the international financial system and monetary policy chapter 22
Post on 22-Dec-2015
216 views
TRANSCRIPT
The International Financial System and Monetary Policy
Chapter 22
Fixed Exchange Rates and Feedback
• Hong Kong has a de facto interest rate target equal to US interest rates (minus expected appreciation rate).
• This means that there is no direct feedback between HK inflation and HK interest rates.
• Credibility tends to be pro-cyclical. – When economy is booming there are sometimes
expectations of future appreciation, interest rates fall.
– When economy is slumping there are sometimes expectations of future depreciation, interest rates rise.
Zero Interest Rate Lower Bound• There is a lower bound on the interest
rate in money markets equal to zero since there is always an asset available that pays at least a zero interest rate (i.e. currency) savers will not accept negative interest rates on their deposits.
• Demand curve for money becomes horizontal at zero.
• Savers will hold as much money as is supplied at zero interest rate.
Increase in Money Demand(Money Target)
M
i MS
MD
MD’
Japanese Interest Rate
Call Money Rate
0
1
2
3
4
5
6
7
8
9
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Jan-
04
Monetary Policy• Beyond some point, monetary policy will
cease to have an effect on the economy.• To stimulate economy, Japan has adopted
a zero interest policy in the call money rate and additionally a quantitative easing policy to buy stocks and foreign exchange to stimulate economy through other channels.
• By increasing the money supply, the central bank hopes to increase inflationary expectations and reduce real interest rates. (it = 0 = rt + πt+1)
Japanese Money Supply
Jul-1998 Jul-1999 Jul-2000 Jul-2001 Jul-2002 Jul-2003 Jul-2004 Jul-2005
400000
380000
360000
340000
320000
300000
280000
260000
240000
220000
200000
180000
JP: Monetary Survey: Liabilities: MoneyJPY bn
Monetary Policy in China
Features• Chinese currency, Renminbi, has long had a
fixed exchange rate with the US dollar.– Since May, 2005 RMB allowed to float within a very
narrow range
• China maintains currency controls, so interest rates in China differ from US.– If Chinese savers could get a better return on their
investments in the US, they are forbidden by law from
China’s Exchange Rate
• Chinese exports have been increasing rapidly. Foreign purchasers want Renminbi to buy Chinese goods. This would put upward pressure on Renminbi exchange rate. To keep foreign exchange rate stable, the central bank sells RMB and buys HK$.
Foreign Reserves in ChinaForeign Reserves China
0
100000
200000
300000
400000
500000
600000
700000
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Mil
US
$
Sterilized Intervention
• Sterilized intervention occurs when the central bank engages in a foreign exchange market intervention combined with an offsetting open market operation which leaves the monetary base unchanged. – When the government conducts a foreign currency
intervention but maintains a fixed interest rate target, defensive transactions will automatically sterilize.
• Sterilized interventions will not affect the domestic interest rate. However, they may create a very liquid currency market which temporarily affects the exchange rate.– Most empirical studies find that sterilized interventions
have little effect on exchange rates in even the medium run.
T-Accounts: Sterilized Intervention
• Sterilized Foreign Currency Purchase/Open Market Sale
• Sterilized Foreign Currency Sale/Open Market Purchase
PBo’C
Assets Liabilities
+100
Foreign Currency-100
Government Securities
+100
Reserve Accounts-100
Reserve Accounts
PBo’C
Assets Liabilities
-100
Foreign Currency+100
Government Securities
-100 Reserve Accounts+100
Reserve Accounts
Rapid Money Growth (in 5 years money supply has tripled)
0
5000
10000
15000
20000
25000
30000
35000
Dec-98
Jun-
99
Dec-99
Jun-
00
Dec-00
Jun-
01
Dec-01
Jun-
02
Dec-02
Jun-
03
Dec-03
Jun-
04
Dec-04
Jun-
05
Base
M2
Money Base growth has been relatively slow. Money multiplier has
been increasing. Money Multiplier
0
2
4
6
8
10
12
14
Dec-98
Apr-9
9
Aug-9
9
Dec-99
Apr-0
0
Aug-0
0
Dec-00
Apr-0
1
Aug-0
1
Dec-01
Apr-0
2
Aug-0
2
Dec-02
Apr-0
3
Aug-0
3
Dec-03
Apr-0
4
Aug-0
4
Dec-04
Apr-0
5
Aug-0
5
Central Bank and Interest Rates
• Central Bank operates a discount window and lends money directly to banks in the interbank market.
• Central bank maintains interbank lending rate target
• People’s Bank of China also directly sets base deposit rate and base lending rate of the big 4 banks.
