The Fundamentals of Exchange Rates - POSC 1020
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
The Fundamentals of Exchange Rates
POSC 1020 – Introduction to International Relations
Steven V. Miller
Department of Political SciencePuzzle(s) for Today
I hear a lot about monetary relations and exchange rates. What are those and why do they
matter?
2/293/29
What Happened in Argentina?
Argentina seems like one of the most peaceful countries in the region. A timeline of what
happened:
• Country had severe inflation problems.
• Inflation even peaked at 3,000% in 1989.
• Corrections made largely came from Washington and included:
• Convertibility Plan of 1991 that pegged peso 1-to-1 to USD.
• Lower trade barriers, privatization of state-owned enterprises.
This made Argentina an attractive foreign market.
• Convertibility made international transactions easy.
• Also made it easier to borrow since loans were denominated in USD.
4/29What Happened in Argentina?
However, Argentina’s fixed convertibility plan soon ran into a brick wall.
• Mexican peso crisis (1995) had an observable but contained effect.
• Currency crises in Asia/Brazil led to Brazil floating its currency.
• This depreciated the real, helping Brazil, but hurting Argentina’s producers.
• USD started to appreciate in value, raising Argentina’s borrowing costs.
Convertibility (i.e. pegging peso to the dollar) facilitated Argentina’s earlier recovery but it
soon became a straitjacket.
5/29The Crisis in 2001
Argentina’s depression starts in 1998 but it become a full crisis in 2001.
• Hundreds of thousands rioted in the streets, leaving dozens dead.
• Rioters were mostly middle-class who found their debts/expenses (e.g. mortgages) were
even more exorbitant.
• President resigned and was air-lifted from his palace to avoid being killed.
• Argentina defaulted on $93-billion in debts, the largest default in history.
6/29Argentina Lost Around 45% of its Dollar Reserves in the First Seven Months of 2001
International investors started to lose faith in the dollar peg around the time Argentina's lawmakers started to tinker with the exchange rate.
Total Reserves (in Dollars, Excluding Gold)
25
20
15
10
1995 1996 1997 1998 1999 2000 2001 2002 2003
Data: International Monetary Fund via Federal Reserve Bank of St. Louis
7/29Argentina's Depression Started in 1999 and Became a Full Crisis in December 2001
The country's GDP shrunk an astounding 67% from 1998 to 2002. By comparison, the U.S. Great Depression was a loss of about 45% of GDP from 1929 to 1933.
10
GDP Growth (Annual %)
9.13%
8.21% 8.11%
7.94%
5.84%
5.53%
5
3.85%
0
-0.79%
-2.47%
-2.85%
-3.39%
-4.41%
-5
-10
-10.89%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Data: OECD National Accounts Data via World Bank API.
8/29Argentina's Unemployment Rate Surged to 20% During its 2001 Depression
The spike followed a similar one as a result of a related 1995 banking crisis.
Modeled Unemployment Rate
20 19.6%
18.8%
17.1% 17.3%
15.4%
14.8% 15%
15
14.1%
13.5%
12.6%
11.8% 11.7%
11.5%
10.1% 10.1%
10 9.8%
9.2%
8.5% 8.6%
8.4%
7.8% 8%
7.7% 7.6%
7.2% 7.2% 7.1% 7.3%
6.4%
5.4%
5
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Data: International Labour Organization via World Bank API.
9/29Inflation Increased to Over 25% from the Previous Year After 2001
Country experts know inflation has historically been the country's most severe recurring problem.
Consumer Price Index (Annual %)
53.5%
40
34.3%
25.9% 25.7%
20
13.4%
10.9% 10.8% 10.6%
9.6% 9.5% 10%
8.8% 8.6%
6.3%
4.4%
0.5% 0.9%
0.2%
0 -1.2% -0.9% -1.1%
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2017 2018 2019
Data: IMF via Federal Reserve Bank of St. Louis API.
10/29Argentina's Peso Tumbled in 2001 and Has Yet to Recover
Losing access to foreign finance played a huge role in the depreciation of the Argentinian peso.
Real Effective Exchange Rate Index (Index, 2010=100)
200
100
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
Data: Bank for International Settlements via Federal Reserve Bank of St. Louis
11/29The Problem of Exchange Rates
The crisis has other factors (e.g. contagion, fiscal mismanagement, banking regulations) but
its core is the problem of exchange rates.
12/29What Are Exchange Rates?
A national monetary system is a classic public good.
• Allows for convenient ability to exchange goods/services.
• Little incentive for private firms to provide it.
However, it exists in relation to other national currencies.
• The exchange rate is the price at which one currency is traded/exchanged for
another.
13/29Appreciation and Depreciation
Exchange rates are variable.
• Appreciation: one currency increases in value relative to others.
• Depreciation: one currency decreases in value relative to others.
When we say Mexico’s peso is depreciating, it means one U.S. dollar can buy more pesos.
• Alternatively: more pesos are required to buy a dollar.
