Chapter 21 - Exchange Rate Regimes
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1 Chapter 21 - Exchange Rate Regimes Equilibrium in the Short Run and in the Medium Run 1
2 When output is below the natural level of output, the price level turns out to be lower than was expected. This leads wage setters to revise their expectation of the price level downward, leading to a lower price level at a given level of output hence, the downward shift of the aggregate supply curve (put di erently, low demand causes the price level to fall) With regard to the aggregate demand curve, as P decreases, " decreases, and output increases Y = Y (" = EP P ; G; T ) In the short run, a xed nominal exchange rate implies a xed real exchange rate. In the medium run, a xed nominal exchange rate is consistent with 2
3 an adjustment of the real exchange rate through movements in the price level. Result: In the medium run, the economy reaches the same real exchange rate and the same level of output whether it operates under xed or under exible exchange rates. 3
4 The Case for and against a Devaluation 4
5 The result that, even under xed exchange rates, the economy returns to the natural level of output in the medium run is important. But it does not eliminate the fact that the process of adjustment may be long and painful. The case for devaluation is that, in a xed exchange rate regime, a devaluation leads to a real depreciation, 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 5
6 Exchange Rate Crises under Fixed Exchange Rates Suppose a country is operating under a xed exchange rate, and that nancial investors start believing there may soon be an exchange rate adjustment: The real exchange rate may be too high, the domestic currency may be overvalued. Internal conditions may call for a decrease in the domestic interest rate, a decrease in the domestic interest rate cannot be achieved under xed exchange rates. Expectations that a devaluation may be coming can trigger an exchange rate crisis that is a speculative attack i t = i t Et+1 e E t E t 6
7 Suppose that a rumor spreads that the central bank is going to abandon the exchange-rate peg. People would respond by rushing to the central bank to convert domestic currency into dollars before the domestic currency loses value. This rush would drain the central bank s reserves and could force the central bank to abandon the peg. In this case, the rumor would prove self-ful lling. 7
8 The government and central bank have a few options: They can try to convince markets they have no intention of devaluing. The central bank can increase the interest rate. Eventually, the choice for the central bank becomes either to increase the interest rate or to validate the market s expectations and devalue. To summarize, expectations that a devaluation may be coming can trigger an exchange rate crisis. Faced with such expectations, the government has two options: Give in and devalue. Fight and maintain the parity. 8
9 Exchange Rate Movements under Flexible Exchange Rates Take the interest parity condition: Multiply both sides by E e t+1 (1 + i t ) = (1 + i t ) E t E e t+1 E t = 1 + i t 1 + i Et+1 e t Then write the equation for year t+1 rather than for year t: E t+1 = 1 + i t i Et+2 e t+1 The expectation of the exchange rate in year t+1, held as of year t, is 9
10 given by E t+1 = 1 + ie t i e Et+2 e t+1 Replacing E e t+1 with the expression above gives E t = (1 + i t)(1 + i e t+1) (1 + i t )(1 + i e t+1 )Ee t+2 Continuing to solve forward in time in the same way we get E t = (1 + i t)(1 + i e t+1):::(1 + i e t+n) (1 + i t )(1 + i e ):::(1 + ie t+1 t+n) Ee t+n+1 This relation tells us that the current exchange rate depends on two sets of factors: 10
11 Current and expected domestic and foreign interest rates for each year over the next 10 years. The expected exchange rate 10 years from now. Exchange Rates and the Current Account Any factor that moves the expected future exchange rate moves the current exchange rate Et. Indeed, if the domestic interest rate and the foreign interest rate are expected to be the same in both countries from t to t+n, the fraction on the right of E t = (1 + i t)(1 + i e t+1):::(1 + i e t+n) (1 + i t )(1 + i e ):::(1 + ie t+1 t+n) Ee t+n+1 is equal to one, so the relation reduces to E t = E e t+1 11
12 Exchange Rates and Current and Future Interest Rates Any factor that moves the current or expected future domestic or foreign interest rates between year t and t+n moves the current exchange rate. Pros and Cons of Di erent Exchange-Rate Systems Fixed rates provide greater certainty for exporters and importers. It also convinces nancial markets that a country is serious about reducing money growth is a pledge to x its exchange rate, now and in the future, which in the long run should keep interest rates down and stimulate increased trade and investment. Yet, in the short run, under xed exchange rates, a country gives up its control of the interest rate and the exchange rate. A system of 12
13 oating exchange rates leaves monetary policy-makers free to pursue other goals, such as stabilizing employment or prices Also if you decide to x your currency, you now have to stand ready to buy and sell foreign currency for a domestic currency Problem: You might run out of foreign currency. In this case, the central bank has no choice but to abandon the xed exchange rate and let the domestic currency depreciate This fact raises the possibility of a speculative attack Moreover, after the world (many of the industrialized nations) abandoned the Bretton Woods system of xed exchange rate, the amount of world trade has continued to rise. In fact, there are many other policy rules than committing to a xed 13
14 exchange rate to discipline a nation s monetary authority. During periods of oating exchange rates, countries often use formal or informal targets for the exchange rate when deciding whether to expand or contract the money supply. Hence, we rarely observe exchange rates that are completely xed or completely oating. Instead, under both systems, stability of the exchange rate is usually one among many of the central bank s objective 14
15 Speculative Attacks, Currency Boards, and Dollarization. If you decide to x your currency, you now have to stand ready to buy and sell foreign currency for a domestic currency Problem: You might run out of foreign currency. In this case, the central bank has no choice but to abandon the xed exchange rate and let the domestic currency depreciate This fact raises the possibility of a speculative attack suppose that a rumor spreads that the central bank is going to abandon the exchange-rate peg. People would respond by rushing to the central bank to convert domestic currency into dollars before the domestic currency loses value. This rush would drain the central bank s reserves and could force the central bank to abandon the peg. In this case, the rumor would prove self-ful lling. 15
16 When the central bank cannot be trusted to follow a responsible monetary policy under exible exchange rates, a strong form of xed exchange rates, such as a currency board or dollarization, may provide a solution. Currency board: the central bank holds enough foreign currency to back each unit of the domestic currency. (No matter how many domestic currency turned up at the central bank to be exchanged, the central bank would never run out of foreign currency.) It is a very strict form of xed exchange rate regime with explicit legislative commitments. Once a central bank has adopted a currency board, it might consider the natural next step: it can abandon the domestic currency altogether and let its country use the U.S. dollar. Such a plan is called dollarization. It happens on its own in high-in ation economies, where foreign currencies o er a more reliable store of value than the domestic 16
17 currency The only loss from dollarization. is the small seigniorage revenue,which accrues to the U.S. government. 17
18 Common Currency Areas For countries to constitute an optimal currency area, two conditions must be satis ed: 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. 18
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