The exchange rate for sterling is determined in much the same way as the price of goods – by the interaction of demand and supply.
When factors change that cause residents abroad to want to hold more or fewer pounds, the demand curve for sterling will shift. If, instead, factors change that cause UK residents to want to buy more or less foreign currency, then the supply curve of sterling will shift. It is these two curves that determine the equilibrium exchange rate of sterling.
There are concerns at the moment that sterling is about to reach a peak, with expectations that the pound will weaken throughout 2013. But is a weakening exchange rate good or bad for the UK?
With lower exchange rates, exports become relatively more competitive. This should lead to an increase in the demand for UK products from abroad. As exports are a component of aggregate demand, any increase in exports will lead to the AD curve shifting to the right and thus help to stimulate a growth in national output. Indeed, throughout the financial crisis, the value of the pound did fall (see chart above: click here for a PowerPoint) and this led to the total value of UK exports increasing significantly. However, the volume of UK exports actually fell. This suggests that whilst UK exporters gained in terms of profitability, they have not seen much of an increase in their overall sales and hence their market share.
Therefore, while UK exporters may gain from a low exchange rate, what does it mean for UK consumers? If a low exchange rate cuts the prices of UK goods abroad, it will do the opposite for the prices of imported goods in the UK. Many goods that UK consumers buy are from abroad and, with a weak pound, foreign prices become relatively higher. This means that the living standards of UK consumers will be adversely affected by a weak pound, as any imported goods buy will now cost more.
It’s not just the UK that is facing questions over its exchange rate. Jean-Claude Junker described the euro as being ‘dangerously high’ and suggested that the strength or over-valuation of the exchange rate was holding the eurozone back from economic recovery. So far the ECB hasn’t done anything to steer its currency, despite many other countries, including Japan and Norway having already taken action to bring their currencies down. Mario Draghi, the ECB’s president, however, said that ‘both the real and the effective exchange rate of the euro are at their long-term average’ and thus the current value of the euro is not a major cause for concern.
So, whatever your view about intervening in the market to steer your currency, there will be winners and losers. Now that countries are so interdependent, any changes in the exchange rate will have huge implications for countries across the world. Perhaps this is why forecasting currency fluctuations can be so challenging. The following articles consider changes in the exchange rate and the impact this might have.
A pounding for sterling in 2013? BBC News, Stephanomics, Stephanie Flanders (17/1/13)
UK drawn into global currency wars as slump deepens Telegraph, Ambrose Evans-Pritchard (16/1/13)
Foreign currency exchange rate predictions for GBP EUR, Forecasts for USD and NZD Currency News, Tim Boyer (15/1/13)
Euro still looking for inspiration, Yen firm Reuters (16/1/13)
Daily summary on USD, EUR, JPY, GBP, AUD, CAD and NZD International Business Times, Roger Baettig (16/1/13)
UK inflation bonds surge on Index as pound falls versus euro Bloomberg, Business News, Lucy Meakin (10/1/13)
Questions
- Which factors will cause an increase in the demand for sterling? Which factors will cause a fall in the supply of sterling?
- In the article by Stephanie Flanders from the BBC, loose monetary policy is mentioned as something which is likely to continue. What does this mean and how will this affect the exchange rate?
- Explain the interest- and exchange-rate transmission mechanisms, using diagrams to help your answer.
- If sterling continues to weaken, how might this affect economic growth in the UK? Will there be any multiplier effect?
- What is the difference between the volume and value of exports? How does this relate to profit margins?
- Why are there suggestions that the euro is over-valued? Should European Finance Ministers be concerned?
- Should governments or central banks intervene in foreign exchange markets?
- If all countries seek to weaken their currencies in order to make their exports more competitive, why is this a zero-sum game?
Japan’s general election on 16 December was won by the centre-right Liberal Democratic Party (LDP), led by Shinzo Abe. It gained a two-thirds majority in the lower house. It returns to power after losing to the Democratic Party in 2009. Previously it had been in office for most of the time since 1955.
The LDP has promised to revive the flagging Japanese economy, which has been suffering from years of little or no growth and returned to recession last quarter. Economic confidence has been damaged by a dispute with China about the sovereignty over some small islands in the East China Sea. The economy, whose exports make up some 13% of GDP, has suffered from the global slowdown and a high yen. The yen has appreciated against the dollar by around 40% since 2007.
The economy has also suffered from the shutdown of all its nuclear reactors following the earthquake and tsunami last year. Nuclear power accounted for over 30% of the country’s electricity generation.
