1 Part 1 : Some Fundamentals of Foreign Exchange Markets ...- bank balances which can be drawn at...

1

C / Intern Macro / § 2

Part 1 : Some Fundamentals of Foreign Exchange Markets and

the International Monetary System

§ 2 The Foreign Exchange Market Bibliography: Bekaert, G. / Hodrick, R. J. (2009): International Financial Management.

London. Caspers, R. (2002): Zahlungsbilanz und Wechselkurse. München/Wien. Deutsche Bundesbank (2011): Monthly Report, Vol. 63, Number 8 (August). Eiteman, D. K. / Stonehill, A. I. / Moffett, M. H. (2007): Multinational

Business Finance. 11th ed., London, pp. 178 - 206. European Central Bank (2011): Monthly Bulletin, September. Frankfurt am

Main. European Union (2010): Consolidated Version of the Treaty on the

Functioning of the European Union. In. Official Journal of The European Union, C 83/47.

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2010:083:0047:0200:en:PDF

Fischer-Erlach, P. (1995): Handel und Kursbildung am Devisenmarkt. 5th ed., Stuttgart.

Harms, P. (2008): Internationale Makroökonomik. Tübingen.Jarchow, H.-J. /

Rühmann, P. (1997): Monetäre Außenwirtschaft II. Internationale Währungspolitik. 4th ed., Göttingen, pp. 27 n, 32 - 63.

King, M. / Mallo, C. (2010): A user’s guide to the Triennial Central Bank

Survey of Foreign Exchange Activity. In: BIS Quarterly Review, December, pp. 71 - 83, http://www.bis.org/publ/qtrpdf/r_qt1012h.pdf.

Krugman, P. R. / Obstfeld, M. (2009): International Economics. 8th ed.,

London. Krugman, P. R. / Obstfeld, M. / Melitz, J. (2012): International Economics.

9th ed., London.

2


MacDonald, R. (2007): Exchange Rate Economics. Theories and Evidence.

London, pp. 1 - 38. Marrewijk, Ch. Van (2007): International Economics. Theory, Application,

and Policy. Oxford, pp. 409 - 425, 466 - 483. Modery, W. (1996): Internationale währungspolitische Arrangements auf

dem Prüfstand ökonomischer Effizienz. Frankfurt am Main. Solnik, B. / McLeavey, D. (2004): International Investments. 5th ed., London,

pp. 3 - 14 [or 5th ed. (2009), pp. 1 - 13]. Stobbe, A. (1998): Volkswirtschaftliches Rechnungswesen. 8th ed., Berlin. Wilms, M. (1995): Internationale Währungspolitik. 2nd ed., München, pp. 17

- 19, 26 - 28. Woll, A. (2008): Wirtschaftslexikon. 10th ed., München.

3


2.1 A First Tour As we know, a market consists of at least three elements: the object of trade, demand and supply, and the price. We will now consider each of these elements step by step. In order to make our introductory glance of the market for foreign exchange as simple as possible, we will look at the bilateral spot market:

- bilateral: only two currencies are involved (when more than two currencies are involved we speak of “multilateral” or “effective”)

- spot: only transactions that aim at immediate delivery of the amounts of

currencies exchanged, i.e. transactions that are carried out at once, “on the spot” (and not at a later point in time: “forward”)

(1) The Object of Trade: Foreign Exchange Defined Foreign exchange – in short: FX – is simply money denominated in a foreign currency. As we know, money has three basic functions: it serves as a unit of account, a store of value, and as a means of payment. In the context of foreign exchange, the function as a means of payment is at the forefront. Krugman / Obstfeld / Melitz [(2012), p. 354] therefore write that in the FX market, there is “… interaction of the households, firms, and financial institutions that buy and sell foreign currencies to make international payments”. The FX market is concerned with the exchange of means of immediate payment. This purpose is fulfilled by the following forms of money:

- bank balances which can be drawn at once (sight deposits) - banknotes and coins (“legal tender”) - checks - drafts

If we have the money of a foreign country in one of these forms, it is foreign exchange; see Eiteman / Stonehill / Moffett (2007), p. 178.

4


The notion of “foreign (!) exchange” is coined from the perspective of a given currency area. The currencies of the world are thus divided into two groups:

- one group consists of the local currency (the domestic currency) - the other group comprises all other currencies (foreign currencies).

These latter currencies are called foreign exchange.

Unless otherwise stated, in the sequel we will consider the Euro as the home currency (domestic currency, our currency). Likewise, the US dollar will typically be taken as the foreign currency. As we shall see in the following sections, the price of a currency in terms of another is just equal to the quantities of the two currencies that are exchanged against each other. Therefore, in the market for foreign exchange the price is called “exchange rate”. Like any other price, a currency’s price is determined by the forces of supply and demand.

5


(2) Supply and Demand for Foreign Currency

(a) Supply of Foreign Currency Where does the supply of US dollars on the FOREX market between euros and dollars come from? The traditional answer to this question is that they stem from transactions recorded on the credit side of the European balance of payments. Thus, the first source is the European export of goods and services to the USA. This is true regardless of whether the European exporter bills his American client in dollars or in euros:

- If the European exporter is paid in dollars, he will offer them on the forex market in order to sell them against euros.

- If, instead, the American client (the foreign importer) is billed in euros,

he will have to buy euros against dollars in order to be able to pay the imported European goods.

Note that the supply of US dollars will also arise from European exports to non-American customers throughout the world which use US dollars to pay for the European goods. Financial inflows constitute the second source of supply of foreign exchange; they are also called inflows of capital or import of capital [Krugman / Obstfeld (2009), p. 306]. These inflows stem from the sale of financial assets to Americans and other citizens that use US dollars for their purchases of European assets. If Europeans sell shares to Americans or take out a loan denominated in US dollars, the foreigners will usually have to convert their dollars into euros in order to pay for their purchases in Europe.

6


The sources mentioned so far have been transactions recorded in the balance of payments of the euro area. However, transactions also exist that do not involve residents from the euro area which may, nevertheless, also lead to a supply of dollars against euros. Take as an example a Japanese company that buys oil from a Russian producer:

- suppose that the Japanese company wants to pay with dollar-denominated deposits that it holds at a London-based bank

- next suppose that the Russian producer wants to be paid in euros - in this case, the Japanese company will have to sell its dollars against

euros on the FX market in order to be able to buy the Russian oil.

(b) Demand for Foreign Currency In analogy to the sources of supply, we can identify transactions recorded on the debit side of the European balance of payments as sources of demand for US dollars (and the corresponding supply of euros):

- imports of goods and services - financial outflows

In addition, we must also, again, take into consideration the transactions not recorded in the balance of payments of the euro area.

7


(3) Functions of the FX market (a) Exchange Function: Transfer of Purchasing Power By allowing the exchange of domestic currency against foreign currency the FX market provides the means by which purchasing power can be transferred from the home country to the foreign country; see Caspers (2002), p. 35. (b) Matching Supply and Demand

The FX market has the further function of equilibrating supply and demand. The way equilibrium is obtained depends crucially on the so-called exchange rate system, which we are going to consider in more detail in section 2.3:

- In a so-called fixed-rate system the level of the exchange rate is set by the government. This means that the price mechanism is suspended and cannot provide for a full equilibration of private supply and demand. As a consequence, commercial supply and demand will not match. Therefore, sales and purchases of the public authorities – so-called interventions in the FX market – match private supply and demand to ensure that an equilibrium in the FX market is realized. [Note, however, that a FX equilibrium entailing “interventions” is not an external equilibrium.]

