Dispense International financial economics, Dispense di Economia Internazionale

Scarica Dispense International financial economics e più Dispense in PDF di Economia Internazionale solo su Docsity! International Financial Economics 55% esame finale 5% class participation 40% group presentations Lecture 1 Countries have different currencies; therefore, a complete understanding of how a country’s economy works requires that we study the exchange rate (the price at which currencies are traded). Based on differences in exchange rate behavior, economists divide the world into two groups of countries: those with fixed (or pegged) exchange rates and those with floating (or flexible) exchange rates. The thing to consider with currencies is the monetary regime. Changes in exchange rates can affect an economy in two ways: - Changing international relative prices of goods: one country’s goods become more or less expensive relative to another’s. - Changing the international relative prices of assets: changes in wealth affect firms, governments, and individuals. Governments in crisis may appeal for external help from international development organizations, such as the International Monetary Fund (IMF) or World Bank, or other entities. In an exchange rate crisis, a currency experiences a sudden and pronounced loss of value against another currency. In the last 21 years there have been more than 37 exchange rate crises (ex. Crisis in Iceland in 2008). At the national level, economic measurements such as income, expenditure, deficit, and surplus are important indicators of economic performance, as well as the subject of heated policy debate. The difference between the gross national disposable income and the gross national expenditure is called current account (if positive is a surplus if negative is a deficit). Total wealth or net worth is equal to your assets (what others owe you) minus your liabilities (what you owe others). When you run a surplus and save money (buying assets or paying down debt), your total wealth, or net worth, tends to rise. Similarly, when you have a deficit and borrow (taking on debt or running down savings), your wealth tends to fall. From an international perspective, a country’s net worth is called its external wealth, and it equals the difference between its foreign assets (what it is owed by the rest of the world) and its foreign liabilities (what it owes to 1 the rest of the world). Positive external wealth makes a country a creditor nation; negative external wealth makes it a debtor nation. Ex. The United States could collect a lot of liquidity (can rise their debt) especially in the years of financial crises because they are trusted by the rest of the world A country can be risky in terms of repaying back his debt; the interest rates associated to the bonds issued by some countries are higher the riskier is the country (the risk associated to one country is called ‘country risk’). Government actions influence economic outcomes in many ways via decisions about exchange rates, macroeconomic policies, debt repayment, and so on. To gain a deeper understanding of the global macroeconomy, economist study not only policies, but also rules and norms, or regimes in which policy choices are made (ex. In the fixed change exchange regime only some choices can be made). At the broadest level, research also focuses on institutions, a term that refers to the overall legal, political, cultural, and social structures that influence economic and political actions (ex. efficiency of a country or the effectiveness of law are something that affect the economic performance of a country; Better-quality institutions are correlated with higher levels of income per capita and with lower levels of income volatility). Three groups of countries that will figure often in our analysis are:  – Advanced countries—countries with high levels of income per person that are well integrated into the global economy  – Emerging markets—mainly middle-income countries that are growing and becoming more integrated into the global economy  – Developing countries—mainly low-income countries that are not yet well integrated into the global economy Generally, the increase in financial openness of one country is strictly linked to the increase of financial transactions within that country. Since 1970’s many restrictions on financial transactions have been lifted (financial openness) and the volume of transactions has increased too. These trends have been strongest in the advanced countries, followed by the emerging markets and the developing countries. Overall, the most adopted exchange regime through the world, is the fixed one (adopted by 141 countries) while the floating exchange regime rate is adopted by 53 countries. The fixed regime eliminates the uncertainties around the volatilities of a 2 The main items in the financial account are: - FDI (foreign direct investment): investments made abroad - Portfolio investment - Derivatives and other investments - Official reserves or reserve assets In an open economy what balances the equivalence is the financial account. Current account + Capital account + Financial Account = 