Chapter 29 Exchange rate regimes ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Key issues Exchange rate regimes and their implications for the world economy International policy co-ordination Policy co-ordination in Europe ©McGraw-Hill Companies, 2010 2

©McGraw-Hill Companies, 2010 Exchange rate regimes Exchange rate Forex intervention Fixed Floating Free float None Gold standard currency board Automatic Adjustable peg Managed float Some discretion ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 The gold standard Characteristics of the gold standard: The government of each country fixes the price of gold in terms of its domestic currency. The government maintains convertibility of domestic currency into gold. Domestic money creation is tied to the government's holding of gold. Adjustment to full employment is via domestic wages and prices creating vulnerability to long and deep recessions. ©McGraw-Hill Companies, 2010 4

The adjustable peg & the dollar standard In an adjustable peg regime, exchange rates are normally fixed, but countries are occasionally allowed to alter their exchange rate. Under the Bretton Woods system, each country announced a par value for their currency in terms of US dollars the dollar standard. ©McGraw-Hill Companies, 2010 5

©McGraw-Hill Companies, 2010 The dollar standard Faced with a balance of payments deficit under the dollar standard, countries could try to avoid monetary contraction by running down foreign exchange reserves. But devaluation could not be postponed for ever, given finite reserves. Expansion of US money supply began to spread inflation world-wide. ©McGraw-Hill Companies, 2010 6

Floating exchange rates Under pure/clean floating, forex markets are in continuous equilibrium. The exchange rate adjusts to maintain competitiveness. But in the short run, the level of floating exchange rates is determined by speculation given that capital flows respond to interest rate differentials. ©McGraw-Hill Companies, 2010 7

Fixed versus floating exchange rates Robustness Bretton Woods system was abandoned because it could not cope with real and nominal strains a flexible rate system is probably more robust Volatility fixed rate system offers fundamental stability flexible rate system is potentially volatile but shocks must be accommodated in other ways under a fixed rate system Financial discipline fixed rate system imposes discipline and policy harmonisation. ©McGraw-Hill Companies, 2010 8

UK exchange rate, 1975–2010 ($/£) Floating exchange rates can be volatile. Since 1975 under floating exchange rates. Not only did the exchange rate fluctuate between $2.50/£ and $1.05/£, it sometimes moved very rapidly. Such volatility, it is argued, leads to great uncertainty, reducing both trade and foreign investment. Source: Bank of England ©McGraw-Hill Companies, 2010 9

International policy co-ordination Can a concerted attempt by a group of countries to co-ordinate their policy bring benefits to the group? Externality argument: non co-operative policy can impose costs that can be avoided by agreement between governments Reputation argument co-ordination may allow individual governments to pre-commit to policies that would otherwise not be credible ©McGraw-Hill Companies, 2010 10

The economics of the Euro: Optimal currency areas An optimal currency area is a group of countries better off with a common currency than keeping separate national currencies. 3 characteristics: Considerable trade between them. Rules out competitive devaluations Similarity of economic and industrial structures of potential partners, Flexible labour markets Politically important: A readiness to make at least some fiscal transfers to partner countries. In practice, a cultural and political identity may be at least as important as economic criteria for success. ©McGraw-Hill Companies, 2010 11

Is Europe an optimal currency area? Europe is quite, but not very, integrated. There is a clear inner core of countries – France, Germany, Netherlands, Belgium, Luxembourg, and perhaps Austria - more closely integrated than the rest. However, the act of joining EMU changes the degree of integration, possibly quite substantially. Even so, a decade of the eurozone was not sufficient to prepare all its members for the severe strain that would be imparted by the financial crash and its fiscal aftermath. ©McGraw-Hill Companies, 2010 12

©McGraw-Hill Companies, 2010 The Stability Pact A 3% ceiling for budget deficits In principle, countries exceeding the limit have to pay fines unless their economy was in evident recession. The pact did not preclude countries from using fiscal policies more vigorously, as they most certainly did in 2008-09 when they were clearly in recession The corollary is that, ideally, they should aim for something more like budget balance in normal times, and for budget surplus during periods of boom. ©McGraw-Hill Companies, 2010 13

The European Central Bank (ECB) Its behaviour is largely explained empirically by a Taylor rule, But the ECB describes its monetary strategy as pursuing two intermediate targets, the ‘twin pillars’: a monetary target, the growth rate of the M3 measure of nominal money. expected inflation. The ECB insists that it takes both pillars into account in setting interest rates in the euro area. But does it? ©McGraw-Hill Companies, 2010 14

©McGraw-Hill Companies, 2010 The ECB in action:1999-2010 -2 2 4 6 8 10 12 14 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 It is easy to see how the rise and fall of actual and expected inflation led to the rise and fall of interest rates in the euro area. It is very hard to detect any clear correlation between nominal money growth and interest rate decisions. HICP M3 r % The ECB insists that monetary targets are important because it wants to emphasize continuity with the Bundesbank, which used monetary targets. HICP : the inflation in harmonized index of consumer prices; M3: is a measure of broad money; r: the short-term interest rate controlled by the ECB. ©McGraw-Hill Companies, 2010 15