EXCHANGE-RATE POLICY &

THE CENTRAL BANK

Chapter 19
Exchange Rates are Volatile

Yen-Dollar Rate

280.00
260.00
240.00
Yen per Dollar

220.00
200.00
180.00
160.00
140.00
120.00
100.00
80.00
Jan-84

Jan-86

Jan-88

Jan-90

Jan-92

Jan-94

Jan-96

Jan-98

Jan-00

Jan-02

Jan-04

Jan-06
Costs of Volatile Exchange Rates
Exchange rate volatility increases risk in international
finance.
Ex. Many developing economy corporates issue securities
in US$. An exchange rate devaluation will make this more
expensive to repay.
Exchange rate volatility increases risk in international
trade.
Ex. Some multinationals earn profits in foreign currency. A
revaluation will reduce the domestic currency value of
those profits.
Ex. Changes in exchange rates will change the relative
competiveness of exports and imports.
 Exchange Rates
Exchange Rate: E - # of domestic currency
units purchased for 1 US$.
An increase in E is a depreciation of
domestic currency and a decrease in E is an
appreciation.
Interest Parity

Et 1
(1 i )
F
(1 it )
t Et
Saving
It is January 1st, and you have D$1000
to save for 1 year. You can put it
into:
1. a domestic currency bank account at an
interest rate i.
2. a foreign currency bank account at
interest rate iF.
 Payoff to strategy #2
Strategy two has three parts.
1. Buy foreign exchange at spot rate Et to get
{D$1000/Et} F dollars.
2. Put {D$1000/St} F dollars into F bank account. After
1 year get F$(1+iF){D$1000/Et }
3. Convert these funds into F$ at exchange rate
prevailing at end of year.

(1 i F ) Et 1
D$1000
Et
Uncovered Interest Parity
(1 i F ) Et 1
If 1 i , deposit funds then deposit in
Et

F$ account.
If (1 i F
) Et 1 , deposit funds then deposit in
1 i
Et
D$ account.
Et 1 (1 i F ) 1 i
Then in equilibrium Et
Interest Rate Parity
The only reason people would be willing to hold a
US$ account when US interest rates were lower
than domestic interest rates would be if they can
achieve an expected gain from an increase in the
value of US$ during the time that they were holding
the account.
Approximately

it i
F Et 1 Et
i g
F E
t t t 1
Et
 Three Reasons UIRP might not hold
1. Future exchange rates are risky, uncovered
interest parity does not account for risk.
A. Interest Parity Works for Forward Prices
1 it
F {t }
Et
t 1
1 itF
{t }
F t 1 : Forward Price for currency delivered at t+1

2. Domestic and foreign currency not perfect

substitutes. People like to hold currency for
liquidity reasons.
3. Currency controls
Midterm Exam
Tuesday, October 21, 2012, 1:30-1:50, LTG
Bring writing materials and calculator.
Coverage: Money, Central Banks, Interest Rates,
Exchange Rates (through Thursday).
Semi-open book: Bring 1 A4 size piece of paper with
handwritten notes on both sides.
Supply and Demand Model
Why do exchange rates change?
Relative values of two currency determined by supply and
demand by traders of the two currencies.
Unlike textbook, we will describe a model of domestic countrys forex
market in which US$ is vehicle currency
Price of US$: E is the price of US$ in terms of
DCU.

Link
From Interest Parity
People trade currencies to engage in foreign
trade and international investment.
Expected (Investment) Profit:
Of Domestic Investors in Foreign Economy

Et 1
(1 itF )
Et
Of Foreign Investors in Domestic Economy

Et
1 it
Et 1
Supply and Demand in Forex Mkt

E Excess
Supply Supply

E*

Excess
Demand Demand

Forex Turnover
Equilibrium in the Forex Market
Gap between supply and demand of US$ is
the Balance of Payments.

