EXCHANGE-RATE POLICY &
THE CENTRAL BANK
Chapter 19
Exchange Rates are Volatile
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
280.00
260.00
240.00
220.00
200.00
180.00
160.00
140.00
120.00
100.00
80.00
Jan-84
Yen per Dollar
Yen-Dollar Rate
Costs of Volatile Exchange Rates
• Exchange rate volatility increases risk in international
finance.
Ex. Many developing economy corporates issue securities
in US$. An exchange rate devaluation will make this more
expensive to repay.
• Exchange rate volatility increases risk in international
trade.
Ex. Some multinationals earn profits in foreign currency. A
revaluation will reduce the domestic currency value of
those profits.
Ex. Changes in exchange rates will change the relative
competiveness of exports and imports.
Exchange Rates
• Exchange Rate: E - # of domestic currency
units purchased for 1 US$.
• An increase in E is a depreciation of
domestic currency and a decrease in E is an
appreciation.
Interest Parity
(1  i ) 
F
t
Et 1
Et
 (1  it )
Saving
It is January 1st, and you have D$1000
to save for 1 year. You can put it
into:
1. a domestic currency bank account at an
interest rate i.
2. a foreign currency bank account at
interest rate iF.
Payoff to strategy #2
•
Strategy two has three parts.
1.
Buy foreign exchange at spot rate Et to get
{D$1000/Et} F dollars.
Put {D$1000/St} F dollars into F bank account. After
1 year get F$(1+iF)×{D$1000/Et }
Convert these funds into F$ at exchange rate
prevailing at end of year.
2.
3.
(1  i F )   Et 1
Et
 D$1000
Uncovered Interest Parity
• If
(1  i F )   Et 1
Et
F$ account.
F
(1

i
)   Et 1
• If
Et
 1  i , deposit funds then deposit in
 1 i
D$ account.
• Then in equilibrium
, deposit funds then deposit in
Et 1  (1  i F )  1  i
Et
Interest Rate Parity
• The only reason people would be willing to hold a
US$ account when US interest rates were lower
than domestic interest rates would be if they can
achieve an expected gain from an increase in the
value of US$ during the time that they were holding
the account.
• Approximately
it
E

E

t

1
t
F
F
E
i 
i g
t
Et
t
t 1
Three Reasons UIRP might not hold
Future exchange rates are risky, uncovered
interest parity does not account for risk.
1.
A.
Interest Parity Works for Forward Prices
{t }
t 1
F
{t }
t 1
F
2.
3.
 Et 
1  it
1  itF
: Forward Price for currency delivered at t+1
Domestic and foreign currency not perfect
substitutes. People like to hold currency for
liquidity reasons.
Currency controls
Midterm Exam
• Tuesday, October 21, 2012, 1:30-1:50, LTG
• Bring writing materials and calculator.
• Coverage: Money, Central Banks, Interest Rates,
Exchange Rates (through Thursday).
• Semi-open book: Bring 1 A4 size piece of paper with
handwritten notes on both sides.
Supply and Demand Model
Why do exchange rates change?
• Relative values of two currency determined by supply and
demand by traders of the two currencies.
Unlike textbook, we will describe a model of domestic country’s forex
market in which US$ is vehicle currency
• Price of US$: E is the price of US$ in terms of
DCU.
Link
From Interest Parity
• People trade currencies to engage in foreign
trade and international investment.
• Expected (Investment) Profit:
• Of Domestic Investors in Foreign Economy
Et 1
Et
 (1  itF )
• Of Foreign Investors in Domestic Economy
Et
Et 1
1  it
Supply and Demand in Forex Mkt
E
Excess
Supply
Supply
Excess
Demand
Demand
E*
Forex Turnover
Equilibrium in the Forex Market
• Gap between supply and demand of US$ is
the Balance of Payments.
• Two types of Forex Markets
• Floating: Forces of supply and demand
equilibrate markets.
• Fixed: Gov’t/Central Bank buys excess foreign
currency in market.
Difference w/ Textbook
• Textbook version examines US dollar forex market from
US perspectives.
• We focus on market from more international perspective.
• Supply of US $ liquidity in local forex market is not
exogenous.
Increase in Desired Capital Inflows by Foreign Investors/
Desired Purchases of Domestic Goods
E
Supply
Supply'
⓪
E*
E**
①
Domestic Currency
Appreciates
Demand
Increase in Desired Capital Outflows by Domestic Investors/
Desired Purchases of Foreign Goods
E
E**
①
Domestic Currency
Depreciates
E*
⓪
Supply
Demand '
Demand
Foreign Interest Rates Go Up
Relative Demand for F$ Goes Up
E
①
E**
E*
⓪
Domestic
Currency
Depreciates
Supply'
Supply
Demand '
Demand
Why are exchange rates so volatile
• Exchange rates are volatile because they are based on
expectations.
• Expectations of future exchange rates determine demand
for forex today.
• Waves of optimism and pessimism of future of currency
affects currency today.
Expectation of Et+1 Increases
E
2
E**
E**
1
Domestic
Currency
Depreciates
Supply'
Supply
Demand '
Demand
D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
E
Supply
Supply'
⓪
E*
Domestic
Currency
Appreciates
E**
①
Demand
Demand '
Foreign Currency Purchase, D.C. Interest Rates Go
Down. Relative Demand for US$ Goes Up
E
①
E**
E*
⓪
Domestic
Currency
Depreciates
Supply'
Supply
Demand '
Demand
Model of the Exchange Rate
• Examine UIRP on a logarithmic scale
 Et 1 
Et 1
F
F
1

