Chapter 19 Macroeconomic Policy and Coordination under Floating Exchange Rates

1
Chapter 19 Macroeconomic Policy and
Coordination under Floating Exchange Rates
2
Introduction

• The floating exchange rate system, in place since
  1973, was not well planned before its inception.
• By the mid-1980s, economists and policymakers had
  become more skeptical about the benefits of an
  international monetary system based on floating
  rates.
• Why has the performance of floating rates been so
  disappointing?
• What direction should reform of the current
  system take?
• This chapter compares the macroeconomic policy
  problems of different exchange rate regimes.

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The Case for Floating Exchange Rates

• There are three arguments in favor of floating
  exchange rates
• Monetary policy autonomy
• Symmetry
• Exchange rates as automatic stabilizers
• Monetary Policy Autonomy
• Floating exchange rates
• Restore monetary control to central banks
• Allow each country to choose its own desired
  long-run inflation rate
• Symmetry
• Floating exchange rates remove two main
  asymmetries of the Bretton Woods system and
  allow
• Central banks abroad to be able to determine
  their own domestic money supplies
• The U.S. to have the same opportunity as other
  countries to influence its exchange rate against
  foreign currencies
• Exchange Rates as Automatic Stabilizers
• Floating exchange rates quickly eliminate the
  fundamental disequilibriums that had led to
  parity changes and speculative attacks under
  fixed rates.

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The Case for Floating Exchange Rates

• Monetary Policy Autonomy
• If banks were no longer obliged to intervene in
  currency markets to fix exchange rates,
  governments would be able to use monetary policy
  to reach internal and external balance.
  Furthermore, no country would be forced to
  import inflation (or deflation) from abroad.
•   Symmetry
• Under a system of floating rates the inherent
  asymmetry of Bretton Woods would
  disappear and the United States would no
  longer be able to set world monetary
  conditions all by itself.
• At the same time, the United States would
  have the same opportunity as other countries
  to influence its exchange rate against foreign
  currencies.

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The Case for Floating Exchange Rates

• Exchange rates as automatic stabilizer
• Even in the absence of an active monetary of
  an active monetary policy, the swift
  adjustment of market-determined exchange rates
  would help countries maintain internal and
  external balance in the face changes in aggregate
  demand. The long and agonizing periods of
  speculation preceding exchange rate realignments
  under the Bretton Woods rules would not occur
  under floating.
• Figure 19-1 shows that a temporary fall in a
  countrys export demand reduces that countrys
  output more under a fixed rate than a floating
  rate.

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Figure 19-1 Effects of a Fall in Export Demand
The Case for Floating Exchange Rates
7
The Case Against Floating Exchange Rates

• There are five arguments against floating rates
• Discipline
• Destabilizing speculation and money market
  disturbances
• Injury to international trade and investment
• Uncoordinated economic policies
• The illusion of greater autonomy

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The Case Against Floating Exchange Rates

• Discipline
• Floating exchange rates do not provide discipline
  for central banks.
• Central banks might embark on inflationary
  policies (e.g., the German hyperinflation of the
  1920s).
• Central banks freed from the obligation to fix
  their exchange rates might embark on
  inflationary policies. In other words, the
  discipline imposed on individual countries by a
  fixed rate would be lost.
• The pro-floaters response was that a floating
  exchange rate would bottle up inflationary
  disturbances within the country whose government
  was misbehaving.

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The Case Against Floating Exchange Rates

• Destabilizing Speculation and Money Market
  Disturbances
• Floating exchange rates allow destabilizing
  speculation.
• Countries can be caught in a vicious circle of
  depreciation and inflation.
• Advocates of floating rates point out that
  destabilizing speculators ultimately lose money.
• Floating exchange rates make a country more
  vulnerable to money market disturbances.
• Figure 19-2 illustrates this point.

Speculation on changes in exchange rates
could lead to instability in foreign exchange
markets, and this instability, in turn, might
have negative effects on countries internal and
external balances. Further, disturbances to the
home money market could be more disruptive under
floating than under a fixed rate.
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The Case Against Floating Exchange Rates

• Injury to International Trade and Investment
• Floating rates hurt international trade and
  investment because they make relative
  international prices more unpredictable
• Exporters and importers face greater exchange
  risk.
• International investments face greater
  uncertainty about their payoffs.
• Supporters of floating exchange rates argue that
  forward markets can be used to protect traders
  against foreign exchange risk.
• The skeptics replied to this argument by pointing
  out that forward exchange markets would be
  expensive.
• Floating rates would make relative
  international prices more unpredictable and thus
  injure international trade and investment.
  