Two types of Forex Markets

Floating: Forces of supply and demand
equilibrate markets.
Fixed: Govt/Central Bank buys excess foreign
currency in market.
Difference w/ Textbook
Textbook version examines US dollar forex market from
US perspectives.
We focus on market from more international perspective.
Supply of US $ liquidity in local forex market is not
exogenous.
Increase in Desired Capital Inflows by Foreign Investors/
Desired Purchases of Domestic Goods

E Supply

Supply'

E*
Domestic Currency
E** Appreciates

Demand
Increase in Desired Capital Outflows by Domestic Investors/
Desired Purchases of Foreign Goods
E

Domestic Currency
Depreciates
E**

E*

Demand '
Supply Demand
Foreign Interest Rates Go Up
Relative Demand for F$ Goes Up
E

E**
Domestic
E* Currency
Depreciates

Supply'

Demand '
Supply Demand
Why are exchange rates so volatile
Exchange rates are volatile because they are based on
expectations.
Expectations of future exchange rates determine demand
for forex today.
Waves of optimism and pessimism of future of currency
affects currency today.
Expectation of Et+1 Increases

E 2

E**
Domestic
E** Currency
1 Depreciates

Supply'

Demand '
Supply Demand
D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
E Supply

Supply'
Domestic
E* Currency
Appreciates

E**
Demand
Demand '
Foreign Currency Purchase, D.C. Interest Rates Go
Down. Relative Demand for US$ Goes Up

E

E**
Domestic
E* Currency
Depreciates

Supply'

Demand '
Supply Demand
 Model of the Exchange Rate
Examine UIRP on a logarithmic scale

Et 1
t
1 i
Et 1
1 it
F
ln t t
1 i ln ln 1 i F

Et Et
ln 1 it ln Et 1 ln Et ln 1 itF
it et 1 et itF et itF it et 1 itF it itF1 it 1 et 2
et itF it itF1 it 1 itF 2 it 2 itF3 it 3 ........eLT
Monetary Policy Transmission
Mechanism
A rise in policy interest rates will raise money market rates
which will lead to forex appreciation. This will raise price
of domestic export goods reducing demand.
A cut in policy rates will reduce money market rates
leading to forex depreciation improving competitiveness of
exports increasing demand.

The impact of monetary policy will affect demand through

an external channel in a way that parallels the effects
through the internal channel.
Exchange Rate Passthrough
Inflation targeting focuses on price stability in consumer
goods.
In most small and medium economies, substantial share
of imported goods in consumer goods.
Exchange rate depreciations make imported goods more
expensive and can be inflationary. Raising interest rates in
the face of depreciation will stabilize exchange rates and
inflation.
Exchange rate depreciations make imported goods more
expensive and can be inflationary. Raising interest rates in
the face of depreciation will stabilize exchange rates and
inflation.
 29

Price Stability and Exchange Rates

Lower interest rates will be associated with

weakening currencies on average but
exchange rate movements are volatile and
unpredictable.
Even central banks that target price
stability intervene in forex markets to
stabilize volatile exchange rates.
Is this consistent with inflation targeting
nominal anchor?
 T-Accounts:
Unsterilized Intervention
UnSterilized Foreign UnSterilized Foreign
Currency Purchase Currency Sale

Central Bank Central Bank

Assets Liabilities Assets Liabilities

+100 +100 -100 -100
Foreign Reserve Foreign Reserve
Currency Accounts Currency Accounts
 31

Forex Intervention
Unsterilized intervention Govt uses open
market operations to purchase (sell) foreign
currency. Changes level of bank reserves,
domestic liquidity, interest rates.
Sterilized interventions Use domestic funds
financed by bill issuance or long-term
borrowing to purchase foreign currency.
Unsterilized Intervention
Central Bank Buys Foreign
iIBR D Reserves & Increases Reserves

Increases liquidity in interbank

market and pushes down interest
rates.
i*
.

i**

Clearing Balances
 33

Three Situations

OK
1. Forex Intervention Aids Price Stability Goal:
Large share of consumer goods are imported in
Asian emerging markets and exchange rates
factor into that price.
2. Forex Intervention Does Not Conflict with
Inflation Target: When inflation is within the
target range, exchange rate stability may work
as an auxiliary goal.
 34

