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After all, prices of goods and services rise and fall throughout a market economy, as demand and supply shift.

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If an economy experiences strong inflows or outflows of international financial capital, or has relatively high inflation, or if it experiences strong productivity growth so that purchasing power changes relative to other economies, then it makes economic sense for the exchange rate to shift as well. Floating exchange rate advocates often argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable.

Exchange rates would bounce around less, too. The economist Milton Friedman — , for example, wrote a defense of floating exchange rates in in his book Capitalism and Freedom :. Advocates of floating exchange rates admit that, yes, exchange rates may sometimes fluctuate. They point out, however, that if a central bank focuses on preventing either high inflation or deep recession, with low and reasonably steady interest rates, then exchange rates will have less reason to vary. A soft peg is the name for an exchange rate policy where the government usually allows the exchange rate to be set by the market, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market.

With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. A central bank can implement soft peg and hard peg policies. Perhaps Brazil sets this lower exchange rate to benefit its export industries. Perhaps it is an attempt to stimulate aggregate demand by stimulating exports. Perhaps Brazil believes that the current market exchange rate is higher than the long-term purchasing power parity value of the real, so it is minimizing fluctuations in the real by keeping it at this lower rate.

Perhaps the target exchange rate was set sometime in the past, and is now being maintained for the sake of stability. The Brazilian central bank could weaken its exchange rate in two ways. One approach is to use an expansionary monetary policy that leads to lower interest rates. In foreign exchange markets, the lower interest rates will reduce demand and increase supply of the real and lead to depreciation. The central bank can expand the money supply by creating reals, use the reals to purchase foreign currencies, and avoid selling any of its own currency.

In this way, it can fill the gap between quantity demanded and quantity supplied of its currency.

Exchange-Rate Policies

Figure 3 b shows the opposite situation. Perhaps Brazil desires the stronger currency to reduce aggregate demand and to fight inflation, or perhaps Brazil believes that that current market exchange rate is temporarily lower than the long-term rate. Whatever the reason, at the higher desired exchange rate, the quantity supplied of 16 billion reals exceeds the quantity demanded of 14 billion reals.


In this case, with an excess supply of its own currency in foreign exchange markets, the central bank must use reserves of foreign currency, like U. Both a soft peg and a hard peg policy require that the central bank intervene in the foreign exchange market. However, a hard peg policy attempts to preserve a fixed exchange rate at all times.

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A soft peg policy typically allows the exchange rate to move up and down by relatively small amounts in the short run of several months or a year, and to move by larger amounts over time, but seeks to avoid extreme short-term fluctuations. When a country decides to alter the market exchange rate, it faces a number of tradeoffs. If it uses monetary policy to alter the exchange rate, it then cannot at the same time use monetary policy to address issues of inflation or recession. If it uses direct purchases and sales of foreign currencies in exchange rates, then it must face the issue of how it will handle its reserves of foreign currency.

Finally, a pegged exchange rate can even create additional movements of the exchange rate; for example, even the possibility of government intervention in exchange rate markets will lead to rumors about whether and when the government will intervene, and dealers in the foreign exchange market will react to those rumors. For example, when a country pegs its exchange rate, it will sometimes face economic situations where it would like to have an expansionary monetary policy to fight recession—but it cannot do so because that policy would depreciate its exchange rate and break its hard peg.

With a soft peg exchange rate policy, the central bank can sometimes ignore the exchange rate and focus on domestic inflation or recession—but in other cases the central bank may ignore inflation or recession and instead focus on its soft peg exchange rate. With a hard peg policy, domestic monetary policy is effectively no longer determined by domestic inflation or unemployment, but only by what monetary policy is needed to keep the exchange rate at the hard peg. Another issue arises when a central bank intervenes directly in the exchange rate market. If a central bank ends up in a situation where it is perpetually creating and selling its own currency on foreign exchange markets, it will be buying the currency of other countries, like U.

Holding large reserves of other currencies has an opportunity cost , and central banks will not wish to boost such reserves without limit. In addition, a central bank that causes a large increase in the supply of money is also risking an inflationary surge in aggregate demand. Conversely, when a central bank wishes to buy its own currency, it can do so by using its reserves of international currency like the U.

Fixed exchange-rate system - Wikipedia

But if the central bank runs out of such reserves, it can no longer use this method to strengthen its currency. Thus, buying foreign currencies in exchange rate markets can be expensive and inflationary, while selling foreign currencies can work only until a central bank runs out of reserves. Yet another issue is that when a government pegs its exchange rate, it may unintentionally create another reason for additional fluctuation. With a soft peg policy, foreign exchange dealers and international investors react to every rumor about how or when the central bank is likely to intervene to influence the exchange rate, and as they react to rumors the exchange rate will shift up and down.

Thus, even though the goal of a soft peg policy is to reduce short-term fluctuations of the exchange rate, the existence of the policy—when anticipated in the foreign exchange market—may sometimes increase short-term fluctuations as international investors try to anticipate how and when the central bank will act. The following Clear It Up feature discusses the effects of international capital flows —capital that flows across national boundaries as either portfolio investment or direct investment.

Some countries like Chile and Malaysia have sought to reduce movements in exchange rates by limiting inflows and outflows of international financial capital. This policy can be enacted either through targeted taxes or by regulations. Taxes on international capital flows are sometimes known as Tobin taxes , named after James Tobin , the Nobel laureate in economics who proposed such a tax in a lecture. For example, a government might tax all foreign exchange transactions, or attempt to tax short-term portfolio investment while exempting long-term foreign direct investment.

Countries can also use regulation to forbid certain kinds of foreign investment in the first place or to make it difficult for international financial investors to withdraw their funds from a country. The goal of such policies is to reduce international capital flows, especially short-term portfolio flows, in the hope that doing so will reduce the chance of large movements in exchange rates that can bring macroeconomic disaster. Tryon, Schwert, G William, William Schwert, Waldmann,, "undated".

Exchange of views: ECB President Mario Draghi with members of the Dutch Parliament

Bollerslev, Tim, Tim Bollerslev, Loopesko, Bonnie E. Menkhoff, Lukas, Taylor, Mark P. Osterberg, William, Engle, Robert F, Humpage, Owen F, Humpage, Anna J. Schwartz, Fatum, Rasmus, Vitale, Paolo, Dominguez, Kathryn M. Kathryn M. Dominguez, Menkhoff, L. Oberlechner, Thomas, Hung, Juann H, William P. Richard T. Peiers, Bettina, Moreover, the author speculates that depending on the causes that motivate a raise in US interest rates, the structural effects will differ.

As a caveat, results are mixed across different economies and must be taken with caution.

29.4 Exchange Rate Policies

It has the following key elements: inflation targeting, a free-floating exchange rate regime, a solid fiscal position, and sound bank regulation and supervision. However, he argues that the traditional framework might not be sufficient to deal with severe financial risks. Two prominent cases in which that is the case are as follows. First, substantial currency mismatches created by unhedged local or external loans in foreign currency; second, exposures to foreign currency liquidity risks, particularly so in dollarized financial systems. Thus, he underscores the need of complementing with non-conventional instruments.

Two factors are of keen interest. The fact that the Peruvian economy is highly dollarized and the relevance of credit cycles. Thus, he explains, the need of additional tools to mitigate risks. He underscores three tools. First, the central bank uses sterilized FX intervention to build international reserves for precautionary purposes and to mitigate the exchange rate volatility.

Second, the authorities might increase the reserve requirements on foreign exchange liabilities with the objective of limiting risks. Third, there might be reserve requirements in domestic and foreign currency, to smooth credit cycles. He explains that in Peru the cyclical use of reserve requirements has contributed to reducing financial risks that associated with credit cycles.

Goldberg underscores three points on capital flows: first, the evolution of international capital flows; second, the size and variable global factor by global factor she means the common movement of capital flows across countries ; third, she covers some open questions on these topics. On the evolution of international capital flows, she underlines that cross-border lending is the most volatile, particularly so, for bank borrowers.

The amplitudes of their swings have been larger for EMEs bank borrowers, especially those that are financed through international bank flows. On non-bank borrowers, bank-based credit slows and, in some cases, even contracts in the global financial crisis aftermath. This is especially the case for AEs. She argues that the relevance of the global factor is intermittent. Moreover, the global factor has received a lot of attention, but its size, generality, and implications for economic activity have been debated. She cites Avdjiev, Gambacorta, Goldberg and Schiaffi to support the intermittent strength in international flows 5.

The referred paper analyzes cross border credit from banks and international debt securities in the QQ4 period, from 64 countries. She argues that the post-crisis spike in sensitivity to US monetary policy was temporarily and mostly driven by the co-movement in AEs monetary policies. She underscores that better capitalized lending banking systems are, in general, less responsive to fluctuations in global risk conditions.

She contends that the exchange rate movements reflect the global factor but are not sufficient indicators of pressures on currencies. The EMP measure is expressed in currency depreciation units. The weighted sum of observed exchange rate moves, plus the currency changes that are not released as foreign exchange intervention and monetary policy changes respond to pressure.

The paper uses cross-country panel, 44 countries, mm Those described as safe-haven currencies appreciated with risk. She then underscores the following points. First, capital flows are not only volatile but are also complex in that their composition evolves, the strength of their drivers can change, as well as the global factors. More specifically, capital flow data and bank-specific data from the International Banking Research Network IBRN enable the identification of specific channels and the different behaviors between borrowers and creditors.

She calls for a better understanding on the dynamics of the different financing, and the relative effectiveness of the different policies in the intervention toolkit. Alfaro raises two key points. First, the risk of future synchronization of the monetary policy normalization of major economies and its effects on financial intermediation and credit. On the first one, he argues that excess of liquidity along with low levels of risk aversion reduced external and local interest rates. To support his points, he presents two sets of time series, risk aversion measures, and long-term sovereign bond rates.

The low-cost environment LCE allows some local firms could refinancing their debt. He highlights the gross bond issuing by nonbanking firms. On the other hand, he underlines the use of resources from corporate bond issuing. After , the proportion to resources allocated to liability refinancing have markedly increased.

Moreover, such an environment makes housing-market very attractive. A threat to financial stability is a sudden adjustment of external financing conditions. In addition, sharp hiked in external interest rates continue to represent an important risk. In that scenario, free-floating FX works as buffer for the impact on long-term interest rates. Chile performs well relative to other EMEs in that its exchange rate and year sovereign rates volatilities have tended to be in the low range, particularly so in the case of the sovereign rates. Do nothing, but communicate potential vulnerabilities, for instances, through the use of heat maps derived from valuation, follow debt-to-income and debt service ratios.

Of course, the use of Reports to explain such vulnerabilities is warranted. He shows some evidence of how such announcements have affected market behavior. To answer this, he assumes a demand driven increase in AEs. To what extent this could be good? There is interest rate correlation, mainly due to fear of floating.

There is the tightening of financial conditions, plausibly through a global financial cycle. He underlines that there is little consensus on either channel, and that there are many open questions. A stronger dollar has accumulated pressure on EMEs. Hitherto, EMEs reactions have been contained.

There are important discussions about the importance of fear of floating, the FX pass-through, and net foreign currency debt, which includes a notable level of corporate debt issue in USD. There is a debate on the dilemma vs. The evidence using reduced form is inconclusive.

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On the financial channel, he argues that there is typically emphasis on capital flows in and out of EMEs. In addition, there has been the policy debate surrounding the policy response to capital flows. He asks whether capital outflows are really contractionary? He argues that at a theoretical level a sudden should be expansionary. He questions whether bond inflows are contractionary, as the FX appreciate, and non-bond inflows are expansionary.

Exchange Rate Policy Options of the European Central Bank

Moreover, he contends that capital inflows while good in the short-term, are detrimental in the medium term. Stracca argues that the evidence on AEs interest rates driving capital flows is mixed, at best. Fundamentals have generally improved since the Asian Crisis. There are several favorable factors, such as more credible monetary and macroprudential policies.

There is also an improvement in reserves adequacy. On other hand, there are vulnerabilities that are a matter of concern. The rotation from external to domestic vulnerabilities such as the case of credit in China.