Econ 340
Lecture 16
Fixed versus Floating
Exchange Rates
Outline: International
Macroeconomics
• Recall Macro from Econ 102
– Aggregate Supply and Demand
– Policies
• Effects ON the Exchange Market
– Expansion
– Interest Rate
• Effects OF the Exchange Market
– Depreciation via Trade
– Depreciation via Net Wealth
• Effects THOUGH the Exchange Market
Econ 340, Deardorff, Lecture 15:
Int Macro
2
Effects THROUGH the Exchange
Market
• The issue here:
– Do macroeconomic effects get transmitted to other
countries, and if so how?
– i.e., does an expansion, for example, in one country
cause an expansion or a contraction in other
countries?
Econ 340, Deardorff, Lecture 15:
Int Macro
3
Effects THROUGH the Exchange
Market
– The answer: Although many exceptions are possible,
it is usually true that changes in one country cause
changes in the same direction in others:
• Expansion here → expansion there
• Inflation here → inflation there
• High interest rates here → high interest rates there
Econ 340, Deardorff, Lecture 15:
Int Macro
4
Effects THROUGH the Exchange
Market
• Example: How a recession in US can
cause recession Canada
– Fall in aggregate demand in US (due to nonmonetary contraction such as a fall in
investment) leads to
• Fall in US income, leads to
• Fall in Canadian exports to US, leads to
• Fall in Canadian income
– To see these links in more detail…
Econ 340, Deardorff, Lecture 15:
Int Macro
5
US Investment Falls
US Income Falls
US Imports Fall
US Interest Rate Falls
US Dollar Depreciates
US Imports Fall More
Canadian Exports Fall
Canadian AD Falls
Canadian Income Falls
Econ 340, Deardorff, Lecture 15:
Int Macro
6
Effects THROUGH the Exchange
Market
• We’ve seen some of this dramatically
during the last few years:
– Crisis started in US
– Effects were transmitted to the world
– Exception: US dollar did not depreciate
immediately; it appreciated at first. (Due to
flight to safety.)
Econ 340, Deardorff, Lecture 15:
Int Macro
7
Outline: Fixed versus Floating
Exchange Rates
• Both Systems Are Used
• What the “Experts” Recommend
• Pros and Cons of Floating
– Disruption When Rates Move
– Automatic Adjustment
• Pros and Cons of Pegging
– Stability
– Instability
• Alternatives
– Crawling Peg
– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
8
Who Uses Fixed and Float
• Lessons from the list of exchange arrangements
(below)
– Floating rates are used by many countries
• Rich & poor
• Large & small
• All over the world
– Pegged rates are used today mostly by small
countries
– Many countries are between fixed and floating
(Source of table below: IMF, “Annual Report on
Exchange Arrangements and Exchange Restrictions
2014”)
Econ 340, Deardorff, Lecture 16:
Fixed/Float
9
Exchange Arrangements
of Sample Countries, as of 2014
Floating Exchange Rates
Australia
Canada
47 countries
+ euro 18
Mexico
Sweden
India
United Kingdom
Japan
United States
Pegged Exchange Rates
Belize
Morocco
Denmark
Nepal
Jordan
Saudi Arabia
Econ 340, Deardorff, Lecture 16:
Fixed/Float
44 countries
10
Exchange Arrangements
of Sample Countries, as of 2014
Between Floating and Pegged:
57 countries
Stabilized Arrangement
21 countries
Iraq
Singapore
Lebanon
Vietnam
Crawling Peg or Crawl-like Arrangement
Nicaragua
China
Other Managed Arrangement
Bangladesh
Russia
Malaysia
Switzerland
Econ 340, Deardorff, Lecture 16:
Fixed/Float
17 countries
19 countries
11
Exchange Arrangements
of Sample Countries, as of 2014
More Fixed than Pegged:
Currency Board
Hong Kong
Lithuania
No Separate Legal Tender
Ecuador ($)
12 countries
12 countries
Montenegro (€)
• Currency Board
– Peg to another currency
– Vary money supply automatically with changes in
international reserves (= forced nonsterilization)
Econ 340, Deardorff, Lecture 16:
Fixed/Float
12
Country Distribution of Currency
Arrangements 2014
Pegged
Float
More
Fixed
0%
None
20%
Cur. Board
More
Flexible
40%
Pegged
60%
Stabilized
80%
Crawl
Econ 340, Deardorff, Lecture 16:
Fixed/Float
Managed
100%
Float
13
Outline: Fixed versus Floating
Exchange Rates
• Both Systems Are Used
• What the “Experts” Recommend
• Pros and Cons of Floating
– Disruption When Rates Move
– Automatic Adjustment
• Pros and Cons of Pegging
– Stability
– Instability
• Alternatives
– Crawling Peg
– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
14
What “Experts” Recommend
• Some favor freely floating rates
– Let exchange rate adjust to fix imbalances
– “Let the market work”
• Others favor perfectly fixed rates
– Define currency rigidly in terms of something you
can’t control
• Gold
• Foreign currency (“Currency Board”)
– AND give up control of the money supply
• Let flows of money fix imbalances
i.e., do not sterilize!