Swiss Monetary Policy

Swiss Inflation Target: 0-2%
Peg: 1.2 SwF to 1 Euro.
Consistent?
 Monetary Policy & Exchange Rates
The central impact of the foreign currency intervention is on
domestic interest rates.
Monetary policy that shifts domestic interest rates will also
shift exchange rates regardless of whether it occurs through
currency intervention, OMO, or some other change in
quantity of bank reserves.
Monetary policy that does not shift interest rates will not
shift exchange rates.
 36

What do you do if?

3. Forex Intervention Conflicts with the

Target.
If inflation near top of the range, then
forex intervention that weakens the
currency will be inflationary and violate
credibility of inflation target.
If inflation near bottom of the range, then
forex intervention that strengthens the
currency will violate target credibility
 T-Accounts:
Sterilized Intervention
Sterilized Foreign Sterilized Foreign
Currency Purchase/ Currency Sale/
Issue non-monetary Open Market Purchase
liabilities
Central Bank

Central Bank
Assets Liabilities
Assets Liabilities -100 -100
+100 +100 Foreign Reserve
Foreign Stabilizati Currency Accounts
Currency on Bonds +100 +100
Stabilization Reserve
Bonds Accounts
 T-Accounts:
Sterilized Intervention
Sterilized Foreign Sterilized Foreign
Currency Purchase/ Currency Sale/
Open Market Sale Open Market Purchase
Central Bank Central Bank

Assets Liabilities Assets Liabilities

+100 +100 -100 -100
Foreign Reserve Foreign Reserve
Currency Accounts Currency Accounts
-100 -100 +100 +100
Government Reserve Government Reserve
Securities Accounts Securities Accounts
South Korean authorities are back in the local
foreign-exchange market, checking the wons gains
after staying fairly quiet for several months, traders
in Seoul say.

The Bank of Korea is suspected to have bought

dollars near the days low of 1,031.40 won and again
towards the end of local trading hours, around the
1,040 won level, according to three Seoul-based
currency traders. Two traders estimated the central
bank may have bought more than $500 million worth
of the U.S. currency to slow the Korean wons gains
Thursday. This would be the second day in a row
that traders suspect the central bank has intervened Link
to cool the won.
 Assets of Bank of Korea

550000
500000
450000
400000
Billions Won

350000
300000
250000
200000
150000
100000
1

4
0

1
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Total Foreign Assets
 41

Effectiveness of Sterilized Intervention

Sterilized Intervention may work by signaling future
monetary policy intentions.
Sterilized purchase of foreign currency increases
relative supply of domestic currency assets & puts
downward pressure on exchange rates.
In developed financial markets, shift of relative assets
would be too small to impact forex rates.
Evidence suggests that in some emerging markets,
sterilization can have some effect on exchange rates.
 42

Evidence from Latin American intervention

Link
Regression of appreciation or first difference on
forex intervention (share of GDP).

Sterilized
intervention can
slow the rate of
exchange rate
movements but
not overall
changes!
FIXED EXCHANGE RATE
Fixed Exchange Rates Link
Fixed Exchange Rate: Weakside Currency
Target
Govt Buys Excess
E Supply US$
Supply
ETGT

Demand

Forex
Turnover
Fixed Exchange Rate: Strongside
Currency Target
E
Supply

ETGT
Demand
Govt Buys Excess
DCU
Forex
Turnover
 Exchange Rate Depreciation
Exchange Rate: S - # of domestic currency units
purchased for 1 US$.
An increase in S is a depreciation and a decrease in S
is an appreciation.
Depreciation Rate

Et 1 Et Et 1
t 1
Et Et
 Fixed Exchange Rate
If the central bank undertakes to keep the exchange rate
fixed and that is a credible undertaking, then .

t 1 0
If the relative values of currency are fixed, then funds will
flow out of the domestic currency if domestic interest rates
are too low and flow into domestic currency if interest
rates are too high.
i = iF
 %

