1. Fixed Exchange Rates and Currency Unions

2. Introduction Why would a government buy or sell foreign exchange?
How does the overall economy and economic policy change when the exchange rate is not allowed to float freely?
How do fixed exchange rate systems work?
How do countries with fixed exchange rates affect the world economy?

3. Inconvertible Currencies
To fix a currency can make it an inconvertible currency
One that cannot be freely traded for another country’s currency among domestic consumers and businesses
Common term for this system is exchange controls
Government or central bank becomes a monopolist controlling all sales of foreign currency at set price
Easy to “fix” the price of foreign exchange
Common among developing countries

4. Inconvertible Currencies
Foreign exchange market
Downward sloping demand
Perfectly inelastic supply
One seller of foreign exchange - government
Equilibrium at intersection determines fixed exchange rate
Government balances available supply of foreign exchange with demand to achieve set exchange rate

5. Inconvertible Currencies

6. Inconvertible Currencies
To keep exchange rate fixed, total outflows and inflows must be equal at all times
Requires government to control flow of capital into and out of the country
Domestic individuals and companies’ ability to purchase foreign financial assets is severely limited.

7. Difficulties & Exchange Controls
Exchange controls lead to
Government initially balancing demand and supply for foreign exchange
Eliminated wide swings in exchange rate
Difficulties with exchange controls
Must deal with government bureaucracy
Government sole source of foreign exchange
Less quality than free market
Efficiency losses with only one provider

8. Difficulties & Exchange Controls
Difference between nominal and real exchange rates
If nominal rate close to PPP rate, then relatively sustainable
Money supplies in developing countries difficult to control
Domestic inflation rate can likely be greater than foreign inflation rate
Country’s real exchange rate is depreciating and nominal rate is becoming over valued

9. Difficulties & Exchange Controls
Difference between nominal and real exchange rates (cont.)
Assume expansionary policies - economy expands and price level increases
Real exchange rate depreciates and nominal rate is fixed
Imports relatively cheaper and domestic demand increasing – rising demand for foreign exchange
Excess demand at fixed exchange rate

10. Difficulties & Exchange Controls

11. Difficulties & Exchange Controls
Balancing demand leaves 3 options
Allow currency to depreciate
Large depreciation can cause higher inflation and lower GDP
Government could implement contractionary policies to reduce demand for foreign exchange
Sacrifice domestic demand to maintain exchange rate

12. Difficulties & Exchange Controls
Balancing demand leaves 3 options
Ration available supply of foreign exchange
Government decides who gets the foreign exchange
Should provide for necessary imports and deny for unnecessary
What is considered necessary?
Obviously gives way to large incentives for government corruption

13. Difficulties & Exchange Controls
Additional problems for economy
Depreciation of real exchange rate makes exports more expensive
Supply for foreign exchange available to country coming from exports decreases
Shortage of foreign exchange increases
Rationing problem is more severe
May cause product and input shortages in domestic markets

14. Difficulties & Exchange Controls

15. Intervention: Foreign Exchange
Government may choose to peg their currency to that of another currency
Mexico might peg peso to US dollar
Mexico uses intervention – buying and selling of foreign exchange to influence value of exchange rate
Mexico selling foreign exchange increases supply and Mexico buying dollars increases demand

16. Intervention: Foreign Exchange
Foreign exchange market in equilibrium with Mexico pegging rate of XRP
Economic growth – increase demand for foreign exchange
To maintain XRP, government sells foreign exchange to increase supply
Maintains exchange rate and prevents depreciation of currency

17. Intervention: Foreign Exchange

18. Intervention: Foreign Exchange
Assume Mexico’s interest rates increase relative to US
Capital flows to Mexico increasing supply of foreign exchange
To peg rate, Mexico purchases foreign exchange increasing demand
Maintains exchange rate and prevents appreciation of currency

19. Intervention: Foreign Exchange

20. Intervention: Foreign Exchange
Long run can hold rate as long as can buy or sell foreign exchange
Mobile portfolio capital can be a good or bad thing for a country with fixed rate
Inflows create additional supply of foreign exchange for country
Capital flows volatile in short run and create problems when outflow from domestic markets
If cannot maintain peg, can lead to “currency crisis” causing severe depreciation of currency

21. Macro Adjustment – Fixed Rates I
Internal balance must be adjusted to stay in line with a fixed exchange rate over time
Example: Assume domestic economy growing quickly
Domestic demand for foreign exchange increases as demand for imports increases
Private sector has balance of payments deficit

22. Macro Adjustment – Fixed Rates I
Example (cont.)
Government sells foreign currency in foreign exchange market to maintain exchange rate
AD increases and hope current account deficit keeps it from going past full employment level
With sufficient reserves, government can intervene until economic growth slows

