Week 11 Handout

PS 140 Handout for Week 11 Week of November 10th, 2024 Lecture 18 Textbook 9.1-9.2.4; Copelovitch & Frieden Key terms and concepts Gold Standard • Definition: • Example & other details: Exchange Rate • Definition: • Example & other details: Convertible Currency • Definition: • Example & other details: Hyperinflation • Definition: • Example & other details: Hard Currency • Definition: • Example & other details: Reserves • Definition: • Example & other details: Fixed Exchange Rates • Definition: • Example & other details: Floating Exchange Fates • Definition: • Example & other details: Managed Float • Definition: • Example & other details: Devaluation • Definition: • Example & other details: Central Bank • Definition: • Example & other details: Discount Rate • Definition: • Example & other details: Discussion 1. What is an exchange rate? What the benefits/costs of fixing your exchange rate? The price at which one country’s currency can be exchanged for another’s. It determines how much of one currency (e.g., the US dollar) is needed to purchase a unit of another currency (e.g., the euro). Fixed exchange rate benefits: • Stability: fixed rates reduce currency fluctuations, making it easier for businesses to plan long-term investments and for consumers to predict import prices. • Inflation control: In economies with high inflation, fixing the exchange rate can help stabilize prices by pegging the currency to a more stable one (often the U.S. dollar). • Stability • Low inflation Fixed exchange rate costs: • Loss of monetary policy flexibility: To maintain a fixed rate, a country often sacrifices independent monetary policy, limiting its ability to respond to economic changes. • Risk of currency crisis: If market pressures make the fixed rate unsustainable, the central bank may be forced to devalue, which can lead to capital flight and financial instability. • No domestic autonomy (currency crisis) 2. What groups benefit from a weak (devalued) exchange rate, and what groups benefit from a strong (appreciated) currency? Weak (devalued) currency: • Exporters: Goods become cheaper for foreign buyers, which can increase demand for exports. • Tourism: Foreign tourists benefit as their money has greater purchasing power, boosting the local tourism industry. • Foreign Investors: Assets (like real estate) in the country become less expensive for foreigners, potentially increasing foreign direct investment. • A country’s currency is less valuable than another country • Producers Strong (Appreciated) Currency: • Importers and Consumers: Imported goods become cheaper, benefiting consumers and businesses that rely on imports for production. • • • Foreign Investors in Domestic Markets: Domestic currency-denominated assets hold higher value, benefiting foreign investors with assets in the appreciated currency. Travelers Abroad: Citizens find it cheaper to travel, as their currency has greater purchasing power in foreign countries. A country’s currency is worth more than another country Level of exchange rate High valuation (appreciated) Fixed International bankers + investors (international focused actors want their currency to be higher with less risk) Floating Domestic consumers (imports are cheaper, consumers want the govt to intervene) Low valuation (depreciated) Export oriented producers (wants imports to be more expensive and exports be less expensive) Import oriented producers (imports are more expensive and import competing industries want the imports to be less expensive so they can appeal to consumers) 3. Referring to Professor’s Copelovitch’s article, what factors or developments would need to occur for the dollar to lose its central role in the global financial system? • • • • • • • U.S. Financial Market Strength: The U.S. has deep, liquid private financial markets and strong protections for property rights, giving the dollar a solid foundation as a global reserve currency. These market features make it highly reliable during times of global financial instability. Lender of Last Resort: The U.S. government frequently acts as a lender of last resort in international financial crises, unlike other nations or unions. This willingness provides additional stability to dollar-denominated assets, further solidifying the dollar’s global role. Global Network Structure: The dollar’s dominance is entrenched within a hierarchical global financial network that favors the currency in international trade and finance, which makes transitioning away from it challenging. Euro Limitations: Although the European Union has a robust economy, the lack of a unified fiscal and political system weakens confidence in the euro’s long-term stability, limiting its potential to replace the dollar as a global reserve currency. Renminbi Restrictions: The Chinese renminbi is also limited as a competitor due to China’s restricted capital mobility, underdeveloped private financial markets, and limited governmental transparency, which reduces trust in the currency globally. Cryptocurrency Constraints: Cryptocurrencies, despite some hype, lack the necessary institutional support and are too volatile and speculative to serve as stable reserve currencies in the current global financial system. Future Prospects: According to Copelovitch, substantial reforms—such as the EU becoming a political and fiscal union or China liberalizing its economy—would be necessary for any currency to displace the dollar. These developments appear improbable in the short term, suggesting the dollar’s dominance will persist well into the future.