0
2
4
6
8
10
12
14

Jul-96

Jul-97

Jul-98

Jul-99

Jul-00

Jul-01

Jul-02

Jul-03

Jul-04

Jul-05

Federal Funds Rate: Month Average

Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12
Interest Settlement Rate (HIBOR Fixing): Period Average: 1 Month

Jul-13

Jul-14
HONG KONGS UNIQUE
MONETARY
INSTITUTIONS
Guide to Hong Kong Monetary and Banking
Terms by HKMA.see http://www.hkma.gov.hk
 Convertibility Undertaking HK
Whenever the price of US At the exchange-rate levels
dollars goes above 7.85, defined by the strong-side and
the central bank will sell weak-side Convertibility
US dollars at E = 7.85. Undertakings, 7.75 and 7.85,
No one will ever pay more the HKMA stands ready to
than 7.85HK$ per US$ exchange any amount of US
dollars against Hong Kong
Whenever the price of US
dollars with licensed banks
dollars goes below 7.75,
maintaining Hong Kong-dollar
the central bank will buy clearing accounts with the
US$ at E = HK$7.75. HKMA. Joseph Yam
No one will ever sell for less
than 7.75HK$ per US$.
Balance Sheets of the Exchange Fund

Hong Kong Exchange Fund Balance Sheet (Millions HK$)

Assets $3,032,818 Liabilites $2,395,310
HK Dollar $227,855 Certificates of Indebtedness $327,372
Foreign Currency $2,804,963 Fiscal Reserves Account $773,862
Coins in Circulation $10,575
Exchange Fund Bills & Notes $782,605
Balances of Banking System $164,093
Placement by Banks & Other FI $50,734
Placement by HK Statutory Body $214,911
Others $71,158

Accumulated Earnings $637,508

 Reserves: Clearing Balances
The reserve requirement in HK is zero. Banks must only
have enough reserves to meet all of their payment
obligations.
Clearing Account: The accounts maintained with the HKMA
for settling inter-bank balances and payments between
banks and the HKMA.
Aggregate Balances: The sum of balances maintained by banks in
clearing accounts at the central bank.
HK Interbank Market Automatic Pilot
HIBOR Interest Rate Above
Fed Funds
iHIBOR

i* Banks willing to cash in US$ to

get more clearing balances to
lend.
iFF Under convertibility
undertaking, HKMA will make
those reserves available.
Interest rates drop.

D
Clearing Balances
HK Interbank Market Automatic Pilot
HIBOR Interest Rate Below Fed
iHIBOR D Funds

i* Banks willing to cash in clearing

balances to get more US$.
Under convertibility undertaking,
iFF
HKMA will make those US$
available.
Interest rates increase.

Clearing Balances
Supply Curve of Reserves
For commercial banks, US$ rate is benchmark in
normal times (i.e. when peg has credibility).
If HIBOR is greater than Fed Funds rate, sell US$
reserves and buy HK$ reserves.
If HIBOR is lower than Fed Funds rate, sell HK$
reserves and buy HK$ reserves.
HKMA undertakes to adjust supply of clearing
balances so that supply of reserves/clearing
balances equals the demand at the HIBOR rate
which will be set at the benchmark.
Automatic Pilot
Demand for HK Reserves Rises
Increased demand pushes up
D D HIBOR
iHIBOR
Upward pressure on interest
rates attracts US$ to HK and
pushes E to strong side of band.

iFF
Banks convert US$ w/ HKMA
and get more reserves until
HIBOR and Fed Funds are
equalized.

R Clearing Balances
Automatic Pilot
Demand for HK Reserves Falls
Decreased demand pushes
D D down HIBOR
iHIBOR
Downward pressure on interest
rates attracts HK$ to US and
pushes E to weak side of band.

iFF
Banks convert HKMA$ w/ HKMA
and get more US$ until HIBOR
and Fed Funds are equalized.

