Transcript The Spot Market for Foreign Exchange Market Characteristics: An Interbank Market • The spot market is a market for immediate delivery 92 to 3

The Spot Market for
Foreign Exchange
Market Characteristics:
An Interbank Market
• The spot market is a market for immediate
delivery 92 to 3 days).
• Primarily an interbank market, which is the
trading of foreign-currency-denominated
deposits between large banks.
• Approximately $US2 trillion daily in global
transactions.
Market Quotes: The WSJ
Currency Trading Table
• Provides spot and forward rates. Forward rates
are for forward contracts, or the future delivery of
a currency.
• US $ equivalent is the dollar price of a foreign
currency (home currency price of a foreign
currency).
• Currency per US $ is the foreign currency price of
one US dollar (foreign currency price of the home
currency)
Market Quotes:
Direct - Indirect Quotes
• The home currency price of a foreign
currency is called ?
• The foreign currency price of the home
currency is called?
Market Quotes:
Direct - Indirect Quotes
• The home currency price of a foreign
currency is called a direct quote.
• The foreign currency price of the home
currency is called?
Market Quotes:
Direct - Indirect Quotes
• The home currency price of a foreign
currency is called a direct quote.
• The foreign currency price of the home
currency is an indirect quote.
• Dollars & Yen? Dollars & pounds?
Appreciating and
Depreciating Currencies
• A currency that has lost value relative to
another currency is said to have ?
• A currency that has gained value relative to
another currency is said to have ?
Appreciating and
Depreciating Currencies
• A currency that has lost value relative to
another currency is said to have depreciated.
• A currency that has gained value relative to
another currency is said to have appreciated.
• These terms relate to the market process and
are different from devaluation and
revaluation.
Appreciating and
Depreciating Currencies
• We use the percentage change formula to
calculate the amount of
depreciation/appreciation.
• Example, on Monday, the peso traded at
0.1021 $/P. On Tuesday the market closed
at 0.1025 $/P.
• The peso has appreciated, as it now takes
more $ to purchase each peso.
Appreciating and
Depreciating Currencies
• Example, on Monday, the peso traded at
0.1021 $/P. On Tuesday the market closed
at 0.1025 $/P.
• The amount of appreciation is:
[(0.1025 - 0.1021)/0.1021] * 100 = 0.39%
1.0039
414%
142%
Bid - Ask Spreads:
Example from Financial Times
• The bid is the price the bank is willing to
pay for the currency, e.g., 1.2002 $/€ is the
bid on the euro in terms of the dollar.
• The ask is what the bank is willing to sell
the currency for, e.g. 1.2010 $/€, is the ask
on the euro in terms of the dollar.
Bid - Ask Spread:
Cost of Transacting
• The bid - ask spread of a currency reflects, in
general, the cost of transacting in that currency.
• It is calculated as the difference between the ask
and the bid.
• Example, 1.2020 - 1.2002 = 0.0018.
Bid - Ask Margin:
Percent Cost of Transacting
• The bid - ask spread can be converted into a percent
to compare the cost of transacting among a number
of currencies.
• The margin is calculated as the spread as a percent
of the ask.
• (Ask - Bid)/Ask * 100
• Example, (1.2020 - 1.2002)/1.2020 * 100 = 0.15%.
Cross-Rates: Unobserved Rates
• A cross-rate is an unobserved rate that is
calculated from two observed rates.
• For example, the spot rate for the
Canadian dollar is 0.70 $/C$, and the spot
rate on the euro is 1.02 $/€. What is the
Canadian dollar price of the euro (C$/€)?
Cross-Rates: Unobserved Rates
• A cross-rate is an unobserved rate that is
calculated from two observed rates.
• For example, the spot rate for the
Canadian dollar is 0.70 $/C$, and the spot
rate on the euro is 1.02 $/€. What is the
Canadian dollar price of the euro (C$/€)?
• Note that ($/€)/($/C$) =
($/€)*(C$/$)=C$/€.
• In this example, 1.02/0.70 = 1.457 C$/€.
Arbitrage:
Consistency of Cross Rates
• Arbitrage is the simultaneous buying and
selling to profit (as opposed to speculation).
• The ability of market participants to
arbitrage guarantees that cross rates will be,
in general, consistent.
• If a cross rate is not consistent, the actions
of currency traders (arbitrage) will bring the
respective currencies in line.
Spatial Arbitrage
• Spatial Arbitrage refers to buying a
currency in one market and selling it in
another.
