Download Fixed Exchange Rates and Currency Unions

Fixed Exchange Rates and
Currency Unions
Introduction
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Why would a government buy or sell foreign
exchange?
How does the overall economy and economic
policy change when the exchange rate is not
allowed to float freely?
How do fixed exchange rate systems work?
How do countries with fixed exchange rates
affect the world economy?
Inconvertible Currencies
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To fix a currency can make it an inconvertible
currency
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One that cannot be freely traded for another
country’s currency among domestic consumers
and businesses
Common term for this system is exchange controls
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Government or central bank becomes a monopolist
controlling all sales of foreign currency at set price
Easy to “fix” the price of foreign exchange
Common among developing countries
Inconvertible Currencies
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Foreign exchange market
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Downward sloping demand
Perfectly inelastic supply
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One seller of foreign exchange - government
Equilibrium at intersection determines fixed
exchange rate
Government balances available supply of
foreign exchange with demand to achieve
set exchange rate
Inconvertible Currencies
Inconvertible Currencies
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To keep exchange rate fixed, total
outflows and inflows must be equal at
all times
Requires government to control flow of
capital into and out of the country
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Domestic individuals and companies’ ability
to purchase foreign financial assets is
severely limited.
Difficulties & Exchange Controls
Exchange controls lead to
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Government initially balancing demand
and supply for foreign exchange
Eliminated wide swings in exchange rate
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Difficulties with exchange controls
1.
Must deal with government bureaucracy
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Government sole source of foreign exchange
Less quality than free market
Efficiency losses with only one provider
Difficulties & Exchange Controls
Difference between nominal and real
exchange rates
2.
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If nominal rate close to PPP rate, then relatively
sustainable
Money supplies in developing countries difficult
to control
Domestic inflation rate can likely be greater than
foreign inflation rate
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Country’s real exchange rate is depreciating and
nominal rate is becoming over valued
Difficulties & Exchange Controls
Difference between nominal and real
exchange rates (cont.)
2.
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Assume expansionary policies - economy
expands and price level increases
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Real exchange rate depreciates and nominal
rate is fixed
Imports relatively cheaper and domestic
demand increasing – rising demand for
foreign exchange
Excess demand at fixed exchange rate
Difficulties & Exchange Controls
Difficulties & Exchange Controls
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Balancing demand leaves 3 options
1.
Allow currency to depreciate
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2.
Large depreciation can cause higher inflation
and lower GDP
Government could implement
contractionary policies to reduce demand
for foreign exchange
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Sacrifice domestic demand to maintain
exchange rate
Difficulties & Exchange Controls
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Balancing demand leaves 3 options
3.
Ration available supply of foreign
exchange
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Government decides who gets the foreign
exchange
Should provide for necessary imports and
deny for unnecessary
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What is considered necessary?
Obviously gives way to large incentives for
government corruption
Difficulties & Exchange Controls
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Additional problems for economy
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Depreciation of real exchange rate makes
exports more expensive
Supply for foreign exchange available to
country coming from exports decreases
Shortage of foreign exchange increases
Rationing problem is more severe
May cause product and input shortages in
domestic markets
Difficulties & Exchange Controls
Intervention: Foreign Exchange
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Government may choose to peg their
currency to that of another currency
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Mexico might peg peso to US dollar
Mexico uses intervention – buying and
selling of foreign exchange to influence
value of exchange rate
Mexico selling foreign exchange increases
supply and Mexico buying dollars increases
demand
Intervention: Foreign Exchange
Foreign exchange market in
equilibrium with Mexico pegging rate
of XRP
I.
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Economic growth – increase demand for
foreign exchange
To maintain XRP, government sells
foreign exchange to increase supply
Maintains exchange rate and prevents
depreciation of currency
Intervention: Foreign Exchange
Intervention: Foreign Exchange
Assume Mexico’s interest rates
increase relative to US
II.
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Capital flows to Mexico increasing supply
of foreign exchange
To peg rate, Mexico purchases foreign
exchange increasing demand
Maintains exchange rate and prevents
appreciation of currency
Intervention: Foreign Exchange
Intervention: Foreign Exchange
Long run can hold rate as long as can buy
or sell foreign exchange
III.
Mobile portfolio capital can be a good or bad
thing for a country with fixed rate
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Inflows create additional supply of foreign exchange
for country
Capital flows volatile in short run and create problems
when outflow from domestic markets
If cannot maintain peg, can lead to “currency crisis”
causing severe depreciation of currency
Macro Adjustment – Fixed Rates I
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Internal balance must be adjusted to
stay in line with a fixed exchange rate
over time
Example: Assume domestic economy
growing quickly
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Domestic demand for foreign exchange
increases as demand for imports increases
Private sector has balance of payments
deficit
Macro Adjustment – Fixed Rates I
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Example (cont.)
