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Chapter 19 Macroeconomic Policy and Coordination under Floating Exchange Rates

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Title: 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.

3
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.

4
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.

5
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.

6
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

8
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.

9
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.
10
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.

11
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.

12
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.

13
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.

16
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.

17
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.

18
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.

19
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.

20
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
23
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.

24
Exchange Rate Trends and Inflation
Differentials,1973-2000
25
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.

26
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.

27
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.

28
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.

29
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.

30
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.

31
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.

32
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.

33
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.

34
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.

35
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.

36
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.

37
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.

38
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.

39
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.

40
Question
41
  • Thanks
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