Description
This is a PPT about Exchange Rate Movements: Explained in Detail.
International Linkages: IS-LM-BP
Foreign Exchange Market
• RBI holds forex reserves - inventories of dollars, other currencies and gold that they can sell for rupees – to sell when they want to or have to intervene in the foreign exchange market. • Intervention: buying or selling of foreign exchange by RBI. • The amount of intervention is determined by the extent of BoP situation: Exchange market pressure. • If a country persistently runs deficits in the BoP: the central bank likely to devalue the currency.
Foreign Exchange Reserve in India
Deployment of FX Reserves
Exchange rate and BoP
• The exchange rate is the price of one currency in terms of domestic currency. Then e = 46 in case of India. • So if the exchange rate falls, the Indian currency is worth more; it costs fewer rupees to buy a unit of the $ US. • Devaluation: price of foreign currencies under a fixed rate regime is increased by official action. The opposite is the Revaluation. • Appreciation and depreciation: generally under flexible exchange rate system. A currency depreciates when it becomes less expensive in terms of foreign currencies.
RBI Intervention
• An overall BoP surplus implies net purchase of foreign exchange by the RBI. • Conversely, a BoP deficit equals net foreign exchange sales by the RBI. • This buying and selling will affect the exchange rate of India. • If RBI decides, not to intervene then exchange rates will have to adjust to eliminate surpluses or deficits in BoP.
Exchange Rate Systems
• Nominal exchange rate • Effective exchange rate: Weighted average of the nominal exchange rates • Real exchange rate: Rate at which home goods exchange for foreign goods • Real exchange rate: ePf
R? P
• For exa, Pf=$4, P=Rs60 and e = Rs 45, R = ? • The real exchange rate measures countries? competitiveness in international trade.
PPP and equilibrium rate of exchange rate
• Demand for Indian goods would increase as long as R is greater than 1. • If along with the depreciation, price also rises, there may not be increase in exports • Eventually, this should either drive up Indian prices or drive down the exchange rate, moving us closer to purchasing power parity. • Market forces prevent the exchange rate from moving too far from PPP or from remaining away from PPP indefinitely.
Disequilibrium Exchange Rate
• However, pressures to move exchange rate towards PPP work very slowly in real world. Reasons are: • Market baskets differ across countries. • There are many barriers to the movement of goods between countries such as transport costs, tariffs, etc. • Workers and capital are not perfectly mobile. • Many goods, for example land, are „non-traded? and can not move.
Exchange Rate Determination
• Determined by demand and supply of forex • If it is done by market, it is called floating exchange rate system • If it is artificially done by RBI, it is called fixed exchange rate system. • It means RBI must stand ready to buy and sell rupees at the fixed rate • India?s rising forex reserve and maintenance of exchange rate
Exchange Rate Systems
• Fixed exchange rate: RBI stands ready to buy and sell rupees at a fixed price in terms of dollars. • Flexible (floating) exchange rate: RBI allows the exchange rate to adjust to equate the supply and demand for foreign currency. • Clean floating: RBI stands aside completely and allow exchange rates to be freely determined in the foreign exchange markets. Thus, the BoP would be zero. • Dirty or managed floating: RBI intervenes to buy and sell foreign currencies. Thus, official reserve transactions are not equal to zero under managed floating.
Current Exchange Rate Arrangements
• Free Float
– The largest number of countries, about 48, allow market forces to determine their currency?s value.
• Managed Float
– About 25 countries combine government intervention with market forces to set exchange rates.
• Pegged to another currency
– Such as the U.S. dollar or euro (through franc or mark).
• No national currency
– Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.
Balance of Trade and Market equilibrium
• What determines domestic output / income? Domestic spending or spending on domestic goods! • Domestic spending = A = C + I + G • Spending on domestic goods = A + NX = C + I + G + NX Net Exports = NX = NX(Y, Yf, R) • ?Yf ? ? home country?s trade balance ? ? AD. • Depreciation ? ? home country?s trade balance ? ? AD. • ? Y ? ? import spending ? ? home country?s trade balance.
Trade Balance and Goods Market Equilibrium
• The marginal propensity to import: the proportion of an extra rupee spent on imports. • IS Curve: Y = A (Y, i) + NX (Y, Yf, R) • Now level of income will depend on two additional factors foreign income and the real exchange rate. • The effect of higher foreign income is higher domestic income with higher interest rate. • The effect of a real depreciation of domestic currency is also increase in income with higher rate of interest.