Econ 340, Deardorff, Lecture 16:
Fixed/Float
15
What “Experts” Recommend
• Advocates of floating rates
– Milton Friedman (Nobel Prize 1976):
“A country that enters into a hard-fixed
rate bears an economic cost. The cost
is discarding a means—a flexible
exchange rate—of adjusting to external
forces that impinge on it differently than
on the other country or countries whose
currency it shares.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
16
What “Experts” Recommend
• Advocates of floating rates
– Jeffrey Sachs:
“Once reserves are gone, investors
panic. The worst mistake is for
countries to wait too long to float their
currencies.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
17
What “Experts” Recommend
• Advocates of fixed rates
– Robert Mundell (Nobel Prize 1999):
“A world currency of some sort has
existed for most of the past 2,500
years. Two thousand years ago, in the
age of Caesar Augustus, it was the
Roman aureus... A hundred years ago it
was the gold sovereign. Less than thirty
years ago it was the 1944 gold dollar.
The world has been without a universal
currency for only a tiny fraction of its
history.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
18
What “Experts” Recommend
– Milton Friedman:
“If [over the last 30 years] the Canadian
dollar had been rigidly tied to the US
dollar, those differences would have
required Canada to deflate relative to
the United States, with unfortunate
consequences for Canada that would
have strained, to put it mildly, the trade
relations between the two countries,
and have put strong pressure on
Canada to devalue or float.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
19
What “Experts” Recommend
– Robert Mundell:
“Exchange rate uncertainty imposes a
cost of trade much like a tariff ... If
Canada and the United States shared a
stable common currency or an
irrevocably fixed exchange rate,
Canada’s real income would soar,
closing a large part of the gap between
the two countries’ GDP per capita.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
20
What “Experts” Recommend
• “Bradford DeLong, an economic historian at the
University of California at Berkeley, explains the
debate to his students this way:
To Mr. Friedman, an exchange rate is a
price; therefore, it is an infringement on
human freedom to peg it. To Mr.
Mundell, an exchange rate is a
promise; to change it is to default on a
commitment.
” (WSJ)
Econ 340, Deardorff, Lecture 16:
Fixed/Float
21
What “Experts” Recommend
• Allan Meltzer (Carnegie-Mellon): “The
best you can say of what economic
research has produced is:
– You can make a case for freely floating
exchange rates if you’re willing to live with
the consequences.
– You can make a case for fixed exchange
rates if you’re willing to live with the
consequences.
– You can’t make much of a case for anything
in between.”
(WSJ)
Econ 340, Deardorff, Lecture 16:
Fixed/Float
22
What “Experts” Recommend
• Where they agree: An “adjustable peg” is
worse than both fixed and floating rates
– Friedman: “The reasons why a pegged
exchange rate is a ticking bomb are well
known.”
– Mundell: “I have never nor ever would
advocate a general system of “pegged” rates.
