Download Devaluations

Fixed versus Floating Rates
Policy Interdependence
Chapter 19
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Advantages of Floating Rates
 Allows countries to choose their own
monetary growth rates & inflation rates
(Policy autonomy).
 However,
critics argue flexible E autonomy is an
illusion - effect of E on CA is too big to ignore.
 Avoids the asymmetries of Bretton Woods.
 ’s in E dampen the economy’s reaction to
goods market disturbance
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’s in E dampen the economy’s reaction to
goods market disturbances
E$/€
DD1
E1
AA1
Y1
Y
3
Figure 19-5 Exchange Rate Trends
and Inflation Differentials, 1973-2000
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Figure 19-1: Effects of a Fall in Export Demand
Exchange rate, E
DD2
DD1
2
E2
(a) Floating
exchange rate
1
E1
AA1
Y2 Y1
Exchange rate, E
Output, Y
DD2
DD1
(b) Fixed
1
exchange rate E
3
1
AA2
Y3 Y2 Y1
AA1
Output, Y
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Disadvantages of Floating Rates
 Fixed E provides discipline for central banks,
floating E does not
 Floating E allows destabilizing speculation

Supporters of floating E are skeptical & point out that
destabilizing speculators ultimately lose money
 Floating E makes a country more vulnerable to
money market disturbances like an  in money
demand.
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Figure 19-2: A Rise in Money Demand
Under a Floating Exchange Rate
Exchange
rate, E
DD
1
E1
2
E2
AA1
AA2
Y2
Y1
Output, Y
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Fixed E dampens the economy’s reaction to
monetary disturbances
E$/€
DD1
E1
AA1
Y1
Y
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Disadvantages of Floating Rates
 Floating E hurts international trade &
investment because it exposes the private
sector to exchange risk.
 Supporters
of floating E argue the forward
market can be used to protect against exchange
risk
 Floating E leaves nations free to engage in
competitive devaluations
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US (Home) Unilateral
Monetary Contraction
 1979 - US shifted to a contractionary M
policy & went into a recession.
 The $ appreciated, US goods became more
expensive, the demand for US goods , &
the demand for foreign goods .
 This policy helped bring inflation down in
the US, but increased inflation in the ROW.
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11
US (Home) Unilateral
Monetary Contraction
E$/€
DD1
E1
AA1
Y1
Y
12
US (Home) Unilateral
Monetary Contraction
E€/$
DD1
E1
AA1
Y1
Y
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Coordinated Monetary Contraction
 Eventually foreign central banks started
selling $ & buying their own currencies, M 
in the US & the ROW
 What happened to R in the US & the ROW?
 What happened to investment in the US &
the ROW?
 What happened to demand in the US & the
ROW?
14
15
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US Unilateral Fiscal Expansion
 In the early 1980's, the US  T &  G.
 Large government budget deficits pushed RUS  &
caused a further appreciation of the $.
 What was the effect of fiscal expansion on US
demand?
 What was the effect of $ appreciation on ROW
demand?
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US Unilateral Fiscal Expansion
E$/€
DD1
E1
AA1
Y1
Y
18
US Unilateral Fiscal Expansion
E€/$
DD1
E1
AA1
Y1
Y
19
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What Has Been Learned Since 1973?
 Mixed evidence on the success of floating rates.
 Experience w/ first oil price shock favors flexible E.
 However the experience w/ US policy shifts shows
policy autonomy under flexible E is exaggerated
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What Has Been Learned Since 1973?
 The best evidence is that the exchange rate
system doesn’t have much effect on
international trade.
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EXPORTS/GDP
0.15
0.1
0.05
96
92
88
84
80
76
72
68
64
60
0
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