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AS Economics Unit 4 – Fixed exchange rates and the end of the Gold Standard

September 26, 2016 Leave a comment

Currently doing some revision on fixed exchange rates which is now part of Unit 4 in the new CIE AS syllabus. The following post is an explanation of how fixed exchange rates worked. For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of NZ can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZdollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.

The arrival of the floating exchange rate system – 15th August 1971

Under the Bretton Woods regime, world currencies were pegged to the dollar, which in turn was tied to a set price of gold. Central banks had the right to convert their dollar holdings into bullion. But on August 15th 1971 Nixon, in the face of economic difficulties, closed the gold window, devalued the dollar against bullion and imposed a 10% surcharge on imports. The era of paper money and floating exchange rates had arrived. Below is a news clip of President Nixon announcing the end of trading gold at the fixed price of $35/ounce. At that point for the first time in history, formal links between the major world currencies and real commodities were severed.

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RBNZ cut OCR but NZ$ on the rise

August 15, 2016 Leave a comment

Last Thursday it was no real surprise that the RBNZ cut the official cash rate to 2%. With this cut you would have expected some fall in the value of the $NZ but instead it appreciated. So why did the $NZ appreciate? Graeme Wheeler was interviewed by NZ Herald reporter Liam Dann and explained to him that we live in a phenomenal situation. Global interest rates have been incredible low especially in countries like Japan, the UK and Australia – see table below. Add to that the impact of quantitive easing since 2009 and negative interest rates in countries which account for 25% of world GDP and you have a very unusual situation.

CB Rate Aug 16

Some key assumptions from the RBNZ are that:

The global economy will start to pick-up which will mean that there will be less pressure on the NZ$ as investors look to other currencies to invest in. Remember that the NZ$ is the 10th most traded currency in the world and at uncertain times in the global economy it is seen as safe place to ‘park’ your money. This therefore increases the demand for NZ$’s appreciating its value.

Also the growth of the domestic economy with GDP expanding by 2.4 percent over the year ended in the March 2016 quarter, could mean a rise in inflationary expectations which should bring the inflation rate closer to the 2% mid point method in the policy target agreement. However this is a drop from 3.2% from the previous year.

According to Stephen Toplis of the BNZ 

Clearly, the NZD is already higher than anticipated and inflation expectations could well be constrained for longer as annual headline inflation falls, potentially, sub-zero. It was also interesting that the RBNZ did not repeat its upside scenario for interest rates due to higher house prices. This reaffirms the Bank’s easing bias.

All things considered then, and noting there is still significant uncertainty as to the exact way ahead, we can reasonably comfortably conclude that:

–  There will be at least one more rate cut;

–  The balance of risk is for even more;

–  The cash rate is going to be at least as low as it is now for a long time;

–  Inflation is likely to continue surprising to the downside in the near term;

–  Only when the rest of the world plays ball will the NZD wilt.

Bank of Japan sits on its hands

May 15, 2016 Leave a comment

Central Bank Rates 6th May 2016Been teaching a lot on the problems that economies have in trying to stimulate more growth to get out of the deflationary threat that is prevalent in many countries. Central Banks around the world running are out of ammunition (cutting interest rates – see rates below) and one wonders what is the next step that economies can take?

Back in February the Bank of Japan (BOJ) pushed interest rates into negative territory with the uncollateralised overnight rate being -0.10%. After saying that it would do everything in its power to get inflation to reach 2% (its target rate) and with inflation expectations moving down from 0.8% to 0.5%, markets were very surprised that it didn’t ease rates further. Two of Japan’s measures of inflation are moving away from the the target rate of 2% – see graph below.

Japan inflation 2016

With this decision the Yen strengthened and it is becoming exceedingly difficult to tell if a central bank has run out of ammunition especially when it doesn’t fire a shot. So why have the BOJ held off on easing?

  1. When rates are cut – especially if they go negative – it takes six to twelve months to judge its impact on the economy. This is something referred to as the ‘Pipeline Effect’.
  2. Governor Haruhiko Kuroka may be concerned with the strengthening of the Yen after the last cut in February. This makes exports more expensive and imports cheaper.
  3. The Governor is waiting for the government fiscal stimulus to kick in with the impending cancellation of an increase in value-added-tax.

There is plenty of room to push interest rates further into negative territory and with the next scheduled BOJ meeting in June they will be watching what the US Fed reserve do. An increase in the US Fed rate will mean a stronger US dollar which might achieve more for Japan than further negative interest rates.

Commodity Currency – Aussie dollar overvalued.

May 12, 2016 Leave a comment

Below is a video from the FT that I showed my A2 class this morning. The significance of it is the Australian dollar and how its value is strongly linked to iron ore prices. Recent growth in China has exceeded expectations and this has led to a rebound in commodity prices especially iron ore. The belief is the AUS$ is higher than the equilibrium level suggests and that this rate will not be sustainable. There are two reasons for this:

  1. Commodity prices have accelerated which has led to more demand for AUS$ which might not be sustained.
  2. Higher relative interest rates has made the AUS$ strong as ‘hot money’ has been attracted in the country. The Reserve Bank of Australia (central bank) has recently cut the cash rate (interest rates) to 1.75% and there is talk of a further cut this year.

A Level Revision – Fixed, Dirty Float Exchange Rate Systems

May 4, 2016 Leave a comment

For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of New Zealand can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

Managed ER

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZ dollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.

New Zealand inflation not expected to hit 2% until March 2018

March 10, 2016 Leave a comment

Today Graeme Wheeler the RBNZ governor announced at 0.25% cut in the OCR – now 2.25%. He listed the following reasons for the cut:

  • Significant fall in inflationary expectations. The RBNZ has forecast that inflation will only reach 0.5% by September this year and 2% in March 2018. Since the GFC in 2008 weak inflation has been prevalent in the world economy and with the collapse in oil prices it has got weaker in the second half of last year.
  • Globally there is also decline in core inflation – a measure of inflation that excludes certain items that face volatile price movements. Therefore there is little or no imported inflation to talk about. A depreciation of the $NZ could mean an increase in the price of imports but would make New Zealand exports more price competitive – something that Graeme Wheeler is keen on given the weakness of New Zealand export prices.
  • A decline in the global outlook – interest rate cuts in Japan, EU and the UK accompanied by weaker growth in China. See graph below of Central Bank rates.

Surprisingly enough he said that the lower Fonterra milk payout was not a major factor in the bank’s decision as it was just a reflection of weaker global demand. Graeme Wheeler did suggest that one more rate cut might be on the cards – ‘monetary policy will continue to be accommodative’

CB rates

History of the Renminbi

February 11, 2016 Leave a comment

Below is a very good video from the FT which outlines the growth of the Chinese currency – the Renminbi (RMB). It includes some excellent graphics including the value of the currency against the US$ from 2005 – 2015 (see graphic below)

  • 1948 – RMB was put into circulation by the Communist party
  • 1997 – RMB was pegged to the US$
  • 2005 – Peg was removed
  • 2009 – China allowed approved companies to settle trade payments with non-Chinese customers using the RMB
  • 2015 – 20% of China foreign trade is settled in RMB compared to 3% in 2010
  • 2015 – RMB the 5th most traded currency although it is a long way behind US$ and €

The Chinese authorities want to have the RMB included in the basket of currencies that make up the IMF’s special drawing rights. This would mean an official endorsement of the RMB as a reserve currency. However one of the conditions of the IMF of being a reserve currency is that it must be freely tradable. Although the Chinese government is reducing its interventionist approach it is not yet ready to give market forces complete free rein over its exchange rate.

Renmimbi

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