0 Some macroeconomic definitions: I = investments C = household consumption G = government consumption (doesn’t include pensions or some military expenses) C + I + G = GNE (gross national expenditure) Y = C + I + G + CA  this one is the national income identity In a closed economy investments are equal to savings, so Y – C - G = I = S (savings) while in an open economy we can have savings that are higher or lower to the investments (so the country can invest more or less than what it saves). To push up investments in a closed economy we must have funds while in an open economy we can borrow from abroad and other countries. We call twin deficit/surplus the event in which we have both a deficit/surplus in the current account and a government deficit/surplus (there coexists a deficit/surplus of the current account and a fiscal deficit/surplus). 5 Lecture 3 Exchange rates affect large flows of international trade by influencing the prices of goods in different currencies, and they affect international trade in assets via the prices of stocks, bonds, and other investments. An exchange rate (E) is the price of some foreign currency expressed in terms of a home (or domestic) currency. To avoid confusion, we must specify which country is the home country and which is the foreign country. E1/2 will denote the exchange rate of country 1, in units of country 1’s currency per unit of country 2’s currency. For example, the U.S. exchange rate with the Eurozone is denoted as E$/€ or number of U.S. dollars per euro. This exchange rate represents the number of U.S. dollars needed to purchase one euro. The relationship that exists in terms of exchange rates between the home and the foreign country is the following: We can use this formula if we want to find the exchange rate dollar-euro knowing the exchange rate euro-dollar and vice versa. If one currency buys more of another currency, we say it has experienced an appreciation. If a currency buys less of another currency, we say it has experienced a depreciation. When the U.S. exchange rate E$/€ rises, the price of one euro goes up in dollar terms, and the U.S. dollar depreciates. When the U.S. exchange rate E$/€ falls, the price of one euro goes down in dollar terms, and the U.S. dollar appreciates. To determine the size of an appreciation or depreciation we can calculate the variation as a percentage (E$/€,t+1 - E$/€,t / E$/€,t ). An exchange rate crisis occurs when the exchange rate experiences a sudden and large depreciation. These events are often associated with broader economic and political turmoil, especially in developing countries. Economists calculate multilateral exchange rate changes by aggregating bilateral exchange rates using trade weights to construct an average for each currency in the basket. The resulting measure is called the change in the effective exchange rate. There are two major types of exchange rate regimes; fixed and floating: 6  A fixed (or pegged) exchange rate fluctuates in a narrow range (or not at all) against some base currency over a sustained period. The exchange rate can remain fixed for long periods only if the government intervenes in the foreign exchange market in one or both countries. The central bank must stand ready to buy or sell its own currency to maintain a fixed exchange rate. Es. Danish krone  A floating (or flexible) exchange rate fluctuates in a wider range, and the government makes no attempt to fix it against any base currency. Appreciations and depreciations may occur yearly, monthly, by the day, or even every minute. Es. United States Some countries may forgo a national currency to form a currency union with other nations (e.g., the Eurozone), or they may unilaterally adopt the currency of another country (“dollarization”) or adopt a digital currency like what happened in ‘El Salvador’ (Bitcoin). The graph shows an IMF classification of exchange rate regimes around the world. Exchange rates of the world are set in the foreign exchange market (or forex or FX market). The simplest forex transaction is a contract for the immediate exchange (“on the spot”) of one currency for another between two parties. This is known as a spot contract. The exchange rate for this transaction is referred to as the spot exchange 7 If the forward rate is higher than the spot rate the market expects the first currency to depreciate. In fact, if in the future for example I will need more euros to buy the same amount of dollars it means that the euro will worth less than it worth today. IS-LM Model The interest rate is the determined by the intersection between demand and supply and therefore is the endogenous variable. In the short term we are assuming a fixed supply of real money balances because P is fixed by assumption (short run), and M is an exogenous policy variable. The demand is a negatively correlated curve; therefore, has a negative slope. If the central bank wants to increase the interest rate it should decrease the level of money supply. So, a fall in the money supply raises the interest rate and vice versa. In this case we assume that the supply function is a function of the interest rate only. Moreover, we make the supply depend not only on the interest rate but also on the income. The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. An increase in income will increase the money demand, this means that we have a shift upward of the demand curve and an increase in the interest rate (that’s why 10 the LM curve has a positive slope). Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. The LM curve summarizes the changes in the money market equilibrium When the FED changes the level of money supply the LM curve just shifts upwards or downwards but the level of income remains stable (for example if the FED reduces the money supply the LM curve shifts upwards). Lecture 4 It is important to state that in the short run prices are sticky and monetary and fiscal policy can affect the aggregate demand while in the long period prices are flexible. In absence of frictions, two equal goods must have the same price (law of one price). Applied to a single good we talk of the law of one price while applied to a basket of goods we talk about the purchasing power parity. The theory of purchasing power parity says that if we consider two same consumptions bundle, they must cost the same (independently on the currency that is used to price them). PPP holds in the 11 long run since prices are flexible and they adjust to re-balance demand and supply. PPP is the absence of arbitrage opportunities in purchasing goods across the borders. The law of one price (LOOP) states that in the absence of trade frictions and under free competition and price flexibility, identical goods sold in different locations must sell for the same price when expressed in a common currency. The law of one price breaks when arbitrage opportunities arise in currency markets. If the LOOP holds, the exchange rate is equal to the ratio of the two prices of two goods (when priced using different currencies). PPP formula Purchasing power parity (absolute PPP) only holds if the real exchange rate qUS/EUR is equal to 1. If qUS/EUR is below 1 then European goods are cheap relative to home (U.S.) goods while if qUS/EUR is above 1 than foreign goods are expensive relative to home goods. Purchasing power parity implies that the exchange rate at which two currencies trade equals the relative price levels of the two countries. 12 income, the higher the number of transactions and the higher the demand for money. All else equal, a rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. The condition for equilibrium in the money market is that the demand for money Md must equal the supply of money Ms (which we assume to be under the control of the central bank). Simple monetary model This equation represents the equilibrium in the long run in the monetary market. Where M is the money supply, P is the price (flexible in the long run), L is the constant and Y is the real income. Prices will adjust in the long term to equalize demand and supply and the changing in price will then determine the nominal exchange rate. Therefore, the nominal exchange rate of each country depends on the monetary policy’s choices of the central banks. Fundamental equation of the monetary approach to exchange rates Suppose the U.S. money supply increases, all else equal. The right-hand side increases (the U.S. nominal money supply increases relative to Europe), causing the exchange rate to increase (the U.S. dollar depreciates against the euro). 15 Now suppose the U.S. real income level increases, all else equal. Then the right-hand side decreases (the U.S. real money demand increases relative to Europe), causing the exchange rate to decrease (the U.S. dollar appreciates against the euro). The model just presented links the level of the exchange rate to the level of prices and uses the quantity theory to link prices to monetary conditions in each country. We can also reason in terms of growth rate and real income and in this case inflation rate is equal to the difference between the growth rate of money supply (μ) and the growth rate of real income (g). When money growth is higher than real income growth, we have “more money chasing fewer goods” and this leads to inflation. For this theory inflation is a monetary phenomenon, so depends on the fact that there is too money circulating. While the rate of depreciation is equal to the difference between the inflation rate at home and the foreign inflation rate. We know that PPP works poorly in the short run. One notable exception to this general failure of PPP in the short run: hyperinflation. Economists traditionally define a hyperinflation as a sustained inflation of more than 50% per month (which means that prices are doubling every 51 days). Hyperinflations usually occur when governments face a budget crisis, are unable to borrow to finance a deficit, and instead choose to print money. Generally, country that suffer hyperinflation have a high deficit (maybe it grows rapidly without being controlled) or high debt/GDP ratio. Example: in the 1980s Argentina suffered hyperinflation and the old peso was replaced by a new one. When there is hyperinflation the value of money collapses and maybe some alternative currencies may start to be used to trade