1. Macroeconomic Policy Objectives
Internal balance
Full employment…maximum output
Stable prices
“Overemployment” rising prices
Less-than-full-employment falling prices
Volatile aggregate demand and output lead to volatile prices.
Price level volatility  uncertainty inefficiency
External balance: Current account
not so much in deficit to be unable to repay foreign debt
not so much in surplus that foreigners can’t repay their debts

2. Achieving Internal and External Balance
Pegged rates
Fiscal policy effective
Exchange rate can be changed
Devaluation/revaluation
Tools:
Expenditure changing: fiscal policy
Expenditure switching: exchange rate setting
Need as many tools as you have objectives
For external balance, XX
G up  Y up  CA down … unless E up (devaluation)
For internal balance, II
E down (revaluation)  CA down  Y down … unless G up

3. Internal Balance (II), External Balance (XX) “Four Zones of Economic Discomfort”

4. The Open-Economy Trilemma The Impossible Trilogy
Impossible for a country to achieve more than two items from the following list:
1. Exchange rate stability…fixed (or managed) rates
2. Monetary policy for internal balance.
3. Freedom of international capital movements.

5. The Policy Trilemma for Open Economies

6. Macroeconomic Policy Under the Classical Gold Standard: 1870–1914
Mechanisms keeping official gold flows (the balance of payments) from becoming too positive or too negative.
Gold stock  Money supply  Price level  Current account
Hume’s Specie Flow Mechanism
Gold stock  Money supply  Output&income  Current account
Gold stock  Money supply  Interest rate  Capital flows
Central banks management of bank rate
Keep private capital flows ≈ Current account
“Rules of the game” not followed
Gold stock  Financial influence  Sterilize gold inflows
Central bank cooperation
Lending to keep gold stocks stable

7. The Gold Standard and Internal Balance
The US economy, 1873 – 1913
Deflation
Frequent financial crises
Frequent recessions
1890 – 1913 unemployment: 6.8% on average
1946 – 1992 unemployment: 5.7% on average

8. Restore London dominance
WW I: Capital flight  breakdown of gold standard
Interwar turbulence
Legacies of WW I
Redrawn borders  disrupted trade patterns
Overhang of “Old Debts”:
reparations/inter-allied loans
Labor empowered: The eight hour day
Excessive claims  hyperinflation
Gold Standard Nostalgia
Restore London dominance

9. $ Dominance/New York Dominance
Classical gold standard, 1870 – 1914
£ dominant despite US economic prowess
US banks couldn’t branch overseas
Bimetalism and its legacy  $ looked risky
WW I  £ instability
$ denominated transactions w/Latin America, Asia
Federal Reserve fostered market in int’l acceptances
Benjamin Strong and his legacy
Post-war credit in $s
European government bonds denominated in $s
National City Bank/Others/Branching Abroad
US financial dominance: from mid-1920s
International economy disrupted in depression, WWII

10. ‘20s Halting return to gold  Prelude to depression  General Strike
The Economic Consequences of Mr. Churchill
 General Strike
US monetary expansion – help to Britain  Roaring ’20s
Capital flow reversal  European downturn
Bubble and collapse
‘30s World in Depression: Who Leads?
UK couldn’t …US wouldn’t  Protection … beggar thy neighbor
1931 European banking crises and contagion
Creditanstalt  German banks  British investment banks
 Flight from the £
September 1931: Britain leaves gold – US defends gold standard
 Crisis and the Great Depression
Golden fetters
Halting recovery: monetary expansion/fiscal measures/rearmament

11. Postwar: Restore Stability  Bretton Woods System
IMF a bank/World Bank a fund
$ pegged to gold … N – 1 currencies pegged to an elastic $
IMF: International lender of last resort
support pegs
allow devaluation when fundamental disequilibrium
Capital controls on international financial transactions
Protect financial account/Prevent balance of payments crisis
Currencies were convertible to encourage trade in goods and services
Fiscal policy the principal tool for internal balance
Principal tools for external balance
borrowing from the IMF
restrictions on financial asset flows
infrequent changes in exchange rates.

