Fixed Exchange Rates and
Foreign Exchange Intervention
Chapter 18 Krugman and Obstfeld 9e
ECO41 International Economics
Udayan Roy
Why Study Fixed Exchange Rates?
• Four reasons to study fixed exchange rates:
– Managed floating
– Regional currency arrangements
– Developing countries and countries in transition
– Lessons of the past for the future
Central Bank Intervention
and the Money Supply
• Any central bank purchase of assets
automatically results in an increase in the
domestic money supply (Ms↑).
– Example: If the US central bank (“The Fed”) buys
some financial asset, it must pay for it with newly
printed dollars. Therefore, the US money supply
must increase.
Central Bank Intervention
and the Money Supply
• Any central bank sale of assets automatically
causes a decrease in the money supply (Ms↓).
– Example: If the Fed sells some financial asset, the
dollars paid by the buyer will no longer be in
circulation. Therefore, the US money supply must
decrease.
• In short, the central bank’s reserves of
financial assets moves in the same direction as
its money supply.
RECAP Fig. 17-8: Short-Run Equilibrium: The
Intersection of DD and AA
The output
market is in
equilibrium
on the DD
curve
The asset
markets are in
equilibrium
on the AA
curve
The short run
equilibrium
occurs at the
intersection
of the DD and
AA curves
17-5
Recap: Shifting the AA and DD Curves
•
The DD curve shifts right
if:

G increases

T decreases

I increases

P decreases

P* increases

C increases for some
unknown reason (C0↑)

CA increases for some
unknown reason (CA0↑,
CAq↑)
•
The AA curve shifts right
if:
–
–
–
–
–
Ms increases
P decreases
Ee increases
R* increases
L decreases for some
unknown reason (L0↓)
Knowing how some exogenous change shifts
the DD and AA curves will help us predict
the consequences of the exogenous change.
16-6
SHORT-RUN MACROECONOMICS
UNDER FIXED EXCHANGE RATES
How a Central Bank Fixes the Exchange Rate
Suppose the central
bank wants to fix the
value of the exchange
rate at E1.
E3
3
2
E2
Y2
Y3
If, for whatever reason,
If, for whatever reason,
the AA curve shifts
the AA curve shifts left,
right, then the shortthen the short-run
run equilibrium shifts
equilibrium shifts from
from point 1 to point 3
point 1 to point 2 and
and the exchange rate
the exchange rate falls.
rises. To return to the
To return to the
exchange rate to the
exchange rate to the
target value of E1,1 all
target value of E , all
that the central bank
that the central bank
has to do is to
has to do is to increase
decrease the money
the money supply and
supply and shift the AA
shift the AA curve back
curve back where it
where it originally was.
originally was.
How a Central Bank Fixes the Exchange Rate
E3
3
2
E2
Y2
Y3
Thus, we see that, under
fixed exchange rate system,
E becomes exogenous and
Ms becomes endogenous.
(Recall from Ch. 17 that
under a flexible exchange
rate system, it is the
reverse: E is endogenous
and Ms is exogenous.)
As the central bank must
continuously adjust the
money supply to keep the
exchange rate fixed at the
target value, Ms can no
longer be used for other
purposes. The usual sort of
monetary policy you’ve
seen before is no longer
possible.
Ch. 17: The AA-DD Model
• AA: 𝑌 =
•
• DD:
𝑀𝑠
𝐿0 ∙𝑃
∙ 𝑅
∗
𝐸𝑒
+
𝐸
−1
 E  P* 

C0  C y  CAm  T  I  G  CA0  CAq  
P 

Y
1  C y  CAm 
• We just saw that in a fixed exchange rate
system E is exogenous
• Therefore, the DD equation expresses Y
entirely in terms of exogenous variables
Summary: The Behavior of Output
Exogenous Change
Effect on Output (Y)
Government Spending (G)
+
Business Investment Spending (I)
+
Net Tax Revenues (T)
–
Foreign Price Level (P*)
+
C-shock (C0)
+
CA-shocks (CA0, CAq)
+
Domestic Price Level (P)
–
Target Exchange Rate (Etarget)
+
As our solution for Y is derived
from the DD curve, it follows
that only the exogenous
variables that can shift the DD
curve can affect output.
The exogenous variables, such
as Ee, R* and L0, that can only
shift the AA curve can have no
effect on Y.
 E target  P * 

