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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. 1 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. 2 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”. 1 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. 3 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). 4