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Fixed Exchange Rates and Currency Unions
Introduction Why would a government buy or sell foreign
exchange? How does the overall economy and
economic policy change when the exchange rate is not allowed to float freely?
How do fixed exchange rate systems work? How do countries with fixed exchange rates
affect the world economy?
Inconvertible Currencies To fix a currency can make it an
inconvertible currency One that cannot be freely traded for another
country’s currency among domestic consumers and businesses
Common term for this system is exchange controls
Government or central bank becomes a monopolist controlling all sales of foreign currency at set price
Easy to “fix” the price of foreign exchange Common among developing countries
Inconvertible Currencies Foreign exchange market
Downward sloping demand Perfectly inelastic supply
One seller of foreign exchange - government
Equilibrium at intersection determines fixed exchange rate
Government balances available supply of foreign exchange with demand to achieve set exchange rate
Inconvertible Currencies
Inconvertible Currencies To keep exchange rate fixed, total
outflows and inflows must be equal at all times
Requires government to control flow of capital into and out of the country Domestic individuals and companies’
ability to purchase foreign financial assets is severely limited.
Difficulties & Exchange Controls Exchange controls lead to
Government initially balancing demand and supply for foreign exchange
Eliminated wide swings in exchange rate Difficulties with exchange controls
1. Must deal with government bureaucracy Government sole source of foreign exchange Less quality than free market Efficiency losses with only one provider
Difficulties & Exchange Controls
2. Difference between nominal and real exchange rates
If nominal rate close to PPP rate, then relatively sustainable
Money supplies in developing countries difficult to control
Domestic inflation rate can likely be greater than foreign inflation rate
Country’s real exchange rate is depreciating and nominal rate is becoming over valued
Difficulties & Exchange Controls
2. Difference between nominal and real exchange rates (cont.)
Assume expansionary policies - economy expands and price level increases
Real exchange rate depreciates and nominal rate is fixed
Imports relatively cheaper and domestic demand increasing – rising demand for foreign exchange
Excess demand at fixed exchange rate
Difficulties & Exchange Controls
Difficulties & Exchange Controls Balancing demand leaves 3 options
1. Allow currency to depreciate Large depreciation can cause higher
inflation and lower GDP
2. Government could implement contractionary policies to reduce demand for foreign exchange Sacrifice domestic demand to maintain
exchange rate
Difficulties & Exchange Controls Balancing demand leaves 3
options3. Ration available supply of foreign
exchange Government decides who gets the foreign
exchange Should provide for necessary imports and
deny for unnecessary What is considered necessary?
Obviously gives way to large incentives for government corruption
Difficulties & Exchange Controls Additional problems for economy
Depreciation of real exchange rate makes exports more expensive
Supply for foreign exchange available to country coming from exports decreases
Shortage of foreign exchange increases Rationing problem is more severe May cause product and input shortages
in domestic markets
Difficulties & Exchange Controls
Intervention: Foreign Exchange Government may choose to peg
their currency to that of another currency Mexico might peg peso to US dollar Mexico uses intervention – buying and
selling of foreign exchange to influence value of exchange rate
Mexico selling foreign exchange increases supply and Mexico buying dollars increases demand
Intervention: Foreign Exchange
I. Foreign exchange market in equilibrium with Mexico pegging rate of XRP
Economic growth – increase demand for foreign exchange
To maintain XRP, government sells foreign exchange to increase supply
Maintains exchange rate and prevents depreciation of currency
Intervention: Foreign Exchange
Intervention: Foreign Exchange
II. Assume Mexico’s interest rates increase relative to US
Capital flows to Mexico increasing supply of foreign exchange
To peg rate, Mexico purchases foreign exchange increasing demand
Maintains exchange rate and prevents appreciation of currency
Intervention: Foreign Exchange
Intervention: Foreign Exchange
III. Long run can hold rate as long as can buy or sell foreign exchange
Mobile portfolio capital can be a good or bad thing for a country with fixed rate
Inflows create additional supply of foreign exchange for country
Capital flows volatile in short run and create problems when outflow from domestic markets
If cannot maintain peg, can lead to “currency crisis” causing severe depreciation of currency
Macro Adjustment – Fixed Rates I Internal balance must be adjusted to
stay in line with a fixed exchange rate over time
Example: Assume domestic economy growing quickly Domestic demand for foreign exchange
increases as demand for imports increases
Private sector has balance of payments deficit
Macro Adjustment – Fixed Rates I Example (cont.)
