Title: Chapter 19 Macroeconomic Policy and Coordination Under Floating Exchange Rates
1 Chapter 19 Macroeconomic Policy and
Coordination Under Floating Exchange Rates
2Preview
- Arguments for flexible exchange rates
- Arguments against flexible exchange rates
- Foreign exchange markets since 1973
- Interdependence of large countries
3Introduction
- The Bretton Woods system collapsed in 1973.
- Central banks thought they would stop trading in
the foreign exchange for a while, and would let
exchange rates adjust to supply and demand, and
then would re-impose fixed exchange rates soon. - But no new global system of fixed rates was
started again.
4The Case for Floating Exchange Rates
- Monetary policy autonomy
- Automatic stabilization
- Symmetry (not possible under Bretton Woods)
5The Case for Floating Exchange Rates
- Monetary policy autonomy
- Without a need to intervene in foreign exchange
markets, central banks are more free to influence
the domestic money supply, interest rates and
inflation. - Central banks can more freely react to changes in
aggregate demand, output and prices in order to
achieve internal balance.
6The Case for Floating Exchange Rates
- Automatic stabilization
- Fundamental disequilibria can be addressed more
easily. - One fundamental disequilibrium is caused by an
excessive increase in money supply and government
purchases, leading to inflation. - Inflation means that the currencys purchasing
power falls, both domestically and
internationally, and flexible exchange rates can
automatically adjust to account for this fall in
value, as PPP predicts should happen.
7The Case for Floating Exchange Rates
- Another fundamental disequilibrium could be
caused by a general shift in aggregate demand for
a countrys products. - Flexible exchange rates would automatically
adjust to stabilize high or low aggregate demand
and output, thereby keeping output closer to its
normal level and also stabilizing price changes
in the long run.
8The Case for Floating Exchange Rates
9The Case for Floating Exchange Rates
- In the long run, a real depreciation of domestic
products occurs as prices fall (due to low
aggregate demand, output and employment) under
fixed exchange rates. - In the short run and long run, a real
depreciation of domestic products occurs through
a nominal depreciation under flexible exchange
rates.
10The Case for Floating Exchange Rates
- 3. Symmetry (not possible under Bretton Woods)
- Under the BW system,
- the US was not allowed to adjust its exchange
rate, like other countries. - Other countries were not allowed to adjust their
money supplies for macroeconomic goals, like the
US. - Under floating rates, both are allowed.
11The Case against Floating Exchange Rates
- Loss of Discipline
- Destabilizing speculation
- Injury to international trade and investment
- Uncoordinated economic policies
- The illusion of greater autonomy
12The Case against Floating Exchange Rates
- 1. Loss of Discipline
- (Pro-fixers) Adherence to a fixed exchange rates
would force central banks not to print so much
money. Flexible ERs mean license for domestic
monetary policy, thus falling into the inflation
bias trap. - (Pro-floaters) Inflation is contained in the
country that creates it under flexible ERs the
US could no longer export inflation after 1973. - And inflation targets may be better discipline
than exchange rate targets.
13The Case against Floating Exchange Rates
- Speculation and volatility in the foreign
exchange market become worse, not better. - Speculation can be destabilizing if speculators
sell (buy) a currency when it depreciates
(appreciates). - Such speculation tends to increase the
fluctuations of exchange rates around their long
run values. - Exchange rate bubbles may develop.
- In fact, volatility of exchange rates since 1973
has become larger.
14The Case against Floating Exchange Rates
- There can be a vicious cycle of depreciation and
inflation. - (Pro-floters)
- Fixed exchange rates are vulnerable to
speculation which is likely to be one-way
betting. - Self-fulfilling devaluation crises may occur
under fixed rates.
15The Case against Floating Exchange Rates
- Uncertainty about exchange rates may reduce trade
and international investment. - Evidence is unclear.
- And international investment and trade have
expanded since the Bretton Woods system was
abandoned. - Forward exchange rates and derivative assets were
created to reduce this uncertainty and to insure
against exchange rate volatility.
16The Case against Floating Exchange Rates
- 4. Uncoordinated macroeconomic policies
- Flexible exchange rates lose the coordination of
monetary polices through fixed exchange rates. - Lack of coordination may cause expenditure
switching policies each country may want to
maintain a low valued currency, so that aggregate
demand is switched to domestic output at the
expense of other economies.