- In a system of flexible exchange rates the exchange rate is free to

adjust to any imbalances between supply and demand for foreign currency. This so-called exchange-rate mechanism succeeds in matching supply and demand.

(c) Pricing Function: Determination of Exchange Rates The exchange rate mechanism not only leads to the equilibrium of supply and demand. It also results in an equilibrium exchange rate. This rate shows the valuation of one currency in terms of another one. For detailed discussions of the purposes of the FX market see Fischer-Erlach (1995), pp. 11 n.

8


(4) Our First Exchange Rate: The Nominal Bilateral Exchange Rate A bilateral exchange rate involves just two currencies. (Later on, we will combine the exchange rates of the home currency against several other currencies in order to get a “multilateral” or “effective” rate.) If we divide the amounts of the two currencies that are exchanged, we get the nominal exchange rate. It is called “nominal” because it simply involves monies, nothing else. As an illustration, suppose that 800 euros are exchanged against 1,000 dollars. We can express this relation in two different ways, thereby obtaining the direct or the indirect quotation of the foreign currency (dollar). (a) Direct Quotation The direct quotation indicates the price of foreign currency in terms of the home currency. It thus has the domestic currency in the numerator:

.

We use the symbol e to represent the direct exchange rate and indicate its dimension in squared brackets. Thus, for the currency amounts just mentioned, the direct rate of the US dollar, from a European perspective, would be

==$€

80.0dollars1000euros800

e .

Unless stated otherwise, in this course we will use the direct rate. In doing so, we are following the bulk of academic literature; see Harms (2008), pp. 25 n and Copeland (2008), p. 4.

currencyforeign

currencydomesticratedirect =

9


A rise in e means a rise in the price of foreign exchange, in our example a rise of the price of an American dollar. This is equivalent to …

- … an appreciation of the dollar against the euro and - … a depreciation of the euro against the dollar.

(b) Indirect quotation The indirect quotation gives the amount of foreign currency that one unit of the home currency will purchase. This “external value” of the euro is just the inverse of the direct quote:

.

In the above example:

1/e = 1/ 0.80 [€/$] = 1.25 [$/€]. The European Monetary Union (EMU) officially established the euro as its currency on January 1, 1999. It was decided to use indirect quotations of foreign currencies in the euro area. The European Central Bank (ECB) publishes so-called reference rates of the euro against about 30 currencies every day. These indirect rates are calculated as averages from the rates quoted in the FX markets of the euro countries at around 2 pm. The following graph shows indirect bilateral rates for three major foreign currencies: the US dollar, the Japanese yen and the British pound.

currencydomestic

currencyforeignrateindirect =

10


Figure 2.1 (4): Bilateral Nominal Exchange Rates of the Euro

Source: European Central Bank (2011), p. S73.

We now turn to the formation of exchange rates on the FX market.

11


(5) Our First Exchange Rate System: Price Formation in a System of

Flexible Exchange Rates (“Floating-Rate System“) In a system of flexible exchange rates the public authorities do not “intervene”, i.e. they do not buy or sell foreign currency with the intention of manipulating the exchange rate. Therefore, the exchange rate between the home currency and the foreign currency is an outcome of the pure and unfettered market mechanism. The following graph shows supply (Ds) and demand (Dd) for foreign currency (here the US dollar, $). The price of the foreign currency in terms of our currency is called the “exchange rate” (“our” currency is the euro, whose symbol is €). The exchange rate takes on the value e* because at this level supply equals demand: (2.1) Ds (e*) = Dd (e*) .

e

$€

Ds A

*e

dD

0

*D D [$]

Exhibit 2.1 (5a): Exchange-Rate Formation in a Floating-Rate System

12


At point A the FX market is in a flexible-rate equilibrium. This is achieved without the government having bought or sold dollars. Thus, only commercial sales and purchases are in equilibrium: this kind of equilibrium is called an external equilibrium. Since the government does not “intervene” in the market, its foreign currency reserves (“official reserves”) remain unchanged. In a floating-rate system, the exchange rate can change at each and every moment. However, the adjustments need neither be strong, nor do they have to move in one direction. The causes of the adjustments are discrepancies between supply and demand. The following scheme shows us that an excess supply leads to a decline in the price of foreign exchange, whereas an excess demand leads to a rise in the value of the foreign currency unit:

Ds > Dd � e ↓

Ds < Dd � e ↑

Discrepancies between supply and demand result because of changes in Ds and Dd. For example, consider a rise in the demand for foreign currency. In the next exhibit, this is illustrated as a rightward shift of the Dd schedule. As a consequence, the price of the foreign currency moves up to the level

*1e .

13


e

$€

Ds

*1e

*0e

d1D

d0D

0 *0D *

1D D [$] Exhibit 2.1 (5b): An Increase in Demand for Foreign Currency in a Floating-

Rate System

We conclude that permanent shifts of demand and supply will lead to fluctuations of the exchange rate over time. The implied uncertainty about the future level of the exchange rate – even in such short periods of time such as from day to day – is an important feature of flexible exchange-rate systems.

14


2.2 Some More Details We have already learned something about spot transactions: in a spot transaction, the two counterparties agree to exchange the two currencies “on the spot”, i.e. immediately. In practice, the exchange typically takes place within two days; see, for example, Eiteman / Stonehill / Moffett (2007), p. 184. The ratio of the quantities of currencies that are exchanged is called the spot exchange rate (in short: spot rate). If nothing specific is mentioned, then a FX transaction is meant to be a spot transaction and the exchange rate is meant to be the spot rate. We now turn to other segments of the FX market.

15


(1) Forward Transactions and Forward Rates

A currency forward transaction is a contract between two parties stipulating that one party (the forward buyer) purchases from the other party (the forward seller)...

• ...a specified amount (the contract volume) • …of a specified currency • ...at a specified date in the future (the delivery date) • ...at a specified price per unit of the currency (the forward exchange

rate); [See Solnik/McLeavey (2004), pp. 14 and 508] Just as in a spot transaction, the two parties make a contract today. However, the transaction is not executed today but at some forward (!) point in time. Note that the transaction’s date of execution is fixed in the contract, i.e. the day of delivery of the two currencies is already agreed upon today. The forward exchange rate (eF) states the amount of our currency units that we will…

- …have to pay for one unit of the foreign currency if we are buying - …get for one unit of the foreign currency if we are selling the foreign

currency.

As an example, let’s take a six-month forward deal. Suppose that we want to buy 1,000 dollars at the six-month rate of eF = 0.90 [€/$]. This means that after six months …

- … we will have to pay 900 euros and - … we will receive 1,000 dollars.

