lecture 16 fixed versus floating exchange rates
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Lecture 16 Fixed versus Floating Exchange Rates. Econ 340. Outline: Fixed versus Floating Exchange Rates. Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating Disruption When Rates Move Automatic Adjustment Pros and Cons of Pegging Stability Instability - PowerPoint PPT PresentationTRANSCRIPT
Lecture 16 Fixed versus Floating
Exchange Rates
Econ 340
Econ 340, Deardorff, Lecture 15: Int Macro
2
Outline: International Macroeconomics
• Recall Macro from Econ 102– Aggregate Supply and Demand– Policies
• Effects ON the Exchange Market– Expansion– Interest Rate
• Effects OF the Exchange Market– Depreciation via Trade– Depreciation via Net Wealth
• Effects THOUGH the Exchange Market
Left over fro
m
Last Time
Econ 340, Deardorff, Lecture 15: Int Macro
3
Effects THROUGH the Exchange Market
• The issue here: – Do macroeconomic effects get transmitted to other
countries, and if so how?– i.e., does an expansion, for example, in one country
cause an expansion or a contraction in other countries?
Econ 340, Deardorff, Lecture 15: Int Macro
4
Effects THROUGH the Exchange Market
– The answer: Although many exceptions are possible,
it is usually true that changes in one country cause changes in the same direction in others:• Expansion here → expansion there• Inflation here → inflation there• High interest rates here → high interest rates there
Econ 340, Deardorff, Lecture 15: Int Macro
5
Effects THROUGH the Exchange Market
• Example: How a recession in US can cause recession Canada– Fall in aggregate demand in US (due to non-
monetary contraction such as a fall in investment) leads to• Fall in US income, leads to• Fall in Canadian exports to US, leads to• Fall in Canadian income
– To see these links in more detail…
Econ 340, Deardorff, Lecture 15: Int Macro
6
US Investment Falls
US Income Falls
US Interest Rate FallsUS Imports Fall
US Dollar Depreciates
US Imports Fall More
Canadian Exports Fall
Canadian AD Falls
Canadian Income Falls
Econ 340, Deardorff, Lecture 15: Int Macro
7
Effects THROUGH the Exchange Market
• We’ve seen some of this dramatically during the last few years:– Crisis started in US– Effects were transmitted to the world– Exception: US dollar did not depreciate
immediately; it appreciated at first. (Due to flight to safety.)
Econ 340, Deardorff, Lecture 16: Fixed/Float
8
Outline: Fixed versus Floating Exchange Rates
• Both Systems Are Used• What the “Experts” Recommend• Pros and Cons of Floating
– Disruption When Rates Move– Automatic Adjustment
• Pros and Cons of Pegging– Stability– Instability
• Alternatives– Crawling Peg– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
9
Who Uses Fixed and Float• Lessons from the list of exchange arrangements
(below)– Floating rates are used by many countries
• Rich & poor• Large & small• All over the world
– Pegged rates are used today mostly by small countries
– Many countries are between fixed and floating(Source of table below: IMF, “Annual Report on
Exchange Arrangements and Exchange Restrictions 2014”)
Econ 340, Deardorff, Lecture 16: Fixed/Float
10
Exchange Arrangementsof Sample Countries, as of 2014
Floating Exchange Rates 47 countries + euro 18
Australia MexicoCanada SwedenIndia United KingdomJapan United States
Pegged Exchange Rates 44 countriesBelize MoroccoDenmark NepalJordan Saudi Arabia
Econ 340, Deardorff, Lecture 16: Fixed/Float
11
Exchange Arrangementsof Sample Countries, as of 2014
Stabilized Arrangement 21 countriesIraq SingaporeLebanon Vietnam
Crawling Peg or Crawl-like Arrangement 17 countriesNicaragua China
Other Managed Arrangement 19 countriesBangladesh RussiaMalaysia Switzerland
Between Floating and Pegged: 57 countries
Econ 340, Deardorff, Lecture 16: Fixed/Float
12
Exchange Arrangementsof Sample Countries, as of 2014
Currency Board 12 countriesHong Kong Lithuania
No Separate Legal Tender 12 countriesEcuador ($) Montenegro (€)
More Fixed than Pegged:
• Currency Board– Peg to another currency– Vary money supply automatically with changes in
international reserves (= forced nonsterilization)
Econ 340, Deardorff, Lecture 16: Fixed/Float
13
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Country Distribution of Currency Arrangements 2014
None Cur. Board Pegged Stabilized Crawl Managed Float
Pegged Float
More Fixed
More Flexible
Econ 340, Deardorff, Lecture 16: Fixed/Float
14
Outline: Fixed versus Floating Exchange Rates
• Both Systems Are Used• What the “Experts” Recommend• Pros and Cons of Floating
– Disruption When Rates Move– Automatic Adjustment
• Pros and Cons of Pegging– Stability– Instability
• Alternatives– Crawling Peg– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
15
What “Experts” Recommend• Some favor freely floating rates
– Let exchange rate adjust to fix imbalances– “Let the market work”
• Others favor perfectly fixed rates– Define currency rigidly in terms of something you
can’t control• Gold• Foreign currency (“Currency Board”)
– AND give up control of the money supply• Let flows of money fix imbalances
i.e., do not sterilize!
