Agenda • Fixed Exchange Rates
Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy, Part 3
• Macroeconomic Policy in an Open Economy with Fixed Exchange Rates • Fixed versus Flexible Exchange Rates
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Fixed Exchange Rates
Fixed Exchange Rates
• Fixed-exchange-rate systems are historically important.
• Two key questions: ¾ How does the use of a fixed-exchange-rate system affect an economy and macroeconomic policy?
¾ The U.S. was on a fixed exchange rate system before the early 1970s.
¾ Which is the better system, flexible or fixed exchange rates?
¾ Fixed exchange rates are still used by many countries.
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1
Fixed Exchange Rates
Fixing the exchange rate
• Fixing the exchange rate:
• An overvalued currency:
¾ The government sets the exchange rate.
¾ When the official rate is above its fundamental value, the currency is said to be overvalued.
• Either unilaterally or in agreement with other countries.
¾ What happens if the official rate differs from the fundamental rate determined by the supply and demand of the currency?
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An overvalued exchange rate P$ or enom
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Fixing the exchange rate • An overvalued currency:
S$
¾ The government has three choices for dealing with an overvalued currency. P$
• First, the government could devalue the currency, reducing the official rate to the fundamental value. D$
Q$ 21-7
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2
Devaluing the currency P$ or enom
Fixing the exchange rate • An overvalued currency:
S$
¾ The government has three choices for dealing with an overvalued currency. P$
• Second, the country could restrict international transactions. – This would reduce the supply of its currency to the foreign exchange market and raise the fundamental value of the currency.
D$
– If a country prohibits people from trading the currency at all, the currency is said to be inconvertible.
Q$ 21-9
21-10
Restricting international transactions
Fixing the exchange rate
P$ or enom
• An overvalued currency:
S$
¾ The government has three choices for dealing with an overvalued currency. P$
• Third, the government can buy (or demand) its own currency to make the fundamental value equal to the official rate. – The central bank buys the domestic currency in the foreign exchange market using its official reserve assets.
D$
– The decline in official reserve assets equals the country’s balance of payments deficit.
Q$ 21-11
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3
Foreign exchange market intervention
Fixing the exchange rate
P$ or enom
• An overvalued currency:
S$
¾ An overvalued currency cannot be maintained forever. P$
• The country will eventually run out of official reserve assets and have to devalue its currency. D$
Q$ 21-13
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Fixing the exchange rate
A speculative run on an overvalued currency
• An overvalued currency:
P$ or enom
S$
¾ A speculative run (or attack) may end the attempt to support an overvalued currency. P$
• If investors think a currency may soon be devalued, they may sell assets denominated in the overvalued currency, increasing the supply of that currency on the foreign exchange market. D$
Q$ 21-15
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Fixing the exchange rate
Fixing the exchange rate
• An overvalued currency:
• An undervalued currency:
¾ A speculative run (or attack) may end the attempt to support an overvalued currency.
¾ When the official rate is below its fundamental value, the currency is said to be undervalued.
• This causes even bigger losses of official reserves from the central bank and speeds up the likelihood of devaluation. – This happened in Mexico in 1994 and Asia in 1997–1998.
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An undervalued exchange rate P$ or enom
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Fixing the exchange rate • An undervalued currency:
S$
¾ The government has three choices for dealing with an undervalued currency. P$
• First, the government could revalue the currency, increasing the official rate to the fundamental value. D$
Q$ 21-19
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5
Revaluing the currency P$ or enom
Fixing the exchange rate • An undervalued currency:
S$
¾ The government has three choices for dealing with an undervalued currency. P$
• Second, the government could ease restrictions on international transactions. – This would increase the supply of its currency to the foreign exchange market and raise the fundamental value of the currency.
D$
Q$ 21-21
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Easing restrictions on int’l transactions
Fixing the exchange rate
P$ or enom
• An undervalued currency:
S$
¾ The government has three choices for dealing with an undervalued currency. P$
• Third, the government can continue to acquire official reserve assets. – The central bank sells the domestic currency in the foreign exchange market to buy official reserve assets. D$
– The increase in official reserve assets equals the country’s balance of payments surplus. Q$ 21-23
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Foreign exchange market intervention
Fixing the exchange rate
P$ or enom
• An undervalued currency:
S$
¾ An overvalued currency can seemingly be maintained forever, except … P$
• If the domestic central bank is gaining official reserve assets, foreign central banks must be losing them. • So the undervalued currency cannot be maintained for forever.
D$
Q$ 21-25
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Macro policy with fixed exchange rates
Macro policy with fixed exchange rates
• Monetary policy and the fixed exchange rate:
• Monetary policy and the fixed exchange rate:
¾ The best way for a country to make the fundamental value of a currency equal the official rate is through the use of monetary policy.
