chapter 13 Flashcards
what is a floating currency
A currency whose exchange rate is determined by the demand for and supply of the currency in the foreign exchange market.
Exchange rate system
An agreement between countries on how exchange rates should be determined.
managed float exchange rate system
Australia has been using a managed float system since 1983 where the $AU is determined by market forces with the occasional intervention of the central bank
the Australian currency is one of the world’s currencies with the
least amount of central bank intervention
fixed exchange rate systems
countries agree to keep the exchange rates between their currencies fixed. e.g. gold standard and Bretton Woods system
The current exchange rate system has three important aspects:
1 Australia, like Britain and the United States, allows its currency to float against other major currencies.
2 Most countries in Western Europe have adopted a single currency, the euro.
3 Some developing countries have attempted to keep their currencies’ exchange rates fixed against the US dollar or another major currency.
TWI
measure the value of the Australian dollar against a basket of currencies of its major trading partners based on volume of trade carried out in that currency
e.g. If Australia carries out most of its trade in Japanese yen, then the index will give a higher weight to the exchange rate against the yen than against the currency of a country with which Australia trades less, such as Thailand.
when was Australian dollar floated
December 1983
by 2011 had reached its highest level in more than 28 years, largely due to
the depreciation of the US dollar against many major currencies and the strong foreign demand for Australia’s minerals and energy.
In the short run, the two most important causes of exchange rate movements are
changes in interest rates and speculators’ expectations
What determines exchange rates in the long run?
describe purchasing power parity
long run exchange rates move to equalise the purchasing power of different currencies.
the purchasing power of every country’s currency should be the same
If exchange rates are not at the values indicated by purchasing power parity
there are opportunities to make profits
as people attempted to make these profits by exchanging pounds for Australian dollars they would bid up the value of the Australian dollar until it reached the purchasing power exchange rate of $1 = £1
§Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run.
- not all products are traded internationally –> exchange rate will not reflect purchasing power of the currencies
- products and consumer tastes are different internationally –> higher price in one country b/c consumers prefer it. identical products may have same price, but similar products do not
- countries impose barriers to trade
The four determinants of exchange rates in the long run
- relative price levels
- relative rates of productivity growth
- preferences for domestic and foreign goods
- tariffs and quotas
The four determinants of exchange rates in the long run
relative price levels
is the purchasing power parity theory correct?
If prices of goods and services rise faster in Australia than in the United States, the value of the Australian dollar has to decline to maintain demand for Australian products.
it is correct
The four determinants of exchange rates in the long run
relatives rates of productivity growth
productivity –> more goods and servicies produced using fewer inputs –> production costs fall –> product price falls
so if jap’s productivity rises faster than australia, value of yen will rise against $AU
The four determinants of exchange rates in the long run
Preferences for domestic and foreign goods
prefer foreign goods, foreign currency will appreciate
The four determinants of exchange rates in the long run
tariffs and quotas
reduced demand for imports –> demand for foreign currencies fell
$AU rises
what is the euro
a common currency used by Eurozone (the EU countries who have adopted the euro)
what happend in 2002?
On 1 January 2002 euro coins and paper currency were introduced
ECB was established
Role of ECB
§The ECB determines monetary policy for the euro zone member nations (but member countries continue to have their own central bank)
adv of common euro
makes it easier for consumers and firms to buy and sell across borders.
reduce costs and increase competition.
cons of euro
participating countries cannot run independent monetary policies
currency cannot depreciate during an economic contraction or a recession, which would normally expand net exports to help revive aggregate demand.
what have some developing economies attempted to do in terms of their exchange rate?
some developing countries have attempted to keep their exchange rates fixed against the US dollar or another major currency.
benefits of a fixed exchange rate
§Formerly used by some developing or emerging nations: e.g. Thailand, South Korea, Indonesia and Malaysia.
–Makes business planning easier.
–Fixes foreign debt levels and repayments.
–Reduces fluctuations in import prices.
§Pegging a currency can create problems.
–Can lead to persistent surpluses or shortages of currency.
–The central bank becomes burdened to buy up currency surpluses to maintain the fixed exchange rate.
