Fixed Exchange Rates and Currency Unions

1. Fixed Exchange Rates and Currency Unions

2. Introduction • Why would a government buy or sell foreign exchange? • How does the overall economy and economic policy change when the exchange rate is not allowed to float freely? • How do fixed exchange rate systems work? • How do countries with fixed exchange rates affect the world economy?

3. Inconvertible Currencies • To fix a currency can make it an inconvertible currency • One that cannot be freely traded for another country’s currency among domestic consumers and businesses • Common term for this system is exchange controls • Government or central bank becomes a monopolist controlling all sales of foreign currency at set price • Easy to “fix” the price of foreign exchange • Common among developing countries

4. Inconvertible Currencies • Foreign exchange market • Downward sloping demand • Perfectly inelastic supply • One seller of foreign exchange - government • Equilibrium at intersection determines fixed exchange rate • Government balances available supply of foreign exchange with demand to achieve set exchange rate

5. Inconvertible Currencies

6. Inconvertible Currencies • To keep exchange rate fixed, total outflows and inflows must be equal at all times • Requires government to control flow of capital into and out of the country • Domestic individuals and companies’ ability to purchase foreign financial assets is severely limited.

7. Difficulties & Exchange Controls • Exchange controls lead to • Government initially balancing demand and supply for foreign exchange • Eliminated wide swings in exchange rate • Difficulties with exchange controls • Must deal with government bureaucracy • Government sole source of foreign exchange • Less quality than free market • Efficiency losses with only one provider

8. Difficulties & Exchange Controls • Difference between nominal and real exchange rates • If nominal rate close to PPP rate, then relatively sustainable • Money supplies in developing countries difficult to control • Domestic inflation rate can likely be greater than foreign inflation rate • Country’s real exchange rate is depreciating and nominal rate is becoming over valued

9. Difficulties & Exchange Controls • Difference between nominal and real exchange rates (cont.) • Assume expansionary policies - economy expands and price level increases • Real exchange rate depreciates and nominal rate is fixed • Imports relatively cheaper and domestic demand increasing – rising demand for foreign exchange • Excess demand at fixed exchange rate

10. Difficulties & Exchange Controls

11. Difficulties & Exchange Controls • Balancing demand leaves 3 options • Allow currency to depreciate • Large depreciation can cause higher inflation and lower GDP • Government could implement contractionary policies to reduce demand for foreign exchange • Sacrifice domestic demand to maintain exchange rate

12. Difficulties & Exchange Controls • Balancing demand leaves 3 options • Ration available supply of foreign exchange • Government decides who gets the foreign exchange • Should provide for necessary imports and deny for unnecessary • What is considered necessary? • Obviously gives way to large incentives for government corruption

13. Difficulties & Exchange Controls • Additional problems for economy • Depreciation of real exchange rate makes exports more expensive • Supply for foreign exchange available to country coming from exports decreases • Shortage of foreign exchange increases • Rationing problem is more severe • May cause product and input shortages in domestic markets

14. Difficulties & Exchange Controls

15. Intervention: Foreign Exchange • Government may choose to peg their currency to that of another currency • Mexico might peg peso to US dollar • Mexico uses intervention – buying and selling of foreign exchange to influence value of exchange rate • Mexico selling foreign exchange increases supply and Mexico buying dollars increases demand

16. Intervention: Foreign Exchange • Foreign exchange market in equilibrium with Mexico pegging rate of XRP • Economic growth – increase demand for foreign exchange • To maintain XRP, government sells foreign exchange to increase supply • Maintains exchange rate and prevents depreciation of currency

17. Intervention: Foreign Exchange

18. Intervention: Foreign Exchange • Assume Mexico’s interest rates increase relative to US • Capital flows to Mexico increasing supply of foreign exchange • To peg rate, Mexico purchases foreign exchange increasing demand • Maintains exchange rate and prevents appreciation of currency

19. Intervention: Foreign Exchange

20. Intervention: Foreign Exchange • Long run can hold rate as long as can buy or sell foreign exchange • Mobile portfolio capital can be a good or bad thing for a country with fixed rate • Inflows create additional supply of foreign exchange for country • Capital flows volatile in short run and create problems when outflow from domestic markets • If cannot maintain peg, can lead to “currency crisis” causing severe depreciation of currency

21. Macro Adjustment – Fixed Rates I • Internal balance must be adjusted to stay in line with a fixed exchange rate over time • Example: Assume domestic economy growing quickly • Domestic demand for foreign exchange increases as demand for imports increases • Private sector has balance of payments deficit

22. Macro Adjustment – Fixed Rates I • Example (cont.) • Government sells foreign currency in foreign exchange market to maintain exchange rate • AD increases and hope current account deficit keeps it from going past full employment level • With sufficient reserves, government can intervene until economic growth slows

23. Macro Adjustment – Fixed Rates I

24. Macro Adjustment – Fixed Rates I • Example (cont.) • With government intervention in foreign exchange market, economic situation will correct itself • When government sells foreign currency they are getting domestic currency in exchange • This leads to decrease in domestic money supply (similar to selling government bonds)

