Exchange Rate Arrangements: Outline

 What’s the exchange rate arrangements? Roughly

speaking, it is a country’s policy about the
fluctuations of its currency value.
 In this class, we will talk about
 Various Exchange Rate Arrangements
 Fixed vs. Floating Exchange Rate Arrangements
 The Impossible Trinity

1
Various Exchange Rate Arrangements
 Independent Floating
 Allowing market forces to determine their currency’s value. Examples:
U.S., Japan, U.K., Canada, …
 Managed Floating
 Combining government intervention with market forces to set exchange
rates. Examples: China, India, Russia, …
 Currency Board Arrangement
 pegged to another currency (usually $ or €), and exchange rates only vary
within the predetermined limits. Examples: Hong Kong, Estonia
 Monetary Union Arrangement
 the country belongs to a currency union in which the same currency is
shared by the union members. Examples: euro zone member countries

2
 Independent Floating:
EUR vs. USD

 Governments are still allowed to intervene in the FX

market, but the purpose is to moderate the rate of change
and prevent undue fluctuations in the exchange rate rather
than to establish a level for it.
3
 Managed Floating:
USD vs. CNY

 From July 21, 2005 to Aug 30, 2008, Chinese Yuan

(CNY) starts to float against USD under the influences of
Chinese monetary authority, but there is no preannounced
path for the exchange rate.
4
Independent Floating vs. Managed Floating
 the two arrangements, independent floating and
managed floating, only differ in terms of the degree of
government intervention.
 However, there is no clear cut between the two: even
government adopting independent floating arrangement
intervene in the FX markets sometimes.
 For example, in September 2010 after four-months’ persistent
and severe appreciation of JPY against USD, the Japanese
government intervened in the FX market which caused a sharp
drop in the JPY exchange rate.

5
 Currency Board Arrangement:
USD vs. HKD

 Under the currency board arrangements, the exchange rate

between HKD and USD can only fluctuate between
HK$7.85 = US$1 and HK$7.75 = US$1 .

6
 Managed Floating vs. Currency Board
 The biggest difference between managed floating
and currency board is that under the former
arrangement there is no preannounced path for
the exchange rates, while under the latter
arrangement, the government typically pre-
specifies a range under which its currency value
can fluctuate.

7
 Currency Board Arrangement
in Hong Kong
 Banknotes in Hong Kong are issued by the three note-
issuing banks (NIBs): HSBC, Standard Chartered Bank,
and Bank of China (HK).
 When the three NIBs issue banknotes, they are required to
submit US dollars (at HK$7.80 = US$1) to the Hong
Kong monetary authority (HKMA) for the account of the
Exchange Fund in return for Certificates of Indebtedness
 The US dollar exchanges are kept as Hong Kong's
Exchange Fund, which is among the largest official
reserves in the world.
8
 Currency Board Arrangement
in Hong Kong
 The HKMA operates Convertibility Undertakings
on both the strong side and the weak side of the
linked rate of 7.80
 Under the strong-side where the exchange rate rises
beyond HK$7.75 = US$1, the HKMA will buy US$
and sell HK$ to keep the exchange rate at 7.75.
 Under the weak-side where the exchange rate drops
beyond HK$7.85 = US$1, the HKMA will sell US$
and buy HK$ to keep the exchange rate at 7.85.

9
Euro and the Monetary Union Arrangement
 On January 1, 1999, 11 European Union (EU) members
adopted a common currency called the euro, voluntarily
giving up their monetary sovereignty. Together with the
launch of euro, European Monetary Union (EMU), was
also created.
 For countries within the Euro zone, their exchange rates
are trivially fixed at one (why?).
 Fixed exchange rate never changes. This is in contrast to the
currency board arrangement which still allows for variations.

10
 Euro Zone

11
 Different Denominations of the Euro
Notes and Coins
 The euro is divided into 100 cents, just like the
U.S. dollar.
 There are 7 euro notes and 8 euro coins.
 €500, €200, €100, €50, €20, €10, and €5.
 The coins are: 2 euro, 1 euro, 50 euro cent, 20
euro cent, 10, euro cent, 5 euro cent, 2 euro cent,
and 1 euro cent.

