Chapter 12-13: Fixed and Floating ER Current Account Imbalances Crisis

Question 1

How do countries practice managed floating exchange rate

Answer 1

􏰀 The central bank manages the exchange rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility.

Question 2

How does a central bank balance sheet look like

Answer 2

Assets
􏰀 Foreign government bonds (official international reserves)
􏰀 Gold (official international reserves)
􏰀 Domestic government bonds
􏰀 Loans to domestic banks

Liabilities
􏰀 Deposits of domestic banks
􏰀 Currency in circulation

Assets=Liabilities + Net Worth

Assume net worth constant, increase in assets lead to increase in liabilities

Decrease in assets lead to decrease in liabilities

Question 3

How does changes in CB balance sheet affect money supply

Answer 3

Changes in the central bank’s balance sheet lead to changes in currency in circulation or changes in deposits of banks, which lead to changes in the money supply.

􏰀 If their deposits at the central bank increase, banks are typically able to use these additional funds to lend to customers, so that the amount of money in circulation increases.

When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases.

Question 4

What happens when CB sells/buys domestic bonds

Answer 4

When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases.

When the central bank sells domestic bonds or foreign bonds, the domestic money supply decreases.

Question 5

What is sterilization

Answer 5

Because buying and selling of foreign bonds in the foreign exchange markets affects the domestic money supply, a central bank may want to offset this effect.

If the central bank sells foreign bonds in the foreign exchange markets, it can buy domestic government bonds in bond markets hoping to leave the amount of money in circulation unchanged.

Question 6

Recap: What is a country’s balance of payment

Answer 6

balance of payments = current account balance + capital account balance + non-reserve portion of financial account balance

Country balance of payments is the net purchases of foreign assets by the home central bank minus the net purchases of domestic assets by foreign central banks

can see it as a payments gap that central bank has to finance to ensure balance of payment accounts can balance

Question 7

What is perfect asset substitutability

Answer 7

Means interest rate parity, where agents are indifferent between domestic and foreign currency deposit as long as they expect same expected return

Question 8

Why is there imperfect asset substitutability
(List 2)

Answer 8

􏰀 Default risk: The risk that the country’s borrowers will default on their loan repayments (making lenders require a higher interest rate to compensate for this risk).

􏰀 Exchange rate risk: If there is a risk that a country’s currency will depreciate or be devalued, then domestic borrowers must pay a higher interest rate to compensate foreign lenders.

Question 9

How to account for imperfect asset substitutability

Answer 9

add a risk premium P:
reflect the need to compensate investors for the difference between the riskiness of foreign and domestic bonds

When risk premium is higher–> foreign curency deposits look better, lead to domestic depreciation

Question 10

What happens when there is sterilized intervention under managed floating

Answer 10

Suppose the central bank does sterilized purchase of foreign assets: buying foreign assets (thereby increasing the money supply) and selling domestic assets (thereby decreasing the money supply proportionally). There is no change in the money supply.

When CB domestic assets fall from A1 to A2, stock of domestic assets now higher than before intervention (B-A2). As a result, the risk premium on domestic assets p increases, making foreign currency deposits look better–> lead to domestic depreciation

Question 11

How to fix a exchange rate

Answer 11

To fix the exchange rate, a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets, so that the exchange rate stays constant.

When exchange rate is fixed, and market expect it to reach at that level R=R*

CB adjust quantity of monetary assets in market until domestic interest rate = foreign interest rate

Question 12

How does the fixed exchange rate look like when applied

Assume central bank fixed E0 but level of output and L(R,Y) shifts out

Answer 12

To maintain the fixed exchange rate, the central bank should buy foreign assets in the foreign exchange market,
􏰀 thereby increase the domestic money supply
􏰀 and thereby reducing domestic interest rate in the short run.

Think of it as buy buying more foreign asset make currency deposits stronger–> value of foreign currency increased and value of domestic currency decrease

Question 13

What is the constraints of buying and selling foreign assets to keep exchange rate fixed

Answer 13

• unable to adjust domestic interest rate for other macroeconomic goals
• In particular, under fixed exchange rate, monetary policy is ineffective in influencing output and employment.

Question 14

Why is monetary expansion ineffective under a fixed exchange rate

Answer 14

• increase in money supply by buying domestic assets and increase circulation of currency to AA2
• but to maintain exchange rate, government need to sell foreign currency, take it out of circulation. This then decreases Money supply and shift back AA curve to the left

thus under a fixed exchange rate, CB can change composition of assets, but lose ability to use monetary policy for macroeconomic stabilization

Question 15

What are devaluation and revaluation

Answer 15

Devaluation and revaluation refer to changes in a fixed exchange rate caused by the central bank.