14/29The Dollar Has Always Been Strong to the Mexican Peso
Mexico dropped its previous peg (i.e. three new pesos to one USD) in 1995, which you can see in the first few years of the data.
25
The Number of Pesos Required to Obtain a Dollar
20
15
10
5
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
Data: Board of Governors of the Federal Reserve System (US). Shaded areas indicate U.S. recessions.
15/29The Euro is Usually Worth More Than the Dollar
A dollar and 18 cents bought one Euro to open 1999 and, despite obvious fluctuation, that's about the exchange rate now.
The Number of U.S. Dollars Required to Obtain a Euro
1.6
1.4
1.2
1.0
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Data: Board of Governors of the Federal Reserve System (US). Shaded areas indicate U.S. recessions.
16/29How Are Currency Values Determined?
Generally: through familiar laws of supply and demand.
• Of note here: the importance of interest rates.
• Higher interest rates = more demand to invest
• But, to invest, you need the national currency.
Central banks (e.g. the Federal Reserve in the U.S.) regulate exchange rates through various
means.
• Raising or lowering interest rates
• Changing the quantity of money in circulation
17/29Allowing Exchange Rates to Vary
Two general strategies for exchange rates: to “fix” or “float.”
• Fixed exchange rate: government commits to keep currency at or around specific
value.
• Nowadays: usually set against another currency. Historically: in gold (i.e. “gold standard”)
• Floating exchange rate: currency changes at market value, more or less freely.
There are intermediate steps.
• Bretton Woods monetary system (1945-1973, “fixed but adjustable”)
18/29Fixed Rate Regimes
Some fixed rate regimes are pegged to other currencies
• Bosnia (1 Bosnian mark = .5 euros, a la Dayton)
• Denmark (7 kroner = 1 euro)
• Saudi Arabia (1 USD = 3.75 riyals)
Others are on other national currencies.
• e.g. Ecuador, El Salvador, and Panama all use U.S. dollars
19/29Who Cares About Exchange Rates?
Exchange rate policies create winners/losers. Each has tradeoffs for these actors.
1. Governments
2. Consumers/businesses
20/29Governments and Exchange Rates
Governments must balance multiple actors in adjusting exchange rates.
• Fixed currency provides stability, which makes investment easier.
• However, a government must commit itself to that exchange rate regime.
• This hamstrings a government’s ability to respond to recessions.
Floating exchange rates give more flexibility, but also volatility.
21/29Consumers and Businesses
Even more difficulty follows in finding an ideal exchange rate in society.
• A strong currency allows citizens to buy more.
• However, a strong currency puts producers at disadvantage with foreign competition.
• A weak currency makes national products more competitive.
• However, it makes consumers worse off and contributes to inflation.
There is no particular reason why one is better for a country overall.
22/29Consumers and Businesses
The exchange rate policies depend on the nature of the economy, interests groups, and the
political system.
• In Europe: biggest cheerleaders for Euro came from smaller countries (e.g. BENELUX)
and not the bigger ones (e.g. France, Italy)
• In Latin America: countries most indebted to U.S. trade pegged to or outright adopted
the dollar.
In China: export-oriented economic planning led to overall renmibi devaluation to be
competitive.
• However, this makes China’s emerging middle class worse off.
• Related: China is presently pushing the value of the renmibi up, not down.
23/29The Real Effective Exchange Rates for the Chinese Renmibi and the U.S. Dollar (1980-2017)
China's currency depreciation strategy was obvious in the 1980s but is less evident now.
Real Effective Exchange Rate Index
250
200
150
100
1980 1985 1990 1995 2000 2005 2010 2015 2020
Country China United States
Data: IMF via World Bank API. Base year: 2010.
24/29China's Currency Tango With the U.S. Is Even More Pronounced in the 1990s
China pegged the RMB to the dollar at 8.28 in 1994 and held that peg until July 2005.
9
The Number of Renmibi Required to Obtain a Dollar
7
5
3
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
Data: Board of Governors of the Federal Reserve System (US). Shaded areas indicate U.S. recessions.
25/29An Aside: A Strong Dollar or Weak Dollar?
A weak dollar is useful if you’re concerned about:
• Increasing exports
• Economic recovery amid downturns
• Current account imbalances
26/29An Aside: A Strong Dollar or Weak Dollar?
Some pitfalls of a weak dollar:
• Dollar’s centrality in global finance requires faith in its value.
• Without this, U.S. borrowing costs go up substantially.
• Weak dollars could lead to higher interest rates and raise borrowing costs.
• i.e. it could actually slow economic recovery.
• Artificial depreciation could lead to reprisals/trade wars.
A strong dollar increases purchasing power and is arguably a critical American interest.
27/29Conclusion
Monetary policy is an obtuse topic with important implications for your life.
• Wealthier/bigger states prefer some kind of flexibility in their monetary policy.
• Is a “strong” dollar better than a “weak” one? Depends on what you want.
28/29Table of Contents
Introduction
What Are Exchange Rates? Why Do They Matter?
Determing Currency Values
Who Cares About Exchange Rates?
Conclusion
29/29You can also read