12
 The European Central Bank

 Monetary policy for the euro zone countries is

conducted by European Central Bank (ECB)
headquartered in Frankfurt, Germany
 The primary objective of ECB is to maintain “price
stability”, defined as an annual inflation rate of less
than but close to 2%
 ECB is independent and is not subject to political
pressures from any member countries.

13
 The Prospects of the Euro
 Will the euro become a global currency rivaling
the U.S. dollar?
 The U.S. dollar has been the dominant global
currency since WWI because dollar is backed by
 The sheer size of the U.S economy
 Relatively sound monetary policy of the Federal
Reserve.

14
 The Prospects of the Euro
 Macroeconomic Data for Major Economies in 2005
Economy Population GDP World International Annual
(Million) ($ Billion) Trade Bonds Inflation
Share Outstanding
($ Billion)
U.S. 294.0 10,951 17.9 3,073 2.2%
%
Euro Zone 306.3 7,745 15.7 5,002 2.3%
%
Japan 127.7 3,625 6.6% 269.6 -0.6%
U.K. 59.3 1,774 5.6% 1,134 2.1%
15
 Floating vs. Fixed
Exchange Rate Arrangements
 So far we’ve seen various exchange rate
arrangement: independent floating, managed
floating, currency board, and fixed, which go
from the one extreme to the other.
 A fundamental question remains: why some
countries allow their currencies to float while the
other countries prefer to fix their currency values?

16
 Floating vs. Fixed
Exchange Rate Arrangements
 Arguments in favor of floating exchange rate
arrangements:
 Easier adjustments of imbalances in international
payments.
 Maintaining the national policy autonomy so that the
government can use its monetary and fiscal policies to
address particular domestic economic issues.

17
 Imbalance in International Payments
 Suppose that at the current exchange rate of $1.4
for £1 the U.S. is running BOP deficit, whereas
the U.K. is running BOP surplus.
 With floating rate arrangement, the imbalance can
be adjusted automatically.
 With fixed rate arrangement, on the other hand,
the U.S. government has to take policy actions to
correct its BOP disequilibrium.

18
Imbalance in International Payments
Supply
Dollar price per £
(exchange rate)

(S)

Demand
$1.40 (D)
Excessive
demand of pound

S D Q of £
19
 Adjustment under the Floating
Exchange Rate arrangement
Supply
Dollar price per £
(exchange rate)

(S)

$1.60
Pound appreciates Demand
$1.40 (floating regime) (D)

Demand (D*)

D=S Q of £
20
 Adjustment under the Fixed
Exchange Rate Arrangement
Supply
Dollar price per £

Contractionary
(exchange rate)

policies (S)
(fixed regime)

Demand
$1.40 (D)

Demand (D*)

D* = S Q of £
21
 National Policy Autonomy
 By adopting the fixed exchange rate
arrangements, a country has to give up part or
even all of its monetary policy autonomy. Hence,
the country can no longer effectively address the
domestic economic issues.

22
 National Policy Autonomy:
Asymmetric Shocks
 Consider Finland, a country that heavily depend on the
paper and pulp industries. Hence, a sudden drop in world
paper and pulp prices could severely hurt the Finnish
economy but affect other euro zone countries little.
 Such a shock is called the asymmetric shock.

 If it maintained the monetary independence, facing the

asymmetric shock, Finland could lower its domestic
interest rate and let its currency depreciate to stimulate the
weak economy. (why?)

23
 National Policy Autonomy:
Asymmetric Shocks
 Because Finland has joined the euro zone, the country
no longer has these policy options at its disposal.
 Worse, European Central Bank (ECB) may even
decide to increase the common interest rate because
the rest part of the euro zone is experiencing
inflation.
 Since the shock is asymmetric, we might be witnessing
overheated economies in the other euro zone countries while
Finland is experiencing a serious recession.

