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Executive Summary

In summary, our analysis of the causes of the Asian crisis in suggests the following conclusions. First, several Asian currencies had appreciated in real terms in the 1990s and large and growing current account imbalances had emerged in the countries that faced a speculative attack in 1997. The overvaluation was due in part to the widespread choice of fixed exchange rate regimes in the region and the related large capital inflows in the1990s. By early 1997, it was clear that several regional currencies were seriously overvalued and that such overvaluation was a factor in the worsening of the current account of many countries in the region. Real depreciations appeared to be increasing needed to adjust the current account position of the deficit countries. Second, the current account imbalances and related growth of foreign debt was also driven by an investment boom (as well a consumption boom). Such investment boom was excessive and often in the wrong sectors (non-traded goods, real estate, speculative assets build-up). Third, because of a moral hazard problem created by government promises of a bailout, banks borrowed too much from abroad and lent too much for investment projects that were too risky; moreover, the interest rate at which domestic banks could borrow abroad and lend at home was too low (relative to the riskiness of the projects being financed) so that domestic firms invested too much in projects that were marginal if not outright not profitable. Once these investment projects turned out not to be profitable, the firms (and the banks that lent them large sum) found themselves with a huge amount of foreign debt (mostly in foreign currencies) that could not be repaid. The exchange rate crisis that ensued exacerbated the problem as the currency depreciation dramatically increased real burden in domestic currencies of the debt that was denominated in foreign currencies. Fourth, a significant fraction of the borrowing and lending was not going to finance new investment projects (that would have increased the stock of capital); instead, the loans were financing speculative demand of existing assets in fixed supply (land, existing real estates, the outstanding stock of equity). Evidence on this is provided by the movements of asset prices (especially stock markets, land values and real estate prices) that were increasing faster than warranted by economic fundamentals. The asset price bubble (in stock markets, land and real estate prices) was fed by the excessive borrowing by banks in international capital markets;

therefore, part of the accumulation of foreign liabilities went to the financing of the speculative asset bubble. When this bubble burst in 1997, the firms, banks and investors that had borrowed these funds were left with a large stock of foreign debt that could not be easily repaid. Again, the collapse of the currencies worsened this debt problem by increasing the real burden of the foreign liabilities. Fifth, in order to understand the currency crisis in 1997 and its contagion from one country to the other, it is important to notice that the depreciation of some regional currency appreciated the "effective" real exchange rate and worsened the competitiveness of the other countries in the region that had not depreciated yet. As one after the other, the currencies of countries that were competing in the same world market came under attack and started to depreciate, the equilibrium fundamental value of other currencies that had not depreciated yet started to become lower and the pressure on such currencies to depreciate to regain some of the competitiveness loss became even higher. This game of competitive devaluations is an important factor that explains why the currency contagion and the domino effects were driven by fundamental factors rather than irrational contagion. In summary, fixed exchange rates regimes, capital inflows and moral hazard jointly led to real appreciation, an investment boom in wrong sectors, an asset price bubble and large current account deficits that led to the accumulation of a large stock of short-term foreign liabilities. Once the firms' investment projects turned out not to be very profitable, the firms and the banks found themselves with a huge amount of currency-denominated foreign debt that could not be repaid. The exchange rate crisis that followed made things only worse as the currency depreciation increased the real burden of the foreign-currency denominated debt.

Introduction of Economics Summary Economics is concerned with the optimal distribution of scarce resources within society. For example, economics is concerned with how individual decisions like how firms produce goods and which goods people buy. An important element in economics is concerned with the extent to which governments can intervene in the economy to improve economic welfare. Economics is also concerned with wider issues such as economic growth and unemployment issues that affect the whole of societ

Should the Unemployed Work for Benefits? If someone is claiming unemployment benefits should the government be able to make them work a full-time jobs to remain eligible for benefits? You could argue that if someone is receiving unemployment benefits, offering them job experience may have certain benefits. Benefits of Unemployed having to Work It makes sure people are not claiming benefits whilst doing another job. But, are actively seeking work. It sounds fair that people who receive benefits give something back to the community in return. The job experience may be helpful in giving the unemployed skills and on the job training. Firms may be more willing to employ someone who has job experience and evidence of being willing to work hard. Having a job to do may increase sense of self-worth and avoid the boredom of being unemployed. However, problems with making the Unemployed work for benefits If someone is working full-time for benefits, they have less time to look for other jobs. If they are doing a full-time job, should they not be paid a full-time wage rather than the very low unemployment benefit of 53 a week? It is not necessary to make a job seeker do a full-time job to make sure they arent scrounging. Checks are already quite rigorous. With 3 million unemployed because of the recession, finding a job is increasingly difficult and it is wrong to label people as benefit scroungers Companies may use it as an opportunity to get workers at very low cost, paid for by the government. There is even a danger that the unemployed on benefits take the place of those on proper jobs. Therefore, it does nothing to solve the unemployment problem. If the job is unskilled such as shelf-stacking the unemployed will not be learning any worthwhile skills. People may feel demeaned to do a 40 hour week for 53 a week benefits.


It depends on the type of job experience on offer. If the unemployed were given a chance to do a work which enabled a useful improvement in their CV, then it may be worthwhile. It depends whether the job experience leads onto a firm job offer at the end of the two week trial. It depends on whether firms see it as an opportunity to get free labour or an opportunity to offer training and experience to the unemployed. It depends whether the unemployed still have time to apply for jobs Example Why Government was wrong to make me work for benefits Cait Reilly at Guardian.

Types of Recession A recession is defined as a period of negative economic growth. However, there can be different causes and types of economic contraction. Different types will influence the length, depth and effects of the recession. These are some of the different types of recessions. 1. Boom and Bust Recession. Many recessions occur after a previous economic boom. In the economic boom, economic growth is well above the long run trend rate of growth; this rapid growth causes inflation and a current account deficit and the growth tends to be unsustainable.

When government / Central Bank see inflation is getting out of control, they respond by implementing tight monetary policy (higher interest rates) and tight fiscal policy (higher taxes and lower government spending)

In addition, an economic boom is often unsustainable, e.g. firms may be able to temporarily produce more through paying workers to do overtime, but this might not last. Also, in a boom, consumer confidence tends to soar. As a result, there tends to be a fall in the savings ratio and a rise in private borrowing to finance higher spending. The economic boom is financed by rising debt. Therefore, when there is a change in economic fortunes, consumers radically change their behaviour, rather than borrowing they seek to pay off their debt and the saving ratio increases causing fall in spending. 1919-21 Recession

GDP fell 25% during three years following end of the First World War. Unemployment rose to 20% UK experienced deflation of 10% in 1921, and 14% in 1922

Causes of fall in GDP End of First World War led to sharp fall in government spending which accounted for a large part of the fall in GDP UKs return to the gold standard made UK exports expensive leading to lower demand. Trade slow to recover in the aftermath of First World War and reparations on Germany. (Keynes opposed Versailles Treaty on ground crippling reparations would harm European trade)

Great Depression 1930-33 GDP feel 5.1% in 1930-31. GDP fell less in the UK than other countries. But, this was against a backdrop of the poor economic performance of the 1920s. Leaving the gold standard in 1931, helped UK recover quicker than other countries. Unemployment rose to over 22% The effects of the great depression were highly geographical. Manufacturing heartlands in north and Wales much more affected than the South and London.

What Determines the Effects of a Recession?

The impacts of a recession can vary depending on the type of recession and also the extent of the existing welfare state.
1. Extent of Welfare state. The impact of a recession in the US tends to be greater than in Europe.

Firstly, the US has no universal health care. A rise in unemployment is likely to increase the percentage of the population with no health care insurance. In European countries, unemployment doesnt change the persons access to health care.
2. Cost of Education. An important concern is that a recession might affect long-term education

standards. If there is a sharp fall in income, some people may not be able to afford an expensive college education. However, if there is free access to higher education, a recession may encourage more people to study rather than enter a difficult labour market.
3. Labour market protection. In the US, the recession caused a more rapid increase in

unemployment. In Europe, the rise in unemployment was correspondingly smaller. This is because the US had a more flexible labour market where it is easier to hire and fire workers. In Europe, unemployment was already higher; there is greater labour market protection making it more difficult to fire workers. The recession has seen US unemployment come close to Europe. But, in the recovery, US unemployment is likely to fall quicker than European unemployment.
4. Extent of unemployment benefits. If unemployment benefits are low or non-existent, the cost

of unemployment will be proportionately higher. If people see a dramatic drop in income, they are at greater risk of falling into homelessness or difficulties in finding suitable living conditions. This can make future job searches more difficult.
5. Length of Recession. A short-lived recession is easier to catch up. Firms can merely delay

investment decisions. Workers only face a short-term gap from the labour market. But, if the recession persists for more than a year, investment projects increasingly get shelved completely. In longer recessions, there tends to be a more permanent fall in output. It may be difficult to catch up with the long run trend rate of growth. Also, if unemployment persists for a long time, workers are more likely to become permanently discouraged and leave the labour market completely. Europes Lost Output Figure 1

6. Type of recession. Similar to the length of recession is the type of recession. If it is caused by an

increase in interest rates (UK 1991-92), it may cause problems in the housing market, leading to a substantial fall in house prices and rise in home repossessions. However, these recessions tend to be quicker to be overcome because when interest rates are cut, the economy can recover. In the current balance sheet recession, there has been a significant fall in investment because of credit shortages. Therefore, there is likely to be a greater impact in the long-term.
7. Speed of Fiscal Consolidation. In a recession, some governments may feel under pressure to

deal with budget deficit quickly. This can lead to a sharp fall in government spending. This can adversely affect public investment and lead to lower economic growth. However, if governments are able to run a large budget deficit without rising bond yields, they can afford to maintain capital investment and avoid sharp and painful policies of spending cuts.

Monopsony Exploitation Monopsony occurs when there is one buyer and many sellers. In the labour market, a monopsony occurs with one employer and many workers wanting to gain employment. Arguably, monopsony power enables firms to exploit workers by setting lower wages and employing fewer workers than in a competitive market.

To visualise monopsony power, we could think of a coal mining town in the nineteenth century. In these towns the principal source of employment was a coal mine owner (or cotton mill owner). If workers couldnt get employment in the coal mine, or cotton mill there were few other alternatives. Hence we can understand why workers in the Victorian era were often facing low wages, and dreadful conditions. In this case of monopsony power, the coal mine owner has the ability to be a wage setter. A monopsony can pay wages lower than in a competitive market. Diagram of Monopsony Exploitation figure 2

The marginal cost of employing extra workers increases at a faster rate than the average cost. Because if you increase the wage rate to attract more workers, you have to pay everyone a higher wage.

A monopsony maximises profits by employing a quantity of workers where MR = MC (Q2). This means they only have to pay a wage of W2. This is lower than wage in competitive market (W1), there are also fewer workers employed.

UK Economy 2012 Since 2007, the UK has experienced a variety of economic shocks which have caused a prolonged period of economic stagnation, high unemployment and uncertainty. In 2011, the economic recovery proved much weaker than expected, yet inflation was stubbornly high. In 2012, fundamental weaknesses are likely to keep the UK economy depressed with high unemployment and low / negative growth. The one small crumb of comfort is the expected fall in headline inflation.

UK Snapshot end of 2011 Figure 3

UK Inflation 2012


In 2011, CPI inflation reached 5.2%. RPI reached over 6%. (CPI RPI Inflation) However, the Bank of England forecast a sharp fall in inflation during 2012. This is because in 2011, inflation was caused by temporary cost-push factors, which will expire during the course of 2012. These cost-push factors include: One-off tax rises, such as VAT Effect of devaluation and higher import prices Rising commodity and food prices In 2012, underlying inflationary pressures will be weak. Spending cuts, high unemployment and weak wage growth will prevent any demand-pull inflation. A global economic slowdown will weaken pressure on commodity prices. There is risk by end of 2012, inflation could fall below governments target of 2% Inflation Forecast 2012/2013

The Bank of England forecast a sharp fall in inflation in 2012. (Bank of Englandinflation forecast) Interest Rate Forecast 2012 With this inflation forecast, and prospect of double dip recession it is highly unlikely the Bank of England will be wanting to increase interest rates during 2012. (Interest rate forecast) Unemployment


2011 was a grim year for unemployment in UK and EU. The ILO measure of unemployment rose to over 2.6 million. Youth unemployment rose to over 1 million, with an increase in the average duration of unemployment. With weak / negative growth predicted for 2012, 2010. How To Increase the Value of Currency Question: I was wondering, what are some of the policies and possibilities a country can use to increase the value of their currency? Specifically countries who would be trying to overthrow the US dollar like China, India, Brazil, Russia etc. To increase the value of their currency, countries could try several policies to cause an appreciation. 1. Sell Dollar Assets and Buy Their Own Currency. China has over $1.4 trillion of US government bonds. If the Chinese sold these Treasury bills and brought back the proceeds to China, this would cause a depreciation in the dollar, and the Chinese Yuan would appreciate. (supply of dollars would rise, and demand for Chinese Yuan


would increase) Because China has substantial dollar assets, they could cause a reasonably significant fall in the value of the dollar. In fact China could appreciate the value of their currency simply by not buying any more dollar assets. Currently China has a large current account surplus with US. This flow of money into China would usually cause an appreciation. However, China has deliberately decided to use its foreign currency earnings to buy US assets. They do this to keep the Yuan undervalued and therefore keep their exports more competitive. In the case of Russia and Brazil, they only have relatively limited dollar reserves. Therefore, there is only limited scope for selling dollars and buying their own currency. 2. Higher Interest Rates Higher interest rates would attract some hot money flows. Hot money flows occurs when banks and financial institutions move money to other countries to take advantage of a better rate of return on saving. Given interest rates are close to zero in the US, higher interest rates in developing countries give a significant incentive to move money and savings there. However, higher interest rates may reduce the rate of economic growth (though higher interest rates will also reduce inflationary pressures) Interest Rates and Economy Question: Hello can you please tell me what the disadvantages of using interest rates would be for the economy? Interest rates are used to try and achieve low inflation and stable, sustainable economic growth. However, interest rates are limited, they cant always achieve all the governments macro economic objectives at once. Interest Rates and Inflation


For example, if an economy is overheating (with inflation increasing), a rise in interest rates can help to reduce growth of aggregate demand and reduce inflationary pressure. If implemented correctly, this can avoid a boom and bust economic cycle. For example, in the late 1980s, interest rates were increased in response to higher inflation. In a recession, interest rates can be cut. This reduces cost of borrowing and helps firms and householders avoid being overwhelmed with debt repayments. Low interest rates can help the economy to recover and achieve positive growth. When Are Interest Rates Damaging for an Economy? Conflicting With different macroeconomic Objectives.



