Exchange Rate Arrangements: Outline

 What’s the exchange rate arrangements? Roughly

speaking, it is a country’s policy about the
fluctuations of its currency value.
 For this issue, we will talk about

 Various Exchange Rate Arrangements

 Fixed vs. Floating Exchange Rate Arrangements
 The Impossible Trinity

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Various Exchange Rate Arrangements
 Independent Floating
 Allowing market forces to determine their currency’s value. Examples:
U.S., Japan, U.K., Canada, …
 Managed Floating
 Combining government intervention with market forces to set exchange
rates. Examples: China, India, Russia, …
 Currency Board Arrangement
 pegged to another currency (usually $ or €), and exchange rates only vary
within the predetermined limits. Examples: Hong Kong, Estonia
 Monetary Union Arrangement
 the country belongs to a currency union in which the same currency is
shared by the union members. Examples: euro zone member countries

2
 Independent Floating:
EUR vs. USD
 See the history of exchange rate between USD and EUR at:
http://finance.yahoo.com/echarts?s=EURUSD
%3DX+Interactive#{"range":"max","allowChartStacking":
true}

 Governments under independent floating still intervene in

the FX market, but the purpose is to iron out some extreme
fluctuations or to stop some dramatic momentum of
exchange rate movements.
 For example, after months’ of dramatic depreciation of JPY against
USD, the Japanese government intervened in October 2022 which
3 caused a sharp rise in the valuation of JPY at the FX.
 Managed Floating:
USD vs. CNY
 See the history of exchange rate between USD and CNY at:
http://finance.yahoo.com/echarts?s=USDCNY
%3DX+Interactive#{"range":"max","allowChartStacking":tr
ue}

 Starting from the May of 2010, Chinese Yuan (CNY) is

allowed to float against USD under the heavy influences of
People Bank of China (PBOC).
 PBOC essentially intervenes every day to ensure that the daily change
of CNY exchange rate won’t exceed 1%.
 In contrast, Japanese central bank intervenes JPY exchange rate only
4
occasionally.
 Currency Board Arrangement:
USD vs. HKD
 See the history of exchange rate between USD and HKD at:
http://finance.yahoo.com/echarts?s=USDHKD
%3DX+Interactive#{"range":"max","allowChartStacking":t
rue}

 Under the currency board arrangements, the exchange rate

between HKD and USD can only fluctuate between
HK$7.85 = US$1 and HK$7.75 = US$1 .
 In contrast, there is no such pre-announced range or pre-announced
path for the exchange rate of CNY.

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 Currency Board Arrangement
at Hong Kong
 Since HK has dollarized its currency, the issuance of
every HK$7.80 has to be backed by one US$. All the US$
reserves are kept as Hong Kong's Exchange Fund, which
is among the largest official reserves in the world.
 Three note-issuing banks (NIBs) are authorized by Hong
Kong monetary authority (HKMA) to issue banknotes at
HK: HSBC, Standard Chartered Bank, and Bank of China.
 Before issuing banknotes, the three NIBs are required to submit
US dollars at HK$7.80 = US$1 to the Hong Kong monetary
authority (HKMA) for the account of the Exchange Fund in return
for Certificates of Indebtedness.
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 Currency Board Arrangement
at Hong Kong
 The HKMA operates Convertibility Undertakings
on both the strong side and the weak side of the
linked rate of 7.80
 Under the strong-side where the exchange rate rises
beyond HK$7.75 = US$1, the HKMA will buy US$
and sell HK$ to keep the exchange rate at 7.75.
 Under the weak-side where the exchange rate drops
beyond HK$7.85 = US$1, the HKMA will sell US$
and buy HK$ to keep the exchange rate at 7.85.

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 Monetary Union and Euro Zone

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 Monetary Union and Euro Zone
 On January 1, 1999, 11 European Union (EU) members
adopted a common currency called the euro, voluntarily
giving up their monetary sovereignty. Together with the
launch of euro, European Monetary Union (EMU), was
also created.
 For countries within the Euro zone, their exchange rates
are trivially fixed at one (why?).
 Fixed exchange rate never changes. This is in contrast to the
currency board arrangement which still allows for variations.

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 Different Denominations of the Euro
Notes and Coins
 The euro is divided into 100 cents, just like the
U.S. dollar.
 There are 7 euro notes and 8 euro coins.

 €500, €200, €100, €50, €20, €10, and €5.

 The coins are: 2 euro, 1 euro, 50 euro cent, 20

euro cent, 10, euro cent, 5 euro cent, 2 euro cent,

and 1 euro cent.

