Exchange Rates John Coleman This lecture attempts to understand the behavior and importance of exchange rates. The particular questions that we will focus on are the following: • What are nominal and real exchange rates? • What causes exchange rates to fluctuate? • How are exchange rates influenced by real and monetary shocks? • How do exchange rate fluctuations affect the relative prices of goods across countries? • How do exchange rate fluctuations affect international trade and capital movements? • Are currency fluctations responsible for the U.S. trade deficit and Japan’s trade surplus? After setting up some basic ideas and definitions, we will focus on explaining a fundamental relationship among exchange rates, differences in real interest rates across countries, and differences in expected inflation rates across countries. We will then discuss the relationship between international trade and exchange rates. Since we already discussed the affects of monetary and real shocks on real interest rates and expected inflation, we will then be in a position to discuss the affects of these shocks on exchange rates and international trade. We will also spend some time discussing different exchange rate regimes, such as the difference between a floating exchange rate regime (which the U.S. has) and a fixed exchange rate regime (which much of Western Europe has). At this point we will discuss issues that surround a European Monetary Union. In the context of a fixed exchange rate regime, we will discuss speculative attacks on a currency.

1

4

exchange rate Pesos per Dollar

3.5 3

2.5 2

1.5 1 Dec00

Jul01

Dec01 date

Collapse of the Argentine Peso

Jul02

Dec02

International Monetary Fund Currency units per dollar, 20th December, 2002 U. S. dollars

US$

1.000

Korean won

W

1200.103

Euro

EUR

0.975

Libyan dinars

LD

1.222

Japanese yen Pounds sterling Australian dollars Brazilian reais

Malaysian ringgit

RIN

3.800

LST

Y

120.770 0.624

Mexican peso

MEX

10.184

$A

1.767

New Zealand dollars

$NZ

1.932

R$

3.504

Pakistan rupees

PRS

58.534

CAN

1.552

Saudi Arabian riyals

SRL

3.750

CY

8.277

Singapore dollars

S$

1.743

Hungarian forint

FT

230.160

Slovenian tolars

SLT

224.387

Indian rupees

RS

48.050

Swedish kronor

SKR

8.890

Iraqi dinars

ID

0.311

Swiss francs

SWF

1.426

NIS

4.736

Venezuelan bolivares

Canadian dollars Chinese yuan

Israel shekels

BS

1304.501

Country Japan Switzerland Morocco Spain Botswana South Africa Greece Philippines Tanzania Iceland Poland Chile

∆E E

π - πus

-2.90 -2.29 1.83 2.72 4.91 5.70 6.29 7.82 12.20 14.02 25.44 37.79

-0.25 -0.52 0.98 4.69 4.76 6.17 7.66 6.54 16.83 17.07 20.66 60.97

change in exchange rate foreign currency per dollar (annual averages, 1960-2000)

45 39 TUR

33 ISR

27

POL

GHA SDN ZMB

SLE ECU

21 COL ISL VEN AFG NGA TZA GUY MWI GIN ZWE CRI JAM LBR PRY MDG IRN PHL KOR LKA DOM DZA BDI GRC PAK KEN EGY SWZ ZAF LSO BTN IND NPL RWA GTM PRT HND BWA GMB SLB MUS MRT WSM HTI CPVTUN TTO SLV CHN ITA ETH SYR PNG NZL ESP TGO BFA SEN BEN GNQ NER TCD CMR CIV CAF COG GAB MLI FJI MDV IRL COM MAR FIN TON JOR AUS KIR THA GBR SWE CYP LCA VCT KNA ATG GRD DMA VUT CAN FRA PYF NCL BLZ LBY HKG NOR MLT MYS SYC OMN MMR DNK BMU CYM BRB USA VIR PAN FSM BHS ANT BEL LUX KWT IRQ DJI NLD SAU SGP BRN AUT DEU CHE JPN

15 9 3 -3 -3

ROM

GNB

MEX LBN

SUR MOZ STP LAO

KHM

3 9 15 21 27 33 39 foreign inflation minus U.S. inflation (annual averages, 1960-2000)

