chapter 21: exchange rate regimes © 2006 prentice hall business publishing macroeconomics, 4/e...

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© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

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CHAPTERS IN ECONOMIC POLICY

Part. II Unit 6

Exchange Rate Regimes

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Exchange Rate CrisesUnder Fixed Exchange Rates

Exchange rate crises

Let’s assume that a country is operating under a fixed exchange rate, and that its domestic currency is overvalued (because domestic inflation rate is higher than foreign inflation rate)

Higher relative inflation implies a steady real appreciation and a steady worsening of NX

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Financial markets start believing that the monetary authorities will be forced to devalue domestic currency

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Expectations that a devaluation may be coming can trigger an exchange rate crisis

The government and the Central bank have a few options:

i) They can try to convince markets that they have no intention of devaluing

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ii) The Central bank can increase the domestic interest rate

However, to fully compensate the risk of a depreciation, usually substantial increases are needed

Let us consider the following equation which provides a good approximation of the interest parity condition:

• it = it* (Eet+1 Et)/Et

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In other words, in equilibrium the domestic interest rate must be (approximately ) equal to the foreign interest rate minus the expected appreciation rate of the domestic currency, or (alternatively)

equal to the foreign interest rate minus the expected depreciation rate of the foreign currency

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Tipically, increases in domestic interest rate only partially compensate the market for the risk of a depreciation: large outflow of capital and loss of Central bank reserves ensue

Eventually, the choice for the central bank becomes either to increase further the interest rate or to validate the market’s expectations and devalue

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Case study: The 1992 EMS Crisis

Started in 1979, the EMS was an exchange rate system based on fixed parities with bands

Each member (among them France, Germany, Italy and starting from 1990, UK) had to maintain its exchange rate within narrow bands

Although no currency was designated as an anchor, the Deutsche Mark and the German Central bank were the centre of the EMS

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At the very beginning the EMS was characterized by many realignments (adjustment of parities) among member countries

From 1987 to 1992, on the contrary, it worked well, with only two realignments

In 1992, however, financial markets became convinced that more realignments were due

Main reason: the reunification process in Germany had brought a substantial increase in demand and inflation in that country

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In order to check inflation, the Bundesbank adopted a restrictionary monetary policy

Germany’s EMS partner, however, needed lower interest rates to reduce increasing unemployment

To financial markets, the position of these countries looked increasingly untenable

This belief led in early September 1992 to speculative attacks on a number of currencies (financial investors started selling in anticipation of devaluation)

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The monetary authorities of the countries under attack reacted by increasing interest rates

This move did not prevent large capital outflows and large losses of foreign exchange reserves

After a few weeks Italy and UK had to suspend their participation in the EMS. Spain devalued its currency

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German Unification, Interest Rates, and the EMS

Table 1 German Unification, Interest Rates, and Output Growth: Germany, France, and Belgium, 1990-1992

Nominal Interest Rates (%) Inflation (%)

1990 1991 1992 1990 1991 1992

Germany 8.5 9.2 9.5 2.7 3.7 4.7

France 10.3 9.6 10.3 2.9 3.0 2.4

Belgium 9.6 9.4 9.4 2.9 2.7 2.4

Real Interest Rates (%) GDP Growth (%)

1990 1991 1992 1990 1991 1992

Germany 5.7 5.5 4.8 5.7 4.5 2.1

France 7.4 6.6 7.9 2.5 0.7 1.4

Belgium 6.7 6.7 7.0 3.3 2.1 0.8

The nominal interest rate is the short-term nominal interest rate. The real interest rate is the realized real interest rate over the year – that is, the nominal interest rate minus actual inflation over the year. All rates are annual.

