Re: Incomes and Exchange rates; part 3

[Basil Moore <bmoore@xxxxxxxxxxxx>]

Leigh

I agree with most of what you say. My obsevations were based in my stay in
South Africa, where the Reserve bank Is desperately attempting to raise
fereign exchange reserve cover; at present reserves are only about two
months imports. They are on a flexible exchange rate regime, and are keeping
Bank rate at 18 percent, in the attempt to attract foreign short term
capital , and also (mistakenly), to reduce the inflation rate. This in the
face of 35-40 percent unemployment.

So the size of foreign exchange reserves are absolutely critical to SA
monetary policy. That is primarily why I disagreed with your (conventional)
story that a flexible exchange rate regime permits the CB to act more
independently.

You say that In Oz the CB has tight control of the domestic short term
nominal interest rate. I doubt that very much. Try to run a regression using
the nominal level of the domestic rate as the dependent variable. Although I
have not looked at OZ data, I feel confident that the level of foreign rates
will be overwhelmingly the single most important variable. In an open
economy with capital mobility, the CB's reaction function refers to the
differential of the domestic rate over the foreign rate. (In SA the domestic
inflation rate is not even significant in the reserve bank's reaction
function on the nominal ST interest rate.

Best  Basil



At 10:30 PM 9/15/97 +1000, you wrote:
>Basil
>
>Its good to hear from you again.
>
>I agree with you that:
>
>>It is NOT true that an increase in exports does not result in an
>>increase in the money supply. This would only be the case if the CB
>>refrained completely from purchases of foreign exchange. But no central
>>bank in the world permits a completely free float. Like bonds and
>>interest rates, CB's always intervene to smooth the exchange rate.
>>Whenever there occurs a net increase in foreign currency inflows, they
>>purchase foreign currency. Whatever the CB buys increases the money
>>supply, just like any other bank. The domestic
>>exporter is paid in foreign currency and wants domestic currency. So the
>>exporter's bank account is credited, and the money supply increases.
>
>
>Because CBs intervene to make the floating exchange rate system behave like
>the fixed exchange rate system at times, it does not mean that the floating
>exchange rate system has the properties of the fixed exchange rate system.
>That would be like saying that the fixed exchange rate system is a variable
>exchange rate system because the CB can enter to change the exchange rate.
>
>What you have described are the exceptional or marginal cases.  The CB does
>not normally intervene in the foreign exchange market.  It is rarely a
>participant.  The great bulk of trading is by the private sector.  The bulk
>of the smoothing out is by private sector speculators.
>
>Your comments acknowledge that the floating exchange rate system does not
>allow international transaction to affect the money supply unless the CB
>intervenes.
>
>
>What happens on a foreign exchange market under the floating exchange rate
>system is that buyers of foreign currency trade domestic currency for
>foreign exchange with sellers of foreign exchange wanting to buy domestic
>currency.  This does not create more money.  Banks will convert small
>amounts of foreign currency into domestic currency at the counter.
>
>For the short time (possibly just a few minutes) banks may hold that foreign
>money, they may increase the money supply. However, they will trade that
>currency on the foreign exchange market and so reduce their foreign assets
>and at the same time reduce the net liabilties of the banking system.  That
>is, when they sell foreign exchange, they exchange it for a bank deposit.
>In so doing, the banking system owes less to its customers.
>
>So the initial increase in deposits from the purchase of foreing exchange is
>offset by a reduction in deposits when the bank sells the foreign exchange.
>Hence, the international transaction has a neutral effect on the money supply.
>
>When banks and other foreign exchange dealers deal in larger foreign
>currency transactions, they may not wish to carry the risk.  In those cases
>they take the foreign currency directly on the foreign exchange market.
>Following the trade agreement, they will receive a transfer of funds from
>the foreign currency buyer which will be directed to the account of the
>seller in exchange for foreign funds sent to the buyer.  In such cases, the
>domestic money is transferred from one person to another and the exchange
>does not increase the money supply for even a short time.
>
>The only way foreign exchange transactions will increase the money supply is
>if the banks hold foreign reserves and these are allowed to rise.  CB's
>normally discourage such speculation on the part of banks.
>
>
>You continue:
>
>>CB's cannot not influence the domestic interest rate, nor the domestic
>>exchange rate. If capital is perfectly mobile,it is true that they will
>>be unable to keep the domestic interest rate VERY FAR above or below the
>>level of foreign rates, since this will then cause capital inflows or
>>outflows.
>
>Basil, you are assuming again that international transactions affect the
>money supply in countries with floating exchange rates.  That is not the
>case.  Actually, one of the arguements for floating exchange rates was that
>it allowed economies to have an independent monetary plicy.
>
>In Australia, the CB has a very strong influence on domestci interest rates.
>
>You continue:
>
>>They can keep the domestic rate above foreign rates if they wish to
>>attract foreign exchange, either to increase their exchange reserves,
>>or to raise their exchange rate.
>
>Foreign reserves are not a feature of the floating exchange rate system.
>They are a remnant of the fixed system.  Higher interest rates do attract
>foreign capital which does increase the demand for domestic currency on the
>foeign exchange market.  This inflates the exchange rate but it does not
>raise foreign reserves (unless we have intervention in the system).
>
>>They may be unable to keep the
>>domestic rate below the level of foreign rates, unless they are willing
>>to let the excchange rate fall, because the will eventually run out
>>of foreign exchange.
>
>This suggests that interest rates in different countries would be equal.
>
>You conclude:
>
>>This is why there is a bias toward higher rather than lower world
>>interest rates. Surplus countries are not forced to lower domestic
>>interest rates or to let their exchange rates depreciate.
>>Whereas deficit countries are forced either to depreciate their
>> currencies, or raise  the level of domestic rates
>>above the level ruling in foreign markets.
>
>Countries with current account deficits usually have high interest rates in
>an attempt to restrain domestic monetary growth and to attract foreign
>capital to keep their currencies inflated.  Japan, with its current account
>deficit is trying to engineer a lower exchange rate and stimulate its
>domestic economy with low interest rates.
>
>
>Regards
>
>
>Leigh
>
>
>______________________________________________________________________
>Leigh Harkness                                      leigh@xxxxxxxxxxx
>
>
>
>


Basil Moore, Department of Economics
Wesleyan University
685-2363