23. Macro Adjustment – Fixed Rates I

24. Macro Adjustment – Fixed Rates I
Example (cont.)
With government intervention in foreign exchange market, economic situation will correct itself
When government sells foreign currency they are getting domestic currency in exchange
This leads to decrease in domestic money supply (similar to selling government bonds)

25. Macro Adjustment – Fixed Rates I
Example (cont.)
Foreign exchange is not part of country’s money supply
The country’s monetary base is reduced by amount of intervention
Domestic money supply contracts by multiple of amount of intervention

26. Macro Adjustment – Fixed Rates I
Example (cont.)
Effects of intervention
The exchange rate is stabilized in the short run as shown earlier
Begun automatic adjustment almost guaranteeing balance of payments deficit will not continue in long run

27. Macro Adjustment – Fixed Rates I
Effects of intervention
AD falls with fall in money supply
Equilibrium levels of output and price level fall
Maintained fixed exchange rate by reducing rate of economic growth
Allows not only exchange rate to be fixed, but automatically adjusts economy for sustainable external equilibrium

28. Macro Adjustment – Fixed Rates I
Maintaining fixed exchange rate takes away governments ability to use discretionary monetary policy to influence the economy
Money supply becomes a function of country’s external balance based on how much government must intervene in foreign exchange market

29. Macro Adjustment – Fixed Rates II
Along with benefits, there is a cost associated with fixed exchange rates
Automatic changes from intervention occur without considering the state of the domestic economy
Assume external balance is in deficit and economy is producing less than full employment

30. Macro Adjustment – Fixed Rates II
Money supply declines and country’s external balance is balanced
Internal balance would change decreasing output and unemployment would increase
Intervention in this case is inconsistent with internal balances
However, some cases it can be consistent

31. Macro Adjustment – Fixed Rates II
Table 17.1 summarizes effects of intervention on external and internal balances
First column – state of internal balance
Second column – position of external balance
Third & fourth – appropriate government response to solve internal and external balance respectively
Last column – lists consistency

32. Macro Adjustment – Fixed Rates II
Two cases where monetary policy solves internal and external balances – consistent
Two case where internal and external balances conflict – inconsistent
These two cases of inconsistency make fixing exchange rates a problem for some countries

33. Macro Adjustment – Fixed Rates II

34. Macro Adjustment – Fixed Rates II
Inconsistencies
External deficit when at less than full employment, adjustment leads to recession to maintain fixed exchange rates
External surplus with high inflation or rapid economic growth, adjustment leads to higher inflation or more rapid economic growth

35. Macro Adjustment – Fixed Rates II
Most participants in international trade prefer fixed exchange rates as it decreases risk of transactions
But, fixed exchange rates mean that on occasion internal and external balances will be mismatched with policy

36. Fiscal Policy & Internal Balance
In the short run, there are solutions to the dilemma between internal and external balances
Government can assign roles
Monetary policy for external balance
Fiscal policy for internal balance
Example: government adopts expansionary fiscal policy

37. Fiscal Policy & Internal Balance
Example (cont.) -
Government budget deficit financed through borrowing
Demand for loanable funds increases raising interest rates (D to D’)
Open economy, rise in interest rates creates inflow of foreign capital
Domestic supply of loanable funds increases (S to S+f)

38. Fiscal Policy & Internal Balance

39. Fiscal Policy & Internal Balance
Example (cont.)
Inflow of capital requires foreign investors to sell foreign currency or buy domestic currency
Supply of foreign exchange increases
Exchange rate to appreciate, but with fixed rate government intervenes
Demand for foreign exchange increases maintaining pegged or fixed rate

40. Fiscal Policy & Internal Balance

41. Fiscal Policy & Internal Balance
Example (cont.)
Secondary effect on market for loanable funds
Government purchases of foreign exchange increases domestic money supply
Increase in money supply leads to increase in supply of loanable funds (S+f to S’+f)
Equilibrium interest rate moves back toward ie

42. Fiscal Policy & Internal Balance

43. Effects of Fiscal Policy - Domestic
Expansionary fiscal policy
Increases AD, increasing output and price level
Intervention in foreign exchange increases money supply
AD increases even more with increase in money supply
With open economy and fixed exchange rates, effect of policy are more pronounced

44. Effects of Fiscal Policy - Domestic

45. Effects of Fiscal Policy - Domestic
Contractionary Fiscal Policy
Demand for loanable funds decreases
Lowers interest rate
Investment in domestic country decreases – capital outflows
Supply of loanable funds decreases
(S to S-f)
Interest rates increase towards original equilibrium

46. Effects of Fiscal Policy - Domestic

47. Effects of Fiscal Policy - Domestic
Contractionary Fiscal Policy (cont.)
Capital outflow causes demand for foreign exchange to increase
Pressure for currency to depreciate
Intervention in foreign exchange market leads to increase in supply of foreign exchange to maintain fixed rate

