Below
is an Article from the FINANCIAL TIMES which i am reproducing to
illustrate my Anwers to the Questions on the Macroeconomics Course
posted by Prof. Peter Navarro, on the Coursera Platform.
Cool article here that really demonstrates relationship between interest rates and currency values.
Questions:
1. When the U.S. and Europe raise interest rates, what does that do to the value of currencies and the inflation rates in emerging markets?
2. What should the central banks of countries like Brazil do in response?
Financial Times Pressure mounts on EM nations to lift rates
By John Paul Rathbone and Jonathan Wheatley in London
Emerging market countries are facing fresh pressure to raise interest rates, after Brazil warned that others would need to follow its lead in tightening monetary policy, and Turkey’s central bank convened an emergency rate-setting meeting.
Alexandre Tombini, Brazil’s central bank governor, told the Financial Times that the “vacuum cleaner” of rising interest rates in the developed world would continue to suck money out of emerging markets and force other central banks to tighten policy to beat inflation.
The emerging markets sell-off continued yesterday with currencies and global equities taking a further hit. The Brazilian real tumbled to its weakest level in five months while the Turkish lira fell by 2.7 per cent to touch an all-time low of T2.39 against the dollar.
The Turkish currency rebounded after the central bank said that it would hold an extraordinary meeting at midnight tonight, prompting expectations of an interest rate rise after 11 straight days of lira declines. “If there isn’t an interest rate hike there will be carnage,” said Refet Gurkaynak, an economist at Bilkent University in Ankara.
By midday in New York, the S&P 500 was down 0.5 per cent, about 3.6 per cent below the record high it struck earlier this month, while the Wall Street “fear index”, the CBOE Vix, was up a further 2 per cent and on track for a three-month high. The FTSE 100 shed 1.7 per cent while the Nikkei 225 tumbled 2.5 per cent to its lowest close since mid-November.
The latest market jitters were triggered by last week’s abrupt devaluation of the Argentine peso, which provided a reminder of the vulnerabilities some countries face as central banks in the developed world tighten monetary policy.
Mr Tombini said the normalisation of world interest rates was ultimately positive for emerging markets as it reflected economic recovery taking hold in the developed world.
“Relative price adjustments should not be confused with fragility,” said Mr Tombini, referring to the 15 per cent depreciation of the Real last year.
“The Brazilian response has been very classic – tightening policy, using foreign reserves as buffers. Other countries will have to follow suit . . . some may be reluctant.”
Economists said other emerging markets that could be forced to tighten monetary policy included India, Indonesia and South Africa.
Luis Videgaray, Mexico’s finance minister, said he did not believe that recent volatility heralded a full-blown emerging markets crisis: “I see some emerging markets that have issues. Investors have been expecting corrections there. So there will be jitters and volatility . . . but also differentiation.”
Copyright The Financial Times Limited 2012. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web.
Team,
Cool article here that really demonstrates relationship between interest rates and currency values.
Questions:
1. When the U.S. and Europe raise interest rates, what does that do to the value of currencies and the inflation rates in emerging markets?
2. What should the central banks of countries like Brazil do in response?
Financial Times Pressure mounts on EM nations to lift rates
By John Paul Rathbone and Jonathan Wheatley in London
Emerging market countries are facing fresh pressure to raise interest rates, after Brazil warned that others would need to follow its lead in tightening monetary policy, and Turkey’s central bank convened an emergency rate-setting meeting.
Alexandre Tombini, Brazil’s central bank governor, told the Financial Times that the “vacuum cleaner” of rising interest rates in the developed world would continue to suck money out of emerging markets and force other central banks to tighten policy to beat inflation.
The emerging markets sell-off continued yesterday with currencies and global equities taking a further hit. The Brazilian real tumbled to its weakest level in five months while the Turkish lira fell by 2.7 per cent to touch an all-time low of T2.39 against the dollar.
The Turkish currency rebounded after the central bank said that it would hold an extraordinary meeting at midnight tonight, prompting expectations of an interest rate rise after 11 straight days of lira declines. “If there isn’t an interest rate hike there will be carnage,” said Refet Gurkaynak, an economist at Bilkent University in Ankara.
By midday in New York, the S&P 500 was down 0.5 per cent, about 3.6 per cent below the record high it struck earlier this month, while the Wall Street “fear index”, the CBOE Vix, was up a further 2 per cent and on track for a three-month high. The FTSE 100 shed 1.7 per cent while the Nikkei 225 tumbled 2.5 per cent to its lowest close since mid-November.
The latest market jitters were triggered by last week’s abrupt devaluation of the Argentine peso, which provided a reminder of the vulnerabilities some countries face as central banks in the developed world tighten monetary policy.
Mr Tombini said the normalisation of world interest rates was ultimately positive for emerging markets as it reflected economic recovery taking hold in the developed world.
“Relative price adjustments should not be confused with fragility,” said Mr Tombini, referring to the 15 per cent depreciation of the Real last year.
“The Brazilian response has been very classic – tightening policy, using foreign reserves as buffers. Other countries will have to follow suit . . . some may be reluctant.”
Economists said other emerging markets that could be forced to tighten monetary policy included India, Indonesia and South Africa.
Luis Videgaray, Mexico’s finance minister, said he did not believe that recent volatility heralded a full-blown emerging markets crisis: “I see some emerging markets that have issues. Investors have been expecting corrections there. So there will be jitters and volatility . . . but also differentiation.”
Copyright The Financial Times Limited 2012. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web.
My Answers to the Questions
-
1.
When
the US and Europe raise interest rates, the values of the currency’s decline,
while inflation rates in Emerging Markets increase. An exchange
rate is the price of one country’s currency expressed in terms of another
country’s currency. Most exchange rates are in terms of the $US. In the foreign
exchange market there are two types of
trades: spot and forward. In
simplicity, spot is the price or exchange agreed on the spot, which means it
will be settled in two days. Forward, is an agreement to exchange currency at
some time in the future.
What determines the value of the currencies over time is the Purchasing
Power Parity. It tells us what determines
the change in the exchange rate over time. If say a dollar costs 0.50 argentine
pesos and the inflation rate in Argentina is say 10%, with this inflation (assuming
zero inflation in the US), prices in Argentina will rise by 10%, thus the price
of the dollar will go up by 10%, and the exchange rate will be 0.50 pesos * 1.1
= 0.55 pesos.
If the
inflation rate in the US is not zero, then we have to take into account the
differences in the two countries inflation rates. So, if inflation in the US
=4%, then prices in Argentina are rising 10% - 4% = 6% annually. So the
expected price of the dollar will rise by 6% and the exchange rate by 0.50
pesos * 1.06= 0.53 pesos
Therefore,
the Purchasing Power Parity tells us
that the change in the exchange rate is determined by the difference in the
inflation rates of the two countries. In other words, the expected percentage
change in the exchange rate is equal to the difference in inflation rates.
Purchasing
Power Parity tells us that the exchange rate will rise if the US inflation rate
is lower than the foreign country’s. The
foreign currency depreciates in value and therefore weakens relative to the US
dollar.
2.
Central
Banks of Emerging Markets should in my view try to formulate policies in such a
way as to prevent capital from exiting their countries. We saw last week what
happened to the Argentine Peso’s devaluation, when foreign capital exited the
country, which essentially diminished the “support” for the national currency. Inflation
has a detrimental effect on the nations’ currency. In the above example, Argentina
needs more Pesos to buy foreign imports (dollar is more expensive) due to a
rise in inflation. So as one minister put it, Emerging Markets have to implement
a tight monetary policy, control of the money supply.