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The Case Against Floating Exchange Rates

• Uncoordinated Economic Policies
• Floating exchange rates leave countries free to
  engage in competitive currency depreciations.
• Countries might adopt policies without
  considering their possible beggar-thy-neighbor
  aspects.
• If the Bretton Woods rules on exchange rate
  adjustment were abandoned, the door would opened
  to competitive currency practices harmful to the
  world economy. As happened during the interwar
  years, countries might adopt policies without
  considering their possible beggar-thy-neighbor
  aspects. All countries would suffer as a result.

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The Case Against Floating Exchange Rates

• The Illusion of Greater Autonomy
• Floating exchange rates increase the uncertainty
  in the economy without really giving
  macroeconomic policy greater freedom.
• A currency depreciation raises domestic inflation
  due to higher wage settlements.
• Floating exchange rate would not really give
  countries more autonomy.
• Changes in exchange rates would have such
  pervasive macroeconomic effects that central
  banks would feel compelled to intervene heavily
  in foreign exchange markets even without a formal
  commitment to peg.
• Thus, floating would increase the uncertainty in
  the economy without really giving macroeconomic
  policy greater freedom.

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The Case Against Floating Exchange Rates
Inflation Rates in Major Industrialized
Countries, 1973-1980 (percent per year)
14
Nominal and Real Effective Dollar Exchange Rates
Indexes, 1975-2000
15
A two-country model of macroeconomic
interdependence under a floating rate

• The model is applied to the short run in
  which output prices can be assumed to be fixed.
• Imagine a world of two countries, Home
  and Foreign. In reality, the level of
  GNP abroad influences foreign demand for the home
  countrys exports and therefore the home
  current account balance.
• We assume that Homes current account is
  a function of the real exchange rate, EP/P, its
  own disposable income, Y-T, and
  Foreigns disposable income Y-T. Homes
  current account is therefore CACA(EP/P, Y-T,
  Y-T).
• A real depreciation of Homes currency is assumed
  to cause an increase in its current account
  balance, while a rise in Home disposable
  income leads to a fall.

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A two-country model of macroeconomic
interdependence under a floating rate

• In the model of two interacting economies, a rise
  in Foreign disposable income raises Foreign
  spending on Home products, it raises Home
  exports, therefore causes an increase in Homes
  current account balance.
• Aggregate supply and demand are equal in Home
  when
• YC(Y-T)IG CA(EP/P, Y-T, Y-T).
• Foreigns current account, CA, also depends
  on the relative price of Home and Foreign
  products, EP/P, and on disposable income in the
  two countries. In a world of two countries,
  Homes current account surplus must exactly equal
  Foreigns current account deficit when both
  balances are measured in terms of a common unit.
  

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A two-country model of macroeconomic
interdependence under a floating rate

• In terms of Foreign output, Foreigns
  current account is
• CA-CA(EP/P, Y-T, Y-T)(EP/P).
• A rise in Home income, by worsening
  Homes current account CA, improves CA in the
  same way, a rise in Foreign income worsens CA.
  We assume that a rise in EP/P(a relative
  cheapening of Home output) causes CA to fall at
  the same time it causes CA to rise.
• Foreign output market supply equals
  demand when
• YC(Y-T)IG-(P/EP)CA(EP/P, Y-T,
  Y-T).
• The HH schedule shows the Home and Foreign
  output levels at which aggregate demand equals
  aggregate supply in Home. HH slopes upward
  because a rise in Y increases Home
  exports, raising aggregate demand and calling
  forth a higher level of Home output, Y.

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A two-country model of macroeconomic
interdependence under a floating rate

• The FF schedule shows the Home and Foreign
  output levels at which aggregate demand equals
  aggregate supply in Foreign. FF also
  slopes upward because a rise in Y raises
  demand for Foreign exports, and Foreign output,
  Y, must rise to meet this increase in aggregate
  demand.
• At the intersection of HH and FF, aggregate
  demand and supply are equal in both countries,
  given the real exchange rate.
• HH is steeper than FF. The slopes of the two
  schedules differ in this way because a rise in a
  countrys output has a greater effect on its own
  output market than on the foreign one.
• Changes in fiscal policy at home or abroad shift
  the schedules by altering government purchases, G
  and G, and net taxes, T and T.
• In addition, both fiscal policies and monetary
  policies can affect HH and FF by influencing the
  exchange rate.

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Macroeconomic Interdependence Under a Floating
Rate

• Assume that there are two large countries, Home
  and Foreign.
• Macroeconomic interdependence between Home and
  Foreign
• Effect of a permanent monetary expansion by Home
• Home output rises, Homes currency depreciates,
  and Foreign output may rise or fall.
• Effect of a permanent fiscal expansion by Home
• Home output rises, Homes currency appreciates,
  and Foreign output rises.