Pegged rate systems always break down.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
23
Outline: Fixed versus Floating
Exchange Rates
• Both Systems Are Used
• What the “Experts” Recommend
• Pros and Cons of Floating
– Disruption When Rates Move
– Automatic Adjustment
• Pros and Cons of Pegging
– Stability
– Instability
• Alternatives
– Crawling Peg
– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
24
Pros and Cons of Floating
• Con: Exchange rates DO MOVE;
And when they do, they cause
– Macro effects (as we saw last time)
• Depreciation
– Stimulates aggregate demand, but not necessarily when
needed: may just cause inflation
– Changes values of assets and liabilities
• Appreciation
– Reduces aggregate demand, may cause recession or
deflaton
Econ 340, Deardorff, Lecture 16:
Fixed/Float
25
Pros and Cons of Floating
• Con: Exchange rates DO MOVE; when
they do, they cause
– Micro effects: exports and imports subject to
• Uncertainty
• Instability
Costly for traders
Like trade barrier
Reduces trade
Econ 340, Deardorff, Lecture 16:
Fixed/Float
26
Pros and Cons of Floating
• Example: The US dollar rose 50% during 19801985
Trade Weighted Dollar Index - Real
140
120
100
80
60
40
Econ 340, Deardorff, Lecture 16:
Fixed/Float
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
20
0
Jan-73
– Caused US auto and
other industries to
contract
– Major dislocation in
middle US
– Ended in 1985 when
in “Plaza Accord”
major central banks
agreed to intervene
27
Pros and Cons of Floating
• Pro: Exchange rate provides efficient and
automatic across-the-board adjustment
– Suppose that, due to inflation, our prices are too high,
causing our imports to rise and exports to fall
• Exchange depreciation fixes this for all sectors
• With fixed rates, individual prices and wages would have to
fall to become competitive: much more painful
– That’s what Greece and other weak countries in the EU have
had to do recently.
– Called “internal devaluation”
– Floating Permits countries to have independent
monetary policies to deal with macroeconomic shocks
Econ 340, Deardorff, Lecture 16:
Fixed/Float
28
Pros and Cons of Floating
• Experience with exchange rates in the
1930s (not really floating, but they moved
a lot) made governments prefer fixed rates
• After WWII, IMF was created, based on
Pegged Exchange Rates
– Most currencies pegged to US $
– IMF helped countries manage this
– When in trouble, countries devalued
Econ 340, Deardorff, Lecture 16:
Fixed/Float
29
Outline: Fixed versus Floating
Exchange Rates
• Both Systems Are Used
• What the “Experts” Recommend
• Pros and Cons of Floating
– Disruption When Rates Move
– Automatic Adjustment
• Pros and Cons of Pegging
– Stability
– Instability
• Alternatives
– Crawling Peg
– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
30
Pros and Cons of Pegging
• Pro: If it succeeds, exchange rate is
stable, avoiding disruptions
• Con: If it fails,
– devaluation causes instability,
– just like floating rates, only worse
• The Problem: Pegged Rates are Prone to
Crisis
Econ 340, Deardorff, Lecture 16:
Fixed/Float
31
Pros and Cons of Pegging
• Why Crisis?
– Pegged rate does not respond to market
changes
– Some currencies become undervalued, others
overvalued
• Inevitable unless all countries have exactly the
same rate of inflation
– Crisis eventually erupts for overvalued
currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
32
Pros and Cons of Pegging
• Why Crisis for Overvalued Currency?
$/€
– Central bank
must sell foreign
currency
– Since reserves
E0
are finite, they
eventually run out E*
– Market knows
that when they
do…
Econ 340, Deardorff, Lecture 16:
Fixed/Float
S€
Fed sells €
D€
Q€
33
Pros and Cons of Pegging
• Why Crisis for Overvalued Currency
$/€
– Intervention will
stop
– Currency will
depreciate
E0
– Knowing this,
people don’t want E*
to hold the
overvalued
currency, so…
Econ 340, Deardorff, Lecture 16:
Fixed/Float
S€
D€
Q€
34
Pros and Cons of Pegging
• Why Crisis for Overvalued Currency
– Before reserves $/€
run out, capital
outflow increases
demand
– And reserves fall E0
faster
E*
– “Speculative
Attack”
S€
Fed sells more € D€
D€1
Q€
Econ 340, Deardorff, Lecture 16:
Fixed/Float
35
Pros and Cons of Pegging
• Pegged rates offer speculators a “one-way
bet”
– Once they see that reserves are falling…
– … they bet on a devaluation by selling the
country’s currency
• If they are right, they win
• If they are wrong, they break even
(since the exchange rate doesn’t change)
– They can’t lose, so they bet a lot
Econ 340, Deardorff, Lecture 16:
Fixed/Float
36
Pros and Cons of Pegging
• Crisis even without Overvaluation
– Crisis only requires expectation of devaluation
• The expectation doesn’t have to be justified;
it only has to be believed
• Can happen even to a currency that is not overvalued
– How? By “contagion”.