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 The European Central Bank
 Monetary policy for the euro zone countries is
conducted by European Central Bank (ECB)
headquartered in Frankfurt, Germany
 The primary objective of ECB is to maintain “price
stability”, defined as an annual inflation rate of less
than but close to 2%
 ECB is independent and is not subject to political
pressures from any member countries.

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 Euro Zone vs. U.S.
 Macroeconomic Data for Euro Zone vs. US in 2018
Economy Population GDP World International Annual
(Million) ($ Billion) Trade Bonds Outstanding Inflation
Share ($ Billion)
Euro Zone 341.2 13,670 15.1% 1,073 2.3%
U.S. 327.2 20,494 17.9% 5,002 2.2%

 Euro was a serious rival to USD. Ever since the

breakout of European sovereign debt crisis in 2010,
however, the status of euro seems to be in decline.
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The “PIIGS” during the European
Sovereign Debt Crisis

13
 Greek Government Bond Yield
14

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 Floating vs. Fixed
Exchange Rate Arrangements
 So far we’ve seen various exchange rate
arrangement: independent floating, managed
floating, currency board, and fixed, which go
from the one extreme to the other.
 A fundamental question remains: why some

countries allow their currencies to float while the

other countries prefer to fix their currency values?

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 Advantages of a Floating
Arrangements
 Arguments in favor of floating exchange rate
arrangements:
 Easier adjustments of imbalances in international
payments.
 Maintaining the national policy autonomy so that the
government can use its monetary and fiscal policies to
address particular domestic economic issues.

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 Imbalance in International Payments
 Suppose that at the current exchange rate of $1.4
for £1 the U.S. is running BOP deficit, whereas
the U.K. is running BOP surplus.
 With floating rate arrangement, the imbalance can

be adjusted automatically.
 With fixed rate arrangement, on the other hand,

the U.S. government has to take policy actions to

correct its BOP disequilibrium.

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Imbalance in International Payments
Supply
Dollar price per £
(exchange rate)

(S)

Demand
$1.40 (D)
Excessive
demand of pound

S D Q of £
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 Adjustment under the Floating
Exchange Rate arrangement
Supply
Dollar price per £
(exchange rate)

(S)

$1.60
Pound appreciates Demand
$1.40 (floating regime) (D)

Demand (D*)

D=S Q of £
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 Adjustment under the Fixed
Exchange Rate Arrangement
Supply
Dollar price per £

Contractionary
(exchange rate)

policies (S)
(fixed regime)

Demand
$1.40 (D)

Demand (D*)

D* = S Q of £
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 National Policy Autonomy vs.
Domestic Economic Issues
 By adopting the fixed exchange rate
arrangements, a country has to give up part or
even all of its monetary policy autonomy. Hence,
the country can no longer effectively address the
domestic economic issues.

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 National Policy Autonomy:
Asymmetric Shocks
 Consider Finland, a country that heavily depend on the
paper and pulp industries. Hence, a sudden drop in world
paper and pulp prices could severely hurt the Finnish
economy but affect other euro zone countries little.
 Such a shock is called the asymmetric shock.
 If it maintained the monetary independence, facing the
asymmetric shock, Finland could lower its domestic
interest rate and let its currency depreciate to stimulate
the weak economy. (why?)

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 National Policy Autonomy:
Asymmetric Shocks
 Because Finland has joined the euro zone, the country
no longer has these policy options at its disposal.
 Worse, European Central Bank (ECB) may even

decide to increase the common interest rate because

the rest part of the euro zone is experiencing
inflation.
 Since the shock is asymmetric, we might be witnessing
overheated economies in the other euro zone countries while
Finland is experiencing a serious recession.

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 Floating vs. Fixed
Exchange Rate Arrangements
 Arguments in favor of fixed exchange rate
arrangements:
 The reduction of transaction costs
 By reducing or even eliminating the foreign exchange
risks, the fixed arrangement fosters cross-border trades
and attract foreign capitals, both of which are beneficial
to economic growths of all countries involved.

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 Fixed Exchange Rate Arrangements
in the Euro Zone
 Take Euro Zone as the example. By adopting a
single currency, resources can now be allocated on
a much larger basis that enhances the overall
efficiency of all economies involved.
 Intra-euro zone trades and investments are promoted.
 Price becomes more transparent, and consumers can
benefit from comparison shopping.
 As the result, the competitiveness of the euro zone
economy in the global markets is greatly enhanced.
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Which Exchange Rate Arrangement?
 Back to previous question. Which exchange rate
arrangement should a country adopt?
 For countries such as the U.S. and U.K., they put their policy
autonomy as the priority, and they also prefer easier external
adjustments of their BOP. Hence, they choose to adopt
floating exchange rates
 The euro zone countries are instead committed to promoting
financial, economic, and even political integration among
each other. As result, they choose to adopt fixed exchange
rates at the sacrifices of their policy independences.

