The Spot Market for Foreign Exchange

1
The Spot Market forForeign Exchange
2
Market CharacteristicsAn Interbank Market

• The spot market is a market for immediate
  delivery 92 to 3 days).
  
• Primarily an interbank market, which is the
  trading of foreign-currency-denominated deposits
  between large banks.
  
• Approximately US2 trillion daily in global
  transactions.

3
Market Quotes The WSJ Currency Trading Table

• Provides spot and forward rates. Forward rates
  are for forward contracts, or the future delivery
  of a currency.
  
• US equivalent is the dollar price of a foreign
  currency (home currency price of a foreign
  currency).
  
• Currency per US is the foreign currency price
  of one US dollar (foreign currency price of the
  home currency)

4
Market QuotesDirect - Indirect Quotes

• The home currency price of a foreign currency is
  called ?
  
• The foreign currency price of the home currency
  is called?

5
Market QuotesDirect - Indirect Quotes

• The home currency price of a foreign currency is
  called a direct quote.
  
• The foreign currency price of the home currency
  is called?

6
Market QuotesDirect - Indirect Quotes

• The home currency price of a foreign currency is
  called a direct quote.
  
• The foreign currency price of the home currency
  is an indirect quote.
  
• Dollars Yen? Dollars pounds?

7
Appreciating and Depreciating Currencies

• A currency that has lost value relative to
  another currency is said to have ?
  
• A currency that has gained value relative to
  another currency is said to have ?

8
Appreciating and Depreciating Currencies

• A currency that has lost value relative to
  another currency is said to have depreciated.
  
• A currency that has gained value relative to
  another currency is said to have appreciated.
  
• These terms relate to the market process and are
  different from devaluation and revaluation.

9
Appreciating and Depreciating Currencies

• We use the percentage change formula to calculate
  the amount of depreciation/appreciation.
  
• Example, on Monday, the peso traded at 0.1021
  /P. On Tuesday the market closed at 0.1025
  /P.
  
• The peso has appreciated, as it now takes more
  to purchase each peso.

10
Appreciating and Depreciating Currencies

• Example, on Monday, the peso traded at 0.1021
  /P. On Tuesday the market closed at 0.1025
  /P.
  
• The amount of appreciation is
• (0.1025 - 0.1021)/0.1021 100 0.39

11
Bid - Ask SpreadsExample from Financial Times

• The bid is the price the bank is willing to pay
  for the currency, e.g., 1.2002 / is the bid on
  the euro in terms of the dollar.
  
• The ask is what the bank is willing to sell the
  currency for, e.g. 1.2010 /, is the ask on the
  euro in terms of the dollar.

12
Bid - Ask SpreadCost of Transacting

• The bid - ask spread of a currency reflects, in
  general, the cost of transacting in that
  currency.
  
• It is calculated as the difference between the
  ask and the bid.
  
• Example, 1.2020 - 1.2002 0.0018.

13
Bid - Ask MarginPercent Cost of Transacting

• The bid - ask spread can be converted into a
  percent to compare the cost of transacting among
  a number of currencies.
  
• The margin is calculated as the spread as a
  percent of the ask.
  
• (Ask - Bid)/Ask 100
• Example, (1.2020 - 1.2002)/1.2020 100 0.15.

14
Cross-Rates Unobserved Rates

• A cross-rate is an unobserved rate that is
  calculated from two observed rates.
  
• For example, the spot rate for the Canadian
  dollar is 0.70 /C, and the spot rate on the
  euro is 1.02 /. What is the Canadian dollar
  price of the euro (C/)?

15
Cross-Rates Unobserved Rates

• A cross-rate is an unobserved rate that is
  calculated from two observed rates.
  
• For example, the spot rate for the Canadian
  dollar is 0.70 /C, and the spot rate on the
  euro is 1.02 /. What is the Canadian dollar
  price of the euro (C/)?
• Note that (/)/(/C) (/)(C/)C/.
• In this example, 1.02/0.70 1.457 C/.