16


(2) Swap Transactions and Swap Rates Foreign exchange swaps aim at a temporary exchange of the principle amounts (stocks) of two separate currencies: at the end of the swap period, each party gets back the currency it had at the outset. To this end, a FX swap consists of “a pair of currency transactions (one purchase, one sale) for two different value dates” [King / Mallo (2010), p. 74]:

- Spot-forward swap: first transaction takes place today, i.e. is a spot transaction, and the second transaction takes place by way of a forward transaction.

today 6 months time swap period

In a spot-forward swap the first exchange is based on today’s spot rate, whereas the second rate is based on today’s 6-month rate.

- Forward-forward swap: consists of two forward transactions with

different dates, e.g. a 3-month forward and a 6-month forward. Thus, the swap is based on the two forward rates as quoted in the forward market today.

today 3 months 6 months time

swap period

17


In any case both transactions and, hence, both exchange rates are fixed at the outset. In practice, “FX swaps are arranged as a single transaction with a single counterparty” [King / Mallo (2010), p. 74]. A nice graphical illustration comprising the payments for both partners can be found in Bekaert/Hodrick (2009), p. 89. The swap rate measures the difference between the two exchange rates involved in a FX swap. If we are considering the case of a spot-forward swap, the swap rate in absolute terms is defined as the difference between the forward rate and the spot rate: (2.2) sabs = eF – e [€/$] . As an example, suppose that the spot rate e is at e = 0.70 [€/$] and that the one-year forward rate is eF = 0.77 [€/$]. Then the swap rate in absolute terms is simply 0.77 – 0.70 = 0.07 [€/$]. Dividing the absolute swap rate by the spot rate gives us the swap rate in relative terms:

(2.3) e

ees

F −= .

If we are simply speaking of “the” swap rate, we generally mean the rate in relative terms. In the above example this is (0.77 – 0.70) / 0.70 = 0.10, or 10%. If the swap rate is positive, the dollar is said to have a “forward premium”; if it is negative, the dollar is said to have a “forward discount”.

18


(3) Real Exchange Rate Up to now, we have been looking at the nominal exchange rate. As a direct rate, it indicates that e units of the home currency exchange for one unit of the foreign currency:

e

=

currencyforeignofunitonecurrencyehomofunits

e$€

.

The real exchange rate (Q) makes an analogous statement for the exchange between domestic goods and foreign goods: it indicates that Q units of the domestic basket of goods exchange for one basket of foreign goods; see Harms (2008), p. 253. This interpretation of the real exchange rate regarding a basket of goods is somewhat difficult to grasp at first. Let us therefore begin with an interpretation based on the use of a single commodity. Please note that the real exchange rate is interested in the purchasing power of the euro in different currency areas. (a) One Good The real exchange rate in a one-good world analyzes the purchasing power of the euro across borders with respect to a well-specified commodity i. More precisely, it compares…

- … the purchasing power of the euro in the euro area - … with the purchasing power of the euro in the dollar area.

Start with the purchasing power of the euro in the dollar area. To calculate this, we first have to know how many units of our currency we must pay for one unit of commodity i if we were to buy it in the US. In order to calculate this price, we must multiply the nominal exchange rate with the foreign-currency price of the foreign good ( )Pf

i :

(2.5) Pfie ⋅ =

⋅

iunit$

$€

=

iunit€

19


The reciprocal of (2.5) describes the purchasing power of the euro with respect to good i in the dollar area. It tells us how many units of good i that can be bought with one euro if, before shopping in the US, we exchange this euro into dollars at the going spot rate e:

(2.6)

=⋅ €

unite

1 ifiP

.

This has to be compared with the purchasing power of the euro with respect to commodity i at home, the so-called internal value. The internal value is calculated as the reciprocal of the price in Europe (pi); see Stobbe (1994), p. 178 and 270:

(2.7)

=

=€

unit

unit€1

p1 i

i

i .

When we examine equations (2.5) and (2.6), we see that the purchasing powers of the euro with respect to good i at home and abroad have the same dimension. Therefore, they can be compared! Purchasing power parity (PPP) requires that one euro buys the same quantity of good i in both currency areas:

(2.8) P f

ii e1

p1

⋅= .

Dividing (2.7) by (2.6) gives us the real exchange rate with respect to good i:

(2.9)

=

⋅=

)abroad(unit)ehomat(unit

p

eQ

i

i

i

fi

iP

20


Note that the real exchange rate has no monetary dimension whatsoever! It can thus even be calculated in a world without money; see Harms (2008), p. 253. In order to buy one unit of good i abroad, we must forsake buying Qi units of good i at home in Europe. In other words, one unit of the American good costs Qi units of the European good. A rise in Qi therefore implies a direct negative welfare effect for European consumers. This sort of an increase is called a “real depreciation” of the euro. We realize from (2.9) that a high Qi is due to a high price in the US relative to the European price. Therefore, a high real exchange rate indicates a high competitiveness of the European producers. Plugging the condition for PPP, equation (2.8), into the definition of Qi, equation (2.9), results in: (2.10) Qi = 1 . Thus, PPP with respect to good i implies that one unit of good i produced at home just “buys” one unit produced abroad. In other words: in order to be able to buy one unit abroad, we must forsake the purchase of unit at home. The real external value of the euro is just the reciprocal value of (2.9). (b) Several Goods In practice, the internal value of a currency, i.e. its purchasing power at home, is analyzed with respect to a basket of goods. This makes it necessary to calculate a price index and its change over time.

A price index has no dimension. However, to explain things clearly, we will attribute the dimension “currency units per one bundle of goods” to the price level.

21


Let’s have a look at an ideal real exchange rate (Q

~ ) at first. It would consider an identical bundle of goods at home and abroad. Assume a bundle that is composed according to European tastes. Its prices are p in Europe and fp~ in the US. We look at the dimension of the left side of the following equation and realize that, as in the one-good case, the real exchange rate does not have any monetary dimension:

(2.10) Q~ = e · pp~f

)USAin(

)inEurope(

unit

unit

europ

europ =

$€

·

)Europein(€

)USAin($

unit

unit

europ

europ

PPP with respect to the cross-border identical basket of goods requires that

(2.11) fp~e

1p1

⋅= .

In this case, Q~ takes on the value of one: (2.12) Q~ = 1 . The actual real exchange rate (Q) uses the American price level (pf) and is based on a basket of goods composed according to American tastes. We replace fp~ by pf in equation (2.12) to obtain:

22


(2.13) Q = e · ppf

unit

unit

europ

europ =

$€

·

unit

unit

europ

europ

€

$

We can see that the real exchange rate denotes the price of an American basket of goods in terms of a European basket of goods. In practice, depending on the issue at hand, real exchange rates are calculated using consumer price indices, unit labor costs, or price indices related to national production (producer price indices, GDP deflators); see European Central Bank (2011), p. S97. (4) Multilateral (“Effective”) Exchange Rates Up to now we have been discussing bilateral exchange rates, i.e. the rate of exchange between just two currencies. In contrast to this the multilateral rate simultaneously looks at the relation of the home currency to several other currencies. It does so by combining the bilateral rates of the home currency against the foreign currencies. (a) Idea The multilateral rate is also called an “effective” exchange rate. It is designed to provide an integral impression of a group of exchange rates which are the most important for a countries foreign trade. In the words of Willms [(1995), p. 27], one is concerned about the “changes in the international competitiveness of a country in foreign trade”.

