Forex Economics 285 Fall 2000 Exchange rates

Forex Economics 285 Fall 2000

Exchange rates • Current rate is ¥ 107 per US dollar – Depreciation of yen means more ¥ per $ • At ¥ 107, an item costing ¥ 107, 000 is US$1, 000 • At ¥ 214 that item costs only US$500 – Appreciation means fewer ¥ per $ • In the mid-1980 s, the rate was ¥ 240 • The yen peaked at ¥ 80 in 1995

Impact of ¥ appreciation • Query: what happens to Nissan’s exports? • What brand TVs do Japanese buy? • What happens to GDP? • Y=C+I+G+X-M • What happens to Japanese life insurers who bought US Treasuries & real estate? • ¥ 240 x $50 bil = ¥ 12 trillion becomes ¥ 4 trillion

Pegs • Fixed exchange rates • Trade dollars (baht) at a fixed rate (B 22. 0=$1) • Choice of pegs • Single currency (e. g. , US$) • Basket (e. g. , by % of trade against ¥, $, E) • Government must be able to control • Supply dollars to meet demand or • Make holding baht more attractive to attract dollars / shift S&D • If the rate is really fixed, where do you borrow? • Query: can you have an independent monetary policy?

Dynamics • Under a fixed rate – What happens with inflation? • Example: Prices double B 22 per shirt to B 44 • How does the price change in US$? • What happens to exports? Imports? – What happens to reserves?

Exchange rate pressure • How keep from running out of reserves – Raise interest rates? – Slow domestic demand? – Supply more dollars? • Requires being able to borrow dollars • But who will loan? • The IMF!!

Thailand • In July 1997 the Thai Baht fell 50% • What happens to the number of baht a Thai bank would need to repay a US$ loan? • Thai banks were rendered insolvent in one night! • So should they use a crawling peg? • Adjust for inflation? • Adjust for shifts in ¥/$ rate, since Japan is a major market

Japan’s case • Under the Dodge Plan, the yen was fixed in 1949 at ¥ 360 = $1 • Modest inflation and rapid growth produced chronic trade deficits • When Japan began running out of US$ they slowed domestic demand rather than depreciating their currency • The tool? - raise interest rates!

But raise interest rates? • Yes, because capital controls didn’t let people freely buy / sell yen • So in the 1997 currency crisis, Malaysia imposed capital controls and avoided the full brunt of the crisis

How to use a hedge fund • When you see a country in trouble: • Borrow lots of baht • Use it to buy US$ • Wait! • If you’re lucky • The exchange rate collapses • You buy back baht on the cheap • Overnight profit • $100 mil gives $50 mil profit

Liberalization • However for Japan accession to the OECD in 1964 required that they gradually remove capital controls • Process largely completed in 1980 • Residual controls remained until 1998 – 34 years, start to finish! – But what happened to the yen?

Response to US inflation • Bretton Woods collapsed in 1971 • ¥ 360 to ¥ 308 • How respond? – Lower interest rates – Increase fiscal expenditures • Tanaka Kakuei’s Rebuilding the Japanese Archipelago – Don’t “sterilize”

Bottom line • Double-digit inflation in mid-1973 • Then the oil crisis hit! • Deep doo-doo