Exchange Rates and Inflation

45

change in exchange rate foreign currency per dollar (annual averages, 1960-2000)

AFG

13

GIN

11

MWI ZWE

LBR

9

MDG

PRY

PHL

LKA BDI PAKKEN EGY LSO IND NPL BTN GTM HND BWA GMB

7 5

KOR DOM DZA GRC ZAF SWZ RWA PRT

SLB WSM HTI TTO SLV CHN ITA SYR ETH TUN PNG CAF NZLCOG GAB ESP TCD BFA SEN CMR BEN CIV NER MLI TGO FJI MDV IRL COM FIN MAR AUS JOR TON KIR THA SWE CYP GBR ATG DMA GRDVCT LCA KNA VUT PYF NCL LBY BLZ CANFRA HKG MYS NOR MLT SYC DNK CYM BRB BMU OMN FSM PAN USABHS VIR ANT BEL LUX KWT SAU DJI NLD AUT BRN SGP DEU CHE JPN CPV

3 1 -1 -3 -3

MRT

MUS

GNQ

MMR IRQ

-1 1 3 5 7 9 foreign inflation minus U.S. inflation (annual averages, 1960-2000)

Exchange Rates and Inflation

11

Country Japan Switzerland Morocco Spain Botswana South Africa Greece Philippines Tanzania Iceland Poland Chile

∆E E

π - πus

R - Rus

-2.90 -2.29 1.83 2.72 4.91 5.70 6.29 7.82 12.20 14.02 25.44 37.79

-0.25 -0.52 0.98 4.69 4.76 6.17 7.66 6.54 16.83 17.07 20.66 60.97

-1.90 -2.74 0.61 4.06 4.27 4.87 7.75 8.52 13.57 16.00 36.20 31.54

change in exchange rate foreign currency per dollar (annual averages, 1960-2000)

45 39

CHL

33 UGA

27

POL

GHA

ZMB

SLE

21

ECU

MOZ SUR

15 9 3 -3

NGA

GUYKHM

LBR PHL KOR BDI DZA LKA GRC KEN EGY SWZ ZAF LSO BTN IND NPL RWA GTM PRT BWA SLB MUS MRT TTO WSM CPV SLV ITA CHN ETH FJI TUN PNG NZL ESP TGO SEN BEN BFA NER GNQ TCD CAF CMR MLI CIV COG GAB IRL COM MAR FIN TON JOR AUS THA GBR SWE CYP LCA VCT KNA ATG DMA GRD VUT CAN FRA LBY MMR HKG NOR MLT MYS SYC DNK BLZ BRB OMN USA PAN FSM BHS ANT BEL LUX KWT DJI AUTSGP NLD DEU CHE JPN

-3

LBN

ISL TZA GIN

GNB

MEX

VEN MWILAO ZWE JAM CRI MDG PRY DOM

COL STP

HND GMB HTI

3 9 15 21 27 33 39 foreign interest rate minus US interest rate (annual avg,1960-2000)

Exchange Rates and Interest Rates

45

change in exchange rate foreign currency per dollar (annual averages, 1960-2000)

9 KOR

7

BDI ZAF

5

BWA

DZA SWZ NPL EGY RWA

MRT

WSM

CPV CHN TUN

3

ETH IRL TONJOR

1

LBY BEL

-1

AUT

FJI

NZL ESP

PNG

TTO

MAR FIN AUS THA SWE CYP GBR DMAGRD LCA VCT KNA ATG CAN FRAHKG MMR NORDNK MLT MYS BRB PAN USABHS OMN ANT LUXKWT DJI SGP

ITA BEN BFA CIV NER MLI SEN TGO COM VUT BLZ SYC

NLD DEU

CHE JPN

-3 -3

-1 1 3 5 7 foreign interest rate minus U.S. interest rate (annual avg,1960-2000)