High interest rates in 1991 and 1992 led to recession of 1991 and early 1992.

In 1990, the UK had high inflation and was a member of the ERM a semi fixed exchange rate. The pound was falling to the lower limit of the exchange rate band. Therefore, between 1990 and 1992, the government increased interest rates to 12% (and for a few hours to 15%). This did help reduce inflation, and for a short period enabled UK to remain in ERM. However, arguably, interest rates were far too high for the economic situation. The government persisted with high interest rates, even when the economy was in recession and unemployment rising. The government were pursuing a strong exchange rate, when this shouldnt have been their primary macroeconomic objective.

High interest rates created several problems Demand in economy fell creating unemployment Home-owners were faced with very high mortgage interest payments. This led to a record rise in home repossessions. It caused a bust in the housing market, which caused house prices to fall for four years.

Problems of Relying on Interest Rates Relying on interest rates to reduce inflation, disproportionately hits debtors and homeowners. Cutting interest rates to boost growth, disproportionately hits savers (currently many savers have negative interest rates) The impact of interest rates can be limited. For example, we are currently in a liquidity trap, which means zero interest rates are being ineffective in boosting growth. This doesnt mean interest rates are always bad. With hindsight, the government should have raised interest rates earlier to prevent inflation and reduce the size of the boom. When the economy went into recession, they should have been quicker to reduce them. Liquidity Trap


In a liquidity trap, lower interest rates can fail to promote economic growth. In March 2009, the UK, cut interest rates to 0.5%, but this failed to prevent the deepest recession since the 1930s. Therefore, lower interest rates may be insufficient to boost demand. In this case it may be necessary to pursue unconventional monetary policies such as quantitative easing.

Recent Interest rates in UK


Internal Devaluation German Style When countries are members of a single currency are, such as the Euro, they cannot depreciate their currencies to boost their exports. The only way to produce the equivalent of a depreciation is to keep costs growing at a lower rate than other countries. This can only be achieved through wage moderation not in absolute terms but relative to productivity growth. This is sometimes called an internal devaluation and it is normally thought as being more difficult to achieve than a straight devaluation or depreciation of the currency because it involves changes in wages. Many see this today as a challenge for Souther European countries as they might have been losing competitiveness relative to the other Euro countries and now they cannot just use their exchange rate to gain it back. The recent OECD economic outlook talked about all this and had a chart that I am reprinting below.


The chart shows unit labor costs of selected Euro countries. The striking pattern of the chart comes from Germany. Germany managed to keep unit labor costs constant while all other countries in the chart saw increasing labor costs since the creation of the Euro. It is important to notice that this is not just about the usual suspects, France looks very similar to all the club med Euro countries. What is really remarkable is the behavior of Germany! What I find interesting in this chart is that with the creation of the Euro, Germany managed to engineer such an increase in competitiveness while it did not manage to do it when it had its own currency. The German Mark, as any of the other large currencies in the world (the US dollar) fluctuated in directions that might not always have been in the interest of the country. In that sense, one could argue that Germany had a stronger control of its real exchange rate post1999 than before. Of course we are talking about the intra-Euro exchange rate. Relative to the US, there is still an exchange rate that Germany cannot control: the Euro/Dollar. And this runs contrary to the way we normally think about exchange rates. It is when you control your own currency that we assume that you can better to influence your real exchange rate. Just to complement the chart above, I produced two additional charts with the behavior of exports and GDP (both in real terms) during the same period. There are, of course, many other


factors that affect these two variables but it is interesting to check what happened to both during the same years. Did Germany benefit from the behavior in unit labor costs?


When we look at exports we see that Germany did better than any of the other countries, although the behavior is not as extreme as one would expect from the behavior of unit labor costs. When we look at GDP then Germany is not an outlier at all and in fact it is one of the countries with the lowest performance during these years (only Portugal and Italy performed worse). There are reasons why we do not expect Germany to grow faster than the other countries (Germany has a higher GDP per capita than all of them) so the absolute comparison might be misleading but it still provides a sense on how the behavior of unit labor costs was reflected in economic activity and exports. What are the reasons for the depreciation of dollar in the current scenario? The year of 2004 was the third consecutive year for the depreciation of US dollar against the Euro-dollar. When entering 2005, the exchange rate of US dollar once showed a tendency of rise, however, it was still unstable. On 30 Dec. 2005, the rate of exchange of one Euro-dollar was equivalent to 1.3623 US dollar, telling the lowest level of the US dollar against Euro in history. The US dollar began to rise to one euro against USD 1.3122 in the latter 20 days of January 2005, and kept on rising to one euro against 1.2957 US dollars in the first 15 days of February. However, the US dollar devalued sharply on Feb. 22 to one euro against 1.3260 US dollars, the lowest point since last August. It is reported that there were many reasons accountable for the depreciation of US dollars: one was that the price of oil has climbed to USD 51 per barrel; the other was the diversification for currency reserve by South Korea. People were worried that the sell of US dollar could have chain reactions upon other major powers. Different predictions could be heard on the issue of the future trend of the US dollar. According to the experts with Merrill Lynch, one of the world's leading financial management and advisory companies, the year of 2005 is the fourth consecutive year to see the weakening of the US dollars. The overvalued US dollar and the tight policy pursued by the US Federal Reserve are the due cause for the sluggish US dollar while other experts believed that the undercurrent that manipulated the depreciation of US dollar was quite likely being reversed. It's impossible to see the US dollar to drop furthermore. If the global economic growth slows down, the US dollar is hopefully to appreciate. Many reasons influence the trend of US dollar

There are many factors that influence the exchange rate of US dollar. Generally speaking, there are mainly four reasons: first, the health condition and the rate of return for investment of the US economy, secondly, the balance of international payment in the US, thirdly, the level of interest rates in the US compared with those in other countries, and fourthly, the rate of inflation. Meanwhile, there are also many other temporary pounding factors from without, such as wars, oil price, scandals from large companies as well as psychological factors etc, which are believed to have connections with former four factors. Judging from the estimation by various parties, evident enough, many economists take the balance of international payments as the decisive factor for the trend of the US dollar. Although this kind of view is not unreasonable, it is partial. If considered from history, people will find out that the balance of international payment featuring trade deficit and current account deficit has been dominating the US economy since 1970s. But the track of the US dollar's circulation does not show a plummet drop. The exchange rate of US dollar used to be high for two times since the US implemented the floating exchange rate: one occurred during Reagan's reign while the other was in Clinton's rule. So far as Reagan's reign is concerned, the federal budget deficit, trade deficit and current account deficit were high, but the exchange rate of US dollar was also high. It is simply because the high deficit triggered the high interest rate and high interest rate consequently resulted in high exchange rate. The trade deficit is not the result of the change of exchange rate but rather its reason. What was worth mentioning is that the surplus was realized during Clinton's rule. But the condition of international payment hadn't been much improved due to the low private saving rate and the exchange rate of US dollar still strong. The major reason is because of the strong growth of the US economy, low returning rate and high interest rate. Therefore, should the balance of international payment exist for a long time, it would definitely be the decisive factors for the depreciation of the US dollar. But some other factors would probably counteract its function in different periods and lead the US dollar to appreciation. This tendency is believed to be likely to happen in medium or short term. Sharp drop of the US dollar exchange rate impossible Generally speaking, the sharp drop of the US dollar exchange rate is impossible unless all the US dollar holders worldwide sell US dollars in large amount simultaneously, just like depositors draw money from banks during the bank credit crisis. First, the US economy still boasts the

highest growth rate and strongest competitiveness among major developed countries, and other countries are still confident about the US economy; secondly, the US dollar, serving a role of a currency for international reserve, has become the natural defense for the sharp devaluation of US dollar; thirdly, since foreigners hold a huge amount of US dollars, they will suffer severe losses if they sell dollars in large amount and will not easily find a suitable substitution. Furthermore, the safety and circulation of euro, Japanese yen and gold are no better than the US dollar. Although there is no sign of sharp drop in the exchange rate of US dollar, the possibility of gradual depreciation of it cannot be removed. In the view of Bush administration, instead of bringing harm on the growth of US economy, the orderly devaluation of US dollar can boost the exportation and narrow the trade deficit, particularly when the inflation is under control. The calculation research finding by an American economic website shows that the current account deficit is likely to drop from current six percent to three percent if the trade weighted value of US dollar drop by ten percent. The correctness of the conclusion has yet to be proved by practice. However, the economic and financial policies of Bush administration will have a vital impact on the implementation of the idea. That is to say, if the fiscal deficit continues to increase, the current account may not shrink even though the residents' saving rises again after a fall. Therefore, from a long-term point of view, the US dollars will face devaluation. However, from medium and short view, the exchange rate of US dollar tends towards stability and even a moderate rise. The best result for the current account deficit is to maintain stability or slight drop, but three percent is difficult to regain. The determination and measure taken by Bush administration to reduce the fiscal deficit will exert a tremendous influence on it. Currency depreciation Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange ratesystem. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears interchangeably with devaluation. Its opposite is called appreciation. The depreciation of a country's currency refers to a decrease in the value of that country's currency. For instance, if the Canadian dollar depreciates relative to the euro, the exchange rate (the Canadian dollar price of euros) rises - it takes more Canadian dollars to purchase 1 euro (1 EUR=1.5CAD 1 EUR=1.7CAD). When the Canadian dollar depreciates relative to the Euro,

the Canadian dollar becomes more competitive because the price of Canadian goods when exchanged to Euro will be cheaper leading to a larger Canadian export. On the other hand, European countries that denominates its goods and services in Euros will have lost competitiveness to the Canadian dollar. The price of European products denominated in Euros will thus become more expensive in Canada. The appreciation of a country's currency refers to an increase in the value of that country's currency. Continuing with the CAD/EUR example, if the Canadian dollar appreciates relative to the euro, the exchange rate falls - it takes fewer Canadian dollars to purchase 1 euro (1 EUR=1.5CAD 1 EUR=1.4CAD). When the Canadian dollar appreciates relative to the Euro, the Canadian dollar becomes less competitive. This will lead to larger imports of European goods and services, and lower exports of Canadian goods and services. A September 21 announcement by the G-7 finance ministers endorsed less intervention in the foreign exchange market, and triggered a large sell-off of the US dollar. On the day of the announcement, in relation to the end of August, the US currency fell by 4.8% against the Euro and 4.1% against the Yen. Many economists have suggested that the weakening in the US dollar could actually be good for the economysince a weaker dollar will boost manufacturing production, which in turn will lift employment and all this will set in motion economic growth. It follows then that the US dollar devaluation is exactly what is needed to keep the US economy going.


The popular way of thinking Figure 4 According to popular thinking the key to economic growth is demand for goods and services. It is held that increases in demand for goods and services gives rise to economic growth by triggering the production of goods and services. Increases or decreases in demand for goods and services are behind rises and declines in the economy's production of goods. Hence in order to keep the economy going economic policies must pay close attention to overall demand. Now, part of the demand for domestic products emanates from overseas. The accommodation of this demand is labelled exports. Likewise, local residents exercise demand for goods and services produced overseas, which is labelled imports. Note that while an increase in exports gives rise to overall demand for domestic output, an increase in imports weakens demand. Hence exports, according to this way of thinking, are a factor that contributes to economic growth while imports are a factor that detracts from the growth of the economy. Because overseas demand for a country's goods and services is an important ingredient in setting the pace of economic growth, it makes sense to make locally produced goods and services attractive to foreigners. One of the ways to make domestically produced goods more in demand by foreigners is by making the prices of these goods more attractive.


For instance, the price of an identical bag of potatoes in the US is $10 and 10 Euro's in Europe. Also, the exchange rate between the US dollar and the Euro is 1:1 i.e. onetoone. At the exchange rate of 1 Euro to $1 a European can get for his 10 Euro one American bag of potatoes. One of the ways of boosting their competitiveness is for Americans to depreciate the US dollar against the Euro. Let us assume that in response to a Fed announcement that it will drastically loosen its monetary stance, the rate of exchange falls to 0.5 Euro per $1. Consequently, this will mean that $10 is now worth 5 Euro, which in turn implies that an American bag of potatoes in Europe is offered for 5 Euro. Consequently, a European can now purchase for 10 Euro two American bags of potatoes instead of one before the depreciation of the US dollar. In other words, the purchasing power of Europeans with respect to American potatoes has doubled. If we were to apply the potatoes example to all goods and services, one can reach the conclusion that as a result of currency depreciation, all other things being equal, the overall demand for domestically produced goods is likely to increase. This in turn will give rise to a better balance of payments and in turn to stronger economic growth. Observe that to lift foreigners' demand, Americans are now effectively offering two bags of potatoes for one European bag of potatoes. This also means that the price of the European bag of potatoes in the US is now twice what it was before the depreciation of the US dollar. This most likely will lower American's demand for European potatoes. What we have here, as far as the US is concerned, is more exports and fewer imports, which according to mainstream thinking is great news for economic growth. Equally, at the original exchange rate of 1:1 a reduction in the domestic price of US potatoes from $10 to $5 would also enable a European to exchange his 10 Euro for two bags of potatoes. In short, changes in the exchange rate or changes in prices in respective countries will determine so-called international competitiveness, which is also labelled as the real exchange rate. This can be summarized as: Real exchange rate = (domestic prices/foreign prices)*exchange rate The exchange rate is the number of foreign currency per unit of local currency. According to this expression, a fall in the real exchange rate implies growing competitiveness and a rise means falling international competitiveness. Hence, following this expression,

currency depreciation (a fall in the number of foreign currency exchanged per local currency) will lead to a fall in the real exchange rate and thus to an increase in international competitiveness. A fall in foreign prices, however, will lift the real exchange rate and therefore reduce competitiveness. In this way of thinking, it is quite clear that currency depreciationall other things being equalis beneficial for economic growth. For instance, in their research study of the Mexican economy, Dornbusch and Werner have concluded that: "If the currency is not devalued, growth will not keep pace with the growth of the labor force; the divisions in Mexican society will widen; and national stability will be threatened."[1] Furthermore, according to Dornbusch and Werner, "recent major devaluations in Finland, Sweden, Italy, Spain and the United Kingdom did not lead to inflationin fact, it has come down, as have interest rates. Devaluation was a boon to these countries."[2] It seems that the message conveyed by the real exchange rate equation tends to confirm the experience in the US. Thus since 1999 US competitiveness viz. Japan has been steadily falling. The real exchange rate, which stood at 138 in November 1999 jumped to 176 in August 2003. The fall in competitiveness during this period was associated with a sluggish economy. In short, the data seems to support the view that a rising real exchange rate may be an important contributing factor to currently subdued economic growth. Moreover, our statistical analysis indicates that the lagged growth momentum of the real exchange rate displays good visual inverse correlation with the growth momentum of industrial production. An increase in the growth momentum of the real exchange rate (deterioration in US competitiveness) is followed by a fall in the growth momentum of industrial production. A fall in the growth momentum of the real exchange rate (improvement in US competitiveness) is followed by an increase in the growth momentum of industrial production.


