Exchange Rate Regimes Fixed Exchange Rates and the

Exchange Rate Regimes

Fixed Exchange Rates and the Adjustment of the Real Exchange Rate n In the medium run, the economy reaches the same real exchange rate and the same level of output (whether it operates under fixed exchange rates or under flexible exchange rates. ) n Under fixed exchange rates, the adjustment takes place through the price level rather than through the nominal exchange rate.

Equilibrium in the Short Run and in the Medium Run n n In the short run, a fixed nominal exchange rate implies a fixed real exchange rate. In the medium run, a fixed nominal exchange rate will not prevent an adjustment of the real exchange rate through movements in the price level.

The Case For and Against a Devaluation in the Short Run n n The case for devaluation is that, in a fixed exchange rate regime, a devaluation leads to a real depreciation (an increase in the real exchange rate), and thus to an increase in output. A devaluation of the right size can return an economy in recession back to the natural level of output.

The Case For and Against a Devaluation n The case against devaluation points out that: n n n In reality, it is difficult to achieve the “right size” devaluation. The initial effects of a depreciation may be contractionary (the J-curve effect). The price of imported goods increases, making consumers worse off temporarily. This may lead workers to ask for higher nominal wages, and firms to increase their prices as well.

The Return of Britain to the Gold Standard: Keynes Vs. Churchill n n n The gold standard was a system in which each country fixed the price of its currency in terms of gold. This system implied fixed nominal exchange rates between countries. Britain decided to return to the gold standard in 1925. This required a large real appreciation of the pound. As a result, the overvaluation of the pound was among the reasons for Britain’s poor economic performance in the late 1920’s.

Exchange Rate Crises Under Fixed Exchange Rates n n n Higher inflation, or the steady increase in the prices of domestic goods, leads to a steady real appreciation and worsening of a country’s trade position. Lowering the domestic interest rate triggers an decrease in the nominal exchange rate, or nominal depreciation. The size of the devaluation can be estimated using the interest parity condition.

Exchange Rate Crises Under Fixed Exchange Rates n Under fixed exchange rates, if markets expect that parity will be maintained, then they believe that the interest parity condition will hold; therefore, the domestic and the foreign interest rates will be equal.

Exchange Rate Crises Under Fixed Exchange Rates n Expectations that a devaluation may be coming can trigger an exchange rate crisis. The government has two options: n n Give in and devalue, or Fight and maintain the parity, at the cost of very high interest rates and a potential recession.

The 1992 EMS Crisis n n Realignments are adjustments of parities between currencies. The September 1992 EMS (European Monetary System) Crisis was caused by the belief that several countries were soon going to devalue. Some countries defended themselves by increasing the overnight interest rate up to 500%. In the end, some countries devalued, others dropped out of the EMS, and others remained. Roughly the same happened in Korea and Thailand in 1997.

International Reserves – Insuring against financial crises

Choosing Between Exchange Rate Regimes n n n In the short run, under fixed exchange rates, a country gives up its control of the interest rate and the exchange rate. Also, anticipation that a country may be about to devalue its currency may lead investors to ask for very high interest rates. An argument against flexible exchange rates is that they may move a lot, may be difficult to control and lead to a volatile macroeconomic environment.

The Euro: A Short Story n n The European Monetary Union (EMU) was consolidated under the Maastricht Treaty (1991). In January 1999, parities between the currencies of 11 countries and the Euro were “irrevocably” fixed. In January 2001, the Euro replaced national currencies. The new European Central Bank (ECB), based in Frankfurt, became responsible for monetary policy for the Euro area.

Advantages of a Common Currency n Reduction in exchange rate risk n n Reduction in transactions costs n n Eliminates the risk of exchange rate variability, which increases capital market stability There is no exchange of currencies among members, so transaction costs are reduced Economies of scale n Along with the dollar, the euro may serve as a reserve currency, so the EU gets interest free loans

Disadvantages of a Common Currency n Loss of independent monetary policy n n With a common currency monetary policy is the same in all countries because there is one money supply and one central bank Loss of national symbol n Losing a national currency may be a loss of national identity or heritage

Optimal Currency Areas n n An optimal currency area is a group of countries suitable to adopt a common currency without significantly jeopardizing domestic policy goals. Criteria for optimal currency areas n n Similar composition of industries Significant mobility for factors of production (labor and capital) Diversified economies Diverse demand shocks

People Changing Region of Residence in the 1990 s (percent of total population)

Optimal Currency Areas n Are the American States an optimal currency area? Is the European Union an optimal currency area? Should Britain join the EMU (the Euro)? Did Ecuador do wisely in dollarizing its economy? What should Argentina do? n Endogenous Optimal Currency Areas n n