goods (therefore money 16 demand collapses too). Generally, governments that suffer from hyperinflation decide to substitute the old currency with a new one. The trouble with the quantity theory we studied earlier is that it assumes that the demand for money is stable, particularly with respect to changing nominal interest rates, and this is implausible. There is an inverse relationship between interest rates and money demand. A rise in the nominal interest rate (the opportunity cost of holding money) will cause the demand for money to fall. Expanded monetary model In fact, when the interest rate increases investments are more attractive than holding money and the demand for money decreases. To know what happens at an exchange rate level we first have to explain the relationship between nominal and real interest rates (fisher effect). Exploiting PPP and UIP we can say that inflation differential is equal to the nominal interest rate differential (Fisher effect). In economics, the Fisher effect is the tendency for nominal interest rates to change to follow the rate of inflation. Rearranging the terms, we have: 17 Imagine 1 Example: If the domestic interest rate increases, then the domestic returns increase too shifting the DR curve up (from the blue to the red one), this shift makes the spot exchange rate decrease, therefore the dollar appreciates, and dollar deposits become more attractive. (Imagine 2) Imagine 2 Example: If the foreign interest rate decreases, then the foreign returns decrease too shifting the FR curve down (from the blue to the red one), this shift makes the spot exchange rate decrease, therefore the dollar appreciates, and dollar deposits become more attractive. (Imagine 3) 20 Imagine 3 Example: If the future exchange rate is expected to decrease, then the foreign returns decrease too shifting the FR curve down (from the blue to the red one), this shift makes the spot exchange rate decrease, therefore the dollar appreciates, and dollar deposits become more attractive. (Imagine 4) Imagine 4 The model that represents the asset approach to exchange rates is a two-country model in which the equilibrium is reached when we have the intersection between real money supply (vertical line since is exogenous) and real money demand. The equilibrium is driven by the movement of the interest rate, which in this case is considered as the price of money, (which is the variable that adjusts to guarantee the equilibrium between demand and supply). 21 The money supply curve (MS) is vertical because the quantity of money supplied does not depend on the interest rate. The money demand curve (MD), which is positively correlated with real income, is downward sloping because an increase in the interest rate raises the cost of holding money and therefore the demand of money decreases. When demand and supply are not in equilibrium the interest rate will adjust until the money market returns to equilibrium. For example, at point 2 the interest rate is too high so that the demand is low and there is an excess in supply and the price (interest rate) is driven down. While at point 3 there is an excess in demand (since the interest rate is low) and this makes the interest rate go up. Therefore, the equilibrium at home and abroad is given by the intersection between money supply and real income (exogenous variables) that determines the nominal interest rate in each country. Through the nominal interest rate, using the UIP condition, we arrive to the determination of the exchange rate. For example, as shown below, in panel (a) the increase in money supply forces the interest rate to decrease in order to restore the equilibrium. While in panel (b) an 22 A permanent increase in domestic money supply, in the short run, increases the real money balances since prices are sticky and decreases the nominal interest rate. A decrease in the nominal interest rate makes the home domestic currency (the dollar) to depreciate, therefore the exchange rate in the FX market increases since it must maintain the equality between domestic and foreign returns. However, since the exchange rate will be permanently depreciated, the foreign return increases too and at the end we will have a domestic currency that depreciates (or an exchange rate that increases) more than with a temporary increase in money supply. - figure below As shown in the picture above, in the short run we have lower level of real money balances, lower interest rate and an exchange rate which is larger than the one found in a temporary increase in domestic money supply. From the short to the long run, prices start to increase proportionally, therefore we arrive at a point in which real money balances are the same that we had in the beginning, the nominal interest rate increases and this is consistent with an appreciation of the exchange rate. - figure below 25 The differences between the different paths followed by the exchange rate (in the short run vs in the long run) are explained by an overshooting of the exchange rate (jumps to a level which is higher to its long run level, the overshoot is caused by the stickiness of prices). The paths followed by the