Chapter 21: Exchange Rates: Adjustments, Crises, and Regimes

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Chapter 21 Exchange Rates Adjustments,
Crises, and Regimes

• 21-1 Fixed Exchange Rates and the Adjustment of
  the Real Exchange Rate
• 21-2 Exchange Rate Crises
• 21-3 Choosing Between Exchange Rate Regimes
• Appendix Exchange Rate Movements

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21-1 Fixed Exchange Rates and the Adjustment of
the Real Exchange Rate

• Aggregate Demand Under Fixed Exchange Rates
• Aggregate Demand and Aggregate Supply

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Aggregate Demand Under Fixed Exchange Rates

• Recall the IS function from Chapter 20
• Y C(Y-T) I(Y,r) G NX(Y,Y,e)
• Adding fixed exchange rates means we have to
  change two parts of this
• Investment
• Net Exports

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Aggregate Demand Under Fixed Exchange Rates
Contd.

• Investment depends on real interest rates, r
• Where r i pe
• However, under fixed exchange rates, i must be
  held equal to foreign rates, i
• Also, real exchange rates, e, can be expressed
  as
• e EP/P
• However, nominal rates are fixed at Eoverbar
• So, the IS becomes
• Y C(Y-T) I(Y, i pe) G NX(Y,Y,
  EoverbarP/P)

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Aggregate Demand Under Fixed Exchange Rates Contd

• The addition of fixed exchange rates hasnt added
  much to how the IS operates
• Changes in interest rates still affect
  investment, but you now import the interest
  rate from the country you pegged your currency to
• The channel explaining how prices move inversely
  with aggregate demand has changed
• Closed Economy increasing prices increase money
  demand, pushing up interest rates, and investment
  - and therefore - output down
• Open Economy increasing prices mean domestic
  goods are relatively expensive, pushing (gross)
  exports down, (gross) imports up, net exports
  down and therefore output down

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Aggregate Demand and Aggregate Supply

• What happens in a recession if you dont devalue
  your currency?
• In the short-run, price expectations are fixed,
  and so is aggregate supply
• In the medium-run, prices and price expectations
  adjust - shifting the AS downward - to return the
  economy (slowly) to the natural level of output
• Essentially, the price adjustment slowly
  depreciates your currency (in real terms)

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Aggregate Demand and Aggregate Supply Contd

• What happens in a recession if you choose to
  devalue your currency?
• Devaluing increases your net exports, and shifts
  aggregate demand to the right
• Devaluing by the right amount can shift you
  immediately out to the natural level of output
• Choosing the right amount is problematic
• The J-curve leads to additional social problems

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21-2 Exchange Rate Crises

• Crises in the European Monetary System

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Crises in the European Monetary System

• The EMS was a system in which currencies floated
  within upper and lower bands
• Devaluations typically result from a
• (Factual) macroeconomics disparity, or the
• (Perception) that a devaluation is imminent
• Generally speaking, the problem is always that
  you cant control your own interest rate yet it
  may be desirable to raise or lower it

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21-3 Choosing Between Exchange Rate Regimes

• The Problems of Flexible Exchange Rates
• The Limited Costs of Fixed Exchange Rates
• The Benefits of Fixed Exchange Rates

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The Problems of Flexible Exchange Rates

• Flexible exchange appears to offer a lot of
  advantages over fixed exchange
• However, there are problems
• Flexible exchange rates fluctuate for
  non-fundamental reasons
• The value of the currency doesnt have a central
  tendency
• Stabilizing these fluctuations may require big
  changes in domestic interest rates

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The Limited Costs of Fixed Exchange Rates

• Fixed exchange seems to work best where there is
  an optimal currency area. For this to appear you
  need
• Regions to be hit by similar shocks
• So that governments in different regions are not
  responding to different shocks
• Factors to be mobile across regions
• Arbitrage of value occurs through productivity
  not the currency

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The Benefits of Fixed Exchange Rates

• Two primary benefits
• Low cost contracting for firms
• Firms can and do negotiate forward contracts
  (which guarantee an exchange rate in the future)
  but they would all prefer not to have to do
  this
• Most governments do not appear to be responsible
  enough to conduct their own monetary policy
• Fixed exchange takes the temptation away

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Appendix Exchange Rate Movements

• Not required