􏰀 With devaluation, a unit of domestic currency is made less valuable, so that more units must be exchanged for 1 unit of foreign currency, i.e. the fixed exchange rate is increased from E to E′.

􏰀 With revaluation, a unit of domestic currency is made more valuable, so that fewer units need to be exchanged for 1 unit of foreign currency.

Question 16

Show how the devaluation process occurs

Answer 16

When the devaluation occur, the central bank announce willingness to buys foreign assets at a higher rate–> increasing money supply

Devaluing currency cause domestic currency to depreciate move to E1 and push economy to new equilibrium with higher output Y and higher money supply

Official international reserve assets increases

Question 17

What about fiscal policy and fixed exchange rates

Answer 17

When economy is in full employment, a fiscal expansion raises output Y, this leads to an appreciation of the domestic currency.

TO maintain exchange rate, central bank must buy foreign assets, thereby increasing the domestic money supply and decreasing interest rates (shift to AA2)

Question 18

What happens to fiscal policy and fixed exchange rates in the long run

What happens following a devaluation

Answer 18

A rising price level makes domestic products more expensive: a real appreciation in the long run (EP∗/P falls) even though there is no short-run real appreciation since E is fixed and prices do not change in the short run.

􏰀 Aggregate demand and output decrease as prices rise: DD curve shifts left.
􏰀 Prices tend to rise until employment, aggregate demand, and output fall to their natural levels

In order to maintain level of nominal exchange rate, CB have to inervene buy buying foreign assets, results in money supply increasing in proportionate to P

Following a devaluation, in the long run, prices adjust to the change in the exchange rate. In the long run, the only effect of a devaluation is a proportional rise in all nominal prices and in the domestic money supply.

Question 19

What is a BOP Crisis

Answer 19

When a central bank does not have enough official international reserve assets to maintain a fixed exchange rate, a balance of payments crisis results.

To sustain a fixed exchange rate, CB must have enough foreign assets to sell in order to satisfy demand at the fixed exchange rate

Question 20

What happens when investors expect the domestic currency to be devalued

Answer 20

This cause them to want foreign assets instead of domestic assets since domestic assets expected to fall, cause them to change into foreign assets, depleting stock of international reserves

(Think of it as investors putting money into economy, CB try to move money out of economy, but money keep heading back)

Question 21

What is a capital flight?

Answer 21

As a result, financial capital is quickly moved from domestic assets to foreign assets
=⇒ capital flight.
⋆ The domestic economy has a shortage of financial capital for investment and has low
aggregate demand

Question 22

What should central bank do when there is a expectation among investors towards a devaluation to E1

Answer 22

To convince investors to keep domestic assets, domestic assets must offer high interest rate
R=R* + (E1-E0)/E0

• CB can facilitate this by reducing money supply. By selling foreign reserves, this occurs until the money market equilibrium has reached
  R=R* + (E1-E0)/E0

The expectation of a future devaluation cause a BOP crisis, where there is a sharp fall in foreign reserves and domestic interest rate above world interest rate

Question 23

What cause expectations to change?

Answer 23

⋆ Expectations about the central bank’s ability and willingness to maintain the fixed exchange
rate.

⋆ Expectations about the economy: shrinking demand of domestic products relative to foreign
products means that the domestic currency should become less valuable.

Expectations of a devaluation can cause a actual devaluation

Question 24

What happens when central bank runs out of official international reserve assets

Answer 24

The central bank must devalue the domestic currency (so that it takes more domestic currency (assets) to exchange for 1 unit of foreign currency (assets)).

This will allow CB to replenish foreign assets by buying them back at a devalued rate

Question 25

What is the result of devaluation

Answer 25

Because you buy the foreign asset

􏰀 increasing the money supply,
􏰀 reducing interest rate,
􏰀 reducing the value of domestic products,
􏰀 increasing aggregate demand, output, and employment over time.

