Trade Policy and Managed Exchange Rates - PowerPoint Presentation

Slide1

Trade Policy and Managed Exchange Rates

Trade policy is one of the most politically-loaded topics in economics.

Tariffs and other trade barriers can help domestic industries, but also increase prices for consumers and can lead to trade wars.

An appreciating currency will hurt exporters and help consumers, while a depreciating currency will help exporters and hurt consumers.Slide2

Why wouldn’t a country want its currency to appreciate?

If a currency appreciates, the country’s exports become more expensive. As exports go down, aggregate demand will also fall, which increases unemployment. Particularly, this will hurt export-oriented industries.

Of course, an appreciated currency also makes foreign goods cheaper. Thus, consumers may wish for an appreciated currency, while exporters wish for a depreciated currency.

For example, Bank of Japan policies have recently devalued the Yen. This might be considered good for exporters like Toyota, but for smaller businesses who rely on American high-tech imports (such as chemicals or semiconductors), or for everyday consumers who want to buy American milk, beef, rice, and wheat, the devaluation of the Yen has been disastrous.Slide3

Options For Devaluing a Currency

Buy foreign currency.

For example, the Chinese government keeps its currency artificially low compared to the U.S. dollar by buying dollars. This keeps the demand for dollars high, and prevents the dollar from devaluing despite the United States’ massive current account deficit. This helps Chinese export industries, which have driven overall economic development in China. However, this policy also arguably hurts Chinese consumers and importers.

Decrease interest rates.

Decreasing interest rates will cause capital outflow (or will stop capital inflow). Foreign savers and investors will demand less of your currency, which will keep the value of that currency down.

Legal options

“Capital controls” and similar policies can make it illegal for foreigners to buy domestic assets. This will reduce the demand for the currency.

Enacting tariffs and other trade barriers on foreign goods will reduce consumers’ and importers’ demand for foreign currency, and reduce the supply of the domestic currency on the foreign exchange market. However, this is likely to cause “retaliation” (revenge) from trade partners, such as retaliatory tariffs in response. “Trade wars” can result.Slide4

Case Study 1: The famous American trade deficit.

America’s trade deficit with China is (famously) more than $300 billion dollars per year.

This may make it seem like the United States simply cannot compete, however the situation is much more complicated.

A big reason that the United States has such a large current account deficit is that people demand dollars for “financial” reasons such as buying assets, putting the money in a “safe” country, investing where there is a higher interest rate (compared to Europe and Japan), and so on. This financial account surplus appreciates the currency, which leads to a current account deficit. If the United States government thought it was important to reduce the current account deficit, it could try to devalue its currency through various policies. However, the U.S. has usually chosen to allow the dollar

to remain strong.Slide5

Case Study 2: 2014 Russian currency crisis

Throughout 2014, in the wake of the Crimea crisis in Ukraine, the Russian ruble was under pressure. As recently as July 2014, the ruble was trading near 35 rubles per dollar (35=RUB/USD). Today it trades closer to 60 rubles per dollar (60=RUB/USD)

In early December 2014, as falling oil prices and sanctions dealt a double-blow to the Russian economy, the Ruble started collapsing.

The Russian Central Bank appears to have responded, using “foreign currency reserves” (government savings) to prevent the collapse.Slide6

RUB/USD

35

50

The collapse (in fact RUB/USD reached 80 at its peak in mid-December)Slide7

FOREX charts show apparent Central Bank interventions.

RUB/USD

46

52

Source:

http://

www.zerohedge.com/news/2014-12-02/russian-ruble-crashes-new-record-lows-intervention-imminent

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So what did the Russian Central Bank likely actually do?

It’s actually fairly simple – they took U.S. dollars and other currencies, and bought rubles. By increasing the demand for the ruble, you cause it to appreciate. By selling other currencies (such as the U.S. dollar), you increase the supply of that currency causing it to depreciate.

Many of these “dollars” were held as U.S. Treasury bonds. So the transaction is a little bit more complicated: sell U.S. Treasury bonds, receive USD. Sell USD, buy RUB.Slide9

Evidence of Russian Central bank having “defended” the Ruble

– A Simple Strategy: Sell U.S. treasures, buy RublesSlide10

Where did Russian foreign currency reserves come from?Slide11

Where did Russian “Foreign

R

eserves” come from?

Our model of “Current Account + Financial Account =0” is essentially true, however it does not include the fact that governments often acquire (or spend) foreign currency. In the case of Russia, large foreign currency reserves (also called “foreign exchange reserves” or “official reserves”) were built up in the 2000s, when the price of oil was very high and Russia ran a current account surplus.Slide12

China has the largest foreign exchange reserves in the world. It is mostly held as U.S. Dollars.

We have already discussed the source of many of these reserves: China has been running a huge current account surplus, and the Chinese government simply uses RMB to buy up U.S. dollars from Chinese exporters. This is done to prevent the RMB from appreciating excessively, though the foreign exchange reserves could also be useful during a fiscal or currency crisis.Slide13

Currency Revaluation

Just as a government can devalue a currency, it can also revalue a currency. The strategies are “simple opposites” of currency devaluation.

Sell foreign currency

The government can sell foreign currency reserves. This increases the supply of foreign currency, depreciating those currencies.

Increase interest rates.

Increasing interest rates may cause capital inflow, which increases the demand for the domestic currency.

Incentivize foreign investment or export

If foreigners spend money inside the country, either for assets or imports, the domestic currency will tend to appreciate.Slide14

FRQ

2011 Form B #2

Assume that yesterday the exchange rate between the euro and the Singaporean dollar was 1 euro = 0.58 Singaporean dollars. Assume that today the euro is trading at 1 euro = 0.60 Singaporean dollars.

How will the change in the exchange rate affect each of the following in Singapore in the short run?

(

i

) Aggregate

demand. Explain.

(ii) The

level of employment. Explain.

Suppose that Singapore wants to return the exchange rate to 1 euro = 0.58 Singaporean dollars.

(

i

) Should

the Singaporean central bank buy or sell euros in the foreign exchange market?

(ii) Instead

of buying or selling euros, what domestic open-market operation can the Singaporean central bank use to achieve the same result? Explain.