1.2 Flashcards
why would countries fix ERs
reduce exchange rate uncertainty (+ve impact on trade and investment flows),
make exports more competitive (gain from undervalued currency),
import credibility of foreign central bank’s monetary policy,
achieve quick reduction in inflation (hyper inflation requires)
what can fixed ERs be vulnerable to
speculative attacks and currency crises
what are a central banks assets
official international reserves - foreign government bonds and gold,
domestic credit - domestic government bonds and loans to domestic banks
what are a central banks liabilities
currency (notes and coins in circulation),
deposits of domestic banks at CB
equation for balance sheet of central bank
assets = liabilities + net worth, dt + rt = ht + nwt, ht high-powered money dt domestic credit rt international reserves nwt net worth
equation for balance sheet of central bank with constant net worth
∆liabilities = ∆assets, ∆ht = ∆dt + ∆rt, ht high-powered money dt domestic credit rt international reserves
what happens to the central banks balance sheet when the cb buys domestic government bonds with fresh money (∆liabilities = ∆assets,
∆ht = ∆dt + ∆rt)
increase in assets leads to equal increase in liabilities, dt up, pays with fresh money ht up,
ht high-powered money
dt domestic credit
what happens to the central banks balance sheet when the cb sells domestic government bonds (∆liabilities = ∆assets,
∆ht = ∆dt + ∆rt)
decrease in assets decrease in liabilities, dt down, it takes money out of the economy ht down
what happens to the central banks balance sheet when the cb buys (sells) foreign government bonds (∆liabilities = ∆assets,
∆ht = ∆dt + ∆rt)
increase (decrease) in assets leads to equal increase (decrease) in liabilities, cb buys (sells) foreign bonds rt up (rt down) (international reserves denominated in foreign currency) pays for these (receives payment) with domestic money ht up
what is the difference between normal interventions by the central bank and sterilized interventions
normal: CB buying/selling international reserves,
sterilized: CB buying/selling international reserves and
CB selling/buying domestic gov. bonds such that ∆dt=-∆rt and therefore ∆ht=0
why would a central bank do a sterilized intervention
keep ht the same therefore interest rates the same,
(sterilized: CB buying/selling international reserves and
CB selling/buying domestic gov. bonds such that ∆dt=-∆rt and therefore ∆ht=0)
what does a credible fixed exchange rate regime require
Etst+1=Etst+2=st=sbar,
FOREX market equilibrium requires it=i*,
cb no longer have control over it,
(look at forex equation if Etst+1=st)
what is one negative of fixed exchange rates
home cb must follow what foreign cb does,
if foreign cb raises it* by contracting money supply mt*… home cb must do the same irrespective of other policy goals
what is normally the fundamental cause of crises
unsustainable fiscal policy,
the gov. has a deficit every period which must be financed by domestic credit creation
what is the relationship between mt and ht
mt = Xht,
X=money multiplier and ht high-powered money
what is the shadow exchange rate
floating ER that would prevail if speculators purchased all remaining reserves rt and the peg were abandoned after a successful attack, st=stildat
what is the shadow exchange rate used for
crucial concept when evaluating profit opportunities of currency speculators, gives price at which they will be able to sell the reserves they bought from cb
what is the gradient of the shadow exchange rate
stildat a line with gradient μ bec once peg abandoned, the floating rate must depreciate at rate μ
what is the basic idea of the currency crisis and speculators p1
cause gov deficit every period (μ),
gov cannot print money (mt fixed) so must borrow every period by issuing bonds rate μ (cb buys, issues domestic credit ∆d=μ)
speculators understand that fixed rate s incompatible with draining FOREX reserves every period
what is the basic idea of the currency crisis and speculators p2
CB dt up (domestic credit up) normally ht up but not compatible with fixed so increase in dt matched by decrease in rt (forex reserves),
attack takes place once forex reserves exhausted rt=0,
ER peg abandones st float,
deficit now financed by printing money ht=dt, ∆h=∆d=μ
how do the speculators make money in currency crises
see that international reserves can only go down so far,
sell home currency short at fixed s rate,
when s goes flexible and depreciates buy back and settle position
why is speculating for a currency crisis harder in reality
uncertainty about rate of domestic credit growth over time or about level of reserves r at which the peg is abandoned, some agents (domestic banks, rich asset holders) have informational advantage
do currency speculators always win
no, plenty of times markets sell currency and CB defends currency and peg remains
what do cbs sometimes do when markets become suspicious the peg is not sustainable and start selling
CBs rather than lose a lot of foreign exchange reserves will just increase interest rates by enough to compensate
what is the second generation model trade off (SGM)
between peg which helps achieve low inflation,
reduction of inflation achieved at cost of loss of competitiveness
what is a conflict of policy objectives for peg to do with interest rates (second generation model SGM)