16
ArbitrageConsistency of Cross Rates

• Arbitrage is the simultaneous buying and selling
  to profit (as opposed to speculation).
  
• The ability of market participants to arbitrage
  guarantees that cross rates will be, in general,
  consistent.
  
• If a cross rate is not consistent, the actions of
  currency traders (arbitrage) will bring the
  respective currencies in line.

17
Spatial Arbitrage

• Spatial Arbitrage refers to buying a currency in
  one market and selling it in another.
  
• Price differences arise from geographical
  (spatial) dispersed markets.
  
• Due to the low-cost rapid-information nature of
  the foreign exchange market, these prices
  differences are arbitraged away quickly.

18
Triangular Arbitrage

• Triangular arbitrage involves a third currency
  and/or market.
  
• Arbitrage opportunities exist if an observed rate
  in another market is not consistent with a
  cross-rate (ignoring transaction costs).

19
Triangular Arbitrage An Example

• The British pound is trading for 1.455 (/) and
  the Thai baht for 0.024 (/b) in New York, while
  the Thai baht is trading for 0.012 (/b) in
  London.
• Does an arbitrage opportunity exist?

20
Triangular Arbitrage An Example

• The British pound is trading for 1.455 (/) and
  the Thai baht for 0.024 (/b) in New York, while
  the Thai baht is trading for 0.012 (/b) in
  London.
• The cross-rate in New York is
• 0.024/1.455 0.016 (/b)
• Hence, an arbitrage opportunity exists.

21
Triangular Arbitrage An Example

• The British pound is trading for 1.455 (/) and
  the Thai baht for 0.024 (/b) in New York, while
  the Thai baht is trading for 0.012 (/b) in
  London.
• The cross-rate in New York is
• 0.024/1.455 0.016 (/b)
• Hence, an arbitrage opportunity exists.
• How do you exploit it?

22
Example Continued

• Buy low, sell high.
• A trader with 1, could buy 0.687 in New York.
  
  
• The 0.687 would purchase b57.274 in London.
• The b57.274 purchases 1.375 in New York, or
  37.5 profit on the transaction.

23
Real Exchange Rates Measuring Relative
Purchasing Power
24
Real Exchange RatesReal Measures

• Nominal variables, such as exchange rates, do not
  consider changes in prices over time.
  
• Real variables, on the other hand, include price
  changes.
  
• A real exchange rate, therefore, accounts for
  relative price changes.

25
Real Exchange Rates

• A nominal exchange rate indicates the purchasing
  power of one nations currency over the currency
  of another nation.
  
• Real exchange rates indicate the purchasing power
  of a nations residents for foreign goods and
  services relative to their purchasing power for
  domestic goods and services.
• A real exchange rate is an index. Hence, we
  compare its value for one period against its
  value in another period.

26
Real Exchange RatesAn Example

• In 2000 the spot rate between the dollar and the
  pound was 1 USD 0.6873 GSB (/).
  
• Yesterday the rate was 1 USD 0.5100 GBP.
• Hence, the pound appreciated relative to the
  dollar by 26 percent (0.5100-0.6873)/0.6873100
  .
  
• Based on this alone, the purchasing power of US
  residents for British goods and services
  (relative to US goods and services) fell by 26
  percent.

27
Example Continued

• Suppose in 2000 the British CPI was 156.4 and the
  US CPI was 154.7. In early 2006, the CPIs were
  170.5 and 172.7 respectively.
  
• Based on this, British prices rose 9.0 percent
  while US prices rose 11.6 percent, a 2.6
  difference.
  
• Since the prices of British goods and services
  rose slower than the prices of US goods and
  services, there was an increase in purchasing
  power of British goods and services relative to
  the purchasing power of US goods and services.