24
 Floating vs. Fixed
Exchange Rate Arrangements
 Arguments in favor of fixed exchange rate
arrangements:
 The reduction and even elimination of the foreign
exchange risks can save transaction costs, foster cross-
border trades, and attract foreign capitals, all of which
are beneficial to the economic growth of a country.

25
 Fixed Exchange Rate Arrangements
in the Euro Zone
 By adopting a single currency,
 Companies that used to hedge exchange risk will save
hedging costs.
 intra-euro zone travel, trades and investments are promoted.
 Price becomes more transparent, and consumers can benefit
from comparison shopping.
 As the result, the efficiency and the competitiveness of
the euro zone economy are greatly enhanced.

26
 Which Exchange Rate Arrangement?
 Back to previous question. Which exchange rate
arrangement should a country adopt?
 For countries such as the U.S. and Japan, they put their
policy autonomy as the priority, and they also prefer easier
external adjustments of their BOP. Hence, they choose to
adopt floating exchange rates
 The euro zone countries are instead committed to promoting
financial, economic, and even political integration among
each other. As result, they choose to adopt fixed exchange
rates at the sacrifices of their policy independences.

27
 Optimum Currency Areas (Deeper Issue)
 Not every country is suitable for adopting the fixed
exchange rate arrangement, even if it wants to.
 According to the theory of optimum currency areas
conceived by Mundell in 1960, two countries or regions
(essentially) adopting the same currency should have high
degrees of factor (i.e., capital and labor) mobility between
each other.
 A high degree of factor mobility would provide an adjustment in
response to country-specific shocks.

28
 Optimum Currency Areas (Deeper Issue)
 For example, the 50 states within the U.S. approximates
an optimum currency area, because the degree of capital
and labor mobility within the U.S. is high.
 For example, when oil prices jumped up in the 1970s, many
workers moved from oil-consuming regions such as New England
which suffered a severe recession to Texas, a major oil-producing
state, which experienced a major boom.
 On the other hand, Finland does not seem to satisfy the
conditions adopting Euro.
 Upon the asymmetric shocks, it is hard for workers in Finland to
move to, for example, Germany or France.

29
 Optimum Currency Areas (Deeper Issue)
 Using the theory of optimum currency areas, let’s
consider again the exchange rate arrangement in HK.
 HKD is largely fixed to the USD.
 Question: do HK and the U.S. have labor and capital
mobility between each other?
 Recently, some economists suggest HKD being
pegged to CNY instead, or even to abolish HKD and
just use CNY in HK.
 This is an open question, which is still under discussion.

30
Attributes of the “Ideal” Arrangement
 Exchange rate stability – the value of the currency would be
fixed in relationship to other currencies so that traders and
investors have no concerns about foreign exchange risks
 Full financial integration – complete freedom of capital flows
would be allowed, so that resources can be optimally allocated
on the global basis.
 Monetary independence – domestic monetary and interest rate
policies would be set by each individual country to pursue
desired national economic policies

31
 The Impossible Trinity

Monetary Exchange Rate

Independence stability

Full Financial Integration

 The Impossible Trinity says a country must give up one of

the three goals described by the three sides of the triangle:
monetary independence, exchange rate stability, and free
capital flows.
32
 The Impossible Trinity
Here are three examples:
 Euro zone countries achieve both exchange rate stability

and full financial integration, but they have to give up

monetary independence
 U.S. and Japan achieve both monetary independence and

full financial integration, but they have to give up

exchange rate stability.
 Before July 21, 2005 when CNY is pegged to $, China

achieves both monetary independence and exchange rate

stability, but it had to give up the full financial integration.
33
 The Impossible Trinity
Full Capital Controls

Monetary Exchange Rate

Independence Stability
Increased Capital
Mobility

Floating Full Financial Monetary Union

Integration
Facing increased capital mobility, countries are “cornered” into being either
independently floating (like the U.S. and Japan) or integrated with other countries
in monetary unions (like the euro zone countries).

34
 Analysis of the China Case
By applying the impossible trinity:
 Like many other countries, China is encouraging

cross-border capital flows, in the direction of full

financial integration.
 On the other hand, with no doubt China will try to

remain independent in its policy making.