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 Optimum Currency Areas: Theory
 While traditionally each country issues its own
currency, the theory of optimum currency areas
proposed by Robert Mundell in the 1960s suggests
that it is not necessarily always the best choice.
 According to this theory, if the two countries or

regions share strong economic ties, then they both

benefit from adopting a common currency.
 The “strong economic ties” means the factor mobility
between the two countries or regions is sufficiently high.

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Optimum Currency Areas: Applied to the
Fifty States within the US
 For example, the 50 states within the U.S. approximates
an optimum currency area, because the degree of capital
and labor mobility within the U.S. is high.
 For example, when oil prices jumped up in the 1970s, many
workers moved from oil-consuming regions such as New England
which suffered a severe recession to Texas, a major oil-producing
state, which experienced a major boom.
 On the other hand, Finland does not seem to satisfy the
conditions adopting Euro.
 Upon the asymmetric shocks, it is hard for workers in Finland to
move to, for example, Germany or France.
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Optimum Currency Areas: Applied to HK
 Using the theory of optimum currency areas, let’s
consider again the exchange rate arrangement in HK
under which HKD is fixed to the USD.
 Question: do HK and the U.S. have labor and capital
mobility between each other?
 There are ongoing debates on whether HK should peg
its currency to CNY instead, or even abolish HKD
and adopt CNY at HK.
 This is an open question, which is still under discussion.

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Attributes of the “Ideal” Arrangement
 Exchange rate stability – the value of the currency would be
fixed in relationship to other currencies so that traders and
investors have no concerns about foreign exchange risks
 Full (A very high degree of) financial integration – complete
freedom of capital flows would be allowed, so that resources
can be optimally allocated on the global basis.
 Monetary independence – domestic monetary and interest rate
policies would be set by each individual country to pursue
desired national economic policies

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 The Impossible Trinity

Monetary Exchange Rate

Independence stability

Full Financial Integration

 The Impossible Trinity says a country must give up at

least one of the three goals described by the three sides of
the triangle: monetary independence, exchange rate
stability, and free capital flows.
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 The Impossible Trinity
Here are three examples:
 Euro zone countries achieve both exchange rate stability

and full financial integration, but they have to give up

monetary independence
 U.S. and Japan achieve both monetary independence and

full financial integration, but they have to give up

exchange rate stability.
 Before July 21, 2005 when CNY was pegged to $, China

achieves both monetary independence and exchange rate

stability, but it had to give up the full financial integration.
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 The Impossible Trinity
Full Capital Controls

Monetary Exchange Rate

Independence Stability
Increased Capital
Mobility

Floating Full Financial Monetary Union

Integration
Facing increased capital mobility, countries are “cornered” into either the
arrangement of independently floating (like the U.S. and Japan) or the arrangement
of monetary union (like Germany and France)

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 Analysis of the China Case
By applying the impossible trinity:
 Like many other countries, China is encouraging

cross-border capital flows, in the direction of a

high degree of financial integration.
 On the other hand, with no doubt China will try to

remain independent in its policy making.

 Hence we can predict that in the future China

must allow CNY to float independently against

other major currencies.
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 Exchange Rate Prediction: Outline
 Approaches on Forecasting Exchange Rates
 Efficient Markets Approach
 Fundamental Approach
 Technical Approach
 Long-Term Trends vs. Short-Term Noise
 Forecasting in Practice

35
 Efficient Markets Approach: an Example
 Efficient market approach essentially says that
today’s rate is the unbiased predictor of tomorrow’s
exchange rate.
 To understand “unbiased predictor”, let’s take a

concrete example. Denote by S1 the exchange rate at

period 1. Assume S1 1 (the real world would be the
exchange rate between C$ and AU$)
 Assume exchange rate at period 2, S , takes only
2
two possible values: 0.8 and 1.2, with equal
probability.
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Today’s Rate as the Unbiased Predictor of
Tomorrow’s Rates
 Relative to today’s rate, the amount of positive
deviation tomorrow, 0.2, is matched by the amount of
the negative innovation, -0.2.
 In addition, the number (frequency) of upward
deviations are matched by the number (frequency) of
the downward deviations, as justified by the assumed
equal probability for the two possible outcomes.
 Today’s exchange rate is thus the unbiased predictor
of tomorrow’s exchange rates.