Mr Abe promises to revive the economy through fiscal and monetary policies. He plans a fiscal stimulus package in early 2013, with increased government expenditure on infrastructure and other public-works. He also wants the Bank of Japan to increase its inflation target from 1% to 3% and to achieve this through various forms of monetary easing.
The initial reactions of markets to the election result were favourable. The stock market rose and the yen fell.
However, as the following articles discuss, there are dangers associated with Mr Abe’s policies. The expansionary fiscal policy will lead to a rise in the country’s general-government debt, which, at some 240% of GDP, is by far the largest in the developed world. This could lead to a loss of confidence in Japanese debt and a fall in the price of bonds on the secondary markets and a rise in government borrowing costs. Also, a depreciation of the yen, while welcomed by exporters, would increase the price of imports, including food and raw materials.
Changing of guard in Japan as PM concedes vote CNN, Yoko Wakatsuki, Brian Walker, and Hilary Whiteman (17/12/12)
LDP Win Clears Pipes for Japan Fiscal Spigot Bloomberg Businessweek, Toru Fujioka (17/12/12)
Economic implications of Japan’s election Huffington Post (16/12/12)
Japan economy contracts again Taipei Times (11/12/12)
Japan elections: Shares rise and yen weakens on Abe win BBC News (17/12/12)
Shinzo Abe’s challenges in reviving Japan’s economy BBC News, Puneet Pal Singh (17/12/12)
Can Shinzo Abe Save Japan? Slate, Matthew Yglesias (30/11/12)
Deflation only natural when politicians refuse to fix oversupplied Japan Japan Times, Teruhiko Mano (17/12/12)
New Year messages from Japan BBC News, Stephanie Flanders (18/12/12)
Japan – Muddling On Or Growing Stronger? Seeking Alpha, Anthony Harrington (12/12/12)
Japanese government unveils £138bn stimulus package The Guardian (11/1/13)
Questions
- Using macroeconomic data from sources such as sites 6, 7 and 9 in the Economics Network’s Economic Data freely available online, describe Japan’s macroeconomic situation over the past 10 years.
- Why has the Japanese yen appreciated so much in recent years?
- What forms could monetary easing take in Japan?
- Why might it prove difficult to stimulate the Japanese economy through fiscal and monetary policies?
- What undesirable side-effects might result from expansionary fiscal and monetary policies?
- What structural weaknesses are there in the Japanese economy that have hindered economic growth? What policies might the new Japanese government pursue in tackling these structural weaknesses?
At present, the Bank of England has an inflation target of 2% CPI at a 24-month time horizon. Most, other central banks also have simple Inflation targets. But central bankers’ opinions seem to be changing.
Consider four facts.
1. Many central banks around the world have had record low interest rates for nearly four years, backed up in some cases by programmes of quantitative easing, officially in pursuit of an inflation target.
2. The world is mired in recession or sluggish growth, on which monetary policy seems to have had only a modest effect.
3. Inflation seems to be poorly related to aggregate demand, at least within an economy. Instead, inflation in recent years seems to be particularly affected by commodity prices.
4. Success in meeting an inflation target could mean failure in terms of an economy achieving an actual growth rate equal to its potential rate.
It’s not surprising that there have been calls for rethinking monetary policy targets.
There have recently been two interesting developments: one is a speech by Mark Carney, Governor designate of the Bank of England; the other is a decision on targets by the Fed, reported at a press conference by Ben Bernanke, Chairman of the Federal Reserve.
Mark Carney proposes the possible replacement of an inflation target with a target for nominal GDP (NGDP). This could be, say, 5%. What is more, it should be an annual average over a number of years. Thus if the target is missed in one year, it can be made up in subsequent years. For example, if this year the actual rate of nominal GDP growth is 4%, then by achieving 6% next year, the economy would keep to the average 5% target. As Stephanie Flanders points out:
Moving to nominal GDP targets would send a signal that the Bank was determined to get back the nominal growth in the economy that has been lost, even if it is at the cost of pushing inflation above 2% for a sustained period of time.
In the USA, Ben Bernanke announced that the Fed would target unemployment by keeping interest rates at their current record lows until unemployment falls below a threshold of 6.5%.
Until recently, the Fed has been more flexible than most other central banks by considering not only inflation but also real GDP when setting interest rates. This has been close to following a Taylor rule, which involves targeting a weighted averaged of inflation and real GDP. However, in January 2012, the Fed announced that it would adopt a 2% long-run inflation target. So the move to targeting unemployment represents a rapid change in policy
So have simple inflation targets run their course? Should they be replaced by other targets or should targeting itself be abandoned? The following articles examine the issues.