23


(b) Nominal Effective Rate The nominal effective rate (eeff) is usually calculated as a weighted geometric average of the bilateral rates of n partner currencies (ei, i = 1, ..., n); see Willms (1995), p. 27. In practice, the ratios (eit/ei0) are used, where the rate of a base period (ei0) is set equal to 100. Thus, the effective rate also takes the form of a ratio; see Stobbe (1994), p. 271:

(2.14) ,ee

...ee

ee

ee ng2g1geff

0n

nt

20

t2

10

t1

0

t

⋅⋅

⋅

=

where gi > 0, ∑=

=n

1ii 1g

The ECB calculates the reciprocal of (2.14) by taking indirect bilateral rates of the partner currencies. This is just the effective nominal external value of the euro. The base period is the first quarter of 1999 whose average is therefore set to 100. The following graph shows that the euro depreciated sharply until autumn 2000. Then it experienced a remarkable appreciation that lasted until autumn 2009.

Monthly averages; Index 1999 Q1 = 100

Figure 2.2 (4b): Effective Exchange Rates of the Euro Source: European Central Bank (2011), p. S73.

24


(c) Real Effective Rate The international competitiveness of a country not only depends on its currencies nominal exchange rates, but also depends on the prices of domestic goods in comparison to the prices of goods produced abroad. This is what the real multilateral exchange rate tries to capture; see Willms (1995), p. 27. Like the nominal rate, it is calculated as a weighted geometric average of bilateral real rates. Again, the bilateral rates are expressed in the form of ratios to a base year. The ECB calculates the reciprocal of the real effective exchange rate, i.e. the real effective external value of the euro. A decrease in this number indicates that the prices in Europe have fallen relative to the foreign prices (the latter also expressed in euros). This indicates a direct negative welfare effect for Europe but an increase in the average European competitiveness compared with those countries whose currencies are taken into consideration. The above graph shows that the real effective external value of the euro displays a high correlation with its nominal counterpart; see Harms (2008), p. 254.

25


The German Central Bank (Deutsche Bundesbank) uses the same procedure as the ECB to calculate “Indicators of Price Competitiveness of the German Economy”. In the right part of the following table, we find time series of this indicator.

Figure 2.2 (4c): Effective Exchange Rates of the Euro and Indicators of Price Competitiveness of the German Economy Source: Deutsche Bundesbank (2011), p. 76*

We realize that, since the introduction of the euro, the development of the German economy’s price competitiveness has not been uniform:

- It has been increasing the entire time against the other euro countries and is now considerably higher than at the beginning of 1999. This has been due to the other euro countries’ higher inflation rates. In contrast to the pre-euro era they could not be compensated by devaluations of their national currencies for this anymore.

26


- In sharp contrast to this, the German competitiveness against other

partners only improved up to 2000; this was due to the strong nominal depreciation of the euro at that time. In the following years, Germany’s international competitiveness deteriorated considerably. For many other euro countries, the development has been even worse: their producers have suffered not only from the nominal appreciation of the euro, but also from the “home-made” problem of experiencing comparatively strong price increases for their products.

(d) Weights The weights (gi) in the above equation (2.14) are supposed to measure the rivalry with the trade partners i = 1, …, n. In this respect, two aspects must be taken into consideration [see Willms (1995), p. 28; Stobbe (1994), pp. 271 n]:

- Direct competition with a county i: this relates to our competition with producers from i in their home markets. It is thus captured by the share of country i in our total exports; we may describe this as the simple export weight of country i.

- Third-market effects: our producers compete with firms from country i

for clients from other countries j ≠ i. For example, German companies compete with Japanese firms in the USA. As a consequence, a change in our exchange rate against country i (Japan) will affect our competitive position in country j (USA). The extent of this shift in competitiveness in country j depends on …

(i) … the share of country j (USA) in our total exports (ii) … and the share of country i (Japan) in the aggregate

supply (GDP) of country j. Combining the third-market effects with the simple export weights brings us to the so-called extended export weight of currency i. By analogy, we are able to calculate broad import weights as well as mixed import and export weights.

27


(6) Addendum: Terms of Trade Much like the effective real exchange rate, the terms of trade are a non-monetary exchange ratio vis-à-vis a group of countries. They can be calculated using export and import prices (an alternative method is based on so-called export unit values and import unit values; see Stobbe (1994), pp. 187 n, 443): export prices (in euro) (2.15) terms of trade = import prices (in euro) In practice, indices of export and import prices are used in (2.15). If the resulting index for the terms of trade is at, for example, 117, this means that the terms of trade have increased by 17 % compared to the base period. In order to get to an illuminating interpretation, we make three simplifications:

- there is only one partner country - there is only one export good and one import good - we do not look at indexed numbers but at absolute prices.

In this case, the terms of trade (QT) can be written as

(2.16)

=

⋅

=⋅

=EX

IM

IM

EXfIM

EXT

unitunit

$€

unit$

unit€

e

p

pQ .

Equation (2.16) simply says that the home country gets QT units of import goods for one unit of its export good. For obvious reasons then, an increase of QT is called an “improvement” of the terms of trade; see Rübel (2004), pp. 58 n.

28


Comparing the terms of trade with the real bilateral exchange rate form section (3) above we note three differences:

- From the point of view of the home country the terms of trade are a revenue variable, while the real exchange rate is an indicator of costs.

- The terms of trade only take account of exported and imported goods,

while the real exchange rate comprises the prices of all goods at home and abroad.

- The real exchange rate tries to use prices of the same goods at home

and abroad. In contrast, the terms of trade take into account very different goods in the numerator (German machines) and in the denominator (African Bananas).

29


2.3 More Basics of Exchange Rate Systems 2.3.1 Fixed Exchange Rates The flexible-rate system and the fixed-rate system represent the “hypothetical extreme” cases of a large variety of exchange rate systems; see Marrewijk (2007), p. 467. MacDonald [(2007), p. 28] speaks of a “rich variety of intermediate cases between the so-called corner positions of a pure float and a rigidly fixed exchange rate”. (1) System with a Fixed Exchange Rate A fixed-rate system consists of two elements: first-of-all an official target rate (e), which is set by the government. Usually, supply and demand for foreign exchange will not be equal at this rate, i.e. there is a disequilibrium at this rate. In the case of the flexible-rate system of section 2.1 (5), this leads to a change in the exchange rate. However, in the fixed-rate system this must be prevented from happening! That is why there is a second element: intervention. This means that the central bank buys or sells foreign currency in order to eliminate the disequilibrium between market-driven supply and demand:

Ds (e) > Dd (e) � purchase of excess supply (see the next exhibit)

Ds (e) < Dd (e) � sale of foreign currency in the amount of the excess demand prevailing in the market (this is also called “financing of the balance of payments”)

30


e

$€

Ds e

dD

0 D [$] Exhibit 2.3 (1): Excess Supply of Foreign Currency in a Fixed-Rate System

(2) FX Market Interventions Change the Quantity of Money This section is intended to explain the following causality: given a fixed exchange rate, a disequilibrium in the FX market leads to changes (∆) in a country’s official reserves (R), its monetary base (B), and the money supply (M): (Ds - Dd) ≠ 0 → ∆ R ≠ 0 → ∆ B ≠ 0 → ∆ M ≠ 0 . (a) First Step: Interventions Change the Official International Reserves Official international reserves comprise gold and convertible foreign currencies. Therefore, they change whenever the central bank “intervenes” in the FX market. Putting things more precisely, the excess supply in the FX market leads to an equal change in the bank’s official reserves (∆ R): (2.20) ∆ R = Ds - Dd . Note that the excess supply can be both positive or negative.