C0  C y  CAm  T  I  G  CA0  CAq  
P


Y
1  C y  CAm 
Summary: The Behavior of Output
Exogenous Change
We saw in Ch. 17 that in a
system of flexible exchange
rates, expansionary
(contractionary) monetary
policy is an increase (a
decrease) in the money supply.
Effect on Output (Y)
Government Spending (G)
+
Business Investment Spending (I)
+
Net Tax Revenues (T)
–
Foreign Price Level (P*)
+
C-shock (C0)
+
CA-shocks (CA0, CAq)
+
Domestic Price Level (P)
–
Target Exchange Rate (Etarget)
+
Now we see that in a system of
fixed exchange rates,
expansionary monetary policy is
devaluation (an increase in the
exchange rate target, Etarget↑).
This makes the domestic
currency cheaper.
E
P
C0  C y  CAm  T  I  G  CA0  CAq  
P

Y
1  C y  CAm 
target
*



Conversely, contractionary
monetary policy is revaluation
(a decrease in the exchange rate
target, Etarget↓). This makes the
domestic currency expensive.
How a Central Bank Fixes the Exchange Rate
E3
3
2
E2
Y2
Y3
We have seen before
that changes in Ee, R*
and L0 affect only the
AA curve. And now we
see that, under fixed
exchange rates, such
changes will have no
effect on E and Y.
How a Central Bank Fixes the Exchange Rate
Let us return to the case in
which the AA curve shifts right
for some reason and moves the
equilibrium from point 1 to
point 3.
E3
3
To bring the exchange rate back
to E1, the central bank must
reduce the money supply to
shift the AA curve back where it
was.
But there’s a slight problem. To
reduce the money supply the
central bank must sell financial
assets from its reserves, as we
saw earlier. But what if the
central bank has exhausted its
reserve of assets and has no
assets left to sell?
Y3
In this case, the central bank
will no longer be able to keep
the exchange rate fixed. The
country will be forced to return
to flexible exchange rates.
More on this later!
Shift of the DD Curve
DD2
2
3
AA2
Suppose the central
bank wants to fix the
value of the exchange
rate at E1.
If, for whatever reason,
the DD curve shifts left
and the short-run
equilibrium shifts from
point 1 to point 2, then
all that the central
bank has to do is to
decrease the money
supply and shift the AA
curve to the left and
take the short-run
equilibrium to point 3.
Y3
17-15
Shift of the DD Curve
DD2
2
3
AA2
We have seen before
that the DD curve
shifts left when there
is a decrease in G, I, or
P*, or changes in other
unspecified factors
that decrease C or CA,
or an increase in T or
P.
We see now that,
under fixed exchange
rates, such changes
will reduce Y, and by a
bigger amount than
under flexible
exchange rates.
Y3
17-16
Shift of the DD Curve
DD2
3
2
AA2
Suppose the central
bank wants to fix the
value of the exchange
rate at E1.
If, for whatever reason,
the DD curve shifts
right and the short-run
equilibrium shifts from
point 1 to point 2, then
all that the central
bank has to do is to
increase the money
supply and shift the AA
curve to the right,
thereby taking the
short-run equilibrium
to point 3.
Y3
17-17
Shift of the DD Curve
DD2
3
2
AA2
We have seen before
that the DD curve
shifts right when there
is an increase in G, I, or
P*, or changes in other
unspecified factors
that increase C or CA,
or a decrease in T or P.
We see now that,
under fixed exchange
rates, such changes
will increase Y, and by
a bigger amount than
under flexible
exchange rates.
Y3
17-18
Devaluation (E↑)
E2
2
Y2
Suppose the exchange rate
has been fixed at E1 in the
past. Now suppose the
central bank wishes to
continue to fix the exchange
rate but at the higher value
of E2. This is called
devaluation.
The central bank can