different variables (money supply, real money balances, nominal interest rate, price level and exchange rate), from the short run to the long run, in the home country are the following: - Money supply increases (jumps from a level to the next one) - Real money balances increase in the short run since money supply increases and then starts to decrease to return to its original levels - Nominal interest rate decreases in the short run and then starts to increase to return to its original levels - Price level is sticky in the short run but in the long run increases as much as the money supply does (fisher effect) - Exchange rate jumps in the short run and then starts to slowly decrease to reach the same proportion/level of price and money supply Until now we have supposed a flexible exchange rate regime. In the case of fixed exchange rates, the central banks buys and sells reserves to maintain the exchange rate stable. If you fix the exchange rate you have some sort of nominal anchor, therefore the monetary policy of one country is constrained in the short run and in the long run. Therefore, if you fix the exchange rate the monetary policy is no longer autonomous. 26 In a fixed exchange rate regime, the model becomes really simple since the home interest rate always equals the foreign interest rate. Home monetary policy loses all autonomy compared with the floating case. In the short run: In a floating exchange rate regime the money supply is an input in the model and the exchange rate is an output of the model; in a fixed exchange rate regime the exchange rate is an input while the money supply is an output (monetary policy autonomy is lost). In the long run: In a floating exchange rate regime the monetary authorities prick the money supply M, this influences the interest rate and the exchange rate. In the long run, prices are determined by the PPP. In a fixed exchange rate regime, the price in Denmark (home country) is just a multiple of the price determined in the Eurozone (foreign country). Therefore, the monetary policy autonomy is lost also in the long run. Trilemma The central bank of a country would like to have: 1. A fixed exchange rate (can be a means to promote stability); a fixed exchange rate regime can be imposed by fixing the depreciation rate equal to 0 2. Free capital mobility (may be useful to promote integration, efficiency, and risk-sharing) and is represented by the UIP contrition’s formula 3. Monetary policy autonomy (may be useful to manage the home economy’s business cycle) and is represented by the inequivalence between the home interest’s rate and the forging’s exchange rate However, achieving all three policy goals at the same time is impossible since: 27  Fall in taxes 𝑇  Fall in the home interest rate 𝑖  Rise in the nominal exchange rate E  Rise in foreign prices 𝑃∗  Fall in home prices 𝑃  Any shift up in the consumption function C  Any shift up in the investment function I  Any shift up in the trade balance function TB We are interested in the general equilibrium in which all the 3 markets (goods, forex, and money market) are in equilibrium. The IS curve shows all the combinations of Y and i for which the good market and the forex market (expressed by the UIP condition) are in equilibrium. The IS curve is downward sloping since as interest rate increases the output/demand decreases. In fact, a decrease in interest rates makes the demand curve shift up since will affect both investments and trade balance. The factors that shift the demand curve will also shift the IS curve right. The LM curve shows all the combinations of Y and i for which the money market is in equilibrium. The equilibrium in the money market is reached when money demand is equal to money supply. The LM curve is upward sloping since an increase in income will make money demand increase and interest rate increase too (considering that money supply is fixed in the short run). Factors that shift the LM curve:  Change in the money supply  Change in the money demand function (L) IS curve  equilibrium in both goods and forex market LM curve  equilibrium in the money market IS-LM model  equilibrium in all 3 markets The following is the equilibrium in all 3 markets: 30 This combined IS–LM–FX diagram can then be used to assess the impact of various macroeconomic policies in the short run. How does a change in the monetary and fiscal policy affect the equilibrium in both fixed and floating exchange rate regimes? However, we should bear in mind that a change in monetary policy is done by changing money supply while a change in fiscal policy is done by changing government spending or taxes. Under a floating exchange rate, the interest rate and exchange rate are free to adjust to maintain equilibrium. Thus, government policy is free to move either the IS or LM curves. The impacts are as follows: • Monetary expansion: Money supply increases, LM curve shifts to the right, output rises, interest rate falls, domestic returns fall, exchange rate rises (the home currency depreciates). What happens to the trade balance cannot be predicted with certainty (on one hand there is an increase in the exchange rate that makes the trade balance increase while on the other hand there is an increase in domestic output that makes the trade balance decrease; depending on which effect prevails we have a different final outcome for the trade balance). 