i

1

i

ln
1

i

ln

ln
1

i
 t
 t    t 

t 
Et
 Et 
ln 1  it   ln Et 1  ln Et  ln 1  itF 
it  et 1  et  itF  et   itF  it   et 1   itF  it    itF1  it 1   et  2
et   itF  it    itF1  it 1    itF 2  it  2    itF3  it 3   ........eLT
Monetary Policy Transmission
Mechanism
• A rise in policy interest rates will raise money market rates
which will lead to forex appreciation. This will raise price
of domestic export goods reducing demand.
• A cut in policy rates will reduce money market rates
leading to forex depreciation improving competitiveness of
exports increasing demand.
The impact of monetary policy will affect demand through
an external channel in a way that parallels the effects
through the internal channel.
Exchange Rate Passthrough
• Inflation targeting focuses on price stability in consumer
goods.
• In most small and medium economies, substantial share
of imported goods in consumer goods.
• Exchange rate depreciations make imported goods more
expensive and can be inflationary. Raising interest rates in
the face of depreciation will stabilize exchange rates and
inflation.
• Exchange rate depreciations make imported goods more
expensive and can be inflationary. Raising interest rates in
the face of depreciation will stabilize exchange rates and
inflation.
29
Price Stability and Exchange Rates



Lower interest rates will be associated with
weakening currencies on average … but…
exchange rate movements are volatile and
unpredictable.
Even central banks that target price
stability intervene in forex markets to
stabilize volatile exchange rates.
Is this consistent with inflation targeting
nominal anchor?
T-Accounts:
Unsterilized Intervention
• UnSterilized Foreign
Currency Purchase
Central Bank
Assets
• UnSterilized Foreign
Currency Sale
Central Bank
Liabilities
+100
+100
Foreign
Reserve
Currency Accounts
Assets
Liabilities
-100
-100
Reserve
Foreign
Currency Accounts
31
Forex Intervention
• Unsterilized intervention –Gov’t uses open
market operations to purchase (sell) foreign
currency. Changes level of bank reserves,
domestic liquidity, interest rates.
• Sterilized interventions – Use domestic funds
financed by bill issuance or long-term
borrowing to purchase foreign currency.
Unsterilized Intervention
iIBR
i*
D
Central Bank Buys Foreign
Reserves & Increases Reserves
Increases liquidity in interbank
market and pushes down interest
rates.
.
i**
Clearing Balances
33
Three Situations
OK
Forex Intervention Aids Price Stability Goal:
Large share of consumer goods are imported in
Asian emerging markets and exchange rates
factor into that price.
2. Forex Intervention Does Not Conflict with
Inflation Target: When inflation is within the
target range, exchange rate stability may work
as an auxiliary goal.
1.
34
Swiss Monetary Policy
• Swiss Inflation Target: 0-2%
• Peg: 1.2 SwF to 1 Euro.
• Consistent?
Monetary Policy & Exchange Rates
• The central impact of the foreign currency intervention is on
domestic interest rates.
• Monetary policy that shifts domestic interest rates will also
shift exchange rates regardless of whether it occurs through
currency intervention, OMO, or some other change in
quantity of bank reserves.
• Monetary policy that does not shift interest rates will not
