Chapter 19
Macroeconomic Policy and
Coordination under Floating
Exchange Rates
Introduction

The floating exchange rate system, in place since 1973,
was not well planned before its inception.

By the mid-1980s, economists and policymakers had
become more skeptical about the benefits of an
international monetary system based on floating rates.

Why has the performance of floating rates been so
disappointing?

What direction should reform of the current system take?

This chapter compares the macroeconomic policy
problems of different exchange rate regimes.
The Case for Floating Exchange Rates

There are three arguments in favor of floating exchange rates:




Monetary Policy Autonomy


Floating exchange rates:
 Restore monetary control to central banks
 Allow each country to choose its own desired long-run inflation rate
Symmetry


Monetary policy autonomy
Symmetry
Exchange rates as automatic stabilizers
Floating exchange rates remove two main asymmetries of the Bretton
Woods system and allow:
 Central banks abroad to be able to determine their own domestic
money supplies
 The U.S. to have the same opportunity as other countries to influence
its exchange rate against foreign currencies
Exchange Rates as Automatic Stabilizers

Floating exchange rates quickly eliminate the “fundamental
disequilibriums” that had led to parity changes and speculative
attacks under fixed rates.
The Case for Floating Exchange Rates

Monetary Policy Autonomy


If banks were no longer obliged to intervene in currency markets
to fix exchange rates, governments would be able to use
monetary policy to reach internal and external balance.
Furthermore, no country would be forced to import inflation (or
deflation) from abroad.
Symmetry


Under a system of floating rates the inherent asymmetry of
Bretton Woods would disappear and the United States
would no longer be able to set world monetary conditions
all by itself.
At the same time, the United States would have the same
opportunity as other countries to influence its exchange rate
against foreign currencies.
The Case for Floating Exchange Rates

Exchange rates as automatic stabilizer

Even in the absence of an active monetary of an active
monetary policy, the swift adjustment of market-determined
exchange rates would help countries maintain internal and
external balance in the face changes in aggregate demand. The
long and agonizing periods of speculation preceding exchange
rate realignments under the Bretton Woods rules would not
occur under floating.

Figure 19-1 shows that a temporary fall in a country’s export
demand reduces that country’s output more under a fixed rate
than a floating rate.
The Case for Floating Exchange Rates
Figure 19-1: Effects of a Fall in Export Demand
Exchange rate, E
DD2
DD1
1
(a) Floating
exchange rate
E1
AA1
Y1
Exchange rate, E
Output, Y
DD2
DD1
(b) Fixed
1
exchange rate E
3
1
AA2
Y3
Y1
AA1
Output, Y
The Case Against Floating Exchange Rates

There are five arguments against floating rates:

Discipline

Destabilizing speculation and money market
disturbances

Injury to international trade and investment

Uncoordinated economic policies

The illusion of greater autonomy
The Case Against Floating Exchange Rates

Discipline

Floating exchange rates do not provide discipline for central banks.

Central banks might embark on inflationary policies (e.g., the
German hyperinflation of the 1920s).

Central banks freed from the obligation to fix their exchange rates
might embark on inflationary policies. In other words, the
“discipline” imposed on individual countries by a fixed rate would
be lost.

The pro-floaters’ response was that a floating exchange rate would
bottle up inflationary disturbances within the country whose
government was misbehaving.
The Case Against Floating Exchange Rates

Destabilizing Speculation and Money Market
Disturbances

Floating exchange rates allow destabilizing speculation.



Countries can be caught in a “vicious circle” of depreciation and
inflation.
Advocates of floating rates point out that destabilizing
speculators ultimately lose money.
Floating exchange rates make a country more vulnerable to
money market disturbances.

Figure 19-2 illustrates this point.
Exchange
rate, E
DD
1
E1
E2
2
AA1
AA2
Y2
Y1
Speculation on changes in exchange rates
could lead to instability in foreign exchange
markets, and this instability, in turn, might
have negative effects on countries’ internal
and external balances. Further, disturbances to
the home money market could be more
disruptive under floating than under a fixed
rate.
Output, Y
The Case Against Floating Exchange Rates

Injury to International Trade and Investment


Floating rates hurt international trade and investment because they
make relative international prices more unpredictable:

Exporters and importers face greater exchange risk.