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Unemployment Rates in Major Industrialized
Countries, 1978-2000 (percent of civilian labor
force)
21
Inflation Rates in Major Industrialized Countries
1981-2000, and 1961-1971 Average (percent per
year)
22
Exchange Rate Changes Since the Louvre Accord
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What Has Been Learned Since 1973?

• Monetary Policy Autonomy
• Floating exchange rates allowed a much larger
  international divergence in inflation rates.
• High-inflation countries have tended to have
  weaker currencies than their low-inflation
  neighbors.
• In the short run, the effects of monetary and
  fiscal changes are transmitted across national
  borders under floating rates.
• There is no question that floating gave central
  banks the ability to control their money supplies
  and to choose their preferred rates of trend
  inflation.
• Over the floating-rate period as a whole, higher
  inflation has been associated with greater
  currency depreciation. The exact relationship
  predicted by relative PPP, however, has not held
  for most countries.

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Exchange Rate Trends and Inflation
Differentials,1973-2000
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Monetary Policy Autonomy

• After 1973 central banks intervened repeatedly in
  the foreign exchange market to alter currency
  values.
• Why did central banks continue to intervene even
  in the absence of any formal obligation to do so?
• To stabilize output and the price level when
  certain disturbances occur
• To prevent sharp changes in the international
  competitiveness of tradable goods sectors
• Monetary changes had a much greater short-run
  effect on the real exchange rate under a floating
  nominal exchange rate than under a fixed one.
• Over the floating-rate period as a whole, higher
  inflation has been associated with greater
  currency depreciation. The exact relationship
  predicted by relative PPP, however, has not held
  for most countries.

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Monetary Policy Autonomy

• While the inflation insulation part of the policy
  autonomy argument is broadly supported as a
  long-run proposition, economic analysis and
  experience both show that in the short run, the
  effects of monetary as well as fiscal changes are
  transmitted across national borders under
  floating rates. The critics of floating were
  right in claiming that floating rates would not
  insulate countries completely from foreign
  policy shocks.
• Experience has also given dramatic support to
  the skeptics who argued that no central bank
  can be indifferent to its currencys value
  in the foreign exchange market.

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Monetary Policy Autonomy

• Advocates of floating had argued that central
  banks would not need to hold foreign reserves.
• Even in the presence of output market
  disturbances, central banks wanted to slow
  exchange rate movements to prevent sharp changes
  in the international competitiveness of their
  tradable goods sectors.
• Those skeptical of the autonomy argument had also
  predicted that while floating would allow central
  banks to control nominal money supplies, their
  ability to affect output would still be limited
  by the price levels tendency to respond more
  quickly to monetary changes under a floating
  rate.

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Symmetry

• The international monetary system did not become
  symmetric until after 1973.
• Central banks continued to hold dollar reserves
  and intervene.
• The current floating-rate system is similar in
  some ways to the asymmetric reserve currency
  system underlying the Bretton Woods arrangements
  (McKinnon).
• Because central banks continued to hold dollar
  reserves and intervene, the international
  monetary system did not become symmetric after
  1973.
• Ronald McKinnon has argued that the current
  floating-rate system is similar in some ways to
  the asymmetric reserve currency system underlying
  the Bretton Woods arrangements. He suggests that
  changes in the world money supply would have
  been dampened under a more symmetric monetary
  adjustment mechanism.

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The Exchange Rate as an Automatic Stabilizer

• Experience with the two oil shocks favors
  floating exchange rates.
• The effects of the U.S. fiscal expansion after
  1981 provide mixed evidence on the success of
  floating exchange rates.
• Under floating, many countries were able to relax
  the capital controls put in place earlier. The
  progressive loosening of controls spurred the
  rapid growth of a global financial industry and
  allowed countries to realize greater gains from
  intertemporal trade.
• The effects of the U.S. fiscal expansion after
  1981 illustrate the stabilizing properties of a
  floating exchange rate.
• The dollars appreciation after 1981 also
  illustrates a problem with the view that floating
  rates can cushion the economy from real
  disturbances such as shifts in aggregate demand.

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The Exchange Rate as an Automatic Stabilizer

• Permanent changes in goods market conditions
  require eventual adjustment in real exchange
  rates that can be speeded by a floating-rate
  system.
• Foreign exchange intervention to peg nominal
  exchange rates cannot prevent this eventual
  adjustment because money is neutral in the long
  run and thus is powerless to alter relative
  prices permanently.
• Some adverse developments followed the adoption
  of floating dollar exchange rates, but this
  coincidence does not prove that floating rates
  were their cause.

