FIN 40500:

International Finance

Exchange Rate Management

Exchange Rate Policy can be
characterized along two dimensions

Currency
Union (Euro)
Commitment

Hard Peg Pure Float

(China) (USA)

Flexibility
With a hard peg, a currency’s price is held
permanently at a fixed level. For example, the
Flexibility
Chinese Yuan.

.1265 $1 = 7.90Yuan

Jan Feb Mar Apr May

 With a soft peg, a currency’s price is returned
to the predefined parity at regular intervals
Flexibility
(monthly, weekly, etc). For example, the
Algerian Dinar.

e
$1 = 76 Dinar

.012

Jan Feb Mar Apr May

With an adjustable peg, the parity price is
adjusted as circumstances warrant (monthly,
Flexibility
weekly, etc). The Bretton Woods System was
an adjustable peg

Jan Feb Mar Apr May

With a crawling peg, a currency’s price is held
permanently at a fixed level, but that parity level
Flexibility
has prescheduled changes For example, the
Mexican Peso followed a crawling peg in the
1990s

Jan Feb Mar Apr May

 With a target zone, a currency’s price
is held permanently between an upper
Flexibility
and lower bound. The Bretton Woods
system used 2% bands

+2%

-2%

Jan Feb Mar Apr May

 From 1971 until 1987 the US followed a policy
of managed floating (market based exchange
Flexibility
rate with periodic “re-alignments”). A pure
float would have no such re-alignments.

USD/JPY The Plaza Accord

400.00
(1985) purposely
350.00
devalued the dollar
300.00
against the Yen and
250.00
Deutschmark by
200.00
51%
150.00

100.00
The Louvre Accord
50.00
(1987) ended the
0.00
Jan-71 Jan-75 Jan-79 Jan-83 Jan-87
dollar devaluation
policy of the plaza
accord
 Policies can also vary by the degree of commitment to the
policy

Fixed Exchange Rate: This is simply a policy

decision of the government or central bank
and can be easily reversed (China).
Commitment

Currency Boards: A currency board is a

monetary authority separate from (or in
replacement of) a country’s central bank
whose sole responsibility is maintaining
convertibility of the country’s currency. (Hong
Kong)

Dollarization/Currency Union: foreign money

replaces domestic money as official currency
(Panama)
Exchange Rate Systems
Pure Float

6% 21% Managed Float

10%
5% Crawling Peg or
Band
Target Zone
14%
20%
Pure Peg

24% Currency Board

Dollarization
Currency Baskets
 Some countries choose to peg to a “basket” of currencies rather
that a single currency. This basket will have a price equal to a
weighted average of the individual currencies
 Latvia: SDR (Euro, JPY, GBP, USD)

 Malta: Euro (67%), USD21%), GBP (12%)

 Iceland: Euro + 6 other countries

 Why peg to a basket?

 Baskets of currency should exhibit less volatility that individual

currencies.
 The central bank has a wider choice of options for official

reserves
Costs/Benefits of Fixed
Exchange Rates
 Main Benefit
 Reduces uncertainty with regard to cross border
trade in both goods and assets
 Main Cost
 Eliminates a country’s ability to use monetary
policy for domestic objectives
 Full Employment
 High Output Growth
 Low Inflation
Suppose that the US decides to peg to the Euro at a price of $1.30 per
Euro – Our ability to maintain the peg depends on our foreign
exchange reserves.

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

Currently, the reserve ratio is 65% (6.5M/10M)

If we are going to analyze the policy options, we need a
structured framework to proceed.

Long Run Short Run

 PPP holds  Commodity prices are
 Relative prices are fixed (PPP fails)
constant. Therefore,  UIP and Currency
the real exchange rate markets determine
equals one exchange rates
 The nominal exchange
rate returns to its
“fundamentals”
 Using PPP and the two Money Market equilibrium conditions, we
get the “fundamentals” for a currency

Domestic Money Market Foreign Money Market

M
( )
*
(
P = 1+ i ) M
P* = 1 + i* *
y y
PPP

P = eP *

 M  Y  1 + i 
*
e =  *   * 
 M  Y  1 + i 
This should give us the long run trend
The US is pegging at $1.30/Euro. This explicitly defines a
monetary policy!

 M  Y  1 + i 
*
1.30 = e =  *   * 
 M  Y  1 + i 

Now, solve for M

 + 
( )
*
 Y  1 i
M = 1.30 M  * 
*

 Y  1 + i 

We now have the US monetary policy rule

This is actually better expressed in percentage terms…

%∆M = %∆M * + ( %∆Y − %∆Y * ) + ( i * − i )

Note: All else equal, money growth rates should be the
same.

Suppose that US economic growth is 4% per year

while Europe is 1% per year.

To maintain the peg, the US would have to

increase the US money supply by 3% relative to
Europe
Mama knows best!
“If Billy jumped off the
Brooklyn Bridge,
would you do it to?”