shift exchange rates.
36
What do you do if?
3. Forex Intervention Conflicts with the
Target.
•
•
If inflation near top of the range, then
forex intervention that weakens the
currency will be inflationary and violate
credibility of inflation target.
If inflation near bottom of the range, then
forex intervention that strengthens the
currency will violate target credibility
T-Accounts:
Sterilized Intervention
• Sterilized Foreign
• Sterilized Foreign
Currency Purchase/
Issue non-monetary
liabilities
Currency Sale/
Open Market Purchase
Central Bank
Central Bank
Assets
Assets
Liabilities
+100
+100
Foreign
Stabilizati
Currency on Bonds
Liabilities
-100
-100
Reserve
Foreign
Currency Accounts
+100
Stabilization
Bonds
+100
Reserve
Accounts
T-Accounts:
Sterilized Intervention
• Sterilized Foreign
• Sterilized Foreign
Currency Purchase/
Open Market Sale
Currency Sale/
Open Market Purchase
Central Bank
Assets
Central Bank
Liabilities
Assets
Liabilities
+100
+100
Foreign
Reserve
Currency Accounts
-100
-100
Reserve
Foreign
Currency Accounts
-100
Government
Securities
+100
Government
Securities
-100
Reserve
Accounts
+100
Reserve
Accounts
South Korean authorities are back in the local
foreign-exchange market, checking the won’s gains
after staying fairly quiet for several months, traders
in Seoul say.
The Bank of Korea is suspected to have bought
dollars near the day’s low of 1,031.40 won and again
towards the end of local trading hours, around the
1,040 won level, according to three Seoul-based
currency traders. Two traders estimated the central
bank may have bought more than $500 million worth
of the U.S. currency to slow the Korean won’s gains
Thursday. This would be the second day in a row
that traders suspect the central bank has intervened
to cool the won.
Link
Assets of Bank of Korea
550000
500000
400000
350000
300000
250000
200000
150000
4
n1
3
Ja
Ja
n1
2
n1
1
Foreign Assets
Ja
n1
0
Ja
n1
9
Ja
n0
8
Ja
n0
7
Total
Ja
n0
6
Ja
n0
5
Ja
n0
4
Ja
n0
3
Ja
n0
2
Ja
n0
Ja
n0
1
100000
Ja
Billions Won
450000
41
Effectiveness of Sterilized Intervention
• Sterilized Intervention may work by signaling future
monetary policy intentions.
• Sterilized purchase of foreign currency increases
relative supply of domestic currency assets & puts
downward pressure on exchange rates.
• In developed financial markets, shift of relative assets
would be too small to impact forex rates.
• Evidence suggests that in some emerging markets,
sterilization can have some effect on exchange rates.
42
Evidence from Latin American intervention
Link
• Regression of appreciation or first difference on
forex intervention (share of GDP).
Sterilized
intervention can
slow the rate of
exchange rate
movements but
not overall
changes!
FIXED EXCHANGE RATE
Fixed Exchange Rates
Link
Fixed Exchange Rate: Weakside Currency
Target
E
Gov’t Buys Excess
Supply US$
Supply
ETGT
Demand
Forex
Turnover
Fixed Exchange Rate: Strongside
Currency Target
E
Supply
ETGT
Gov’t Buys Excess
DCU
Demand
Forex
Turnover
Exchange Rate Depreciation
• Exchange Rate: S - # of domestic currency units
purchased for 1 US$.
• An increase in S is a depreciation and a decrease in S
is an appreciation.
• Depreciation Rate
Et 1  Et Et 1
t 1 