¾ For an overvalued currency, a monetary contraction is desirable. • In a Keynesian model, a monetary contraction causes:
¾The nominal exchange rate is given by:
– – – –
enom = ePFor/P
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Nominal exchange rate appreciation in the short-run, Real exchange rate appreciation in the short-run, Nominal exchange rate appreciation in the long-run, and No real exchange rate effect in the long-run.
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The money supply and fixed exchange rates
Macro policy with fixed exchange rates • Monetary policy and the fixed exchange rate:
enom
¾ For an overvalued currency, a monetary contraction is desirable: • The relationship between the money supply and the nominal exchange rate determines the level of the money supply for which the fundamental value of the exchange rate equals the official rate.
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Macro policy with fixed exchange rates
Macro policy with fixed exchange rates
• Monetary policy and the fixed exchange rate:
• Monetary policy and the fixed exchange rate:
¾A large money supply yields an overvalued currency.
¾ IMPLICATION: Countries cannot both maintain the exchange rate and use monetary policy to affect output.
• Larger than the level of the money supply for which the fundamental value of the exchange rate equals the official rate.
• Expansionary monetary policy to fight a recession would lead to an overvalued currency. • Contractionary monetary policy to fight rising inflation would lead to an undervalued currency. 21-31
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Macro policy with fixed exchange rates
Macro policy with fixed exchange rates
• Monetary policy and the fixed exchange rate:
• Monetary policy and the fixed exchange rate: ¾ A group of countries may be able to coordinate their use of monetary policy.
¾ A group of countries may be able to coordinate their use of monetary policy.
• One country increasing its money supply by itself would lead to a depreciation.
• If two countries that have fixed their exchange rates both increase their money supplies to fight joint recessions, there need not be an overvaluation.
• When the other country increases its money supply, it provides an offsetting effect. • If the money supplies expand in each country, they offset each other, so the exchange rate need not change. 21-33
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Fixed versus flexible exchange rates
Coordinated monetary expansion enom
• Currency unions: ¾ Under a currency union, countries agree to share a common currency:
Fixed enom
• They often agree to cooperate economically and politically as well.
Ms 21-35
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Fixed versus flexible exchange rates
Fixed versus flexible exchange rates
• Currency unions:
• Currency unions:
¾ To work effectively, a currency union must have just one central bank.
¾ Major advantages of currency unions:
• Because countries do not usually want to give up control over their own monetary policy, currency unions are very rare. • Advantages of currency unions over fixed exchange rates: reduces the costs of trading goods and assets across countries and because speculative attacks on a national currency can no longer occur.
• Reduces the costs of trading goods and assets across countries. • Speculative attacks on a national currency can no longer occur.
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Fixed versus flexible exchange rates
Fixed versus flexible exchange rates
• Currency unions:
• Which is better?
¾ Major disadvantages of currency unions:
¾ Both fixed and flexible exchange rate systems have benefits and disadvantages.
• All countries share a common monetary policy.
¾ Which exchange rate system is better for an individual countries depends on its economic and political circumstances and those of its major trading partners.
– A problem that also arises with fixed exchange rates. – If one country is in recession while another is concerned about inflation, monetary policy can not help both. – With flexible exchange rates, the countries could have independent monetary policies to help their particular situation.
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Fixed versus flexible exchange rates
Fixed versus flexible exchange rates
• Major benefits of fixed exchange rates:
• Major benefits of flexible exchange rates:
¾ First, stable exchange rates make international trades easier and less costly.
¾ First, flexible exchange rates allow countries to use monetary policy to combat recessions and inflations.
¾ Second, fixed exchange rates help discipline monetary policy, making it impossible for a country to engage in expansionary policy.
¾ Second, flexible exchange rates permit countries follow independent monetary and fiscal policies.
– The result may be lower inflation in the long run.
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Fixed versus flexible exchange rates
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Fixed versus flexible exchange rates
• Major disadvantages to fixed exchange rates:
• Major disadvantages to flexible exchange rates:
¾ First, they take away a country’s ability to use expansionary monetary policy to combat recessions.
¾ First, exchange rate volatility introduces uncertainty into international transactions, making them more costly.
¾ Second, disagreement among countries about the conduct of monetary policy may lead to the breakdown of the system.
¾ Second, there is no independent restraint on expansionary monetary and fiscal policies.
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Fixed versus flexible exchange rates
Fixed versus flexible exchange rates
• Which is better?
• Which is better?
¾ Which is better depends on the circumstances.
¾ Which is better depends on the circumstances.
• Fixed exchange rates are more desirable:
• Flexible exchange rates are more desirable:
– If there are large benefits to be gained from increased trade and integration, AND – If countries can coordinate their monetary policies closely.
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– If countries that value having independent monetary policies. » Either because they face different macroeconomic shocks or hold different views about the costs of unemployment and inflation than other countries.
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