International Finance Unit 4

Floating Rate

Value of the currency is left to be determined freely in the forex market without any restrictions or interventions by monetary authorities

2 Types of Floating Rates

1. Dirty Floating: almost all countries intervene sometimes, so this is more appropriate name

2. Managed Floating: when interventions are not uncommon, IMF classifies the system as managed

Fixed Rates

monetary objective intervenes in order to the exchange rate of their currency at a particular revel

Conventional Pegs

fixed at a particular level

Stabilization Arrangements

Fixed within some upper and lower limits that are adjusted regularly

Crawling Pegs

Take into account inflation differentials to let the currency depreciate slowly

No National Tender

the country adopts the currency of another country, importing both the money and its monetary policy

• country loses income from seniorage

• can happen oficially or unofficially

Goal of the Central Bank

increase the monetary base in the economy in parallel with the growth rate of the economy

Monetary Base

the liabilities of the central bank

1. currency in circulation: coins and bills used by the public

2. required reserves

Domestic Interventions by the CB

• Stimulating growth and lowering unemployment

• Decrease the burden of deficits by monetizing public debt

Stimulating Growth and Lowering Unemployment

• Long run: Money is neutral → faster money growth only causes inflation.

• If inflation is perfectly anticipated: Not harmful.

• Short run (price rigidity): More money → higher consumption → firms hire more → temporary boost in output and employment.

• Risk: Repeated use raises inflation expectations, harming investment and real growth.

• Typical tool: Lowering the interest rate at which the CB lends to banks (not directly printing money).

Monetizing Public Debt

• CB prints money to buy government bonds → reduces government’s deficit burden.

• More common when CB lacks independence.

• Leads to:

  • Inflation expectations

  • Investor distrust → higher cost of government debt

Non-Sterilized Interventions (Forex)

To depreciate the domestic currency, the CB buys foreign currency from a domestic bank and credits the bank reserves

• this increases the base of money and decreases the interest rate

Sterilized interventions

Non-sterilized interventions are complemented by the sale of domestic bonds to another domestic bank → the bank pays, buys reducing its holding of domestic currencies, increases the interest rate by creasing base of money and demand for public debt

Central Banks Policy Trilemma

in an open economy, only two of the three following objectives can be achieved at the same time

1. Perfect Capital Mobility

2. Fixed Exchange Rate

3. Monetary Authority: freedom to change interest rate

Direct Effects of Interventions

• very small

• seen as a drop in the ocean compared to total transactions in forex trading, total country money supply, and total bond portfolio of banks

Indirect Effects of Interventions

• more important

• signaling effect: conveys credible information about the CB’s assessment of expected LT exchange rate or economic growth

Benefits of Fixed Exchange Rates

1. stability

2. discipline

Stabilit

• Floating regimes create more uncertainty for exporters/importers, but this risk is cheap to hedge in forex derivatives markets.

• Fixed regimes look stable, but stability is illusory: they have rare, sudden, and large adjustments (Klein & Shambaugh, 2008).

• Even the EMU—most credible fixed system—still carries non‑zero risk

Discipline

• With a fixed exchange rate and free capital flows, the monetary policy trilemma prevents the CB from controlling its money base.

• If the country creates inflation, its exports lose competitiveness → the regime imposes discipline.

• Extending domestic credit becomes more costly under a fixed rate.

• Effectiveness depends on the credibility and independence of the central bank.

• To strengthen credibility, some countries use a Currency Board to manage foreign exchange interventions instead of the CB.

European Monetary Union (The EMU)

the most successful fixed exchange rate system

The Maastricht Treaty

5 criteria that countries had to satisfy to join the monetary union

1. inflation within 1.5% of best three performing states

2. interest rate on long term government bonds within 2% of the best three inflation performing states

3. Budget deficit of less than 3% fo GDP

4. Government debt of less than 60% of GDP

5. No devaluation in the past two year

The Road to EMU

• Phase I: all remaining restrictions on capital movements and payments across member states removed

• Phase II: required independence of CBs, forbidding of monetary financing of budget deficits

• Phase III: the European Central Bank and the national central banks free to conduct coordinated monetary and exchange rate policy for the euro with the objective of maintaining price stability

Optimum Currency Areas

1. Asymmetric shocks are expected to be rare (similar industry structures)

2. Capital and labor can move freely

3. Countries must be prepared to balance budgets and make economic reforms that can be unpopular in the short term

4. Central Fiscal Authority has the power to make transfers across regions

Supporting Arguments for EMU

• price convergence

• lower cost of capital

• increase trade and economic growth