Figure 4 It seems, therefore, that it makes a lot of sense to depreciate the US dollar in order to revive the economy. Why boost in exports due to currency depreciation cannot grow the economy When a central bank announces a loosening in its monetary stance, this leads to a quick response by the participants in the foreign exchange market through selling the domestic currency in favor of other currencies, thereby leading to domestic currency depreciation. In response to this, various producers now find it more attractive to boost their exports. In order to fund the increase in production, producers approach commercial banks, which on account of a rise in central bank monetary pumping are happy to expand their credit at lower interest rates. By means of new credit producers can now secure resources required to expand their production of goods in order to accommodate growing overseas demand. In other words, by means of newly created credit producers divert real resources from other activities. As long as domestic prices remain intact, exporters will record an increase in profits. However, the so-called improved competitiveness on account of currency depreciation means that the citizens of a country are now getting less real imports for a given amount of real exports. In short, while the country is getting rich in terms of foreign currency, it is getting poor in terms of real wealth, i.e., in terms of the goods and services required for maintaining peoples' life and well-beings. As time goes by however, the effects of loose monetary policy filters through a

broad spectrum of prices of goods and services and ultimately undermine exporters profits. In short, a rise in prices puts to an end the illusory attempt to create economic prosperity out of thin air. According to Ludwig von Mises, The much talked about advantages which devaluation secures in foreign trade and tourism, are entirely due to the fact that the adjustment of domestic prices and wage rates to the state of affairs created by devaluation requires some time. As long as this adjustment process is not yet completed, exporting is encouraged and importing is discouraged. However, this merely means that in this interval the citizens of the devaluating country are getting less for what they are selling abroad and paying more for what they are buying abroad; concomitantly they must restrict their consumption. This effect may appear as a boon in the opinion of those for whom the balance of trade is the yardstick of a nation's welfare. In plain language it is to be described in this way: The British citizen must export more British goods in order to buy that quantity of tea which he received before the devaluation for a smaller quantity of exported British goods. Contrast the policy of currency depreciation with a conservative policy where money is not expanding. Under these conditions, when the pool of real wealth is expanding, the purchasing power of money will follow suit. This, all other things being equal, will lead to currency appreciation. With the expansion in the production of goods and services and falling prices and thus production costs, local producers can improve their competitiveness and profitability in overseas markets while the currency is actually appreciating. Within the framework of loose monetary policy exporters' temporary gains are at the expense of other activities in the economy, within the framework of a tight monetary stance gains are not at any one's expense but just the manifestation of real wealth generation. Can currency depreciation take place in a free market? The entire issue of the alleged benefits of currency depreciation is only of relevance in a hampered market where paper money is enforced by the government through its central bank. In a free-market economy, there cannot be such a thing as currency depreciation, which supposedly can grow the economy. Within the free market, there cannot be currency depreciation as such. Since in a true free-market economy money is gold, there cannot be an independent entity such as a "dollar." Prior to 1933,

the name "dollar" was used to refer to a unit of gold that had a weight of 23.22 grains. Since there are 480 grains in one ounce, this means that the name dollar also stood for 0.048 ounce of gold. This in turn, means that one ounce of gold referred to $20.67. Now, $20.67 is not the price of one ounce of gold in terms of dollars as popular thinking has it, for there is no such entity as a dollar. Dollar was just a name for 0.048 ounce of gold. On this Rothbard wrote, "No one prints dollars on the purely free market because there are, in fact, no dollars; there are only commodities, such as wheat, cars, and gold.[3] Likewise, the names of other currencies stood for a fixed amount of gold. The habit of regarding these names as a separate entity from gold emerged with the enforcement of the paper standard. Over time, as paper money assumed a life of its own, it became acceptable to set the price of gold in terms of dollars, francs, pounds, etc. The absurdity of all this reached new heights with the introduction of the floating-currency system. In a free market, currencies do not float against each other. They are exchanged in accordance with a fixed definition. If the British pound stands for 0.25 of an ounce of gold and the dollar stands for 0.05 ounce of gold, then one British pound will be exchanged for five dollars. This exchange stems from the fact that 0.25 of an ounce is five times larger than 0.05 of an ounce, and this is what the exchange of 5-to-1 means. In other words, the exchange rate between the two is fixed at their proportionate gold weight, i.e., one British pound = five US dollars. The absurdity of a floating currency system is no different from the idea of having a fluctuating market price for dollars in terms of cents. How many cents equal one dollar is not something that is subject to fluctuations. It is fixed forever by definition. [4] The present floating exchange rate system is a byproduct of the previously discredited Bretton Woods system of fixed currency rates of exchange, which was in operation between 1944 to 1971. Within the Bretton Woods system the US dollar served as the international reserve currency upon which all other currencies could pyramid their money and credit. The dollar in turn was linked to gold at $35 per ounce. Despite this supposed link to gold, only foreign governments and central banks could redeem their dollars for gold.


A major catalyst behind the collapse of the Bretton Woods system was the loose monetary policies of the US central bank which pushed the price of gold in the gold market above the official $35 per ounce. The price, which stood at $35/oz in January 1970 jumped to $43/oz by August 1971 an increase of almost 23%. The growing margin between the market price of gold and the official $35 per ounce (see chart) created enormous profit opportunity, which some European central banks decided to exercise by demanding the US central bank redeem dollars for gold.

Figure 4 Since Americans didn't have enough gold to back up all the printed dollars, they had to announce effective bankruptcy and cut off any link between dollar and gold as of August 1971. In order to save the bankrupt system policymakers have adopted the prescription of Milton Friedman to allow a freely floating standard. While in the framework of the Bretton Woods system the dollar had some link to the gold and all the other currencies were based on the dollar, all that has now gone. In the floating framework there are no more limitations on money printing. According to Murray Rothbard: One virtue of fixed rates, especially under gold, but even to some extent under paper, is that they keep a check on national inflation by central banks. The virtue of fluctuating ratesthat they prevent sudden monetary crises due to arbitrarily valued currenciesis a mixed blessing, because at least those crises provided a much-needed restraint on domestic inflation.


Through policies of coordination, central banks maintain synchronized monetary pumping so as to keep the fluctuations in the rate of exchanges as stable as possible. Obviously, in the process such policies set in motion, a persistent process of impoverishment through consumption is not backed up by production of real wealth.

Reasons for intentional devaluation

Cumulative current account balance 1980-2008 (US$ Billions) based on International Monetary Fund data for an interactive overview of global imbalances and other macro trends, over the past 2 decades and also future proejections, visit the OECD Data visualization Devaluation, with its adverse consequences, has historically rarely been a preferred strategy. According to economist Richard N. Cooper, writing in 1971, a substantial devaluation is one of the most "traumatic" policies a government can adopt it almost always results in cries of outrage and calls for the government to be replaced.[4] Devaluation can lead to a reduction in citizens' standard of living as their purchasing power is reduced both when they buy imports and when they travel abroad. It also can add to inflationary pressure. Devaluation can make interest payments on international debt more expensive if those debts are denominated in a foreign currency, and it can discourage foreign investors. At least until the 21st century, a strong currency was commonly seen as a mark of prestige while devaluation was associated with weak governments.[5] However, when a country is suffering from high unemployment or wishes to pursue a policy of export led growth, a lower exchange rate can be seen as advantageous. From the early 1980s the International Monetary Fund (IMF) has proposed devaluation as a potential solution for

developing nations that are consistently spending more on imports than they earn on exports. A lower value for the home currency will raise the price for imports while making exports cheaper.

This tends to encourage more domestic production, which raises employment and gross

domestic product (GDP) though the effect may not be immediate due to the MarshallLerner condition. Devaluation can be seen as an attractive solution to unemployment when other options, like increased public spending, are ruled out due to high public debt, or when a country has a balance of payments deficit which a devaluation would help correct. A reason for preferring devaluation common among emerging economies is that maintaining a relatively low exchange rate helps them build up their foreign exchange reserves, which can protect them against future financial crises.

Mechanism for devaluation A state wishing to devalue, or at least check the appreciation of its currency, must work within the constraints of the prevailing International monetary system. During the 1930s, countries had relatively more direct control over their exchange rates through the actions of their central banks. Following the collapse of the Bretton Woods system in the early 1970s, markets substantially increased in influence, with market forces largely setting the exchange rates for an increasing number of countries. However, a state's central bank can still intervene in the markets to effect a devaluation if it sells its own currency to buy other currencies[10] then this will cause the value of its own currency to fall a practice common with states that have a managed exchange rate regime. Less directly, quantitative easing (common in 2009 and 2010), tends to lead to a fall in the value of the currency even if the central bank does not directly buy any foreign assets. A third method is for authorities simply to talk down the value of their currency by hinting at future action to discourage speculators from betting on a future rise, though sometimes this has little discernible effect. Finally, a central bank can effect a devaluation by lowering its base rate of interest, however this sometimes has limited effect, and, since the end of World War II, most central banks have set their base rate according to the needs of their domestic economy. If a country's authorities wish to devalue or prevent appreciation against market forces exerting upwards pressure on the currency, and retain control of interest rates, as is usually the case, they will need capital controls in placedue to conditions that arise from the impossible trinity trilemma.

Quantitative easing Quantitative easing (QE) is the practice where a central bank tries to mitigate a potential or actual recession by increasing the money supply for their home economy. This can be done by creating money and injecting it into the domestic economy with open market operations. There may be a promise to destroy any newly created money once the economy improves, so as to avoid inflation. Quantitative easing was widely used as a response to the financial crises that began in 2007, especially by the United States and the United Kingdom, and, to a lesser extent, the Eurozone.The Bank of Japan was the first central bank to claim to have used such a policy. Although the US administration has denied that devaluing their currency was part of their objectives for implementing quantitative easing, the practice can act to devalue a country's currency in two indirect ways. Firstly, it can encourage speculators to bet that the currency will decline in value. Secondly, the large increase in the domestic money supply will lower domestic interest rates, often they will become much lower than interest rates in countries not practising quantitative easing. This creates the conditions for a carry trade, where market participants can engage in a form of arbitrage, borrowing in the currency of the country practising quantitative easing, and lending in a country with a relatively high rate of interest. Because they are effectively selling the currency being used for quantitative easing on the international markets, this can increase the supply of the currency and hence push down its value. By October 2010 expectations in the markets were high that the US, UK and Japan would soon embark on a second round of QE, with the prospects for the Eurozone to join them less certain.

Currency war


Brazilian Finance Minister Guido Mantega, who made headlines when he raised the alarm about a Currency Warin September 2010. In July 2011 he told the Financial Times that in his opinion the war is "absolutely not over. Currency war, also known as competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. As the price to buy a particular currency falls, so too does the real price of exports from the country. Imports become more expensive too, so domestic industry, and thus employment, receives a boost in demand both at home and abroad. However, the price increase in imports can harm citizens' purchasing power. The policy can also trigger retaliatory action by other countries which in turn can lead to a general decline in international trade, harming all countries. Competitive devaluation has been rare through most of history as countries have generally preferred to maintain a high value for their currency; have been content to allow its value to be set by the markets or have participated in systems of managed exchanges rates. An exception was the episode of currency war which occurred in the 1930s. The period is considered to have been an adverse situation for all concerned, with all participants suffering as unpredictable changes in exchange rates reduced international trade.

According to Guido Mantega, the Brazilian Minister for Finance, a global currency war broke out in 2010. This view was echoed by numerous other financial journalists and government officials from around the world. Other senior policy makers and journalists have suggested the phrase "currency war" overstates the extent of hostility, though they agree that a risk of further escalation exists. States engaging in competitive devaluation since 2010 have used a mix of policy tools, including direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing. While many countries have experienced undesirable upward pressure on their exchange rates and taken part in the on-going arguments, the most notable dimension has been the rhetorical conflict between the United States and China over the valuation of the yuan.The episode which began in the early 21st century is being pursued by different mechanisms than was the case in the 1930s, and opinions among economists have been divided as to whether it will have a net negative effect on the global economy. By April 2011 journalists had began to report that the currency war had subsided; though Guido Mantega has continued to assert that the conflict is still on-going.

International conditions required for currency war For a widespread currency war to occur a large proportion of significant economies must wish to devalue their currencies at once. This has so far only happened during a global economic downturn. An individual currency devaluation has to involve a corresponding rise in value for at least one other currency. The corresponding rise will generally be spread across all other currencies[23] and so unless the devaluing country has a huge economy and is substantially devaluing, the offsetting rise for any individual currency will tend to be small or even negligible. In normal times other countries are often content to accept a small rise in the value of their own currency or at worst be indifferent to it. However if much of the world is suffering from a recession, from low growth or are pursuing strategies which depends on a favourable balance of payments, then nations can begin competing with each other to devalue. In such conditions, once a small number of countries begin intervening this can trigger corresponding interventions from others as they strive to prevent further deterioration in their export competitiveness.