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Discipline

• Inflation rates accelerated after 1973 and
  remained high through the second oil shock.
• The system placed fewer obvious restraints on
  unbalanced fiscal policies.
• Example The high U.S. government budget deficits
  of the 1980s.
• The concerted disinflation in industrial
  countries after 1979 proved that central
  banks could resist the temptations of inflation
  under floating rates .
• The system placed fewer obvious restraints on
  unbalanced fiscal policies.

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Destabilizing Speculation

• Floating exchange rates have exhibited much more
  day-to-day volatility.
• The question of whether exchange rate volatility
  has been excessive is controversial.
• In the longer term, exchange rates have roughly
  reflected fundamental changes in monetary and
  fiscal policies and not destabilizing
  speculation.
• Experience with floating exchange rates
  contradicts the idea that arbitrary exchange rate
  movements can lead to vicious circles of
  inflation and depreciation.
• Exchange rates are asset prices, and so
  considerable volatility is to be expected. The
  asset price nature of exchange rates was not well
  understood by economists before the 1970s.

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Destabilizing Speculation

• Even with the benefit of hindsight, however,
  short-term exchange rate movements can be quite
  difficult to relate to actual news about economic
  events that affect currency values.
• Over the long term, however, exchange rates have
  roughly reflected fundamental changes in monetary
  and fiscal policies, and their broad movements do
  not appear to be the result of destabilizing
  speculation.
• The experience with floating rates has not
  supported the idea that arbitrary exchange rate
  movements can lead to vicious circles of
  inflation and depreciation.

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International Trade and Investment

• International financial intermediation expanded
  strongly after 1973 as countries lowered barriers
  to capital movement.
• For most countries, the extent of their
  international trade shows a rising trend after
  the move to floating.
• Critics of floating had predicted that
  international trade and investment would suffer
  as a result of increased uncertainty. The
  prediction was certainly wrong with regard to
  investment.
• There is controversy about the effects of
  floating rates on international trade.

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International Trade and Investment

• A very crude but direct measure of the extent of
  a countrys international trade is the average
  of its imports and exports of goods and services,
  divided by its output.
• Evaluation of the effects of floating rates on
  world trade is complicated further by the
  activities of multinational firms, many of which
  expanded their international production
  operations in the years after 1973.
• International trade has recently been threatened
  by the resurgence of protectionism, a symptom of
  slower economic growth and wide swings in real
  exchange rates, which have been labeled
  misalignments.

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Policy Coordination

• Floating exchange rates have not promoted
  international policy coordination.
• Critics of floating have not made a strong case
  that the problem of beggar-thy-neighbor policies
  would disappear under an alternative currency
  regime.
• Government are often motivated by their own
  interest rather than that of the community. It
  seems doubtful that an exchange rate system alone
  can restrain a government from following its own
  perceived interest when it formulates
  macroeconomic policies.

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Are Fixed Exchange Rates Even an Option for Most
Countries?

• Maintaining fixed exchange rates in the long-run
  requires strict controls over capital movements.
• Attempts to fix exchange rates will necessarily
  lack credibility and be relatively short-lived.
• Fixed rates will not deliver the benefits
  promised by their proponents.
• The post - Bretton Woods experience
  suggests another hypothesis durable fixed
  exchange rate arrangements may not even be
  possible.
• This pessimistic view of fixed exchange
  rates is based on the theory that speculative
  currency crises can, at least in part, be
  self-fulfilling events.
• At the end of the twentieth century, speculative
  attacks on fixed exchange rate arrangements were
  occurring with seemingly increasing frequency.

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Directions for Reform

• The experience with floating exchange rates since
  1973 shows that neither side in the debate
  over floating was entirely right in its
  predictions.
• No exchange rate system works well when
  countries go it alone and follow narrowly
  perceived self-interest.
• Severe limits on exchange rate flexibility are
  unlikely to be reinstated in the near future.
• Increased consultation among policymakers in the
  industrial countries should improve the
  performance of floating rates.
• Globally balanced and stable policies are a
  prerequisite for the successful performance of
  any international monetary system.

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Directions for Reform

• Current proposals to reform the international
  monetary system run the gamut from a more
  elaborate system of target zones for the dollar
  to the resurrection of fixed rates to the
  introduction of a single world currency.
  Because countries seem unwilling to give up
  the autonomy floating dollar rates have given
  them, it is unlikely that any of these changes is
  in the cards.
• With greater policy cooperation among the main
  players, there is no reason why floating
  exchange rates should not function tolerable well
  in the future.
• Cooperation should be sought as an end in itself
  and not as the indirect result of exchange rate
  rules.

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Question
41

• Thanks