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Choosing BetweenExchange Rate Regimes

The pros and cons of flexible vs. fixed exchange rates

On the whole, flexible exchange rates appear to be preferable to fixed exchange rates:

i) In the short run, under flexible exchange rates, monetary authorities are able to control the interest rate and the exchange rate

ii) Also, under flexible exchange rates, a country is less vulnerable to speculative attacks

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However: flexible exchange rates are characterized by high volatility and this has negative effects on the international trade and on domestic production

In some circumstances (high economic integration, the need to enforce a disinflationary process) fixed exchange rates appear to be the right solution

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The case for a common currency:

when a group of countries is already highly integrated and aims at fostering the integration process, a common currency may be the right solution

A common currency:

i) reduces the transactions costs of trade

ii) enhances competition

iii) bring economic convergence

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Common Currency Areas

Properties of an optimal currency area (R. Mundell):

A set of countries is an optimal currency area when one of these two conditions is satisfied:

i) symmetric shocks

Countries have to experience similar fluctuations of their economic activity

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ii) High factor mobility

Internal mobility of factors (particularly of labour) allows countries to adjust to shocks

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A smooth functioning of a optimal currency area requires also a coordination of fiscal policies

Furthermore, following asymmetric shocks (shocks affecting regions within a common currency area in a different way), substantial transfers of fiscal resources from the relatively prosperous regions towards the adversely affected regions are desirable to mitigate the burden of real adjustment

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In the US: asymmetric shocks are quite common. However, US economy is characterized by an high factor mobility and by substantial interregional transfers of fiscal resources

Euro zone: asymmetric shocks are quite common and, at the same time, the EU labour market is characterized by a low degree of mobility.

Furthermore, interregional transfers of fiscal resources are not satisfactory

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The Euro: a short history

1991-93: the Maastricht treaty. This treaty set several main convergence criteria for joining the EMU:

i) The ratio of the annual government deficit to GDP must not exceed 3%

ii) The ratio of gross government debt to GDP must not exceed 60% (if the target could not be achieved due to specific conditions, the ratio had to be approaching the reference value at a satisfactory pace).

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iii) The inflation rate must be no more than 1.5% higher than the average of the three best performing (lowest inflation) member states of the EU

iv) The nominal long-term interest rate must not be more than 2% higher than in the three lowest inflation member states.

May 1998: 11 countries qualified (Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, the <netherlands, Portugal, Spain)

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May 1998: 11 countries qualified (Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, the Netherlands, Portugal, Spain); 3 decided to stay out (UK, Denmark, Sweden); 1 did not qualify (Greece)

January 1999: the parities between the 11 currencies and the euro were “irrevocably” fixed and the European Central Bank became responsible for monetary policy in the Euro zone

2001: Greece qualifiesJanuary 2002: euro coins and banknotes are

introduced

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Currency Boardsand Dollarization

One way of convincing financial markets that a country is serious about reducing money growth is a pledge to fix its exchange rate, now and in the future.

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Dollarization is an extreme form of a “hard peg”: it is enacted by replacing the domestic currency with the dollar

A less extreme way is the use of a currency board involving the central bank: under a currency board, i) the central bank is ready to buy and to sell any amount of foreign currency at the official exchange rate; ii) the central bank cannot engage in open market operations and anticipate any resource to the government

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Currency boards are required to hold realizable financial assets in the reserve currency at least equal to the value of domestic currency

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A case study: Argentina’s currency board:

During the ’70s and early ’80s Argentina was characterized by hyperinflation and recession

Early ’90s: in order to reduce inflation, the government decided to peg Argentina’s currency to the dollar (nominal exchange rate peso/dollar = 1)

The currency board was at the beginning very successful: in 1994 Argentina was characterized by substantial price stability and by a strong output growth

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However, in the second half of the ’90s:

Substantial appreciation of the dollar (and of the peso)

This brought a loss of competitiveness for Argentina trade deficit recession worsening of fiscal deficit and of government debt

As a consequence of an increasing default risk and exchange rate risk, financial investors asked very high interest rates this increased the risk of default (self-fulfilling expectation)

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December 2001: default

January 2002: the government let the peso fluctuate

Substantial depreciation of the peso (3.75 pesos for dollar) increase of the burden of debt bankrupcies severe recession (GDP growth rate in 2002 = 11%)

chapter 21: exchange rate regimes © 2006 prentice hall business publishing macroeconomics, 4/e...

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