1. Slide 19-1Copyright © 2003 Pearson Education, Inc. The Case for Floating Exchange Rates –Monetary policy autonomy –Allow each country to choose its own desired long-run inflation rate –Symmetry –Allow each country to choose its own desired long-run inflation rate –Restore monetary control to central banks –Exchange rates as automatic stabilizers –Depreciation in the face of reduced demand for a nation’s exports restores equilibrium automatically »Unlike Bretton Woods, where there would be “fundamental disequilibrium”.

2. Slide 19-2Copyright © 2003 Pearson Education, Inc. AA 1 DD 1 Effects of a Temporary Fall in Export Demand AA 2 DD 2 AA 1 DD 2 DD 1 E2E2 2 Y2Y2 Y2Y2 Output, Y Exchange rate, E (a) Floating exchange rate Output, Y Exchange rate, E (b) Fixed exchange rate Y1Y1 E1E1 1 Y1Y1 E 1 1 Y3Y3 3 The Case for Floating Exchange Rates

3. Slide 19-3Copyright © 2003 Pearson Education, Inc. The Case Against Floating Exchange Rates  Discipline … and lack of discipline … but a floating exchange rate bottles up inflation in a country whose government is “misbehaving”.  Destabilizing speculation –Countries can be caught in a “vicious circle” of depreciation and inflation. –Floating exchange rates make a country more vulnerable to money market disturbances.

4. Slide 19-4Copyright © 2003 Pearson Education, Inc. AA 1 DD Output, Y Exchange rate, E E1E1 Y1Y1 1 A Rise in Money Demand Under a Floating Exchange Rate AA 2 E2E2 Y2Y2 2 The Case Against Floating Exchange Rates

5. Slide 19-5Copyright © 2003 Pearson Education, Inc.  Injury to International Trade and Investment –Exporters and importers face greater exchange risk. –International investments face greater uncertainty about payoffs denominated in home country currency. –But forward markets can protect traders against foreign exchange risk.  Uncoordinated Economic Policies Countries can engage in competitive currency depreciations. The Case Against Floating Exchange Rates

6. Slide 19-6Copyright © 2003 Pearson Education, Inc. Floating and Discipline: Inflation Rates in Major Industrialized Countries, 1973-1980 (percent per year) The Case Against Floating Exchange Rates

7. Slide 19-7Copyright © 2003 Pearson Education, Inc. Purchasing Power Parity? Nominal and Real Effective Dollar Exchange Rates Indexes, 1975-2000 The Case Against Floating Exchange Rates

8. Slide 19-8Copyright © 2003 Pearson Education, Inc. Macroeconomic Interdependence Under a Floating Rate  Macroeconomic interdependence between “Home” and “Foreign” Countries: Effect of a permanent monetary expansion by Home –Home output rises, Home’s currency depreciates, and Foreign output may rise or fall. Effect of a permanent fiscal expansion by Home –Home output rises, Home’s currency appreciates, and Foreign output rises.

9. Slide 19-9Copyright © 2003 Pearson Education, Inc. Macroeconomic Interdependence Under a Floating Rate Unemployment Rates in Major Industrialized Countries, 1978-2000 (percent of civilian labor force)

10. Slide 19-10Copyright © 2003 Pearson Education, Inc. Macroeconomic Interdependence Under a Floating Rate Inflation Rates in Major Industrialized Countries 1981-2000, and 1961-1971 Average (percent per year)

11. Slide 19-11Copyright © 2003 Pearson Education, Inc. Macroeconomic Interdependence Under a Floating Rate Exchange Rate Changes Since the Louvre Accord

12. Slide 19-12Copyright © 2003 Pearson Education, Inc. 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.

13. Slide 19-13Copyright © 2003 Pearson Education, Inc. Exchange Rate Trends and Inflation Differentials, 1973-2000 What Has Been Learned Since 1973?

14. Slide 19-14Copyright © 2003 Pearson Education, Inc. 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. What Has Been Learned Since 1973?

15. Slide 19-15Copyright © 2003 Pearson Education, Inc.  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). What Has Been Learned Since 1973?

16. Slide 19-16Copyright © 2003 Pearson Education, Inc.  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. What Has Been Learned Since 1973?

17. Slide 19-17Copyright © 2003 Pearson Education, Inc.  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. What Has Been Learned Since 1973?

18. Slide 19-18Copyright © 2003 Pearson Education, Inc.  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. What Has Been Learned Since 1973?

19. Slide 19-19Copyright © 2003 Pearson Education, Inc.  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. What Has Been Learned Since 1973?

20. Slide 19-20Copyright © 2003 Pearson Education, Inc. 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.