Government sells foreign currency in foreign exchange market to maintain exchange rate
AD increases and hope current account deficit keeps it from going past full employment level
With sufficient reserves, government can intervene until economic growth slows
Macro Adjustment – Fixed Rates I
Macro Adjustment – Fixed Rates I
Example (cont.) With government intervention in
foreign exchange market, economic situation will correct itself
When government sells foreign currency they are getting domestic currency in exchange
This leads to decrease in domestic money supply (similar to selling government bonds)
Macro Adjustment – Fixed Rates I
Example (cont.) Foreign exchange is not part of
country’s money supply The country’s monetary base is
reduced by amount of intervention Domestic money supply contracts by
multiple of amount of intervention
Macro Adjustment – Fixed Rates I
Example (cont.) Effects of intervention1. The exchange rate is stabilized in
the short run as shown earlier2. Begun automatic adjustment almost
guaranteeing balance of payments deficit will not continue in long run
Macro Adjustment – Fixed Rates I Effects of intervention
AD falls with fall in money supply Equilibrium levels of output and price
level fall Maintained fixed exchange rate by
reducing rate of economic growth Allows not only exchange rate to be
fixed, but automatically adjusts economy for sustainable external equilibrium
Macro Adjustment – Fixed Rates I Maintaining fixed exchange rate takes
away governments ability to use discretionary monetary policy to influence the economy
Money supply becomes a function of country’s external balance based on how much government must intervene in foreign exchange market
Macro Adjustment – Fixed Rates II Along with benefits, there is a cost
associated with fixed exchange rates Automatic changes from intervention
occur without considering the state of the domestic economy
Assume external balance is in deficit and economy is producing less than full employment
Macro Adjustment – Fixed Rates II
Money supply declines and country’s external balance is balanced
Internal balance would change decreasing output and unemployment would increase
Intervention in this case is inconsistent with internal balances
However, some cases it can be consistent
Macro Adjustment – Fixed Rates II Table 17.1 summarizes effects of
intervention on external and internal balances
First column – state of internal balance Second column – position of external balance Third & fourth – appropriate government
response to solve internal and external balance respectively
Last column – lists consistency
Macro Adjustment – Fixed Rates II Two cases where monetary policy
solves internal and external balances – consistent
Two case where internal and external balances conflict – inconsistent
These two cases of inconsistency make fixing exchange rates a problem for some countries
Macro Adjustment – Fixed Rates II
Macro Adjustment – Fixed Rates II Inconsistencies
1. External deficit when at less than full employment, adjustment leads to recession to maintain fixed exchange rates
2. External surplus with high inflation or rapid economic growth, adjustment leads to higher inflation or more rapid economic growth
Macro Adjustment – Fixed Rates II
Most participants in international trade prefer fixed exchange rates as it decreases risk of transactions
But, fixed exchange rates mean that on occasion internal and external balances will be mismatched with policy
Fiscal Policy & Internal Balance
In the short run, there are solutions to the dilemma between internal and external balances
1. Government can assign roles Monetary policy for external balance Fiscal policy for internal balance Example: government adopts
expansionary fiscal policy
Fiscal Policy & Internal Balance Example (cont.) -
Government budget deficit financed through borrowing
Demand for loanable funds increases raising interest rates (D to D’)
Open economy, rise in interest rates creates inflow of foreign capital
Domestic supply of loanable funds increases (S to S+f)
Fiscal Policy & Internal Balance
Fiscal Policy & Internal Balance Example (cont.)
Inflow of capital requires foreign investors to sell foreign currency or buy domestic currency
Supply of foreign exchange increases Exchange rate to appreciate, but with
fixed rate government intervenes Demand for foreign exchange
increases maintaining pegged or fixed rate
Fiscal Policy & Internal Balance
Fiscal Policy & Internal Balance
Example (cont.) Secondary effect on market for loanable
funds Government purchases of foreign
exchange increases domestic money supply
Increase in money supply leads to increase in supply of loanable funds (S+f to S’+f)
Equilibrium interest rate moves back toward ie
Fiscal Policy & Internal Balance
Effects of Fiscal Policy - Domestic Expansionary fiscal policy
Increases AD, increasing output and price level
Intervention in foreign exchange increases money supply
AD increases even more with increase in money supply
With open economy and fixed exchange rates, effect of policy are more pronounced
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic Contractionary Fiscal Policy
Demand for loanable funds decreases Lowers interest rate Investment in domestic country
decreases – capital outflows Supply of loanable funds decreases
(S to S-f) Interest rates increase towards
original equilibrium
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic
Contractionary Fiscal Policy (cont.) Capital outflow causes demand for
foreign exchange to increase Pressure for currency to depreciate Intervention in foreign exchange
market leads to increase in supply of foreign exchange to maintain fixed rate
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic
Contractionary Fiscal Policy (cont.) Secondary effect from change in
money supply Selling foreign exchange buys
domestic currency decreasing money supply
Supply of loanable funds decreases even further moving equilibrium interest rate back toward original rate
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic Contractionary Fiscal Policy (cont.)