Et
Et
Fixed Exchange Rate
• If the central bank undertakes to keep the exchange rate
fixed and that is a credible undertaking, then
.
t 1  0
• If the relative values of currency are fixed, then funds will
flow out of the domestic currency if domestic interest rates
are too low and flow into domestic currency if interest
rates are too high.
i = iF
Federal Funds Rate: Month Average
Interest Settlement Rate (HIBOR Fixing): Period Average: 1 Month
Jul-14
Jul-13
Jul-12
Jul-11
Jul-10
Jul-09
Jul-08
Jul-07
Jul-06
Jul-05
Jul-04
Jul-03
Jul-02
Jul-01
Jul-00
Jul-99
Jul-98
Jul-97
Jul-96
%
14
12
10
8
6
4
2
0
HONG KONG’S UNIQUE
MONETARY
INSTITUTIONS
“Guide to Hong Kong Monetary and Banking
Terms” by HKMA.see http://www.hkma.gov.hk
Convertibility Undertaking HK
• Whenever the price of US
dollars goes above 7.85,
the central bank will sell
US dollars at E = 7.85.
• No one will ever pay more
than 7.85HK$ per US$
• Whenever the price of US
dollars goes below 7.75,
the central bank will buy
US$ at E = HK$7.75.
• No one will ever sell for less
than 7.75HK$ per US$.
• “At the exchange-rate levels
defined by the strong-side and
weak-side Convertibility
Undertakings, 7.75 and 7.85,
the HKMA stands ready to
exchange any amount of US
dollars against Hong Kong
dollars with licensed banks
maintaining Hong Kong-dollar
clearing accounts with the
HKMA.” Joseph Yam
Balance Sheets of the Exchange Fund
Hong Kong Exchange Fund
Assets
HK Dollar
Foreign Currency
Balance Sheet (Millions HK$)
$3,032,818 Liabilites
$227,855 Certificates of Indebtedness
$2,804,963 Fiscal Reserves Account
Coins in Circulation
Exchange Fund Bills & Notes
Balances of Banking System
Placement by Banks & Other FI
Placement by HK Statutory Body
Others
Accumulated Earnings
$2,395,310
$327,372
$773,862
$10,575
$782,605
$164,093
$50,734
$214,911
$71,158
$637,508
Reserves: Clearing Balances
• The reserve requirement in HK is zero. Banks must only
have enough reserves to meet all of their payment
obligations.
• Clearing Account: The accounts maintained with the HKMA
for settling inter-bank balances and payments between
banks and the HKMA.
• Aggregate Balances: The sum of balances maintained by banks in
clearing accounts at the central bank.
HK Interbank Market Automatic Pilot
iHIBOR
i*
iFF
HIBOR Interest Rate Above
Fed Funds
Banks willing to cash in US$ to
get more clearing balances to
lend.
Under convertibility
undertaking, HKMA will make
those reserves available.
Interest rates drop.
D
Clearing Balances
HK Interbank Market Automatic Pilot
iHIBOR
i*
iFF
D
HIBOR Interest Rate Below Fed
Funds
Banks willing to cash in clearing
balances to get more US$.
Under convertibility undertaking,
HKMA will make those US$
available.
Interest rates increase.
Clearing Balances
Supply Curve of Reserves
• For commercial banks, US$ rate is benchmark in
normal times (i.e. when peg has credibility).
• If HIBOR is greater than Fed Funds rate, sell US$
reserves and buy HK$ reserves.
• If HIBOR is lower than Fed Funds rate, sell HK$
reserves and buy HK$ reserves.
• HKMA undertakes to adjust supply of clearing
balances so that supply of reserves/clearing
balances equals the demand at the HIBOR rate
which will be set at the benchmark.
Automatic Pilot
Demand for HK Reserves Rises
iHIBOR
D
Increased demand pushes up
HIBOR
D´
Upward pressure on interest
rates attracts US$ to HK and
pushes E to strong side of band.
iFF
Banks convert US$ w/ HKMA
and get more reserves until
HIBOR and Fed Funds are
equalized.
ΔR
Clearing Balances
Automatic Pilot
Demand for HK Reserves Falls
iHIBOR
D
Decreased demand pushes
down HIBOR
D´
Downward pressure on interest
rates attracts HK$ to US and
pushes E to weak side of band.
iFF
Banks convert HKMA$ w/ HKMA
and get more US$ until HIBOR
and Fed Funds are equalized.
ΔR
Clearing Balances
Automatic Pilot: Fed Funds Rate Drops
US Policy Rates Drop