• If one country has a crisis, for whatever reason
• Other countries that are near it, or similar to it, may become
suspect
• That’s part of what happened in the Asian Crisis that started
in 1997
• Some countries fear contagion today
Econ 340, Deardorff, Lecture 16:
Fixed/Float
37
Pros and Cons of Pegging
• Result: “Pegged Rates” are not Fixed
– In a world of pegged exchange rates, over
time
• Some currencies become undervalued
• Other currencies become overvalued
– Why? Many reasons (see Makin)
• Bretton Woods: US inflation caused dollar to
become overvalued
• Europe in the 1990s: German tight money after
reunification, caused others to become overvalued
Econ 340, Deardorff, Lecture 16:
Fixed/Float
38
Pros and Cons of Pegging
• Result: “Pegged Rates” are not Fixed
– Overvalued currencies are subject to
speculative attacks
– When they do devalue, they do it
• Suddenly
• By large amounts
– This is just as disruptive as changes in a
floating rate, perhaps more so
Econ 340, Deardorff, Lecture 16:
Fixed/Float
39
Pros and Cons of Pegging
• The choice is not between fixed and
floating:
E
Econ 340, Deardorff, Lecture 16:
Fixed/Float
Time
40
Pros and Cons of Pegging
• The choice is between pegged and
floating:
E
Which is more stable?
Econ 340, Deardorff, Lecture 16:
Fixed/Float
Time
41
Outline: Fixed versus Floating
Exchange Rates
• Both Systems Are Used
• What the “Experts” Recommend
• Pros and Cons of Floating
– Disruption When Rates Move
– Automatic Adjustment
• Pros and Cons of Pegging
– Stability
– Instability
• Alternatives
– Crawling Peg
– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
42
Alternatives
• Mixtures of pegged and floating rates
– Crawling peg
• Change the pegged rate slowly and predictably in
response to a fall or rise in reserves
• Slow movement of the peg is supposed to stop the
loss of reserves before crisis hits
• Still subject to speculative attack
Econ 340, Deardorff, Lecture 16:
Fixed/Float
43
Alternatives
• Mixtures of pegged and floating rates
– Wider band
• Let the rate move freely in a large band around the
official pegged rate
• Less intervention should be needed
• Does not help if country has, say, higher inflation
than others: crisis still inevitable
Econ 340, Deardorff, Lecture 16:
Fixed/Float
44
Alternatives
• Truly Fixed Exchange Rate
– Use another country’s currency
“Dollarization”
– Form a monetary union
The Eurozone
(we’ll look more at this next week)
Econ 340, Deardorff, Lecture 16:
Fixed/Float
45
Alternatives
• Truly Fixed Exchange Rate
– Currency Board
• Peg to another currency
• Replace central bank with “board” that
automatically varies money supply one-for-one
with international reserves
– If reserves fall, so does money supply, forcing
adjustment
– This mimics the Gold Standard, where gold flowed
among countries
Econ 340, Deardorff, Lecture 16:
Fixed/Float
46
Alternatives
• Truly Fixed Exchange Rate
– Currency Board
• How it’s supposed to work
– If exchange rate is over-valued (excess demand for
foreign currency)
» Currency board sells reserves
» This reduces the domestic money supply 1-for-1
» Falling money causes falling income and prices
» Imports fall, exports rise, and excess demand for
foreign currency disappears
– If exchange rate is under-valued: Opposite
Econ 340, Deardorff, Lecture 16:
Fixed/Float
47
Alternatives
• Truly Fixed Exchange Rate
– Currency Board
• Didn’t work for Argentina, which had a crisis
anyway
– Must not have followed the rules
Econ 340, Deardorff, Lecture 16:
Fixed/Float
48
Alternatives
• Pegged Rate with Capital Controls
– Why did pegged rates work in the 1950s &
60s?