Historical overview Up to 1930 For centuries, governments have slowly devalued their currencies by reducing its intrinsic value. Methods have included reducing the percentage of gold in coins or substituting less precious metals for gold. However until the 19th century,[25] the proportion of the world's trade that occurred between nations was very low, so exchanges rates were not generally a matter of great concern.[26] Rather than being seen as a means to help exporters, the debasement of currency was motivated by a desire to increase the domestic money supply and the ruling authorities' wealth through seigniorage, especially when they needed to finance wars or pay debts. A notable example is the substantial devaluations which occurred during the Napoleonic wars. When nations wished to compete economically they typically practicedmercantilism this still involved attempts to boost exports while limiting imports, but rarely by means of devaluation.

A favoured method was to protect home industries using current account controls such

as tariffs. From the late 18th century, and especially in Great Britain which for much of the 19th century was the world's largest economy, mercantilism became increasingly discredited by the rival theory of free trade, which held that the best way to encourage prosperity would be to allow trade to occur free of government imposed controls. The intrinsic value of money became formalised with a gold standard being widely adopted from about 18701914, so while the global economy was now becoming sufficiently integrated for competitive devaluation to occur there was little opportunity. Following the end of WWI, many countries other than the US experienced recession and few immediately returned to the gold standard, so several of the conditions for a currency war were in place. However currency war did not occur as Great Britain was trying to raise the value of her currency back to its pre-war levels, effectively cooperating with the countries that wished to devalue against the market. By the mid 1920s many former members of the gold standard had rejoined, and while the standard did not work as successfully at it had pre war, there was no widespread competitive devaluation.

Currency War in the Great Depression


During the Great Depression of the 1930s, most countries abandoned the gold standard, resulting in currencies that no longer had intrinsic value. With widespread high unemployment, devaluations became common. Effectively, nations were competing to export unemployment, a policy that has frequently been described as "beggar thy neighbour".[30] However, because the effects of a devaluation would soon be counteracted by a corresponding devaluation by trading partners, few nations would gain an enduring advantage. On the other hand, the fluctuations in exchange rates were often harmful for international traders, and global trade declined sharply as a result, hurting all economies. The exact starting date of the 1930s currency war is open to debate.[24] The three principal parties were Great Britain, France, and the United States. For most of the 1920s the three generally had coinciding interests, both the US and France supported Britain's efforts to raise Sterling's value against market forces. Collaboration was aided by strong personal friendships among the nations' central bankers, especially between Britain's Montagu Norman and America's Benjamin Strong until the latter's early death in 1928. Soon after the Wall Street Crash of 1929, France lost faith in Sterling as a source of value and begun selling it heavily on the markets. From Britain's perspective both France and the US were no longer playing by the rules of the gold standard. Instead of allowing gold inflows to increase their money supplies (which would have expanded those economies but reduced their trade surpluses) France and the US began sterilising the inflows, building up hoards of gold. These factors contributed to the Sterling crises of 1931; in September of that year Great Britain substantially devalued and took the pound off the gold standard. For several years after this global trade was disrupted by competitive devaluation. The currency war of the 1930s is generally considered to have ended with the Tripartite monetary agreement of 1936.

Bretton Woods era From the end of World War II until about 1971, the Bretton Woods system of semi-fixed exchange rates meant that competitive devaluation was not an option, which was one of the design objectives of the systems' architects. Additionally, global growth was generally very high in this period, so there was little incentive for currency war even if it had been possible.[35]

1973 to 2000

While some of the conditions to allow a currency war were in place at various points throughout this period, countries generally had contrasting priorities and at no point were there enough states simultaneously wanting to devalue to for a currency war to break out.[36] On several occasions countries were desperately attempting not to cause a devaluation but to prevent one. In these instances states were striving not against other countries but against market forces that were exerting undesirable downwards pressure on their currencies. Examples include Great Britain during Black Wednesday and various tiger economies during the Asian crises of 1997. During the mid 1980s the US did desire to devalue significantly, but they were able to secure the cooperation of other major economies with the Plaza accord agreement. As free market influences approached their zenith during the 1990s advanced economies and increasingly transition and even emerging economies moved to the view that it was best to leave the running of their economies to the markets and not to intervene even to correct a substantial current account deficit.

2000 to 2008 During the 1997 Asian crisis several Asian economies ran critically low on foreign reserves, leaving them forced to accept harsh terms from the IMF and, often, to accept low prices for the forced sale of their assets. This shattered faith in free market thinking among emerging economies, and from about 2000 they generally began intervening to keep the value of their currencies low.[38] This enhanced their ability to pursue export led growth strategies while at the same time building up foreign reserves so they would be better protected against further crises. No currency war resulted because on the whole advanced economies accepted this strategyin the short term it had some benefits for their citizens who could buy cheap imports and thus enjoy a higher material standard of living. The current account deficit of the US grew substantially but, until about 2007, the consensus view among free market economists and policy makers like Alan Greenspan, then Chairman of the Federal Reserve, and Paul O'Neill, US Treasury secretary, was that the deficit was not a major reason for worry. This is not say there was no popular concern; by 2005 for example a chorus of US executives along with trade union and mid-ranking government officials had been speaking out about what they perceived to be unfair trade practices by China.[41] These concerns were soon partially allayed. With global economy doing well, China was able to abandon her dollar peg in 2005,

allowing a substantial appreciation of the Yuan up to 2007, while still increasing her exports. The dollar peg was re-established as the financial crises began to reduce China's export orders. Economists such as Michael P. Dooley, Peter M. Garber, and David Folkerts-Landau described the new economic relationship between emerging economies and the US as Bretton Woods II.

Competitive devaluation after 2009 Currency War of 20092011 As the world's leading Reserve currencythe US dollar has been central to the recent outbreak of currency war. By 2009 some of the conditions required for a currency war had returned, with a severe economic downturn seeing global trade in that year decline by about 12%. There was a widespread concern among advanced economies concerning the size of their deficits; they increasingly joined emerging economies in viewing export led growth as their ideal strategy. In March 2009, even before international co-operation reached its peak with the 2009 G-20 London SummitEconomist Ted Truman became one of the first to warn of the dangers of competitive devaluation breaking out. He also coined the phrase competitive non-appreciation. On 27 September 2010, Brazilian Finance Minister Guido Mantega announced that the world is "in the midst of an international currency war." [47][48]Numerous financial journalists agreed with Mantega's view, such as the Financial Times' Alan Beattie and The Telegraph's Ambrose EvansPritchard. Journalists linked Mantega's announcement to recent interventions by various countries seeking to devalue their exchange rate including China, Japan, Colombia, Israel and Switzerland. Other analysts such as Goldman Sach's Jim O'Neill asserted that fears of a currency war were exaggerated.[54] In September, senior policy makers such asDominique Strauss-Kahn, then Managing Director of the IMF, and Tim Geithner, US Secretary of the Treasury, were reported as saying the chances of a genuine currency war breaking out were low; however by early October, Strauss-Kahn was warning that the risk of a currency war was real. He also suggested the IMF could help resolve the trade imbalances which could be the underlying casus belli for conflicts over currency valuations. Mr Strauss-Kahn said that using currencies as weapons "is


not a solution [and] it can even lead to a very bad situation. Theres no domestic solution to a global problem."[55] Considerable attention had been focused on the US, due to its quantitative easing programmes, and on China. For much of 2009 and 2010, China has been under pressure from the US to allow the yuan to appreciate. Between June and October 2010, China allowed a 2% appreciation of the yuan, but there are concerns from Western observers that China only relaxes her intervention when under heavy pressure. The fixed peg was not abandoned until just before the June G20 meeting, after which the yuan appreciated by about 1%, only to devalue slowly again, until further US pressure in September when it again appreciated relatively steeply, with the imminent September US Congressional hearings to discuss measures to force a revaluation.[56] Reuters suggested that both China and the United States were "winning" the currency war, holding down their currencies while pushing up the value of the Euro, the Yen, and the currencies of many emerging economies.[57] Martin Wolf, an economics leader writer with the Financial Times, has suggested there may be advantages in western economies taking a more confrontational approach against China, which in recent years has been by far the biggest practitioner of competitive devaluation. Though he suggests that rather than using protectionist measures that may spark a trade war, a better tactic would be to use targeted capital controls against China to prevent them buying foreign assets in order to further devalue the yuan, as previously suggested by Daniel Gros, Director of the Centre for European Policy Studies.[58][59] A contrasting view was published on October 19, with a paper from Chinese economist Yiping Huang arguing that the US did not win the last "currency war" with Japan,[60] and has even less of a chance against China; but should focus instead on broader "structural adjustments" at the November 2010 G-20 Seoul summit.[61] Discussion over currency war and imbalances dominated the 2010 G-20 Seoul summit, but little progress was made in resolving the issue. In the first half of 2011 analysts and the financial press widely reported that the currency war had ended or at least entered a lull, though speaking in July 2011 Guido Mantega told theFinancial Times that the conflict was still ongoing.


As investor confidence in the global economic outlook fell in early August, Bloomberg suggested the currency war had entered a new phase. This followed renewed talk of a possible third round of quantitative easing by the US and interventions over the first three days of August by Switzerland and Japan to push down the value of their currencies. In September, as part of her opening speech for the 66th United Nations Debate, and also in an article for the Financial Times, Brazilian president Dilma Rousseff called for the currency war to be ended by increased use of floating currencies and greater cooperation and solidarity among major economies, with exchange rate policies set for the good of all rather than having individual nations striving to gain an advantage for themselves.

Comparison between 1930s and 2000s Migrant Mother by Dorothea Lange(1936). This portrait of a 32 year-old farm-worker with seven children became an iconic photograph symbolising defiance in the face of adversity. A currency war contributed to the world wide economic hardship of the 1930s Great Depression. Both the 1930s episode and the outbreak of competitive devaluation that began in 2009 occurred during global economic downturns. An important difference with the 2010s period is that international traders are much better able to hedge their exposures to exchange rate volatility due to more sophisticated financial markets. A second difference is that during the later period devaluations have invariably been effected by nations expanding their money supplieseither by creating money to buy foreign currency, in the case of direct interventions, or by creating money to inject into their domestic economies, with quantitative easing. If all nations try to devalue at once, the net effect on exchange rates could cancel out leaving them largely unchanged, but the expansionary effect of the interventions would remain. So while there has been no collaborative intent, some economists such as Berkeley's Barry Eichengreen and Goldman Sachs's Dominic Wilson have suggested the net effect will be similar to semi-coordinated monetary expansion which will help the global economy.[50][75][76]James Zhan of the United Nations Conference on Trade and Development (UNCTAD) however warned in October 2010 that the fluctuations in exchange rates were already causing corporations to scale back their international investments.[77]


Comparing the situation in 2010 with the currency war of the 1930s, Ambrose EvansPritchard of the Daily Telegraph suggested a new currency war may be beneficial for countries suffering from trade deficits, noting that in the 1930s it was the big surplus countries that were severely impacted once competitive devaluation began. He also suggested that overly confrontational tactics may backfire on the US as they may damage the status of the dollar as a global reserve currency.[78] Ben Bernanke, chairman of the US Federal Reserve, also drew a comparison with competitive devaluation in the inter-war period, referring to the sterilisation of gold inflows by France and America which helped them sustain large trade surpluses, but which also caused deflationary pressure on their trading partners, contributing to the Great Depression. Bernanke has stated the example of the 1930s implies that the "pursuit of export-led growth cannot ultimately succeed if the implications of that strategy for global growth and stability are not taken into account."[79] What is the reason behind rupee value depreciation ?

How do Countries Devalue Their Currencies? Countries devalue their currencies only when they have no other way to correct past economic mistakes - whether their own or mistakes committed by their predecessors. The ills of a devaluation are still at least equal to its advantages. True, it does encourage exports and discourage imports to some extents and for a limited period of time. As the devaluation is manifested in a higher inflation, even this temporary relief is eroded. In a previous article in this paper I described WHY governments resort to such a drastic measure. This article will deal with HOW they do it. A government can be forced into a devaluation by an ominous trade deficit. Thailand, Mexico, the Czech Republic - all devalued strongly, willingly or unwillingly, after their trade deficits exceeded 8% of the GDP. It can decide to devalue as part of an economic package of measures which is likely to include a freeze on wages, on government expenses and on fees charged by the government for the provision of public services. This, partly, has been the case in Macedonia. In extreme cases and when the government refuses to respond to market signals of economic

distress - it may be forced into devaluation. International and local speculators will buy foreign exchange from the government until its reserves are depleted and it has no money even to import basic staples and other necessities. Thus coerced, the government has no choice but to devalue and buy back dearly the foreign exchange that it has sold to the speculators cheaply. In general, there are two known exchange rate systems: the floating and the fixed. In the floating system, the local currency is allowed to fluctuate freely against other currencies and its exchange rate is determined by market forces within a loosely regulated foreign exchange domestic (or international) market. Such currencies need not necessarily be fully convertible but some measure of free convertibility is a sine qua non. In the fixed system, the rates are centrally determined (usually by the Central Bank or by the Currency Board where it supplants this function of the Central Bank). The rates are determined periodically (normally, daily) and revolve around a "peg" with very tiny variations. Life being more complicated than any economic system, there are no "pure cases". Even in floating rate systems, Central banks intervene to protect their currencies or to move them to an exchange rate deemed favourable (to the country's economy) or "fair". The market's invisible hand is often handcuffed by "We-Know-Better" Central Bankers. This usually leads to disastrous (and breathtakingly costly) consequences. Suffice it to mention the Pound Sterling debacle in 1992 and the billion dollars made overnight by the arbitrageur-speculator Soros - both a direct result of such misguided policy and hubris. Floating rates are considered a protection against deteriorating terms of trade. If export prices fall or import prices surge - the exchange rate will adjust itself to reflect the new flows of currencies. The resulting devaluation will restore the equilibrium. Floating rates are also good as a protection against "hot" (speculative) foreign capital looking to make a quick killing and vanish. As they buy the currency, speculators will have to pay more expensively, due to an upward adjustment in the exchange rates. Conversely, when they will try to cash their profits, they will be penalized by a new exchange rate. So, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most of the emerging economies (also known as the Third World).


