The Impossible Trinity The Impossible Trinity Where are the Us, Euro countries and china? Where will China be? Erchange rate stabilin What is the cost and benefit of the gradual path in reforming RMB? Why Determines the Exchange Rate? A somewhat popular argument xchange rate stable 4.2: Purchasing Power Parity and Interest Rate Parity but every country can do so More fundamentally Issue more RMB- inflation Try to buy the whole world >sell RMB) depreciation Stabilize exchange rate thorough FX cont nflation currency depreciation Why Determines the Exchange Rate? Why Determines the Exchange Rate? Another popular argument Our major purposes for holding a foreign currency If we raise interest rate and attract more foreign capital our currency will appreciate. consumption: to buy products from that counts\,to An intuitive refutation but then you have to keep them in our country and Parity conditions Purchasing Power Parity: Price levels(inflation rates) More fundamentally affect exchange rat Raising interest rate is costly for the domestic economy Interest Rate Parity: rates of return on financial assets acts hot money and brings instability in the affect exchange rate Deviation on one variable will be FDI capital looks for better investment environment ther if there is no limit to arb 42016/11/2 4 The Impossible Trinity 4-19 Where are the US, Euro countries and China? Pure floating Full capital controls Monetary independence Monetary union Full financial integration Exchange rate stability Increased capital mobility The Impossible Trinity 4-20 Where will China be? Pure floating Full capital controls Monetary independence Monetary union Full financial integration Exchange rate stability Increased capital mobility • If pure floating is the only direction that China will go, why don’t we jump to it over one night? • What is the cost and benefit of the gradual path in reforming RMB? 4.2: Purchasing Power Parity and Interest Rate Parity 4-21 Why Determines the Exchange Rate? • A somewhat popular argument – If we issue RMB as much as possible and keep RMB exchange rate stable, we can buy the whole world! • An intuitive refutation – but every country can do so! • More fundamentally – Issue more RMB inflation – Try to buy the whole world sell RMB  depreciation – Stabilize exchange rate thorough FX control?Then you have no way of buying the world • Inflation  currency depreciation 4-22 Why Determines the Exchange Rate? • Another popular argument – If we raise interest rate and attract more foreign capital, our currency will appreciate. • An intuitive refutation – but then you have to keep them in our country and never let them go back • More fundamentally – Raising interest rate is costly for the domestic economy – It attracts hot money and brings instability in the FX market – FDI capital looks for better investment environment 4-23 Why Determines the Exchange Rate? • Our major purposes for holding a foreign currency – Consumption: to buy products from that country – Investment: to invest in that country (FDI or portfolio investment) • Parity conditions – Purchasing Power Parity: Price levels (inflation rates) affect exchange rate – Interest Rate Parity: rates of return on financial assets affect exchange rate – Deviation on one variable will be compensated by the other if there is no limit to arbitrage 4-24