• Price differences arise from geographical
(spatial) dispersed markets.
• Due to the low-cost rapid-information
nature of the foreign exchange market,
these prices differences are arbitraged away
quickly.
Triangular Arbitrage
• Triangular arbitrage involves a third
currency and/or market.
• Arbitrage opportunities exist if an
observed rate in another market is not
consistent with a cross-rate (ignoring
transaction costs).
Triangular Arbitrage: An Example
• The British pound is trading for 1.455 ($/£)
and the Thai baht for 0.024 ($/b) in New
York, while the Thai baht is trading for 0.012
(£/b) in London.
• Does an arbitrage opportunity exist?
Triangular Arbitrage: An Example
• The British pound is trading for 1.455 ($/£)
and the Thai baht for 0.024 ($/b) in New
York, while the Thai baht is trading for 0.012
(£/b) in London.
• The cross-rate in New York is:
0.024/1.455 = 0.016 (£/b)
• Hence, an arbitrage opportunity exists.
Triangular Arbitrage: An Example
• The British pound is trading for 1.455 ($/£)
and the Thai baht for 0.024 ($/b) in New
York, while the Thai baht is trading for 0.012
(£/b) in London.
• The cross-rate in New York is:
0.024/1.455 = 0.016 (£/b)
• Hence, an arbitrage opportunity exists.
• How do you exploit it?
Example Continued
• “Buy low, sell high.”
• A trader with $1, could buy £0.687 in
New York.
• The £0.687 would purchase b57.274 in
London.
• The b57.274 purchases $1.375 in New
York, or 37.5% profit on the transaction.
Real Exchange Rates:
Measuring Relative
Purchasing Power
Real Exchange Rates
Real Measures
• Nominal variables, such as exchange
rates, do not consider changes in prices
over time.
• Real variables, on the other hand,
include price changes.
• A real exchange rate, therefore, accounts
for relative price changes.
Real Exchange Rates
• A nominal exchange rate indicates the purchasing
power of one nation’s currency over the currency
of another nation.
• Real exchange rates indicate the purchasing power
of a nation’s residents for foreign goods and
services relative to their purchasing power for
domestic goods and services.
• A real exchange rate is an index. Hence, we
compare its value for one period against its value
in another period.
Real Exchange Rates
An Example
• In 2000 the spot rate between the dollar and the
pound was 1 USD = 0.6873 GSB (£/$).
• Yesterday the rate was 1 USD = 0.5100 GBP.
• Hence, the pound appreciated relative to the dollar
by 26 percent {[(0.5100-0.6873)/0.6873]*100}.
• Based on this alone, the purchasing power of US
residents for British goods and services (relative to
US goods and services) fell by 26 percent.
Example: Continued
• Suppose in 2000 the British CPI was 156.4 and the
US CPI was 154.7. In early 2006, the CPI’s were
170.5 and 172.7 respectively.
• Based on this, British prices rose 9.0 percent while
US prices rose 11.6 percent, a 2.6 difference.
• Since the prices of British goods and services rose
slower than the prices of US goods and services,
there was an increase in purchasing power of
British goods and services relative to the
purchasing power of US goods and services.
Combining the Two Effects
• A real exchange rate combines these two effects the fall in purchasing power of US residents due to
the nominal appreciation of the pound and the gain
in relative purchasing power due to British prices
rising at a slower rate than US prices.
• To construct a real exchange rate, the spot rate, as
it is quoted here, is multiplied by the ratio of the
US CPI to the UK CPI.
(£/$) x (US CPI/UK CPI)
Combining the Two Effects
• 2000 Real Rate = 0.6873 x (154.7/156.4) =
0.6798
• 2007 Real Rate = 0.51 x (172.7/170.5) =
0.52.
• The real appreciation of the pound was only
24 percent.
Conclusion
• The nominal exchange rate change resulted in a 26
percent fall in the purchasing power of US
residents for UK goods and services.
• The difference in price changes resulted in a 2.6
percent gain in purchasing power of UK goods
and services relative to US goods and services for
US residents.
• Consequently, the 26 percent rise was offset by the
2.6 gain, resulting in an overall 24 percent loss in
purchasing power.
Effective Exchange Rate
A measure of the general value of a
currency.
Effective Exchange Rate
• On any given day, a currency may appreciate in
value relative to some currencies while
depreciating in value against others.
• An effective exchange rate is a measure of the
weighted-average value of a currency relative to a
select group of currencies.