 Hence we can predict that in the future China

must allow CNY to float freely against other

major currencies.
35
 Exchange Rate Prediction: Outline
 Approaches on Forecasting Exchange Rates
 Long-Term Trends vs. Short-Term Noise
 Forecasting in Practice

36
 Approaches on Forecasting
Exchange Rates
 Efficient Markets Approach
 Fundamental Approach
 Parity Conditions
 Balance of Payments
 Monetary Approach
 Technical Approach

37
 Efficient Markets Approach
 Financial Markets are efficient if prices reflect all
available and relevant information. If so, exchange
rates will only change when new information arrives.
 Mathematically, efficient market approach is usually
expressed as:
St  E ( St 1 | I t )
 Intuitively, based on the currently available information, a
fund manager does not know in which direction the future
exchange rate will differ from today’s exchange rate.

38
 Efficient Markets Approach
 The relationship
St  E ( St 1 | I t )
is sometimes called the random walk hypothesis,
suggesting that today’s rate is the unbiased predictor of
tomorrow’s rate.
 Recall in chapter 3, we talked about a theory in which
forward rate is the unbiased predictor of the future
exchange rate based on the available information if the
markets are efficient:
Ft ,t 1  E ( St 1 | I t )
39
Spot Rate vs. Forward Rate as the Predictor
 Recall 1  i$
Ft ,t 1  St
1  i£
To the extent that interest rates are different between the
two countries, the forward exchange rate will differ from
the current spot exchange rate.
 Those who subscribe to the efficient market hypothesis
may predict the future exchange rate using either Ft ,t 1 or
St . A natural question: which one is better?

40
Spot Rate vs. Forward Rate as the Predictor
 Agmon and Amihud (1981) compared the
performance of the forward rate with that of the
random walk model in which current spot rate is used
as the predictor of the future spot rate.
 They found that in the short run, forward rate failed to
outperform the random walk model.
 The two prediction models that are based on the efficient
market hypothesis registered largely comparable
performances for short-run predictions!

41
 Efficient Markets Approach
 Predicting the exchange rates using the efficient
market approach has two advantages:
 The market data are publicly available.
 The market-based forecasts are hard to be outperformed
unless forecaster has access to private information that
is not yet reflected in the current exchange rate.

42
 Fundamental Approach
The fundamental approach to exchange rate forecasting
uses various models/ methods such as:
 the international parity conditions that integrate exchange rates with
inflation and interest rates
 the relations between a country’s balance of payments and the level of
its exchange rate
The monetary method belongs to the fundamental approach
which suggests that the exchange rate is determined by
three independent (explanatory) variables: i) relative
money supplies; ii) relative velocity of monies; iii) relative
outputs.
43
 Monetary Method
One can formulate the monetary method in the following empirical
form:
s    1 (m  m* )   2 (v  v* )   3 ( y *  y )  u
where:
s natural logarithm of the spot exchange rate
m  m*  natural logarithm of domestic/foreign money supply
v  v*  natural logarithm of domestic/foreign velocity of money
y*  y  natural logarithm of foreign/domestic output
u  random error term, with mean zero
 ,  ' s  model parameters

44
 Monetary Method
 Generating forecasts involve:
 step 1: Estimate the model parameters such as  and
 s
m  m*
using the past realizations of and the explanatory
variables such as
 step 2: Estimate the future values of the explanatory
variables
 step 3: Substitute estimates in step1&2 into the model to
develop forecasts of the future spot rates

45
 Monetary Method
 The monetary method has three main difficulties
 Forecasting the explanatory variables may not be

necessarily easier than forecasting exchange rate

directly.
 The parameter values, that is,  and  ' s may change

over time.
 the model itself can be mis-specified.

 Researchers found that the monetary method does not

work any better than the market-based forecasts in the
short to the medium run.
46
 Technical Approach
 Technical approach first analyzes the past behavior of
exchange rates to identify “patterns”, and then projects
them into the future to generate forecasts.
 An example of moving average crossover rule for
exchange rate of £ (in American terms).
 Two types of moving averages: short term moving average (SMA)
and long term moving average (LMA). SMA weighs recent
exchange rate changes more heavily than LMA
 A crossover of the SMA above LMA signals that £ is appreciating,
while a crossover of the SMA below LMA signals that £ is
depreciating.