31


In order to thoroughly understand this relation, we must look at the following equations (2.21) to (2.25): (2.21) ∆ R = CA + FA

This is just the equation of the balance of payments (where we neglect the capital account): the sum of the current account balance (CA) and the financial account balance (FA) correspond to the change in the official reserves.

Note: in the practice of balance-of-payments accounting, the change in official reserves is included in the financial account. Here, we have separated it from the other financial transactions so that FA only comprises non-reserve transactions.

(2.22) CA = EX - IM , (2.23) FA = CIM - CEX . These equations represent the definitions of the current account and the financial account balances. The next two equations describe the sources of the supply of foreign exchange (Ds) and demand (Dd) for foreign exchange: (2.24) Ds = EX + CIM (2.25) Dd = IM + CEX . Plugging (2.22) to (2.25) into (2.21) gives (2.20). We note that the control of the exchange rate comes at a price: the central bank must buy or sell foreign currency on the FX market, thus changing its official international reserves!

32


(b) Changes in Official Reserves Change the Monetary Base The official reserves are part of the asset side of the central bank’s balance sheet:

- on the left side we see the sources of the so-called monetary base (B): credits to the domestic economy (H) and official international reserves (R)

- on the right side we have the two uses of the monetary base: cash

balances (C) and reserves which commercial banks hold at the central bank (MR)

Sources Uses

Cash (C) Domestic Credits (H) Reserve holdings of Official international commercial banks’ (MR) reserves (R) Monetary Base (B) Monetary Base (B)

Figure 2.3 (2): Balance Sheet of the Central Bank We realize from the above balance sheet that a change in the size of the reserves (∆ R) leads to a change of equal size in the monetary base (∆ B), provided the other uses and sources of B remain constant: (2.26) ∆ B = ∆ R .

33


(c) Changes in the Monetary Base Change the Quantity of Money The quantity of money (M) in an economy is a multiple (m) of the monetary base. Therefore, changes in the monetary base (∆ B) will lead to multiple changes of the domestic money supply: (2.27) M = m · B (2.28) ∆ M = m · ∆ B . (d) Putting Things Together: An Excess Supply in the FX Market Leads to

(Strong) Reactions in the Money Supply We plug (2.20) into (2.26) and then into (2.28) to obtain: (2.29) ∆ M = m · (Ds - Dd) . This equation shows clearly that an excess supply in the FX market which is offset by official “intervention” leads to a multiplied change in the money supply:

- (Ds - Dd) > 0 → ∆ M > 0 - (Ds - Dd) < 0 → ∆ M < 0 .

This creates a dilemma of utmost importance! We therefore want to have a closer look at it.

34


(3) The Dilemma: Control of the Money Supply Versus Control of the

Exchange Rate (a) Flexible Exchange Rate: Control of the Money Supply In the case of a flexible exchange rate regime, the price of foreign currency is determined on the market. In other words, because the exchange rate is free to move it adjusts so that supply will equal demand. In section 2.1 (5) we expressed this flexible-exchange rate equilibrium by equation (2.1), where e* is the equilibrium rate: (2.1) Ds (e*) = Dd (e*) . Much like many other financial market rates, it is a “quick” variable so that we may assume to have an equilibrium at any point in time. From the point of view of economic model building, the exchange rate in a floating-rate system is an endogenous variable. Plugging (2.1) successively into (2.20), (2.26), and (2.28), we find that (2.29) ∆ R = ∆ B = ∆ M = 0 . This means that the international transactions of an economy – as they are reflected in the supply and demand for foreign exchange – do not have any impact on the money supply: the money supply is exogenous. (b) Fixed Exchange Rate: Control of the Exchange Rate In a fixed-rate system the exchange rate is “imposed” onto the market from outside by the government: it is an exogenous variable. However, as summarized in (2.28), the money supply changes in reaction to the economy’s international transactions. As these are market-driven the quantity of money is endogenous. The central bank cannot control it! Monetary policy has to “react” to international developments in order to keep the level of the exchange rate at its par value (e). In fact, the par value of the exchange rate becomes the target of monetary policy (instead of domestic variables such as the price level or employment).

35


(c) Dilemma The preceding analysis has made clear that the government faces a dilemma: it can…

- …either fix the exchange rate: in this case, it gives up control of the money supply

- …or control the money supply: in this case, it has to accept an

exchange rate set by the market.

(5) Addendum: Are “Fixed” Exchange Rates Reliable? At first sight, we would suppose that there is no uncertainty about the future exchange rate in a fixed-rate system. However, this is true only as long as the official target rate remains unchanged! As a matter of fact, for certain reasons an excess supply as well as an excess demand cannot be supported in the long run. As a consequence, “fixed” exchange rates are not really fixed in the end; rather, they are adjusted by the government after longer time intervals (after several months or even years) and by more or less large degrees. (Remember that in contrast to this a flexible rate changes continuously in more or less small steps.) Over time, the path of the exchange rate will then correspond to the graph of a staircase, thus exhibiting “steps”. Instead of a “fixed” rate, we should therefore rather speak of a “stepwise flexible” rate. As a result, at least in the long run, there is exchange-rate uncertainty in a fixed-rate system. There are indicators for adjustments of the official target rate which cannot be discussed here.

36


2.3.2 Generalizing the Discussion (1) Trade-Offs in Economic Policy The exchange rate system is chosen with respect to economic policy objectives. We know from the theory of economic policy that these targets may have the following relationships:

- harmony: a higher degree of achievement of target A implies a higher degree of realization of target B

- neutrality: there is no relation between the two targets - rivalry: a higher degree of achievement of target A implies a lower

degree of realization of target B.

In the case of rivalry, there is a so-called trade-off, i.e. a sort of exchange (“trade”) between the two targets: we have to “pay” with a lower level of target B in order to “buy” a higher level of A. In the context of choosing an exchange rate system, two trade-offs are discussed. One of them is the dilemma discussed above, i.e. the inevitable choice between the control of the money supply and the control over the exchange rate. In practice, there do not just exist the two polar cases of completely fixed or freely floating exchange rates. Instead, “ (…) there is a sliding scale (with associated colorful typology) from one hypothetical extreme to the other”; Marrewijk (2007), p. 467. Thus, one can really “trade” between “a bit more” control of e and “a bit less” control of M and vice versa: in this sense, there is a true trade-off between the two policy objectives. Moreover, the history of exchange rate regimes is closely connected to that of capital market integration. For this reason, it has become standard to consider a trilemma when discussing the choice of an exchange rate system; see Marrewijk (2007), p. 468.

37


(2) Trilemma A trilemma in economic policy denotes a situation where you have three objectives but can pursue only two of them. You must thus make a choice which policy to forsake. The following exposition is based on Marrewijk (2007), pp. 468 n. His point of departure is the so-called uncovered interest-rate parity. We will analyze this relation in more detail in § 4. Assuming a zero risk premium, this theorem says that the domestic interest rate (i) is equal to the sum of the foreign interest rate (if), the expected change of the spot exchange rate (ee- e), and transaction costs in the financial markets (trans):

(2.30) transe

ei e

ie

f +−+= .