–This has meant some countries have had to borrow money from overseas to buy up their own currency surplus, e.g. Thailand.
how may a surplus be created by pegging the exchange rate to the US
in thailand, a surplus in Baht was created b/c it was above the market equlibrium rate. It is overvalued
define
overvalued
undervalued
A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued.
A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued.
what did thailand do to keep keep the exchange rate at the pegged level
the Thai central bank, the Bank of Thailand, had to buy these baht with US dollars.
gradually used up its US dollar reserves —> the Bank of Thailand borrowed additional US dollar reserves from the International Monetary Fund (IMF).
also raised interest rates to attract more foreign investors to investments in Thailand, thereby increasing the demand for the baht –> lowered AD –> recession
destabilising speculation?
As investors became convinced that Thailand would have to abandon
its pegged exchange against the US dollar and allow the value of the baht to fall, they decreased their demand for baht from D1 to D2
This increased the quantity of baht the Bank of Thailand had to purchase in exchange for US dollars from 70 million per day to 140 million to defend the pegged exchange rate.
The destabilising speculation by investors caused Thailand to abandon its pegged exchange rate in July 1997
Destabilising speculation may occur in
–in anticipation of abandoning the peg, which makes maintaining the peg even more difficult.
–capital flight.
Foreign investors also began to sell off their investments in Thailand and exchange the baht they received for US dollars.
This capital flight forced the Bank of Thailand to run through its US dollar reserves quickly. Dollar loans from the IMF temporarily allowed Thailand to defend the pegged exchange rate.
speculative attacks
Many currency traders became convinced that other East Asian countries, such as South Korea, Indonesia and Malaysia, would have to follow Thailand and abandon their pegged exchange rates.
The result was a wave of speculative selling of these countries’ currencies.
Even if a country’s currency was not initially overvalued at the pegged exchange rate, the speculative attacks would
cause a large reduction in the demand for the country’s currency. The demand curve for the currency would shift to the left, which would force the country’s central bank to run through its US dollar reserves quickly.
Due to speculative attacks
a few months, South Korea, Indonesia, the Philippines and Malaysia abandoned their pegged currencies. All these countries also plunged into recession.
what happened to pegged exchange rates after the east asian exchange rate crisis?
sharply declined
graph destabilising speculation
what happened to china in 1994
The chinese yuan was peggeed against the US dollar at a fixed rate of 8.28 yuan to the US dollar
it was undervalued against the US dollar
pegging against the US dollar assured what?
US dollar ensured that Chinese exporters would face stable US dollar prices for the goods they sold to the United States
what did the undervalued yuan give?
e undervaluation of the yuan gave Chinese firms an unfair competitive advantage on international markets.
how did China support their undervalued yuan?
the Chinese central bank had to buy large amounts of US dollars with yuan. By 2005 the Chinese government had accumulated more than US$700 billion
what did China’s trading partners pressure it to do?
to allow the yuan to increase in value b/c it chinese textile exports drove textile producers out of business in Japan, US, Australia and Europe
why was the chinese gov reluctant to revalue the yuan
since China’s had large holdings of US dollars, it would also incur significant losses if the yuan increases in value.
what happened in July 2005 in China?
switched from a peg to a managed floating exchange rate
he government announced that it would switch from pegging the yuan against the US dollar to linking the value of the yuan to the average value of a basket of currencies—the dominant currencies were the US dollar, the Japanese yen, the euro and the Korean won, while several other currencies were also considered, including the Australian dollar
what did economists argue after 2005
Some economists and policy-makers were sceptical that anything had changed b/c because initial increase in the value of the yuan was small and because the Chinese central bank did not explain the details of how the yuan would be linked to the basket of other currencies
in 2010, they believed the yuan was still undervalued
In 2010 China announced
a renewed commitment to moving towards a more flexible exchange rate system and the value of the yuan slowly increased and by 2014 had reached above US$1 = 6 yuan
after 2010, what was argued
ome economists and policy-makers still believe the yuan is undervalued and urged the Chinese government to allow its currency to become more responsive to changes in demand and supply in the foreign exchange market
2014: how much $US did China hold
3.4 trillion
One important reason exchange rates fluctuate is that
nvestors seek out the best investments they can find anywhere in the world.