47
 Technical Approach

LMA D

SMA
A

tA tD
 One can forecast exchange rate movement based on the
crossover of the moving average.
48
 Technical Approach
 The technical approach is based upon the premise
that history repeats itself, which is at odds with
the random walk hypothesis (RWH).
 The RWH states that the incremental changes in the
exchange rate will be independent of the past history of
the exchange rate.
 Technically oriented traders tend to view price patterns
as repetitive but with an element of chaos.

49
 Technical Approach
 While academic studies tend to discredit its
validity, the technical approach is still widely used
 If enough traders use technical analysis, the predictions
based on it can become self-fulfilling to some extent.
 The technical approach is often used together with the
fundamental approach, and it is far easier to hold a
technical position on both emotional and intellectual
grounds if the fundamental picture also supports your
position.

50
 Long-Term Trends
vs. Short-Term Noise
 Decades of empirical studies show that in the long run,
exchange rates do adhere to the fundamental principles
and theories such as the international parity conditions –
fundamentals do apply in the long term :
 There exists something of a fundamental equilibrium path for a
currency’s value
 In the short and the medium term, however, a variety of
random events, institutional frictions, and technical factors
may cause currency values to deviate significantly from
their long term fundamental path – this is sometimes
referred to as noise
51
 Long-Term Trends
vs. Short-Term Noise
Foreign currency per
unit of domestic currency
Fundamental
Occasional large events may Equilibrium
drive the exchange rate out of Path
the ranges of the long-term path

The paths in the

short and the
medium run are
chaotic

52
Time
 Long-Term Trends
vs. Short-Term Noise
 Currency markets do not pay much attention to
the theories on a day-to-day basis:
 In the short run, the arrivals of information and
investors’ sentiment, both of which are unpredictable,
play important roles in the exchange rate determination.
 One example to illustrate the short term chaos
over the exchange rate dynamics is the
phenomenon known as overshooting.

53
 Exchange Rate Dynamics: Overshooting
If the U.S. Federal Reserve were to announce a change in its monetary policy, which in the long
run should drive the exchange rate from S0 to S1 based on IRP.

Spot Dollar
Exchange Rate S2
Overshooting

S1

S0

time
t1 t2
The Fed announces a monetary policy change at time t1. Instead of driving the dollar exchange rate from
S0 to S1 as is predicted by IRP, however, the exchange rate over-adjusted to S2. Over the next few weeks,
(from t1 to t 2 ), exchange rate gradually adjusts back to S1. Both the magnitude of over-adjustment and
the time that it takes to adjust back are unpredictable.
54
 Forecasting in Practice
Forecast Period Regime Recommended Forecast Methods

SHORT-RUN Fixed Rate 1. Assume that fixed rate is maintained

(< 3m)

SHORT-RUN Floating Rate 1. Efficient market approach

2. Technical methods which capture short

term trend

55
55
 Forecasting in Practice
Forecast Period Regime Recommended Forecast Methods

MEDIUM-RUN Fixed Rate 1. Assume that fixed rate is maintained

(3m-1y)

MEDIUM-RUN Floating Rate 1. monetary method

2. technical methods which capture medium
term trend

56
56
 Forecasting in Practice
Forecast Period Regime Recommended Forecast Methods

LONG-RUN Fixed Rate 1. BOP management

(>1y) 2. PPP

LONG-RUN Floating Rate 1. PPP and IRP

2. monetary method
3. technical methods which capture long term
trend

57
57
 Performance of the Forecasters
 Many firms and investors subscribe to professional
forecasting services for a fee. A question: in the short run,
can professional forecasters outperform the market?
 Substantial variations in the performance records across individual
services (e.g., page 153)
 As a whole, forecasters do not perform a better job of forecasting
future exchange rates than the forward rate,
 The founder of Forbes Magazine once said:
“You can make more money by selling financial advice
than by following it.”

58