28
Combining the Two Effects

• A real exchange rate combines these two effects -
  the fall in purchasing power of US residents due
  to the nominal appreciation of the pound and the
  gain in relative purchasing power due to British
  prices rising at a slower rate than US prices.
• To construct a real exchange rate, the spot rate,
  as it is quoted here, is multiplied by the ratio
  of the US CPI to the UK CPI.
  
• (/) x (US CPI/UK CPI)

29
Combining the Two Effects

• 2000 Real Rate 0.6873 x (154.7/156.4) 0.6798
• 2007 Real Rate 0.51 x (172.7/170.5) 0.52.
• The real appreciation of the pound was only 24
  percent.

30
Conclusion

• The nominal exchange rate change resulted in a 26
  percent fall in the purchasing power of US
  residents for UK goods and services.
  
• The difference in price changes resulted in a 2.6
  percent gain in purchasing power of UK goods and
  services relative to US goods and services for US
  residents.
• Consequently, the 26 percent rise was offset by
  the 2.6 gain, resulting in an overall 24 percent
  loss in purchasing power.

31
Effective Exchange Rate

• A measure of the general value of a currency.

32
Effective Exchange Rate

• On any given day, a currency may appreciate in
  value relative to some currencies while
  depreciating in value against others.
  
• An effective exchange rate is a measure of the
  weighted-average value of a currency relative to
  a select group of currencies.
  
• Thus, it is a guide to the general value of the
  currency.

33
Weighted Average Value

• To construct an EER, we must first pick a set of
  currencies we are most interested in.
  
• Next, we must assign relative weights. In the
  following example, we weight the currency
  according to the countrys importance as a
  trading partner.

34
Weights

• Suppose that of all the trade of the US with
  Canada, Mexico, and the UK, Canada accounts for
  50 percent, Mexico for 30 percent, and the UK for
  20 percent.
• These constitute our weights (0.50, 0.30, and
  0.20).
  
• Now consider the following exchange rate data.

35
Exchange Rate Data
36
Calculating the EER

• The EER is calculating by summing the weighted
  values of the current period rate relative to the
  base year rate.
  
• The weighted-average value is calculated as
• (weight i)?(current exchange value i)/(base
  exchange value i)
  
• where i represents each individual country
  included in the weighted average.

37
Calculating the EER

• Commonly this sum is multiplied by 100 to express
  the EER on a 100 basis.
  
• Hence, an EER is an index.
• As we shall see next, the base-year value of the
  index is 100.
  
• The index, therefore, is useful is showing
  changes in the weighted average value from one
  period to another.

38
Example

• Let last year be the base year.
• The effective exchange rate last year was
• (1.52/1.52)0.50 (10.19/10.19)0.30
• (0.61/.61)0.20100
• 100.
• As with any index measure, the base year value is
  100.
  

39
Example

• Todays value of the EER is
• (1.44/1.52)0.50 (9.56/10.19)0.30
• (0.62/0.61)0.20
• or (0.958) 95.8
• The dollar, therefore, has experienced a 4.2
  percent depreciation in weighted value.

40
Effective Exchange Measures

• There are a number of effective exchange measures
  available in the popular press. Some common
  measures are
  
• Bank of England Index The Economist.
• J.P. Morgan The Wall Street Journal and the
  Financial Times.

41
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42
Purchasing Power Parity
43
Purchasing Power ParityAbsolute or the Law of
One Price

• Suppose The Economist magazine sells for 2.50 in
  the UK and 3.95 in the US.
  
• Arbitrage, therefore, should guarantee that the
  exchange rate between the dollar and the pound be
  s 3.95/2.50 1.580 (/).
  
• In words, the dollar price of The Economist in
  the UK should equal the dollar price of the
  Economist in the US (ignoring transportation
  costs).

44
Absolute PPP

• Absolute PPP is expressed as P PS, where P is
  the domestic price, P is the foreign price, and
  S is the spot rate, expressed as domestic to
  foreign currency units.
• Often it is rearranged as S P/P.

