Exchange Rate Exchange Rate RegimesRegimes

Fixed Exchange Rates and the Adjustment of Fixed Exchange Rates and the Adjustment of the Real Exchange Ratethe Real Exchange Rate

In the medium run, the economy reaches the In the medium run, the economy reaches the same real exchange rate and the same level of same real exchange rate and the same level of outputoutput(whether it operates under fixed exchange rates or (whether it operates under fixed exchange rates or

under flexible exchange rates.)under flexible exchange rates.) Under fixed exchange rates, the adjustment Under fixed exchange rates, the adjustment

takes place through the price level rather than takes place through the price level rather than through the nominal exchange rate.through the nominal exchange rate.

Equilibrium in the Short Run and in the Equilibrium in the Short Run and in the Medium RunMedium Run

In the short run, a fixed nominal exchange rate In the short run, a fixed nominal exchange rate implies a fixed real exchange rate.implies a fixed real exchange rate.

In the medium run, a fixed nominal exchange In the medium run, a fixed nominal exchange rate will not prevent an adjustment of the real rate will not prevent an adjustment of the real exchange rate through movements in the price exchange rate through movements in the price level.level.

The Case For and Against a Devaluation in the Short Run

The case for devaluation is that, in a fixed The case for devaluation is that, in a fixed exchange rate regime, a devaluation leads to a exchange rate regime, a devaluation leads to a real depreciation (an increase in the real real depreciation (an increase in the real exchange rate), and thus to an increase in exchange rate), and thus to an increase in output.output.

A devaluation of the right size can return an A devaluation of the right size can return an economy in recession back to the natural level economy in recession back to the natural level of output.of output.

The Case For and Against a DevaluationThe Case For and Against a Devaluation

The case against devaluation points out that:The case against devaluation points out that: In reality, it is difficult to achieve the “right size” In reality, it is difficult to achieve the “right size”

devaluation.devaluation. The initial effects of a depreciation may be The initial effects of a depreciation may be

contractionary (the J-curve effect).contractionary (the J-curve effect). The price of imported goods increases, making The price of imported goods increases, making

consumers worse off temporarily. This may lead consumers worse off temporarily. This may lead workers to ask for higher nominal wages, and workers to ask for higher nominal wages, and firms to increase their prices as well.firms to increase their prices as well.

The Return of Britain to the Gold The Return of Britain to the Gold Standard: Keynes Vs. ChurchillStandard: Keynes Vs. Churchill

The The gold standardgold standard was a system in which was a system in which each country fixed the price of its currency in each country fixed the price of its currency in terms of gold. This system implied fixed terms of gold. This system implied fixed nominal exchange rates between countries.nominal exchange rates between countries.

Britain decided to return to the gold standard Britain decided to return to the gold standard in 1925. This required a large real in 1925. This required a large real appreciation of the pound. appreciation of the pound.

As a result, the overvaluation of the pound As a result, the overvaluation of the pound was among the reasons for Britain’s poor was among the reasons for Britain’s poor economic performance in the late 1920’s.economic performance in the late 1920’s.

Exchange Rate CrisesExchange Rate CrisesUnder Fixed Exchange RatesUnder Fixed Exchange Rates

Higher inflation, or the steady increase in the Higher inflation, or the steady increase in the prices of domestic goods, leads to a steady real prices of domestic goods, leads to a steady real appreciation and worsening of a country’s appreciation and worsening of a country’s trade position.trade position.

Lowering the domestic interest rate triggers an Lowering the domestic interest rate triggers an decrease in the nominal exchange rate, or decrease in the nominal exchange rate, or nominal depreciation.nominal depreciation.

The size of the devaluation can be estimated The size of the devaluation can be estimated using the interest parity condition.using the interest parity condition.

Exchange Rate CrisesExchange Rate CrisesUnder Fixed Exchange RatesUnder Fixed Exchange Rates

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

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Exchange Rate CrisesExchange Rate CrisesUnder Fixed Exchange RatesUnder Fixed Exchange Rates

Expectations that a devaluation may be Expectations that a devaluation may be coming can trigger an exchange rate crisis. coming can trigger an exchange rate crisis. The government has two options:The government has two options: Give in and devalue, orGive in and devalue, or Fight and maintain the parity, at the cost of very Fight and maintain the parity, at the cost of very

high interest rates and a potential recession.high interest rates and a potential recession.

The 1992 EMS CrisisThe 1992 EMS Crisis

RealignmentsRealignments are adjustments of parities between are adjustments of parities between currencies.currencies.

The September 1992 EMS (European Monetary The September 1992 EMS (European Monetary System) Crisis was caused by the belief that several System) Crisis was caused by the belief that several countries were soon going to devalue. Some countries were soon going to devalue. Some countries defended themselves by increasing the countries defended themselves by increasing the overnight interest rateovernight interest rate up to 500%. up to 500%.

In the end, some countries devalued, others dropped In the end, some countries devalued, others dropped out of the EMS, and others remained.out of the EMS, and others remained.

Roughly the same happened in Korea and Thailand Roughly the same happened in Korea and Thailand in 1997.in 1997.

International Reserves – Insuring against financial crises

Choosing Between Exchange Rate Choosing Between Exchange Rate RegimesRegimes

In the short run, under fixed exchange rates, a country In the short run, under fixed exchange rates, a country gives up its control of the interest rate and the gives up its control of the interest rate and the exchange rate.exchange rate.

Also, anticipation that a country may be about to Also, anticipation that a country may be about to devalue its currency may lead investors to ask for devalue its currency may lead investors to ask for very high interest rates.very high interest rates.

An argument against flexible exchange rates is that An argument against flexible exchange rates is that they may move a lot, may be difficult to control and they may move a lot, may be difficult to control and lead to a volatile macroeconomic environment.lead to a volatile macroeconomic environment.

The Euro: A Short StoryThe Euro: A Short Story

The European Monetary Union (EMU) was The European Monetary Union (EMU) was consolidated under the consolidated under the Maastricht Treaty Maastricht Treaty (1991).(1991).

In January 1999, parities between the currencies of In January 1999, parities between the currencies of 11 countries and the Euro were “irrevocably” fixed.11 countries and the Euro were “irrevocably” fixed.

In January 2001, the Euro replaced national In January 2001, the Euro replaced national currencies.currencies.

The new The new European Central Bank (ECB),European Central Bank (ECB), based in based in Frankfurt, became responsible for monetary policy Frankfurt, became responsible for monetary policy for the Euro area.for the Euro area.

Advantages of a Common CurrencyAdvantages of a Common Currency

Reduction in exchange rate risk Eliminates the risk of exchange rate variability, which

increases capital market stability Reduction in transactions costs

There is no exchange of currencies among members, so transaction costs are reduced

Economies of scale Along with the dollar, the euro may serve as a reserve

currency, so the EU gets interest free loans

Disadvantages of a Common CurrencyDisadvantages of a Common Currency

Loss of independent monetary policy 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 Losing a national currency may be a loss

of national identity or heritage

Optimal Currency AreasOptimal Currency Areas An An optimal currency area is a group of is a group of

countries suitable to adopt a common countries suitable to adopt a common currency without significantly jeopardizing currency without significantly jeopardizing domestic policy goals.domestic policy goals.

Criteria for optimal currency areasCriteria for optimal currency areas Similar composition of industriesSimilar composition of industries Significant mobility for factors of production Significant mobility for factors of production

(labor and capital)(labor and capital) Diversified economiesDiversified economies Diverse demand shocksDiverse demand shocks

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

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

Endogenous Optimal Currency AreasEndogenous Optimal Currency Areas