Question 26

Why central bank cannot buy domestic bonds sell domestic currency to

Answer 26

the central bank may buy domestic bonds and sell domestic currency (to increase the money supply) to prevent a high interest rate, but this only depreciates the domestic currency more.

central bank cannot satisfy goals of low domestic interest rate and fixed exchange rate simulataneously

Question 27

What is the national savings identity

Answer 27

CA —> S-I

If national savings S is less than domestic investment I, the country will run a current account deficit CA < 0. However, by running a current account deficit and borrow from foreign countries, the country can finance domestic investment I even if domestic saving S is low. =⇒ Intertemporal trade

Question 28

What does a developing country financial crisis look like

Answer 28

A debt crisis: inability to repay sovereign or private sector debt

A BOP Crisis: under a fixed exchange rate system

A banking crisis: Bankruptcy and other problem for private sector banks

Question 29

What is a loan in default

Answer 29

A loan is in default when the borrower fails to repay on schedule according to the loan contract.

A sudden stop occurs when a country suddenly loses all access to foreign funds (usually because the lenders lost confidence in the country’s ability to repay in the future)

Question 30

What is the problem of defaulting

In a debt crisis

Answer 30

􏰀 Fear of default reduces financial asset inflows and increases financial asset outflows (capital flight), decreasing investment and increasing interest rates, leading to low aggregate demand, output, and income.

Financial asset outflows must be matched with an increase in net exports or a decrease in official international reserves in order to pay individuals and institutions who desire foreign funds.

The domestic government may have no choice but to default on its sovereign debt (paid for with foreign funds) when it comes due and when investors are unwilling to reinvest.

Question 31

What are the problems of a debt crisis

Answer 31

􏰀 High interest rates cause high interest payments for both the government and the private sector.
􏰀 Low income causes low tax revenue for the government.
􏰀 Low income makes loans made by private banks harder to repay: the default rate
increases, which may cause bankruptcy.

Question 32

Problem of default: BOP Crisis

Answer 32

Official international reserves may quickly be depleted because governments and private institutions need to pay for their debts with foreign funds, forcing the central bank to abandon the fixed exchange rate.

Question 33

Problem of default: Banking crisis

Answer 33

High default rates on loans made by banks reduce their income to pay for liabilities and
may increase bankruptcy.

if depositors fear bankruptcy, will likely spark a bank run

If people expect a default on sovereign debt, a currency devaluation or bankruptcy of private banks can lead to another

Question 34

What are international capital markets

Answer 34

International asset (capital) markets are a group of markets (in London, Tokyo, New York, Singapore among others) that trade different types of financial and physical assets (capital), including

􏰀 stocks
􏰀 bonds (government and private sector)
􏰀 deposits denominated in different currencies
􏰀 commodities (like petroleum, wheat, bauxite, gold)
􏰀 forward contracts, futures contracts, swaps, options contracts
􏰀 real estate and land
􏰀 factories and equipment

Question 35

How are transactions being made between buyer and seller

Answer 35

􏰀 goods or services for other goods or services
􏰀 goods or services for assets
􏰀 assets for assets

Question 36

What are assets classified as?

Answer 36

Debt instruments
􏰀 Examples include bonds and deposits.
􏰀 They specify that the issuer must repay a fixed amount regardless of economic
conditions.
or,

Equity instruments
􏰀 Examples include stocks or a title to real estate.
􏰀 They specify ownership (equity = ownership) of variable profits or returns, which vary

Question 37

What is home bias in equity portfolios?

Answer 37

US residents hold 86% of total market value of all US company equities through individual investors or pension funds

Question 38

What is Open-Economy Trilemma

Answer 38

Country can only pursue 2/3 policies

􏰀 A country that fixes its currency’s exchange rate while allowing free international capital movements gives up control over domestic monetary policy.

􏰀 A country that fixes its exchange rate can have control over domestic monetary policy if it restricts international financial flows so that interest parity need not hold.

􏰀 Or a country can allow international capital to flow freely and have control over domestic monetary policy if it allows the exchange rate to float.

Question 39

What is the case for floating exchange rate

Answer 39

1. Monetary policy autonomy
   - When central banks do not need to trade currency in foreign exchange markets, they are more free to influence the domestic money supply, interest rates, and inflation and more freely react to changes in aggregate demand, output, and prices in order to achieve internal and external balance.
2. Automatic stabilization
   - flexible exchange rate reduce fundamental disequilibria

• fundamental disequilibrium cause by excessive increase in money supply and G–> leading to high inflation
• Inflation causes the currency’s domestic and international purchasing power to fall. Flexible exchange rates can automatically adjust to account for this fall in value, as purchasing power parity predicts.