31 • Fiscal expansion (increase in government spending G or decrease in taxes collection T): IS shifts to the right, output rises, interest rate rises, exchange rate falls (the domestic currency appreciates) and trade balance decreases since we have a fall of the exchange rate. In this case, as the government pursues a fiscal expansion, government spending increases, the interest rate increases making investments to decrease (this impact of fiscal expansion is often referred to as ‘crowding out’). Fiscal expansion ‘crowds out’ investments (by raising the interest rate) and decreases net exports (by causing the exchange rate to appreciate). The fiscal expansion leads to crowding out of investment and exports, and thus limits the rise in output to less than an increase in government spending. Under a fixed exchange rate, the interest rate always equals the foreign interest rate, and the exchange rate is pegged. Thus, the government is not free to move the LM curve: monetary policy must be adjusted to ensure that LM is in such a position that these exchange rate and interest rate conditions hold. The impacts are as follows: • Monetary expansion: not feasible (because of the trilemma in an open economy a fixed exchange rate regime and a monetary policy autonomy cannot coexist; fixing the exchange rate means giving up monetary policy autonomy). • Fiscal expansion (increase in government spending G or decrease in taxes collection T): IS shifts to the right, LM follows it and also shifts to the right (to guarantee the unchanging of the exchange rate), output rises strongly, interest rate and exchange rate are unchanged. Trade balance decreases since domestic income increases. 32 find gold (it is similar to what is happening now with cryptocurrencies). Then between the two world wars the countries that implemented a floating exchange rate regime increased. Then, in 1944, after World War II, there was the Bretton Woods systems in which the dollar was the only currency that could be converted into gold (so many countries’ currencies were fixed against the U.S. dollar). The Bretton Woods system ended in 1971, and then many countries decided to adopt a floating exchange rate regime. There is no regime (floating or fixed) which is the best in absolute terms. Each one has features that fit better depending on the countries’ features. Practical example How does the fixed exchange regime of Germany and Britain work in 1990s? There is a leader that decides the policy mix to adopt and the other countries in the exchange rate mechanism (ERM) have to follow the leader’s decision in order to maintain the exchange rate fixed. Ex: Germany was the leader (or center country) and Britain had to follow it, in terms of monetary policy, but since Britain didn’t want German’s shocks to have an impact on its economy decided to abandon the ERM. This revealed to be a good choice for Britain since it let the country grow at a faster rate that it could have grown if remaining in the ERM peg. N.B. the fiscal shock that Germany experienced after the reunification caused the country to pursue a monetary policy that was appropriate only for Germany, since neither Britain nor other ERM nations experienced a similar shock 35 The elements to consider when deciding if to enter a fixed exchange rate regime are:  Economic similarity between countries (how likely it is that countries are hit by similar and symmetric shocks)  the more similar are the shocks, the more a fixed exchange rate is convenient. A fixed exchange rate can be costly when the shocks between countries are dissimilar, and the home country that unilaterally pegs to a foreign country wants to pursue monetary policies different from those of the center country.  Economic integration (measured by trade and other transactions)  the higher is the economic integration between markets in two countries, the more a fixed exchange rate is convenient To determine if a fixed exchange regime is preferable compared to a floating exchange regime, we can look at the FIX line graph or symmetry-integration diagram. In the graph the points above the FIX line will benefit from being in a fixed regime while the points below the FIX line will not (in fact, being in a fixed exchange rate regime generates costs). Therefore, the area below the line is the optimal region to float while above the line is the optimal region to fix. But do exchange rates promote trade? We can look at some evidence from a recent study in which country pairs A–B were classified in four different ways: a. The two countries are using a common currency (i.e., A and B are in a currency union or A has unilaterally adopted B’s currency). b. The two countries are linked by a direct exchange rate peg (i.e., A’s currency is pegged to B’s). 