Clearing Balances
R
Automatic Pilot: Fed Funds Rate Drops
US Policy Rates Drop
iHIBOR D
US$ move to HK increasing
liquidity
Under convertibility undertaking,
HKMA increases reserves
iFF
Interest rates decrease.

iFF

Clearing Balances
Automatic Pilot: Fed Funds Rate Rises
US Policy Rates Rise
iHIBOR
Banks cash in HK$ to get more
iFF US$ to lend.
Under convertibility
undertaking, HKMA will drain
iFF reserves.
Interest rates fall.

D
Clearing Balances
 Loss of Credibility
A fixed exchange rate will lose credibility if people
come to believe that the central bank will:
devalue the currency, (ie. raise S in the future)
revalue the currency (ie. reduce S in the future)
If market expects an exchange rate change,
commercial banks will adjust comparison rate for
the expectations of devaluation.

i HIBOR
i FF
NextYear
Market Expects Revaluation, < 0
Willingness to Hold HK$ Rises
iHIBOR D
US$ move to HK increasing
liquidity
Under convertibility undertaking,
HKMA increases reserves
iFF
Interest rates decrease.

iFF+

Clearing Balances
 Market and

Revaluation
HK Interbank

Expectations of

Million HK$

Ja
%

10000
20000
30000
40000
50000
60000

0
n-
02
-2.5
-1.5
-0.5
0.5

-2
-1
0
1

Ap
r- 0
2 Jan-02
Ju
l-0 Mar-02
2
O May-02
ct
-0
2 Jul-02
Ja
n- Sep-02
03
Ap Nov-02
r- 0
3 Jan-03
Ju
l-0 Mar-03
3 May-03
O
ct
-0
3 Jul-03
Ja
n- Sep-03
04
Nov-03
HIBOR - FF

Aggregate Balances

Ap
r- 0 Jan-04
4
Ju Mar-04
l-0
4 May-04
O
ct Jul-04
-0
4
Ja Sep-04
n-
05 Nov-04
Ap
r- 0 Jan-05
5
Mar-05
Ju
l-0
5 May-05
Jul-05
Sep-05
Market Expects Revaluation
<0
iIBR

1
iFF S

2
iFF+ S

R D

Clearing Balances
Market Expects Devaluation
>0
iHIBOR
2
iFF +
S
1
iFF S

R D

Clearing Balances
 Currency
Hong Kongs central bank does not print money.
Bank of China, HSBC, and Standard Chartered
print banknotes but
the banks can only issue paper notes if they buy licenses from
the central bank with US$ at a rate of $1 per HK$7.8 printed.
The Licenses are called Certificates of Indebtedness
Certificates issued by the Financial Secretary to be held by
note-issuing banks as cover for the banknotes they issue.
CIs appear as liabilities on HKMA balance sheet.
Certificates of Indebtedness increase when currency increases
Exchange Fund: Liabilities: Certificates of Indebtedness

400000

350000
Millions HK$

300000

250000

200000

150000
09

Au 0

11

12

13

14
08

09

10

11

12

13

14
1
b-

b-

b-

b-

b-

b-
g-

g-

g-

g-

g-

g-

g-
Fe

Fe

Fe

Fe

Fe

Fe
Au

Au

Au

Au

Au

Au
Coins

Coins (and recent 10 Banknotes) are issued by the

central bank unlike the USA where they are issued by
the Treasury.

Definitions here are from the Guide to Hong Kong Monetary and Banking
Terms by HKMA.see http://www.hkma.gov.hk
Reserves: Exchange Fund Bills
Exchange Fund Bills and Notes Debt Instruments
issued by the HKMA for the account of the Exchange
Fund.
Since 1990, the Exchange Fund has sold short-term
bonds (stretching the maturity structure as time goes on ).
Exchange Fund bonds are listed on HKEX and traded in
secondary markets.
Should government debt be part of the
monetary base?
Exchange Fund Paper can be held by anyone,
but large share is owned by local banks.
Therefore, they can be thought of as being mostly
secondary reserves of banks.
ExFund paper is held primarily for HK$ liquidity
management purposes.
These instruments are fully backed by Foreign
Reserves. The HKMA has undertaken that new
Exchange Fund paper will only be issued when
there is an inflow of funds.
Hong Kong Exchange Fund Bills &Notes:
August 2009
Held by Banks
Held Outside Banks
 HKMA & Fed: Similarities & Differences
Assets Base
Same Central Bank
Liabilities
Different Fed assets are HK liabilities
primarily Treasury include interest
securities paying tradable
HKMA assets are securities primarily
primarily foreign held by banks
currency securities Fed Liabilities
dont pay interest.
Ex Fund bonds do.
 HKMA & Fed Similarities & Differences
(Monetary Base)