45
Absolute PPP as a Guide to Exchange Values

• Suppose the actual spot rate pertaining to the
  previous example is 1.7743 whereas PPP says the
  rate should be 1.580.
  
• A difference exists so we can conclude (for
  instructional purposes) that the pound is
  overvalued relative to the dollar.
  
• In percentage terms (1.580 - 1.7743) /1.7743 x
  100 -11 percent.

46
Relative PPP - A Weaker Version

• Rearrange APPP to S P/P.
• Divide one period equation by another period,
  e.g., S1/S0 (P1/P0)/(P1/P0)
  
• Rearrange as S1 S0(P1/P0)/(P1/P0)
• Can be used as a model of exchange rate
  movements.
  
• Note that the emphasis is on exchange rate
  movements, not levels, though it may appear
  otherwise.

47
Example

• Suppose the exchange rate between the dollar and
  the pound was 1.58 in 2000 and is 1.77 today.
  Further, the UK CPI was 110 and is now 115, while
  the US CPI was 108 and is now 111.
• Plugging this into the formula we have
• st (1.58) (111/108)/(115/110) 1.55
• Hence the is overvalued (14).

48
Another Expression

• In words, domestic inflation less foreign
  inflation should equal the change in the spot
  rate.
  
• Implies that the higher inflation country should
  see its currency depreciate.

49
Interest Rates and Currency Markets
50
Question of the dayWhy does investment capital
flow from some economies to others?
51
The MacDougall Diagramof International
Investment Flows

• Model for understanding the interaction of supply
  of and demand for investment capital in different
  countries.
  
• Provides us with a benchmark for interpreting
  cross-border capital movements.
  
• Simple but quite useful - will be revisited later
  in course.