shift only the AA curve.
So, it would have to
increase the money
supply and shift the AA
curve to the right till the
equilibrium exchange
rate increases to the
desired level of E2.
Therefore, we see that a
devaluation raises
output. Conversely, a
revaluation—opposite of
devaluation—reduces
output.
17-19
Summary: The Behavior of Output
Exogenous Change
Effect on Output (Y)
Government Spending (G)
+
Business Investment Spending (I)
+
Net Tax Revenues (T)
–
Foreign Price Level (P*)
+
C-shock (C0)
+
CA-shocks (CA0, CAq)
+
Domestic Price Level (P)
–
Target Exchange Rate (Etarget)
+
Expected Future Exchange Rate (Ee)
0
Foreign Interest Rate (R*)
0
L-shock (L0)
0
Only DD shifts
Both DD and AA shift
Only AA shifts
Summary: The Behavior of Output
Exogenous Change
Effect on Output (Y)
Government Spending (G)
+
Business Investment Spending (I)
+
Net Tax Revenues (T)
–
Foreign Price Level (P*)
+
C-shock (C0)
+
CA-shocks (CA0, CAq)
+
Domestic Price Level (P)
–
Target Exchange Rate (Etarget)
+
Expected Future Exchange Rate (Ee)
0
Foreign Interest Rate (R*)
0
L-shock (L0)
0
Whenever there is
an effect on Y, the
magnitude of the
effect is bigger
under fixed
exchange rates than
under flexible
exchange rates.
THE INTEREST RATE
The Interest Rate
• Recall that the foreign exchange market is in
equilibrium when: R = R* + (Ee – E)/E
– When the central bank fixes the exchange rate at E =
Etarget, people will expect E to continue at that level.
– So, Ee = Etarget.
– Therefore, (Ee – E)/E = (Etarget – Etarget)/Etarget = 0.
– Therefore, R = R*.
– Under fixed exchange rates, the domestic interest rate
will always be equal to the foreign interest rate.
Devaluation and the Interest Rate
• R = R* + (Ee – E)/E = R* + (Ee/E) – 1
• If a devaluation occurs and takes everybody by
surprise, then E will increase but Ee will not.
• Therefore, R < R*.
• Eventually, however, Ee will increase to the postdevaluation target value of E
• So, E and Ee will again be equal and, therefore,
we will again have R = R*.
The Interest Rate
Fixed Exchange Rates
Y
R
Government Spending (G)
+
0
Business Investment Spending (I)
+
0
Net Tax Revenues (T)
–
0
Foreign Price Level (P*)
+
0
C-shock (C0)
+
0
CA-shocks (CA0, CAq)
+
0
Domestic Price Level (P)
–
0
Target Exchange Rate (Etarget)
+ (–)
Expected Future Exchange Rate (Ee)
0 (+)
Foreign Interest Rate (R*)
0
+
L-shock (L0)
0
0
As R = R*, only R* affects R.
The inverse effect of Etarget on R is true
only when the change in Etarget takes
people by surprise. When the surprise
wears off the effect will disappear.
If the change in Etarget is anticipated,
then there will be an equal change in
Ee. As a result, R = R* will continue to
hold. Therefore, the change in Etarget
will have no effect on R.
Ee may change without a
corresponding change in Etarget if
people believe that the fixed exchange
rate system will soon be abandoned
THE CURRENT ACCOUNT
The Current Account
• Recall from Ch. 17 that there are two ways of
expressing the domestic country’s net exports
(or, current account):
1. 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙ 𝑞 − 𝐶𝐴𝑚 ∙ 𝑌 − 𝑇
2. 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 − 𝐼 − 𝐺
16-28
The Current Account
𝐸∙𝑃∗
𝑃
• Method 1: 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙
− 𝐶𝐴𝑚 ∙
𝑌−𝑇
• In this case, as the current account is inversely
related to after-tax income
• Therefore, if there is a change in any
exogenous variable other than those in the
above equation, its effect on CA will be the
opposite of its effect on Y.
– Next slide
Summary: The Behavior of Y and CA