It looks surprising that only a very small minority of these states has them until one recalls their high rates of inflation. Nothing like a fixed rate (coupled with consistent and prudent economic policies) to quell inflationary expectations. Pegged rates also help maintain a constant level of foreign exchange reserves, at least as long as the government does not stray from sound macroeconomic management. It is impossible to over-estimate the importance of the stability and predictability which are a result of fixed rates: investors, businessmen and traders can plan ahead, protect themselves by hedging and concentrate on long term growth. It is not that a fixed exchange rate is forever. Currencies - in all types of rate determination systems - move against one another to reflect new economic realities or expectations regarding such realities. Only the pace of changing the exchange rates is different. Countries have invented numerous mechanisms to deal with exchange rates fluctuations. Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all the local currency in circulation is covered by foreign exchange reserves in the coffers of the Central bank. All, government, and Central Bank alike - cannot print money and must operate within the straitjacket. Other countries peg their currency to a basket of currencies. The composition of this basket is supposed to reflect the composition of the country's international trade. Unfortunately, it rarely does and when it does, it is rarely updated (as is the case in Israel). Most countries peg their currencies to arbitrary baskets of currencies in which the dominant currency is a "hard, reputable" currency such as the US dollar. This is the case with the Thai baht. In Slovakia the basket is made up of two currencies only (40% dollar and 60% DEM) and the Slovak crown is free to move 7% up and down, around the basket-peg. Some countries have a "crawling peg". This is an exchange rate, linked to other currencies, which is fractionally changed daily. The currency is devalued at a rate set in advance and made known to the public (transparent). A close variant is the "crawling band" (used in Israel and in some countries in South America). The exchange rate is allowed to move within a band, above and below a central peg which, in itself depreciates daily at a preset rate. This pre-determined rate reflects a planned real devaluation over and above the inflation rate. It denotes the country's intention to encourage its exports without rocking the whole monetary boat. It also signals to the markets that the government is bent on taming inflation.

So, there is no agreement among economists. It is clear that fixed rate systems have cut down inflation almost miraculously. The example of Argentina is prominent: from 27% a month (1991) to 1% a year (1997)!!! The problem is that this system creates a growing disparity between the stable exchange rate and the level of inflation which goes down slowly. This, in effect, is the opposite of devaluation the local currency appreciates, becomes stronger. Real exchange rates strengthen by 42% (the Czech Republic), 26% (Brazil), even 50% (Israel until lately, despite the fact that the exchange rate system there is hardly fixed). This has a disastrous effect on the trade deficit: it balloons and consumes 4-10% of the GDP. This phenomenon does not happen in non-fixed systems. Especially benign are the crawling peg and the crawling band systems which keep apace with inflation and do not let the currency appreciate against the currencies of major trading partners. Even then, the important question is the composition of the pegging basket. If the exchange rate is linked to one major currency - the local currency will appreciate and depreciate together with that major currency. In a way the inflation of the major currency is thus imported through the foreign exchange mechanism. This is what happened in Thailand when the dollar got stronger in the world markets. In other words, the design of the pegging and exchange rate system is the crucial element. In a crawling band system - the wider the band, the less the volatility of the exchange rate. This European Monetary System (EMS - ERM), known as "The Snake", had to realign itself a few times during the 1990s and each time the solution was to widen the bands within which the exchange rates were allowed to fluctuate. Israel had to do it twice. On June 18th, the band was doubled and the Shekel can go up and down by 10% in each direction. But fixed exchange rates offer other problems. The strengthening real exchange rate attracts foreign capital. This is not the kind of foreign capital that countries are looking for. It is not Foreign Direct Investment (FDI). It is speculative, hot money in pursuit of ever higher returns. It aims to benefit from the stability of the exchange rate - and from the high interest rates paid on deposits in local currency. Let us study an example: if a foreign investor were to convert 100,000 DEM to Israeli Shekels last year and invest them in a liquid deposit with an Israeli bank - he will have ended up earning an interest rate of 12% annually. The exchange rate did not change appreciably - so he would


have needed the same amount of Shekels to buy his DEM back. On his Shekel deposit he would have earned between 12-16%, all net, tax free profit. No wonder that Israel's foreign exchange reserves doubled themselves in the preceding 18 months. This phenomenon happened all over the globe, from Mexico to Thailand. This kind of foreign capital expands the money supply (it is converted to local currency) and when it suddenly evaporates - prices and wages collapse. Thus it tends to exacerbate the natural inflationary-deflationary cycles in emerging economies. Measures like control on capital inflows, taxing them are useless in a global economy with global capital markets. They also deter foreign investors and distort the allocation of economic resources. The other option is "sterilization": selling government bonds and thus absorbing the monetary overflow or maintaining high interest rates to prevent a capital drain. Both measures have adverse economic effects, tend to corrupt and destroy the banking and financial infrastructure and are expensive while bringing only temporary relief. Where floating rate systems are applied, wages and prices can move freely. The market mechanisms are trusted to adjust the exchange rates. In fixed rate systems, taxes move freely. The state, having voluntarily given up one of the tools used in fine tuning the economy (the exchange rate) - must resort to fiscal rigor, tightening fiscal policy (=collect more taxes) to absorb liquidity and rein in demand when foreign capital comes flowing in. In the absence of fiscal discipline, a fixed exchange rate will explode in the face of the decision makers either in the form of forced devaluation or in the form of massive capital outflows. After all, what is wrong with volatile exchange rates? Why must they be fixed, save for psychological reasons? The West has never prospered as it does nowadays, in the era of floating rates. Trade, investment - all the areas of economic activity which were supposed to be influenced by exchange rate volatility - are experiencing a continuous big bang. That daily small fluctuations (even in a devaluation trend) are better than a big one time devaluation in restoring investor and business confidence is an axiom. That there is no such thing as a pure floating rate system (Central Banks always intervene to limit what they regard as excessive fluctuations) - is also agreed on all economists. That exchange rate management is no substitute for sound macro- and micro-economic practices and policies - is the most important lesson. After all, a currency is the reflection of the country in

which it is legal tender. It stores all the data about that country and their appraisal. A currency is a unique package of past and future with serious implications on the present.

The Asian Currency Crisis of 1997.

In this chapter study a number of questions regarding the relation between monetary policy, interest rates and exchange rates and how currency crises occur. How does monetary policy affect interest rates? Why does a monetary expansion lead to lower interest rates? What is the effect of monetary policy on exchange rates? Why do some countries try to fix the level of their exchange rate while others let the value of their currency to be freely determined in the foreign exchange market? How does monetary policy differ in a regime of fixed and flexible exchange rates? After presenting the theory of currency crisis, we will analyze in detail the causes of the Asian currency crisis of 1997.

Money Supply and the Determination of the Interest Rate. We consider first the equilibrium in the money market. The portfolio choice of individuals is to decide how much to invest in various financial assets. Suppose, for simplicity, that an investor has to decide how much to invest of her assets into money (cash balances that have a zero interest rate return) and how much to invest into interest bearing assets (short term Treasury bills). Money (cash) balances have the disadvantage of not offering any nominal return (zero interest rate); they have the advantage that you can use them to do transactions (buy/sell goods). Short term bonds have the advantage that they earn interest; however, they have the disadvantage that they cannot be used to make transactions (you need money to buy goods and services). So, an investor will decide to allocate its portfolio between money and bonds considering the benefits and costs of both instruments. So the demand for money will depend positively on the amount of transactions made (GDP, Y) and negatively on the opportunity cost of holding money: this is the difference between the rates of return on currency and other assets (bonds):

Asset Cash T-bill

Real Return -p r i=r+p

Nominal Return 0 i=r+p i=r+p


where p is the inflation rate, i is the nominal interest rate and r is the real interest rate. So the nominal demand for money is: + - +

MD = P L( i , Y) MD is the number of dollars demanded P is the price of goods L is the function relating how many $ are demanded to Y and i. The equation suggests that there are three main determinants of the nominal demand for money: 1. Interest rates. An increase in the interest rate will lead to a reduction in the demand for money because higher interest rates will lead investors to put less of their portfolio in money (that has a zero interest rate return) and more of their portfolio in interest rate bearing assets (Treasury bills). 2. Real income. An increase in the income of the investor will lead to an increase in the demand for money. In fact, if income is higher consumer will need to hold more cash balances to make transactions (buy goods and services). 2. The price level. An increase in the price level P will lead to a proportional increase in the nominal demand for money: in fact, if prices of all goods double, we need twice as much money to make the same amount of real transactions. Since the nominal money demand is proportional to the price level, we can write the real demand for money as the ratio between MD and the price level P. Then, the real demand for money depends only on the level of transactions Y and the opportunity cost of money (the nominal interest rate): MD/P = L(Y, i*)

We can represent the relation between the real demand for money and the interest rate on a graph where the interest rate is on the vertical axis and the real demand for money is on the horizontal

axis (see Figure 1). The relation will be downward-sloping because a higher (lower) interest rate will cause a reduction (increase) in the demand for money. Note that the position of the curve depends on the other variables that affect the demand for money. For example, an increase in the level of income Y will lead to an increase in the demand for money, at any level of the interest rate. So, an increase in Y leads to a rightward shift of the money demand curve. Therefore, in changes in the interest rate are represented by a movement along the same money demand curve while changes in the income are represented by shifts of the entire curve. To find the equilibrium in the money market, we need now to determine the supply of money. The nominal supply of money is determined by the Fed that decides how much money should be in circulation. The supply of money by the Fed is defined as MS; the real value of this money supply is the nominal supply divided by the price level P, or MS/P. Therefore, the equilibrium in the money market is given by: MS/P = L(i, Y) Real Money Supply = Real Money Demand where MS is the amount of money/currency supplied by the Central Bank (through open market operations). This equilibrium in the money market is represented in . Given the supply of money MS (and a given price level P), the real money supply (MS/P) is exogenously given. Given the demand for money curve, there is only one interest rate (i*) at which the money demand is equal to the money supply. Note that, if the interest rate is above (below) the equilibrium one, the demand for money will be lower (higher) than the money supply and this will tend to decrease (increase) the interest rate until the equilibrium interest rate is restored. To understand the economic mechanism that leads to this adjustment, note that the investor must decide how much to invest in money and how much to invest in bonds. Since the demand for money is a negative function of the interest rate, the demand for bonds will be a positive function of the interest rate: as interest rates become higher, the investor would like to put more of her wealth in bonds and less of her wealth in cash. This positive relation between the interest rate and the demand for bonds (BD) is represented in Figure 3. In Figure 3, we also show the supply

of bonds: the total supply of bonds is equal to the total amount of bonds issued by the government that are now held by private investors. Note that the equilibrium interest rate that ensures that the demand for money is equal to the supply of money is the same as the interest rate at which the demand for bonds is equal to the supply of bonds. The total supply of bonds is determined by the bond issues of the government and the open market operations of the central bank .We can consider next the effects of changes in monetary policy on the level of interest rates, i.e. how changes in the money supply affect short term interest rates. Consider first how the money supply is increased. In general, the central bank changes the supply of money through open market purchases or sales of government bonds. Consider the following balance sheet of the central bank:

Central Bank Balance Sheet Assets -------------Treasury Bills held by the CB Foreign Exchange Reserves 300 200 Liabilities -----------------Currency 500

The assets of the central banks are essentially two: Treasury Bills that can be used for open market operations; and foreign exchange reserves (in Yen, Marks and other currencies) that can be used for foreign exchange rate intervention. These foreign exchange reserves can take the form of central bank holdings of foreign cash and holdings of foreign countries government bonds. The liabilities of the central bank are equal to the total amount of currency in circulation. Money is, in fact, a liability of the government, a zero interest rate loan that the private sector makes to the public sector by being willing to hold cash. Correspondingly, the balance sheet of the private sector is: Private Sector Balance Sheet Assets Currency 500 Liabilities and Net Worth Net Worth 2000

Treasury Bills held by public 1200


Foreign T-Bills held by public 300

Here, we assume that all private wealth is held only in three assets, money and domestic and foreign Treasury Bills; private agents do not have any liabilities so that their net worth is equal to their assets. Now, consider the effects on the supply of money of an open market purchase by the central bank of 100b of domestic T-bills previously held by the public. Since the central bank buy these bonds from the public by printing more money, this open market purchase of T-bills leads to an increase in the money supply by 100b, from 500 to 600b: Central Bank Balance Sheet Assets Treasury Bills 400 Forex Reserves 200 Liabilities Currency 600

Private Sector Balance Sheet Assets Currency 600 Treasury Bills held by public 1100 Foreign T-Bills held by public 300 Liabilities and Net Worth Net Worth 2000