52
Optimal International Investment
x-axis measures total capital available for
investment in a country
O
Capital
53
Optimal International Investment
y-axis reflects the prevailing rate of return per
unit of capital (i.e. per ) available in a
country.
r (rate of return)
O
Capital
54
Optimal International Investment
Then draw a line which reflects the prevailing
rate of return in an economy, depending on the
total stock of capital.
r (rate of return)
O
Capital
55
Optimal International Investment
Why does the line slope downward?
r (rate of return)
O
Capital
56
Optimal International Investment
If a country only has one unit of capital, the
rate of return must be high.
r (rate of return)
O
Capital
57
Optimal International Investment
If a country only has one unit of capital, the
rate of return must be high.
r (rate of return)
Lots of land, lots of workers, little equipment,
few factories.
O
Capital
58
Optimal International Investment
r (rate of return)
As more capital is around competing, land
becomes scarce and workers become expensive.
O
Capital
59
Optimal International Investment
r (rate of return)
If k is the total stock of capital in a
particular country
O
Capital
k
60
Optimal International Investment
r (rate of return)
Then r0 is the prevailing interest rate in the
economy.
r0
O
Capital
k
61
Optimal International Investment
r (rate of return)
The shaded area then represents the economys
gross domestic product (GDP).
r0
O
Capital
k
62
Optimal International Investment
Now consider a second country with a different
(better) schedule of return possibilities...
r (rate of return)
O
Capital
k
63
Optimal International Investment
Now consider a second country with a different
(better) schedule of return possibilities...
r (rate of return)
O
Capital
k
64
Optimal International Investment
a lower supply of capital...
r (rate of return)
O
Capital
k
k
65
Optimal International Investment
a lower supply of capital...
r (rate of return)
O
Capital
k
66
Optimal International Investment
and therefore a higher prevailing interest rate.
r (rate of return)
r0
O
Capital
k
67
Optimal International Investment
r (rate of return)
Denoting variables of this second (call it
foreign) country with asterisk.
r0
O
Capital
k
68
We then can take this graph and flip it around.
r (rate of return)
r0
O
Capital
k
69
We then can take this graph and flip it around.
r (rate of return)
r0
O
Capital
k
70
Then add the graph of the original country (home
country).
r (rate of return)
r0
O
Capital
k
k
71
How far over do we bring it?
r (rate of return)
r0
r0
O
O
Capital
k
k
72
Until the length of the horizontal axis
represents the total quantity of capital in the
two economies...
r (rate of return)
r0
r0
O
O
Capital
k
k
73
So that the length from 0 to k0 is the amount of
capital in the domestic economy...
r (rate of return)
r0
r0
O
O
Capital
k0
74
So that the length from 0 to k0 is the amount of
capital in the foreign economy...
r (rate of return)
r0
r0
O
O
Capital
k0
75
Now what happens if both countries allow capital
to flow freely between them?
r (rate of return)
r0
r0
O
O
Capital
k0
76
The owners of capital in the home country are
only earning r0
r (rate of return)
r0
r0
O
O
Capital
k0
77
Whereas capital in the foreign country is earning
a higher return of r0
r (rate of return)
r0
r0
O
O
Capital
k0
78
So owners of capital in the home country will
begin to move capital overseas...
r (rate of return)
r0
r0
O
O
Capital
k0
79
Shifting k to the left
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
80
Increasing the supply of capital in the foreign
country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
81
Decreasing the supply of capital in the home
country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
82
Increasing interest rates in the home country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
83
And decreasing the returns to capital in the
foreign country
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
84
When will the flows of capital from the home to
the foreign country cease?
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
85
When incentives to transfer capital no longer
exist...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
86
When rates of return to capital are equated
when r1 r1
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
87
This concept is know as Real Interest Parity
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
88
QuestionWhich economy benefits from the flow
of capital?
89
The foreign countrys GDP increases from this...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
90
to this.
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
91
The home country loses some GDP...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
92
The home country loses some GDP...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
93
But total world production has now increased by
this amount.
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
94
For use of the home countrys capital, the
foreign country pays r1 times the amount
borrowed.
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
95
GNP (which equals GDP Overseas Income) is
therefore...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
96
So the home country GNP increases by...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
97
Similarly, after paying the interest bill, the
foreign GNP increases by...
r (rate of return)
r0
r1
r1
r0
O
O
Capital
k0
k1
98
Why Does Capital Flow?

• According to the optimal investment analysis...
• Whenever returns are different in two countries.
• According to the Balance of Payments Equation...
• It doesnt have much choice.
• That is, it must flow into any country that is
  importing more than it is exporting.
  
• How do we reconcile these two perspectives?
• With changes in prices, returns, and exchange
  rates.
  

99
Key Points

• 1. MacDougall diagram can account for
  international investment in a frictionless
  world.
  
• 2. It produces Real Interest Parity, which says
  that when international capital markets are
  frictionless, real returns are equated across
  countries.
• 3. Capital will flow from capital-rich countries
  with ordinary returns to capital-poor countries
  with attractive possibilities.
  
• 4. MacDougall analysis can account for shocks to
  capital stock and technological shifts.
  
• 5. From a GNP standpoint, all countries benefit
  from international capital mobility.

100
Key Points

• 6. MacDougall analysis is highly simplified -
  only a benchmark from which to proceed.
  
• 7. Later in course we will introduce frictions
  (i.e. risk, taxes, government intervention,
  etc.).
  
• 8. The Balance of Payments equation tells us that
  goods and capital must flow together or
  differences must be offset by government
  intervention (resulting in changes in reserve
  levels).
• 9. Not always clear whether goods drive capital
  or capital drives goods (i.e. are residents of
  one country demanding too much consumption or are
  foreigners too eager to invest).
• 10. Adjustments in prices, exchange rates, and
  returns will be important for balancing the
  balance of payments.