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Government sells foreign currency in
foreign exchange market to maintain
exchange rate
AD increases and hope current account
deficit keeps it from going past full
employment level
With sufficient reserves, government can
intervene until economic growth slows
Macro Adjustment – Fixed Rates I
Macro Adjustment – Fixed Rates I
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Example (cont.)
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With government intervention in foreign
exchange market, economic situation will
correct itself
When government sells foreign currency
they are getting domestic currency in
exchange
This leads to decrease in domestic money
supply (similar to selling government bonds)
Macro Adjustment – Fixed Rates I
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Example (cont.)
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Foreign exchange is not part of country’s
money supply
The country’s monetary base is reduced by
amount of intervention
Domestic money supply contracts by
multiple of amount of intervention
Macro Adjustment – Fixed Rates I
Example (cont.)
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1.
2.
Effects of intervention
The exchange rate is stabilized in the
short run as shown earlier
Begun automatic adjustment almost
guaranteeing balance of payments deficit
will not continue in long run
Macro Adjustment – Fixed Rates I
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Effects of intervention
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AD falls with fall in money supply
Equilibrium levels of output and price level
fall
Maintained fixed exchange rate by
reducing rate of economic growth
Allows not only exchange rate to be fixed,
but automatically adjusts economy for
sustainable external equilibrium
Macro Adjustment – Fixed Rates I
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Maintaining fixed exchange rate takes
away governments ability to use
discretionary monetary policy to
influence the economy
Money supply becomes a function of
country’s external balance based on
how much government must intervene
in foreign exchange market
Macro Adjustment – Fixed Rates II
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Along with benefits, there is a cost
associated with fixed exchange rates
Automatic changes from intervention
occur without considering the state of
the domestic economy
Assume external balance is in deficit
and economy is producing less than full
employment
Macro Adjustment – Fixed Rates II
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Money supply declines and country’s external
balance is balanced
Internal balance would change decreasing
output and unemployment would increase
Intervention in this case is inconsistent with
internal balances
However, some cases it can be consistent
Macro Adjustment – Fixed Rates II
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Table 17.1 summarizes effects of intervention
on external and internal balances
First column – state of internal balance
Second column – position of external balance
Third & fourth – appropriate government
response to solve internal and external
balance respectively
Last column – lists consistency
Macro Adjustment – Fixed Rates II
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Two cases where monetary policy
solves internal and external balances –
consistent
Two case where internal and external
balances conflict – inconsistent
These two cases of inconsistency make
fixing exchange rates a problem for
some countries
Macro Adjustment – Fixed Rates II
Macro Adjustment – Fixed Rates II
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Inconsistencies
1.
2.
External deficit when at less than full
employment, adjustment leads to
recession to maintain fixed exchange
rates
External surplus with high inflation or
rapid economic growth, adjustment leads
to higher inflation or more rapid
economic growth
Macro Adjustment – Fixed Rates II
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Most participants in international trade
prefer fixed exchange rates as it
decreases risk of transactions
But, fixed exchange rates mean that on
occasion internal and external balances
will be mismatched with policy
Fiscal Policy & Internal Balance
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1.
In the short run, there are solutions to
the dilemma between internal and
external balances
Government can assign roles
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Monetary policy for external balance
Fiscal policy for internal balance
Example: government adopts
expansionary fiscal policy
Fiscal Policy & Internal Balance
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Example (cont.) 
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Government budget deficit financed
through borrowing
Demand for loanable funds increases
raising interest rates (D to D’)
Open economy, rise in interest rates
creates inflow of foreign capital
Domestic supply of loanable funds
increases (S to S+f)
Fiscal Policy & Internal Balance
Fiscal Policy & Internal Balance
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Example (cont.)
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Inflow of capital requires foreign investors
to sell foreign currency or buy domestic
currency
Supply of foreign exchange increases
Exchange rate to appreciate, but with fixed
rate government intervenes
Demand for foreign exchange increases
maintaining pegged or fixed rate
Fiscal Policy & Internal Balance
Fiscal Policy & Internal Balance
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Example (cont.)
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Secondary effect on market for loanable
funds
Government purchases of foreign exchange
increases domestic money supply
Increase in money supply leads to increase
in supply of loanable funds (S+f to S’+f)
Equilibrium interest rate moves back toward
ie
Fiscal Policy & Internal Balance
Effects of Fiscal Policy - Domestic
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Expansionary fiscal policy
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Increases AD, increasing output and price
level
Intervention in foreign exchange increases
money supply
AD increases even more with increase in
money supply
With open economy and fixed exchange
rates, effect of policy are more pronounced
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic
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Contractionary Fiscal Policy
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Demand for loanable funds decreases
Lowers interest rate
Investment in domestic country decreases
– capital outflows
Supply of loanable funds decreases
(S to S-f)
Interest rates increase towards original
equilibrium
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic
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Contractionary Fiscal Policy (cont.)