The Effect of a Rise in Foreign Income or a Real Depreciation
Repercussion Effects
• In an interdependent world, our policy changes affect other countries as well as ourselves. • ? Government spending ? ? Y ? ? imports ? ? Yf. • Depreciation ? ? export demand ? ? Y ? ? demand abroad ? ? Yf. • Whereas an expansionary fiscal policy increases both our GDP and that of other countries, a depreciation of our exchange rate increases our income while reducing foreign incomes.
Balance of Payment and Capital Mobility
• Perfect capital mobility: Capital is perfectly mobile internationally when investors can purchase assets in any country they choose in unlimited quantity. • In this case we would expect all asset holders to pick the asset that has the highest return ? asset returns into strict equality in the world capital markets and interest rates are equal across countries. • But reality is interest rates are not equal: tax differences among countries, exchange rates can change significantly and obstacles to capital flows brought in by countries time and again. • Thus, the differences in interest rates affect capital flows and the BoP which has implications for stabilization policy.
The BoP and Capital Flows
• The BoP surplus (BP) is equal to the trade surplus (NX) plus the capital account surplus (CF): BP = NX (Y, Yf, R) + CF (i – if) • The trade balance is a function of domestic and foreign income and the real exchange rate. • The capital account is depending on the interest rate differential. • An increase in income worsens the trade balance, and an increase in the interest rate above the world level pulls in capital from abroad and thus improves the capital account.
Policy Dilemmas: Internal and External Balance
• Countries frequently face policy dilemmas, a policy designed to deal with one problem worsens another problem. • BoP deficit and unemployment: An expansionary monetary policy would deal with unemployment but worsens the BoP. • If the country can find a way of raising the interest rate, it would obtain financing for the deficit.
Perfect Capital Mobility, Fixed Exchange Rate and IS-LM-BP
• “Under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy” • Tight monetary policy ? ? i ? huge capital inflow ? BoP surplus ? exchange rate appreciation? forcing the RBI to hold the ER constant by buying forex and supplying rupees ? ? money stock ? initial contractionary monetary policy action is reversed. • This process comes to an end when home interest rates have been pushed back down to the initial level.
Monetary Expansion Under Fixed Rates and Perfect Capital Mobility
Fiscal Policy
• “While monetary policy is infeasible, fiscal expansion under fixed exchange rates with perfect capital mobility is extremely effective”. • Expansionary fiscal policy ? ? AD ? ? Y? ? i ? ? capital inflow ? BoP surplus ? exchange rate appreciation ? forcing the RBI to hold the ER constant by buying forex and supplying rupees ? ? money stock ? ? i back to its initial level equal to if with further ? Y .
Fiscal Expansion Under Fixed Rates and Perfect Capital Mobility
E’’
IS’
Under Flexible Exchange Rate
• Under flexible exchange rate BoP must be equal to zero. • The RBI can set the money supply at will. Since there is no obligation to intervene in the market. • The changes in real exchange rate shift the IS curve. • A depreciation (i < if) makes the home country more competitive, improves net exports, and hence shifts the IS curve to the right. • A real appreciation (i > if) means our goods become relatively more expensive; hence the trade balance worsens and demand for domestic goods declines, so the IS curve shifts to the left.
Effects of an Increase in the Demand for Exports
Fiscal Policy under Flexible Exchange Rate
• Expansionary fiscal measures ? increase in demand ? the tendency for interest rates to rise ? appreciation of rupee ? to a fall in exports and increased imports. • For flexible rates, a fiscal expansion does not change equilibrium output. Instead, it produces an offsetting exchange rate appreciation and a shift in the composition of domestic demand toward foreign goods and away from domestic goods. • The US faced this problem during 1980s and India is facing something similar to this now when a fiscal expansion is accompanied by a current account deficit.
Flexible Exchange Rate and Change in Monetary Policy
• Under fixed rates, the monetary authorities cannot control the money stock , and an attempt to expand money would lead to decrease in the money stock. • Under flexible rates, the central bank can control the money stock is a key aspect and finally it increases the output of the country.
Effects of an Increase in the Money Stock
Beggar-thy-Neighbor Policy
• Monetary expansion leads to exchange depreciation, an increase in net exports, and therefore an increase in output and employment. • This declines the output and employment abroad. • It is for this reason that a depreciation induced change in the trade balance has been called a Beggar-thy-Neighbor policy.