101
The Monetary Base and the Money Stock
102
Example US Capital Inflows, Sony, and Ford
(1997-1998)

• January 1997
• - Yen/ exchange rate reaches 115 - a 45-month
  high.
  
• - DJIA finishes 1996 up 26, fueled by
  near-record 142 billion US capital account
  inflows.
  
• - Sony announces they will halt production of
  Playstation home-video game in the U.S. and
  shift it back to Japan.
  

103
Example US Capital Inflows, Sony, and Ford
(1997-1998)

• January 1997
• - Yen/ exchange rate reaches 115 - a 45-month
  high.
  
• - DJIA finishes 1996 up 26, fueled by
  near-record 142 billion US capital account
  inflows.
  
• - Sony announces they will halt production of
  Playstation home-video game in the U.S. and
  shift it back to Japan.
  
• January 1998
• - Yen/ exchange rate reaches 133.6 - a 5.5 year
  high.
  
• - US capital account expands to 157 billion as
  weak Asian currencies prompt a flight to dollar
  deposits.
  
• - Ford announces plans to build autos in Japan
  for export.

104
Central Bank Functions

• Fiscal Agents
• Bankers Bank
• Lenders of Last Resort
• Macroeconomic and Monetary Policy Makers
• Exchange market intervention
• Monetary policy

105
The Monetary Base

• A nations monetary base can be measured by
  viewing either the assets or liabilities of the
  central bank.
  
• The assets are domestic credit (DC) and foreign
  exchange reserves (FER).
  
• The liabilities are currency in circulation (C)
  and total reserves of member banks (TR).

106
Simplified Balance Sheet of the Central Bank
Assets
Liabilities
Currency (C)
Domestic Credit (DC)
Foreign Exchange Reserves (FER)
Total Reserves (TR)
Monetary Base (MB)
Monetary Base (MB)
107
Money Stock

• There are a number of measures of a nations
  money stock (M).
  
• The narrowest measure is the sum of currency in
  circulation and the amount of transactions
  deposits (TD) in the banking system.

108
Money Multiplier

• Most nations require that a fraction of
  transactions deposits be held as reserves.
  
• The required fraction is determined by the
  reserve requirement (rr).
  
• This fraction determines the maximum change in
  the money stock that can result from a change in
  total reserves.

109
Money Multiplier

• Under the assumption that the monetary base is
  comprised of transactions deposits only, the
  multiplier is determined by the reserve
  requirement only.
• In this case, the money multiplier (m) is equal
  to 1 divided by the reserve requirement,
  
• m 1/rr.

110
Relating the Monetary Base and the Money Stock

• Under the assumptions above, we can write the
  money stock as the monetary base times the money
  multiplier.
  
• M m?MB m(DC FER) m(C TR).
• Focusing only on the asset measure of the
  monetary base, the change in the money stock is
  expressed as
  
• ?M m(?DC ?FER).

111
Example - BOJ Intervention

• Suppose the Bank of Japan (BOJ) intervenes to
  strengthen the yen by selling 1 million of US
  dollar reserves to the private banking system.
  
• This action reduces the foreign exchange reserves
  and total reserves component of the BOJs balance
  sheet.

112
BOJ Balance Sheet
Assets
Liabilities
C
DC
FER
TR
-1 million
-1 million
MB
MB
-1 million
-1 million
113
BOJ Intervention

• Because the monetary base declined, so will the
  money stock.
  
• Suppose the reserve requirement is 10 percent.
  The change in the money stock is
  
• ?M m(?DC ?FER),
• ?M (1/.10)(-1 million) -10 million.

