Exchange Rates and Open Economy Macroeconomics Ondrej Bednar This lesson should teach you: •What is ER •Types of ER •How it is determined •How its movements affect economies • What is an Exchange Rate? •Value of one currency expressed in terms of another •It is customary to use foreign currency in terms of the domestic currency. i.e.: 1EUR = 25.24CZK •When speaking about the movement of the Exchange Rates, it is necessary to be careful about increases and declines because the meaning will be opposite depending on from what country one looks at it • • • Exchange Rate Chart Foreign eXchange (FX) Market •Worldwide •The most traded currency is USD •Also functions as intermediary currency •Retail clients, commercial banks, FX Brokers and central banks •FX arbitrage: financial centers/cross currency arbitrage •The spot vs forward Types of ER •Nominal •The value displayed in exchange rate charts •Real •Adjusted for inflation •Effective •An index that describes the strength of a currency relative to a basket of other currencies. • Types of ER regimes Fixed Float Free Float Managed Float Peg Band Crawling Peg Currency Basket Peg Currency Board Bulgarian Leva Hong Kong Dollar Danish Krona Botswana Singapore Czech Koruna United States Dollar Euro Chinese Yuan Russian Ruble Determination of the spot ER •Many theories •The most simple model is here: •Demand for domestic currency is derived from demand for the Export •Supply domestic currency is derived from demand for the Import EUR/CZK Quantity of CZK Sczk Dczk Power Purchasing Parity Interest Rate Parity Determination of forward ER • •The exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor. •Parity relationship among the spot exchange rate •Differences in interest rates between two countries Central Banking • What to expect in this lesson •Brief history od central banks •Goals of central banks •Main theories underlying the central banks’ policies •Their operational regimes •Monetary policy implementation • • Central Banking •Prior to Central Banking •Coin sorting and storing •Banknote Issuance •Banker to the government •Banker to the banks •Lender of last resort •Banks supervisor •Monetary policy conductor Central Banks goals •Monetary and price stability •Financial Stability •Full employment • • Central Banks - Theory •The Quantity Theory of Money •M × V = P × Q The Phillips Curve and NAIRU The Rational Expectation Theory •It assumes that individuals' actions are based on the best available economic theory and information. • • •Departure from Adaptive Expectation Theory •Under adaptive expectations, expectations of the future value of an economic variable are based on past values The impossibility trinity aka Trilemma Why: a? b? c? Oxelheim, L. (1990) Monetary policy regimes Monetary policy regimes •To follow a particular monetary policy rule is to adopt a monetary policy regime •Since the demise of Bretton-Wood system (1971), these monetary rules were pursued: 1.Exchange Rate Targeting 2.Money Supply Growth Targeting 3.Risk Management Approach 4.Inflation Targeting 5.Unconventional Monetary Policy 6. Exchange Rate Targeting •CBs influence the supply curve at FX market to adjust for changes in the demand •Thus influencing also supply of the currency at the domestic market •In small open economy, international capital movements may easily overwhelm the CB’ s ability to keep the ER target • Money supply growth targeting •Coming from quantitative theory of money •M × V = P × Q •The relationship does not always hold as V happens to be unstable (1980’s FED experience) • Risk Management Approach •no announced specific targets for money supply growth or the inflation rate •Taylor’ s rule: • •It…. Policy interest rate at time t •πt… Inflation at time t •πt*… Desired inflation at time t •rt*… Equilibrium interest rate at time t •yt … The actual GDP growth rate at time t •yt*… GDP growth rate at full potential at time t •ay , aπ … Relative weights given to GDP growth and inflation growth rate • • Inflation Targeting Monetary Policy Implementation Types of Financial markets Monetary policy through money market 1 •Borrowing and lending funds with short maturity (<1 year) •At the core is interbank lending •Commercial banks lend and borrow among themselves •CBs affect the accessibility of the funds by changing the interest rates •Commercial banks wat to hold as little cash as possible since it does not yield interest, unlike loans. Although they need to hold minimum reserves. •Commercial banks demand the funds for example if unexpectedly high settlement occurs. Also government, and other financial institution might demand funds on this market •On the other hand, if commercial banks find out, that they have too much cash, they supply it to the market •EURIBOR, LIBOR, SOFR, PRIBOR…. • Monetary policy through money market 2 •Policy Interest Rates •Open market operations •Reserve requirements Monetary Policy Transmission - Households Monetary Policy Transmission- Firms Central Bank’ s Balance Sheet Balance of Payments •One of the most important macroeconomics indicator •Difference between all money flowing into the country in a particular period of time and the outflow of money to the rest of the world. Current Account •Trade Balance •Income from abroad • • • Capital Account •Direct Investments •Portfolio Investments •Loans • BoP examples… assuming ER 2USD/1GBP Current Account Imbalances…Do they matter? •Obviously it does to Some Macroeconomics Identities with CA • Money Creation 1 Money Creation 2 Money Creation 3 Money Creation 4 However, this is not how it is done in real world… •CBs mostly do not set targets on money supply, but rather on inflation •Reserve requirements(RR) are mostly not used to affect the economy •For example: In case of hike in RR, it would be very costly for banks and economy to call in the loans from the banks customers •Therefore the CBs prefer to impact conditions on money market by changing interest rates and direct market operations • •Oxelheim, L. (1990), International Financial Integration, Heidelberg: Springer Verlag. ISBN 3-540-52629-3 •