For instance, if Chinese investors increase their demand for Australian securities, the demand for Australian dollars will increase and the value of the Australian dollar will rise. But if interest rates in Australia decline, foreign investors may sell Australian securities and the value of the Australian dollar will fall.
capital markets?
where shares in companies and long-term debt, including corporate and government bonds and bank loans are bought and sold
what happened In the 1980s and 1990s
European governments removed many restrictions on foreign investments in financial markets.
It became possible for foreign investors to invest freely in Europe and for European investors to invest freely in foreign markets.
in the 1980s, what happened in Australia?
§Australia deregulated its capital markets to allow the free flow of capital into and out of Australia.
The globalisation of financial markets has
helped increase growth and efficiency in the world economy.
The globalisation of financial markets has made it possible
for the savings of households around the world to be channelled to the best investments available
firms borrow from overseas to finance investment
Disadvantage of globalisation of financial markets?
financial securities are held by investors around the world, if they decline in value, the financial impact will be widespreading
e.g. the sharp decline in the value of mortgage-backed securities issued in the United States hurt not only US investors and financial institutions but investors and financial institutions in many other countries as well.
If the average rate of productivity growth in South Korea is greater than in Australia over the next five years, then, all else being equal, will the savings that you accumulate (in Korean won) be worth more or less in Australian dollars than it would have been worth without the relative gains in Korean productivity?
the value of the faster-growing (productivity) country’s currency should—all else being equal—rise against the slower-growing (productivity) country’s currency.
- savings that you accumulate in won while you are in South Korea are likely to be worth more in Australian dollars than they would have been worth without the gains in Korean productivity
describe feature of the gold standard
the currency of a country consisted of gold coins and paper currency that could be redeemed for gold.
the exchange rate between two currencies was automatically determined by the quantity of gold in each currency.
why was the gold standard abandoned?
- country’s money supply relied on gold supply which dependend on disoveries of gold –> central bank had no control of money supply (to pursue monetary policy) b/c it did not know how much gold would be discovered
when was the gold standard abandoned
before, during and after the Great Depression to allow the Central Bank to expand the money supply in pursuit of an expansionary monetary policy
the later the gold standard was abandoned, the further the fall in productoin
The Bretton Woods System
§An exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the US dollar.
distinguish between revaluation and devaluation
§Devaluation: A reduction in a fixed exchange rate.
§Revaluation: An increase in a fixed exchange rate.
The collapse of the Bretton Woods System
what happened in the 1960s?
- The number of $US held by foreign banks was more than the gold reserves in the US.
- Some countries with undervalued currencies refused to revalue them, e.g. West Germany.
Under the Bretton Woods System central banks were committed to
selling US dollars in exchange for their own currencies. They had to hold US dollar reserves. If a central bank ran out of US dollar reserves it could borrow them from IMF
Under the Bretton Woods System, a fixed exchange rate was
Under the Bretton Woods System, a fixed exchange rate was known as a par exchange rate.
explain this graph
Qty of British pounds demanded is lower than the Qty of british pounds supplied in exchage for $US
so Bank of England must use US dollars to buy the surplus
when is there a fundamental disequilibrium in a country’s exchange rate?
when there is a persistent shortage or surplus of a currency
in the early years of the Bretton Woods system,
many countries found that their currencies were overvalued against the US dollar, meaning that their par exchange rates were too high.
The collapse of the bretton woods
why was it a problem that the US dollars held by foreign central banks was larger than the gold reserves of the United States?
Due to the large gap, the US could not redeem US for gold
Collapse of the Bretton Wood
why did gov with undervalued exchange rates refuse to revalue it?
it would have increased the prices of their countries’ exports.
diagram of an undervalued exchange rate
Under the Under the Bretton Woods System, what did Germany’s central bank have to do?
Bundesbank had sell deutsche marks and buy $US. The supply = the shortage at the par exchange rate
what happpened in the 1960s in europe
most European countries, including Germany, relaxed their capital controls (limits on the flow of foreign exchange and financial investment across countries)
what were effects of loosening capital control?
made it easier for investors to speculate on changes in exchange rates.
§Destabilising speculation made it very difficult to maintain a fixed exchange rate: investors expectated Bundasbek to revalue so they demanded marks to make profit
draw diagram to show DESTABILISING SPECULATION AGAINST THE DEUTSCHE MARK