Thank you!
doc_305862232.pptx
This is a PPT about Exchange Rate Movements: Explained in Detail.
International Linkages: IS-LM-BP
Foreign Exchange Market
• RBI holds forex reserves - inventories of dollars, other currencies and gold that they can sell for rupees – to sell when they want to or have to intervene in the foreign exchange market. • Intervention: buying or selling of foreign exchange by RBI. • The amount of intervention is determined by the extent of BoP situation: Exchange market pressure. • If a country persistently runs deficits in the BoP: the central bank likely to devalue the currency.
Foreign Exchange Reserve in India
Deployment of FX Reserves
Exchange rate and BoP
• The exchange rate is the price of one currency in terms of domestic currency. Then e = 46 in case of India. • So if the exchange rate falls, the Indian currency is worth more; it costs fewer rupees to buy a unit of the $ US. • Devaluation: price of foreign currencies under a fixed rate regime is increased by official action. The opposite is the Revaluation. • Appreciation and depreciation: generally under flexible exchange rate system. A currency depreciates when it becomes less expensive in terms of foreign currencies.
RBI Intervention
• An overall BoP surplus implies net purchase of foreign exchange by the RBI. • Conversely, a BoP deficit equals net foreign exchange sales by the RBI. • This buying and selling will affect the exchange rate of India. • If RBI decides, not to intervene then exchange rates will have to adjust to eliminate surpluses or deficits in BoP.
Exchange Rate Systems
• Nominal exchange rate • Effective exchange rate: Weighted average of the nominal exchange rates • Real exchange rate: Rate at which home goods exchange for foreign goods • Real exchange rate: ePf
R? P
• For exa, Pf=$4, P=Rs60 and e = Rs 45, R = ? • The real exchange rate measures countries? competitiveness in international trade.
PPP and equilibrium rate of exchange rate
• Demand for Indian goods would increase as long as R is greater than 1. • If along with the depreciation, price also rises, there may not be increase in exports • Eventually, this should either drive up Indian prices or drive down the exchange rate, moving us closer to purchasing power parity. • Market forces prevent the exchange rate from moving too far from PPP or from remaining away from PPP indefinitely.
Disequilibrium Exchange Rate
• However, pressures to move exchange rate towards PPP work very slowly in real world. Reasons are: • Market baskets differ across countries. • There are many barriers to the movement of goods between countries such as transport costs, tariffs, etc. • Workers and capital are not perfectly mobile. • Many goods, for example land, are „non-traded? and can not move.
Exchange Rate Determination
• Determined by demand and supply of forex • If it is done by market, it is called floating exchange rate system • If it is artificially done by RBI, it is called fixed exchange rate system. • It means RBI must stand ready to buy and sell rupees at the fixed rate • India?s rising forex reserve and maintenance of exchange rate
Exchange Rate Systems
• Fixed exchange rate: RBI stands ready to buy and sell rupees at a fixed price in terms of dollars. • Flexible (floating) exchange rate: RBI allows the exchange rate to adjust to equate the supply and demand for foreign currency. • Clean floating: RBI stands aside completely and allow exchange rates to be freely determined in the foreign exchange markets. Thus, the BoP would be zero. • Dirty or managed floating: RBI intervenes to buy and sell foreign currencies. Thus, official reserve transactions are not equal to zero under managed floating.
Current Exchange Rate Arrangements
• Free Float
– The largest number of countries, about 48, allow market forces to determine their currency?s value.
• Managed Float
– About 25 countries combine government intervention with market forces to set exchange rates.
• Pegged to another currency
– Such as the U.S. dollar or euro (through franc or mark).
• No national currency
– Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.
Balance of Trade and Market equilibrium
• What determines domestic output / income? Domestic spending or spending on domestic goods! • Domestic spending = A = C + I + G • Spending on domestic goods = A + NX = C + I + G + NX Net Exports = NX = NX(Y, Yf, R) • ?Yf ? ? home country?s trade balance ? ? AD. • Depreciation ? ? home country?s trade balance ? ? AD. • ? Y ? ? import spending ? ? home country?s trade balance.
Trade Balance and Goods Market Equilibrium
• The marginal propensity to import: the proportion of an extra rupee spent on imports. • IS Curve: Y = A (Y, i) + NX (Y, Yf, R) • Now level of income will depend on two additional factors foreign income and the real exchange rate. • The effect of higher foreign income is higher domestic income with higher interest rate. • The effect of a real depreciation of domestic currency is also increase in income with higher rate of interest.
