Exchange rate policy 1  Fixed and floating exchange rates  Alternatives to foreign exchange intervention  Monetary policy and  floating exchange rates  fixed exchange rates  The international business cycle

Introduction 2 Exchange rates freely determined by market forces of supply and demand are called floating exchange rates. Exchange rates that are determined by government policy are fixed exchange rates.

Fixed exchange rate 3 Suppose a country wishes to keep its exchange rate at a certain level, or fix the exchange rate. A fixed exchange rate may have advantages:  Certainty regarding exchange rates for domestic businesses who export and import.  Makes exports more competitive if the fixed exchange rate is lower than the market rate.

Fixed exchange rate 4 The following diagram shows that the country of Fredonia has fixed its exchange rate at 0.6 dollars per lire, clearly lower than the market equilibrium of 0.75 dollars per lire. Fredonia does this by moving the market toward its target exchange rate.

Fixed exchange rate 5 Dollars per lire Quantity of lire Demand 0.75 QDQD Supply Forex market for lire 0.60 QSQS Shortage Target exchange rate

Fixed exchange rate 6 Problem: a shortage of lire exists at the target of 0.6 dollars per lire. To keep the exchange rate from rising above 0.6, Fredonia must intervene in the market by increasing the supply of lire. This will shift the supply curve to the right, keeping the exchange rate at the target of 0.6 dollars per lire (next slide).

Fixed exchange rate 7 Dollars per lire Quantity of lire Demand 0.75 QDQD S0S0 Forex market for lire 0.60 QSQS Shortage Target exchange rate S1S1 Fredonia supplies more lire to the forex market

Fixed exchange rate 8 How does Fredonia increase the supply of lire in the forex market? It makes a trade: it prints lire and purchases dollars in the forex market. This action increases the supply of lire, pushing the exchange rate down to the target of 0.6 dollars per lire.

Fixed exchange rate 9 Of course, this policy works only when the market has a desire for additional lire. This would be true if Fredonia exports more than it imports, or if Fredonia is an attractive location for foreign capital investment. In these cases the demand for lire will be strong.

Fixed exchange rate 10 Real world example: China has long kept a fixed exchange rate for its currency, the yuan. Strong demand for Chinese exports has steadily increased the demand for the yuan on the forex market. Growing demand should have caused the yuan to appreciate, resulting in slower export growth.

Fixed exchange rate 11 But China’s economic policymakers have managed to limit the appreciation of the yuan through foreign exchange intervention: they sold more and more yuan in exchange for dollars in the forex market. The effect of this policy is that the yuan is priced lower than equilibrium, and China’s exports are priced lower relative to U.S. goods.

Fixed exchange rate 12 Manufacturers of competing goods in the U.S., such as steel producers, are not pleased with China’s fixed exchange rate policy. They believe that a market-determined yuan would rise above the fixed value, and make domestic goods more competitive with Chinese imports.

Fixed exchange rate 13 In other circumstances, a country may decide to support an exchange rate at higher than the market equilibrium. In this case, a surplus of currency would exist. To keep the exchange rate from declining, the country must purchase its own currency in the forex market using dollars or euros which it has accumulated in reserves. This will soak up the excess currency and keep the exchange rate from falling to the equilibrium (next slide).

Fixed exchange rate above equilibrium 14 Dollars per lire Quantity of lire 0.75 QDQD S0S0 Forex market for lire 0.85 QSQS Surplus Target D1D1 Fredonia buys lire on the forex market D0D0

Fixed exchange rate 15 The problem with this policy, of supporting an exchange rate above equilibrium, is that the country may run out of foreign currency reserves. If the country runs out of reserves, then it will be forced to devalue the currency to the market equilibrium exchange rate. Devaluation occurs when a country cuts its exchange rate in a fixed rate system. Devaluation does not apply to a floating exchange rate system where market forces prevail.

Fixed exchange rate 16 By contrast, a revaluation occurs when a country increases its exchange rate in a fixed rate system.

Alternatives to foreign exchange intervention 17 Foreign exchange intervention is not the only means a government has to support a fixed exchange rate.

Alternatives to foreign exchange intervention 18 First, the government could use monetary policy to help fix the exchange rate. If the government wants an exchange rate lower than equilibrium, it needs to cause a decrease in the demand or increase in the supply of lire in the forex market. A lower interest rate, caused by money supply growth, would both decrease the demand and increase the supply of lire.

