exchange rate regimes fixed exchange rate tri...

Exchange Rate RegimesFixed exchange rate

Tri-lemma

International MacroeconommicsChapter 4: Exchange Rate Regimes and the Tri-lemma

Instructor: Yuan Liu

Department of Economics, UCDavis

Instructor: Yuan Liu CH3


Tri-lemma

Outline

1 Exchange Rate Regimes

2 Fixed exchange rate

3 Tri-lemma



Tri-lemma

Exchange rate regime: Different Patterns of exchange ratebehavior.Two major types:

Floating/Flexible exchange rate regimeA government allows market forces in the foreignexchange market to determine the exchange rate.Exchange rate fluctuates in a wide range

Fixed/Pegged exchange rate regimeA government intervenes in the foreign exchange marketto make the equilibrium value of the exchange rate equalsome desired value.Exchange rate fluctuates in a a very narrow range (ornot at all) against some base currency.



Tri-lemma

In practice, annual variation of exchange rate within 2% iscategorized as fixed exchange rate regime.

Band a tiny variation around the fixed exchange ratelevel is allowed.7.44 Denmark krone/euro, 2% variation around7.44 is allowed.

Crawl not target at the level of exchange rate, but therate of change of exchange rate.currency steadily appreciates/depreciates at aconstant rate.

Crawling peg: a simple trendCrawling band: a tiny variation about thetrend is allowed.



Tri-lemma

Currency union A single central bank for the member nations.European Union; Eastern Caribbean CurrencyUnion; CFA Franc Zones; CFP Franc Zones.

Dollarization Adopt the currency of another country.Popular choices: US dollar, New zealand dollars,Australian dollars.

nation is two small to operate its ownmonetary system.poor record of managing its own monetaryaffairs.



Tri-lemma



Tri-lemma

Outline



3 Tri-lemma



Tri-lemma

Study the polar cases: tight fixing and free floatingFree floating: theories of exchange rate determination,the overshooting theory.Tight fixing: theories of exchange rate determination arestill useful to understand the fixed exchange rate.



Tri-lemma

How does a country fix its exchange rate against some basecurrency?

The central bank maintains a commitment to always bewilling to trade national currency for foreign currencywith anyone at the official rate.This means the central bank must satisfy the extrademand of foreign currency (home currency overvalued)or take the extra supply of foreign currency (homecurrency undervalued).



Tri-lemma

Ekr/euro = 7.44

Suppose there is extra demand of e(extra supply of krone).buy eusing krone at 7.44 krone per euro from the centralbank.Central bank sells e, take krone as payment.Krone in circulation decreases, money supply decreases inDenmark.Must have enough eto satisfy the extra demand. Enoughholdings of foreign reserves.



Tri-lemma

Ekr/euro = 7.44

Suppose there is extra supply of e(extra supply of krone).sell eto get krone at 7.44 krone per euro from the centralbank.Central bank buys e, pays krone.Krone in circulation increases, money supply increases inDenmark.Central bank accumulates e. Foreign reserves increases.



Tri-lemma

Outline



3 Tri-lemma



Tri-lemma

Central bank loses control over money supply by fix itsexchange rate at a certain level.Apply our model to the fixed exchange rate.

ikr = ieuro +E e

kr/euro − Ekr/euro

Ekr/euro

Under fixed exchange rate,E e

kr/euro−Ekr/euro

Ekr/euro= 0

ikr = ieuroDenmark pegs its currency to the euro. Its interest rateshould be the same as the euro interest rate.This means that monetary policy is out of the question.During recession, expansionary monetary policy increasesmoney supply thus decreases nominal interest rate. A lownominal interest rate stimulate investment thus help theeconomy recover. Under fixed exchange rate, this can notbe achieved.



Tri-lemma

Suppose Denmark increases nominal money supply to decreasenominal interest rate.

As nominal money supply in Denmark increases, nominalintereat rate in krone drops.This implies a lower return to krone assets than to euroassets at the fixed exchange rate between krone andeuruo.Trades sell krone to Denmark central bank to get euro atthe fixed rate.This means that the central bank is selling euro andtaking krone as payment. Money supply decreases.As money supply decreases, nominal interest rate in kroneincreases. Until money supply and nominal interest rateboth back to the initial level. Returns to krone assets areequal to returns to euro assets at the fixed rate. No morearbitrage transactions.



Tri-lemma

A way to avoid losing monetary policy autonomy underfixed exchange rate regime is ”capital control”.legally prevent traders from taking advantage of thearbitrage opportunities involving cross-border trades inassets

Conclusions: among the following three objectives:(1) exchange rate stability (fixed exchange rate)(2) monetary policy autony (set own monetary policyindependently)(3) capital mobility (no capital controls)only two are possible at one time. Called the tri-lemma.



Tri-lemma


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