International investments face greater uncertainty about their payoffs.
Supporters of floating exchange rates argue that forward markets can
be used to protect traders against foreign exchange risk.


The skeptics replied to this argument by pointing out that forward
exchange markets would be expensive.
Floating rates would make relative international prices more
unpredictable and thus injure international trade and investment.
The Case Against Floating Exchange Rates

Uncoordinated Economic Policies

Floating exchange rates leave countries free to engage in competitive
currency depreciations.


Countries might adopt policies without considering their
possible beggar-thy-neighbor aspects.
If the Bretton Woods rules on exchange rate adjustment were
abandoned, the door would opened to competitive currency practices
harmful to the world economy. As happened during the interwar
years, countries might adopt policies without considering their
possible beggar-thy-neighbor aspects. All countries would suffer as a
result.
The Case Against Floating Exchange Rates

The Illusion of Greater Autonomy

Floating exchange rates increase the uncertainty in the economy
without really giving macroeconomic policy greater freedom.

A currency depreciation raises domestic inflation due to higher
wage settlements.

Floating exchange rate would not really give countries more
autonomy.

Changes in exchange rates would have such pervasive
macroeconomic effects that central banks would feel compelled
to intervene heavily in foreign exchange markets even without a
formal commitment to peg.

Thus, floating would increase the uncertainty in the economy
without really giving macroeconomic policy greater freedom.
The Case Against Floating Exchange Rates
Inflation Rates in Major Industrialized Countries, 1973-1980 (percent per year)
Nominal and Real Effective Dollar Exchange Rates Indexes, 1975-2000
A two-country model of macroeconomic
interdependence under a floating rate

The model is applied to the short run in which output prices can be
assumed to be fixed.

Imagine a world of two countries, Home and Foreign. In reality,
the level of GNP abroad influences foreign demand for the home
country’s exports and therefore the home current account balance.

We assume that Home’s current account is a function of the real
exchange rate, EP*/P, its own disposable income, Y－T, and
Foreign’s disposable income Y*－T*. Home’s current account is
therefore CA=CA(EP*/P, Y－T, Y*－T*).

A real depreciation of Home’s currency is assumed to cause an
increase in its current account balance, while a rise in Home
disposable income leads to a fall.
A two-country model of macroeconomic
interdependence under a floating rate

In the model of two interacting economies, a rise in Foreign disposable
income raises Foreign spending on Home products, it raises Home
exports, therefore causes an increase in Home’s current account
balance.

Aggregate supply and demand are equal in Home when
Y=C(Y－T)+I+G+ CA(EP*/P, Y－T, Y*－T*).

Foreign’s current account, CA*, also depends on the relative price of
Home and Foreign products, EP*/P, and on disposable income in the
two countries. In a world of two countries, Home’s current account
surplus must exactly equal Foreign’s current account deficit when both
balances are measured in term’s of a common unit.
A two-country model of macroeconomic
interdependence under a floating rate

In terms of Foreign output, Foreign’s current account is
CA*=－CA(EP*/P, Y－T, Y*－T*)÷(EP*/P).
A rise in Home income, by worsening Home’s current account
CA, improves CA*; in the same way, a rise in Foreign income
worsens CA*. We assume that a rise in EP*/P(a relative cheapening
of Home output) causes CA* to fall at the same time it causes CA to
rise.

Foreign output market supply equals demand when
Y*=C*(Y*－T*)+I*+G*－(P/EP*)×CA(EP*/P, Y－T, Y*－T*).

The HH schedule shows the Home and Foreign output levels at
which aggregate demand equals aggregate supply in Home. HH
slopes upward because a rise in Y* increases Home exports,
raising aggregate demand and calling forth a higher level of
Home output, Y.
A two-country model of macroeconomic
interdependence under a floating rate

The FF schedule shows the Home and Foreign output levels at
which aggregate demand equals aggregate supply in Foreign. FF
also slopes upward because a rise in Y raises demand for Foreign
exports, and Foreign output, Y*, must rise to meet this increase in
aggregate demand.