Econ 340, Deardorff, Lecture 16: Fixed/Float
16
What “Experts” Recommend
• Advocates of floating rates– Milton Friedman (Nobel Prize 1976):
“A country that enters into a hard-fixed rate bears an economic cost. The cost is discarding a means—a flexible exchange rate—of adjusting to external forces that impinge on it differently than on the other country or countries whose currency it shares.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
17
What “Experts” Recommend
• Advocates of floating rates– Jeffrey Sachs:
“Once reserves are gone, investors panic. The worst mistake is for countries to wait too long to float their currencies.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
18
What “Experts” Recommend
• Advocates of fixed rates– Robert Mundell (Nobel Prize 1999):
“A world currency of some sort has existed for most of the past 2,500 years. Two thousand years ago, in the age of Caesar Augustus, it was the Roman aureus... A hundred years ago it was the gold sovereign. Less than thirty years ago it was the 1944 gold dollar. The world has been without a universal currency for only a tiny fraction of its history.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
19
What “Experts” Recommend– Milton Friedman:
“If [over the last 30 years] the Canadian dollar had been rigidly tied to the US dollar, those differences would have required Canada to deflate relative to the United States, with unfortunate consequences for Canada that would have strained, to put it mildly, the trade relations between the two countries, and have put strong pressure on Canada to devalue or float.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
20
What “Experts” Recommend– Robert Mundell:
“Exchange rate uncertainty imposes a cost of trade much like a tariff ... If Canada and the United States shared a stable common currency or an irrevocably fixed exchange rate, Canada’s real income would soar, closing a large part of the gap between the two countries’ GDP per capita.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
21
What “Experts” Recommend• “Bradford DeLong, an economic historian at the
University of California at Berkeley, explains the debate to his students this way:
” (WSJ)
To Mr. Friedman, an exchange rate is a price; therefore, it is an infringement on human freedom to peg it. To Mr. Mundell, an exchange rate is a promise; to change it is to default on a commitment.
Econ 340, Deardorff, Lecture 16: Fixed/Float
22
What “Experts” Recommend• Allan Meltzer (Carnegie-Mellon): “The
best you can say of what economic research has produced is: – You can make a case for freely floating
exchange rates if you’re willing to live with the consequences.
– You can make a case for fixed exchange rates if you’re willing to live with the consequences.
– You can’t make much of a case for anything in between.” (WSJ)
Econ 340, Deardorff, Lecture 16: Fixed/Float
23
What “Experts” Recommend
• Where they agree: An “adjustable peg” is worse than both fixed and floating rates– Friedman: “The reasons why a pegged
exchange rate is a ticking bomb are well known.”
