Chapter 10 (part 2) Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy. Copyright 2009 Pearson Education Canada

Today Last class we saw the policy implications in the Mundell-Fleming model with flexible exchange rates: Fiscal policy was found to be ineffective in stimulating the economy: instead it crowded out net exports Monetary policy was very effective in stimulating output in the short run (Keynesian), but not if prices responded immediately (Classical) Today, we ll consider fixed exchange rates Copyright 2009 Pearson Education Canada 10-2

Fixed Exchange Rates In a fixed-exchange-rate system, the value of the nominal exchange rate is officially set by the government. e nom is fixed relative to some standard such as gold, US $, etc. The open market gives the fundamental value of the exchange rate. In contrast, a fixed e nom doesn t adjust to the S and D for currency How does the use of a fixed-exchange rate system affect an economy and macro policy? Which regime is better: flexible or fixed? Copyright 2009 Pearson Education Canada 10-3

Fixing the Exchange Rate The fundamental value of the exchange rate (e 1 nom) is the exchange rate that would be determined d by S and D in the foreign exchange market, without government intervention. An overvalued exchange rate (or overvalued currency) is a situation when an fixed exchange rate (e nom ) is higher that its fundamental value (e 1 nom) nom Copyright 2009 Pearson Education Canada 10-4

Overvalued Exchange Rate In a situation of an overvalued exchange rate a government can: make value of the exchange rate equal to the fundamental value (devaluation) restrict inflows/outflows of capital and imports (reduce the supply of domestic currency) the country s central bank can use official reserve assets to buy back its own currency y( (most common) Copyright 2009 Pearson Education Canada 10-5

Can this happen forever? No: there is a finite amount of reserves An attempt to support an overvalued currency can also be ended by a speculative run to avoid losses, financial investors frantically sell assets denominated in the overvalued currency. when investors believe an overvalued currency will be devalued, they sell off the currency supply of currency shifts deficit widens as e nom is maintained Occurred: UK in late 1992 and Mexico in 1994 Copyright 2009 Pearson Education Canada 10-7

How to Support an Overvalued Currency To support an overvalued currency a country could: impose strong restrictions on international trade and finance; devalue its currency; introduce a policy change to raise the fundamental value of the exchange rate (use monetary policy). Copyright 2009 Pearson Education Canada 10-10

Undervalued Exchange Rate Undervaluation is possible too. An undervalued exchange rate exists if the officially fixed value is lower than the fundamental value of the exchange rate. An undervalued u d exchange rate also cannot be maintained indefinitely since the country s trading partners will continue to lose their reserves. Copyright 2009 Pearson Education Canada 10-11

A Monetary Policy and the Fixed Exchange Rate Let's apply the IS-LM framework: Suppose there s an increase in M: shifts the LM curve to the right, r is below r For ; downward pressure on e nom (overvalued) and the central bank must maintain e nom so it will respond by reducing M; LM returns to i it s original i position ii Similarly, a decrease in M: shifts the LM curve to the left, r is above r For ; e nom is undervalued so the M has to be increased. With a fixed exchange rate monetary policy can t be used for macroeconomic stabilization Copyright 2009 Pearson Education Canada 10-13

Fiscal Policy and Fixed Exchange Rates An increase in G: IS shifts right, r rises, upward pressure on e nom The central bank responds: it raises M and the LM shifts right. M rises until r falls to r For, e nom stays put at its fixed level There is an important SR effect on Y here Y>Y FE : firms are over-heating so P rises Recall: e=(e nom P)/P for so e rises, NX falls and IS shifts back to it s original position LM shifts back to maintain e nom (although e changes because of P changing) Copyright 2009 Pearson Education Canada 10-16

Fiscal Policy (continued) Under a fixed exchange rate regime, and increase in G: Keynesian: can have big short run effect if P adjustment is sluggish Fiscal policy can be useful for stimulating output and employment in the SR Classical: l has no impact, since the price increase is instantaneous (NX is crowded out immediately) Copyright 2009 Pearson Education Canada 10-18

Fixed Exchange Rates: A Summary Monetary policy Completely ineffective given that the authorities must maintain the nominal exchange rate fixed. Fiscal policy Effective in the Keynesian short run at raising output. In the long run, fiscal policy has no effect on output. t Essentially causes the central bank to accommodate the increase in G because of the pressure put on the exchange rate. Copyright 2009 Pearson Education Canada 10-19

How to Choose an Exchange Rate System? Two benefits of the fixed system: stable exchange rates reduce uncertainty and make goods and asset trade easier disciplines central banks from running expansionary monetary policy constantly Three problems with the fixed system: Can't use monetary policy to offset recessions Lose monetary policy independence Vulnerable to speculative attacks No clear winner, depends on circumstances Copyright 2009 Pearson Education Canada 10-20

Open-Economy Trilemma In selecting an exchange rate system a country can choose only two of the three features: 1. a fixed exchange rate to promote trade 2. free international movement of capital 3. autonomy for domestic monetary policy. Copyright 2009 Pearson Education Canada 10-21

Fixed vs Flexible Exchange Rate System Fixed exchange rates can be useful when used in a group of countries: large benefits can be gained from increased trade and integration; monetary policies can be coordinated closely. A flexible exchange rate system is useful if a country has specific macroeconomic shocks: then they can be reduced with help of monetary policy. Copyright 2009 Pearson Education Canada 10-22

Currency Unions A currency union is an alternative to fixing exchange rates by sharing of a common currency with a group of countries. Pros: Promotes trade, since, with a single currency, trading cost is even less Using the common currency, speculative attacks can be avoided Con: must share monetary policy (asymmetric shocks are problematic to deal with) Copyright 2009 Pearson Education Canada 10-23

The Self-Correcting Small Open Economy After some sort of economic disturbance, price level adjustment will eventually restore the economy to general equilibrium i A small open economy has more sources of unexpected shocks (NX, foreign assets) than a closed economy However, (if the exchange rate is flexible) there also exists a self correcting mechanisms in addition to the price level an exchange rate adjustment. Copyright 2009 Pearson Education Canada 10-24

The Self-Correcting Small Economy (continued) In a closed economy, an unexpected shift in the IS curve requires a change in the domestic price to bring the economy back to general equilibrium In an open economy with flexible exchange rates, the same shift would require no changes in the price level On the other hand, unexpected shocks to the LM curve have a magnified impact on output in an open economy (though NX) than in a closed economy Copyright 2009 Pearson Education Canada 10-25

The Self-Correcting Small Economy (continued) In contrast, with fixed exchange rates, unexpected shifts to the IS curve have a magnified impact on output though the response of the domestic money supply to prevent an exchange rate over/under valuation Unexpected shifts to the LM curve are immediately counteracted by the selfcorrecting adjustment by way of the money supply, preventing output t from changing. Copyright 2009 Pearson Education Canada 10-26