At the intersection of HH and FF, aggregate demand and supply are
equal in both countries, given the real exchange rate.

HH is steeper than FF. The slopes of the two schedules differ in this way
because a rise in a country’s output has a greater effect on its own output
market than on the foreign one.

Changes in fiscal policy at home or abroad shift the schedules by
altering government purchases, G and G*, and net taxes, T and T*.

In addition, both fiscal policies and monetary policies can affect HH and
FF by influencing the exchange rate.
Macroeconomic Interdependence Under a
Floating Rate

Assume that there are two large countries, Home and
Foreign.

Macroeconomic interdependence between Home and
Foreign:

Effect of a permanent monetary expansion by Home

Home output rises, Home’s currency depreciates, and Foreign
output may rise or fall.

Effect of a permanent fiscal expansion by Home

Home output rises, Home’s currency appreciates, and Foreign
output rises.
Unemployment Rates in Major Industrialized Countries, 1978-2000
(percent of civilian labor force)
Inflation Rates in Major Industrialized Countries 1981-2000, and 19611971 Average (percent per year)
Exchange Rate Changes Since the Louvre Accord
What Has Been Learned Since 1973?

Monetary Policy Autonomy

Floating exchange rates allowed a much larger international divergence
in inflation rates.

High-inflation countries have tended to have weaker currencies than their
low-inflation neighbors.

In the short run, the effects of monetary and fiscal changes are transmitted
across national borders under floating rates.

There is no question that floating gave central banks the ability to
control their money supplies and to choose their preferred rates of
trend inflation.

Over the floating-rate period as a whole, higher inflation has been
associated with greater currency depreciation. The exact relationship
predicted by relative PPP, however, has not held for most countries.
Exchange Rate Trends and Inflation Differentials,1973-2000
Monetary Policy Autonomy

After 1973 central banks intervened repeatedly in the foreign
exchange market to alter currency values.

Why did central banks continue to intervene even in the absence of
any formal obligation to do so?

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.

Over the floating-rate period as a whole, higher inflation has been
associated with greater currency depreciation. The exact relationship
predicted by relative PPP, however, has not held for most countries.
Monetary Policy Autonomy

While the inflation insulation part of the policy autonomy argument is
broadly supported as a long-run proposition, economic analysis and
experience both show that in the short run, the effects of monetary as
well as fiscal changes are transmitted across national borders under
floating rates. The critics of floating were right in claiming that
floating rates would not insulate countries completely from foreign
policy shocks.

Experience has also given dramatic support to the skeptics who
argued that no central bank can be indifferent to its currency’s
value in the foreign exchange market.
Monetary Policy Autonomy

Advocates of floating had argued that central banks would not need
to hold foreign reserves.

Even in the presence of output market disturbances, central banks
wanted to slow exchange rate movements to prevent sharp changes in
the international competitiveness of their tradable goods sectors.

Those skeptical of the autonomy argument had also predicted that
while floating would allow central banks to control nominal money
supplies, their ability to affect output would still be limited by the
price level’s tendency to respond more quickly to monetary changes
under a floating rate.
Symmetry

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 (McKinnon).

Because central banks continued to hold dollar reserves and intervene,
the international monetary system did not become symmetric after
1973.

Ronald McKinnon has argued that the current floating-rate system is
similar in some ways to the asymmetric reserve currency system
underlying the Bretton Woods arrangements. He suggests that changes
in the world money supply would have been dampened under a more
symmetric monetary adjustment mechanism.
The Exchange Rate as an Automatic
Stabilizer





Experience with the two oil shocks favors floating exchange rates.
The effects of the U.S. fiscal expansion after 1981 provide mixed
evidence on the success of floating exchange rates.
Under floating, many countries were able to relax the capital controls
put in place earlier. The progressive loosening of controls spurred the
rapid growth of a global financial industry and allowed countries to
realize greater gains from intertemporal trade.
The effects of the U.S. fiscal expansion after 1981 illustrate the
stabilizing properties of a floating exchange rate.
The dollar’s appreciation after 1981 also illustrates a problem with the
view that floating rates can cushion the economy from real disturbances
such as shifts in aggregate demand.
The Exchange Rate as an Automatic
Stabilizer

Permanent changes in goods market conditions require eventual
adjustment in real exchange rates that can be speeded by a floating-rate
system.

