Exporting US Inflation:
1966–1972
Effect on Internal and External Balance of a Rise in the Foreign (US) Price
Level, P*
The “simple” solution for the £, M,
¥, FF, …
• Revalue against the $
• Let the $ depreciate
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
– Exchange rates as automatic stabilizers
• Floating cushions output against real shocks
– Something’s gotta adjust…if not E, then Y
• Temporary reduction in demand for country’s exports
 depreciation attenuates output reduction
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
(b) Fixed
1
exchange rate E
Output, Y
DD2
3
1
AA2
Y3 Y2 Y1
DD1 Fixed exchange
rates mean output
falls as much as
the initial fall in
aggregate demand
AA1
Output, Y
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
– Exchange rates as automatic stabilizers
• Floating cushions output against real shocks
– Something’s gotta adjust…if not E, then Y
• Temporary reduction in demand for country’s exports
 depreciation attenuates output reduction
• Permanent reduction in demand for country’s exports
 depreciation restores equilibrium automatically
The Case Against Floating Exchange Rates
• Lack of discipline
• Destabilizing speculation
– Hot money
…but “fundamental disequilibrium”  one-way bet under fixed rates
– A “vicious circle” of depreciation and inflation.
E deprec Pim up CoL up W up P up
 E deprec
– Floating exchange rates make a country more vulnerable to
money market disturbances…that’s the tradeoff:
L up  R up  E-apprec.  CA & Y down
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
• Lack of discipline
• Destabilizing speculation
– Hot money
…but “fundamental disequilibrium”  one-way bet under fixed rates
– A “vicious circle” of depreciation and inflation.
E deprec Pim up CoL up W up P up
 E deprec
– Floating exchange rates make a country more vulnerable to
money market disturbances…that’s the tradeoff:
L up  R up  E-apprec.  CA & Y down
• Recall: fixed rates cushion output against monetary shocks
L up  M up  nothing shifts under fixed rates
The Case Against Floating Exchange Rates
• Injury to International Trade and Investment
– Exchange rate 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.
– A large country’s fiscal and monetary policies affect other
economies
…aggregate demand, output, and prices become more volatile
across countries if policies diverge.
Macroeconomic Interdependence Under Floating Rate
The Large Country Case
– Effect of a permanent monetary expansion by US
• $ depreciates, US output rises
• Small country’s output may rise or fall.
Its currency appreciates  Its CA and output decrease
US economy expands It sells more to US  Its output rises
– Effect of a permanent fiscal expansion by US
• US output rises, US currency appreciates
• Small country’s output rises
Its currency depreciates  Its CA and output rise
US economy expands  It sells more to US  Its output rises
Large Country => Locomotive
The Case Against Floating Exchange Rates
• Injury to International Trade and Investment
– Exchange rate 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.
– 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
More Case Against Floating Exchange Rates
•
Speculation and volatility in the foreign exchange market
• Expectation of depreciation in short-run
 Rush to sell currency
 Depreciation in short-run
… and recovery to fundamental value in long-run
High nominal and real exchange rate volatility under floating
Violation of Purchasing Power Parity
Disruption of trade ???
Nominal and Real Effective Dollar Exchange Rate Indexes, 1975–2010
Purchasing Power Parity???
Source: International Monetary Fund, International Financial Studies.
Milestones ‘a Floating
Vietnam Expansion
– Inflation
– Commodity price
boom
F L O A T I N G
Yom Kippur War
Oil Shock
Stop – Go Inflation
Plaza Accord
Louvre Accord
– Black Monday
– Japan Bubble
– S & L Debacle
Berlin Wall Down
– Maastricht
– ERM Crisis
Global Savings Glut
– China rising
– Developed country
aging
– Reserve buildup
– Tech slowdown
Global Housing
Tequila Crisis
– Recycling petrodollars Emerging Mkt Boom
America Held Hostage
East Asia Crisis
– Contagion
2nd O i l S h o c k
– Leveraging
Volcker Disinflation
– Deleveraging
– Twin Deficits
– Rust Belt
– Lost Decade
– LTCM
Dot.com bubble
– US Capital Inflow
– US CA Deficit
– Greenspan Put
Bubble
• US Saving down
CRISIS
The Great Recession
Rush to safety