requires it up when it* up, i up may increase fragilities: banking sector, sustainability of public debt, sustainability of private debt, markets understand this conflict and may attack the currency
expectations-augmented PC equation
πt = Etπt+1 + λ(yt-ȳ) + ut,
ut inflation shock
what is the impact on the UIP of speculation of devaluation in a fixed currency area
it=i*+Est+1-sbar,
if totally credible Est+1=s and i=i, but once people expect devaluation Est+1>sbar so it has to rise above i
what does Etst+1 depend on for fixed ERs
what markets think the correct LT rate st+N is,
probability of devaluation taking place,
the greater the currency misalignment and prob of deval the greater the needed increase in it
difference between second and first generation models
reason for attack doesn’t have to be too much spending by gov., key reason is because of conflict of interest (inflation controlled by peg vs independent monetary policy allowing currency to depreciate useful in recession)
what is the European Exchange Rate Mechanism (ERM)
introduced in 1979,
anchor country West Germany and the DM,
aim to reduce variability of European exchange rates and prepare for economic and monetary union
tell me about the UK and the ERM (exchange rate mechanism)
UK joined in 1990 at sbar=.33£/DM,
Bundesbank raised interest rates to reduce inflationary pressures 90-92,
under interest rate parity and fixed ER other countries had to follow,
UK did same and raised even though entered recession in 1991,
markets became suspicious and huge speculative attack 1992,
initially gov defended by selling forex reserves and raising IRs but in end have in and allowed ER to float
what is the balance of payments
summary of transactions of domestic residents with the rest of the world
what are the two key accounts in the balance of payments
current account (CA), financial and capital account (KA)
what does the current account include (CA)
includes balance of trade (in goods and services),
BT almost always (by far) biggest item of CA
what does the financial and capital account include (KA)
includes FDI (foreign direct investment) eg direct investment by multinationals, includes PI (portfolio investment) eg acquisition of foreign stocks or bonds, loans to foreign govs. commercial banks or firms
under flexible exchange rates what is the balance of payments identity
CA + KA = 0,
current account + financial and capital account
under fixed exchange rates what is the balance of payments identity
CA + KA + OFR = 0,
current account + financial and capital account + change in official foreign exchange reserves
explain how many currency crises coincide with crises in the financial sector
crisis begins with reassessment by international investors of debt riskiness of EM,
triggers capital flight KA go from large positive to large negative,
if fixed rate cb must sell forex reserves to cope,
fear of devaluation increases it then yt down,
low yt makes loans by banks harder to repay so default rate up some banks may go bankrupt,
also low yt makes harder for gov. to repay debt (lower tax revenue),
result initial expectations of investors are confirmed
what is a currency mismatch
when countries borrow in a foreign currency:
income (assets) in domestic currency,
but borrow in international financial capital markets in foreign currency,
so when domestic devalued (or depreciates) value of debt (liabilities) rises
what is a maturity mismatch
often domestic banks and large firms rely on short-term debt-financing from international capital markets; but assets are long-term illiquid investments (mortgages, yearly loans to firms)
what happened in the east asian crisis 1997-98
fast growing economies (indonesia, south korea, malaysia, thailand) in early 90s attracted large foreign investment KA positive and CA negative,
growth slowing with loss of competitiveness due to $ appreciation (were pegged),
weak enforcement of financial regulation and cozy ties between firms and banks and gov. regulators, double mismatch of dollar debt and short-term,
crisis start thailand fall in real estate prices, then stock prices,
speculation of devaluation led to unsustainable loss of reserves had to turn to IMF for conditional loans (reduce gt and CA)
how can countries protect themselves from speculative attacks
have large amount of forex reserves,
limit international borrowing (v difficult),
current account under control,
money growth and domestic credit growth
what do first, second and third generation models mean
first: focus on unsustainable fiscal policy,
second: focus on costs of keeping peg when gov. has several objectives and on multiple equilibria,
third: focus on financial sector, on balance sheets, moral hazard and imperfect information
what did Kaminsky (2003) say about financial contagion
financial contagion after floatation of the Thai baht, triggered financial turmoil across Indonesia, Korea, Malaysia and the Philippines. On average currencies had depreciated 75%
what were some of the effects of financial contagion from Kaminsky (2003)
spikes in cost of borrowing,
decline in equity prices,
decline in value of currency,
falls in economic output
what is contagion defined as from Kaminsky (2003)
episode in which there are significant immediate effects in a number of countries following an event