17The Case against Floating Exchange Rates
- Lack of coordination may cause volatility in
national economies because a large countrys
fiscal and monetary policies affect other
economies aggregate demand, output and prices
become more volatile across countries as policies
diverge.
18The Case against Floating Exchange Rates
- Illusion of greater monetary policy autonomy
- Central banks still need to intervene in the
foreign exchange market because the exchange
rate, like inflation, affects the economy a great
deal. - But for the US, exchange rate stability is
usually considered less important by the Federal
Reserve than price stability and output stability.
19Since 1973
- In 1975, IMF members met in Rambouillet, France
to allow flexible exchange rates, but to prevent
erratic fluctuations. - In 1976 in Kingston, Jamaica, they amended the
articles of agreement for IMF membership to
formally endorse flexible rates, - but prevented members from manipulating exchange
ratesto gain an unfair competitive advantage,
i.e., no expenditure switching policies were
allowed. - The articles allowed surveillance of members by
other members to be sure they were playing fairly.
20Since 1973
- Due to contractionary monetary policy and
expansive fiscal policy in the US, the dollar
appreciated by about 50 relative to 15
currencies from 19801985. - This contributed to a growing current account
deficit by making imports cheaper and US goods
more expensive.
21Since 1973 (cont.)
22Since 1973 (cont.)
- To reduce the value of the US , the US, Germany,
Japan, Britain and France announced in 1985 that
they would jointly intervene in the foreign
exchange markets in order to depreciate the value
of the dollar. - The dollar dropped sharply the next day and
continued to drop as the US continued a more
expansionary monetary policy, pushing down
interest rates. - Announcement was called the Plaza Accords,
because it was made at the Plaza Hotel in New
York.
23Since 1973 (cont.)
- After value of the dollar fell, countries were
interested in stabilizing exchange rates. - US, Germany, Japan, Britain, France and Canada
announced renewed cooperation in 1987, pledging
to stabilize current change rates. - They calculated zones of about /- 5 around
which current exchange rates were allowed to
fluctuate. - Announcement was called the Louvre Accords,
because it was made at the Louvre in Paris.
24Since 1973 (cont.)
- It is not at all apparent that the Louvre accord
succeeded in stabilizing exchange rates. - Stock market crash in October 1987 made output
stability a primary goal for the US central bank,
and exchange rate stability a secondary goal. - New targets were (secretly) made after October
1987, but by the early 1990s, central banks were
no longer attempting to adhere to these or other
targets. - Price stability (low inflation) was also a main
goal of the US central bank, not exchange rate
stability.
25Since 1973 (cont.)
- Many fixed exchange rate systems have nonetheless
developed since 1973. - European Monetary System and euro zone (studied
in chapter 20). - China fixes its currency (until 2005).
- ASEAN countries have considered a fixed exchange
rates and policy coordination. - No system is right for all countries at all times.
26Interdependence of Large Countries
- Previously, we assumed that countries are small
in that their policies do not affect world
markets. - For example, a depreciation of the domestic
currency was assumed to have no significant
influence on aggregate demand, output and prices
in foreign countries. - For countries like Costa Rica, this may be an
accurate description. - However, large economies like the U.S., EU,
Japan, and China are interdependent because
policies in one country affect other economies.
27Interdependence of Large Countries (cont.)
- If the US permanently increases the money supply,
the DD-AA model predicts for the short run - an increase in U.S. output and income
- a depreciation of the U.S. dollar.
- What would be the effects for Japan?
- an increase in U.S. output and income would raise
demand of Japanese products, thereby increasing
aggregate demand and output in Japan. - a depreciation of the U.S. dollar means an
appreciation of the yen, lowering demand of
Japanese products, thereby decreasing aggregate
demand and output in Japan. - The total effect of (1) and (2) is ambiguous.
28Interdependence of Large Countries (cont.)
- If the U.S. permanently increases government
purchases, the DD-AA model predicts - an appreciation of the U.S. dollar.
- What would be the effects for Japan?
- an appreciation of the U.S. dollar means an
depreciation of the yen, raising demand of
Japanese products, thereby increasing aggregate
demand and output in Japan. - What would be the subsequent effects for the
U.S.? - Higher Japanese output and income means that more
income is spent on U.S. products, increasing
aggregate demand and output in the U.S. in the
short run.
