Free Slides from Ed Dolan’s Econ Blog Why Exchange Rates Matter in a Crisis: Latvia vs. Czech Republic Posting prepared May 24, Terms of Use: You are free to use these slides in your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers. Check it out at

Posting P from Ed Dolan’s Econ Blog The Economic Crisis in Europe  The 27 countries of the European Union, like the United States, have been hit hard by the global economic crisis  But average figures for the EU tell only part of the story  We need also to ask what has caused the impact of the crisis to vary from country to country within the EU

Posting P from Ed Dolan’s Econ Blog Fixed and Flexible Exchange Rates  Exchange rate policy is one factor that has made a big difference  16 EU countries are members of the euro area, and several others have currencies that are firmly pegged to the euro  Other EU countries have exchange rates that vary from day to day depending on supply and demand Source: Europa.eu

Posting P from Ed Dolan’s Econ Blog A Comparison: Latvia and the Czech Republic  The Czech Republic has a flexible exchange rate, while the Latvian exchange rate is firmly fixed to the euro  In the first years after joining the EU ( ), both countries enjoyed a boom  The crisis caused a sharp recession in both countries, but the recession in Latvia was more severe  Why the difference?

Posting P from Ed Dolan’s Econ Blog Exchange Rates in Latvia and the Czech Republic  After 2004, rapid growth and a strong inflow of capital caused appreciation of the Czech koruna.  In 2004, it took 33 koruna to buy one euro; by 2008, the koruna had strengthened to 23 per euro.  After 2008, the koruna depreciated sharply, back to almost 30 per euro at one point  During the whole period, the Latvian currency, the lats, remained firmly fixed at an exchange rate of.71 lats per euro Stronger Koruna

Posting P from Ed Dolan’s Econ Blog Rapid Inflation in Latvia  In Latvia, the boom years after 2004 brought rapid inflation, the fastest in the EU  The fixed exchange rate kept interest rates low and helped fuel a housing bubble  Central bank actions to hold the exchange rate steady led to rapid growth of the money supply, further fueling inflation  Wages rose and the country lost competitiveness

Posting P from Ed Dolan’s Econ Blog Low Inflation in the Czech Republic  In contrast, inflation in the Czech Republic remained low in the boom years, barely higher than the EU average  A stengthening exchange rate kept import prices low, holding average price increases down  Not needing to hold the exchange rate fixed, the Czech central bank was able to use monetary policy to avoid overheating of the economy

Posting P from Ed Dolan’s Econ Blog In Czech Republic, Exchange Rate Helps Absorb Impact of Crisis  When the global financial crisis hit, the Czech koruna depreciated sharply, from 23 per euro to almost 30 per euro  The depreciation absorbed much of the impact of the crisis by quickly improving the country’s competitiveness relative to its EU trading partners  Inflation slowed moderately, but there was no threat of deflation Weaker Koruna

Posting P from Ed Dolan’s Econ Blog The Crisis in Latvia Forces Adjustment through “Internal Devaluation”  The crisis hit Latvia much harder  With no change in the exchange rate, Latvia could restore competitiveness only through deflation  Restoring competitiveness through a fall in prices and wages is sometimes called a strategy of “internal devaluation”

Posting P from Ed Dolan’s Econ Blog The Consequences for Unemployment  “Internal devaluation” through deflation has been very painful to Latvia, and has brought soaring unemployment  The extra flexibility of a floating exchange rate has helped the Czech Republic adjust more smoothly to the crisis  Unemployment in Latvia is the highest in the EU, but in the Czech Republic, it has stayed below the EU average

Posting P from Ed Dolan’s Econ Blog The Bottom Line  During good times, a fixed exchange rate is beneficial in promoting trade and economic integration  However, during a boom, a fixed exchange rate can contribute to overheating  When there is a sharp downturn, a flexible exchange rate can speed adjustment compared with the painful process of “internal devaluation” that a fixed-rate country must undergo