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Capital outflow causes demand for foreign
exchange to increase
Pressure for currency to depreciate
Intervention in foreign exchange market
leads to increase in supply of foreign
exchange to maintain fixed rate
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic
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Contractionary Fiscal Policy (cont.)
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Secondary effect from change in money
supply
Selling foreign exchange buys domestic
currency decreasing money supply
Supply of loanable funds decreases even
further moving equilibrium interest rate
back toward original rate
Effects of Fiscal Policy - Domestic
Effects of Fiscal Policy - Domestic
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Contractionary Fiscal Policy (cont.)
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Initially AD decreases, lowering equilibrium
output and price level
Intervention in foreign exchange market
decreasing money supply has additional
effect of decreasing AD further
Net result in open economy, effects on
output and price level are more
pronounced
Effects of Fiscal Policy - Domestic
Sterilization
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The separation of monetary policy from
intervention in foreign exchange market
Allows achieving external balance to not
affect the money supply of the country
Can solve mismatch between external
and internal balance under fixed
exchange rate in short run
Sterilization
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Assume private demand foreign exchange
increases
Balance of payments deficit
Government must sell foreign exchange to
maintain exchange rate
Decrease in domestic money supply
A central bank in developed country with
active government bond market can use open
market operations
Sterilization
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Government knows how much domestic
currency it purchased
Government can purchase like amount
of government bonds
Net effect of intervention and
sterilization on domestic money supply
is zero
Sterilization
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Problems
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Best used when there are small short run
deviations in exchange rate from PPP
Necessary exchange rate is kept fairly close to PPP
or policy likely to fail
Example
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If domestic inflation is higher than foreign inflation
(usual case), intervention and sterilization result in
overvalued real currency
Sterilization
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Example (cont.)
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Supply of foreign reserves held by
government not enough to maintain
exchange rate and currency must be
devalued
Sharp devaluations have consequences
discussed in chapter 15
Sterilization
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Sterilization can work if we vary what
we mean by fixed exchange rate
We can fix or peg the real exchange
rate instead of nominal rate
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Nominal rate is allowed to change while
real rate is held constant – crawling peg
Remember equation for real exchange rate
Sterilization
PFC
RXR($ / FC )  [R($ / FC )] *
PUS
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Maintaining nominal rate requires ratio of
prices to be constant
To maintain real exchange rate, calculate
change in price ratio and change nominal rate
to account for difference
Sterilization
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Country may set pre-announced rate of
change in nominal rate based on differences
Although exchange rate is changing,
participants know by how much
Real exchange rate is held steady
Still a need for intervention to smooth out
changes from announced rate
Monetary policy can now focus on domestic
economic conditions and exchange rate in
real sense is stable
Pegging w/Monetary Policy
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A country may be willing to sacrifice
domestic monetary policy for fixed rate
Could have two countries very closely
related
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Larger and smaller country with high level
of trade
May have high correlation between
changes in GDP (one in larger than other)
Pegging w/Monetary Policy
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These circumstances may lead to
smaller country fixing its exchange rate
to larger country
Monetary policy is sacrificed, but
smaller country may not have any
influence with domestic monetary policy
to begin with b/c of connection with
larger country
Pegging w/Monetary Policy
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Recession in larger country most likely leads
to recession in smaller country
If monetary policy does not matter, smaller
country may feel makes sense to forgo
monetary policy in exchange for fixed
exchange rates
May require some intervention, but does not
matter if sterilized or not
Smaller country’s monetary and price level
growth rate almost identical to larger country
Currency Unions
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If maintaining fixed rate has so many
problems, then why continue to try?
If really want to keep exchange rate
stability between two countries, then
more logical to merge two currencies
into one – currency union
Obviously benefits and costs associate
with this decision
Currency Unions
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Consider Germany and Austria before the
formation of the euro
Benefit from monetary efficiency gains
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Gains derived from not having to change
currencies when conduction trade between the
countries
Cost from economic stability loss
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Countries no longer have ability to conduct
independent monetary policy
Currency Unions
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Must weigh the size of gains and losses
for each country
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The greater the trade between the
countries, the greater the monetary
efficiency gains
There is not, however, a precise cutoff
point where common currency is good or
bad
Currency Unions
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Common currency will ease transaction of
capital flows across countries
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Not changing currency will increase efficiency of
financial markets in both countries
Similarly, would be easier to make direct
investments (FDI) if did not have to convert
currency
Some uncertainty with investing across
boarders would be eliminated as well
Currency Unions
1.
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3.
Ability of labor to move across boarders
when one country has a recession can
reduce losses of recession
If two countries have similar average rate of
inflation, less change joint monetary policy
is undesirable
Economic stability losses smaller if common
fiscal policy – similar taxation and spending
systems
Currency Unions
Smaller economic stability losses the
more correlated the GDP’s of the
countries
4.
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Recession in one country means
recession in another so joint policies
appropriate for both countries
Using these measure of gains and
losses, can better determine if
common currency is best choice