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Today’s Rates as the Unbiased Predictor:
Neither Under- Nor Over-Estimation
 Statistically, the distribution of tomorrow’s rates
is centered on today’s rate as indicated by the
perfect cancellation of the errors or deviations. (So
the sum of errors equals zero).
 Economically, “unbiased predictor” means that
today’s rate has neither over- nor under-estimated
the rates to be realized in the future, hence there is
no bias when using it as the predictor.

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Today’s Rates as the Unbiased Predictor of
the Future Rate: Real Data
Percent error in today’s exchange rate between Swiss Franc and $
15
compared to actual exchange rate one month later

10

5
Percent error

-5
4/1/1984

4/1/1986

4/1/1988

4/1/1990

4/1/1992

4/1/1994

4/1/1996

4/1/1998

4/1/2000

4/1/2002

4/1/2004
-10

-15
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 Efficient Markets Approach ：
the Mathematical Formula
Mathematically, if today’s rate, St can be
regarded as the unbiased predictor of the future
spot exchange rates, ST , we write

St E ( ST | I t )
where I t denotes the set of all relevant
information that is available today.
The above equation is also the mathematical
formula for the efficient market approach.
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 Efficient Markets Approach:
the Concept of Market Efficiency
 Economically, efficient market approach says that
the financial markets are efficient because prices
reflect all available and relevant information.
 All relevant information is reflected
 The information is reflected as soon as they become avaiable
 As a result, a fund manager does not know in
which direction the future exchange rate will differ
from today’s exchange rate based on the currently
available information.
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 Fundamental Approach
 The fundamental approach to exchange rate
forecasting uses various models/ methods such as:
 the international parity conditions that integrate
exchange rates with inflation and interest rates
 the relations between a country’s balance of payments
and the level of its exchange rate
 Of course, there are many other methods that
belong to the fundamental approach, e.g., the
monetary method. Due to the scope of this course,
we will not talk about them one by one.
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 Technical Approach
(Not in PS or Exam)
 Technical approach first analyzes the past behavior of
exchange rates to identify “patterns”, and then
projects them into the future to generate forecasts.
 While academic studies tend to discredit its validity,

the technical approach is still widely used

 Technically oriented traders tend to view price patterns as
only partially repetitive with an element of chaos.
 If enough traders use technical analysis, the predictions
based on it can become self-fulfilling to some extent.

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 Long-Term Trends
vs. Short-Term Noise
 Decades of empirical studies show that in the long run,
exchange rates do adhere to the fundamental principles
and theories such as the international parity conditions –
fundamentals do apply in the long term :
 There exists something of a fundamental equilibrium path for a
currency’s value
 In the short and the medium term, however, a variety of
random events, institutional frictions, and technical factors
may cause currency values to deviate significantly from
their long term fundamental path – this is sometimes
referred to as noise
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 Long-Term Trends
vs. Short-Term Noise
Foreign currency per
unit of domestic currency
Fundamental
Occasional large events may Equilibrium
drive the exchange rate out of Path
the ranges of the long-term path

The paths in the

short and the
medium run are
chaotic

45
Time
 Short-Term Noise
Due to Overshooting
 Currency markets do not pay much attention to
the theories on a day-to-day basis:
 In the short run, the arrivals of information and
investors’ sentiment, both of which are unpredictable,
play important roles in the exchange rate determination.
 One example to illustrate the short term chaos
over the exchange rate dynamics is the
phenomenon known as overshooting.

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 Exchange Rate Dynamics: Overshooting
If the U.S. Federal Reserve were to announce a change in its monetary policy, which in the long
run should drive the exchange rate from S0 to S1 based on IRP.

Spot Dollar
Exchange Rate S2
Overshooting

S1

S0

time
t1 t2
The Fed announces a monetary policy change at time t 1. Instead of driving the dollar exchange rate from
S0 to S1 as is predicted by IRP, however, the exchange rate over-adjusted to S2. Over the next few weeks,
(from t1 to t 2 ), exchange rate gradually adjusts back to S1. Both the magnitude of over-adjustment and
the time that it takes to adjust back are unpredictable.
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 Performance of the Forecasters
 Many firms and investors pay a fee to subscribe to
professional forecasting services. A question: in the short
run, can professional forecasters outperform the market?
 Substantial variations in the performance records across individual
services (e.g., page 153)
 As a whole, forecasters do not perform a better job of forecasting
future exchange rates than using today’s rate,
 The founder of Forbes Magazine once said:
“You can make more money by selling financial advice
than by following it.”

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