36 c. The two countries are linked by an indirect exchange rate peg, via a third currency (i.e., A and B have currencies pegged to C but not directly to each other). d. The two countries are not linked by any type of peg (i.e., their currencies float against each other, even if one or both might be pegged to some other third currency) The study evidenced that trade increased by 38% for countries in a currency union, by 21% for countries in a direct peg and decreased by -1% for countries with an indirect exchange rate peg. To measure the cost of being in a fixed exchange rate regime we can look at the volatility of output (output volatility is higher in a fixed exchange regime). The output volatility represents one of the costs of the fixed exchange rate regime. 37 and monetary autonomy. In the advanced countries, the trilemma was resolved by a shift to floating rates, which preserved autonomy and allowed for the present era of capital mobility. The main exception was the Eurozone which sacrificed monetary policy autonomy to attain fixed exchange rate and capital mobility. However, in August 1971 the United States abandon its commitment to convert dollars into gold and the Bretton Woods system collapsed. To conclude, we can affirm that exchange rate regimes reflect the sovereign choice of each country and depending on the specific situation the country decides its best exchange rate regime (so there is no one best regime). Lecture 8 Krugman’s model of currency crisis This is a model that predicts when a country enters a currency crisis (especially interesting for developing countries). And, in particular, it is a perfect-foresight monetary model. We are in a small open economy model characterized by PPP ad UIP, and we have 2 policy markers: one is the government, and one is the central bank. The government runs a fiscal deficit and finances it through bonds while the central bank monetizes part of the fiscal deficit by buying domestic bonds and at the same time it defends a fixed exchange rate, so it has a double objective (finance deficit and maintain a fixed exchange rate regime). However, in this case, the objective of financing deficit is slightly more important than maintaining the exchange rate fixed. For what regards the central bank balance sheet (composed by domestic and foreign government bonds), the money supply should remain constant (this is not a surprise since in order to maintain the exchange rate fixed also the money supply should remain fixed otherwise the exchange rate will be floating). Therefore, to maintain a fixed exchange rate regime and to finance public deficit the central bank has to balance the level of domestic bonds and foreign bonds (so to change the composition of the asset side of its balance sheet). This is possible as long as there are sufficient foreign bonds available in the market. When there are not any foreign bonds available in the market, the central bank has to alter its monetary policy and the exchange rate will start to float. Therefore, we can assume that the fixed exchange rate regime will exists until there are foreign bonds available. However, the model shows us that the end of the fixed exchange rate regime occurs before foreign reserves are equal to 0 (this is due to the fact that we have perfect future foresight, so rational agents known that the 40 model will come to an end and anticipate its end in order to reduce the impact of the future depreciation of the currency related to the collapse). The rational agents know that the central bank at some point will have to increase its money supply to finance public debt and that there will be a depreciation (increase in the exchange rate), therefore try to anticipate the collapse by buying foreign currency before foreign reserves are equal to 0, in order to do the opposite when the exchange rate will be depreciated (making a profit exploiting an arbitrage opportunity)  this anticipation is called speculative attack). N.B. the higher foreign reserves are the more distant in time is the speculative attack and the longer the fixed-rate regime will last Example: what happened in Greece, in that case the government imposed a maximum amount of money to be withdrawn from the ATM so that not to anticipate the currency crisis The speculative attack anticipates the time of collapse which is before the time in which foreign reserves are exhausted without the speculative attack. To calculate the effective (anticipated) time of the collapse Krugman introduced the so called ‘shadow exchange rate’ (which is the floating exchange rate that will be on the market once the foreign reserves will be equal to 0). The speculative attack occurs when the shadow exchange rate becomes equal to the fixed rate since losses and profits from intertemporal arbitrage are equal (there are no arbitrage opportunities). So, the speculative attack occurs at time T (time of collapse, time when the fixed exchange rate is abandoned). 