48. Effects of Fiscal Policy - Domestic

49. Effects of Fiscal Policy - Domestic
Contractionary Fiscal Policy (cont.)
Secondary effect from change in money supply
Selling foreign exchange buys domestic currency decreasing money supply
Supply of loanable funds decreases even further moving equilibrium interest rate back toward original rate

50. Effects of Fiscal Policy - Domestic

51. Effects of Fiscal Policy - Domestic
Contractionary Fiscal Policy (cont.)
Initially AD decreases, lowering equilibrium output and price level
Intervention in foreign exchange market decreasing money supply has additional effect of decreasing AD further
Net result in open economy, effects on output and price level are more pronounced

52. Effects of Fiscal Policy - Domestic

53. Sterilization
The separation of monetary policy from intervention in foreign exchange market
Allows achieving external balance to not affect the money supply of the country
Can solve mismatch between external and internal balance under fixed exchange rate in short run

54. Sterilization Assume private demand foreign exchange increases
Balance of payments deficit
Government must sell foreign exchange to maintain exchange rate
Decrease in domestic money supply
A central bank in developed country with active government bond market can use open market operations

55. Sterilization Government knows how much domestic currency it purchased
Government can purchase like amount of government bonds
Net effect of intervention and sterilization on domestic money supply is zero

56. Sterilization Problems Example
Best used when there are small short run deviations in exchange rate from PPP
Necessary exchange rate is kept fairly close to PPP or policy likely to fail
Example
If domestic inflation is higher than foreign inflation (usual case), intervention and sterilization result in overvalued real currency

57. Sterilization Example (cont.)
Supply of foreign reserves held by government not enough to maintain exchange rate and currency must be devalued
Sharp devaluations have consequences discussed in chapter 15

58. Sterilization
Sterilization can work if we vary what we mean by fixed exchange rate
We can fix or peg the real exchange rate instead of nominal rate
Nominal rate is allowed to change while real rate is held constant – crawling peg
Remember equation for real exchange rate

59. Sterilization
Maintaining nominal rate requires ratio of prices to be constant
To maintain real exchange rate, calculate change in price ratio and change nominal rate to account for difference

60. Sterilization
Country may set pre-announced rate of change in nominal rate based on differences
Although exchange rate is changing, participants know by how much
Real exchange rate is held steady
Still a need for intervention to smooth out changes from announced rate
Monetary policy can now focus on domestic economic conditions and exchange rate in real sense is stable

61. Pegging w/Monetary Policy
A country may be willing to sacrifice domestic monetary policy for fixed rate
Could have two countries very closely related
Larger and smaller country with high level of trade
May have high correlation between changes in GDP (one in larger than other)

62. Pegging w/Monetary Policy
These circumstances may lead to smaller country fixing its exchange rate to larger country
Monetary policy is sacrificed, but smaller country may not have any influence with domestic monetary policy to begin with b/c of connection with larger country

63. Pegging w/Monetary Policy
Recession in larger country most likely leads to recession in smaller country
If monetary policy does not matter, smaller country may feel makes sense to forgo monetary policy in exchange for fixed exchange rates
May require some intervention, but does not matter if sterilized or not
Smaller country’s monetary and price level growth rate almost identical to larger country

64. Currency Unions
If maintaining fixed rate has so many problems, then why continue to try?
If really want to keep exchange rate stability between two countries, then more logical to merge two currencies into one – currency union
Obviously benefits and costs associate with this decision

65. Currency Unions
Consider Germany and Austria before the formation of the euro
Benefit from monetary efficiency gains
Gains derived from not having to change currencies when conduction trade between the countries
Cost from economic stability loss
Countries no longer have ability to conduct independent monetary policy

66. Currency Unions
Must weigh the size of gains and losses for each country
The greater the trade between the countries, the greater the monetary efficiency gains
There is not, however, a precise cutoff point where common currency is good or bad

67. Currency Unions
Common currency will ease transaction of capital flows across countries
Not changing currency will increase efficiency of financial markets in both countries
Similarly, would be easier to make direct investments (FDI) if did not have to convert currency
Some uncertainty with investing across boarders would be eliminated as well

68. Currency Unions
Ability of labor to move across boarders when one country has a recession can reduce losses of recession
If two countries have similar average rate of inflation, less change joint monetary policy is undesirable
Economic stability losses smaller if common fiscal policy – similar taxation and spending systems

69. Currency Unions
Smaller economic stability losses the more correlated the GDP’s of the countries
Recession in one country means recession in another so joint policies appropriate for both countries
Using these measure of gains and losses, can better determine if common currency is best choice