Download INTERNATIONAL FACTOR MOVEMENT

Chapter 28
Fixed or
Flexible
Exchange
Rates?
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
 Describe the differing impacts of fixed and
flexible exchange rates on international
trade, international investment, and
resource allocation.
 Discuss how the macroeconomic responses
to foreign and domestic shocks are
influenced by the exchange rate system in
place.
 Explain the advantages and disadvantages
of a currency board.
 Compare and contrast the strengths and
weaknesses of exchange rate systems that
combine elements of both fixed and flexible
exchange rates.
28-2
Do Fixed or Flexible
Exchange Rates Provide
Greater “Discipline?”
 Some argue for fixed exchange rates:
• As we’ve seen, with a fixed rate system,
there should be no tendency for greater
inflation in one country than in the world
as a whole.
• The “vicious circle hypothesis”: flexible
exchange rate systems may aggravate
inflationary tendencies.
 Suppose a country has high inflation because
of excess supply of money.
 If the exchange rate is flexible it will
depreciate; this adds to aggregate demand and
worsens inflation.
28-3
Do Fixed or Flexible
Exchange Rates Provide
Greater “Discipline?”
 In response the following have been
suggested:
• The inflation is a signal to monetary
authorities to reduce Ms – with fixed
exchange rates this signal may not be
noticed.
• Is the alleged discipline of a fixed
exchange rate system really desirable?
There may be other goals (such as
generation of employment and economic
growth) that may have to be sacrificed in
a fixed system.
28-4
Would Fixed or Flexible
Exchange Rates Provide
Greater Growth in Trade and
Investment?
 Some argue for fixed exchange rates:
• Flexible exchange rates vary – this
introduces risk into trade decisions.
• Hedging options exist, but these are
costly.
• Foreign direct investment may be less
under flexible exchange rates due to
exchange rate risk.
 This means that world resource allocation may
be sub-optimal under flexible exchange rates.
28-5
Would Fixed or Flexible
Exchange Rates Provide
Greater Growth in Trade and
Investment?
 In response the following have been
suggested:
• If there is exchange rate risk, FDI may
occur more frequently, rather than
producing at home and exporting.
• Under fixed rate systems, dealing with
BOP deficits requires internal
macroeconomic adjustments (e.g.,
contracting national income) that many
countries have been unwilling to tackle.
28-6
Would Fixed or Flexible
Exchange Rates Provide
Greater Efficiency in
Resource Allocation?
 Some argue for fixed exchange rates:
• With fluctuating exchange rates there are
constantly changing incentives to
producers.
• A depreciation induces labor and capital
to flow into the tradeable goods sector
and out of the nontradeable goods sector.
• An appreciation has the opposite effect.
• This may create waste, since factors are
temporarily displaced and workers may
need to be retrained.
28-7
Would Fixed or Flexible
Exchange Rates Provide
Greater Efficiency in
Resource Allocation?
 In response the following have been
suggested:
• Efficient resource allocation depends on
not fixing prices such as the exchange
rate – economic agents react optimally
when prices reflect true scarcity values.
• Fixed exchange rate systems require that
resources be tied up in the form of
international reserves – flexible exchange
rate systems don’t.
28-8
Is Policy More Effective at
Influencing National Income
Under Fixed or Flexible
Systems?
 Argument for fixed exchange rates:
• Fiscal policy is largely ineffective under a
flexible exchange rate system.
• Fiscal policy can be very effective under a
fixed exchange rate system.
28-9
Is Policy More Effective at
Influencing National Income
Under Fixed or Flexible
Systems?
 In response the following have been
suggested:
• Monetary policy is more effective in a
flexible exchange rate system.
• Flexible rate systems allow monetary and
fiscal policies to be directed solely
towards attainment of internal goals.
28-10
Will Destabilizing
Speculation in Exchange
Markets Be Greater Under
Fixed or Flexible Systems?
 Argument for fixed exchange rates:
• When a currency depreciates, speculators
may project this forward and decide their
best strategy is to sell the currency,
thereby worsening the depreciation.
• When a currency appreciates, speculators
may project this forward and decide their
best strategy is to buy the currency,
thereby worsening the appreciation.
28-11
Will Destabilizing Speculation
in Exchange Markets Be
Greater Under Fixed or
Flexible Systems?
 In response the following have been
suggested:
• Speculative purchases may in fact be
stabilizing.