Interest Rates have been very stable
Interest Rates in China%
0
1
2
3
4
5
6
7
Jun-
99
Oct-99
Feb-0
0
Jun-
00
Oct-00
Feb-0
1
Jun-
01
Oct-01
Feb-0
2
Jun-
02
Oct-02
Feb-0
3
Jun-
03
Oct-03
Feb-0
4
Jun-
04
Oct-04
Feb-0
5
Jun-
05
Lending Rate Savings Deposit Rate
Increase in Money Demand/ Interest Rate Target
M
i MS
MD
i*
MD’
MS’
Interest Rate Policy
• Central Bank has increased money supply in response to increased money demand at given interest rates. Not an attempt to push down interest rates.
• Central bank does not raise interest rate to stabilize the economy. – Possible reason: Banks aren’t effective at
allocating credit. Raising interest rates may have adverse selection effects.
Exchange Rates
• Currency board/Convertibility Undertaking in Hong Kong is a systematic monetary policy which targets a particular level of the exchange rate at a permanent level.
• Monetary policy of many neighboring economies often are targeted toward changing the exchange rate.
• Reason: Prices of goods in domestic currencies are sticky, so changes in the exchange rate will (in the short run) change the relative prices of domestic exports and foreign imports.
Terms
• Depreciation: A reduction in the value of exchange rate under a monetary policy in which exchange rate is not the target.– Appreciation: An increase in the value of
exchange rate.
• Devaluation: A reduction in the value of exchange rate under a fixed exchange rate regime.– Revaluation: An increase in the value of the
exchange rate.
Uncovered Interest Parity
• The central equation for thinking about the exchange rate will be uncovered interest parity.
• Define the domestic currency returns from investing in foreign bonds as
• Uncovered Interest Parity indicates that
• UIP is 1 equation and 4 variables. It can only determine the exchange rate if we take the others as given.
1
1 1F F tt t
t
EXR i
EX
1 1Ft tR i
Exchange Market
Return
1+RF
EX
EX*
1+R
Exchange Market
• We have treated domestic and foreign interest rates as well as the future exchange rates as exogenous. We can examine the effects of changes in each of these on the current exchange rate.
• Because we are treating the future exchange rate as a given, we can only consider the effects of temporary changes in interest rates (because we are by definition analyzing temporary changes in the economy).
FAQ
• Q: Why is the domestic currency returns from investing in foreign currency bonds increasing in the exchange rate?– A: The greater is the current exchange rate,
the more foreign currency you can buy with each unit of domestic currency. Holding the future exchange rate constant, this will be associated with higher returns.
Equilibrium Interest Rate
• If exchange rate is above EX*, investors can gain more funds if they buy foreign currency bonds. In order to buy foreign currency bonds, they must sell their domestic currency to buy foreign currency. This will drive down the price of domestic currency.
• If exchange rate is below EX*, investors will sell foreign currency driving up the price of domestic currency.
Rise in Foreign Interest Rates
Return
1+RF
EX
EX*
EX**
Rise in Domestic Interest Rates
Return
1+RF
EX
EX*
1+i
EX**
Foreign Exchange Rate Intervention
• Purchase of Foreign Currency increases the monetary base. – An increase in the monetary base (combined
with the money multiplier) will increase the money supply.
• An increase in the money supply will (with fixed money demand) lead to a decline in domestic interest rates.
– A decline in the interest rate leads to a decline in equilibrium exchange rates.
• Putting more domestic currency on the market reduces the value of the domestic currency.
History of Exchange Rate Regimes
• Prior to World War I: Metal Standard• Interwar Period: Return to Gold Standard
with less credibility.• 1945:1971 Bretton Woods System. Most
economy’s fix the exchange rate relative to the US$.
• 1979: European Monetary System. European economies link their exchange rates relative to one another. In 1998, a new currency the Euro was created.
Fixed Exchange Rate Regimes
• When central banks choose a monetary policy of a fixed exchange rate, they must engage in foreign currency interventions to maintain that level.
• When foreign interest rates rise, the central bank must sell foreign currency to reduce the domestic monetary base.
• This will raise domestic interest rates and keep the exchange rate stable.
• Convertibility Undertaking in HK makes this automatic.
Rise in Foreign Interest Rates/Exchange Rate Target
Return
1+RF
EX
EX*
Foreign Reserves
• To depreciate the exchange rate using foreign exchange market intervention the central bank must buy foreign currency with domestic currency. Central bank has an infinite amount of domestic currency.
• To appreciate the exchange rate using foreign exchange market intervention the central bank must sell foreign currency to buy domestic currency. Central bank has a finite amount of foreign currency. – It may be impossible to buy enough domestic currency to
stabilize the exchange rates if they run out of foreign reserves.
– Stabilizing the exchange rate may destabilize the interest rates.