George Alogoskoufis, International Macroeconomics and Finance Chapter 7 Fixed Exchange Rate Regimes and Short Run Macroeconomic Policy Up to now we have been assuming that the exchange rate is determined freely in foreign exchange markets. However, many governments and central banks choose to fix (peg) the exchange rate of their currency, or even to have no national currency at all. Fixed exchange rate regimes also applied for the major economies in many historical periods, such as the gold standard period (1870-1914) and the Bretton Woods system (1944-1973). Furthermore, between 1978 and the creation of the euro in 1999, most of the countries of the European Union operated a fixed exchange regime among their currencies, called the European Monetary System. In addition, many countries follow exchange rate regimes that are between fixed and floating exchange rates. Such regimes are called soft pegs, and include pegs with fluctuations within a wide band, or a crawling peg. Most countries that follow pegs, peg against the US dollar (43), then the euro (29) or a composite of major currencies (12). Many adopt monetary or inflation targets as well. When a central banks wants to stabilize the exchange rate of its currency under free capital mobility, it has to intervene in the foreign exchange market by buying and selling foreign currencies at the fixed exchange rate. Thus, the monetary base and the money supply fluctuate as a result of continuous foreign exchange market interventions, and the central bank loses control of its money supply and cannot follow an independent monetary policy. To put it differently, a fixed (pegged) exchange rate means that for uncovered interest parity to hold, domestic interest rates may not depart from foreign interest rates. Monetary policy is subordinated to the goal of maintaining a fixed exchange rate. An open economy cannot simultaneously select control of its foreign exchange rate, control over its monetary policy and free movement of capital This is the essence of the trilemma of open economies. In this chapter we concentrate on the implications of fixed exchange rate regimes for the conduct of macroeconomic policy. 7.1 The Ineffectiveness of Monetary Policy under Capital Mobility and Fixed Exchange Rates The analysis of the ineffectiveness of monetary policy under fixed exchange rate regimes and free capital mobility will be conducted with the help of our familiar DD-AA-XX diagram.
Consider an economy that is in short run equilibrium with a balanced current account. The central bank is committed to a fixed exchange rate and there is free capital mobility, so that uncovered interest parity must hold. The situation is depicted in Figure 7.1. The exchange rate is fixed at S0, output is at Y0 and the current account is in balance. However, the central bank is dissatisfied with output at Y0 because this implies high unemployment. It thus seeks to expand the money supply by increasing domestic credit. The moment it does this, there will be a tendency for domestic interest rates to fall below international interest rates, and for the exchange rate to depreciate towards S1. The central bank will thus be forced to intervene in the foreign exchange market selling foreign exchange rate reserves and buying back its currency at the exchange rate S0. This will continue until the original increase in the money supply is fully reversed, and the economy returns to the initial point E0. The attempt of the central bank to expand the money supply was totally fruitless. 7.2 The Effects of Fiscal Policy under Fixed Exchange Rates On the other hand, suppose that, instead of a monetary expansion by the central bank, the government of the country increased government expenditure or cut taxes. This amounts to a fiscal expansion. The analysis of this case is in terms of Figure 7.2. The fiscal expansion increases aggregate demand, and therefore output and employment. As a result, for a given money supply, there is upward pressure on interest rates and the exchange rate. The central bank intervenes by buying foreign exchange in order to stop the appreciation of the exchange rate. As a result, the money supply expands. The process continues until the money supply has increased by enough to ensure that domestic interest rates are back to their original level, equal to international interest rates and the exchange rate has remained at S0. Thus the fiscal expansion has resulted in an increase in output for Y0 to Y1, and a fall in unemployment, and the exchange rate has remained constant, through the interventions of the central bank and the concomitant increase in the money supply. Fiscal policy is indeed more effective in raising output and employment under fixed exchange rates than under floating exchange rates, because there is no appreciation of the exchange rate to reduce the effectiveness of fiscal policy. However, a fiscal expansion results in a potential conflict between internal and external balance even under fixed exchange rates, as the current account moves into deficit through the expansion in income and the increase in imports that results. In effect, a country that faces both high unemployment and high current account deficits would not be able to reduce unemployment without causing even higher current account deficits by using fiscal policy. If one the other hand it aimed to reduce its current account deficits through a fiscal contraction, this would result in a further increase in unemployment. Thus, the country would be faced with a stark conflict between the objectives of internal and external balance. 7.3 The Effects of a Discrete Devaluation under Fixed Exchange Rates There have been many occasions where countries have been faced with the conflict between the objectives of internal and external balance in a fixed exchange rate regime.!2
The only solution that does not imply a reversion to a regime of floating exchange rates has been a discrete one off devaluation of the exchange rate, and a new fixed exchange rate with a devalued exchange rate. The effects of a devaluation are analyzed with the help of Figure 7.3. A devaluation from S0 to S1 automatically causes an increase in the domestic currency value of the reserves of the central bank, and automatically results in an increase in the domestic money supply. This shifts the AA curve to the left, and causes an increase in output from Y0 to Y1, as aggregate demand increases along the DD curve, through the increase in exports and the contraction of imports. Furthermore the current account improves, and there is no conflict between the reduction in unemployment and the current account. Hence, a one off devaluation can work as a short term solution for an economy that has adopted a fixed exchange rate regime and is plagued by both internal and external imbalances. 7.4 Conclusions Under perfect capital mobility and fixed exchange rate, a country loses control of monetary policy, as monetary policy targets the exchange rate and cannot affect output and employment. Fiscal policy, whether it is based on temporary or permanent changes, becomes more effective, as fiscal policy changes do not induce changes in the exchange rate. However, as in the case of floating exchange rates, fiscal policy still implies a tradeoff between internal and external balance. Unlike fiscal policy, a one off devaluation can cause a short run increase in output and employment with an improvement in the current account. Thus, a one off devaluation is not characterized by a tradeoff between the objectives of internal and external balance.!3
Figure 7.1 Ineffectiveness of Monetary Policy under Capital Mobility and Fixed Exchange Rates!4
Figure 7.2 Fiscal Policy under Capital Mobility and Fixed Exchange Rates A Conflict between Internal and External Balance!5
Figure 7.3 Effects of a one off Devaluation of the Exchange Rate No Conflict between Internal and External Balance!6