• Fixed rate systems may actually invite
speculation if central banks are unable to
enforce ceiling and floor limits.
28-12
Will Countries Be Better
Protected from External
Shocks Under Fixed or
Flexible Systems?
 Argument for flexible exchange rates:
• Business cycles may be transmitted from
one country to another under fixed
exchange systems.
• This may be less likely under a flexible
system, since the exchange rate helps
mitigate the transmission.
28-13
Fixed vs. Flexible
 Most countries relied on fixed
exchange rate systems in the 1950s
and 1960s.
 There has been a movement since
1973 toward more flexible systems.
 There are some hybrid systems,
however.
28-14
Currency Boards
 A relatively new arrangement that is
a form of fixed exchange system has
emerged – the currency board.
 A currency board is a monetary
authority that is allowed to issue
domestic currency that can be
exchanged for a foreign currency (the
“anchor”) at a fixed exchange rate.
 The currency board is not allowed to
change the monetary base.
 Governments cannot monetize budget
deficits under this system.
28-15
Currency Boards:
Advantages
 Convertibility is ensured.
 Macroeconomic discipline is
instilled – currency boards cannot
finance budget deficits, so
governments must either maintain
budgetary discipline or borrow from
the public.
 A guaranteed payment adjustment
mechanism is provided, increasing
confidence in the system.
28-16
Currency Boards:
Advantages (cont’d)
 Greater confidence in the system
promotes higher rates of
 trade,
 investment, and
 growth.
28-17
Currency Boards:
Disadvantages
 The seigniorage problem
 Currency boards earn interest on
foreign currency holdings, but those
holdings could have been used to make
investments at home.
 The difference in yield could represent
a loss.
 The startup problem
 It’s not easy to gather enough reserve
currency to back the monetary base
100%.
28-18
Currency Boards:
Disadvantages
 The transition problem
 The local currency may become
overvalued in a high inflation economy.
 The fixed exchange rate will eventually
bring inflation under control – how long
will the transition last?
 The adjustment problem
 It’s costly to correct BOP imbalances –
adjustments would be automatic under
a flexible rate system.
 The management problem
 The normal monetary policy tools are
off the table.
28-19
Currency Boards:
Disadvantages
 The crisis problem
 The currency board cannot serve as the
lender of last resort, so banking crises
may be difficult to head off.
 The political problem
 Will the government actually balance
its budget? Currency boards have no
authority to force them to do so.
 The monetary sovereignty problem
 The normal monetary policy tools are
off the table – the “anchor” economy
may have much influence.
28-20
Optimum Currency Areas
 An optimum currency area is an area
that has fixed exchange rates among
member countries, but flexible
exchange rates with external trading
partners.
 For example, the European Union
fixed exchange rates among 11
countries beginning in 1999.
 Optimum currency areas may make
macroeconomic policy more effective
and assist with BOP adjustments.
28-21
Optimum Currency Areas
 Relatively open countries may do
better with a fixed exchange rate.
 Relatively closed economies may do
better with flexible exchange rates.
 Therefore, open economies that have
a high degree of factor mobility
between them may be the best
candidates for an optimum currency
area.
28-22
Hybrid Systems
 Several arrangements attempt to
incorporate the attractive features of
each exchange rate system while
minimizing the unattractive features.
 Examples include
 wider bands,
 crawling pegs, and
 managed floating.
28-23
Wider Bands
 Basic idea: let exchange rates vary
around parity values to a much
greater extent (say 10% instead of
1%).
 Some BOP adjustment can take place
via changes in the exchange rate.
 Still, if countries have consistently
different inflation rates, the system
will break down.
 There will be additional risks from
exchange rate fluctuations that aren’t
present with a fixed system.
28-24
Crawling Pegs
 Basic idea: allow small variation
around parity, but adjust the parity
value regularly.
 That is, periodically devalue or
revalue according to circumstances.
 In principle, the ceilings and floors
may instill some monetary discipline.
 However, a major change in the BOP
position due to an external or
external shock may require major
changes in the exchange rate.
28-25
Managed Floating
 Basic idea: some interference with
exchange rate movements are
permitted, but the intervention is
discretionary on the part of the
central bank.
 That is, there are no announced rules
or guidelines, but monetary
authorities intervene when they judge
it to be in the country’s best
interests.
 However, without any rules nations
may be working at cross-purposes.
28-26