• Thus, it is a guide to the general value of the
currency.
Weighted Average Value
• To construct an EER, we must first pick a
set of currencies we are most interested in.
• Next, we must assign relative weights. In
the following example, we weight the
currency according to the country’s
importance as a trading partner.
Weights
• Suppose that of all the trade of the US with
Canada, Mexico, and the UK, Canada
accounts for 50 percent, Mexico for 30
percent, and the UK for 20 percent.
• These constitute our weights (0.50, 0.30,
and 0.20).
• Now consider the following exchange rate
data.
Exchange Rate Data
Today
Year Ago
$C
1.44
1.52
P
9.56
10.19
£
0.62
0.61
Calculating the EER
• The EER is calculating by summing the
weighted values of the current period rate
relative to the base year rate.
• The weighted-average value is calculated
as:
(weight i)(current exchange value i)/(base exchange
value i)
where i represents each individual country
included in the weighted average.
Calculating the EER
• Commonly this sum is multiplied by 100 to
express the EER on a 100 basis.
• Hence, an EER is an index.
• As we shall see next, the base-year value of
the index is 100.
• The index, therefore, is useful is showing
changes in the weighted average value from
one period to another.
Example
• Let last year be the base year.
• The effective exchange rate last year was:
[(1.52/1.52)*0.50 + (10.19/10.19)*0.30
+ (0.61/.61)*0.20]*100
= 100.
• As with any index measure, the base year
value is 100.
Example
• Today’s value of the EER is:
(1.44/1.52)*0.50 + (9.56/10.19)*0.30
+ (0.62/0.61)*0.20
• or (0.958) 95.8
• The dollar, therefore, has experienced a 4.2
percent depreciation in weighted value.
Effective Exchange Measures
• There are a number of effective exchange
measures available in the popular press.
Some common measures are:
• Bank of England Index: The Economist.
• J.P. Morgan: The Wall Street Journal and
the Financial Times.
180
160
United States
140
120
United Kingdom
100
80
Japan
60
40
20
0
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
19
00
20
Purchasing Power Parity
Purchasing Power Parity
Absolute or the Law of One Price
• Suppose The Economist magazine sells for
£2.50 in the UK and $3.95 in the US.
• Arbitrage, therefore, should guarantee that the
exchange rate between the dollar and the pound
be s = 3.95/2.50 = 1.580 ($/£).
• In words, the dollar price of The Economist in
the UK should equal the dollar price of the
Economist in the US (ignoring transportation
costs).
Absolute PPP
• Absolute PPP is expressed as P = P*×S,
where P is the domestic price, P* is the
foreign price, and S is the spot rate,
expressed as domestic to foreign currency
units.
• Often it is rearranged as: S = P/P*.
Absolute PPP as a Guide to
Exchange Values
• Suppose the actual spot rate pertaining to
the previous example is 1.7743 whereas
PPP says the rate should be 1.580.
• A difference exists so we can conclude (for
instructional purposes) that the pound is
overvalued relative to the dollar.
• In percentage terms (1.580 - 1.7743)
/1.7743 x 100 = -11 percent.
Relative PPP - A Weaker Version
• Rearrange APPP to S = P/P*.
• Divide one period equation by another period,
e.g., S1/S0= (P1/P0)/(P*1/P*0)
• Rearrange as: S1 = S0(P1/P0)/(P*1/P*0)
• Can be used as a “model” of exchange rate
movements.
• Note that the emphasis is on exchange rate
movements, not levels, though it may appear
otherwise.
Example
• Suppose the exchange rate between the
dollar and the pound was 1.58 in 2000 and
is 1.77 today. Further, the UK CPI was 110
and is now 115, while the US CPI was 108
and is now 111.
• Plugging this into the formula we have
• st = (1.58) [(111/108)/(115/110)] = 1.55
• Hence the £ is overvalued (14%).
Another Expression
In words, domestic inflation less foreign
inflation should equal the change in the spot
rate.
Implies that the higher inflation country should
see its currency depreciate.
Interest Rates and
Currency Markets
Question of the day:
Why does investment capital flow
from some economies to others?
The MacDougall Diagram
of International Investment Flows
Model for understanding the interaction of supply of
and demand for investment capital in different
countries.
Provides us with a benchmark for interpreting crossborder capital movements.
Simple but quite useful - will be revisited later in
course.