• Most countries had capital controls
• In spite of that, the system of pegged rates didn’t
work perfectly: there were some crises
– Capital controls prevent inflow and outflow of
capital, and thus limit speculation
– Today, most countries see capital controls as
too costly
• But not all: China, Malaysia
Econ 340, Deardorff, Lecture 16:
Fixed/Float
49
Alternatives
The
Impossible
Trinity
Goal: Monetary
Independence
Policy:
Pure
Float
Policy: Full
Capital Controls
Increased
Capital
Mobility
See Frankel (This
is the Missing
Figure 3)
Goal: Exchange
Rate Stability
Goal: Full
Financial
Integration
Econ 340, Deardorff, Lecture 16:
Fixed/Float
Policy:
Monetary
Union
50
Exchange Rates Since 1945
• See reading by Buttonwood (column in
The Economist)
• Bretton-Woods System, 1945-1971
– Overseen by IMF
– Currencies were pegged, mostly to US $
– Capital mobility was restricted, but gradually
liberalized over time
– Frequent crises, as currencies became
overvalued due to inflation
Econ 340, Deardorff, Lecture 16:
Fixed/Float
51
Exchange Rates Since 1945
• August 15, 1971:
– Nixon cut the link of US $ to gold, signaling
the end of pegged rates
– Countries stopped pegging, then restarted at
different rates, but by 1973 they had given up
Econ 340, Deardorff, Lecture 16:
Fixed/Float
52
Exchange Rates Since 1945
• Since 1973, major currencies have floated
– Exchange rates moved more than expected
– Crises did not disappear
– Monetary policy became more free:
• “ ‘the Greenspan put’: the use of interest-rate cuts
to rescue financial markets, in effect underwriting
asset prices.”
Econ 340, Deardorff, Lecture 16:
Fixed/Float
53
Outline: Fixed versus Floating
Exchange Rates
• Both Systems Are Used
• What the “Experts” Recommend
• Pros and Cons of Floating
– Disruption When Rates Move
– Automatic Adjustment
• Pros and Cons of Pegging
– Stability
– Instability
• Alternatives
– Crawling Peg
– Monetary Unification
• The Problem of Undervalued Currencies
Econ 340, Deardorff, Lecture 16:
Fixed/Float
54
The Problem of
Undervalued Currencies
• Overvalued currencies lead to crisis
– In that sense they are self correcting, since
countries are forced, eventually, to devalue or
float
• Undervalued currencies
– Do not lead to crisis, but only to accumulation
of reserves
– May be viewed as harmful to trading partners
Econ 340, Deardorff, Lecture 16:
Fixed/Float
55
The Problem of
Undervalued Currencies
• Today, the Chinese yuan is considered
undervalued
– US administration puts pressure on China to
appreciate
– US Congress threatens to restrict imports
Econ 340, Deardorff, Lecture 16:
Fixed/Float
56
2000 Jan
2000 Aug
2001 Mar
2001 Oct
2002 May
2002 Dec
2003 Jul
2004 Feb
2004 Sep
2005 Apr
2005 Nov
2006 Jun
2007 Jan
2007 Aug
2008 Mar
2008 Oct
2009 May
2009 Dec
2010 Jul
2011 Feb
2011 Sep
2012 Apr
2012 Nov
2013 Jun
2014 Jan
2014 Aug
0.180
US$/yuan Exchange Rate
0.160
0.140
0.120
0.100
0.080
0.060
0.040
0.020
0.000
Econ 340, Deardorff, Lecture 14:
Pegging
57
M1 2000
M9 2000
M5 2001
M1 2002
M9 2002
M5 2003
M1 2004
M9 2004
M5 2005
M1 2006
M9 2006
M5 2007
M1 2008
M9 2008
M5 2009
M1 2010
M9 2010
M5 2011
M1 2012
M9 2012
M5 2013
M1 2014
M9 2014
China Reserves, $bill.
4500
4000
3500
3000
2500
2000
1500
1000
500
0
Recent Pronouncements
• Obama: "As I've said before, China
moving to a more market-oriented
exchange rate would make an essential
contribution to that global rebalancing
effort.”
Recent Pronouncements
• Wen Jiabao:
– “The Chinese currency is not undervalued.” “We
oppose all countries engaging in mutual fingerpointing or taking strong measures to force other
nations to appreciate their currencies.”
– “What I don’t understand is depreciating one’s
own currency, and attempting to pressure others
to appreciate, for the purpose of increasing
exports. In my view, that is protectionism.”
Krugman’s Argument
(From NYT, Mar 15, 2010)
• China’s current account surplus in 2010 will be over
$450 billion
• US should declare China a “currency manipulator” in
next report, Apr 15
– (US did not, and hasn’t since.)
• China does not have US “over a barrel.” We have China
over a barrel.
• We should repeat what we did in 1971:
– Then Nixon used a 10% surcharge on imports, so as to prod
Japan, Germany, and others to appreciate
– We should use (or threaten) a 25% surcharge on Chinese
exports.
Next Time
• The Euro
– What is it?
– History of European monetary integration
– Pros and cons of currency unification
– Effects on US
– What happened?
Econ 340, Deardorff, Lecture 16:
Fixed/Float
62