Exchange Rate Regimes

1. Exchange RateRegimes

2. Fixed Exchange Rates and the Adjustment of the Real Exchange Rate in the Medium Run 21-1 • 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. • Under fixed exchange rates, the adjustment takes place through the price level rather than through the nominal exchange rate.

3. Aggregate Demand UnderFixed Exchange Rates • The equilibrium condition in the goods market is: • The real interest rate and real exchange rate equal: • Under fixed exchange rates: • Then, the equilibrium condition becomes:

4. Aggregate Demand UnderFixed Exchange Rates • The focus of this chapter is on the real exchange rate, government spending, and taxes. Therefore, we simplify the relation above as follows:

5. Aggregate Demand UnderFixed Exchange Rates • In a closed economy, the price level affects output through its effect on the real money stock: • In an open economy, the price level affects output through its effects on the real exchange rate.

6. Equilibrium in the Short Runand in the Medium Run Aggregate Demand and Aggregate Supply in an Open Economy Under Fixed Exchange Rates An increase in the price level leads to a real appreciation and a decrease in output: The aggregate demand curve is downward sloping. An increase in output leads to an increase in the price level: The aggregate supply curve is upward sloping. The aggregate supply relation is:

7. Equilibrium in the Short Runand in the Medium Run Adjustment Under Fixed Exchange Rates The aggregate supply shifts down over time, leading to a decrease in the price level, to a real depreciation, and to an increase in output. The process ends when output has returned to the natural level of output.

8. Equilibrium in the Short Runand in the Medium Run • So long as output is below the natural level of output, the price level decreases, leading to a steady real depreciation. • In the short run, a fixed nominal exchange rate implies a fixed real exchange rate. • In the medium run, a fixed nominal exchange rate is consistent with an adjustment of the real exchange rate through movements in the price level.

9. The Case For andAgainst a Devaluation • The case for devaluation is that, in a fixed exchange rate regime, a devaluation (an increase in the nominal exchange rate) 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.

10. The Case For andAgainst a Devaluation Adjustment with a Devaluation The right size devaluation can shift aggregate demand to the right, leading the economy to go to point C. At point C, output is back to the natural level of output, and the real exchange rate is the same as at point B.

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

12. The Return of Britain to the Gold Standard: Keynes Versus Churchill • 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. Overvaluation of the pound among the reasons for Britain’s poor economic performance after World War I.

13. Exchange Rate CrisesUnder Fixed Exchange Rates 21-2 • 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 increase in the nominal exchange rate, or nominal depreciation. • The size of the devaluation can be estimated using the interest parity condition.

14. Exchange Rate CrisesUnder Fixed Exchange Rates • 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.

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

16. The 1992 EMS Crisis • Realignments are adjustments of parities between currencies. • The September 1992 EMS (European Monetary System) Crisis was the belief that several countries were soon going to devaluate. Some countries defended themselves by increasing the overnight interest rate by up to 500%. • In the end, some countries devalued, others dropped out of the EMS, and others remained.

17. Exchange Rate MovementsUnder Flexible Exchange Rates 21-3 • The current exchange rate depends on: • Current and expected domestic and foreign interest rates for each year over a given period. • The expected exchange rate at the end of the period.

18. Exchange Rate MovementsUnder Flexible Exchange Rates • Factors that influence the current exchange rate include: • Any factor which moves the expected future exchange rate. For example, forecasts of the current account balance. Trade deficits may lead to a depreciation. • Any factor that moves current or expected future domestic or foreign interest rates. For example, anticipations of high short-term interest rates in the future.

19. Choosing BetweenExchange Rate Regimes 21-4 • 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 and may be difficult to control them through monetary policy.

20. Choosing BetweenExchange Rate Regimes • In general, flexible exchange rates are preferable except when: • A group of countries is tightly integrated • A central bank cannot be trusted.

21. Common Currency Areas • For countries to constitute an optimal currency area, two conditions must be satisfied: • The countries experience similar shocks; thus, can choose roughly the same monetary policy. • Countries have high factor mobility, which allow countries to adjust to shocks. • A common currency, such as the Euro, allows countries to lower the transaction costs of trade.

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

23. Hard Pegs, Currency Boards,and 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. • A hard peg is the symbolic or technical mechanism by which a country plans to maintain exchange rate parity. • Dollarization is an extreme form of a hard peg. A less extreme way is the use of a currency board involving the central bank.

24. Key Terms • gold standard, • realignments, • overnight interest rate, • optimal currency area, • Euro, • Maastricht Treaty • European Central Bank (ECB), • hard peg, • dollarization, • currency board,