iHIBOR
D
US$ move to HK increasing
liquidity
iFF
Under convertibility undertaking,
HKMA increases reserves
Interest rates decrease.
iFF´
Clearing Balances
Automatic Pilot: Fed Funds Rate Rises
US Policy Rates Rise
iHIBOR
iFF´
iFF
Banks cash in HK$ to get more
US$ to lend.
Under convertibility
undertaking, HKMA will drain
reserves.
Interest rates fall.
D
Clearing Balances
Loss of Credibility
• A fixed exchange rate will lose credibility if people
come to believe that the central bank will:
• devalue the currency, (ie. raise S in the future)
• revalue the currency (ie. reduce S in the future)
• If market expects an exchange rate change,
commercial banks will adjust comparison rate for
the expectations of devaluation.
i
HIBOR
i
FF
  NextYear
Market Expects Revaluation, η < 0
Willingness to Hold HK$ Rises
iHIBOR
D
US$ move to HK increasing
liquidity
iFF
Under convertibility undertaking,
HKMA increases reserves
Interest rates decrease.
iFF+η
´
Clearing Balances
%
HK Interbank
Market and
Expectations of
Revaluation
Ja
n02
Ap
r- 0
2
Ju
l-0
2
O
ct
-0
2
Ja
n03
Ap
r- 0
3
Ju
l-0
3
O
ct
-0
3
Ja
n04
Ap
r- 0
4
Ju
l-0
4
O
ct
-0
4
Ja
n05
Ap
r- 0
5
Ju
l-0
5
Million HK$
Jan-02
-0.5
-1
-1.5
-2
-2.5
Aggregate Balances
60000
50000
40000
30000
20000
10000
0
Sep-05
Jul-05
May-05
Mar-05
Jan-05
Nov-04
Sep-04
Jul-04
May-04
Mar-04
Jan-04
Nov-03
Sep-03
Jul-03
May-03
Mar-03
Jan-03
Nov-02
Sep-02
Jul-02
May-02
Mar-02
HIBOR - FF
1
0.5
0
Market Expects Revaluation
η<0
iIBR
iFF
1
S
2
iFF+η
S´
ΔR
D
Clearing Balances
Market Expects Devaluation
η>0
iHIBOR
iFF +η
2
S´
1
iFF
ΔR
S
D
Clearing Balances
Currency
• Hong Kong’s central bank does not print money.
• Bank of China, HSBC, and Standard Chartered
print banknotes but…
• the banks can only issue paper notes if they buy licenses from
the central bank with US$ at a rate of $1 per HK$7.8 printed.
• The Licenses are called Certificates of Indebtedness
Certificates issued by the Financial Secretary to be held by
note-issuing banks as cover for the banknotes they issue.
• CI’s appear as liabilities on HKMA balance sheet.
Certificates of Indebtedness increase when currency increases
Exchange Fund: Liabilities: Certificates of Indebtedness
400000
300000
250000
200000
150000
Au
g08
Fe
b09
Au
g09
Fe
b10
Au
g10
Fe
b11
Au
g11
Fe
b12
Au
g12
Fe
b13
Au
g13
Fe
b14
Au
g14
Millions HK$
350000
Coins
• Coins (and recent 10 Banknotes) are issued by the
central bank unlike the USA where they are issued by
the Treasury.
Definitions here are from the “Guide to Hong Kong Monetary and Banking
Terms” by HKMA.see http://www.hkma.gov.hk
Reserves: Exchange Fund Bills
• Exchange Fund Bills and Notes Debt Instruments
issued by the HKMA for the account of the Exchange
Fund.
• Since 1990, the Exchange Fund has sold short-term
bonds (stretching the maturity structure as time goes on ).
• Exchange Fund bonds are listed on HKEX and traded in
secondary markets.
Should government debt be part of the
monetary base?
• Exchange Fund Paper can be held by anyone,
but large share is owned by local banks.
Therefore, they can be thought of as being mostly
secondary reserves of banks.
• ExFund paper is held primarily for HK$ liquidity
management purposes.
• These instruments are fully backed by Foreign
Reserves. The HKMA has undertaken that new
Exchange Fund paper will only be issued when
there is an inflow of funds.
Hong Kong Exchange Fund Bills &Notes:
August 2009
Held by Banks
Held Outside Banks
HKMA & Fed: Similarities & Differences
Assets
Same
Different
Base
Central Bank
Liabilities
•Fed assets are
primarily Treasury
securities
•HKMA assets are
primarily foreign
currency securities
• HK liabilities
include interest
paying tradable
securities primarily
held by banks
•Fed Liabilities
don’t pay interest.
Ex Fund bonds do.
HKMA & Fed Similarities & Differences
(Monetary Base)
Currency
Reserve Accounts
