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Chapter 12

International Financial Markets and Foreign Exchange Policy

Major World Currencies

The Big Three currencies are the dollar, the euro, and the yen. Active foreign exchange (forex) futures markets also exist for the British pound, Swiss franc, Canadian dollar, Australian dollar, and Mexican peso Cash forex markets exist for all currencies, but are unregulated markets among bankers instead of organized exchanges.

Trade-weighted indexes of the value of the dollar

The Fed prepares several indexes of the tradeweighted average of the dollar. The major distinctions are: Nominal or real Major-country index or broad index The real index accounts for differential rates of inflation. This is particularly important for countries where the inflation rate is very rapid. For the major-country index, it does not make much difference.

Purchasing Power Parity

In equilibrium, the value of the dollar would be at a level where the trade-weighted average cost of a market basket of traded goods is the same in the U.S. and the average of other economies. The same concept would hold for all currencies. Some components of costs are difficult to measure. However, a useful approximation can be obtained from average wage rates in manufacturing. The BLS prepares such tables.

Difficulties in Predicting Foreign Exchange Rates

Predicting forex rates is even more difficult than predicting interest rates and stock prices for several reasons. Expectations play an even more important role Central banks may intervene Values may remain far away from economic equilibrium for many years or even decades

Strategies for Fluctuating Forex Rates

In the short run, foreign currency exposure can be hedged. This isnt costless, but it does define and limit the risk In the long run, major trends in forex will help managers determine whether expansion should be made in the U.S. or abroad. In that sense, an understanding of the underlying trends determining forex rates is useful.

Determinants of Forex Rates

The principal factor has been and still remains the relative rates of inflation. If, for example, inflation averages 7% per year in Country A and 2% per year in Country B, in the long run, the currency of B will depreciate about 5% per year relative to A

Impact of the Trade Balance on Rates

Except for the U.S., the value of the currency will be correlated with the size of the current account balance. A surplus will boost the value of the currency; a deficit will reduce it. This doesnt hold for the U.S. because the world is on a de facto dollar standard.

Financial Determinants of Forex Rates

It is often claimed that high interest rates will boost the value of the currency. Actually, though, it is the expected rate of return on a weighted average of all assets that is the relevant variable. This includes short-term money market assets, bonds, stocks, and the rate of return on physical assets, or profits. Tax rates are also important, as is the free flow of capital.

Financial Determinants of Forex Rates, Slide 2

High nominal rates will not attract more foreign capital if they are due to higher inflation. The real rate must have also risen. If the stock market rises sharply, the value of the currency may increase even if real interest rates remain at low levels.

Expectations and Political Considerations

It used to be said that money moves to the right. Obviously foreign capital flees situations where revolutions or economic unrest are expected. In general, investors look for a pro-growth atmosphere regardless of the particular party in power. Credibility of the central bank to keep inflation low and stable is always important. In this sense, large deficits are worrisome only if they are funded by monetizing the debt.

The Dollar Bubble of the 1980s

The overvalued dollar was due primarily to the unprecedented 10% real rate of interest on U.S. Treasury bonds. In addition, the stock market was rising rapidly, profit margins were increasing, tax rates were cut, and the government was considered pro-business. When real interest rates returned to normal, the dollar returned to normal.

The Overvalued Japanese Yen

The Japanese yen remained severely overvalued from the late 1980s until the late 1990s, yet interest rates fell to zero, the stock market plunged 75%, and the economy entered an extended recession. Obviously financial factors did not keep the value of the yen high. In this case, Japan refused to allow imports to rise very much, and restricted inflows of foreign capital. Hence the current account balance remained in surplus. The Japanese ministers thought they were helping the economy, but in fact they were harming it.

The J-Curve Effect

The J-curve effect means that for a while, an increase (say) in the value of the currency is accompanied by an increase in the current account surplus, instead of the decline that would be expected. The situation usually is reversed after about a year, but in the interim, the normal stabilizing mechanism does not work.

The J-Curve Effect, Slide 2

The J-curve effect usually occurs because of the leads and lags in ordering, and habit persistence means it takes people a while to change their purchasing patterns. However, if a stronger currency leads to lower import prices, lower costs of production, and hence higher exports, the J-curve effect could continue indefinitely. That appears to be what happened in Japan.

Which is Better: Fixed or Flexible Exchange Rates?

There are advantages and disadvantages to both. Fixed rates reduce the cost of doing business and permit better planning for capital expenditures. Imagine how difficult it would be to do business in the U.S. if, for example, New York, Florida, Texas, and Ohio all had different currency values.

Fixed or Flexible, Slide 2

The key here, of course, is that all states in the U.S. have a common currency. If countries do not have a common currency, they are likely to have different rates of inflation. Thus if fixed rates remain in place under that circumstance, eventually there will have to be a major devaluation, which could cause a severe recession in one or more countries.

Fixed or Flexible, Slide 3

The collapse of the Korean won, Thai baht, Indonesian rupee, and Malaysian ringgit in the late 1990s indicates what happens when countries remain on fixed exchange rates with the dollar but have a higher rate of inflation than the U.S. From an economic viewpoint, the optimal solution would be a single world currency. The Europeans have moved in that direction. So far, though, the political realities dictate that there will be many different currencies indefinitely.

Optimal Trade and Forex Policies

If all major countries followed these rules, world real growth would be maximized, and the resulting trade surpluses or deficits in individual countries would be irrelevant. 1. Keep the value of the dollar and other key currencies near their trade-weighted purchasing power parity equivalent.

Optimal Policies, Slide 2

Balance the budget at full employment and maintain a credible monetary policy Reduce tax rates that will encourage saving and investment within the confines of the above condition. Continue to advocate free trade practices around the world.