114
Exchange Rate Intervention
Why do governments attempt to fix exchange
rates? Why do governments attempt to fix prices?
1. They think ER volatility is destabilizing -
that by removing volatility they will be making
people better off. 2. Like any other price fix
(i.e. U.S. sugar supports), ER fixes are a
political tool. They subsidize one group at the
expense of others. 3. To signal intentions.
115
How to Fix Exchange Rates
How can a government fix an exchange rate?
The same way a government fixes any other price
1. By controls (much like U.S. price controls in
early 1970s). Make trade at a different price
illegal. 2. By intervention in the market (much
like sugar). By committing to buy/sell at a
certain price.
116
1. Exchange Rate Controls
Recall our original supply-demand graph for
exchange rate determination
/Peso
Supply
s
Demand
Quantity of Pesos
117
1. Exchange Rate Controls
If demand for Argentine pesos decreases...
/Peso
Supply
s
Demand
Quantity of Pesos
118
1. Exchange Rate Controls
But the Argentine Banco Central makes exchanges
of FX illegal at any rate other than s...
/Peso
Supply
s
Demand
Quantity of Pesos
119
1. Exchange Rate Controls
Dollars will be rationed - there will be excess
supply of pesos (demand for ) at the fixed
exchange rate of s...
/Peso
Supply
s
Demand
Quantity of Pesos
120
1. Exchange Rate Controls
A black market will invariably emerge which
trades pesos at a discount relative to the fixed
rate.
/Peso
Supply
s
sb
Demand
Quantity of Pesos
121
Example The Uzbek Sum

• In 1996, the Uzbek central bank fixed the
  exchange rate at an overvalued level of 0.02 /
  Sum
  
• Imports were cheap exports expensive
  imports rose by 50 in 1996 exports were
  down.
  
• The central bank started running short of
  reserves.
  
• Daewoo and British American Tobacco
  experienced delays in converting Sum
  revenues.
  
• Black market exchange rate began falling
  steadily.
  
• In October, the Central bank canceled all
  conversion licenses and handed out dollar
  quotas.

122
Example The Uzbek Sum

• The government banned the use of dollars inside
  Uzbekistan.
  
• Inflation soared.
• The black market rate fell to 0.0074 / Sum.
• Foreign investment inflows dried up - decreasing
  Sum demand further.

123
2. Exchange Rate Intervention
Central Bank Balance Sheet
C (Currency) R (Reserves of Commercial Ban
ks)
(Domestic DA Assets/Bonds) (Foreign Assets FAC
B of Central Bank)
124
2. Exchange Rate Intervention
Central Bank Balance Sheet
C (Currency) R (Reserves of Commercial Ban
ks)
(Domestic DA Assets/Bonds) (Foreign Assets FAC
B
of Central Bank)
H (High Powered Money)
Accounting Identity DA FACB H
125
2. Exchange Rate Intervention
To insure that the exchange rate remains at a
constant level, the central bank must
purchase/sell FX to ensure supply intersects
demand at the appropriate price
/Peso
Supply
s
Demand
Quantity of Pesos
126
2. Exchange Rate Intervention
Suppose the central bank is trying to target an
exchange rate of s.
/Peso
Supply
s
Demand
Quantity of DM
127
2. Exchange Rate Intervention
What happens if demand for Pesos increases?
/Peso
Supply
s
s
Demand
Quantity of Pesos
128
2. Exchange Rate Intervention
Unless something is done, the exchange rate will
appreciate to s.
/Peso
Supply
s
s
Demand
Quantity of Pesos
129
What should the Central Bank Do?
3 Options 1. Discourage capital inflows. Curb d
emand. Example Chile.
130
Option 1. Discourage Inflows
Enact policies which curb demand for peso (i.e.
Tobin Taxes) and push intersection back to
original level.
/Peso
Supply
s
s
Demand
Quantity of Pesos
131
Option 2 Unsterilized Intervention
Banco Central offers sufficient peso supply in
the FX market to meet demand at s
/Peso
Supply
s
s
Demand
Quantity of Pesos
132
Option 2 Unsterilized Intervention
What does this mean for the Central Banks
balance sheet? They supply Pesos for .
Reserves of will increase D FACB 0 Since th
e central bank is selling Pesos, the supply of
currency must increase too