Consider now the effects of this open market operation on the money and bond markets : the supply of money increases (as the MS curve shifts to the right) while the supply of bonds available to the public decreases (as the BS curve shifts to the left). At the initial interest rate, the open market purchase of bonds leads to an increase in the money supply (from 500 to 600) and a reduction in the supply of T-bills available to the private sector (1200 to 1100). Given the initial interest rate i*, the increase in the money supply implies that now the money supply is greater than the money demand: agents were happy with their initial holdings of cash and are now forced to hold more cash than they desire. Conversely, in the bond market, the reduction in the supply of T-bills implies that the demand for bonds is now greater than its

supply. Since private agents have now more cash than they desire and less bonds than they desire, they try to get rid of the excess money balances by buying more T-bills. Their attempt to buy bonds in exchange for cash leads to an increase in the price of bonds and a fall in the interest rate. The interest rate fall, in turn, reduces the excess supply of money and the excess supply of bonds. Since the supply of money and bonds is exogenously given, the attempt of agents to get rid of excess cash in exchange of more bonds cannot succeed: in equilibrium the greater amount of cash has to be willingly held by agents and the lower supply of bonds has to be willingly held by agents. Then, the interest rate has to fall so that the demand for money is increased and demand for bonds is decreased. This process has to continue up to the point in which the interest rate has fallen enough so that the demand of money is equal to the higher money supply while the bond demand is equal to the lower bond supply. Therefore, an increase in the money supply through an open market purchase of T-bills leads to a reduction in the equilibrium interest rate. The previous example clarifies how the central bank affects the level of short term interest rate via changes in the money supply. When the Fed wants to tighten (loosen) monetary policy, it will perform an open market sale (purchase) of government bonds that will lead to a reduction (increase) in the money supply and an equilibrium increase (fall) in the short term interest rate. The Foreign Exchange Rate Market We will consider next the determination of the exchange rate in the foreign exchange market and the difference between a regime of fixed exchange rates and a regime of flexible exchange rates. Consider the case of a small open economy such as Mexico. In the exchange rate market, there are some economic agents who demand US Dollars (i.e. they sell/supply Mexican Pesos) and others who sell/supply Dollars in exchange for Pesos. The demand for US Dollars (supply of Pesos) in the exchange market comes from different types of agents: Mexican importers of U.S. goods and services who have to pay in Dollars for their imports; U.S. exporters of American goods in Mexico who have been paid in Pesos and want to convert their Pesos into U.S. Dollars; and investors who are selling Pesos and buying Dollars because they want to buy U.S. assets (bonds, equity, and other U.S. assets). This demand for U.S. Dollars is represented in the curve D$. The curve shows that, as the exchange rate of Mexico (Pesos per Dollar) depreciates the demand for U.S. dollars is reduced. In fact, if the Peso depreciates, U.S. goods become more expensive and Mexican imports of U.S. goods are reduced;

since imports of U.S. goods have to be paid in U.S. Dollars, a depreciation of the Pesos reduces the demand for Dollars as the reduced imports by Mexico of American goods leads to a reduced demand for Dollars. On the other side of the exchange rate markets there are agents who are selling (supplying) U.S. Dollars in exchange of Mexican Pesos. These agents are: Mexican exporters of goods to the U.S. who have been paid in U.S. Dollars and need to convert them in Pesos, U.S. importers of Mexican goods who need Pesos if they need to pay in Pesos for their imports; and investors who are buying Pesos in order to buy Mexican securities (bonds, stock and any other asset). This supply of U.S. Dollars (demand of Pesos) is represented in the curve S$. The curve shows that, as the exchange rate of Mexico (Pesos per Dollar) depreciates the supply of U.S. dollars is increased. In fact, if the Peso depreciates, Mexican goods become cheaper in international markets and Mexican exports to the U.S. goods are increased; since Mexican exporters are paid in U.S. Dollars, a depreciation of the Pesos increases the supply of Dollars as the greater exports of Mexican goods lead to larger Dollar receipts that need to be converted into Pesos. Consider now the equilibrium in the exchange rate market: there is going to be an exchange rate S (Pesos per Dollar) at which the demand for Dollars (supply of Pesos) is equal to the supply of Dollars (demand for Pesos): this equilibrium exchange rate is S*that, if the initial Peso/Dollar exchange rate is depreciated relative to its equilibrium value (i.e. S' > S*), the supply of Dollars will be greater than the demand for Dollars (as Mexican exports are higher and their imports lower) and this will tend to appreciate the Peso relative to the $. In the figure S will fall, meaning that the Peso will appreciate until the equilibrium exchange rate S* is restored. The reverse will happen if the initial S is below (appreciated relative to) the equilibrium one. When a country has a regime of "flexible exchange rates", it will allow the demand and supply of foreign currency in the exchange rate market to determine the equilibrium value of the exchange rate. So the exchange rate is market determined and its value changes at every moment in time depending on the demand and supply of currency in the market. Some countries, instead, do not allow the market to determine the value of their currency. Instead they "peg" the value of the foreign exchange rate to a fixed parity, a certain amount of Pesos per Dollar. In this case, we say that a country has a regime of "fixed exchange rates". In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must also


commit to defend that parity by being willing to buy (sell) foreign reserves whenever the market demand for foreign currency is greater (smaller) than the supply of foreign currency. To understand how fixed and flexible exchange rate regimes work suppose that, initially, the exchange rate is equal to a value S* such that the demand and supply of foreign currency are equal . But, then, some shock occurs that leads to an increase in the demand for foreign currency: for example, a boom in income in the domestic economy leads to an increase in imports that have to be paid in foreign currency. Such a shock is represented in Figure 8 by a rightward shift in the demand for foreign currency. If a country has a regime of flexible exchange rates, it will allow the increase in the demand of foreign currency to cause a depreciation of the domestic currency: the equilibrium exchange rate depreciates from S* to the new equilibrium value S'. Conversely, suppose that the country has a regime of fixed exchange rates: in this case the country is committed to defend the parity S*: it will not allow the currency to depreciate to S'. In technical terms, the central bank intervenes in the foreign exchange rate market by selling foreign currency. Therefore, a country can defend a fixed exchange rate parity that differs from the equilibrium exchange rate (that would hold under flexible rates) only as long as it has a sufficient amount of foreign exchange reserves to satisfy the market excess demand for the foreign currency. If the country runs out of foreign exchange reserves, the fixed parity becomes unsustainable and the central bank will be forced to give up the defense of the currency: the exchange rate will depreciate to its flexible rate value S'. Note also that foreign exchange rate intervention affects the money supply of the country under consideration. In fact, when the central bank intervenes to defend its parity, it is selling foreign exchange currency to investors in the market; in exchange of its sale of foreign currency the central bank receives domestic currency that is therefore taken out of circulation: investors pay with domestic currency their purchase of foreign currency from the central bank. In this sense, foreign exchange intervention taking the form of a sale of foreign reserves has an effect on the money supply that is identical to an open market sale of government securities; in both cases, the money supply is reduced. To see the effects of foreign exchange intervention on the money supply, consider the following example. Suppose the central bank intervenes in the foreign exchange rate market by selling 50b worth of foreign reserves. Before, the intervention, the balance sheet of the private sector and central bank were:

Private Sector Balance Sheet Assets Currency 600 Treasury Bills held by public 1100 Foreign assets held by public 300 Liabilities and Net Worth Net Worth 2000

Central Bank Balance Sheet Assets Treasury Bills 400 Forex Reserves 200 After the 50b sale of foreign exchange represented by the forex intervention: Private Sector Balance Sheet Assets Currency 550 Treasury Bills held by public 1100 Foreign assets held by public 350 Liabilities and Net Worth Net Worth 2000 Liabilities Currency 600

Central Bank Balance Sheet Assets Treasury Bills 400 Forex Reserves 150 Therefore, foreign exchange rate intervention taking the form of a sale of foreign reserves leads to a reduction in the money supply. Conversely, foreign exchange rate intervention taking the form of a purchase of foreign reserves leads to an increase in the money supply. Liabilities Currency 550

The Effects of Open Market Operations Under Flexible and Fixed Exchange Rate Regimes


We discussed above in the section on the money market equilibrium how open market purchases and sales of domestic government bonds affect the money supply and the interest rate of an economy. Open market operations are the standard way in which a central bank controls the money supply and interest rates. We should consider now the effects of such open market operations when the economy is open. We will show that open market operations have very different effects under flexible and fixed exchange rate regimes. Consider first the effect of an open market purchase of government bonds under flexible exchange rates. Under flexible rates, the central bank does not intervene to defend its currency when market pressures lead to its weakening. Therefore, an open market purchase of domestic bonds will lead to an increase of the money supply. In turn, this increase in the money supply will cause a reduction of the domestic interest rate . What will be the effect of this monetary expansion on the exchange rate? The exchange rate will depreciate: in fact, as interest rate at home are now lower than before, investors will want to reduce their holding of domestic bonds and increase their holding of foreign bonds that are now relatively more attractive in terms of their return. Therefore, domestic investors will try to sell domestic bonds, buy foreign currency and buy foreign bonds. The attempt to sell domestic currency in order to buy foreign bonds will, in turn, cause a depreciation of the domestic currency. The effects of the open market purchase of bonds (say 50b) on the money supply under flexible exchange rate will be identical to the one obtained in a closed economy: the money supply will increase and interest rates will fall. As an example, before the open market purchase, the central bank balance sheet was: Central Bank Balance Sheet Assets Treasury Bills held by the CB 300 Foreign Exchange Reserves 200 Liabilities Currency 500

After the open market operation:

Central Bank Balance Sheet Assets Liabilities


Treasury Bills held by the CB 350 Foreign Exchange Reserves 200

Currency 550

The increase in the money supply and reduction in the interest rate will lead to a depreciation of the domestic currency but since the central bank does not defend the current parity under flexible exchange rates, no foreign reserve intervention will occur and foreign reserves will remain the same as before: then, the exchange rate will depreciate. Now, under fixed exchange rate, the exchange is not allowed to change: therefore the expected depreciation of the domestic currency (dS/S) must be, by definition, equal to zero. This also means that, under fixed exchange rate, the nominal interest rate of a small open economy must always be equal to the world interest rate (i=i*): if it was lower, no one would hold domestic bonds. Now consider how this equality of domestic and world interest rates affects the equilibrium in the domestic money market. Assume that, in the short-run framework here considered, the domestic output (Y) is constant and the domestic price level (P) is constant. The equilibrium in the money market implies that real money demand must be equal to real money supply: M/P = L (Y, i) = L(Y, i*) or: M = P L(Y, i*) Since P, Y and i* are exogenously given under fixed exchange rates, the equilibrium value of the money supply M is determined residually and the central bank has no control over it: given the domestic price level, the domestic output and the world interest rate, there is only one value of the money supply such that the money market is in equilibrium. Therefore, open market operations cannot affect the level of the money supply under fixed exchange rates. Suppose that the central bank tries to increase the money supply through an open market operation, in spite of this endogeneity of the money supply under fixed rates. Why would this attempt to increase M fail under fixed rates ? The reason is simple: any attempt to increase the money supply through an open market operation in domestic bonds will cause a loss of foreign exchange reserves that will bring back the money supply to its original level. Why will this loss of reserves occur? Consider the mechanics of an open market operation under fixed exchange rates. In the first moment, the open market purchase of bonds will lead to an

increase in the money supply (as in the flex rate case) and the money supply will increase from 500 to 550: Central Bank Balance Sheet Assets Treasury Bills held by the CB 350 Foreign Exchange Reserves 200 However, as soon as the open market operation is conducted, the increase in the money supply would tend to reduce the domestic interest rate below the world interest rate (i<i*). As this reduction in domestic interest rate starts to occur, all investors will try to sell the lower yielding domestic bonds in order to buy the now higher yielding foreign bonds. In order to buy foreign bonds, agents have first to buy foreign currency. So these incipient capital outflows will put pressure on the domestic exchange rate. If the exchange rate regime were flexible, these incipient capital outflows would cause a devaluation of the currency. However, we are now under fixed exchange rates and the central bank is committed to defend the domestic parity. As the domestic agents try to get rid of their domestic money in order to buy foreign currency and foreign assets, they will sell the domestic currency to the central bank and purchase the foreign currency from the central bank. Since the central bank is committed to the fixed exchange rate, it is forced to intervene and sell and sell to the public as much foreign reserves as they want. So the central bank will lose foreign exchange reserves and this intervention will reduce the domestic money supply. Note that the loss of foreign reserves must be equal to the initial open market operation that has led to the excess supply of money and the downward pressure on domestic interest rates. In fact, only when the loss of reserves equals the initial open market purchase of bonds, the money supply will go back to its initial level, the domestic interest rate will rise back to a level equal to the world rate and the pressure to lose further reserves will be eliminated. So, after this combined open market purchase and ensuing loss of reserves has occurred, the money supply will go back to the value (500) it had before the central bank had tried to change the money supply: Liabilities Currency 550

Central Bank Balance Sheet Assets Liabilities


Treasury Bills held by the CB 350 Foreign Exchange Reserves 150

Currency 500

The only effect of this failed attempt to increase the money supply is that the money supply is the same as before while the asset side of the balance sheet of the central bank has changed: now the central bank has more domestic bonds in its asset portfolio and less foreign reserves. The implication of the above discussion is as follows: under fixed exchange rates and perfect capital mobility, the central bank has no control on the money supply. Under fixed exchange rate there is no monetary autonomy: the central bank has no independent power to set the money supply and the domestic interest rate. Any attempt to increase the money supply through an open market operation will lead to an equal and offsetting loss of foreign exchange reserves with no overall effect on the money supply. Note that an extreme form of a fixed exchange rate regime is a "currency board" such as the one instituted by Argentina in 1991. As we will discuss in more detail below, in the case of the currency board, the commitment to defend the fixed parity is reinforced by a constitutional law and by automatic monetary intervention rules that guarantee the stability of the exchange rate. The reasons why countries decide to have fixed exchange rates are several but can be summarized as follows. First, if exchange rate depreciation is an exogenous cause of domestic inflation (as the price of imported goods goes up with a depreciation), a country with a fixed exchange rate will be able to achieve an inflation rate that is close to the world inflation rate. In fact, if the PPP holds, domestic inflation is equal to foreign inflation plus the percentage depreciation of the domestic currency. If the currency depreciation rate is zero, as in fixed rates, domestic inflation will equal foreign inflation. Second, countries with large budget deficits might be tempted to finance their budget deficit by printing money rather than by issuing bonds. In turn, this monetary financing of the deficits causes a vicious circle of high inflation and currency depreciation. Fixed exchange rates then force the country to avoid devaluations and high inflation rates. But the only way to avoid eventual high inflation and currency devaluation is to stop financing budget deficits by printing money (seigniorage). So fixed exchange rate prevent countries from creating seigniorage and inflation taxes: budget deficits will have to be financed with bonds bought by the private sector because a central bank financing of the deficit will cause a persistent reduction of the foreign reserves of the central bank. Moreover, under fixed rates, this lack of inflation revenues might