– Mundell: “I have never nor ever would advocate a general system of “pegged” rates. Pegged rate systems always break down.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
24
Outline: Fixed versus Floating Exchange Rates
• Both Systems Are Used• What the “Experts” Recommend• Pros and Cons of Floating
– Disruption When Rates Move– Automatic Adjustment
• Pros and Cons of Pegging– Stability– Instability
• Alternatives– Crawling Peg– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
25
Pros and Cons of Floating
• Con: Exchange rates DO MOVE; And when they do, they cause
– Macro effects (as we saw last time)• Depreciation
– Stimulates aggregate demand, but not necessarily when needed: may just cause inflation
– Changes values of assets and liabilities• Appreciation
– Reduces aggregate demand, may cause recession or deflaton
Econ 340, Deardorff, Lecture 16: Fixed/Float
26
Pros and Cons of Floating
• Con: Exchange rates DO MOVE; when they do, they cause– Micro effects: exports and imports subject to
• Uncertainty• Instability
Costly for tradersLike trade barrier
Reduces trade
Econ 340, Deardorff, Lecture 16: Fixed/Float
27
Pros and Cons of Floating• Example: The US dollar rose 50% during 1980-
1985
Trade Weighted Dollar Index - Real
020406080
100120140
Jan-
73
Jan-
75
Jan-
77
Jan-
79
Jan-
81
Jan-
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Jan-
85
Jan-
87
Jan-
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Jan-
91
Jan-
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05
– Caused US auto and other industries to contract
– Major dislocation in middle US
– Ended in 1985 when in “Plaza Accord” major central banks agreed to intervene
Econ 340, Deardorff, Lecture 16: Fixed/Float
28
Pros and Cons of Floating• Pro: Exchange rate provides efficient and
automatic across-the-board adjustment– Suppose that, due to inflation, our prices are too high,
causing our imports to rise and exports to fall• Exchange depreciation fixes this for all sectors• With fixed rates, individual prices and wages would have to
fall to become competitive: much more painful– That’s what Greece and other weak countries in the EU have
had to do recently.– Called “internal devaluation”
– Floating Permits countries to have independent monetary policies to deal with macroeconomic shocks
Econ 340, Deardorff, Lecture 16: Fixed/Float
29
Pros and Cons of Floating
• Experience with exchange rates in the 1930s (not really floating, but they moved a lot) made governments prefer fixed rates
• After WWII, IMF was created, based on Pegged Exchange Rates– Most currencies pegged to US $– IMF helped countries manage this– When in trouble, countries devalued
Econ 340, Deardorff, Lecture 16: Fixed/Float
30
Outline: Fixed versus Floating Exchange Rates
• Both Systems Are Used• What the “Experts” Recommend• Pros and Cons of Floating
– Disruption When Rates Move– Automatic Adjustment
• Pros and Cons of Pegging– Stability– Instability
• Alternatives– Crawling Peg– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
31
Pros and Cons of Pegging
• Pro: If it succeeds, exchange rate is stable, avoiding disruptions
• Con: If it fails, – devaluation causes instability, – just like floating rates, only worse
• The Problem: Pegged Rates are Prone to Crisis
Econ 340, Deardorff, Lecture 16: Fixed/Float
32
Pros and Cons of Pegging
• Why Crisis?– Pegged rate does not respond to market
changes– Some currencies become undervalued, others
overvalued• Inevitable unless all countries have exactly the
same rate of inflation– Crisis eventually erupts for overvalued
currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
33
Pros and Cons of Pegging
• Why Crisis for Overvalued Currency?– Central bank
must sell foreign currency
– Since reserves are finite, they eventually run out
– Market knows that when they do…
S€
D€
Q€
$/€
E*Fed sells €
E0
Econ 340, Deardorff, Lecture 16: Fixed/Float
34
Pros and Cons of Pegging
• Why Crisis for Overvalued Currency– Intervention will
stop– Currency will
depreciate– Knowing this,
people don’t want to hold the overvalued currency, so…
S€
D€
Q€
$/€
E*
E0
Econ 340, Deardorff, Lecture 16: Fixed/Float
35
Pros and Cons of Pegging
