Download Fixed.v.s.floating 2012

Bo Sjö
2012-09-24
Lecture: Some Basic Arguments for and Against Floating
and Fixed Exchange rates - A Summary.
Learning objectives:
This memo contains a list of argument for and against floating or fixed exchange regimes.
Historically, floating rates have been associated with high inflation and ‘loose’ monetary
policy. The modern view is that floating rates without an independent central bank with a
clear inflation target will lead to inflation and instability. These views can and should be
discussed and developed.
You should know the principal arguments for and against fixed versus floating. Why a
country should chose one system rather than the other? Identify the conditions required to
choose a system.
This lecture is related to 1) the balance of payments and the basic difference between fixed
and floating rates, 2) the various hybrid systems between the absolutely fixed and absolutely
freely floating rates, and the discussion of optimum currency areas.
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Fixed Exchange Rates
Floating Exchange Rates
Derivative markets, forward, futures, options
and swaps offers cost effective ways of
eliminating (hedging for) risk. Most risk can
be hedged. This size of the risk premium we
calculate is low.
Also, risk is part of the game. Fixing the
exchange rate, to eliminate all risks, would
imply a subsidisation of foreign trade.
Taxpayer’s money will be used to build up
liquid reserves, which could have been used in
a more productive way (as risk capital in
investment)
1) Eliminate risk in foreign trade. =>The
benefits of trade can be fully
explored.
With fixed rates international
competition in both financial and real
markets becomes more effective.
Information spreads easier among
market participants. Floating rates
facilitate segmentation of markets that
might lead to inefficiency in
production. (Think Greece 2012, will
leaving the euro solve, hide or
permanent the problems in Greece?)
It is up to the politicians to instruct the central
bank on how to formulate the targets of
monetary policy. If you want low inflation
instruct the central bank to defend a stable
price level (perhaps zero inflation target).
Make the central bank independent of political
decision-making etc. We don’t need a fixed
exchange rate regime to achieve low inflation.
2) Fixed rates put a restriction on
domestic monetary policy. By fixing
the rate towards a low inflation area,
like Germany or the EMU, a country
will get the same rate of inflation as
the low inflation area. This is a quick
way to gain credibility and reputation
as a stable low inflation country.
Some argue that monetary policy is not very
good at changing output and income. It is good
at controlling inflation. With floating rates it is
possible to choose zero inflation, if that is the
optimal rate of the economy. Or, to chose the
optimal rate of inflation conditional on
stabilizing output and employment as well.
But, under floating rates, if you target
monetary policy to very low inflation,
you might not be able to use monetary
policy to smooth out changes in
income and employment.
Floating rats solves your balance of payments
problems, since BoP=0 follows automatically.
Policy is no longer restrained by keeping
BoP=0, given the level of the exchange rate, in
the long run.
.
3)
a) This argument is outdated. With
free goods and capital markets, the
BoP is no longer a restraint for
domestic policy. Well functioning
markets creates long run BoP
equilibrium automatically, according
to the principle, what you borrow you
must pay back.
b) There can be vicious circles.
S ↑ → P↑→W ↑→S↑→P↑
These circles can be costly to break in
terms of loss of income and
employment.
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Fixed cont.
Floating cont.
c) Even if markets are not working
well in an open economy, floating
rates do not solve all problems.
Floating rates means BoP =0, but
does not insulate the real economy
from changes in income created by
exchange rates affecting imports and
exports. Furthermore, expectations
will affect portfolio allocation, and
savings, which results in changes in
savings (consumption).
4) Floating rates are unstable rates. FX
markets do not work well. The excess
volatility on FX markets are harmful
for trade. In addition there is also
overshooting effects (Dornbush),
created by asset markets, which will
have negative effect on the real
economy and the business cycle.
There also bubbles and sunspots.
Hysterisis effects in the current
account will reinforce the income
effects created by changes in the
exchange rate (Baldwin and Krugman
1989).1
There many examples showing that
speculation, even based on
fundamentals, can be destabilising.
There is no real scientific proof that
FX markets are creating “excess
volatility, bubbles, sunspots or
hysterisis effects.