Optimal International Investment
x-axis measures total capital
available for investment in a
country
O
Capital
Optimal International Investment
y-axis reflects the prevailing rate
of return per unit of capital
(i.e. per $) available in a
country.
r
(rate of
return)
O
Capital
Optimal International Investment
Then draw a line which reflects
the prevailing rate of return in
an economy, depending on the
total stock of capital.
r
(rate of
return)
O
Capital
Optimal International Investment
Why does the line slope
downward?
r
(rate of
return)
O
Capital
Optimal International Investment
If a country only has one unit
of capital, the rate of return
must be high.
r
(rate of
return)
O
Capital
Optimal International Investment
If a country only has one unit
of capital, the rate of return
must be high.
r
(rate of
return)
Lots of land, lots of
workers, little equipment,
few factories.
O
Capital
Optimal International Investment
r
(rate of
return)
As more capital is around
competing, land becomes scarce
and workers become expensive.
O
Capital
Optimal International Investment
r
(rate of
return)
If k is the total stock of
capital in a particular country
O
k
Capital
Optimal International Investment
r
(rate of
return)
Then r0 is the prevailing
interest rate in the economy.
r0
O
k
Capital
Optimal International Investment
r
(rate of
return)
The shaded area then
represents the economy’s
gross domestic product
(GDP).
r0
O
k
Capital
Optimal International Investment
Now consider a second country
with a different (better) schedule
of return possibilities...
r
(rate of
return)
O
k
Capital
Optimal International Investment
Now consider a second country
with a different (better) schedule
of return possibilities...
r
(rate of
return)
O
k
Capital
Optimal International Investment
a lower supply of capital...
r
(rate of
return)
O
k
k
Capital
Optimal International Investment
a lower supply of capital...
r
(rate of
return)
O
k
Capital
Optimal International Investment
and therefore a higher
prevailing interest rate.
r
(rate of
return)
r0
O
k
Capital
Optimal International Investment
r
(rate of
return)
Denoting variables of this
second (call it ‘foreign’)
country with asterisk.
r0*
O*
k*
Capital
We then can take this graph
and flip it around.
r
(rate of
return)
r0*
O*
k*
Capital
We then can take this graph
and flip it around.
r
(rate of
return)
r0*
k*
Capital
O*
Then add the graph of the
original country (home country).
r
(rate of
return)
r0*
k
k*
Capital
O*
How far over do we bring it?
r
(rate of
return)
r0*
r0
O
k
k*
Capital
O*
Until the length of the horizontal axis represents the
total quantity of capital in the two economies...
r
(rate of
return)
r0*
r0
O
k
k*
Capital
O*
So that the length from 0 to k0 is the amount
of capital in the domestic economy...
r
(rate of
return)
r0*
r0
O
k0
Capital
O*
So that the length from 0* to k0 is the amount
of capital in the foreign economy...
r
(rate of
return)
r0*
r0
O
k0
Capital
O*
Now what happens if both
countries allow capital to flow
freely between them?
r
(rate of
return)
r0*
r0
O
k0
Capital
O*
The owners of capital in the
home country are only
earning r0
r
(rate of
return)
r0*
r0
O
k0
Capital
O*
Whereas capital in the foreign
country is earning a higher
return of r0*
r
(rate of
return)
r0*
r0
O
k0
Capital
O*
So owners of capital in the
home country will begin to
move capital overseas...
r
(rate of
return)
r0*
r0
O
k0
Capital
O*
Shifting k to the left
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
Increasing the supply of
capital in the foreign country
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
Decreasing the supply of
capital in the home country
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
Increasing interest rates
in the home country
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
And decreasing the returns to
capital in the foreign country
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
When will the flows of capital
from the home to the foreign
country cease?
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
When incentives to transfer
capital no longer exist...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
When rates of return to capital
are equated: when r1 = r1*
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
This concept is know as:
Real Interest Parity
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
Question:
Which economy benefits from the
flow of capital?
The foreign country’s GDP
increases from this...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
to this.
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
The home country
loses some GDP...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
The home country
loses some GDP...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
But total world production has
now increased by this amount.
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
For use of the home country’s capital,
the foreign country pays r1* times the
amount borrowed.
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
GNP (which equals GDP + Overseas Income)
is therefore...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
So the home country GNP increases by...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
Similarly, after paying the
interest bill, the foreign
GNP increases by...
r
(rate of
return)
r0*
r1*
r1
r0
O
k1
k0
Capital
O*
Why Does Capital Flow?