Exchange Rates and Interest Rates

9

LexisNexis(TM) Academic - Document

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file:///C:/classnotes/macro/lectures/BrazilDeficit98_full.htm

The New York Times Thursday, October 29, 1998

BRAZIL INTRODUCES $80 BILLION PLAN FOR ECONOMIC ILLS By DIANA JEAN SCHEMO The Brazilian Government introduced a three-year, $80 billion package of spending cuts and tax increases today in an effort to restore the country's flagging credibility in world markets and prepare the way for a rescue program led by the International Monetary Fund. The plan calls for $23.5 billion in savings in 1999, with about $11 billion coming from tax increases and $7 billion from spending cuts. The rest is to come from pension and fundamental financial changes. Part of the plan sets up controversial mechanisms to force states and municipalities to limit spending. "The time has come for us to make government live within its limits -- with clarity, conscience and determination," Finance Minister Pedro Malan said, elaborating on themes that President Fernando Henrique Cardoso raised in a televised speech Tuesday night, bracing Brazilians for the austerity measures. "The time for gradualism is over." The blueprint was anxiously awaited by investors and United States policy makers who fear that the collapse of the country's financial system could set off defaults and devaluations across Latin America, worsening a broader crisis and threatening stronger economies. Washington's response to Brazil's action today was congratulatory but also cautionary, reflecting concerns that the program could flounder when it reaches the Brazilian Congress. Some economists said the austerity plan and the I.M.F. bailout package might not be sufficient to pull Brazil out of its financial crisis. Economic Scene, page C2. Investors reacted warily, and said the measures did not go as far as they hoped in making structural changes to permanently reduce Brazil's burgeoning budget deficit, which is now running at 7 percent of the gross national product. In Sao Paulo, Brazil's financial center, the benchmark stock index fell 42.63 points, or five-eighths of a percent today, to 6,826.51. Jorge Mariscal, chief investment strategist for Latin America of Goldman, Sachs & Company, said, "It's a step in the right direction, but if you think of Brazil climbing a wall of disbelief, this is just a few inches up." The giant of South America, with half the continent's population and the world's ninth-largest economy, Brazil has been the focus of world attention since the collapse in Russian finances two months ago. Interest rates for Brazilian debt doubled, and the country began using up roughly $30 billion of its foreign-currency reserves. The International Monetary Fund, along with other lending agencies, and officials in Washington have been preparing a safety net for Brazil of at least $30 billion, with President Clinton prepared to commit American taxpayer dollars as part of a package of direct aid from the Group of Seven industrial nations. In a statement after the plan was detailed today, Secretary of the Treasury Robert E. Rubin said, "It is essential that Brazil implement its program promptly and convincingly." That message was reinforced, a White House official said, in a brief conversation between Mr. Clinton and Mr. Cardoso. Mr. Clinton, the official said, was returning a call Mr. Cardoso placed several days ago to congratulate the American President on the Middle East agreement, But Mr. Clinton's underlying message was that Brazil had to act quickly. United States officials have made no secret of their exasperation at Brazil's slowness to act, leaving the country vulnerable, in their view, to another market upheaval. Mr. Clinton, though, reportedly made no reference to an American contribution to an I.M.F.-led rescue package. Brazilian officials said they would travel to Washington to discuss the plan with I.M.F. officials by next week. Today, a spokesman for the fund said the plan represented "important progress in the implementation of Brazil's stabilization and reform program, which will be supported by the I.M.F. and other members of the international community." Party leaders of President Cardoso's governing coalition, who learned details of the plan over breakfast with Mr.