Exogenous Change
Output (Y)
Current Account (CA)
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
Foreign Price Level (P*)
+
C-shock (C0)
+
CA-shocks (CA0, CAq)
+
Domestic Price Level (P)
–
Target Exchange Rate (Etarget)
+
Expected Future Exchange Rate (Ee)
0
0
Foreign Interest Rate (R*)
0
0
L-shock (L0)
0
0
We saw this
column earlier
–
The Current Account
𝐸∙𝑃∗
𝑃
• Method 1: 𝐶𝐴 = 𝐶𝐴0 + 𝐶𝐴𝑞 ∙
− 𝐶𝐴𝑚 ∙
𝑌−𝑇
• Suppose taxes increase (T↑) and all other
exogenous variables remain unchanged.
• We saw before that Y↓. Therefore, after-tax
income decreases (Y – T↓).
• As the current account is inversely related to
after-tax income, the current account
increases (CA↑)
Summary: The Behavior of Y and CA
Exogenous Change
Output (Y)
Current Account (CA)
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
+
Foreign Price Level (P*)
+
C-shock (C0)
+
CA-shocks (CA0, CAq)
+
Domestic Price Level (P)
–
Target Exchange Rate (Etarget)
+
Expected Future Exchange Rate (Ee)
0
0
Foreign Interest Rate (R*)
0
0
L-shock (L0)
0
0
We saw this
column earlier
–
The Current Account
• Method 2: 𝐶𝐴 = 1 − 𝐶𝑦 ∙ 𝑌 − 𝐶0 + 𝐶𝑦 ∙ 𝑇 −
𝐼−𝐺
• It then follows that all the exogenous factors
other than those in the above equation that
affect Y must affect CA in the same way
Summary: The Behavior of Y and CA
Exogenous Change
Output (Y)
Current Account (CA)
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
+
Foreign Price Level (P*)
+
+
C-shock (C0)
+
–
CA-shocks (CA0, CAq)
+
+
Domestic Price Level (P)
–
–
Target Exchange Rate (Etarget)
+
+
Expected Future Exchange Rate (Ee)
0
0
Foreign Interest Rate (R*)
0
0
L-shocks (L0)
0
0
We saw this
column earlier
Summary: The Behavior of Y and CA
Exogenous Change
Output (Y)
Current Account (CA)
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
+
Foreign Price Level (P*)
+
+
C-shock (C0)
+
–
CA-shocks (CA0, CAq)
+
+
Domestic Price Level (P)
–
–
Target Exchange Rate (Etarget)
+
+
Expected Future Exchange Rate (Ee)
0
0
Foreign Interest Rate (R*)
0
0
L-shocks (L0)
0
0
The Current Account
• Note that, as under flexible exchange rates,
contractionary fiscal policies (“fiscal austerity”
or “belt tightening”) can raise a country’s
current account balance in the short run.
• But so can protectionist policies such as tariffs
and quotas.
COMPARING FLEXIBLE AND FIXED
EXCHANGE RATE REGIMES
Comparing the Regimes
• As output (Y) and the current account (CA) are
usually the two main topics, let us look at how
the various exogenous variables affect Y and
CA in the two exchange rate regimes
It’s Basically the Same!
Fixed Exchange Rates
Y CA
Flexible Exchange Rates (Ch. 17)
Y CA
Government Spending (G)
+
–
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
+
Net Tax Revenues (T)
–
+
Foreign Price Level (P*)
+
+
Foreign Price Level (P*)
+
+
C-shock (C0)
+
–
C-shock (C0)
+
–
CA-shocks (CA0, CAq)
+
+
CA-shocks (CA0, CAq)
+
+
Domestic Price Level (P)
–
–
Domestic Price Level (P)
–
–
Target Exchange Rate (Etarget)
+
+
Money Supply (Ms)
+
+
Expected Future Exchange Rate (Ee)
0
0
Expected Future Exchange Rate (Ee)
+
+
Foreign Interest Rate (R*)
0
0
Foreign Interest Rate (R*)
+
+
L-shock (L0)
0
0
L-shock (L0)
–
–
It’s Basically the Same!
Fixed Exchange Rates
Y CA
Flexible Exchange Rates (Ch. 17)
Y CA
Government Spending (G)
+
–
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
+
Net Tax Revenues (T)
–
+
Foreign Price Level (P*)
+
+
Foreign Price Level (P*)
+
+
C-shock (C0)
+
–
C-shock (C0)
+
–
CA-shocks (CA0, CAq)
+
+
CA-shocks (CA0, CAq)
+
+
Domestic Price Level (P)
–
–
Domestic Price Level (P)
–
–
Target Exchange Rate (Etarget)