According to the optimal investment analysis...
Whenever returns are different in two countries.
According to the Balance of Payments Equation...
It doesn’t have much choice.
That is, it must flow into any country that is importing more
than it is exporting.
How do we reconcile these two perspectives?
With changes in prices, returns, and exchange rates.
Key Points
1. MacDougall diagram can account for international
investment in a frictionless world.
2. It produces Real Interest Parity, which says that when
international capital markets are frictionless, real returns
are equated across countries.
3. Capital will flow from capital-rich countries with ordinary
returns to capital-poor countries with attractive
possibilities.
4. MacDougall analysis can account for shocks to capital
stock and technological shifts.
5. From a GNP standpoint, all countries benefit from
international capital mobility.
Key Points
6. MacDougall analysis is highly simplified - only a benchmark from
which to proceed.
7. Later in course we will introduce frictions (i.e. risk, taxes,
government intervention, etc.).
8. The Balance of Payments equation tells us that goods and capital
must flow together… or differences must be offset by government
intervention (resulting in changes in reserve levels).
9. Not always clear whether goods drive capital or capital drives goods
(i.e. are residents of one country demanding too much consumption
or are foreigners too eager to invest).
10. Adjustments in prices, exchange rates, and returns will be important
for balancing the balance of payments.
The Monetary Base and the
Money Stock
Example: US Capital Inflows, Sony, and
Ford (1997-1998)
January 1997:
- Yen/$ exchange rate reaches 115 - a 45-month high.
- DJIA finishes 1996 up 26%, fueled by near-record $142
billion US
capital account inflows.
- Sony announces they will halt production of Playstation
home-video
game in the U.S. and shift it back to
Japan.
Example: US Capital Inflows, Sony, and
Ford (1997-1998)
January 1997:
- Yen/$ exchange rate reaches 115 - a 45-month high.
- DJIA finishes 1996 up 26%, fueled by near-record $142 billion US
capital account inflows.
- Sony announces they will halt production of Playstation home-video
game in the U.S. and shift it back to Japan.
January 1998:
- Yen/$ exchange rate reaches 133.6 - a 5.5 year high.
- US capital account expands to $157 billion as weak Asian currencies
prompt a flight to dollar deposits.
- Ford announces plans to build autos in Japan for export.
Central Bank Functions
•
•
•
•
Fiscal Agents
Bankers’ Bank
Lenders of Last Resort
Macroeconomic and Monetary Policy
Makers
– Exchange market intervention
– Monetary policy
The Monetary Base
• A nation’s monetary base can be measured
by viewing either the assets or liabilities of
the central bank.
• The assets are domestic credit (DC) and
foreign exchange reserves (FER).
• The liabilities are currency in circulation
(C) and total reserves of member banks
(TR).
Simplified Balance Sheet of the
Central Bank
Assets
Liabilities
Currency
(C)
Domestic Credit
(DC)
Foreign Exchange Total Reserves
Reserves (FER)
(TR)
Monetary Base Monetary Base
(MB)
(MB)
Money Stock
• There are a number of measures of a
nation’s money stock (M).
• The narrowest measure is the sum of
currency in circulation and the amount of
transactions deposits (TD) in the banking
system.
Money Multiplier
• Most nations require that a fraction of
transactions deposits be held as reserves.
• The required fraction is determined by the
reserve requirement (rr).
• This fraction determines the maximum
change in the money stock that can result
from a change in total reserves.
Money Multiplier
• Under the assumption that the monetary
base is comprised of transactions deposits
only, the multiplier is determined by the
reserve requirement only.
• In this case, the money multiplier (m) is
equal to 1 divided by the reserve
requirement,
m = 1/rr.
Relating the Monetary Base and
the Money Stock
• Under the assumptions above, we can write
the money stock as the monetary base times
the money multiplier.
M = mMB = m(DC + FER) = m(C + TR).
• Focusing only on the asset measure of the
monetary base, the change in the money
stock is expressed as
M = m(DC + FER).
Example - BOJ Intervention
• Suppose the Bank of Japan (BOJ)
intervenes to strengthen the yen by selling
¥1 million of US dollar reserves to the
private banking system.
• This action reduces the foreign exchange
reserves and total reserves component of the
BOJ’s balance sheet.
BOJ Balance Sheet
Assets
DC
Liabilities
C
FER
-¥1 million
TR
-¥1 million
MB
-¥1 million
MB
-¥1 million
BOJ Intervention
• Because the monetary base declined, so will
the money stock.