In this equation, all variables are assumed to be percentage rates of one unit of the home currency. (a) Three Policy Objectives We now want to consider the three objectives of a country’s economic policy: why are they desirable and how can we express them within equation (2.30)? The first objective is monetary policy independence: this allows a country to pursue its monetary policy according to the needs of its internal economic targets (price level, employment). In the trilemma discussion, the possibility of an independent monetary policy is measured by the ability to have a domestic interest rate (i) that is different from the rate abroad (if). The second objective is a fixed exchange rate. It is often considered desirable because it reduces the uncertainty of calculations regarding cross-border transactions. (However, recall that in practice this is true only for a limited period of time.) In the above equation a fixed rate is modeled using a zero-expectation of changes in the exchange rate: if market participants believe that the rate will stay as it is, then ee = e and thus (ee – e)/e = 0.

38


The third objective is international capital mobility. This is judged desirable as it allows investors to diversify their assets internationally. At the same time, it enables borrowers to seek cheap funds abroad. In (2.30) we model (complete) international capital mobility with the absence of transaction cost (trans = 0). (b) Trilemma: The Need to Choose Two Out of Three Suppose we choose international capital mobility as the desired policy goal. In this case, (2.30) reads

(2.30 a) e

ei e

ie

f −+= .

In addition to capital mobility, we can then choose …

- … either a fixed exchange rate (such that (ee – e)/e = 0): in this case, (2.30 a) can be further reduced to

(2.30 aa) i = if .

This shows that the choice of capital mobility with a fixed exchange rate forces us to accept the foreign interest rate level at home: in this sense, we loose our monetary policy independence.

- … or a level of our interest rate that diverges from the foreign rate. Now

(2.30a) clearly shows that i can only diverge from if if the expected change in the exchange rate is unequal to zero: we must therefore allow the exchange rate to change over time! We thus realize that the choice of capital mobility with monetary policy autonomy forces us to accept a flexible exchange rate: we loose the possibility of fixing the exchange rate.

39


Suppose next that we fix the exchange rate. In this case (2.30) reads (2.30b) transi i f += . In addition to a fixed rate, we can then choose…

- … either free capital mobility. As trans = 0 then, we have (2.30aa) and we have to accept the foreign interest rate level, i.e. we loose the independence of our monetary policy.

- … or monetary policy independence. In this case, we need to restrict

capital mobility by imposing transaction costs (such as special taxes on foreign assets and/or liabilities, …)

(c) Summing Up: The “Impossible Trinity” Capital Mobility Monetary Policy Fixed Independence Exchange rate

40


2.4 Exchange Rate Systems in Practice The international monetary and foreign exchange system has changed considerably over time. The following graph provides a historical overview and is based on Marrewijk (2007), p. 469.

1870 1914 1945 1971 time

Figure 2.4: Historical Overview of International Monetary Systems Source: Adapted from Marrewijk (2007), p. 469

Gold Standard: World Wars and Recessions

Bretton Woods

Floating Rates

- fixed exchange rates: currencies pegged to gold

- Gold Standard given up → exchange rates floating (more or less: often managed, partly abuse by beggar-thy neighbour policy)

- fixed exchange rates: n-1 currencies pegged to dollar, nth currency (dollar) pegged to gold

- flexible exchange rates (more or less: often forms of managed floating)

- mostly free capital mobility

- capital controls - mostly free capital mobility (controls only initially)

- free capital mobility

- no autonomy of monetary policy

- autonomous monetary policy


- autonomous monetary policy

41


Gold Standard:

World Wars and Recessions

Bretton Woods

Floating Rates

- fixed exchange rates: currencies pegged to gold

- Gold Standard given up → exchange rates floating (more or less: often managed, partly abuse by beggar-thy neighbour policy)

- fixed exchange rates: n-1 currencies pegged to dollar, nth currency (dollar) pegged to gold

- flexible exchange rates (more or less: often forms of managed floating)

- mostly free capital mobility

- capital controls - mostly free capital mobility (controls only initially)

- free capital mobility


- autonomous monetary policy


- autonomous monetary policy

1870 1914 1945 1971 time

42


2.4.1 The Gold Standard 2.4.1.1 Introduction The Gold Standard was a currency system that corresponded to classical postulates of economic policy: public authorities should not intervene in the economy at their own discretion. Rather, they should establish and respect (!) a set of rules, thereby creating a stable and reliable framework for the market mechanism and market processes. In the case of the Gold Standard, this framework was given by the Standard’s four “rules of the game”. Historically, the Gold Standard started in Britain in 1844 when it was stated that the notes of the Bank of England, fully backed by gold, should become the legal tender. It became an international standard in 1871, when Germany introduced the Reichsmark also backed by gold. Many other countries soon followed; see Marrewijk (2007), p. 470. On the one hand, the Classical Gold Standard contained rules for national monetary policies, especially concerning a country's supply of money. These rules can be summed up under the headline “National Gold Standard”; confer Woll (2008), p. 317. On the other hand, the Classical Gold Standard encompassed the self-obligation of member countries to allow the import and export of gold. Together, all of these “rules of the game” made up the International or Classical Gold Standard: an international monetary system with fixed exchange rates, the automatic balance of the balance-of-payments, and a passive national monetary policy. The monetary policy can be dubbed as having been “passive” because its primary aim was to maintain exchange rate stability, which required it to accept an endogenous stock of money. This meant that a nation's monetary policy gave up its ability to autonomously control the supply of money as an exogenous magnitude in the economy.

43


2.4.1.2 The National Gold Standard The national gold standard embraced the following rules (1) – (3). Its immediate goal was to ensure that the domestic currency was tradeable into gold at any time. The purpose of the gold-convertibility was to limit the amount of money circulating in the economy and to secure the stability of the national monetary unit’s value. In this way, the central economic grounds for economic agent’s acceptance of money was provided for, since the promise of a stability-oriented monetary policy of the central bank was underpinned by the rules of the national gold standard (monetary policy credibility). These rules, which will elaborate on below, “seriously curbed the national central banks' ability to implement monetary policy” [Modery (1996), p. 12]. (1) Gold Parity A specific amount of gold is defined by the state as one unit of currency. For example, at the end of the 19th century, the Reichsmark (RM) had a parity of 1 RM = 1/2790 kg gold 1 RM = 0,000359 kg gold. This simultaneously meant that you had to pay approximately 86.60 RM for one ounce of gold (31.1 grams) [see Jarchow / Rühmann (1997), p. 34 and Rübel (2002), p. 161].

44


(2) Free Access to Gold A nation's monetary authority was obligated to buy gold in any amounts at the defined gold parity and to sell each demanded amount of gold. This free access to gold guaranteed private economic agents that no other alternate trade ratio between gold and money could prevail on the market:

– No market participant would sell her gold to another market participant at a rate lower than parity, since she could sell her gold to the central monetary authority for more.

– No market participant would buy gold from another party for more than gold parity, if she could buy gold from the monetary authority at a lower rate.