• Why Crisis for Overvalued Currency– Before reserves
run out, capital outflow increases demand
– And reserves fall faster
– “Speculative Attack”
S€
D€
Q€
$/€
E*
E0
D€1
Fed sells more €
Econ 340, Deardorff, Lecture 16: Fixed/Float
36
Pros and Cons of Pegging
• Pegged rates offer speculators a “one-way bet”– Once they see that reserves are falling…– … they bet on a devaluation by selling the
country’s currency• If they are right, they win• If they are wrong, they break even
(since the exchange rate doesn’t change)– They can’t lose, so they bet a lot
Econ 340, Deardorff, Lecture 16: Fixed/Float
37
Pros and Cons of Pegging• Crisis even without Overvaluation
– Crisis only requires expectation of devaluation• The expectation doesn’t have to be justified;
it only has to be believed• Can happen even to a currency that is not overvalued
– How? By “contagion”. • If one country has a crisis, for whatever reason• Other countries that are near it, or similar to it, may become
suspect• That’s part of what happened in the Asian Crisis that started
in 1997• Some countries fear contagion today
Econ 340, Deardorff, Lecture 16: Fixed/Float
38
Pros and Cons of Pegging
• Result: “Pegged Rates” are not Fixed– In a world of pegged exchange rates, over
time• Some currencies become undervalued• Other currencies become overvalued
– Why? Many reasons (see Makin)• Bretton Woods: US inflation caused dollar to
become overvalued• Europe in the 1990s: German tight money after
reunification, caused others to become overvalued
Econ 340, Deardorff, Lecture 16: Fixed/Float
39
Pros and Cons of Pegging
• Result: “Pegged Rates” are not Fixed– Overvalued currencies are subject to
speculative attacks– When they do devalue, they do it
• Suddenly• By large amounts
– This is just as disruptive as changes in a floating rate, perhaps more so
Econ 340, Deardorff, Lecture 16: Fixed/Float
40
Pros and Cons of Pegging
• The choice is not between fixed and floating:
Time
E
Econ 340, Deardorff, Lecture 16: Fixed/Float
41
Pros and Cons of Pegging
• The choice is between pegged and floating:
Time
E
Which is more stable?
Econ 340, Deardorff, Lecture 16: Fixed/Float
42
Outline: Fixed versus Floating Exchange Rates
• Both Systems Are Used• What the “Experts” Recommend• Pros and Cons of Floating
– Disruption When Rates Move– Automatic Adjustment
• Pros and Cons of Pegging– Stability– Instability
• Alternatives– Crawling Peg– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
43
Alternatives
• Mixtures of pegged and floating rates– Crawling peg
• Change the pegged rate slowly and predictably in response to a fall or rise in reserves
• Slow movement of the peg is supposed to stop the loss of reserves before crisis hits
• Still subject to speculative attack
Econ 340, Deardorff, Lecture 16: Fixed/Float
44
Alternatives
• Mixtures of pegged and floating rates– Wider band
• Let the rate move freely in a large band around the official pegged rate
• Less intervention should be needed• Does not help if country has, say, higher inflation
than others: crisis still inevitable
Econ 340, Deardorff, Lecture 16: Fixed/Float
45
Alternatives
• Truly Fixed Exchange Rate– Use another country’s currency
“Dollarization”– Form a monetary union
The Eurozone (we’ll look more at this next week)
Econ 340, Deardorff, Lecture 16: Fixed/Float
46
Alternatives• Truly Fixed Exchange Rate
– Currency Board• Peg to another currency• Replace central bank with “board” that
automatically varies money supply one-for-one with international reserves
– If reserves fall, so does money supply, forcing adjustment
– This mimics the Gold Standard, where gold flowed among countries
Econ 340, Deardorff, Lecture 16: Fixed/Float
47
Alternatives• Truly Fixed Exchange Rate
– Currency Board• How it’s supposed to work
– If exchange rate is over-valued (excess demand for foreign currency)
» Currency board sells reserves» This reduces the domestic money supply 1-for-1» Falling money causes falling income and prices» Imports fall, exports rise, and excess demand for
foreign currency disappears– If exchange rate is under-valued: Opposite
Econ 340, Deardorff, Lecture 16: Fixed/Float
48
Alternatives• Truly Fixed Exchange Rate