Articles
UK
Mark Carney hints at need for radical action to boost ailing economies The Telegraph, Philip Aldrick (11/12/12)
George Osborne welcomes inflation target review The Telegraph, Philip Aldrick and James Kirkup (13/12/12)
Monetary policy: Straight talk The Economist, R.A. (12/12/12)
New Bank of England governor Mark Carney mulls end of inflation targets The Guardian, Larry Elliott (12/12/12/)
Carney’s trail of carnage Independent, Ben Chu (12/12/12)
Mark Carney suggests targeting economic output BBC News (12/12/12)
A new target for the Bank of England? BBC News, Stephanie Flanders (14/12/12)
Should the UK really ditch inflation target? Investment Week, Katie Holliday (14/12/12)
BoE economist Spencer Dale warns on Mark Carney’s ideas The Telegraph, Philip Aldrick (12/12/12)
USA
Ben Bernanke Outlines Fed Policy for 2013 IVN, Alex Gauthier (14/12/12)
Fed gives itself a new target BBC News, Stephanie Flanders (13/12/12)
Fed to Keep Easing, Sets Target for Rates CNBC, Jeff Cox (12/12/12)
Bernanke calls high unemployment rate ‘an enormous waste’ Los Angeles Times, Jim Puzzanghera (12/12/12)
Think the Fed has been too timid? Check out Britain and Japan. Washington Post, Brad Plumer (13/12/12)
Inflation Targeting is Dead, Long Live Inflation! The Market Oracle, Adrian Ash (14/12/12)
Speech and press conference
Guidance Bank of Canada, Mark Carney (11/12/12)
Transcript of Chairman Bernanke’s Press Conference Federal Reserve Bank, Ben Bernanke (12/12/12)
Questions
- Which of the following would meet an NGDP target of 5%: (a) 5% real growth and 0% inflation; (b) 5% real growth and 5% inflation; (c) 5% inflation and 0% growth?
- What are the main arguments in favour of an NGDP target?
- What factors would need to be taken into account in deciding the target rate of NGDP?
- What are the main arguments against an NGDP target?
- Is it possible to target two indicators with one policy instrument (interest rates)? Explain.
- Explain what is meant by Taylor rule?
- Is having an unemployment target a type of Taylor rule?
- Why may the rate of inflation (whether current or forecast) be a poor indicator of the state of the real economy?
Should the object of monetary policy be simply one of keeping inflation within a target range? In a speech given on 9 October, the Governor of the Bank of England, Sir Mervyn King, questioned whether the interest-rate setting policy of the Monetary Policy Committee (MPC) has been too narrow.
He considered whether interest rates should have been higher before the financial crisis and crash of 2007–9. This could have helped to reduce the asset price bubble and discouraged people from taking out excessive loans.
But then there is the question of the exchange rate. Would higher interest rates have pushed the exchange rate even higher, with damaging effects on exports? Today the trade weighted exchange rate is some 20% lower than before the crash. The government hopes that this will encourage a growth in exports and help to fuel recovery in demand. But as Dr King said, “The strategy of reducing domestic spending and relying more on external demand is facing a real problem because not everyone can do it at the same time.”
Then there is the question of economic growth. Should a target rate of growth be part of the MPC’s target? Should the MPC adopt a form of Taylor rule which targets a weighted average of the inflation rate and the rate of economic growth?
Certainly monetary policy today in the UK and many other countries is very different from five years ago. With interest rates being close to zero, there is little scope for further reductions; after all, nominal rates cannot fall below zero, otherwise people would be paid for borrowing money! So the focus has shifted to the supply of money. Several attempts have been made to control the money supply through programmes of quantitative easing. Indeed many economists expect further rounds of quantitative easing in the coming months unless there is a substantial pick up in aggregate demand.
So what should be the targets of monetary policy? The following articles look at Dr King’s speech and at various alternatives to a simple inflation target.
Articles
Mervyn King says must face up to monetary policy’s limits’ Reuters, David Milliken and Sven Egenter (9/10/12)
Bank of England’s Mervyn King defends low interest rates pre-crisis The Telegraph, Emma Rowley (9/10/12)
Banks should have had a leverage cap before crash, says Mervyn King The Guardian, Heather Stewart and Phillip Inman (9/10/12)
King Says BOE Must Keep Targeting Inflation as Tool Revamp Looms Bloomberg, Scott Hamilton and Svenja O’Donnell (9/10/12)
After 20 years, time to change Merv’s medicine? Channel 4 News blogs, Faisal Silam (9/10/12)
King signals inflation not primary focus Financial Times, Norma Cohen and Sarah O’Connor (9/10/12)
Should Bank start the helicopter? BBC News, Stephanie Flanders (12/10/12)
Speech
Twenty years of inflation targeting Bank of England speeches, Mervyn King (9/10/12)
Questions
- What are the arguments for using monetary policy to target a particular rate of inflation?
