Post on 15-Aug-2015
transcript
Why might one country peg its currency to that of another?
Where one currency’s value is tied to the value of:1) that of another currency - e.g., USD/HKD = 7.75001) a basket of currencies to minimize
currency fluctuations- e.g., SDR (composite currency)1) some other measure of value (like gold)
What is a “pegged” exchange rate?
Some basic economic reasonsExports and Trade- Pegging holds attraction to economies seeking export-
driven growthEx. USD/LKR = 133
Helps limit inflation and other instabilities- Moves in step with the reference currency/ies or
commodity/ies to which its pegged- Nations with high inflation rates typically face high
deficits and loss of foreign currency reserves
Helps central banks acquire credibility - patterns currency to that of a more
disciplined/developed nation Reduces uncertainty -- i.e., “exchange rate risk”Facilitate investment flowsFixed/pegged exchange rates diminish the degree of volatility and variation in relative prices
Provide money markets in a nation in whichthese are illiquid, undeveloped, and otherwise unviable
Money market elaboration1) Facilitates industry- provides short-term loans1) Helps trade w/ commercial finance available2) Good for central banks- money markets provide short-term interest rates1) Self-sufficiency of commercial banks- paucity of funds, can recall loans1) Allows commercial banks to be financially successful- excess bank reserves converted into bills of exchange
Economic Disadvantages
Enables trade deficits- under a floating rate system this automatically balancesEconomics of trade deficit rebalancing- demand for foreign currency ↑- price of foreign currency ↑- in turn, foreign goods less appealing to domestic market- trade deficit thereby diminishes
Disadvantages
Limits the ability to use monetary and fiscal policy at liberty- stimulatory efforts typically decrease trade balancesTo close a trade deficit, deflationary measures may be utilized- can lead to negative economic outcomes like
unemployment
Disadvantages
Floating exchange rates may help to determine CA between nations- has implications for efficient resource allocationBroader array of sophisticated modern financial instruments may render exchange rate pegging unnecessaryForex markets may not operate as efficiently as they would otherwise due to government intervention efforts
Disadvantages
Desired exchange rate may not coincide with the equilibrium exchange rate- leads to excess supply or demand of a currencyIn order to peg exchange rates, reserve currencies are needed to absorb any excess supply or demand
How are exchanged rates fixed?
Open market trading- Buying/selling its currency on the open market- For a currency to appreciate, it will buy its own currency
using its foreign currency reserves (increase demand)- For a currency to depreciate, it will sell its own currency
and buy foreign currency (decrease demand)- To avoid inflation/deflation as a result of money supply
fluctuation, gov’t bonds may be sold/purchased
How are exchanged rates fixed?
Through fiat (legal decree)- unpopular due to the threat of black market activity- can be used effectively with government monopolies
designed to govern currency conversion
Notable Int’l Examples of Pegging- European Union (EU)- Denmark (through ERM II), Bosnia and Herzegovina
(Deutschmark), Bulgaria (Deutschmark)- Switzerland (tied to Euro until January 2015)- China yuan to USD- Ecuador, El Salvador, Panama (dollarization)
ReferencesCalvo, Guillermo A., and Carmen M. Reinhart. Fear of floating. No. w7993. National Bureau of Economic ____Research, 2000.Calvo, Guillermo, and Frederic S. Mishkin. The mirage of exchange rate regimes for emerging market countries. ____No. w9808. National Bureau of Economic Research, 2003.Caramazza, Francesco, and Jahangir Aziz. "Economic Issues No. 13 -- Fixed or Flexible?--Getting the ____Exchange Rate Right in the 1990s." IMF -- International Monetary Fund Home Page. Last modified 1998. ____http://www.imf.org/external/pubs/ft/issues13/index.htm.Dooley, Michael. International financial stability: Asia, interest rates, and the dollar. Deutsche Bank AG, 2005.Garber, Peter M., and Lars EO Svensson. The operation and collapse of fixed exchange rate regimes. No. ____w4971. National Bureau of Economic Research, 1994.Obstfeld, Maurice, and Kenneth Rogoff. The mirage of fixed exchange rates. No. w5191. National bureau of ____economic research, 1995.Poirson, Helene. "How do countries choose their exchange rate regime?." (2001): 1-34.Reinhart, Carmen M. "The mirage of floating exchange rates." American Economic Review (2000): 65-70.Tatom, John A. "The US-China currency dispute: Is a rise in the yuan necessary, inevitable or desirable?." ____Global Economy Journal 7, no. 3 (2007).