eventually force the government to actually reduce the budget deficit through increases in taxes and cuts in government spending. Therefore, the monetary discipline provided by fixed exchange rates might eventually also lead to fiscal discipline. Effect of Economic Shocks on the Exchange Rate Under Fixed Exchange Rate Regimes As discussed above, under a regime of flexible exchange rates economic shocks such as a change in foreign interest rates or an exogenous change in expectations about future exchange rates lead to a devaluation of the domestic currency. What will be the effect of such shocks in a regime of fixed exchange rates? For example, suppose that starting from an initial equilibrium, the foreign interest rate goes up. The domestic interest rate will also increase and this will lead to a reduction of money demand. To restore the equilibrium the money supply must also fall. How will this reduction of the money supply be achieved? When the foreign interest rate goes up, the domestic interest rate is initially unchanged: so agents try to sell domestic bonds and buy foreign currency in order to buy the higher yielding foreign bonds. In order to prevent the currency depreciation that this capital outflow would cause under flex rates, the central bank intervenes and sells foreign currency. In turn, this intervention reduces the money supply and leads to an increase in the domestic interest rate up to the new higher world interest rate. At that point, the loss of reserves stops, the money supply is lower than before (as the forex intervention took domestic liquidity out of circulation) and the domestic interest rate has risen to the level of the world interest rates. Alternatively, the central bank could achieve the same reduction in the equilibrium level of the money supply necessary to restore the equilibrium in the money market via an open market sale of domestic government bonds rather than the above sale of foreign reserves. Both actions lead to the same required result: the money supply is reduced and the domestic interest rate goes up to the level of the world rate. In this example, open market operations are effective in changing the money supply but this does not mean that the monetary authority had any autonomous power to change the money supply. Quite to the contrary, the initial increase in the world interest rate forces the central bank to engineer an equilibrium reduction in the domestic money supply: this reduction can be achieved either through a loss of foreign reserves or alternatively, if the central bank wants to avoid the reserve loss, through a required open market operation that takes liquidity out of the market and pushes the domestic interest rate up to the new world interest rate level. In this example, open market operations do affect the money supply under fixed rates but

not because the central bank has an autonomous power to change the money supply: the central bank has to passively intervene to adjust the money supply to the level required by higher world Another shock that might occur in a regime of fixed exchange rates is a change in expectations that leads to an expected future depreciation of a fixed exchange rate. How should monetary authorities that are trying to defend a fixed parity react to a change in investors' sentiments about the credibility of the country commitment to fixed exchange rates? To understand this case, one must first note that, under fixed exchange rates, the exchange rate parity is constant. So, in normal times when the commitment to a fixed parity is credible the future exchange rate is expected to remain equal to the current fixed parity as agents believe that the parity will not be changed. However, being in a regime of fixed exchange rates does not mean that the fixed parity will never be changed. For example, if the central bank runs out of reserves to defend the currency, a devaluation might occur at some point. This means that a fixed parity may not be fully credible in the sense that there is a positive probability that the future exchange rate will be different from the current one if a devaluation occurs. In other terms, in spite of the current fixity of the exchange rate, changes in the expectations about the future value of the exchange rate might occur even in a regime of fixed exchange rates (that is not fully credible). Such changes in expectations may be due to good reasons such as changes in fundamental variables (high domestic inflation, large budget deficits, political risks and so on) or might, at times, also be caused by "irrational" changes in the investors' sentiments. Self-fulfilling changes in expectations may lead investors to believe that a fixed parity will collapse and this will lead them to a speculative attack on a currency that has a fixed parity, even if there has been no change in the underlying fundamental determinants of exchange rates. Suppose that, for whatever reason, there is a shock that leads investors to expect that the domestic exchange rate will depreciate in the future. Assume that, before this shock, the fixed rate regime was fully credible and agents were not expecting any depreciation of the exchange rate in the future, i.e. Et(St+1)= St. For example, assume that both actual and expected exchange rates were equal to 1. Since Et(St+1)= St, the domestic interest rate is initially equal to the foreign interest rate (i=i*), say 5%. Now suppose that after the shock occurs, market investors start to believe that a 7% future devaluation of the domestic currency might occur; now we have Et(St+1)=1.07>St=1 as the fixed exchange rate parity is not fully credible. The effect of this change in expectations is presented in Figure 15. The shock to expectations shifts to the right the

curve representing the overall return on foreign bonds: for any given current exchange rate, the change in expectations increases the expected return on foreign assets from 5 to 12% (5% plus the 7% expected devaluation). As discussed in a previous section, if the economy was in a regime of flexible exchange rates, the change in expectations about the future exchange rate from 1 to 1.07 would lead to an immediate depreciation of the current domestic exchange rate at time t, from 1 to 1.07. In a regime of fixed exchange rates, instead, such a devaluation of the currency must be prevented. As Figure 15 shows, the only way to maintain the original exchange rate parity of 1 is to have an increase in the domestic interest rate from 5% to 12%. In fact, given the shock to expectations, domestic residents will not try to dump the domestic assets and currency in favor of the foreign assets only as long as the domestic assets provide a return equal to the expected return on foreign assets. Since the expected devaluation has increased the expected return on foreign assets from 5% to 12% the domestic interest rate has to go up from 5% to 12%. Sterilized and Non-Sterilized Foreign Exchange Rate Intervention Suppose now that the defense of the domestic currency occurs, as it is usually the case, through foreign exchange intervention: the central bank sells foreign reserves to the public and this leads to a reduction in the money supply and an increase in domestic interest rates. Before the intervention the central bank balance sheet was: Central Bank Balance Sheet Assets Treasury Bills held by the CB 300 Foreign Exchange Reserves 200 After the open market operation the money supply falls from 500 to 450: Central Bank Balance Sheet Assets Treasury Bills held by the CB 300 Foreign Exchange Reserves 150 This example of foreign exchange intervention is formally called "non-sterilized intervention" since the central bank allows the intervention to affect the equilibrium level of the money supply in the domestic economy. Liabilities Currency 450 Liabilities Currency 500


There is however another type of forex intervention that takes the name of "sterilized intervention". To understand this type of intervention, suppose that you intervene in the foreign exchange market; such intervention, if it is not sterilized, would lead to a reduction in the money supply and an increase in domestic interest rates (as in Figures 14 and 15). Now suppose that, after you intervene, you want to sterilize, i.e. you want to eliminate the effects of your intervention on your money supply and interest rates. You might want to do that for a number of reasons: for example high interest rate might lead the economy into a recession. Then, how do you sterilize your intervention? The answer is that, after you intervene in the forex market, you bring back the money supply to its previous level via an open market purchase of domestic bonds. If you do that the central bank balance sheet becomes: Central Bank Balance Sheet Assets Treasury Bills held by the CB 350 Foreign Exchange Reserves 150 so that the money supply goes back to the level it had before the original forex intervention. Central banks often attempt to sterilize the effects of their intervention in the forex market to prevent changes in the domestic money supply and interest rates coming from such forex interventions. However, such sterilization policies have the negative consequences: in fact, in times when the domestic currency is subject to devaluation pressures, sterilized interventions do not allow the intervention to increase the domestic interest rate. Therefore, sterilized interventions do not eliminate the original cause for a pressure on the exchange rate. When your currency is subject to devaluation pressures and you are trying to maintain fixed exchange rates, the only way to defend the currency is to perform non-sterilized interventions that reduce the money supply and increase interest rates so that the incentive to dump domestic assets is eliminated. If your interventions are sterilized, you do not allow the intervention to affect your money supply and interest rates. Therefore, such sterilized interventions lead to further losses of foreign reserves as the original cause of the initial pressure on the exchange rate (higher expected returns on foreign assets relative to domestic assets) is not eliminated through higher domestic interest rates. So, if the market is telling you that your money supply should be equal to 450 and your interest rates equal to 12%, your attempt to keep the money supply at 500 will lead to further losses of forex reserves. In fact, after the sterilized intervention described above, the

Liabilities Currency 500

foreign exchange rate reserves will further fall from 150 to 100 to push down the money supply to its equilibrium value of 450:

Central Bank Balance Sheet Assets Treasury Bills held by the CB 350 Foreign Exchange Reserves 100 This means that the only way to avoid persistent and continuous losses of foreign reserves is to allow the forex interventions to affect the money supply and interest rates, i.e. you should perform non-sterilized interventions. This also means that, if sterilized interventions continue (in spite of exogenous pressures on your exchange rates), these policies will lead to a continuous fall of forex reserves and the eventual loss of all of them. However, when that occurs, you do not have any more reserves to defend your currency and the fixed exchange rate collapses. In other terms, a speculative attack on your currency leads to a loss of forex reserves and the collapse of the fixed exchange rate regime. You then get a big devaluation that restores the equilibrium in the foreign exchange market. One lesson deriving from the above discussion is that fixed exchange rate regimes are often shaky and liable to collapse. The reasons for the observed collapse of fixed rate regimes is that the exchange rate is often fixed at a parity that is not consistent with the fundamentals in the economy. If that happens, the commitment to fixed exchange rates is not fully credible and, over time, investors will start to believe that a devaluation of the exchange rate might occur. This expectation of a future devaluation of the exchange rate is by itself a cause of pressure in the exchange rate market that forces the central bank to intervene and lose reserves. In the example of if the fixed parity S* is set at a level that is appreciated relative to the equilibrium exchange rate S', the central bank will be forced to intervene continuously in order to prevent a currency depreciation. At every point in time, the market demand for foreign currency will be above the market supply of foreign currency and the central bank will keep on losing foreign reserves. Such loss of reserve is more likely to continue when the central bank intervention is sterilized so that domestic interest rates are not allowed to increase and stem the capital outflows that are putting pressure on the exchange rate.

Liabilities Currency 450

Since the amount of foreign reserves in the central bank coffers is always limited, a fixed rate set at a value different from the fundamental equilibrium exchange rate will eventually lead reserves down to zero; at that point, the fixed parity cannot be defended and the currency is subject to a big devaluation that forces the central bank to move to a regime of flexible exchange rates. There are several reasons why the fixed parity might be inconsistent with fundamentals and a fixed rate regime may be not fully credible. If domestic prices are higher than foreign prices (or domestic inflation is greater than foreign inflation) fixed exchange rates lead to a real appreciation of the domestic currency. Remember that the real exchange rate RER is equal to SP*/P. If domestic prices P are growing faster than foreign prices P* and the nominal exchange rate S is fixed, the real exchange rate appreciates, i.e. the relative price of imported good falls. This real appreciation causes a reduction in domestic exports and an increase in imports from the rest of the world. The ensuing reduction in supply of foreign currency (from reduced exports) and increase in the demand for foreign currency (from the increased demand for imports) leads to a pressure for the currency to depreciate. If the central bank wants to prevent this devaluation because of the goal of a fixed exchange rate, it will be forced to keep on losing reserves through foreign exchange interventions. That is not eventually sustainable as reserve losses will drive the latter to zero and cause a currency collapse. Central Bank Balance Sheet Assets Treasury Bills held by the CB 300 Foreign Exchange Reserves 200 Next, suppose that the government runs a budget deficit equal to 50b. Suppose that the government wants the central bank to finance this deficit via seigniorage, i.e. by printing money. Then, the government will sell 50b worth of government bonds to the central bank in exchange of 50b of new currency (note that if the government bonds had been sold to the private sector, the budget deficit would have been bond-financed rather than money-financed). In this case the, the central bank purchase of government bonds changes the central bank balance sheet as follows: Liabilities Currency 500

Central Bank Balance Sheet


Assets Treasury Bills held by the CB 350 Foreign Exchange Reserves 200

Liabilities Currency 550

However, now the money supply is higher than what is required to guarantee that domestic interest rates remain as high as foreign interest rates. The increase in the money supply tends to reduce domestic interest rates below foreign ones and leads investors to sell domestic assets and currency in order to buy foreign assets. In a regime of flexible exchange rates, such an increase in the money supply would lead to a currency depreciation. However, in a regime of fixed exchange rates, these incipient capital outflows and pressures on the exchange rate force the central bank to intervene to prevent the devaluation of the currency. Then, foreign reserves are lost in a quantity equal to the initial monetary financing of the budget deficit, i.e. the central bank loses 50b of foreign reserves and the money supply goes back to its initial value of 500:

Central Bank Balance Sheet Assets Treasury Bills held by the CB 350 Foreign Exchange Reserves 150 If the budget deficit persists over time and the central bank financing of it persists as well, foreign reserves will be eventually run down to zero and a fixed parity collapse will again occur. The lesson is that, under fixed exchange rates, a budget deficit that is financed with monetary means, will lead to a persistent and unstoppable loss of foreign reserves that will eventually lead to a currency collapse. As an example of inconsistency of fixed exchange rate with fundamentals we look next at a case study from Mexico in the early 1980s. Fundamentals. There are several dimensions to this question, but the most obvious one is that Mexico's fixed exchange rate was inconsistent with its other policies. You can see in Figure 17 that while Mexico attempted to fix its currency, its monetary policy led to much more rapid growth in its stock of money than in the US. This is illustrated by the "dash-dot" line in the figure, denoting the ratio of the money stock in Mexico to that in the US. The reason for this

Liabilities Currency 500

excessive increase in the Mexican money supply was the existence of large budget deficits in Mexico that were being financed by the central bank purchases of government debt; these purchases, in turn, led to excessive creation of money supply. As a result of the monetary financing of its budget deficit, prices in Mexico rose more rapidly than those in the US, with Mexico averaging between 20 and 30 percent inflation between 1979 and 1981. The dashed line in Figure 17 depicts the sharp rise in the ratio of Mexican prices to American. By the end of 1981, prices had risen substantially more in Mexico than the US, leading many Mexicans to shift their spending and investments outside the country. By February 1982, the discrepancy in prices proved to be indefensible, and the peso imploded. In short, the enormous departure from PPP was too much for the system to withstand, so the exchange rate collapsed. You can see in the figure that the decline in the peso brought prices back into line with PPP (for a while). Fixing the Exchange Rate. Another dimension to our question is the central bank's behavior. You might think that the central bank can simply announce an exchange rate, but a little thought will tell you it's not so easy. To take a slightly frivolous example, I could claim that my apartment is worth 2 million dollars, but if no one is willing to buy it for that price it's not clear that the statement means anything. For related reasons, the central bank must back up its claim to fix the exchange rate. In the simplest version of a fixed exchange rate, the central bank supports the price by buying and selling as much foreign currency as people want at the set price. If people want dollars, the bank supplies dollars, if they want pesos, the bank supplies pesos. 1. Fixed exchange rates aren't fixed forever. They simply substitute infrequent large movements for more frequent smaller movements. If you get caught, they can kill you. Anyone holding pesos on February 19, 1982, lost 29 percent of their dollar-equivalent value in a day, and more after that. 2. Operate in hard currencies when you can. One strategy for dealing with such risk is to do business in dollars, or some other hard currency. US banks, for example, denominated their loans in dollars, so the collapse in the peso did not hurt them on its own. But the collapse of the economy that went with the fall in the peso did hurt them, with the result that most loans were repaid only in part. Mexicans, too, tried to switch to dollars, but government restrictions made this difficult to do on a large scale.