– Currency Board• Didn’t work for Argentina, which had a crisis
anyway– Must not have followed the rules
Econ 340, Deardorff, Lecture 16: Fixed/Float
49
Alternatives• Pegged Rate with Capital Controls
– Why did pegged rates work in the 1950s & 60s?• Most countries had capital controls• In spite of that, the system of pegged rates didn’t
work perfectly: there were some crises– Capital controls prevent inflow and outflow of
capital, and thus limit speculation– Today, most countries see capital controls as
too costly• But not all: China, Malaysia
Econ 340, Deardorff, Lecture 16: Fixed/Float
50
AlternativesThe
Impossible Trinity
See Frankel (This is the Missing
Figure 3)
Goal: Exchange Rate Stability
Goal: Monetary Independence
Goal: Full Financial
Integration
Policy: Full Capital Controls
Policy: Pure Float
Policy: Monetary
Union
Increased Capital Mobility
Econ 340, Deardorff, Lecture 16: Fixed/Float
51
Exchange Rates Since 1945
• See reading by Buttonwood (column in The Economist)
• Bretton-Woods System, 1945-1971– Overseen by IMF– Currencies were pegged, mostly to US $– Capital mobility was restricted, but gradually
liberalized over time– Frequent crises, as currencies became
overvalued due to inflation
Econ 340, Deardorff, Lecture 16: Fixed/Float
52
Exchange Rates Since 1945
• August 15, 1971: – Nixon cut the link of US $ to gold, signaling
the end of pegged rates– Countries stopped pegging, then restarted at
different rates, but by 1973 they had given up
Econ 340, Deardorff, Lecture 16: Fixed/Float
53
Exchange Rates Since 1945
• Since 1973, major currencies have floated– Exchange rates moved more than expected– Crises did not disappear– Monetary policy became more free:
• “ ‘the Greenspan put’: the use of interest-rate cuts to rescue financial markets, in effect underwriting asset prices.”
Econ 340, Deardorff, Lecture 16: Fixed/Float
54
Outline: Fixed versus Floating Exchange Rates
• Both Systems Are Used• What the “Experts” Recommend• Pros and Cons of Floating
– Disruption When Rates Move– Automatic Adjustment
• Pros and Cons of Pegging– Stability– Instability
• Alternatives– Crawling Peg– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16: Fixed/Float
55
The Problem of Undervalued Currencies
• Overvalued currencies lead to crisis– In that sense they are self correcting, since
countries are forced, eventually, to devalue or float
• Undervalued currencies – Do not lead to crisis, but only to accumulation
of reserves– May be viewed as harmful to trading partners
Econ 340, Deardorff, Lecture 16: Fixed/Float
56
The Problem of Undervalued Currencies
• Today, the Chinese yuan is considered undervalued– US administration puts pressure on China to
appreciate– US Congress threatens to restrict imports
Econ 340, Deardorff, Lecture 14: Pegging
57
US$/yuan Exchange Rate
2000 Jan 2002 Jan 2004 Jan 2006 Jan 2008 Jan 2010 Jan 2012 Jan 2014 Jan0.000
0.020
0.040
0.060
0.080
0.100
0.120
0.140
0.160
0.180
M1 2000 M5 2002 M9 2004 M1 2007 M5 2009 M9 2011 M1 20140
500
1000
1500
2000
2500
3000
3500
4000
4500
China Reserves, $bill.
Recent Pronouncements
• Obama: "As I've said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort.”
Recent Pronouncements
• Wen Jiabao: – “The Chinese currency is not undervalued.” “We
oppose all countries engaging in mutual finger-pointing or taking strong measures to force other nations to appreciate their currencies.”
– “What I don’t understand is depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is protectionism.”
Krugman’s Argument(From NYT, Mar 15, 2010)• China’s current account surplus in 2010 will be over $450
billion• US should declare China a “currency manipulator” in next
report, Apr 15 – (US did not, and hasn’t since.)
• China does not have US “over a barrel.” We have China over a barrel.
• We should repeat what we did in 1971:– Then Nixon used a 10% surcharge on imports, so as to prod
Japan, Germany, and others to appreciate– We should use (or threaten) a 25% surcharge on Chinese exports.
Econ 340, Deardorff, Lecture 16: Fixed/Float
62
Next Time
• The Euro– What is it?– History of European monetary integration– Pros and cons of currency unification– Effects on US– What happened?