A Society-Centered Approach to
Monetary and Exchange-Rate Policies
READING ASSIGNMENT: Oatley – Chapter 12
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Killing me softly
•
•
•
•
•
Song about a song
Multivocality
Expression over content
(content is in the “ear” of the beholder)
Recalls:
– Ad campaigns (cola wars)
– Political campaigns
2
Plan for today
1. The Trilemma
2. France vs. Germany in the 1980s
3. How to deal with imbalances: fix vs. float
4.
Electoral models
5.
Partisan models
6.
Sectoral models
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The saga continues…
The story of the contemporary international
monetary system is the story about the
search for the elusive ideal-balance between
domestic economic autonomy and exchange
4
rate stability.
The Unholy Trinity
• Fixed Exchange Rate
• Autonomy of Monetary Policy
• Capital Mobility
Mundell-Fleming: Only 2 out of 3 are possible
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Eurozone countries
Switzerland
PRC
Fixed Exchange Rate
The Trilemma
Open Capital Flows
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Sovereign Monetary Policy
The point of the unholy trinity – you can’t have it all…
• “The point is that you can't have it all: A country must
pick two out of three. It can fix its exchange rate without
emasculating its central bank, but only by maintaining
controls on capital flows (like China today); it can leave
capital movement free but retain monetary autonomy,
but only by letting the exchange rate fluctuate (like
Britain--or Canada); or it can choose to leave capital free
and stabilize the currency, but only by abandoning any
ability to adjust interest rates to fight inflation or
recession (like Argentina today, or for that matter most of
Europe).”
• – Paul Krugman http://slate.com/id/36764
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The European Monetary System
• 1979
• Fixed but adjustable
• The
Bundesbank
(Germany)
used
monetary policy to keep inflation low, and
other countries engaged in foreign
exchange market intervention to fix their
currencies to the German mark
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French-German fight in 1981-3
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Or:
François tests the Adele-hypothesis
• Is the trilemma wrong?
• Can we have it all?
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French-German fight in 1981-3
• Mitterand – socialist president – believed
German monetary policy was strangling
• Expansionist monetary policy (e.g., lowered
interest rates)
• French inflation began to rise
• Called on Germany to lower their interest rates
• 18 month stand-off… the French backed down
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1988-2002: Monetary Union
• 1988: Planning begins
• Gradually moved towards fixing their currency
XR’s (1999 – “permanently” fixed)
• Jan 2002: The Euro!
• Why union?
• High degree of economic openness across
Europe 
• Sacrificed monetary autonomy for XR stability
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Fixed XR
• Also may act as a kind of commitment
• To avoid SPECULATATION governments try to make a
credible commitment to a fixed XR
• If the commitment is not credible, speculation can be
disastrous
• Argentine Currency Board (1991-2002)
– Pegged the Argentine peso to the U.S. dollar in an attempt to
eliminate hyperinflation
– Credibility? Required legislative vote to change the value of the
currency (public discussion undermines the point of a devaluation!)
– But deficit spending ultimately undermined confidence
– And tied hands prevented the government from acting
– Run on the currency in 2002  disaster!!
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To fix or to float?
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Trade & international capital flows
lead to imbalances
How do governments deal with these imbalances?
 Fixed exchange rate  sacrifice monetary policy
OR:
 Floating exchange rate  sacrifice certainty in international exhanges
Trade-off between
 exchange rate stability
versus
 domestic price stability with monetary policy autonomy
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What will governments choose?
Society-based models of monetary & XR politics
1. Electoral models
2. Partisan models
3. Sectoral models
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The triangle behind the scenes of all these models:
r
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Assuming free capital flows…
• Governments must choose between
– monetary policy autonomy
– XR stability
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1. Electoral models
• Prediction: Democracies choose floating XR 
– monetary autonomy used to manipulate politicalbusiness cycles
• If there is a fixed XR 
– commitment may not be credible before elections
(elections like the Sirens!)
• Pocketbook voter model – people vote according to
changes in their income
–
http://www.youtube.com/watch?v=loBe0WXtts8
• Sociotropic model – voters consider macro
performance (economic growth, unemployment,
inflation)
–
http://www.douglas-hibbs.com/HibbsArticles/Welt-am-Sonntag-2008-08-22.pdf
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2. Partisan models
• Left-wing parties are “pro-employment”
– Tied to organized labor
• Right-wing parties are “anti-inflation”
– Tied to business interests
• Prediction:
– Right-wing governments more likely than left-wing governments
to establish & maintain a fixed XR
• It is possible to connect this to the electoral model:
– Voters choose left-wing parties during recessions & right-wing
parties under inflation
• Some partisan models suggest, however, *convergence*
of party positions (specifically in 2 party systems)
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Downs offers a “spatial” model
of party competition.
• Based on Hotelling’s (1929) model
– Where should PUMA locate if people shop at stores closest to their house?
NIKE
Dems
PUMA
Reps
민주당
한나라당
Employment
concerns
Inflation
concerns
Vote single-peaked preferences
In a 2-party system, where will the left & right parties locate?
What happens when somebody decides not to vote?
Median preference shifts away from the absent voter
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Final thought on “partisan” models
• As we move into “sectoral models,”
• Consider that in the “partisan” model, we have
– Left – labor-oriented – parties
– VS
– Right – business oriented – parties
• What does this “ontology” recall from our trade models?
• What model is based on labor & owners of capital?
