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Fixed versus Floating Rates Policy Interdependence Chapter 19 1 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 2 ’s in E dampen the economy’s reaction to goods market disturbances E$/€ DD1 E1 AA1 Y1 Y 3 Figure 19-5 Exchange Rate Trends and Inflation Differentials, 1973-2000 4 Figure 19-1: Effects of a Fall in Export Demand Exchange rate, E DD2 DD1 2 E2 (a) Floating exchange rate 1 E1 AA1 Y2 Y1 Exchange rate, E Output, Y DD2 DD1 (b) Fixed 1 exchange rate E 3 1 AA2 Y3 Y2 Y1 AA1 Output, Y 5 Disadvantages of Floating Rates Fixed E provides discipline for central banks, floating E does not Floating E allows destabilizing speculation Supporters of floating E are skeptical & point out that destabilizing speculators ultimately lose money Floating E makes a country more vulnerable to money market disturbances like an in money demand. 6 Figure 19-2: A Rise in Money Demand Under a Floating Exchange Rate Exchange rate, E DD 1 E1 2 E2 AA1 AA2 Y2 Y1 Output, Y 7 Fixed E dampens the economy’s reaction to monetary disturbances E$/€ DD1 E1 AA1 Y1 Y 8 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 9 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. 10 11 US (Home) Unilateral Monetary Contraction E$/€ DD1 E1 AA1 Y1 Y 12 US (Home) Unilateral Monetary Contraction E€/$ DD1 E1 AA1 Y1 Y 13 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 16 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? 17 US Unilateral Fiscal Expansion E$/€ DD1 E1 AA1 Y1 Y 18 US Unilateral Fiscal Expansion E€/$ DD1 E1 AA1 Y1 Y 19 20 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 21 What Has Been Learned Since 1973? The best evidence is that the exchange rate system doesn’t have much effect on international trade. 22 EXPORTS/GDP 0.15 0.1 0.05 96 92 88 84 80 76 72 68 64 60 0 23