It must be added that, in practice, the central bank's bid rate tended to be lower than the official gold parity rate. In this manner, the central bank was able to generate a certain amount of proceeds from its trade in gold. Vice versa, private parties were burdened with transaction costs. Adequate gold reserves were the prerequisite for a central bank to be able to sell gold.

45


(3) Supply of Money Covered by Gold The stock of money in a country was bound by the gold reserves of the national monetary authority. The money supply could be covered by gold by 100 per cent or by a lesser percentage. The central bank thus had to change the money supply in accordance to changes in its stock of gold:

– An increase in gold reserves lead to an increase in the supply of money.

– A decrease of the gold stock lead to a reduction in the money supply. “A minimum cover requirement on the national level provided that bank notes, but also sight deposits could be traded at the official gold parity at any time, as well as vice versa” [Modery (1996), p. 12]. What is important is that an adequate amount of gold reserves convinced the private market participants that he or she could exchange his or her – innately valueless and infinitely reproducible – money for – innately valuable and scarce – gold at any time. This prevented “runs” or the market wide endeavor of market participants to trade their money for gold now out of fear that no more gold would be available at a later point in time. The credibility of this basic ability to trade money for gold at any time was supposed to ensure that the natural scarceness of gold was translated into a scarcity of money. The value and the acceptance of gold transferred onto money and guaranteed its purchasing power in the flow of goods.

46


(4) Forms of the Gold Standard (a) Gold Specie Standard The gold specie standard in its pure form is characterized by a circulation of gold that consists entirely of gold coins. With these so-called face-value coins (german: Kurantmünzen) the material value – that is the value of the gold – is equal to the minted value of the coin (its face value, nominal value) less the cost of its production; see Woll (2008), p. 268 and 680. Thus, …

– … the means of payment in circulation is covered by gold by 100 per cent ex definitione,

– … the gold parity follows from the nominal value of coins, – … the aspect of exchanging money for gold becomes irrelevant.

In reality, the pure gold specie standard was not implementable because of its very high demand for gold [see Dieckheuer (1991), p. 391].

47


(b) Mixed Gold Specie Standard With this type of gold standard bank notes and so-called secondary coins (german: Scheidemünzen) are also in circulation next to full-fledged gold coins. With secondary coins the material value is far less than the value minted on the coin [see Woll (2008), p. 680]. They contain no gold or their value in gold is substantially less than their nominal value. The notes in circulation are covered completely or in part by the stock of gold held at the central bank [see Jarchow/Rühman (1997), p. 33]. The coverage requirements limit the amount or gold in circulation.

(c) Gold Bullion Standard With the gold bullion standard no face-value coins are in circulation. The circulation of bank notes and minted coins is covered up to a certain amount by the central bank’s stock of gold. In accordance with the coverage requirements the monetary authority buys and sells bank notes against gold bars. Hence, the gold bullion standard is also called a gold bar currency [Jarchow/Rühman (1997), p. 34]. Woll [(2008), p. 317] speaks of a “representative currency”.

48


2.4.1.3 The International Gold Standard As we have already noted, the Classical Gold Standard was an international monetary system with fixed exchange rates. More specifically, the exchange rate could only vary above or below the official exchange rate by a certain degree. The rules of the game for national monetary authorities played the decisive role in limiting fluctuations of the exchange rate. Namely, these rules pertained to the permission to import and export gold. The free trade in gold allowed cross-border arbitrage, which kept the exchange rate within certain bounds – between the so-called gold export point and gold import point. (1) Mint Par Exchange Rate As we mentioned in section 2.4.1.2 (1) the gold parity of the Reichsmark (PG) at the time of the Gold Standard was equal to 86.6 RM per fine ounce of gold. Combine this with the value of the then prevailing gold parity of the US dollar (PGa) of 20.6 USD per fine ounce of gold and we get the Reichsmark/USD mint par exchange rate (eL):

(2.40) eL =

=

=USDRM

20,4

FeinunzeUSD

FeinunzeRM

6,206,86

PP

Ga

G

(2) Free Gold Traffic The participating countries in the international gold standard were constrained to permit the import and export of gold. Together with the national monetary authority's obligation to buy and sell gold, this meant that internationally operating agents could buy and sell gold in any amounts at home and abroad. Thus, there existed cross-border free access to gold. Free gold traffic is the fourth rule of the international gold standard, together with the three points (1) – (3) detailed in the respective sections (1) – (3) in 2.4.1.2 above.

49


(3) Gold Arbitrage Arbitrage is worth while as long as the difference between the market exchange rate of the Reichsmark and the dollar is large enough. A difference is sufficient if it surpasses the sum of information and transportation costs as well as forgone interest [see Jarchow / Rühman (1997), p. 35]. Assume these arbitrage costs amount to t = 0.10 RM regarding an amount of gold equivalent to the value of one USD. Assume further that the market exchange rate is at e = 4.00 [RM/USD]. In this case the dollar is relatively inexpensive on the market, where it can be bought for 4.00 RM. In comparison, the dollar is expensive at the central bank, where it exchanges for 4.20 RM:

– the arbitrageur sells one dollar to the US American central bank and receives 1/20.6 = 0.0485 fine ounces of gold

– he then imports this gold to Germany incurring 0.10 RM in arbitrage costs

– in Germany the arbitrageur sells the gold to the Reichsbank and

receives 0.0485 · 86.6 = 4.20 RM

In sum, the transaction results in costs of 4.10 RM and revenue of 4.20 RM. The arbitrage profit is thus 0.10 RM per dollar: 4.20 - 4.00 - 0.10 = 0.10 (2.41) eL - e - t = ARG .

50


If we have the opposed case in which the dollar is quoted at, for example, e = 4.50 [RM/USD] on the market (i.e. the dollar is undervalued), the arbitrageur will buy dollars from the central banks and sell them on the market for 4.50 RM. The purchase from the central banks at 4.20 RM includes the export of gold from Germany:

– the arbitrageur buys that amount of gold in Germany which is needed to purchase one dollar in America, i.e. 0.0485 fine ounces of gold. This leads to costs of 0.0485 · 86.6 = 4.20 RM

– this gold is exported to the USA, which results in arbitrage costs of t = 0.10 RM

– the gold is sold to the Federal Reserve in the USA for the price of one

dollar This transaction leads to revenue of 4.50 RM and costs of 4.30 RM. The arbitrage profit is thus: (2.41 a) ARG = e - eL - t = 4.50 - 4.20 - 0.10 = 0.20 . Arbitrage in the latter case leads to a decreasing market exchange rate because of the increased supply of USD, which causes the rate to sink below the original value of 4.50 RM. In the former case, the increased demand for dollars leads to an increase in the market rate e above the original value of 4.00 RM.