25. Macro Adjustment – Fixed Rates I • Example (cont.) • Foreign exchange is not part of country’s money supply • The country’s monetary base is reduced by amount of intervention • Domestic money supply contracts by multiple of amount of intervention

26. Macro Adjustment – Fixed Rates I • Example (cont.) • Effects of intervention • The exchange rate is stabilized in the short run as shown earlier • Begun automatic adjustment almost guaranteeing balance of payments deficit will not continue in long run

27. Macro Adjustment – Fixed Rates I • Effects of intervention • AD falls with fall in money supply • Equilibrium levels of output and price level fall • Maintained fixed exchange rate by reducing rate of economic growth • Allows not only exchange rate to be fixed, but automatically adjusts economy for sustainable external equilibrium

28. Macro Adjustment – Fixed Rates I • Maintaining fixed exchange rate takes away governments ability to use discretionary monetary policy to influence the economy • Money supply becomes a function of country’s external balance based on how much government must intervene in foreign exchange market

29. Macro Adjustment – Fixed Rates II • Along with benefits, there is a cost associated with fixed exchange rates • Automatic changes from intervention occur without considering the state of the domestic economy • Assume external balance is in deficit and economy is producing less than full employment

30. Macro Adjustment – Fixed Rates II • Money supply declines and country’s external balance is balanced • Internal balance would change decreasing output and unemployment would increase • Intervention in this case is inconsistent with internal balances • However, some cases it can be consistent

31. Macro Adjustment – Fixed Rates II • Table 17.1 summarizes effects of intervention on external and internal balances • First column – state of internal balance • Second column – position of external balance • Third & fourth – appropriate government response to solve internal and external balance respectively • Last column – lists consistency

32. Macro Adjustment – Fixed Rates II • Two cases where monetary policy solves internal and external balances – consistent • Two case where internal and external balances conflict – inconsistent • These two cases of inconsistency make fixing exchange rates a problem for some countries

33. Macro Adjustment – Fixed Rates II

34. Macro Adjustment – Fixed Rates II • Inconsistencies • External deficit when at less than full employment, adjustment leads to recession to maintain fixed exchange rates • External surplus with high inflation or rapid economic growth, adjustment leads to higher inflation or more rapid economic growth

35. Macro Adjustment – Fixed Rates II • Most participants in international trade prefer fixed exchange rates as it decreases risk of transactions • But, fixed exchange rates mean that on occasion internal and external balances will be mismatched with policy

36. Fiscal Policy & Internal Balance • In the short run, there are solutions to the dilemma between internal and external balances • Government can assign roles • Monetary policy for external balance • Fiscal policy for internal balance • Example: government adopts expansionary fiscal policy

37. Fiscal Policy & Internal Balance • Example (cont.) - • Government budget deficit financed through borrowing • Demand for loanable funds increases raising interest rates (D to D’) • Open economy, rise in interest rates creates inflow of foreign capital • Domestic supply of loanable funds increases (S to S+f)

38. Fiscal Policy & Internal Balance

39. Fiscal Policy & Internal Balance • Example (cont.) • Inflow of capital requires foreign investors to sell foreign currency or buy domestic currency • Supply of foreign exchange increases • Exchange rate to appreciate, but with fixed rate government intervenes • Demand for foreign exchange increases maintaining pegged or fixed rate

40. Fiscal Policy & Internal Balance

41. Fiscal Policy & Internal Balance • Example (cont.) • Secondary effect on market for loanable funds • Government purchases of foreign exchange increases domestic money supply • Increase in money supply leads to increase in supply of loanable funds (S+f to S’+f) • Equilibrium interest rate moves back toward ie

42. Fiscal Policy & Internal Balance

43. Effects of Fiscal Policy - Domestic • Expansionary fiscal policy • Increases AD, increasing output and price level • Intervention in foreign exchange increases money supply • AD increases even more with increase in money supply • With open economy and fixed exchange rates, effect of policy are more pronounced

44. Effects of Fiscal Policy - Domestic

45. Effects of Fiscal Policy - Domestic • Contractionary Fiscal Policy • Demand for loanable funds decreases • Lowers interest rate • Investment in domestic country decreases – capital outflows • Supply of loanable funds decreases (S to S-f) • Interest rates increase towards original equilibrium

46. Effects of Fiscal Policy - Domestic

47. Effects of Fiscal Policy - Domestic • Contractionary Fiscal Policy (cont.) • Capital outflow causes demand for foreign exchange to increase • Pressure for currency to depreciate • Intervention in foreign exchange market leads to increase in supply of foreign exchange to maintain fixed rate

48. Effects of Fiscal Policy - Domestic

49. Effects of Fiscal Policy - Domestic • Contractionary Fiscal Policy (cont.) • Secondary effect from change in money supply • Selling foreign exchange buys domestic currency decreasing money supply • Supply of loanable funds decreases even further moving equilibrium interest rate back toward original rate

50. Effects of Fiscal Policy - Domestic