Lecture 7

Asset theory

-Exchange rate adjusts to eliminate the motive to shift assets between currencies

-Penson Fud Tuleva in Estonia, idea that no fund managers needed--> investments to index funds. Remember BlackRock fund

-markets highly rational, consumers invest money according to where the expected higher return is

-Warren Buffet investment strategy: Investment into undervalued assets

- 2 ways to think: Prices already reflect the through value (perfect markets) or Price are not in the equilibrium and some are undervalued. 

 

Supply and Demand model of the market for Foreign Exchange 

Foreign exchange than foreign currency. Nit the marker for holding currency such as studied in some courses eg the Money Market. 

- Example  Price of E= Exchange rate, Quantity of Euro

-Sources of supply of E

- US exports to EU and gets payment in Euros. , US Capital inflows.. US investors buy US bonds etc...Other...

Sources of Demand for E

-US imports, US capital outflows

Use of the model- price in the diagram E= price of the foreign exchange, E= S/Eur--> DOLLAR in the Y axis--> change in demand for Eur re

-Implications of the model

Nixon 10% surcharge on imports--> reduces demand for imports and demand for Eur, shifts dEur to the left--> causes dollar to appreciate

US interest rates increase

--> US bonds more attractive, causes increased capital inflow to US, increased demand for  S and thus supply of Eur -> shifts Supply of Eur right

 

Pegging the exchange rate

- fixed or floating exchange rates

-Central bank buys and sells currencies so that supply and demand are not perfect in the market

PEGGING meaning

- central banks set a par value, intervene only if rate moves some distance above or below this par value--> this range of movement is called an exchange rate band

-Manager float-does not try to set new target to the exchange rate, but to slow its rate of change. Purpose: to dampen fluctuations.

-Crawling peg-slow and predictable

Who pegs?

-developing counties, Brazil float Argentina Pegged to US Dollar, Bulgaria pegged to euro, China pegged to the dollar until summer 05 and july 08 ot july 2010, Costa Rica crawling peg, India and Egypt managed float

-Money supply--> money in the circulation--> US bank buys EUr, Dollars to circulation and increase in money supply.As US sells the EUR dollars out of circulation and money supply decreases. 

-Reserve ratio:  how much money the banks need to keep in reserve to secure its functions. 

-Overvalued peg leads to a crisis, undervalued not

-US Dollar special case: many countries reserves are dollar-denominated assets, mostly US govt bonds--> if currencies kept undervalued, that means the dollar is overvalued 

-Americans benefit from the high dollar they can buy cheap food and services

-americans borrow in dollars in order to do it--> if other countries stopped lending for the US, the dollar would fall so would the value of US debt. 

The US DOllar vs Chinese Renminbi

-why US pressures China to appreciate yuan? to make it easier to sell US goods. 

-Levy argues: Tariffs against China won't work-> US will jsut switch to importing from other low-cost countries-> US trade deficit will be unchanged

---> Instead usa should reduce gov. spending. 

PEGGING vs FLOATING

China currency floating, USA expansion, the supply of dollar shifts right, more US imports from China, Yuan appreciates.

 

Fixed versus Floating Exchange Rates

-Pegged are more fixed and floating exchange rates are more flexible. 

 

Pros and cons of floating

-macro effects- depreciation

-Micro- uncertainty exports and imports, instability --> both can be costly for traders

 

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17.11

 

-Capital controls limit inflows and outflows of capital. 

The impossible trinity- Triangle  1.Full capital controls--> USA federal reserve Goal: Exchange rate stability, security for investors 2. Policy Monetary Unions Goal: Full financial integration 3. Pure float Goal: Monetary Independence. 

Not all can be used at the same time!

NB Check the goals!!! Important

Example Estonia: Full capital controls--> European Central bank, No individual monetary policy--> No monetary independence. Exchange rate stability achieved and at the same time full financial integration. Capital can flow across borders. 

-Bretton woods system down as a result of it couldn't handle inflation, caused overvaluation of currencies. These lead to crisis. Correction devaluation or floating.