt to us th diagrams to show that this would lad to a dprciation of th domstic currncy. (Shift Dfx to th right and Sfx to th lft. Dos th () go up or down?) 3

4 This is a long-run ffct bcaus of th Law of On Pric. This concpt stats that in th long run th pric of tradabl goods must b th sam across countris. If this was not th cas, thn th opportunity for arbitrag profits, buying low in on country and slling high in anothr, would rsult in a movmnt in th bringing about th qualization. For xampl, suppos Argntin what, at th prvailing, is chap in US dollars. As North Amricans buy mor and mor Argntin what, thy incras th dmand for th Argntin currncy, driving up its valu, thus making what mor xpnsiv in dollar trms. Th s which would prvail undr th Law of On Pric ar calld purchasing powr parity s (PPP). Whil ths do not xist in rality (thr ar many othr factors affcting s) thr is an undrlying prssur moving s in this fashion. PPP s ar usd in comparing th conomic prformanc btwn countris. Th World Bank compars countris in thir World Dvlopmnt Rport using a PPP. Mdium Trm - Diffrntial Growth Rats As an conomy grows, its dmand for imports will also grow. As incom incrass, som portion of that incras will b spnt on importd goods. In th jargon of macroconomics, th proportion of th additional dollar of incom spnt on imports is calld th marginal propnsity to import. Assum that th marginal propnsity to import is th sam across countris. Should a country s conomy grow fastr than its trading partnrs, thn its dmand for imports will also b growing fastr. In th contxt of Figur 4, this is rprsntd by incrass in both th dmand and supply of forign, but th dmand would incras by mor. This would rsult in a slight dprciation of th domstic currncy. Short-Run - Diffrntial Intrst Rats $/ This factor has bcom xtrmly important as countris hav libralizd thir conomis, allowing th flow of financial capital into and out of thir countris. It has playd an important rol in th East Asian and Mxican Pso financial criss. Figur 4 S fx or D $ 4

5 Libralization bnfits a country by forign financial capital ntring into that country. Ths rsourcs financ th building of factoris and roads and incras mploymnt opportunitis. But it is a doubl-dgd sword. financial capital can flow back out. Whn it dos, it wraks havoc on a country s conomy. On aspct of th financial criss in Asia and Mxico was that intrnational invstors lost thir confidnc in th scurity of thir assts in ths countris. This loss of confidnc jopardizd ths $/ Figur 5 S fx or D $ countris currncy valus and th valu of financial assts dnominatd in thir currncis. Faring that currncis would dprciat (or dvalu in th cas of fixd rgims), invstors startd a panic slling-off of thir financial assts dnominatd in psos, ringgit or won and purchasd dollars or othr stabl currncis. Ths invstors, in ssnc, cratd a slffulfilling prophcy. Th rturn to financial assts across countris has an important ffct on s. If a country s rturn to financial assts riss rlativ to othr countris, forign invstors hav an incntiv to purchas ths assts. First, th invstors will hav to chang thir currncis into that country s currncy in ordr to purchas ths assts. Simultanously, th country s own invstors will b lss inclind to purchas forign assts, kping thir mony at hom. This is picturd in Figur 5 as an incras in th supply of forign (Sfx to S fx) and a dcras in th dmand for forign (Dfx to D fx). Th nd rsult is a dcras in th pric of forign ( to ), of cours bing an apprciation of th country s currncy. On xampl of this occurrd in th 1980s. Th US govrnmnt ran up unprcdntd budgt dficits which ld to an incras in th of rturn on financial assts in th US. Th govrnmnt acts as a borrowr in financial markts to obtain th rsourcs rquird to bridg th dficit. This incras in th dmand for crdit incrass th intrst paid on financial assts or borrowing. invstors bgan to buy dollars in ordr to purchas Trasury Bills - govrnmnt bonds. This ld to an incras in th supply of forign, and th valu of th dollar wnt way up. As th valu of th dollar ros, th US trading sctor bcam lss and lss comptitiv. Th dollar pric of imports fll, 5

6 lading to incrasing dmand for forign products and at th sam tim incrasing th forign cost of US xports. Th US trad dficit grw trmndously as a rsult. Th US budgt and trad dficits ar somtims calld th twin dficits bcaus of bing intrrlatd. Th financial crisis in Southast Asia can also b partially xplaind in ths trms. Suppos you, as an invstor, wish to purchas stock on th Hong Kong stock markt. You first nd to US dollars for HK$ in ordr to mak th purchas. Now you buy a financial asst dnominatd in HK$. But suppos a rumor has it that thr will b a wakning in th valu of th HK$. If this happns, you will los mony whn you sll your HK asst and chang HK$ back into US $. You and a hoard of othr invstors would sll now in ordr to avoid ths losss. But this, in and of itslf, would caus th HK$ to dprciat. You and th othr invstors just mad th rumor tru. Whatvr gains you mad in th valu of th stock may b wipd out by th chang in th valu of th currncis. If many invstors try to gt back into US dollar assts, thr would b a larg sll off of Hong Kong financial assts and, as invstors switchd from HK$ to US$, th HK$ would dprciat. Fixd Rats Th prvious story, whil it maks sns in conomic trms, has not bn compltly honst. Th systm in Hong Kong is not a fr float. Th cntral bank in Hong Kong maintains a fixd. This mans thy stablish th for th HK$. Th mannr in which this is don is that th cntral bank stands rady, willing and, hopfully abl, to buy or sll HK$ at th stablishd or fixd. Buyrs and sllrs would thn transact this pric. $/ * *=f Figur 6 qs qd fall in intrnational rsrvs For a fixd systm to work, th cntral bank nds to hav forign rsrvs, should popl wish to buy it. This is calld th bank s intrnational rsrvs. Whn th bank buys forign, its rsrvs incras; and whn thy sll forign, thir rsrvs fall. Figur 6 paints a pictur of a situation that a cntral bank may fac in maintaining a fixd systm. Suppos th fixd is qual to th prvailing quilibrium that would hav obtaind by markt forcs (* = f). If this situation continus, thn th amount of forign that th bank is rquird to sll 6

7 is xactly qual to th amount it is rquird to buy. In ths circumstancs, its intrnational rsrvs do not chang. Now suppos for whatvr rason (svral wr givn abov in discussing floating s) that th dmand for forign incrass. Now at th fixd, f, thr is an xcss dmand for forign. Th cntral bank, in ordr to maintain th fixd, has to sll mor forign, qd, than it is buying, qs. Intrnational rsrvs dcras by th amount of th diffrnc. Th big qustion facing th cntral bank at this point is whthr this incras in dmand is a tmporary phnomnon or a prmannt chang. If it is tmporary, thn th bank suffrs only a short-trm fall in its intrnational rsrvs which it may b abl to rcoup latr. If it is a prmannt chang, thn th bank will s its intrnational rsrvs dplt. It will nd to chang its policis to bring th markt back in lin with th fixd. Usually whn it can, it will chang intrst s, making its country s financial assts mor attractiv and thus attract forign. Somtims this dos not work. No mattr what th intrst, invstors ar too concrnd about th risk. Now things gt nasty! Should th cntral bank s intrnational rsrvs bgin to dplt, thn holdrs of th currncy or financial assts dnominatd in that currncy will bgin to far a dvaluation. Th smart invstor will want to dump th currncy so as not to gt caught with it onc th dvaluation occurs. For xampl, suppos it cost 4 HK$ for a US$ and you hav 1000 HK$ or a HK financial asst worth 1000 HK$. You hav th quivalnt of US $250. If th Hong Kong cntral bank dvalus th HK$ so that it costs 5HK$ pr US$ - you just lost US $50. If thr is concrn about th Hong Kong banks' ability to support its fixd, thn a panic can occur whr invstors dump HK $. This causs th dmand for forign to incras and thr is a sll off of HK$, dpning th cntral bank s crisis as intrnational rsrvs plummt. 7