41 As long as there are foreign reserves available on the market the strategy of the central bank to balance the asset side of the balance sheet is feasible, but when the foreign reserves start to run out the fixed exchange regime will be abandoned at some point. The main conclusion of the model is that fixed exchange rate regime collapses because there is not the right interaction between fiscal and monetary policy. However, this model only works for developing countries and is not able to explain currency crisis in advanced economies. A limit of this model is that everything is mechanical (we never question the possibility of leaving or remaining in the fixed exchange rate regime). We do not include the pros and cons of the fixed vs floating exchange regime since we want to maintain this model basic (otherwise with all the assumptions it will become much more complex). N.B. in the model the objective to finance the public deficit (financial reason) is what accelerates the end of the fixed exchange rate regime Lecture 9 (exchange rate crises) Recent history shows that the typical fixed exchange rate succeeds for a few years and then breaks. One study found that the average duration of any peg was about five years. When the break occurs, there can be a large and sudden depreciation. This is known as an exchange rate crisis. There is a key asymmetry in regime changes: the shift from floating to fixed (typically occurs because a country is suffering from a high level of inflation) is generally smooth and planned, but the shift from fixed to floating is usually unplanned and catastrophic. Exchange rate crises can occur in advanced countries as well as in emerging markets and developing countries. However, the magnitude of the crisis (measured by the depreciation rate) is greater in emerging and developing countries than in advanced countries, as we can see also from the graphs below. Therefore, the time to recover is longer for emerging and developing countries. 42 rate less sustainable (the risk premium accelerates the time of collapse as Krugman’s model suggests). UIP adjusted formula The UIP formula is adjusted by adding a currency premium (exchange rate risk premium) and a country premium (default risk premium). These premiums are higher for emerging markets and developing economies as a result of credibility problems. Why does the central bank change the composition of its money supply? 1. Insolvency and bailouts (when the value of liabilities exceeds the value of assets) 2. Illiquidity and bank runs (depositors cannot withdraw at any time) A central bank must change the composition of its money supply (by re-balancing home and foreign reserves) in order to defend the peg. In particular, when the bank starts selling reserves to keep the money supply fixed, we talk about sterilization (which is impossible in the case of a currency board because the currency board requires that domestic credit always equals 0). Sterilization is just a way to change the backing ratio, all else equal. Most of the reserves in the world are hold (especially by emerging markets) in dollars since the dollar is considered a safe and liquid currency. 45 Reserves in $ in emerging markets First-generation crisis model: the government has as main objective to finance the deficit and the central bank adapts to the government’s goal. When the reserves will be equal to 0 (suppose at time T), the peg will break, and the floating regime will begin  this is the case with myopia (no future expectations) Case with myopia (gradual decrease of the reserves) In the case with perfect foresight (Krugman’s model) the end of the fixed exchange rate regime will occur before reserves are equal to 0 since expectations of the investors are self-fulfilling and immediately anticipate the collapse of the fixed regime. 46 Case with perfect foresight (sudden decrease of the reserves) The perfect foresight or speculative attack model teaches that one moment, a central bank may have a pile of reserves on hand, draining away fairly slowly, giving the illusion that there is no imminent danger. The next moment, the reserves are all gone. The model explains why fixed exchange rates sometimes witness a sudden collapse rather than a long, lingering death. Why does the exchange rate break? - Inconsistent fiscal policy  fiscal dominance (government decides its fiscal policy and the central bank adapts which is the opposite of what is happening in the last 40-years. In fact, in advanced economies is the central banks that sets the monetary policy and then the government adapts). First-generation crisis model - Contingent monetary policies cases in which the policymaking is rational, but the pegs break for no apparent reason. Second-generation crisis model First and second-generation crisis model differ for the presence of multiple equilibria. In second-generation crisis models the government is not committed to maintaining the peg but the objective of defending the peg is a contingent commitment that holds until the benefits associated to the fixed regime (that are fixed and constant over time ex. Lower inflation) are higher than the costs (that are not constant over time since there might be shocks, es. Recession, that make it costly to maintain the fixed exchange rate regime). We have different equilibria depending on the cost of the fixed regime; that’s why we talk about multiple equilibria model. Until costs are below the benefit line the fixed regime is maintained otherwise it will be abandoned in favor of the floating regime. 47