Alternatives to foreign exchange intervention 19 Demand would decline since lower interest rates make Fredonia less attractive for foreign investors. Supply would increase since domestic investors wish to invest less in Fredonia and more in foreign markets. Thus, a cut in interest rates will push the exchange rate lower for Fredonia.

Alternatives to foreign exchange intervention 20 Second, the government could impose foreign exchange controls; individuals would require a license, or permission, from the government to trade currencies. A government might do this when it wants to prevent the exchange rate from falling. By limiting the number of licenses issued, the government could limit the supply of lire on the forex market, thus supporting its price.

Floating v Fixed 21 A fixed exchange rate has advantages and disadvantages. Trade among the states in the U.S. occurs, in effect, within a fixed exchange rate system: a dollar is a dollar no matter which state you are in. Similarly, countries that adopted the euro as the common currency in 1999 benefit from the certainty created by trading with a common currency. A fixed exchange rate significantly reduces the risk involved with international transactions.

Floating v Fixed 22 A fixed exchange rate significantly reduces the risk involved with international transactions. Buyers and sellers don’t worry about losses that might occur simply because the exchange rate has changed.

Floating v Fixed 23 Disadvantage of a fixed exchange rate A fixed exchange rate system limits the ability of the country to use monetary policy to manage aggregate demand. Instead, monetary policy must focus on stabilizing the exchange rate. For example, suppose real GDP growth in Fredonia is slowing, and Fredonia wants to use monetary policy to pump up aggregate demand.

Floating v Fixed 24 Disadvantage of a fixed exchange rate But if Fredonia increases the money supply enough to boost aggregate demand, it will have to give up on a fixed exchange rate. A rising money supply will cause interest rates to fall. And falling interest rates make Fredonia a less attractive location for investment spending, either foreign or domestic. As a result, the demand for lire declines and the supply increases (next slide) on the forex market, pushing the exchange rate lower.

Floating v Fixed 25 Floating exchange rates A disadvantage of floating exchange rates is the risk to those who engage in trade: profits and losses may depend heavily on shifts in the exchange rate. An important advantage to a floating exchange rate is that the country is free to use monetary policy to pursue goals other than exchange rate stabilization. In fact, floating exchange rates make monetary policy more effective in managing aggregate demand.

Floating v Fixed 26 For example, we know that increasing the money supply will reduce interest rates and increases investment spending, thus boosting aggregate demand. But lower interest rates will also depreciate the currency (next slide). And when the currency depreciates, exports rise and imports decline, both boosting aggregate demand. So, monetary policy can affect aggregate demand through two channels: investment spending and net exports (exports – imports) in a floating exchange rate system.

Interest rates decline in the U.S. 27 euros per dollar Quantity of dollars D0D0 e0e0 Q0Q0 S0S0 Forex market for dollars Target exchange rate D1D1 S1S1 e1e1 Supply rises and demand declines. The dollar depreciates.

International business cycle 28 Aggregate demand shocks that begin in one country will have more or less impact in other countries depending on the exchange rate system in place. Imagine that a large country is moving into a recession. Spending declines, including spending on imports from smaller country trading partners. Exports decline from the smaller countries. Thus, aggregate demand of the countries are linked.

International business cycle 29 Declining exports will decrease the demand for the currencies of the smaller countries, putting downward pressure on exchange rates. If the small countries have a fixed exchange rate system, it will have to use foreign exchange reserves to purchase their own currencies on the forex markets in order to prop up the exchange rate.

International business cycle 30 On the other hand, if the small countries have a floating exchange rate system, the currency will depreciate, causing exports to rise and imports to fall. Both rising exports and falling imports help reduce the impact of the initial shock from the large country. Thus, floating exchange rates help insulate a trading partner from recessions that begin overseas.

Summary 31 Floating exchange rates are determined by market forces of supply and demand. Fixed exchange rates require a government to intervene in the foreign exchange market in order to move the market to the exchange rate target. Monetary policy and exchange controls are alternatives to foreign exchange intervention.

Summary 32 The effectiveness of monetary policy in managing aggregate demand and real GDP is very limited in a fixed exchange rate system. In a floating rate system, monetary policy is free to pursue goals other than stabilizing the exchange rate. Also, recessions that begin overseas will have less impact with a floating exchange rate system compared with fixed exchange rates.