1/6/2003 10:21 PM

LexisNexis(TM) Academic - Document

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file:///C:/classnotes/macro/lectures/BrazilDeficit98_full.htm

Cardoso and Finance Minister Malan today, did not rule out tinkering with some of its more controversial elements, but pledged to maintain the savings targets the Government would promise to the I.M.F. "The measures are bitter measures, but in our view they're extremely necessary," said Aecio Neves, leader in the lower house of Congress of the President's Brazilian Social Democracy Party, which relies on five allied parties to form its majority. "The governing coalition has an enormous responsibility to overcome this moment of instability," he said. With this sudden sense of urgency and national mission, few in the President's governing coalition were willing to openly challenge the austerity package. But many raised objections to specific elements, and said there could be alternatives offered for debate in coming weeks. Among the most difficult items to pass, congressional leaders said, would be a requirement that retired public workers contribute to the Social Security coffers, with contributions of 11 percent to 20 percent of their benefits. The austerity package also increases the contribution of public workers to Social Security, and would introduce a minimum age for retirement of civil servants, which does not currently exist. The Social Security system for public workers in Brazil is far more generous than that in the United States. Civil servants here retire with full salaries, according to time served, without regard to their age. "Reduction of expenses and the increase of tax collection, it's an indigestible cocktail for any congress in the world," said Geddel Vieira Lima, leader of a Government-allied party. "But we know the moment we're living through, and that we have to show the world we're capable of doing what's necessary to address our problems." The package also calls for the extension of several taxes that were originally passed as temporary measures several years ago. Under one, the emergency stabilization fund, the national Government impounds 20 percent of all taxes destined for state and local governments. The package proposes doubling the amount impounded to 40 percent and extending the life of the fund, which was to have expired in 1999, to 2006. It will also double a tax on financial transfers. Senator Fernando Bezerra, president of Brazil's National Confederation of Industry, said today that the tax increases would have "a very negative impact on national production." But the Government justified the measures as necessary to relieve a credit squeeze and bring down interest rates, which are now running above 40 percent. The austerity package also calls on Congress to require states to limit spending on active and retired employees to 60 percent of their budgets, at the same time cutting the resources available by impounding some tax revenue. It is by no means sure, however, that fiscal discipline can successfully be imposed on state and city governments by fiat. Anthony Garotinho, who was elected governor of Rio de Janeiro state on Sunday, said today, "Does the Government expect us to make miracles?" He noted that Rio, which is seeking a $300 million loan from the national Government, is responsible like other states for providing basic services including education, health and security. "I was elected to be a governor, not a magician," Mr. Garotinho said. Mr. Mariscal of Goldman, Sachs also called the impoundment fund's extension "another negative," and said: "Brazil is in the mess it's in because it has too much debt, too many employees and too high a Social Security deficit. It's an issue of spending too much and lowering the debt, and everything else is peripheral." Lawrence Goodman, chief economist at Santander Investment Securities, called the package "mildly favorable regarding the potential for an ongoing 'muddling through' scenario." This week marks the year anniversary of the last package Mr. Cardoso announced, with much fanfare. That plan, intended to raise $18 billion and hailed then as a great show of decisiveness, was substantially passed by Congress. But the only measures that were carried out involved raising taxes, not cutting cutting costs. "Brazil will remain captive to a $300 billion domestic debt that is extraordinarily short term in nature, which is one of the paramount issues coming out of the Asia crisis," Mr. Goodman said. On Thursday, Mr. Malan and other officials are to testify on the austerity package before Congress, which is to begin action, starting with Social Security changes, next week. Copyright 1998 The New York Times Company

1/6/2003 10:21 PM

Dow Jones Interactive

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file:///C:/classnotes/macro/lectures/BrazilDevalued.htm

The Wall Street Journal Thursday, January 14, 1999 *** Business and Finance BRAZIL DEVALUED its currency, the real, and its central bank head quit, raising worries about renewed global financial turmoil. Brazil's move to let the real fall 8.3% sent its stocks down 5.1%. Throughout Latin America, stock markets slid and interest rates rose. Economists expect the region to tip into recession for much of 1999, and multinational firms scrambled to reassess their projections for Brazil and its neighbors. (Copyright (c) 1999, Dow Jones & Company, Inc.)

1/6/2003 10:33 PM

12 10

Hong Kong

inflation rate

8 6 4

United States

2 0 1991

1992

1993

1994 year

1995

Hong Kong and U.S. Inflation Rates

1996

1997