• Suppose the reserve requirement is 10
percent. The change in the money stock is
M = m(DC + FER),
M = (1/.10)(-¥1 million) = -¥10 million.
Exchange Rate Intervention
Why do governments attempt to fix exchange rates?
Why do governments attempt to fix prices?
1. They think ER volatility is destabilizing - that by
removing volatility they will be making people
better off.
2. Like any other price fix (i.e. U.S. sugar supports),
ER fixes are a political tool. They subsidize one
group at the expense of others.
3. To signal intentions.
How to Fix Exchange Rates
How can a government fix an exchange rate?
The same way a government fixes any other price:
1. By controls (much like U.S. price controls in early
1970s). Make trade at a different price illegal.
2. By intervention in the market (much like sugar).
By committing to buy/sell at a certain price.
1. Exchange Rate Controls
Recall our original supply-demand graph
for exchange rate determination…
$/Peso
Supply
s
Demand
Quantity of Pesos
1. Exchange Rate Controls
If demand for Argentine pesos decreases...
$/Peso
Supply
s
Demand
Quantity of Pesos
1. Exchange Rate Controls
But the Argentine Banco Central makes exchanges of FX
illegal at any rate other than s...
$/Peso
Supply
s
Demand
Quantity of Pesos
1. Exchange Rate Controls
Dollars will be rationed - there will be excess
supply of pesos (demand for $) at the fixed
exchange rate of s...
$/Peso
Supply
s
Demand
Quantity of Pesos
1. Exchange Rate Controls
A black market will invariably emerge which trades
pesos at a discount relative to the fixed rate.
$/Peso
Supply
s
sb
Demand
Quantity of Pesos
Example: The Uzbek Sum
In 1996, the Uzbek central bank fixed the exchange
rate at an overvalued level of $0.02 / Sum:
• Imports were cheap; exports expensive;
imports rose by 50% in 1996; exports were down.
• The central bank started running short of reserves.
• Daewoo and British American Tobacco
experienced delays in converting Sum revenues.
• Black market exchange rate began falling steadily.
• In October, the Central bank canceled all
conversion licenses and handed out dollar quotas.
Example: The Uzbek Sum
• The government banned the use of dollars inside
Uzbekistan.
• Inflation soared.
• The black market rate fell to $0.0074 / Sum.
• Foreign investment inflows dried up - decreasing
Sum demand further.
2. Exchange Rate Intervention
Central Bank Balance Sheet
(Domestic
DA
Assets/
C
(Currency)
R
(Reserves of
Commercial Banks)
Bonds)
(Foreign Assets
of Central Bank)
FACB
2. Exchange Rate Intervention
Central Bank Balance Sheet
(Domestic
DA
Assets/
C
(Currency)
R
(Reserves of
Commercial Banks)
Bonds)
(Foreign Assets
of Central Bank)
FACB
H (High Powered Money)
Accounting Identity: DA + FACB = H
2. Exchange Rate Intervention
To insure that the exchange rate remains at a constant
level, the central bank must purchase/sell FX to ensure
supply intersects demand at the appropriate price:
$/Peso
Supply
s
Demand
Quantity of Pesos
2. Exchange Rate Intervention
Suppose the central bank is trying
to target an exchange rate of s.
$/Peso
Supply
s
Demand
Quantity of DM
2. Exchange Rate Intervention
What happens if demand for
Pesos increases?
$/Peso
Supply
s
s
Demand
Quantity of Pesos
2. Exchange Rate Intervention
Unless something is done, the
exchange rate will appreciate to s.
$/Peso
Supply
s
s
Demand
Quantity of Pesos
What should the Central Bank Do?
3 Options:
1. Discourage capital inflows. Curb demand.
Example: Chile.
Option 1. Discourage Inflows
Enact policies which curb demand for
peso (i.e. ‘Tobin Taxes’) and push
intersection back to original level.
$/Peso
Supply
s
s
Demand
Quantity of Pesos
Option 2: Unsterilized Intervention
Banco Central offers sufficient peso supply
in the FX market to meet demand at s
$/Peso
Supply
s
s
Demand
Quantity of Pesos
Option 2: Unsterilized Intervention
What does this mean for the Central Bank’s
balance sheet? They supply Pesos for $.
Reserves of $ will increase:
 FACB > 0
Since the central bank is selling Pesos, the
supply of currency must increase too: