Multiple Market Intervention for Target Zones

Exchange Rate Dynamics in a Target Zone - A Heterogeneous Expectations Approach

Chapter 7 - Prices, Exchange Rates, and Purchasing Power Parity

This article presents a new way of modeling the dynamics of an exchange rate target zone. In the presence of a single upper (lower) target boundary, the exchange rate is precisely represented as the sum of a free float and a short (long) position in a call (put) option with strike price at the boundary. To model a target zone (with two boundaries), a natural approach consists of describing the exchange rate dynamics as the combination of the two, namely the sum of free float together with a long position in a put written on the lower boundary and a short position in a call option written on the upper boundary, respectively. The authors show that this first order approximation leads to significant mispricing (as much as 20%) and must be iterated, leading to an infinite sequence of compounded “mirrored” option prices. They analyze basic properties of such mirrored nested options analytically, describe how to calculate them numerically, and show why it is crucial to take into account higher order corrections in realistic target zones. They argue that this analogy to option prices allows for conceptually simple generalizations that describe different target zone arrangements. They then apply their methodology to the estimation of the fundamental value of the Hong Kong dollar that is hidden by the target zone pegged to the US dollar. They also estimate the implied maturity and explain how this parameter serves as direct proxy for target zone credibility.

Inflation defined as a continuous rise in the general price level should be distinguished from seasonal variation in the price level and changes in the relative prices of commodities whatever the reason for this change may be. The rise in prices of goods and services during inflation is not restricted to goods and servies produced locally but also extends to goods and services crossing the national frontiers due to a rise in the foreign exchange rate if the country in question is adopting a free and fluctuating exchange rate or due to difficulties in its balance of payment if it adheres to fixed exchange rate. There is dearth of statistical figures as far as price indeces are concerned in Libya and the figures that are available do not indicate a sharp rise in the local prices ; thus while the quantity of money in circulation has risen by eleven times from 1957 to 1967, the retail price index of the principal food commadities has risen by about 63%. The wide discrepency between the rise in quantity of money & the reported figures on price indeces, I believe is due to the following factors : (1) The rise in income has induced a rise in the quantity of money held by the private sector, i.e. a fall in the income velocity of circulation of money ; (2) The rise in the quantity of money during this period was due to a favorable balance on the capital and current account of the balance of payment and not due to local credit expansion or the printing press method of increase_ions that ing the supply of money. The country has never used locall.. the capital resources available to it; (3) part of the increas quantity of money may have been used to finance transactions were financed previously on a barter basis. The rise in the general price level is an accepted fact as far as the average person in the country is concerned ; however there is no reason to infere that this rise constitute more than a case of disquilibrum in the market due to shift in the demand function brought about primarily by a rise in the real income. The rise in the real income itself was a result of growth in the production of goods and services that is not directly suitable for consumption ; thus the relative inelasticity of the supply of the various consumer products caused a rise in the general price level in the country, but had the rise in the real income been the result of a rise in the supply of consumption goods, prices would have remained relatively stable. In a market economy every supply is elastic in the long run, therefore sooner or later the aggregate supply of goods and services will respond to the increase in demand and the rise in prices will find a limit providing that the monetary and fiseal authorities are not behaving in a manner that will produce a deficit on the balance of payment and there by causing a deterioration in the position of the Libyan pound. A rise in the price level such as happened in Libya is necessary in order to allow the market forces to get momentum and reestablish equilibruim again.

Background/Objectives: Export competitiveness of an economy is determined by exchange rate and price level movements. This paper endeavors to analyze relative price and exchange rate movements in selected Asian countries visà-vis India and theirimplications for trade policy. Methods/Statistical analysis: The trends in changes in relative prices, exchange rates and trade are analyzed for years 1993, 2003 and 2013. Unit value index for exports is used to calculate relative price ratios. The relative prices and exchange rates are calculated using simple mathematical equations. Then, the price ratios and exchange rates are compared with export and imports movements of each country vis-à-vis another to assess effects of these movements on trade competitiveness. Findings: The study elucidates thatthe greater the increase in the exchange rate than the increase in the relative price level, the beneficial it is for a country to trade with another country. India’s exports to selected five countries reflected an upward trend whenever the depreciation of currency was greater that the upward movements in the price levels. An analysis of percentage changes in price and exchange rates and growth rates of exports and imports also reflects that India experienced a slow growth in exports in all those years when price rise was not compensated equally by exchange rate depreciations.It also indicates that whenever the price rise was compensated by the equivalent or greater depreciation of currency, there was surplus in trade with the competing country. These findings are in tune with fundamental macroeconomic theory of exchange rates and price movements. This analysis clearly indicates that unlike other competing economies India lacks active policy interventions that will help in enhancing export competitiveness through precise exchange rate movements. Applications/Improvements: The study puts forward a strong case in favor of an exchange rate policy that brings about the movements in exchange rate in such a manner as to compensate for the changing price level in India. Keywords: Exchange Rate Movements, Export Competitiveness, Price Level, Trade Policy

Inflation continues to decline but remains well above 3%. It is anticipated to decrease significantly in 2024 and draw closer to the established target in the first half of 2025. The ongoing moderation in the economy's price levels is evidenced by the decline in headline inflation from 11% to 9.3% between September and December 2023. A noteworthy contributor to the decrease in inflation has been the reduction of food prices adjustments throughout 2023, complemented by favorable trends in the price of goods. The decrease in inflation has, however, been constrained by the behavior of the price of services, which continue to exhibit high consumption levels, acerbated by the indexation of prices to recent elevated inflation rates. Additionally, necessary adjustments in fuel prices have curbed the inflation’s decline. Going forward, the outlook is for inflation to continue its downward trajectory, converging toward the 3% target by the first half of 2025. Factors supporting the prospect of a gradual inflation reduction include the absence of significant appreciations in the exchange rate, together with lower external inflation, reduced pressure on spending over prices due to the economic deceleration, and the cumulative impact of Banco de la República’s monetary policy measures. However, persistent risks remain that could slow down the anticipated fall in inflation, such as an unforeseen increase in the exchange rate or heightened impacts of the El Niño (ENSO) phenomenon on food and energy prices. The decrease in inflation would occur against a backdrop of slow economic growth for 2024 and a recovery thereof in 2025. Towards the close of 2023, economic activity persisted in its deceleration, reflecting the low levels of investment and, to a lesser extent, a moderation in consumption. The unemployment rate, while still relatively low, has witnessed a recent uptick in the past months. The economy is poised to sustain modest growth rates for 2024, further consolidating the ongoing convergence of inflation toward the established target. An acceleration in economic activity should begin in the latter half of 2024, attaining sustainable levels in 2025 in line with the economy's productive capacity. The monetary policy stance has contributed towards mitigating inflation and addressing broader macroeconomic imbalances within the country. Notably, inflation rates and associated expectations have declined, albeit persisting above the 3% target, concurrent with an overall deceleration of economic activity. Against this backdrop, the Board of Directors of Banco de la República adjusted its monetary policy interest rate, lowering it from 13.25% to 12.75%. The monetary policy decisions enacted by Banco de la República have contributed to rectifying prevailing macroeconomic imbalances accumulated in recent years, including elevated inflation, excessive spending and credit levels, and a pronounced external deficit. Consequently, the macroeconomic landscape has undergone requisite adjustments characterized by: A realignment of economic activity towards levels more consistent with the economy’s productive capacity. Attainment of a more sustainable balance in foreign transactions. A reduction in both inflation rates and associated expectations. Considering these outcomes and amid diminishing inflationary pressures and subdued economic growth, the Board of Directors of Banco de la República opted to decrease the monetary policy interest rate by 25 basis points during its meetings of December 2023 and January 2024, bringing it down to 12.75%. This interest rate adjustment acknowledges the reduction in inflation and its associated expectations, in alignment with the overarching goal of steering inflation towards the 3% target by mid-2025 while fostering sustained economic growth over time. Box 1 - Regional Economic Pulse: High-Frequency, Short-Lag Indicators to Understand Local Economies Autor: Dora Alicia Mora Pérez, Diana María Cortázar Gómez, Carolina Ramírez Rodríguez and Antonio José Orozco Gallo

The adjustment through exchange-rate changes relies upon the effect of the relative price of domestic and foreign goods on the trade flows with the rest of the world. The idea behind the adjustment process under consideration is that a change in the relative price of goods, ceteris paribus, brings about a change in the demands for the various goods by both domestic and foreign consumers, thus inducing changes in the flows of exports and imports which will hopefully adjust a disequilibrium in the payments balance considered.The terms of trade may vary both because of a change in the prices of goods expressed in the respective national currencies, and because the exchange rate changes. The analysis with which we are concerned in this chapter focuses mainly on the changes in the exchange rate.

This paper analyzes credibility in the Colombian exchange rate target zone. A model of imperfect credibility, in the spirit of Bertola and Svensson (1993) is derived, and is used to explain why the exchange rate in Colombia has remained for prolonged periods near the borders of the zone. The main feature of the model is that central parity depreciation expectations are endogenous with respect to the position of the exchange rate inside the target zone. The krugman(1991) perfectly credible setup turns out to be a particular case of this general model. One of the main implications of the model is that depreciation expectations increase rather than decrease as the exchange rate approaches the upper band. Hence a model as the one presented in this paper, is useful to explain the recent dynamics of interest rates in Colombia. It is also shown, that this model shares empirical features with the basic target zone model. Hence, policy makers might be misled when trying to recognize their credibility stance. A estructural estimation of the underlying parameters of the model, using McFadden's (1989) method of simulated moments, is suggested to identify the presence of non credibility issues. Econometric evidence suggest that Colombia's exchange rate target zone is properly described by a model of this nature.

An algorithmic approach to exchange rate stabilization

Part 1 International policy co-ordination and exchange rate management: the European monetary system, exchange rate expectations and the reputation of authorities, P.Artus would US protectionism be a threat to economic stability?, A.J.Hughes Hallett and G.J.Huston international adjustment and the dollar - a game theoretic approach, J.C.Martinez Oliva exchange rates and policy co-ordination in an asymmetric model, P.Kennen international policy co-ordination, imperfect information and target zones, A.Bisin and P.Tedeschi target zones, currency options and the dollar, P.Weller. Part 2 Strategic aspects of international policy co-ordination: time inconsistency, discounting and the returns to co-operation, M.Miller, et al policy co-operation among benevolent governments may be undesirable - an extension, P.J.Kehoe can international policy co-ordination really be counterproductive?, C.Carraro and F.Giavazzi profit shifting motives and international trade union co-ordination, D.Laussel and A.Soubeyran. Part 3 Information and uncertainty: robust lyapunov games under bounded uncertainty, C.Diessenberg asymmetric information and policy co-ordination, M.Cripps international policy co-ordination in a world with model uncertainty, A.R.Ghosh and P.R.Masson.

THE speed with which a country's imports and exports respond to exchange rate changes and inflation at home and abroad has important policy implications, but most of the work in this area has been somewhat conjectural. Some writers have pointed out that under a fixed exchange rate system, import and export flows may respond differently to price changes that result from changes in exchange rates than to those resulting from changes in national currency prices of exportable goods. Orcutt (1950, pp. 541-542) noted that trade flows may respond differently to small and temporary changes in prices than to large and fairly permanent changes, such as those caused by a devaluation. Among others, Leamer and Stem (1970, p. 34) interpreted Orcutt's point to mean that adjustment to large price changes stemming from devaluations will be more rapid than adjustment to small changes, but the long-run adjustment would be the same. Junz and Rhomberg (1973, p: 413) adduce reasons why the short-run response to a devaluation could be either faster than the response to a price change, because of the usually larger size of par value changes and the publicity that surrounds them, or slower, because of the large resource shifts necessary to correct large disequilibria that have accumulated over some period of time. The empirical evidence on the above suppositions appears inconclusive. Both T. C. Liu (1954) and Goldstein and Khan (1976) searched for evidence that trade flows responded differently to large than to small price changes. Although some of Liu' s results indicated the presence of a "quantum effect," Goldstein and Khan found that neither the size of the price elasticity nor the speed of adjustment seemed related to the size of the change in prices. Neither of these studies tested exchange -rate effects directly. The only direct test for different responses of trade flows to changes in prices and exchange rates is the 1973 study by Junz and Rhomberg. Using a pooled sample of 13 industrial countries, they concluded that the response to exchange rate changes is very similar to the response to price changes measured in local currency. The Junz-Rhomberg method, however, has certain shortcomings: they measure market-share changes, not trade flows directly; pooling the sample imposes the same parameters on each country in the pool; and measuring partial correlations with price and exchange rate variables lagged one period at a time yields no picture of the length or shape of the full response pattern through time. In this paper we estimate directly price and exchange rate response patterns, using quarterly import and export equations for six major industrial countries during the Bretton Woods period. Our results support two general conclusions: (a) the length of the full response lags on exchange rates during the fixed-rate period tended to be shorter than for changes in prices; and (b) the initial impact of exchange rate changes on trade flows tended to be greater than that of price changes.

The growth of agricultural trade in the 1970s and the strong dollar and depressed commodity prices in the 1980s have increased awareness of the vulnerability of agricultural markets to economic forces outside the agricultural sector. Some of the recent agricultural developments are attributable to changes in exchange rate movements that transmit macroeconomic forces to a trade-dependent agricultural sector. Under the flexible exchange rate system, exchange rate volatility has increased (Artus and Young) because exchange rates adjust to balance external accounts for an independent level of money supply across countries. Volatility has also increased because asset markets and adjustments on the capital side of the balance of payments determine the exchange rate in the short run (Dornbush). Regardless of the sources of exchange rate movements, exchange rate changes can affect terms of trade and international competitiveness as long as they affect relative prices between traded and nontraded goods (Krueger). Even if exchange rate changes primarily adjust price levels between countries for a given level of the money supply, there are terms of trade changes in the short run. However, recent evidence indicates that exchange rate changes are greater than can be attributed to changes in domestic price levels across countries (Frenkel, Stockman).

A majority of countries neither freely float their currencies nor firmly peg. But most of the remainder in practice also don’t obey such well-defined intermediate exchange rate regimes as target zones. This paper proposes to define an intermediate regime, to be called “systematic managed floating,” as an arrangement where the central bank regularly responds to changes in total exchange market pressure by allowing some fraction to be reflected as a change in the exchange rate and the remaining fraction to be absorbed as a change in foreign exchange reserves. An operational criterion for judging systematic managed floaters is a high correlation between exchange rate changes and reserve changes. The paper rejects the view that exchange rate regimes make no difference. In regressions to test effects on real exchange rates, we find that positive external shocks tend to cause real appreciation for most systematic managed-floaters; more strongly so for pure floaters; and not at all for most firm peggers. Two measures of exogenous external shocks are used: (i) for commodity-exporters, a country-specific index of global prices of the export commodities and (ii) for other Asian emerging market economies, the VIX.

On the mean-reverting properties of target zone exchange rates: Some evidence from the ERM

In this paper, we use cross-county and time series evidence to argue that retail price sensitivity to exchange rates may have increased over the past decade. This finding applies to traded goods, as well as to non-traded goods. We highlight three reasons for changing pass through at the level of retail prices of goods. First, pass through may have declined at the level of import prices, but the evidence is mixed over types of goods and countries. Second, there has been a large expansion of imported input use across sectors. This means that the costs of imported goods as well as home tradable goods have heightened sensitivity to import prices and exchange rates. The final channel we consider is whether there have been changing sectoral expenditures on distribution services, with the direction of change negatively correlated with pass through into final consumption prices. We find that this channel, which has been a means of insulating consumption prices from import content and exchange rates, has not systematically changed in recent years. The balance of effects weighs in favor of increased sensitivity of consumption prices to exchange rates, even if exchange-rate pass-through into import prices has declined for some types of goods.