51


(4) Gold Points The arbitrage process comes to an end as soon as profit opportunities have been exhausted, that is not until the arbitrage profit is simply equal to zero: (2.42) ARG = 0 Once this is the case the absolute difference between parity and market rate is just equal to the costs of arbitrage. Plugging (2.42) into (2.41) gives the lower bound of the market rate up to which the import of gold is profitable: (2.43) eIM = eL - t = 4.20 - 0.10 = 4.10 Should the market rate rise to or above eIM, the purchase of dollars on the market and the sale of dollars to the American central bank together with the necessary gold import to Germany will no longer profitable. Hence, arbitrage that leads to a rising exchange rate only takes place for values below eIM, since arbitrage will prevent the exchange rate from rising above eIM. Only for values lower than this “gold import point” does the import of gold ensue. This form of arbitrage, however, takes place in unlimited amounts, i.e. arbitrageurs will demand an unlimited amount of dollars on the market. The next diagram delineates the demand curve for foreign exchange with a perfectly elastic branch at the level of eIM. The market rate will only sink below this value temporarily, at best. e [RM/USD]

eL = 4.20 eIM = 4.10 D [USD]

52


If we plug (2.42) into (2.41a) we receive the upper bound, also called the gold export point: (2.44) eEX = eL + t = 4.20 + 0.10 = 4.30 For all values at or beyond eEX it is no longer profitable to sell dollars on the market and buy dollars at the Federal Reserve together with the corresponding costs of exporting gold out of Germany. Arbitrage that results in a decreasing market rate only occurs for rates beyond or above eEX: arbitrage, at best, will cause the rate to sink to eEX. However, arbitrage takes place in unlimited amounts, which results in arbitrageurs supplying dollars in unlimited amounts at rates above eEX. The next diagram depicts this situation by drawing the supply curve for foreign exchange with an infinitely elastic branch at the value of eEX. Note that because of this, the market rate cannot rise above the upper gold point eEX. e Dd eEX eL

eIM Ds D

53


2.4.1.4 Evaluating the Gold Standard As indicated in figure 2.4, the Gold Standard had its heyday between 1870 and 1914. (1) Advantages According to Jarchow/Rühmann [(1997), pp. 32 n], this period was characterized by the following key features:

− constant exchange rates over the whole period − little control (rationing) of foreign currency holdings and transactions,

few import controls − relatively few holdings of official international reserves.

Jarchow/Rühmann conclude that there were no disequilibria in the FX market worth mentioning. This implies that, likewise, there were no strong fluctuations of international reserve holdings. Obviously, the Gold Standard provided for “automatic” external adjustment mechanisms that prevented serious balance-of-payments disequilibria. In addition, the national price levels were relatively stable; see Marrewijk (2007), p. 470.

54


(2) Disadvantages Marrewijk points to the following drawbacks:

− The money supply of each country, but also of the system as a whole

depended on the availability of gold:

(i) on the one hand, discoveries of gold were random and could thus cause random increases of national price levels

(ii) on the other hand, a lack of new gold prevented increases in

the supply; in a growing economy, this tends to create deflationary pressures

− large gold-producing countries can influence the world economy by

selling (or not selling) gold − with respect to the “trilemma”, the Gold Standard implies that

monetary policy cannot pursue internal national targets. 2.4.2 The International Monetary System in the War and Inter-War Periods

Marrewijk (2007), pp 470 - 472 2.4.3 The Bretton-Woods System: a Gold-Dollar Standard

Marrewijk (2007), pp 472 - 474 2.4.4 “Modern Times”: (More or less) Floating Rates

Marrewijk (2007), pp 474 – 476 plus § 10 from “Monetäre Außenwirtschaftstheorie und -politik”

55


2.5 Exchange Rate Policy of the Euro System (1) Foundations

− Common currency:

o Article 3, paragraph 4, Treaty on EU (henceforth TEU): “The Union shall establish an economic and monetary union whose currency is the euro.”

o Article 3, paragraph 1 (c), Treaty on the Functioning of the EU (henceforth TFEU): “The Union shall have exclusive competence in the following areas: (…) (c) monetary policy for the Member States whose currency is the euro (…).”

� Nominal exchange rates between Member States disappear and

a common stance towards third states must be acquired.

− Title VIII on ‘Economic and Monetary Policy’ of the TFEU establishes

in Article 119, paragraph 2 the Union’s single exchange rate policy:

… as provided in the Treaties and in accordance with the procedures set out therein, these activities shall include a single currency, the euro, and the definition and conduct of a single monetary policy and exchange-rate policy …

(2) Goals Article 119, paragraph 2 also puts forth the goals of the Union’s exchange rate policy:

… the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Union, in accordance with the principle of an open market economy with free competition.

See also Article 127 TFEU on ‘Monetary Policy’.

56


(3) Decision-Making Competency Regarding the Exchange-Rate Regime:

Article 219 TFEU Decision-making authority related to the establishment of the euro area’s exchange-rate arrangement lies in the hands of the Council of Ministers, not the European System of Central Banks!! (a) Formal Agreements on an Exchange-Rate System in Relation to the

Currencies of Third States: Article 219, paragraph 1

− Unanimously after consulting the European Parliament

− Either on a recommendation from the ECB or on a recommendation from the Commission and after consulting the ECB

− In an endeavor to reach a consensus consistent with the objective of

price stability

(b) Adoption, Adjustment, or Abandonment of Euro Central Rates:

Article 219, paragraph 1


− In an endeavor to reach a consensus consistent with the objective of

price stability

(b) Formulation of General Orientations for Exchange-Rate Policy:

Article 219, paragraph 2

− In the absence of an exchange-rate system in relation to one or more currencies of third States


− Must be without prejudice to the primary objective of the ESCB to

maintain price stability

57


(4) Conduct of Foreign-Exchange Operations = basic task of the ESCB (according to Article 127, paragraph 2,

second indent)

− In a system of fixed exchange rates: interventions − In a system of flexible exchange rates: mostly free to act individually,

since potential ‘orientations’ provided by the Council are ex definitione not binding

(5) Exchange Rate Mechanism II This section draws on Baldwin / Wyplosz (2006), pp. 482 - 485. The purpose of the Exchange Rate Mechanism II (ERM II) is to limit fluctuations in the exchange rates between the euro area Member States and the currencies of countries in the European Union that have not yet adopted the common monetary unit. The idea is to…

− …prohibit excessive nominal and real exchange rate movements between Member States and

− …foster an orderly economic environment in the single market. Participation is optional, but States that have applied for membership to EMU are expected to join. Currently (October, 2011), the following Member States are part of the ERM II: Denmark, Lithuania, and Latvia (Sweden and Great Britain have decided not to participate). Latest information can be found, for example, in the German Bundesbank’s “Statistical Supplement 5: Exchange Rate Statistics”, which is published each quarter and contains a chapter on “Central rates and intervention rates in ERM II”.

58


The ERM II consists of the following:

o Central exchange rate between the euro and the respective currency + a standard fluctuation band (for most participating countries +15%, for Denmark the band is +2,25%).

o Both the respective State and the ECB are obligated to intervene

once the limits of the fluctuation margins are reached. o They may intervene beforehand (so-called ‘intramarginal

interventions’) to prevent reaching the upper or lower band.

Limitations of the obligation to intervene in the FX market:

o No obligation to intervene if interventions would endanger price

stability.

o Central bank credits that have been granted among central banks for intervention purposes must be paid back no later than eight months after credit has been extended.

Date post:	22-May-2020
Category:	Documents
Upload:	others
View:	2 times
Download:	0 times

1 Part 1 : Some Fundamentals of Foreign Exchange Markets ...- bank balances which can be drawn at...

Documents