Currency Reserve Accounts

Same Large part of Banks keep funds at

monetary base. central bank
Different Fed prints US US Reserve accounts
currency are required by
3 private banks regulation.
purchase licenses HK Clearing balances
to print currency. are only necessary for
transactions.
MANAGED FLOAT
Managed Floating
Most developed/OECD central banks set
domestic interest rates in response to domestic
price levels.
Many emerging markets or developing
economies either set a fixed exchange rate or
simply use the currency of another country
Dollarization
Many other emerging markets also practice
managed floating which sometimes adjusts the
interest rate in response to domestic conditions
and sometimes intervenes in foreign currency
markets to stabilize the price level.
 Managed Floats
Singapore BBC Anchor
BBC: Basket, Band, Crawl
Basket: Singapore anchors currency to a weighted
average of different currency to immunize from changes
among large economies.
Band: Weighted average allowed to float within a fairly
large range of the target.
Crawl: Average is scheduled to adjust in a path over time.
Weights in the basket, size of the band, rate of crawl are
all secrets.
Interventions occur in both forex markets and money
markets to stabilze interbank rates.
Long-term goal is price stability.
In October 2013, MAS maintained the modest and gradual appreciation path of the S$NEER policy band, with no change
to its slope, width, and the level at which it was centred. This policy stance, which has been in place since April 2012, was
assessed to be appropriate, taking into account the balance of risks between external demand uncertainties and rising
domestic inflationary pressures. Link
Foreign Currency Intervention
Managed Floating: Purchase
Foreign Central Bank cuts interest rate
Domestic Forex rate strengthens
Domestic Central Bank purchases forex
directly increasing demand for forex.
Forex Purchase also expands domestic
money supply and reduces domestic interest
rates.
This helps to keep domestic forex rate from
strengthening.
Foreign Currency Intervention
Managed Floating: Sale
Foreign Central Bank raises interest rate
Domestic Forex rate weakens
Domestic Central Bank sells forex directly
increasing supply of forex.
Forex Purchase also reduces domestic
money supply and increases domestic
interest rates.
This helps to keep domestic forex rate from
weakening.
Foreign Currency Sale, D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down

E Supply

Supply'

1 Domestic
E* Currency
Appreciates

E**
2 Demand
Demand '
 Capital Controls
China among other developing economies operates system of
foreign exchange controls.
To obtain foreign exchange, Chinese residents must acquire
permission from State Administration of Foreign Exchange.
Possible for ex/im firms to obtain foreign currency but limit of
US$20,000 for individuals investing overseas though banks and
mutual funds can apply for a quota of foreign currency.
Capital Controls & Interest Rates
Chinas financial markets remain heavily regulated and are
dominated by banks which are owned by central or
provincial governments.
Central bank is able to set the base lending rate and
deposit rate of banks as an instrument of monetary.
Since depositors cannot invest overseas, domestic interest
rates do not affect demand for US dollars in Chinas forex
market.
Current Account

IMF Data Mapper

State Administration of Foreign Exchange
(SAFE)
Large demand for RMB for investment and international
trade but demand for dollars limited in China forex market
due to capital controls.
SAFE sells RMB and acquires US dollar assets. In turn,
SAFE sells domestic currency sterilization bonds and
large reserve requirements to Chinese banks to soak up
the money supply.
Link