The Case for Floating Exchange Rates
• Monetary policy autonomy…w/o capital controls
– Each country can choose “appropriate” long-run inflation rate
• Symmetry
– $ can “devalue” as necessary…not constrained as leader
– Other countries can use monetary tool
• Exchange rates as automatic stabilizers
– Floating cushions output against real shocks
– Something’s gotta adjust…if not E, then Y
– Depreciation in the face of reduced demand for a nation’s
exports restores equilibrium automatically
– Unlike Bretton Woods, where there would be a “fundamental
disequilibrium”
…ongoing CA deficit until price level fell or currency devalued
The Case for
Floating Exchange Rates
Effects of a Temporary Fall in Export Demand
Exchange rate, E
DD2
DD1
2
E2
(a) Floating
exchange rate
1
E1
Depreciation
leads to higher
demand for and
output of
domestic products
AA1
Y2 Y1
Exchange rate, E
Output, Y
DD2
DD1
(b) Fixed
1
exchange rate E
3
1
AA2
Y3 Y2 Y1
Fixed exchange
rates mean output
falls as much as
the initial fall in
aggregate demand
AA1
Output, Y
The Case Against Floating Exchange Rates
 Lack of discipline
• … but a floating exchange rate bottles up inflation in a
country whose government is “misbehaving”.
 Destabilizing speculation
• Hot money
…but “fundamental disequilibrium”  one-way bet under fixed rates
• Countries can be caught in a “vicious circle” of depreciation and
inflation.
E  Pim  CoL  W  P  E
• Floating exchange rates make a country more vulnerable to money
market disturbances.
– Fixed rates cushion output against monetary shocks
L  M  nothing shifts under fixed rates
The Case Against Floating Exchange Rates
A Rise in Money Demand Under a Floating Exchange Rate
Exchange
rate, E
DD
1
E1
2
E2
AA1
AA2
Y2
Y1
Output, Y
The Case Against Floating Exchange Rates
 Injury to International Trade and Investment
• Exporters and importers face greater exchange risk.
– But forward markets can protect traders against foreign exchange risk.
• International investments face greater uncertainty about payoffs
denominated in home country currency.
 Uncoordinated Economic Policies
• Countries can engage in competitive currency depreciations.
…under Bretton Woods, policies “coordinated” via US privilege
• A large country’s fiscal and monetary policies affect other
economies
…aggregate demand, output, and prices become more volatile
across countries if policies diverge.
 Free Float Really Managed Float
• Fear of depreciation – inflation spiral  intervention
The Case Against Floating Exchange Rates
•
Speculation and volatility in the foreign exchange market
• If traders expect a currency to depreciate in the short run, they
may quickly sell the currency to make a profit, even if it is not
expected to depreciate in the long run.
• Expectations of depreciation lead to actual depreciation in the
short run.
• The assumption we’ve been using that expectations do not
change when temporary economic changes occur is not valid
if expectations change quickly in anticipation of even
temporary economic changes.
• In fact, exchange rate volatility has increased since 1973
Macroeconomic Data for Key Industrial Regions,
1963–2006
The Case Against Floating Exchange Rates
Floating and Discipline:
Inflation Rates in Major Industrialized Countries, 1973-1980
(percent per year)
Nominal and Real Effective Dollar Exchange Rate Indexes,
1975–2006
Purchasing Power Parity???
Source: International Monetary Fund, International Financial Studies.


Due to contractionary monetary policy and expansive fiscal policy in
the U.S., the dollar appreciated by about 50% relative to 15 currencies
from 1980–1985.
– This contributed to a growing US current account deficit
Countries then engaged in 2 major efforts to influence exchange
rates:
• The 1985 Plaza Accord reduced the value of the dollar relative to
other major currencies… “bringing down dollar”
• The 1987 Louvre Accord: intended to stabilize exchange rates
–
Specified zones of +/- 5% around which current exchange
rates were allowed to fluctuate.
–
Quickly abandoned
– The October 1987 stock market crash made production, employment
and price stability the primary goals for the U.S. central bank
 exchange rate stability became less important.
– New targets were (secretly) made after October 1987, but central banks
had abandoned these targets by the early 1990s.
Macroeconomic Interdependence Under Floating Rate
The Large Country Case
• Effect of a permanent monetary expansion by Home
– Home’s currency depreciates, Home output rises
– Foreign output may rise or fall.
– Foreign’s currency appreciates  Foreign’s output falls
– Home’s economy expands Foreign sells more to Home
• Effect of a permanent fiscal expansion by Home
– Home output rises, Home’s currency appreciates
– Foreign output rises
– Foreign’s currency depreciates  Foreign’s output rises
– Home’s economy expands  Foreign sells more to Home
Macroeconomic Interdependence Under Floating Rate
Unemployment Rates in Major Industrialized Countries,
1978-2000 (percent of civilian labor force)
Exchange Rate Trends and Inflation Differentials,
1973–2006
High-inflation
countries have tended
to have weaker
currencies than their
low-inflation
neighbors.
Source: International Monetary Fund and Global Financial Data.
Interdependence of “Large” Countries:
Rebalancing
 The U.S. has depended on saved funds from many
countries, while it has borrowed heavily.
• The U.S. has run a current account deficit for many years due to its
low saving and high investment expenditure.
 As foreign countries spend more and lend less to the U.S.,
• interest rates may rise
• the U.S. dollar will depreciating
• the U.S. current account will improve (becoming less negative).
Global External Imbalances, 1999–2006
Source: International Monetary Fund, World Economic Outlook, April 2007.
19-15
U.S. Real Interest Rate, 1997–2007
Source: Global Financial Data. Real interest rates are defined as ten-year government bond rates less average inflation over the preceding twelve months. The data are twelve-month
moving averages of monthly real interest rates so defined.
What Has Been Learned Since 1973?
• After 1973 central banks intervened repeatedly in the foreign
exchange market to alter currency values.
– To stabilize output and the price level when certain
disturbances occur
– To prevent sharp changes in the international competitiveness
of tradable goods sectors
• Monetary changes had a much greater short-run effect on the
real exchange rate under a floating nominal exchange rate
than under a fixed one.
• The international monetary system did not become symmetric
until after 1973.
– Central banks continued to hold dollar reserves and intervene.
• The current floating-rate system is similar in some ways to
the asymmetric reserve currency system underlying the
Bretton Woods arrangements … exorbitant privilege
What Has Been Learned Since 1973?
 The Exchange Rate as an Automatic Stabilizer
• Experience with the oil shocks of 1973 and 1979 favors
floating exchange rates.
• The effects of the U.S. fiscal expansion after 1981 provide
mixed evidence on the success of floating exchange rates.
 Discipline
• Inflation rates accelerated after 1973 and remained high
through the second oil shock.
• The system placed fewer obvious restraints on unbalanced
fiscal policies.
– Example: The high U.S. government budget deficits of the
1980s.
What Has Been Learned Since 1973?
 Destabilizing Speculation
• Floating exchange rates have exhibited much more day-today volatility.
– The question of whether exchange rate volatility has been
excessive is controversial.
• In the longer term, exchange rates have roughly reflected
fundamental changes in monetary and fiscal policies and not
destabilizing speculation.
• Experience with floating exchange rates contradicts the idea
that arbitrary exchange rate movements can lead to “vicious
circles” of inflation and depreciation.
 International Trade and Investment
• For most countries, the extent of their international trade
shows a rising trend after the move to floating.
 Many fixed exchange rate systems have developed since
1973.
• European monetary system and euro zone
• The Chinese central bank currently fixes the value of its currency.
• ASEAN countries have considered a fixed exchange rates and
policy coordination.