4/14/2011. Exchange Rate Policy and Devaluation. The Central Bank Balance Sheet. Central Bank Policy Options in a Crisis

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1 Exchange Rate Policy and Devaluation BOP Surpluses: excess supply of Forex CB buys BOP Deficits: excess demand for Forex CB sells OSB must offset BOP ISLM-FX with an unexpected devaluation ISLM-FX with devaluation expectations The Central Bank Balance Sheet How Deposit Expansion Works Tools of the Central Bank MB = Bonds + FXR Graph of Bonds vs. MB: Falling off the Cliff Central Bank Policy Options in a Crisis Active defense: sell bonds to increase interest rates (the case of Sweden) Passive defense: sell Forex reserves to clear market, OSB Surplus counteracts BOP Deficit Sterilization Unilateral vs. Multilateral Rates: one-sided risk for speculators, self-fulfilling prophecy The Problem of Credibility Currency Boards The Trilemma 1

2 Inflation and Deflation Importing inflation: fixed vs. floating regimes Effects of Deflation: Real exchange rate rises, real balances rise, but Fisher s debt-deflation problem Consumption rises after deflation, but falls on anticipation Anticipation increases real interest rates, reduces Investment Deposit expansion multiplier decreases cash pays Money demand increases zero interest rates Supply-driven vs. Demand-driven deflation International Evidence (Guerrero & Parker) Macroeconomic Policy in the Short-Run, Medium-Run, and Long-Run AD downward-sloping in (P, real Y) but deflation can shift it backwards LRAS is vertical though it can shift with capital investment and depreciation SRAS is flat, especially if Y is low, but it stops at the LRAS. It shifts up with expected inflation. In short-run, P is sticky and Y slow, but i and E adjust. In medium-run, P is sticky, and ISLM-FX fits. In long-run, P adjust to LRAS, and E adjusts to PPP. Supply shocks can lead to stagflation in medium run. Macroeconomic Policy in the Short-Run, Medium-Run, and Long-Run Under Fixed Rates: Monetary policy can affect i, BOP in SR, but in medium-run you are back where you began. Fiscal policy is slow to affect i, BOP, and Y, but in medium-run Y increases. In long-run, this causes inflation unless economy is in a serious recession. Under Floating Rates: Monetary policy can affect i and E in SR, and in medium-run Y and CA increase. In long-run, this causes inflation. Fiscal policy is slow to affect I or E in SR, but in medium-run CA falls so increase in Y is crowded out. In long-run, this has little effect on Y or P. A permanent policy change is more likely to affect E e and P. 2

3 Monetary Discipline Because of the trilemma, fixed rates and open financial markets makes monetary autonomy impossible. If central banks act responsibly, targeting low inflation rates or long-run price paths, then monetary autonomy allows for some flexibility during shocks. If central banks act irresponsibly, then monetary autonomy can lead to high inflation. Fixed rates may impose discipline, but fixing rates without discipline leads to much worse crises. Devaluations are worse than depreciations, because of credibility and lack of hedging. Seignorage Fixed vs. Floating Rates Fixed Rates Monetary discipline. Less need for hedging forex markets. Encourages international trade and investment. Tail wagging the dog: equilibrium maintained through money supply. Diversification for fiscal shocks. Floating Rates Monetary autonomy. Capital markets develop. Hedging markets offset exchange risk, depreciation less catastrophic. Exchange rates insulate from foreign shocks. Diversification for monetary shocks. 3

4 Alternatives for Fixing Rates Fixed, Clean Floating, Dirty Floating. Adjustable bands and crawling pegs. Currency boards: single-currency vs. trade-weighted market basket (none fixed). IMF Special Drawing Rights. Dollarization: U.S. gets seignorage. Symmetry and Integration Fixing an exchange rate can cause trouble when countries have asymmetric shocks. Fixing an exchange rate has benefits of improved stability when economies are have integrated financial and labor markets. Tradeoff? More of one compensates for less of another. See graph. Brief History of Exchange Rate Regimes: The Gold Standard Private banking and specie money U.K Resumption Act. U.S. Coinage Act of 1873, 1879 Dollar pegged to gold, 1900 Gold Standard Act. Hume s Specie-Flow Mechanism. Beggar Thy Neighbor approach to international trade. Gold supply limited, money demand rising, deflation resulted. Central bank preference for contractionary monetary policy to create gold inflows. Short-run instability in prices, recessions, deflation. 4

5 The Interwar Period U.S. Federal Reserve System created in First World War: gold standard suspended. U.S. repegged to gold in Weimar Germany experienced hyperinflation , then repegged new Mark to gold. U.K. repegged to gold on Churchill s advice in 1925, at pre-war rate. This forced a monetary contraction, and Britain s economy stagnated. London lost role of world s financial capital. Not enough gold to back up world money supply: a modified gold exchange system, with increased use of fiat money. The Depression FRB had expansionary monetary policy , to help stabilize Pound. Financial bubble in property and stocks, aided by unregulated banks lending on margin. Tight monetary policy in 1928 helped burst the bubble in 1929, margin calls led to massive selloff. Fed defended currency against speculation in 1931 with higher rates, failed to rescue banks from collapse. U.K., Sweden, some others left Gold Standard in Germany did not, causing monetary contraction. Price deflation led to rising debt ratios, balanced budget issues led to downward spiral. FRB accumulated large gold reserves. U.S. went off gold standard, budget balancing in States continued to balance budgets. Bretton Woods System 1944 Agreement: Keynes, White, 44 countries. Multicurrency concept of Bancors replaced by Dollar Reserve system at $35/oz. IBRD/World Bank for development lending. International Monetary Fund lending for BOP crises. Pegged rates with adjustable bands. Asymmetric adjustment for U.S. Triffin Dilemma: the need for more, but stable, dollars. Tax cuts, military spending, U.S. BOP deficits. Germany and Japan buying Dollars, France selling. 5

6 The End of Fixed Rates Johnson s capital flow taxes, Two-Tier Agreement. Volcker Commission findings. August 1971 U.S. severed ties to gold, imposed tariffs to devalue Dollar. Smithsonian Agreement of Lower Dollar plus OPEC Embargo? Rambouillet Agreement of FRB continued to target interest rates until 1979, when Volcker became Chairman. Many other central banks accommodated. U.S. tight money plus tax cuts and military spending led to rising real interest rates, rising Dollar. Plaza Accord of 1985, Louvre Accord of 1987, Japanese bubble of Macroeconomic Coordination Model Home and Foreign countries linked through CA, BOP or E. Assume CA(Y*) and CA*(Y) positive. Under fixed rates, a BOP deficit at Home makes M fall, M* rise, or both. Under floating rates, excess forex demand makes E rise, so CA rises. E* and CA* fall. Price inflation in one country is exported under fixed rates, insulated under floating rates. Fiscal policy is accommodated by monetary policy under fixed rates, offset by E CA under floating. Monetary policy is offset under fixed rates, but assisted by E CA under floating. Using the Coordination Model HH-FF Model in (Y,Y*) space. Expansionary fiscal and monetary policies shift HH line, but then you have to consider adjustment to M or E. Protectionism increases CA, decreases CA*, but then consider adjustment to M or E. What policy in Foreign is in Home country s best interest? U.S. advice for Japan. What happens if Home uses fiscal policy, and Foreign uses monetary policy? Germany in What are the benefits of coordination? 6