3. Enter after the fall. A colleague of George Soros's said once that the best opportunities come when situations change from "disaster" to "bad". Anyone entering the Mexican market in late 1982 or 1983 had, at least, the advantage of buying low. Why Countries Fix the Exchange Rate and Why Fixed Exchange Rates Collapse We observed before that it is often quite hard to permanently fix exchange rates and that fixed exchange rate regime often collapse with a big devaluation. So why do countries like to fix their exchange rates? There are many reasons: 1. Under flexible exchange rates, the exchange rate might be affected by speculative factors that have little to do with fundamentals. These speculative factors might lead to excessive exchange rate volatility, misalignments of the nominal and real exchange rate from their equilibrium level and negative effects of production, trade and investment. High exchange rate volatility might increase the risk of assets and investment in a country and also reduce real trade in goods. 2. Flexible exchange rate leads to "beggar thy neighbour" policies where countries try to gain competitive advantage for their exports through policies of devaluation of the domestic currency. This is a source of conflict among countries since devaluation exchange rate policies may be a substitute for protectionist trade policies. 3. Flexible exchange rates may be a cause of high inflation (p) and fixed exchange rates allow a country to converge very fast to low levels of international inflation. This is very important. Suppose that the PPP holds either in the short-run or the long-run. Then: P = S Pf In growth rates, the domestic inflation rate (p) is equal to the foreign inflation rate (pf)plus the rate of exchange rate depreciation (dS/S) p = dS/S +pf 100% = 97% + 3% . The Asian Currency Crisis of 1997 We will consider next the economic and currency crisis in Asia in 1997-98. We will try to understand the causes of the currency crisis in light of what we have learned in the previous parts. The Table below presents the data on the current account balance of a sample of Asian countries in the 1990s. As the Table suggests, large and growing current account deficits were


the norm in a number of Asian countries, Thailand, Malaysia, the Philippines and Korea in particular. Current Account Balances (as a % of GDP)

1990 1991 1992 1993 1994 1995 1996

Korea Indonesia Malaysia

-1.24 -3.16 -4.4

-1.7 -0.16 -1.45 -1.91 -4.89

-4.4 -2.46 -0.82 -1.54 -4.25 -3.41 - -11.51 -13.45 -5.99 10.11

-2.27 -9.08 -4.06

Philippines Singapore Thailand Hong Kong China

-6.3 -2.46 -3.17 -6.69 -3.74 -5.06 -5.86 9.45 12.36 12.38 -8.74 -8.61 -6.28 8.4 3.02 6.58 3.07 5.26 8.48 18.12 17.93 16.26 -6.5 -7.16 8.14 -9 -9.18 0.58

1.98 -2.21 1.17

1.09 -2.17

1.02 -0.34

Note first that in Asia, the official exchange rate policy of many countries was one of pegging to the U.S. dollar. Hong Kong has actually a currency board with the parity tied to that of the US dollar. Other countries were formally pegging their exchange rate to a basket of currencies; however, the effective weight of the US dollar in the basket was so high that their policy can be characterized as an implicit peg to the US currency. In Malaysia, the currency moved in a 10% range of 2.7 to 2.5 ringitt to the US$ for most of the years between 1990 and the beginning of 1997. The Thai Bath was effectively fixed in a narrow 25.2 to 25.6 to the US$ from 1990 until 1997. In the Philippines, the Peso fluctuated in a 15% range of 28 to 24 between 1990 and the beginning of 1995 but was practically fixed at a 26.2 rate to the US dollar from the spring of 1995 until the beginning of 1997. Other countries followed a somewhat more flexible exchange rate policy. The Korean won followed periods of fixity to the US $ but had a more flexible exchange rate regime. The Won depreciated in nominal terms from 1990 until the beginning of

1993 (from 700 to almost 800 won per dollar); next, it traded in a very narrow range of 800 to 770 won/$ between the beginning of 1993 and the middle of 1996. Then, it started to depreciate by about 10% reaching a rate of 884 at the end of 1996. The Indonesian policy can be described as a policy of explicit real exchange rate targeting with the nominal rate falling from 1900 rupieh to the US $ in 1990 to 2400 by the beginning of 1997. Taiwan also followed a policy of real exchange rate targeting allowing its currency to fall from a rate of 24 New Taiwan dollars per US$ in 1990 to a rate of 27.8 by the end of 1996. In Singapore, the currency actually appreciated in nominal terms throughout the 1990s going from a rate of 1.7 in 1990 to a rate of 1.4 by the end of 1996. Finally, in China where inflation was in the double digits in the early 1990s, the currency was allowed to modestly depreciate between 1990 and 1993 but was drastically devalued by almost 50% in 1994; since then, the currency remained stable with a slight drift towards a nominal appreciation. While such policy of pegging the exchange rate ensured in many Asian countries ensured the stability of the nominal exchange rate relative to the US currency, it also had the consequence that change in the nominal and real value of the dollar relative to the Japanese Yen and the European currencies had the consequence of affecting the real exchange rate of the Asian currencies pegged to the US dollar. Specifically, the dollar was on a downward nominal trend relative to the yen and mark between 1991 and 1995 reaching a low of 80 yen per dollar in the spring of 1995. During that period, the Asian currencies pegged to the U.S. experienced a real depreciation of their currencies, as they were depreciating relative to the Japanese and European currencies. However, after the spring of 1995, the dollar started to rapidly appreciated relative to most world currencies (the yen/dollar rate went from 80 in the spring to 1995 to over 125 in the summer of 1997, a 56% appreciation). As a consequence, the Asian currencies that were tied in nominal terms to the dollar also experienced a very rapid real appreciation. . Therefore, the problem of anti-inflation stabilization policies that use the fixed exchange rate as the policy tool to fight inflation is that fixed rates lead to a real exchange rate appreciation and to a significant worsening of the current account. While the Asian countries had not experienced the large inflation rates of some Latin countries, their inflation rates were usually above those of the OECD group; therefore a policy of pegged parities might have contributed to the real appreciation observed in the 1990s.


CONCLUSION If we look at the data on the real exchange rate of the Asian countries, we see the following. Taking 1990 as the base year, we observe that by the spring of 1997 the real exchange rate had appreciated by 19% in Malaysia, 23% in the Philippines, 12% in Thailand, 8% in Indonesia, 18% in Singapore, 30% in Hong Kong. In Korea, the currency had depreciated in real terms by 14% while in Taiwan there was a 10% real depreciation. Find data on China (real depreciation). This suggests that, with the exception of Korea, all the currencies that crashed in 1997 had experienced a significant amount of real appreciation. Note also that in several countries, a large part of the real appreciation occurred after 1995 in the period in which the dollar (to which these currencies were pegged) was becoming stronger. It is important to note that the degree of real exchange rate appreciation seems to be correlated with the choice of the exchange rate regime: countries with a more fixed exchange rate regime experienced a much larger real appreciation. Conversely, countries such as Korea, Taiwan and China that followed a more flexible exchange rate regime experience a real depreciation. Note that Indonesia, that followed a regime closer to real exchange rate targeting, the degree of real appreciation was smaller than that of countries such as Thailand, Malaysia, Hong Kong and the Philippines that followed more closely regimes of fixed exchange rates. The data also suggest that the degree of overvaluation was correlated with worsening of the current account: countries with more overvalued currencies were generally experiencing a larger worsening of the current account; while countries such as China and Taiwan that had experienced a real depreciation had current account surpluses. The exception was Korea that had large and increasing current account deficits while its currency had depreciated in real terms in the 1990s. By early 1997, it was clear that several regional currencies were seriously overvalued and that such overvaluation was a factor in the worsening of the current account of many countries in the region. Real depreciations appeared to be necessary to adjust the current account position of the deficit countries. It is important to not that in the 1990s there were several other factors that affected the competitive positions of the Asian currencies. First of all, the 50% nominal of the Chinese currency in 1994 led to a sharp real depreciation of the renminbi; the ensuing large and growing

trade surpluses of China led to a significant loss of competitiveness in the rest of Asia. During the 1990s China, with wage level at a fraction of those in the rest of the region, started to produce and compete in many manufacturing sectors that had been the source of export growth for the East Asian countries. Second, after 1995 the rapid appreciation of the dollar led to a significant real appreciation of the Asian currencies that were pegged to it. Third, in 1995-96 there was a slump in the world demand for semi-conductors, one of important export products in the region. This led to a significant reduction in export growth by the region in 1996. Fourth, the continued economic weakness of Japan, that remained in a state of economic stagnation throughout the 1990s dampened the demand for regional exports, as over 30% of the Asian exports were going to the region. Therefore, while the degree of real appreciation of the Asian currencies in the 1990s was not as large as the one observed in previous episodes of currency collapse (such as Mexico in 1994), the combination of the factors discussed above made the competitive position of most Asian countries quite fragile by the beginning of 1997. In order to understand the currency crisis in 1997 and its spread from one country to the other, it is important to note that the measures of the real exchange rate presented above do not fully measure the competitiveness loss suffered by regional currencies whose currency had not yet depreciated once some countries in the region had started to devalue. Take for example the case of the Korean won. As many countries in the region compete in similar products in world and regional markets (US, Europe and Japan), when the currencies of Thailand, Malaysia, Indonesia and the Philippines started to depreciate over the summer while the Korean won remained relatively stable until October, this implied a significant loss of competitiveness for the Korean exporters. Specifically, if we take the end of 1996 as the base period, by the end of September 1997, the Thai Baht had depreciated relative to the US$ by 42%, the Indonesian Rupiah by 37%, the Malaysian Ringitt by 26%, the Philippines Peso by 28%. The Korean won, instead, by the end of September had depreciated only by 8% (relative to December 1996). This implied that by the end of September, the won had appreciated in nominal (and real) terms by 34%, 29%, 20% and 18%, relative to the currencies of Thailand, Indonesia, the Philippines and Malaysia respectively. If we look at the official figures for the real exchange rate of the won we do not observe the drastic loss of competitiveness of the won between July and the end of September as such data are based on aggregate trade-weighted (with 1990 base) data.


This effect of the depreciation of some regional currency on the "effective" real exchange rate and competitiveness of the other countries in the regions is a crucial element to understand why the currency contagion was importantly determined by fundamental factors. As one after the other, the currencies of countries that were competing in the same world market came under attack and started to depreciate, the equilibrium fundamental value of other currencies that had not depreciated yet started to become lower and the pressure on such currencies to depreciate to regain some of the competitiveness loss became even higher. This is important because while, on a net basis, the increase in the external debt of the Asian countries was equal to the current account deficit (minus the non-debt creating net FDI inflows), the increase in the gross external liabilities of these countries was significantly larger in the 1990s as large short-term capital inflows were also accompanied by very large capital outflows. This increase in gross external liabilities became a serious issue in 1997 because, once the currency crisis started, large gross capital outflows exacerbated the crisis in two ways. First, as the currencies were falling, non-residents were repatriating the capital inflows by dumping domestic bonds, equities and other financial assets; on the other side, resident who had accumulated large stocks of financial capital abroad via the large capital outflows of the 1990s were unwilling to repatriate such foreign currency outflows as their domestic currencies were falling. Second, a large fraction of the gross capital inflows and outflows were in the banking sector. For example, in 1996 in Korea, of the $23.3b "other investment capital inflows", $12.3 went to the banking sector while of the $11.8b "other investment capital outflows", $9.5b were made by the banking system. This is consistent with the BIS data presented above that show a much larger increase in liabilities towards BIS reporting banks (gross capital inflows) than the increase in assets towards BIS reporting banks (gross capital outflows). This process of large gross intermediation of capital inflows and outflows through the banking system implied that the domestic Asian bank were increasing their foreign short-term liabilities towards BIS banks much faster than their foreign assets. For example in Korea, at the end 1993 the liabilities of the domestic banks towards BIS banks were equal to $34.6b while their foreign assets (towards BIS banks) were equal to 13.7b, for a net liability position of 20.8b. But, between the end of 1993 and the second quarter of 1997, the gross liabilities went up to $90.6b, a whopping increase of $56b in only three years and six months; the gross assets went up to only to $33.5b, an increase of $19.8b. As a consequence, the net liability position of the Korean banking system went from

$20.8b at the end of 1993 to $57.0b by 1997:2, an increase of $36.2b. Note that similarly large increases in gross external liabilities of the banking and non-banking system are observed, controlling for country scale, in the other countries in the region where a currency crisis occurred, especially Thailand, Malaysia, Philippines and Indonesia. The increase in the gross liabilities of the banking system in the 1990s was an independent cause of the worsening of the crisis and currency depreciation in 1997. For example, in Korea, once the real burden of the heavy gross borrowing by banks and non-banks was worsened by the depreciation of the currency and some financial institutions started to go bankrupt, a financial panic ensued. Since it was not clear which banks were solvent and which were not, foreign banks that had heavily lent to Korean banks started to refused to roll-over the loans that would have been automatically renewed in normal times. . The situation calmed down only around Christmas when, faced with the prospect of a default induced by a self-fulfilling unwillingness to roll-over short-term debts, the American, European and Japanese banks jointly agreed to negotiate an orderly renewal of such short-term loans and the major creditor countries decided to anticipate a fraction of the bail-out package approved by the IMF in early December.