Exchange Rate Regimes

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Exchange Rate Regimes
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Fixed Exchange Rates and the Adjustment of the
Real Exchange Rate

• In the medium run, the economy reaches the same
  real exchange rate and the same level of output
• (whether it operates under fixed exchange rates
  or under flexible exchange rates.)
• Under fixed exchange rates, the adjustment takes
  place through the price level rather than through
  the nominal exchange rate.

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Equilibrium in the Short Run and in the Medium Run

• In the short run, a fixed nominal exchange rate
  implies a fixed real exchange rate.
• In the medium run, a fixed nominal exchange rate
  will not prevent an adjustment of the real
  exchange rate through movements in the price
  level.

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The Case For and Against a Devaluation in the
Short Run

• The case for devaluation is that, in a fixed
  exchange rate regime, a devaluation leads to a
  real depreciation (an increase in the real
  exchange rate), 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.

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The Case For and Against a Devaluation

• The case against devaluation points out that
• In reality, it is difficult to achieve the right
  size devaluation.
• The initial effects of a depreciation may be
  contractionary (the J-curve effect).
• The price of imported goods increases, making
  consumers worse off temporarily. This may lead
  workers to ask for higher nominal wages, and
  firms to increase their prices as well.

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The Return of Britain to the Gold Standard
Keynes Vs. Churchill

• The gold standard was a system in which each
  country fixed the price of its currency in terms
  of gold. This system implied fixed nominal
  exchange rates between countries.
• Britain decided to return to the gold standard in
  1925. This required a large real appreciation of
  the pound.
• As a result, the overvaluation of the pound was
  among the reasons for Britains poor economic
  performance in the late 1920s.

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Exchange Rate CrisesUnder Fixed Exchange Rates

• Higher inflation, or the steady increase in the
  prices of domestic goods, leads to a steady real
  appreciation and worsening of a countrys trade
  position.
• Lowering the domestic interest rate triggers an
  decrease in the nominal exchange rate, or nominal
  depreciation.
• The size of the devaluation can be estimated
  using the interest parity condition.

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Exchange Rate CrisesUnder Fixed Exchange Rates

• Under fixed exchange rates, if markets expect
  that parity will be maintained, then they believe
  that the interest parity condition will hold
  therefore, the domestic and the foreign interest
  rates will be equal.

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Exchange Rate CrisesUnder Fixed Exchange Rates

• Expectations that a devaluation may be coming can
  trigger an exchange rate crisis. The government
  has two options
• Give in and devalue, or
• Fight and maintain the parity, at the cost of
  very high interest rates and a potential
  recession.

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The 1992 EMS Crisis

• Realignments are adjustments of parities between
  currencies.
• The September 1992 EMS (European Monetary System)
  Crisis was caused by the belief that several
  countries were soon going to devalue. Some
  countries defended themselves by increasing the
  overnight interest rate up to 500.
• In the end, some countries devalued, others
  dropped out of the EMS, and others remained.
• Roughly the same happened in Korea and Thailand
  in 1997.

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International Reserves Insuring against
financial crises
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Choosing Between Exchange Rate Regimes

• In the short run, under fixed exchange rates, a
  country gives up its control of the interest rate
  and the exchange rate.
• Also, anticipation that a country may be about to
  devalue its currency may lead investors to ask
  for very high interest rates.
• An argument against flexible exchange rates is
  that they may move a lot, may be difficult to
  control and lead to a volatile macroeconomic
  environment.

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The Euro A Short Story

• The European Monetary Union (EMU) was
  consolidated under the Maastricht Treaty (1991).
• In January 1999, parities between the currencies
  of 11 countries and the Euro were irrevocably
  fixed.
• In January 2001, the Euro replaced national
  currencies.
• The new European Central Bank (ECB), based in
  Frankfurt, became responsible for monetary policy
  for the Euro area.

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Advantages of a Common Currency

• Reduction in exchange rate risk
• Eliminates the risk of exchange rate variability,
  which increases capital market stability
• Reduction in transactions costs
• There is no exchange of currencies among members,
  so transaction costs are reduced
• Economies of scale
• Along with the dollar, the euro may serve as a
  reserve currency, so the EU gets interest free
  loans

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Disadvantages of a Common Currency

• Loss of independent monetary policy
• With a common currency monetary policy is the
  same in all countries because there is one money
  supply and one central bank
• Loss of national symbol
• Losing a national currency may be a loss of
  national identity or heritage

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Optimal Currency Areas

• An optimal currency area is a group of countries
  suitable to adopt a common currency without
  significantly jeopardizing domestic policy goals.
• Criteria for optimal currency areas
• Similar composition of industries
• Significant mobility for factors of production
  (labor and capital)
• Diversified economies
• Diverse demand shocks

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People Changing Region of Residence in the 1990s
(percent of total population)
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Optimal Currency Areas

• Are the American States an optimal currency area?
• Is the European Union an optimal currency area?
• Should Britain join the EMU (the Euro)?
• Did Ecuador do wisely in dollarizing its economy?
• What should Argentina do?
• Endogenous Optimal Currency Areas