The question is, what do we want to
stabilise? The exchange rate or the
level of output? With fixed rates, we
get more fluctuations in interest rates
and output instead.
Speculation can be both stabilizing
and destabilizing. There is no proof
that destabilising speculation
dominates. Speculation occurs on all
markets are not an evil thing.
Speculation means that an agent
trades because the current market
price is not in line with the agent’s
prediction of what the future price
will or should be. If speculation is
based on economic fundamentals it
will in general have a stabilising
effect on the whole economy in the
long run, in terms of growth, income
etc.
5)
Floating rates imply an optimal
adjustment. Wages are sticky
downwards, an external shock will
lead to unemployment, not to a
reduction in real wages through
negotiations. A flexible exchange
rate will adjust automatically. A
depreciation implies a reduction in
real wages, and an increase in output
that offsets the original disturbance. It
is more optimal to change one price,
the exchange rate, rather than many
prices, or wages, which are sticky in
the short run.
The problem with this argument is
that it is not based on fair comparison
of regimes. Wages are, or can be,
more flexible that we assume. If we
have fixed exchange rates, wage
earners will adapt to this regime and
set wages so they remaining
competitive on the international
market.
Furthermore, most (if not all) big
shocks are either common to all
countries or created by domestic
politicians trying to run an
independent economic policy. Force
politicians (and authorities) to follow
“the rules of the game”.
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Hysterisis effects imply that the current account will
behave close to a random walk. High autocorrelation,
reflecting that it takes a very long time before shocks
disappear.
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6)
With fixed rates we can offset foreign
real shocks by changing government
expenditure, by we cannot offset
foreign monetary shocks. The latter
will have full impact on the domestic
economy (inflation). Fixed rates are
good if our economy is mostly
dominated by foreign real shocks.
(Export disturbances
in turn reflect our idea about the future and
attitudes towards risk. When the future is
hard to understand prices will fluctuate up
and down, as a reflection of our
uncertainty of the future. Usually we also
expect this uncertainty and price volatility
to be associated with increased trade in
derivative instrument (trade in risk). If
you try to regulate prices, you are aiming
at people's uncertainty of the future. The
outcome of restricting financial prices is
often higher fluctuations in real incomes
instead, and worse perhaps a halt in the
economic growth. The really big
advantage with markets is the price
mechanism.
With floating rates we can protect ourselves
against foreign monetary shocks, but not
foreign real (demand) shocks.
(These are basic Mundell-Fleming
conclusions)
Some facts to consider. Canada has a floating
rate against the US, but a Canadian province
does only one-twentieth the amount of trade
with a US state as it does with a Canadian
province that is equidistant and equally
wealthy. This is (circumstantial) evidence that
floating rates helps to segment markets, creates
isolation for Canada, and one reason why
Canadian income is only four-fifths that of the
US.
In Addition consider the following:
1) Empirical studies show that trade grows
at approximately the same rate during
periods of fixed rates and floating rates.
Floating exchange rates therefore does not
seem harmful for exploiting the benefits of
trade, in general. Of course, this does not
exclude the possibility that trade could
have grown even faster if the exchange
rate fluctuations were decreased. But,
compared to periods of fixed exchange
rates, flexible exchange rates do not seem
to hinder trade.
According to a study in American Economic
Review March 2003, fixed exchange rates
have a tendency to be associated higher
volatility in GDP, especially so for Less
Developed Countries (LDC:s). Floating rates
are associated with less volatility in GDP
2) Empirical studies also reveal that there
is no significant difference between the
fluctuation of real income (GDP) during
periods of fixed and flexible exchange
rates. If there is a difference it points
toward the conclusion that GDP is more
volatile during periods of fixed exchange
rate regimes. (Barry Eichengreen)
3) Why do prices move up and down,
especially on financial assets? The answer
is more than demand and supply. The
prices reflect discounted cash flows, which
Is the discussion about fixed or floating
exchange rate dead? Are countries going to
the extremes, rather than crawling pegs,
baskets etc?
There are real economic problems
independently of the choice exchange rate
regime. These problems should be put in
focus. Choosing one regime implies that a
certain monetary policy should be picked
and followed (the rules of the game
discussion).
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