12. Policy Mix for Internal and External Balance: 2 Goals – 2 Tools Starting with CA Deficit and Underemployment  Fiscal stimulus + Devaluation
Under the fixed exchange rates of the Bretton Woods system, devaluations were supposed to be infrequent
fiscal policy was supposed to be the main policy tool to achieve both internal and external balance.
In general, fiscal policy cannot attain both internal balance and external balance at the same time.
A devaluation, however, can move toward both internal balance and external balance at the same time.
Speculator anticipation of devaluation  greater internal or external imbalances.

13. Reserve Currencies in Int’l Monetary System
Bretton Woods: $ Standard…more flexible than gold
Each central bank fixed the dollar exchange rate of its currency through foreign exchange market trades for $s
Exchange rates between any two currencies fixed by arbitrage.
The US could use M-policy for macroeconomic stabilization despite fixed rates.
Purchase of domestic assets by the Federal Reserve leads to
Excess US demand for foreign currencies in the foreign exchange market
Purchases of $s by foreign central banks to keep $ from depreciating
Expansionary monetary policies by all other central banks
Higher world output … and/or INFLATION

14. Speculative attacks against weak currencies Gold & $ Shortage $ Glut
Bretton Woods System
Problems/breakdown:
Speculative attacks against weak currencies
Gold & $ Shortage
Buildup of $ reserves > US gold stock
$ Glut
Vietnam era expansion  Pus up  overvalued $
 Rush out of $s…try to redeem gold the US doesn’t have
Nixon Economic Program, August 15, 1971
Close gold window…8% devaluation against gold in 12/71
Import surcharge
Wage/price controls
1973 Collapse of Bretton Woods system
Foreign central banks refused to buy overvalued $ assets

15. Exporting US Inflation: 1966–1972

16. Effect on Internal and External Balance of a Rise in the Foreign (US) Price Level, P*
The “simple” solution for the £, DM,
¥, FF, …
Revalue against the $

17. The Case for Floating Exchange Rates
Monetary policy autonomy…w/o capital controls
Each country can choose “appropriate” long-run inflation rate
Symmetry
$ can “devalue” as necessary…not constrained as leader
Other countries can use monetary tool
Exchange rates as automatic stabilizers
Floating cushions output against real shocks
Something’s gotta adjust…if not E, then Y
Depreciation in the face of reduced demand for a nation’s exports restores equilibrium automatically
Unlike Bretton Woods
there would be a “fundamental disequilibrium”
and ongoing CA deficit and loss of reserves
until price level fell or currency devalued

18. The Case for Floating Exchange Rates
Effects of a Temporary Fall in Export Demand
Output, Y
Exchange rate, E
(a) Floating
exchange rate
DD2
Depreciation
leads to higher
demand for and
output of
domestic products
AA1
DD1 E2 2 Y2 Y1 E1 1
Output, Y
Exchange rate, E
(b) Fixed
exchange rate
DD2
AA1
DD1
Fixed exchange
rates mean output
falls as much as
the initial fall in aggregate demand
AA2 Y3 3 Y1 E1 1

19. The Case Against Floating Exchange Rates
Lack of discipline
… but a floating exchange rate bottles up inflation in a country whose government is “misbehaving”.
Destabilizing speculation
Hot money
…but “fundamental disequilibrium”  one-way bet under fixed rates
Countries can be caught in a “vicious circle” of depreciation and inflation. E deprec Pim up CoL up W up P up  E deprec
Floating exchange rates make a country more vulnerable to money market disturbances: L up  R up  E-apprec.  CA & Y down
Fixed rates cushion output against monetary shocks
L up  M up  nothing shifts under fixed rates

20. The Case Against Floating Exchange Rates
A Rise in Money Demand Under a Floating Exchange Rate
Output, Y
Exchange
rate, E DD
AA1
AA2 E1 Y1 1 E2 Y2 2

21. What really matters? Recall:
With fixed rate, monetary policy is ineffective (given free capital flows)
Similarly, monetary shocks have no real effect
With floating rates, fiscal policy is ineffective
Similarly, temporary real shocks [like drop in demand for exports] have little real effect
Permanent real shocks have “no” real effects