 Y  1 + i 
( )
*
M = 1.30 M  * 
*

 Y  1 + i 

Suppose that Europe was following an irresponsible monetary

policy (excessive money growth). If the US was pegging to the
Euro, we would be forced into the same irresponsible behavior!
You need to choose a currency regime that is
compatible in the long run with your economic
fundamentals
e

Jan Feb Mar Apr May

Mexico’s crawling peg to the US was due to its high inflation rate
relative to the US (high inflation is a result of low economic growth
and high money growth
Suppose the Federal Reserve conducts an open market purchase of
$1,000,000 in Treasuries to increase the money supply, what will the short
run impact be?

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

+ $1,000,000 (T-Bills)

The reserve ratio drops to 59% (6.5M/11M)

The increase in money increases income (this worsens the trade
balance as imports increase) and lowers domestic interest rates (this
worsens the capital account by cutting off foreign investment)

i
LM
BOP = 0

IS
y

With a BOP deficit, Federal Reserve must use Euro

reserves to buy dollars in order to maintain the peg
The Fed Conducts an open market purchase of Dollars

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
- $1,000,000 X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+ $1,000,000 (T-Bills)
- $1,000,000 (Euros)

The reserve ratio drops to 55% (5.5M/10M)

Note: The money supply returns to $10M
 Suppose that the US Government runs a deficit (either
spending increases or tax cuts) to stimulate the economy
 Increased spending increases the trade deficit
 Higher government debt raises the interest rate (this attracts foreign
capital)

i
LM

Can this policy be maintained

under a currency peg system?
i

IS
y
If capital mobility is sufficiently high, the increase in domestic interest
rated creates sufficient capital inflow to finance the trade deficit. The
dollar begins to appreciate

i
LM

BOP = 0
i
BOP = CA + KFA
IS
y

The balance of payments surplus forces the dollar to appreciate in

the short run.
The Fed Conducts an open market sale of Dollars to maintain
the peg with the Euro

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

+$1,000,000 (Euros)

The reserve ratio rises to 68% (7.5M/11M)

 With low capital mobility, high US interest rates are unable to
attract sufficient financing for the trade deficit. A BOP deficit
causes the dollar to depreciate

i BOP = 0 LM

i
BOP = CA + KFA
IS
y

The balance of payments surplus forces the dollar to depreciate in

the short run.
The Fed Conducts an open market purchase of Dollars to
maintain the peg with the Euro

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

-$1,000,000 (Euros)

The reserve ratio falls to 61% (5.5M/9M)

The purchase of dollars contracts the money supply. Can the
Fed avoid this monetary contraction?
The Fed Conducts an open market purchase of Treasuries to
“Sterilize” the currency intervention

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

-$1,000,000 (Euros)
+$1,000,000 (T-Bills)

The reserve ratio falls to 55% (5.5M/10M)

 Suppose that foreign investors view US debt as too risky?
Financial flows reverse, the US runs a BOP deficit requiring
a purchase of dollars

i
LM

Reversal of capital flows causes

i the dollar to begin to depreciate.
The US must correct this by
buying dollars.
IS
y

Note: This would contract the money supply – raising interest rates and
lowering output.
The Fed Conducts an open market purchase of dollars to
stabilize the exchange rate

Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000

-$1,000,000 (Euros)

The reserve ratio falls to 61% (5.5M/9M)

 Suppose that foreign investors view US debt as too risky?
Financial flows reverse, the US runs a BOP deficit.

i
LM

Alternatively, if capital is mobile

i enough, the government could
“bail out” the private companies
– replacing private debt with
IS public debt
y

This is risky…total indebtedness increase!!

 Foreign Reserves are dangerously low! What can we do?

Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.30 $/E
$ 2,600,000
$ 3,500,000 (T-Bills)
$6,100,000

The reserve ratio is at 42% (2.6M/6.1M)

The Fed could fix this problem by devaluing the dollar (i.e. raising the
dollar price of Euro)
The drop in value would hopefully stop the selling
The devaluation would also improve the Fed’s reserve position
A devaluation from $1.30 to $1.50 helps

Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.50 $/E
$ 3,000,000
$ 3,500,000 (T-Bills)
$6,500,000

The reserve ratio is at 49% (3M/6.1M)

Speculation and “Peso
Problems”
 Even a strong currency can become the
victim of a speculative attack.
 If the market believes that a currency might
devalue in the future, they will sell that
country’s currency and assets.
 The resulting balance of payments deficit
forces the country to devalue (self fulfilling
prophesy)
Short Run Management
 Currency Pegs work well as long as times are
good
 A country can maintain an appreciating currency
forever
 Currency pegs are not terribly successful during
tough times
 You can’t maintain a depreciating currency forever –
and markets know this!
 A peg forces you to follow policies that tend to make
economic conditions worse (tight money, balanced
government budgets)
 Pearls of wisdom from “The Karate
Kid”

“Daniel-san, must talk. Man walk on road. Walk left side, safe. Walk right
side, safe. Walk down middle, sooner or later, get squished just like
grape. Same here. You karate do "yes," or karate do "no." You karate do
"guess so," just like grape. Understand?”
Committed Floater
Committed Pegger

Uncertain Pegger