Same
Large part of
monetary base.
Banks keep funds at
central bank
Different
• Fed prints US
currency
•3 private banks
purchase licenses
to print currency.
• US Reserve accounts
are required by
regulation.
•HK Clearing balances
are only necessary for
transactions.
MANAGED FLOAT
Managed Floating
• Most developed/OECD central banks set
domestic interest rates in response to domestic
price levels.
• Many emerging markets or developing
economies either set a fixed exchange rate or
simply use the currency of another country –
“Dollarization”
• Many other emerging markets also practice
“managed floating” which sometimes adjusts the
interest rate in response to domestic conditions
and sometimes intervenes in foreign currency
markets to stabilize the price level.
• Managed Floats
Singapore BBC Anchor
BBC: Basket, Band, Crawl
• Basket: Singapore anchors currency to a weighted
average of different currency to immunize from changes
among large economies.
• Band: Weighted average allowed to float within a fairly
large range of the target.
• Crawl: Average is scheduled to adjust in a path over time.
• Weights in the basket, size of the band, rate of crawl are
all secrets.
• Interventions occur in both forex markets and money
markets to stabilze interbank rates.
• Long-term goal is price stability.
In October 2013, MAS maintained the modest and gradual appreciation path of the S$NEER policy band, with no change
to its slope, width, and the level at which it was centred. This policy stance, which has been in place since April 2012, was
assessed to be appropriate, taking into account the balance of risks between external demand uncertainties and rising
domestic inflationary pressures.
Link
Foreign Currency Intervention
Managed Floating: Purchase
• Foreign Central Bank cuts interest rate
• Domestic Forex rate strengthens
• Domestic Central Bank purchases forex
directly increasing demand for forex.
• Forex Purchase also expands domestic
money supply and reduces domestic interest
rates.
• This helps to keep domestic forex rate from
strengthening.
Foreign Currency Intervention
Managed Floating: Sale
• Foreign Central Bank raises interest rate
• Domestic Forex rate weakens
• Domestic Central Bank sells forex directly
increasing supply of forex.
• Forex Purchase also reduces domestic
money supply and increases domestic
interest rates.
• This helps to keep domestic forex rate from
weakening.
Foreign Currency Sale, D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
E
Supply
Supply'
1
E*
Domestic
Currency
Appreciates
E**
2
Demand
Demand '
Capital Controls
• China among other developing economies operates system of
foreign exchange controls.
• To obtain foreign exchange, Chinese residents must acquire
permission from State Administration of Foreign Exchange.
• Possible for ex/im firms to obtain foreign currency but limit of
US$20,000 for individuals investing overseas though banks and
mutual funds can apply for a quota of foreign currency.
Capital Controls & Interest Rates
• China’s financial markets remain heavily regulated and are
dominated by banks which are owned by central or
provincial governments.
• Central bank is able to set the base lending rate and
deposit rate of banks as an instrument of monetary.
• Since depositors cannot invest overseas, domestic interest
rates do not affect demand for US dollars in China’s forex
market.
Current Account
IMF Data Mapper
State Administration of Foreign Exchange
(SAFE)
• Large demand for RMB for investment and international
trade but demand for dollars limited in China forex market
due to capital controls.
• SAFE sells RMB and acquires US dollar assets. In turn,
SAFE sells domestic currency “sterilization” bonds and
large reserve requirements to Chinese banks to soak up
the money supply.
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