+
+
Money Supply (Ms)
+
+
Expected Future Exchange Rate (Ee)
0
0
Expected Future Exchange Rate (Ee)
+
+
Foreign Interest Rate (R*)
0
0
Foreign Interest Rate (R*)
+
+
L-shock (L0)
0
0
L-shock (L0)
–
–
Recall that expansionary monetary policy is an increase in Ms under flexible exchange rates and an increase in Etarget
under fixed exchange rates. Note that their effects are the same: output and the current account both increase.
It’s Basically the Same!
Fixed Exchange Rates
Y CA
Flexible Exchange Rates (Ch. 17)
Y CA
Government Spending (G)
+
–
Government Spending (G)
+
–
Business Investment Spending (I)
+
–
Business Investment Spending (I)
+
–
Net Tax Revenues (T)
–
+
Net Tax Revenues (T)
–
+
Foreign Price Level (P*)
+
+
Foreign Price Level (P*)
+
+
C-shock (C0)
+
–
C-shock (C0)
+
–
CA-shocks (CA0, CAq)
+
+
CA-shocks (CA0, CAq)
+
+
Domestic Price Level (P)
–
–
Domestic Price Level (P)
–
–
Target Exchange Rate (Etarget)
+
+
Money Supply (Ms)
+
+
Expected Future Exchange Rate (Ee)
0
0
Expected Future Exchange Rate (Ee)
+
+
Foreign Interest Rate (R*)
0
0
Foreign Interest Rate (R*)
+
+
L-shock (L0)
0
0
L-shock (L0)
–
–
As we saw earlier, under fixed exchange rates, any variable that shifts the AA curve is totally reversed by the central
bank in order to keep the exchange rate fixed. That explains the zeroes on the left table.
BALANCE OF PAYMENTS CRISES
Fig. 18-4: Effect of the Expectation of a Currency
Devaluation
If a devaluation (an increase in E) is
widely expected, there is an increase in
Ee. As a result, the AA curve shifts right.
To keep E fixed, the central bank must
sell its foreign currency reserves and
thereby reduce the domestic money
supply and bring the AA curve back to
where it was.
So, the mere expectation of a devaluation
may cause the central bank to lose a lot
of its reserves.
If its reserves are inadequate, the central
bank may be forced to devalue or to
simply abandon the fixed exchange rate
system and switch to flexible exchange
rates.
Balance of Payments
Crises and Capital Flight
• Balance of payments crisis
– It is a sharp fall in official foreign reserves sparked
by a change in expectations about the future
exchange rate.
Balance of Payments
Crises and Capital Flight
• The mere expectation of a future devaluation
causes:
– A balance of payments crisis marked by a sharp
fall in reserves
– A rise in the home interest rate above the world
interest rate
• An expected revaluation causes the opposite
effects of an expected devaluation.
Balance of Payments
Crises and Capital Flight
• Capital flight
– The reserve loss accompanying a devaluation
scare
• The associated debit in the balance of payments
accounts is a private capital outflow.
• Self-fulfilling currency crises
– It occurs when an economy is vulnerable to
speculation.
– The government may be responsible for such
crises by creating or tolerating domestic economic
weaknesses that invite speculators to attack the
currency.
THE MONEY SUPPLY
What is Monetary Policy Under Fixed
Exchange Rates?
• As the central bank in a fixed exchange rate
system must keep the money supply at the
precise level necessary to keep the exchange
rate fixed at the target rate, it becomes unable
to use the money supply to pursue any other
objective (such as fighting a recession)
The Money Supply is no longer a
policy tool
• Under a fixed exchange rate, the money
supply is an endogenous variable
• It is no longer a policy tool
• The monetary policy tool is now Etarget, the
rate at which the exchange rate is pegged
What is Monetary Policy Under Fixed