Question 40

Explain automatic stabilzation using a graph for floating exchange

Suppose there is a fall in demand for home country’s exports

Answer 40

Lead to shift in DD curve leftwards, demand shift is temporary (no change in expected exchange rate)

Under floating exchange rate, AA curve does not shift. Demand for output fall. Home interest rate R must decline to keep money market in equilibrium

Lower R correspond to equilibrium in foreign exchange market with higher exchange rate –> domestic currency depreciation from E1 to E2

Question 41

Explain automatic stabilzation using a graph for fixed exchange

Suppose there is a fall in demand for home country’s exports

Answer 41

CB need to maintain exchange rate at E1 so it buys domestic currency by selling foreign reserves. Cause money supply to fall and shift AA curve down –> cause output to drop even more

THus in this case floating exchange work as stabilizer, prevent economy output falling all the way to Y3. Employment fall less since depreciation has an offsetting effect

Question 42

What are macroeconomic policy goals

Think of internal balance and external balance

Answer 42

Internal balance describes the macroeconomic goals of producing at potential output (at full employment) and of price stability (low inflation).

External balance is achieved when a current account is

􏰀 neither so deeply in deficit that the country may be unable to repay its foreign debts,
􏰀 nor so strongly in surplus that foreigners are put in that position. (For example, the
U.S. trying to put pressure on Japan in the 1980s and China in the 2000s.)

Question 43

Recall the national savings identity

Answer 43

S=CA-I

Question 44

Recap, when talking about small countries, do they affect world markets?

Answer 44

􏰀 For example, a depreciation of the domestic currency was assumed to have no significant influence on aggregate demand, output, and prices in foreign countries.

􏰀 For large economies like the US, EU, Japan, and China are interdependent because policies in one country affect other economies.

Question 45

Macroeconomic Interdependence under floating exchange rates

What happens when the US permanently increase money supply in the short run

Answer 45

􏰀 an increase in U.S. output and income
􏰀 a depreciation of the U.S. dollar

Question 46

Macroeconomic Interdependence under floating exchange rates

What will be US effect on Japan

Answer 46

􏰀 an increase in US output and income would raise demand for Japanese products, thereby increasing aggregate demand and output in Japan.

􏰀 a depreciation of the US dollar means an appreciation of the yen, lowering demand for Japanese products, thereby decreasing aggregate demand and output in Japan.

􏰀 The total effect of is ambiguous.

Question 47

Macroeconomic Interdependence under floating exchange rates

What happens when the US permanently increase govt purchases

Answer 47

predict an appreciation of the US dollar

Question 48

Macroeconomic Interdependence under floating exchange rates

What will be the US impact on Japan be?

Answer 48

an appreciation of the U.S. dollar means an depreciation of the yen, raising demand for Japanese products, thereby increasing aggregate demand and output in Japan.

Higher Japan income and output means more money spent on US products–> increasing aggregare demand and output in US in the short run

Question 49

What is the Nash Equilibrium when choosing to consider somewhat restrictive vs very restrictive policies

Answer 49

If no coordination, (each country goes alone), they both choose very restrictive policy. If somewhat restrictive policies adopted by both countries, lead to better outcome for both

Question 50

What is the theory of comparative advantage

Answer 50

Theory of CA describes the gains from trade of goods and services for other goods and services

• with a finite amount of resources and time, countries use those resources and time to produce what they are most productive, and then trade those products for goods and services they want

Question 51

Theory of intertemporal trade

Answer 51

Theory of intertemporal trafe describes gains from trade of goods and services for assets

• savers want to buy assets and borrowers want to use assets to consume or invest in goods they can buy with current income

Question 52

Theory of portfolio diversification

Answer 52

describes the gains from trade of assets for assets, of assets with one type of risk for assets with another type of risk.

People usually display risk aversion: where they are usually averse to risk

Question 53

What is the extent of international intertemporal trade on economy

Answer 53

Some countries should have large current account surpluses as they save a lot and lend to foreign countries. Some countries should have large current account deficits as they borrow a lot from foreign countries. But, in reality, national saving and investment levels are highly correlated.

Question 54

What is the fieldstein Horioka puzzle

Answer 54

despite international capital markets, domestic savings largely finance domestic investment (Feldstein and Horioka, 1980).

Factors such as high saving rate generate high investment rate

Question 55

What is a financial trilemma

Answer 55

A financial trilemma constrains what policymakers in an open economy can achieve. At most two goals from the following three are simultaneously feasible:

􏰀 Exchange rate stability
􏰀 monetary policy autonomy
􏰀 freedom of financial flows