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Lecture11 - Lecture 11 Fixed Exchange Rates Capital Flows...

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ECON1002 Introductory Macroeconomics 1 Lecture 11: Fixed Exchange Rates, Capital Flows and the Balance of Payments At the end of this lecture, we expect you to understand… 1. How to fix exchange rates. 2. What speculative attacks mean and how they occur. 3. How monetary policy can/cannot be used under a fixed exchange rate system . 4. The logic of currency crises and the lessons from the 1992 EMS crisis and the 1996-97 Asian financial crisis. 5. Determination of the Balance of Payments and the Current Account 6. Understanding global financial equilibrium.
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ECON1002 Introductory Macroeconomics 2 Fixed Exchange Rates Fixed Exchange Rates Central Bank intervention in the international currency market to cause a divergence between the actual value of the nominal exchange rate and the fundamental value of the nominal exchange rate
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ECON1002 Introductory Macroeconomics 3 $ e S D fundamental value official value An overvalued exchange rate Fixed Exchange Rates
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ECON1002 Introductory Macroeconomics 4 Why fix the exchange rate? [1] Promote certainty (why?) [2] “Cheap” imports May help to achieve inflation target How to fix the exchange rate? [1] The government becomes a demander of its own currency [2] Restrict imports and the acquisition of foreign assets Fixed Exchange Rates [3] International competitiveness Increase NX and aggregate demand
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ECON1002 Introductory Macroeconomics 5 $ e S D official value Fixed Exchange Rates [1] The government becomes a demander of its own currency Govt. buys the excess supply of it’s own $
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ECON1002 Introductory Macroeconomics 6 Problem? The government must use (ie, sell) its international reserves (e.g. US dollars or US bonds) These are limited. Govt. may be forced to borrow in order to maintain the overvalued exchange rate. Fixed Exchange Rates
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ECON1002 Introductory Macroeconomics 7 What if the govt restricts imports and the acquisition of foreign assets (capital controls) Lose gains from free trade Fixed Exchange Rates
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ECON1002 Introductory Macroeconomics 8 Proposition : The expectation of a deprecation can cause a depreciation $ e S 0 D e 0 If I expect a deprecation next week, I can make money by selling the $ today while the price is high (after all, I can always buy it back next week at the lower price). S 1 e 1 Speculation in the currency market
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ECON1002 Introductory Macroeconomics 9 Suppose that the CB wants a monetary expansion (lowers the interest rate) $ e S D 1 e 1 D 0 Large capital outflow The CB buys more $ to keep $ fixed at e 1 . Cannot run an independent monetary policy i.e., MP must be used exclusively to support the $ MP and Fixed exchange rates
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ECON1002 Introductory Macroeconomics 10 One way to attempt to maintain an overvalued exchange rate is through tight monetary policy $ e S D 0 e 1 D 1 MP used to support e at e 1 But can’t be used for stabilising the domestic economy MP and Fixed exchange rates
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ECON1002 Introductory Macroeconomics 11 MP and Exchange Rate System Aim Flexible ER Fixed ER Full employment ( Y ) Yes No Price stability ( ) Yes No Stable exchange rates (e) No Yes Can Monetary policy be used to achieve the following macroeconomic objectives?
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