Exchange Rates?
• We saw in Chapters 16 and 17 that in an
economy with flexible exchange rates,
monetary policy consists of changes in the
money supply (Ms)
– Ms↑ is expansionary monetary policy
– Ms↓ is contractionary monetary policy
• But in a fixed exchange rate system, the
money supply is no longer controlled by the
central bank
What is Monetary Policy Under Fixed
Exchange Rates?
• The central bank does, however, control the
target rate Etarget at which the exchange rate is
kept fixed
– Etarget ↑ (devaluation) is expansionary monetary
policy
– Etarget ↓ (revaluation) is contractionary monetary
policy
Money Market Equilibrium Under a
Fixed Exchange Rate
• We saw in Chapter 15 that equilibrium in the
𝐿0 ∙𝑌
𝑠
money market requires 𝑀 = 𝑃 ∙
𝑅
• We saw earlier in this chapter that under
fixed exchange rates R = R*
𝑠
• Therefore, 𝑀 = 𝑃 ∙
𝐿0 ∙𝑌
𝑅∗
Money Market Equilibrium Under a
Fixed Exchange Rate
𝑠
• 𝑀 =𝑃∙
𝐿0 ∙𝑌
𝑅∗
• Suppose P, L0, and R* remain unchanged, but
some other exogenous variable changes.
• If, as a result, Y increases, then Ms must
increase.
• In other words, the effects on Y and Ms must
be in the same direction.
Behavior of Money Supply
𝑠
• 𝑀 =𝑃∙
𝐿0 ∙𝑌
𝑅∗
• We saw earlier that if P increases, Y decreases.
• So, the effect of P on Ms is ambiguous.
Behavior of Money Supply
𝑠
• 𝑀 =𝑃∙
𝐿0 ∙𝑌
𝑅∗
• We saw earlier that R* has no effect on Y.
• Therefore, an increase in R* leads to a
decrease in Ms.
Behavior of Money Supply
𝑠
• 𝑀 =𝑃∙
𝐿0 ∙𝑌
𝑅∗
• We saw earlier that L0, which represents any
of the unspecified factors that affect L, has no
effect on Y.
• Therefore, any increase in L0 leads to an
increase in Ms.
Summary: The Behavior of Y and Ms
Fixed Exchange Rates
Y MS
Government Spending (G)
+
+
Business Investment Spending (I)
+
+
Net Tax Revenues (T)
–
–
Foreign Price Level (P*)
+
+
C-shock (C0)
+
+
CA-shocks (CA0, CAq)
+
+
Domestic Price Level (P)
–
?
Target Exchange Rate (Etarget)
+
+
Expected Future Exchange Rate (Ee)
0
0
Foreign Interest Rate (R*)
0
–
L-shocks (unspecified factors that increase L)
0
+
THE LONG RUN UNDER FIXED
EXCHANGE RATES
Summary: Long-Run, Flexible Exchange
Rates (Chapter 16)
• q = 𝑞, relative PPP
• Y = Yf
How will these results change under
fixed exchange rates?
• 𝜋 = 𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔
• 𝑅=
• 𝑃=
The first two are real variables. Under
the principle of monetary neutrality,
∗
𝑠
𝑓
∗
𝑅 + 𝑀 𝑔 − 𝑌 𝑔 − 𝜋 they will not be affected by a change
in the monetary system.
𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗
• 𝐸𝑔 =
• 𝐸=
𝐿0 ∙𝑌 𝑓
𝑀 𝑠 𝑔 − 𝑌𝑓 𝑔
− 𝜋∗
𝑞∙𝑀𝑠 ∙ 𝑅 ∗ +𝑀𝑠 𝑔 −𝑌 𝑓 𝑔 −𝜋∗
𝐿0 ∙𝑌 𝑓 ∙𝑃∗
We saw earlier that R = R*. Also, it is
obvious that E = Etarget and Eg = 0.
Only P and π remain to be
determined.
Inflation
• As we saw in Chapter 16, under either
absolute purchasing power parity or relative
purchasing power parity we get 𝐸𝑔 = 𝜋 − 𝜋 ∗
• But under fixed exchange rates, the rate at
which the exchange rate appreciates must be
zero: 𝐸𝑔 = 𝜋 − 𝜋 ∗ = 0
• Therefore, 𝝅 = 𝝅∗
– This is a major weakness of the fixed exchange
rate system: the economy loses control over its
own inflation rate
The Price Level
• Absolute PPP: 𝑞
𝐸×𝑃∗
=
𝑃
𝒕𝒂𝒓𝒈𝒆𝒕
• Therefore, 𝑷 = 𝑬
• Relative PPP: 𝑞 =
• Therefore, 𝑷 =
𝐸×𝑃∗
𝑃
=1
× 𝑷∗
= 𝑞, a constant
𝑬𝒕𝒂𝒓𝒈𝒆𝒕 ×𝑷∗
𝒒
Summary: Long-Run, Fixed Exchange
Rates
•
•
•
•
•
•
q = 1, absolute PPP
One major weakness of a
fixed exchange rate system is
q = 𝑞, relative PPP
that the country adopting
such a system loses control
f
Y=Y
of its inflation and interest
rates.
∗
𝜋=𝜋
𝑅 = 𝑅∗
𝑃 = 𝐸𝑡𝑎𝑟𝑔𝑒𝑡 ∙ 𝑃∗ , absolute PPP
• 𝑃=
𝐸 𝑡𝑎𝑟𝑔𝑒𝑡 ∙𝑃∗
,
𝑞
relative PPP