• FACTOR MODEL
• So, you can think of the “partisan model” as analogous
to the “factor model”
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3. Sectoral models
• Interest groups have different preferences on the trade-off
between domestic
• economic autonomy & XR stability
• Some groups prefer XR stability
• Others groups prefer domestic economic autonomy
(sovereign monetary policy)
• Obviously (given the name of the model) the interest
groups are based on *sector*
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NIKE
Domestic
economic
autonomy
PUMA
XR stability
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Strong currency
Domestic
economic
autonomy
XR stability
Weak currency
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Four domestic interest groups
1. Export-oriented producers
2. Import-competing producers
3. Nontraded-goods producers
4. Financial services industry
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Fixed or Float / Strong or Weak?
•
Export-oriented producers prefer…
–
Fixed XR: stability for their international transactions
–
Weak XR: keeps the price of their products world markets low
(keeps demand high) 
•
Import-competing producers prefer…
–
Floating XR: prefers monetary policy to address
recessions/inflation
–
Weak XR: keeps the price of imports high! This spurs domestic
demand 
•
Nontraded-goods producers prefer…
–
Floating XR: prefers monetary policy to address
recessions/inflation
–
Strong XR: consume more traded goods, travel more, pay for
tuition 
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Fixed or Float / Strong or Weak?
• Financial services industry prefer…
– XR stability leads to more international transactions…
– But XR volatility leads to XR-risk business…
– And monetary autonomy helps maintain a stable
domestic banking system, low inflation, and more
stable interest rates
– So: A weak preference for Floating XR
– As for currency strength: buy foreign assets when XR
is strong, repatriate returns when the XR is weak
– So: No preference on XR strength
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Sectoral XR preferences summary
XR stability preference
High/fixed
Strong
currency
XR strength
preference
Weak
currency
Exporters colonial
in
Imperialist
???
other
countries
–
powers?
Get them
keep
them out of
out
of our
our elections!
countries!
Export-oriented
low/float/ monetary
autonomy
Nontradable
Import-competing
Financial services
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Take aways
1. The Trilemma
2. France vs. Germany in the 1980s
3. Floating XR allows for flexibility in monetary policy
4.
Electoral models – democracies prefer floating XR
5.
Partisan models – left prefers float, right prefers fixed
6.
Sectoral models:




export-oriented prefers weak, fixed
import-competing prefers weak, float
non-tradable prefers strong, float
finance prefers float (strength doesn’t matter
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Thank you
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Political-business cycles (PBC)?
• Governments may be less willing to accept monetary
policy constraints before an election
• Problem 1: empirical – debate over whether we really
observe PBCs
• Problem 2: theoretical – if voters are rational, they
shouldn’t be fooled by a PBC (short-run employment
eaten up by eventual inflation)
• Kaplan: Lately in Latin America, we see COUNTERPBCs!
– International explanation: lack of international finance since Latin
American Debt Crisis
– Domestic explanation: Hyper-inflation history makes voters
“inflation-averse”
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Connecting monetary policy to
unemployment: The Phillips curve
• Governments can reduce unemployment
only by causing more rapid inflation & can
reduce inflation only by causing higher
unemployment
• More on this tomorrow…
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Thought…
• If poor voters have more trouble solving their
collective action problem to “rock the vote,”
• What effect should mandatory voting laws
(which provide all voters selective incentives to
vote) have on politics?
• Answer: Move policy platforms of parties to the
LEFT
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Why are there imbalances?
• These days, foreign exchange markets
conduct between $1 trillion and $1.5 trillion
worth of business… PER DAY!!
•  Exchange rate volatility!
•  Exchange rate misalignments
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Consequences of XR volatility?
• Uncertainty hurts international transactions?
• Suppose you work on a profit margin of 5%-9%
and the XR changes 5% between the time you
ship an export and the time it arrives…
• But businesses can purchase options to buy a
foreign currency 30, 60, or 90 days in the future
at today’s XR, thereby insuring themselves
against short-term XR volatility
• Nevertheless, a reduction in investment is one
possible consequence of currency
misalignments
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Free Capital Flow
USA
PRC
Inconsistent/Unholy
Trinity
Or
“Trilemma”:
a country can only have 2 out of
3 of these
Fixed Exchange Rate
Sovereign Monetary Policy
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Why is the US dollar special?
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Overvaluation of the Dollar
• International reserve currency
• Early 1980s: Reagan’s fiscal expansion – cut taxes,
increased spending 
• Current account deficit 
• Increased interest rates and capital inflows (from, e.g.,
Japan)
• Value of the dollar goes up!
• Plaza Accord (fall 1985): G5 agreed to reduce the value
of the dollar against the yen & mark by 10-12% – sell
dollars if it appeared the value was going to increase
• By early 1987, dollar had depreciated 40%
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Similar situation today
• US twin deficits: fiscal & current account
• Japan, Europe, China, current account
surpluses 
• Finance the American deficit
– US absorbs about 6% of the world’s savings
• US international investment position:
– foreign-owned assets in 2007: $17.8 trillion
– US residents’ foreign assets in 2007: $15.4 trillion
– international investment position: –$2.4 trillion
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What’s the worry?
• Catastrophe!
• Doubts about the solvency of American
financial institutions & American assets
• Foreign lenders reluctant to continue to
accumulate dollar-denominated assets
• Trigger massive sales of current
holdings?
• http://www.youtube.com/watch?v=qu2uJWSZkck
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Hope?
• Competition for scarce resources pressures China to
revalue?
• Forces the United States to tighten the belt?
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