- Would it ever be a good idea to adjust the targeted rate of inflation up or down and if so when and why?
- Explain how a Taylor rule would work and in what ways it is superior or inferior to pursuing a simple inflation target.
- Are attempts to control the money supply through quantitative easing (or tightening) consistent or inconsistent with pursuing an inflation target? Explain.
- What are the arguments for and against abandoning targeting in monetary policy and replacing it with discretionary policy that takes a number of different macroeconomic indicators into account?
The ECB president, Mario Draghi, has announced a new programme of ‘Outright Monetary Transactions (OMTs)’ to ease the difficulties of countries such as Greece, Spain, Portugal and Italy. The idea is to push down interest rates for these countries’ bonds. If successful, this will make it more affordable for them to service their debts.
OMTs involve the ECB buying these countries’ bonds on the secondary market (i.e. existing bonds). This will be limited to bonds with no more than three years to maturity. Although restricting purchases to the secondary market would not involve the ECB lending directly to these countries, the bond purchases should push down interest rates on the secondary market and this, in turn, should allow the countries to issue new bonds at lower rates on the primary market.
The OMT programme replaces the previous Securities Markets Programme (SMP), which began in May 2010. This too involved purchasing bonds on the secondary market. By the time of the last actions under SMP in January 2012, €212 billion of purchases had been made. Unlike the SMP, however, OMTs are in principle unlimited, with the ECB president, Mario Draghi, saying that the ECB would do ‘whatever it takes’ to hold the single currency together. This means that it will buy as many bonds on the market as are necessary to bring interest rates down to sustainable levels.
Critics, however, argue that this will still not be enough to stimulate the eurozone economy and help bring countries out of recession. They give two reasons.
The first is that OMTs differ from the quantitative easing programmes used in the UK and USA. OMTs would not increase the eurozone money supply as the ECB would sell other assets to offset the bond purchases. This process is known as ‘sterilisation’, which is defined as actions taken by a central bank to offset the effects of foreign exchange flows or its own bond transactions so as to leave money supply unchanged.
The second reason is that OMTs will be conducted only if countries stick to previously agreed strong austerity measures. This is something that it looking increasingly unlikely as protests against the cuts mount in countries such as Greece and Spain.
Articles
Super Mario to the rescue Financial Standard, Benjamin Ong (7/9/12)
Outright monetary transactions: Lowdown on bond-buying scheme Irish Times, Dan O’Brien (7/9/12)
Draghi comments at ECB news conference Reuters (6/9/12)
ECB’s Mario Draghi unveils bond-buying euro debt plan BBC News (6/9/12)
ECB Market Intervention: Outright Monetary Transactions (“OMT”) – A Preliminary Assessment Place du Luxembourg (9/9/12)
Evaluating the OMT: OrlMost Too late? Social Europe Journal, Andrew Watt (7/9/12)
Mario Draghi speech: what the analysts said The Telegraph (6/9/12)
ECB challenges German concern over bond-buying Irish Times, Derek Scally (26/9/12)
Draghi: efforts helping to support stable future MarketWatch, Tom Fairless (25/9/12)
Mario and Mariano versus the man with the beard BBC News, Paul Mason (6/9/12)
Good week for the euro – but also a warning BBC News, Stephanie Flanders (12/9/12)
The price of saving the eurozone BBC News, Robert Peston (26/9/12)
Special Report – Inside Mario Draghi’s euro rescue plan Reuters, Paul Carrel, Noah Barkin and Annika Breidthardt (25/9/12)
ECB to face biggest test on euro gambit Financial Times, Michael Steen and Peter Spiegel (25/9/12)
Press release
ECB: Monetary policy decisions ECB Press Release, (6/9/12)
Questions
- What are the key features of the OMT programme? How does it differ from the former Securities Markets Programme (SMP)?
- In what ways does the OMT programme differ from the quantitative easing programmes in the USA and UK?
- How will the ECB’s buying bonds in the secondary market influence the primary bond market? What will influence the size of the effect?
- How does sterilisation work in (a) the bond market; (b) the foreign exchange market?
- Why is it claimed that the OMT programme is a necessary but not sufficient condition for solving the crisis in the eurozone? What additional measures would you recommend and why?
- What are the risks associated with the OMT programme?