Foreign exchange intervention to peg nominal exchange rates cannot
prevent this eventual adjustment because money is neutral in the long
run and thus is powerless to alter relative prices permanently.

Some adverse developments followed the adoption of floating dollar
exchange rates, but this coincidence does not prove that floating rates
were their cause.
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.
The concerted disinflation in industrial countries after
1979 proved that central banks could resist the
temptations of inflation under floating rates .
The system placed fewer obvious restraints on
unbalanced fiscal policies.
Destabilizing Speculation





Floating exchange rates have exhibited much more day-to-day 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.
Exchange rates are asset prices, and so considerable volatility is to be
expected. The asset price nature of exchange rates was not well
understood by economists before the 1970s.
Destabilizing Speculation

Even with the benefit of hindsight, however, short-term exchange rate
movements can be quite difficult to relate to actual news about
economic events that affect currency values.

Over the long term, however, exchange rates have roughly reflected
fundamental changes in monetary and fiscal policies, and their broad
movements do not appear to be the result of destabilizing speculation.

The experience with floating rates has not supported the idea that
arbitrary exchange rate movements can lead to “vicious circles” of
inflation and depreciation.
International Trade and Investment

International financial intermediation expanded strongly after 1973 as
countries lowered barriers to capital movement.

For most countries, the extent of their international trade shows a rising
trend after the move to floating.

Critics of floating had predicted that international trade and investment
would suffer as a result of increased uncertainty. The prediction was
certainly wrong with regard to investment.

There is controversy about the effects of floating rates on international
trade.
International Trade and Investment

A very crude but direct measure of the extent of a country’s
international trade is the average of its imports and exports of goods
and services, divided by its output.

Evaluation of the effects of floating rates on world trade is complicated
further by the activities of multinational firms, many of which
expanded their international production operations in the years after
1973.

International trade has recently been threatened by the resurgence of
protectionism, a symptom of slower economic growth and wide swings
in real exchange rates, which have been labeled misalignments.
Policy Coordination

Floating exchange rates have not promoted international policy
coordination.

Critics of floating have not made a strong case that the problem of
beggar-thy-neighbor policies would disappear under an alternative
currency regime.

Government are often motivated by their own interest rather than that
of the community. It seems doubtful that an exchange rate system
alone can restrain a government from following its own perceived
interest when it formulates macroeconomic policies.
Are Fixed Exchange Rates Even an
Option for Most Countries?

Maintaining fixed exchange rates in the long-run requires strict controls
over capital movements.

Attempts to fix exchange rates will necessarily lack credibility and
be relatively short-lived.

Fixed rates will not deliver the benefits promised by their proponents.

The post - Bretton Woods experience suggests another hypothesis:
durable fixed exchange rate arrangements may not even be possible.

This pessimistic view of fixed exchange rates is based on the theory
that speculative currency crises can, at least in part, be self-fulfilling
events.

At the end of the twentieth century, speculative attacks on fixed
exchange rate arrangements were occurring with seemingly increasing
frequency.
Directions for Reform

The experience with floating exchange rates since 1973 shows
that neither side in the debate over floating was entirely right in
its predictions.

No exchange rate system works well when countries “go it alone”
and follow narrowly perceived self-interest.

Severe limits on exchange rate flexibility are unlikely to be
reinstated in the near future.

Increased consultation among policymakers in the industrial
countries should improve the performance of floating rates.

Globally balanced and stable policies are a prerequisite for the
successful performance of any international monetary system.
Directions for Reform

Current proposals to reform the international monetary system run
the gamut from a more elaborate system of target zones for the
dollar to the resurrection of fixed rates to the introduction of a single
world currency. Because countries seem unwilling to give up the
autonomy floating dollar rates have given them, it is unlikely that
any of these changes is in the cards.

With greater policy cooperation among the main players, there is
no reason why floating exchange rates should not function tolerable
well in the future.

Cooperation should be sought as an end in itself and not as the
indirect result of exchange rate rules.
Question
Thanks