Initially AD decreases, lowering equilibrium output and price level
Intervention in foreign exchange market decreasing money supply has additional effect of decreasing AD further
Net result in open economy, effects on output and price level are more pronounced
Effects of Fiscal Policy - Domestic
Sterilization The separation of monetary policy
from intervention in foreign exchange market
Allows achieving external balance to not affect the money supply of the country
Can solve mismatch between external and internal balance under fixed exchange rate in short run
Sterilization Assume private demand foreign
exchange increases Balance of payments deficit Government must sell foreign exchange
to maintain exchange rate Decrease in domestic money supply A central bank in developed country
with active government bond market can use open market operations
Sterilization Government knows how much
domestic currency it purchased Government can purchase like
amount of government bonds Net effect of intervention and
sterilization on domestic money supply is zero
Sterilization Problems
Best used when there are small short run deviations in exchange rate from PPP
Necessary exchange rate is kept fairly close to PPP or policy likely to fail
Example If domestic inflation is higher than foreign
inflation (usual case), intervention and sterilization result in overvalued real currency
Sterilization Example (cont.)
Supply of foreign reserves held by government not enough to maintain exchange rate and currency must be devalued
Sharp devaluations have consequences discussed in chapter 15
Sterilization Sterilization can work if we vary what we
mean by fixed exchange rate We can fix or peg the real exchange rate
instead of nominal rate Nominal rate is allowed to change while real
rate is held constant – crawling peg Remember equation for real exchange rate
Sterilization
Maintaining nominal rate requires ratio of prices to be constant
To maintain real exchange rate, calculate change in price ratio and change nominal rate to account for difference
US
FC
P
PFCRFCRXR *)]/($[)/($
Sterilization Country may set pre-announced rate of
change in nominal rate based on differences Although exchange rate is changing,
participants know by how much Real exchange rate is held steady Still a need for intervention to smooth out
changes from announced rate Monetary policy can now focus on domestic
economic conditions and exchange rate in real sense is stable
Pegging w/Monetary Policy A country may be willing to sacrifice
domestic monetary policy for fixed rate
Could have two countries very closely related Larger and smaller country with high level
of trade May have high correlation between
changes in GDP (one in larger than other)
Pegging w/Monetary Policy These circumstances may lead to
smaller country fixing its exchange rate to larger country
Monetary policy is sacrificed, but smaller country may not have any influence with domestic monetary policy to begin with b/c of connection with larger country
Pegging w/Monetary Policy Recession in larger country most likely
leads to recession in smaller country If monetary policy does not matter, smaller
country may feel makes sense to forgo monetary policy in exchange for fixed exchange rates
May require some intervention, but does not matter if sterilized or not
Smaller country’s monetary and price level growth rate almost identical to larger country
Currency Unions If maintaining fixed rate has so many
problems, then why continue to try? If really want to keep exchange rate
stability between two countries, then more logical to merge two currencies into one – currency union
Obviously benefits and costs associate with this decision
Currency Unions Consider Germany and Austria before
the formation of the euro Benefit from monetary efficiency gains
Gains derived from not having to change currencies when conduction trade between the countries
Cost from economic stability loss Countries no longer have ability to conduct
independent monetary policy
Currency Unions Must weigh the size of gains and
losses for each country The greater the trade between the
countries, the greater the monetary efficiency gains
There is not, however, a precise cutoff point where common currency is good or bad
Currency Unions Common currency will ease transaction
of capital flows across countries Not changing currency will increase
efficiency of financial markets in both countries
Similarly, would be easier to make direct investments (FDI) if did not have to convert currency
Some uncertainty with investing across boarders would be eliminated as well
Currency Unions
1. Ability of labor to move across boarders when one country has a recession can reduce losses of recession
2. If two countries have similar average rate of inflation, less change joint monetary policy is undesirable
3. Economic stability losses smaller if common fiscal policy – similar taxation and spending systems
Currency Unions
4. Smaller economic stability losses the more correlated the GDP’s of the countries
Recession in one country means recession in another so joint policies appropriate for both countries
Using these measure of gains and losses, can better determine if common currency is best choice