22. The Case Against Floating Exchange Rates
Injury to International Trade and Investment
Exporters and importers face greater exchange risk.
But forward markets can protect traders against foreign exchange risk.
International investments face greater uncertainty about payoffs denominated in home country currency.
Uncoordinated Economic Policies
Countries can engage in competitive currency depreciations.
…under Bretton Woods, policies “coordinated” via US privilege
A large country’s fiscal and monetary policies affect other economies
…aggregate demand, output, and prices become more volatile across countries if policies diverge.
Free Float Really Managed Float
Fear of depreciation – inflation spiral  intervention

23. The Case Against Floating Exchange Rates
Speculation and volatility in the foreign exchange market
If traders expect a currency to depreciate in the short run, they may quickly sell the currency to make a profit, even if it is not expected to depreciate in the long run.
Expectations of depreciation lead to actual depreciation in the short run.
The assumption we’ve been using that expectations do not change when temporary economic changes occur is not valid if expectations change quickly in anticipation of even temporary economic changes.
In fact, exchange rate volatility has increased since 1973

24. Macroeconomic Data for Key Industrial Regions, 1963–2009

25. The Case Against Floating Exchange Rates
Floating and Discipline:
Inflation Rates in Major Industrialized Countries, (percent per year)

26. Nominal and Real Effective Dollar Exchange Rate Indexes, 1975–2006 Purchasing Power Parity???
Source: International Monetary Fund, International Financial Studies.

27.  growing US CA deficit & rest-of-world capital shortage
Due to contractionary monetary policy (Volcker disinflation) and expansive fiscal policy (Reagan tax cut and military buildup, the $ appreciated by about 50% relative to 15 currencies from 1980–1985.
 growing US CA deficit & rest-of-world capital shortage
Major efforts to influence exchange rates:
The 1985 Plaza Accord reduced the value of the dollar relative to other major currencies… “bringing down dollar”
The 1987 Louvre Accord: intended to stabilize exchange rates
Specified zones of +/- 5% around which current exchange rates were allowed to fluctuate.
Quickly abandoned
The October 1987 stock market crash made production, employment and price stability the primary goals for the U.S.
Did tightening to support $ trigger “Black Monday”?
After Black Monday, exchange rate stability became less important.
New targets were (secretly) made after October 1987, but central banks had abandoned these targets by the early 1990s.

28. Large Country => Locomotive
Macroeconomic Interdependence Under Floating Rate The Large Country Case
Effect of a permanent monetary expansion by US
$ depreciates, US output rises
Foreign output may rise or fall.
Foreign’s currency appreciates  Foreign’s output falls
US economy expands Foreign sells more to US
Effect of a permanent fiscal expansion by US
US output rises, US currency appreciates
Foreign output rises
Foreign’s currency depreciates  Foreign’s output rises
US economy expands  Foreign sells more to US
Large Country => Locomotive

29. Exchange Rate Trends and Inflation Differentials, 1973–2009
Source: International Monetary Fund and Global Financial Data.

30. Global External Imbalances, 1999–2009
Source: International Monetary Fund, World Economic Outlook database.
The U.S. has run a current account deficit for many years due to its low saving and high investment expenditure.
Rebalancing: As foreign countries spend more and lend less to the U.S.,
interest rates may rise
the U.S. dollar will depreciating
the U.S. current account will improve (becoming less negative).

31. Long-Term Real Interest Rates for the United States, Canada, and Sweden, 1999–2010
Source: Global Financial Data and Datastream. Real interest rates are six-month moving averages of monthly interest rate observations on ten-year inflation-indexed government bonds.

32. Macroeconomic Interdependence Under Floating Rate
Unemployment Rates in Major Industrialized Countries,
(percent of civilian labor force)

33. What Has Been Learned Since 1973?
After 1973 central banks intervened repeatedly in the foreign exchange market to alter currency values.
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.
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 … exorbitant privilege

34. What Has Been Learned Since 1973?
The Exchange Rate as an Automatic Stabilizer
Experience with the oil shocks of 1973 and 1979 favors floating exchange rates.
The effects of the U.S. fiscal expansion after 1981 provide mixed evidence on the success of floating exchange rates.
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.

35. What Has Been Learned Since 1973?
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.
International Trade and Investment
For most countries, the extent of their international trade shows a rising trend after the move to floating.

36. Many fixed exchange rate systems have developed since 1973.
European monetary system and euro zone
The Chinese central bank currently fixes the value of its currency.
ASEAN countries have considered a fixed exchange rates and policy coordination.