29Interdependence of Large Countries (cont.)
- In fact, the U.S. has depended on saved funds
from many countries, while it has borrowed
heavily. - The U.S. has run a current account deficit for
many years due to its low saving and high
investment expenditure.
30Fig. 19-5 Global External Imbalances, 19992006
Source International Monetary Fund, World
Economic Outlook, April 2007.
31Interdependence of Large Countries (cont.)
- But as foreign countries spend more and lend less
to the U.S., - interest rates are rising slightly after 2005
- the U.S. dollar is depreciating
- the U.S. current account is increasing (becoming
less negative).
32Fig. 19-4 U.S. Real Interest Rate, 19972007
Source Global Financial Data. Real interest
rates are defined as ten-year government bond
rates less average inflation over the preceding
twelve months. The data are twelve-month moving
averages of monthly real interest rates so
defined.
33Case Study Disinflation, Crisis, and Global
Imbalances, 1980-2008
34What has been learned since 1973?
- Monetary policy autonomy
- Symmetry
- The exchange rate as an automatic stabilizer
- Discipline
- Destabilizing speculation
- International trade and investment
- Policy coordination
35What has been learned since 1973?
- 1. Monetary Policy Autonomy
- Floating gave central banks the ability to
control their money supplies ? Greater
international divergence in inflation - Floating would not insulate countries from
foreign policy shocks. E.g., foreign monetary
shocks affect the real exchange rate. - Central banks intervened repeatedly
- Why?
36What has been learned since 1973?
- 2. Symmetry
- The international monetary system did not become
symmetric as central banks continued to hold
dollar reserves and intervene in the forex
market.
37What has been learned since 1973?
- 3. The Exchange Rate as an Automatic Stabilizer
- In industrial countries, labor productivity and
real GDP growth rates dropped in the 1970s. - Does it prove that floating rates were their
cause? - Should consider the period was marked by large
structural changes such as - Two oil shocks
- Restrictive labor market practices
38What has been learned since 1973?
- 4. Discipline
- Did countries abuse the autonomy afforded by
floating rates? - Inflation rates accelerated and remained high in
the 1970s. - However, the temptation of inflation was
resisted - Concerted disinflation after 1979
- Expansionary monetary policy actions were
cancelled due to currency depreciation, which was
viewed as a sign of economic mismanagement -
39What has been learned since 1973?
- 4. Destabilizing Speculation
- Over the long term, exchange rates have roughly
reflected changes in economic fundamentals - The dollar depreciation of the 1970s and the
appreciation of the 1980s - However, short-term ER movements can be difficult
to relate to actual economic events - Are exchange rate excessively volatile? This is
a very controversial question. - There were no evidence of vicious cycles of
inflation and depreciation.
40What has been learned since 1973?
- 5. International Trade and Investment
- International investment expanded vastly since
1973. - The role of ER flexibility on international trade
is controversial. - The volume of trade and international openness
show a rising trend. - Forward markets and other innovative financial
development have helped traders avoid ER risk.
These still constitute increases in transport
costs. - Resurgence of protectionism due to slower
economic growth and wide swings in real ERs
(misalignments).
41What has been learned since 1973?
- 6. Policy Coordination
- Floating ERs have not prmoted international
policy coordination. - Beggar-thy-neighbor policies can exist whether
exchange rates are fixed or floating. - An exchange rate system alone cannot restrain a
government from following its own interest when
it formulates policies.
42Are fixed exchange rate even an option for most
countries?
- The bipolar view or the hypothesis of hollowing
intermediate zones suggests that - In a world of mobile capital, countries will have
to choose either hard fix (a currency board or
currency union) or free floating. - Intermediate zones are fragile as they are
subject to speculative crises that can be
self-fulfilling. - The jury is out on this too.
43Directions for reform
- The floating exchange rate system has not been
free of problems, but it has not been the fiasco. - No exchange rate system works well when countries
go it alone and follow narrowly perceived
self-interest. International coordination is
important. - Globally balanced and stable policies are a
prerequisite for the successful performance of
any international monetary system. - Current proposals to reform the international
monetary system such as target zones for the
dollar and the resurrection of fixed rates to the
introduction of a single world currency are not
realistic.