The Effect of a Rise in Foreign Income or a Real Depreciation
Repercussion Effects
• In an interdependent world, our policy changes affect other countries as well as ourselves. • ? Government spending ? ? Y ? ? imports ? ? Yf. • Depreciation ? ? export demand ? ? Y ? ? demand abroad ? ? Yf. • Whereas an expansionary fiscal policy increases both our GDP and that of other countries, a depreciation of our exchange rate increases our income while reducing foreign incomes.
Balance of Payment and Capital Mobility
• Perfect capital mobility: Capital is perfectly mobile internationally when investors can purchase assets in any country they choose in unlimited quantity. • In this case we would expect all asset holders to pick the asset that has the highest return ? asset returns into strict equality in the world capital markets and interest rates are equal across countries. • But reality is interest rates are not equal: tax differences among countries, exchange rates can change significantly and obstacles to capital flows brought in by countries time and again. • Thus, the differences in interest rates affect capital flows and the BoP which has implications for stabilization policy.
The BoP and Capital Flows
• The BoP surplus (BP) is equal to the trade surplus (NX) plus the capital account surplus (CF): BP = NX (Y, Yf, R) + CF (i – if) • The trade balance is a function of domestic and foreign income and the real exchange rate. • The capital account is depending on the interest rate differential. • An increase in income worsens the trade balance, and an increase in the interest rate above the world level pulls in capital from abroad and thus improves the capital account.
Policy Dilemmas: Internal and External Balance
• Countries frequently face policy dilemmas, a policy designed to deal with one problem worsens another problem. • BoP deficit and unemployment: An expansionary monetary policy would deal with unemployment but worsens the BoP. • If the country can find a way of raising the interest rate, it would obtain financing for the deficit.
Perfect Capital Mobility, Fixed Exchange Rate and IS-LM-BP
• “Under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy” • Tight monetary policy ? ? i ? huge capital inflow ? BoP surplus ? exchange rate appreciation? forcing the RBI to hold the ER constant by buying forex and supplying rupees ? ? money stock ? initial contractionary monetary policy action is reversed. • This process comes to an end when home interest rates have been pushed back down to the initial level.
Monetary Expansion Under Fixed Rates and Perfect Capital Mobility
Fiscal Policy
• “While monetary policy is infeasible, fiscal expansion under fixed exchange rates with perfect capital mobility is extremely effective”. • Expansionary fiscal policy ? ? AD ? ? Y? ? i ? ? capital inflow ? BoP surplus ? exchange rate appreciation ? forcing the RBI to hold the ER constant by buying forex and supplying rupees ? ? money stock ? ? i back to its initial level equal to if with further ? Y .
Fiscal Expansion Under Fixed Rates and Perfect Capital Mobility
E’’
IS’
Under Flexible Exchange Rate
• Under flexible exchange rate BoP must be equal to zero. • The RBI can set the money supply at will. Since there is no obligation to intervene in the market. • The changes in real exchange rate shift the IS curve. • A depreciation (i < if) makes the home country more competitive, improves net exports, and hence shifts the IS curve to the right. • A real appreciation (i > if) means our goods become relatively more expensive; hence the trade balance worsens and demand for domestic goods declines, so the IS curve shifts to the left.
Effects of an Increase in the Demand for Exports
Fiscal Policy under Flexible Exchange Rate
• Expansionary fiscal measures ? increase in demand ? the tendency for interest rates to rise ? appreciation of rupee ? to a fall in exports and increased imports. • For flexible rates, a fiscal expansion does not change equilibrium output. Instead, it produces an offsetting exchange rate appreciation and a shift in the composition of domestic demand toward foreign goods and away from domestic goods. • The US faced this problem during 1980s and India is facing something similar to this now when a fiscal expansion is accompanied by a current account deficit.
Flexible Exchange Rate and Change in Monetary Policy
• Under fixed rates, the monetary authorities cannot control the money stock , and an attempt to expand money would lead to decrease in the money stock. • Under flexible rates, the central bank can control the money stock is a key aspect and finally it increases the output of the country.
Effects of an Increase in the Money Stock
Beggar-thy-Neighbor Policy
• Monetary expansion leads to exchange depreciation, an increase in net exports, and therefore an increase in output and employment. • This declines the output and employment abroad. • It is for this reason that a depreciation induced change in the trade balance has been called a Beggar-thy-Neighbor policy.
Thank you!
doc_305862232.pptx