Lecture 9
International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
Exchange Rate Policy
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What exchange rate policy should a country use? Is
there a “best” exchange rate policy?
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Clean Float
Fixed (never change)
Dirty Float
Adjustable Peg
Each approach has its strengths and weaknesses.
Different countries might do well to choose different
policies. There is no one right chose that is correct for
every country for all time.
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Five Major Issues in Choosing
1. The effects of macroeconomic shocks;
2. The effectiveness of government monetary
and fiscal policies;
3. Differences in macroeconomic goals,
priorities, and policies;
4. Controlling inflation;
5. The real effects of exchange rate variability.
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Shocks
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Generally countries prefer exchange rate
policies that minimize shocks because this
results in a more stable economy.
Types of shocks to consider:
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Internal Shocks
External Shocks
The effects of shocks vary with exchange rate
regime and with type of shock.
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Shocks (Overview)
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Monetary and fiscal shocks operate like any (deliberate)
expansionary or contractionary monetary or fiscal policy.
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An adverse international trade shock reduces both the
current account and GDP, causing the country’s currency
to depreciate.
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The analysis previously given applies.
The depreciation makes the country’s exports more desirable, and
exports improve, reversing the deterioration in the current account
balance. GDP improves.
The adjusting exchange rate always restores external
balance after a shock. It does not always restore internal
balance.
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Choosing an Exchange Rate Regime:
Internal Shocks
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Internal (domestic) shocks are generally less of a
problem for a country under fixed exchange rates.
Monetary Shock:
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Domestic interest rate changes trigger capital flows and
pressure on exchange rates.
Under a fixed rate, domestic monetary shocks create a
need for intervention which tends to reverse and offset
the shock.
Under a floating rate, the resulting change in the
exchange rate magnifies the effect of the shock.
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Choosing an Exchange Rate Regime:
Internal Shocks (2)
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Domestic Spending Shock
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This may be an unexpected change in C, I or G.
Result depends upon how responsive international capital
flows are to interest rate changes.
Under a fixed exchange rate, if capital is not responsive,
then it is less disruptive than under floating rates.
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E.g., a decline in spending reduces imports, improving the trade
balance. The intervention required expands the domestic money
supply, lowering interest rates, and restoring aggregate demand.
Under a fixed exchange rate, if capital is responsive, then
domestic spending shocks are more disruptive than under
floating rates.
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Choosing an Exchange Rate Regime:
Internal Shocks (3)
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Domestic Spending Shock, continued
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Under floating rates, the changes in exchange
rates tend to magnify changes in domestic
production and demand even more.
The floating rate makes things worse.
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Choosing an Exchange Rate Regime:
External Shocks
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Foreign trade shocks are a major way in which business
cycles are transmitted from country to country.
Incomes fall in one country, resulting in declines in
purchases of exports from another, which reduces the
incomes in the second country.
Consider a foreign trade shock:
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Example: demand for our exports fall.
Under a float, the currency depreciates, making our exports
cheaper in other countries.
Demand for exports rise.
 Better under floating exchange rates.
(Floating) Exchange rate changes insulate economies
from foreign trade shocks.
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Choosing an Exchange Rate Regime:
External Shocks (2)
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International Capital Shocks
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Under a float, adverse effects of capital outflows
result in exchange rate changes that cause
offsetting improvements in trade.
Under a fixed exchange rate, the intervention
required tends to exacerbate the negative effects
of the int’l capital shock.
 Floating rates are generally better.
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Choosing an Exchange Rate Regime:
Domestic Policy Effectiveness
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Fixed Exchange Rates:
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Monetary policy is useless.
Fiscal policy is made stronger.
Floating Exchange Rates:
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Monetary policy is reinforced by the exchange rate change.
The effectiveness of fiscal policy depends upon how responsive
capital is (capital mobility).
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If capital is highly mobile, then fiscal policy is made stronger. If
capital is not mobile, then fiscal policy is made weaker.
One thing is clear: if a country wants to use monetary
policy to conduct domestic policy, it will favor a floating
exchange rate.
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Choosing an Exchange Rate Regime:
Goals, Priorities, and Policies
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Culture, history, exigencies, among other
things, may result in countries having different
goals and priorities. These lead to different
policies.
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Economic growth
Low unemployment
Low inflation
External balance
Income distribution equality or inequality
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Choosing an Exchange Rate Regime:
Goals, Priorities, and Policies (2)
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To be successful, fixed exchange rates require
consistency or coordination in these areas.
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Multiple objectives within a country may require
conflicting policies, so priorities may be critically important.
Independent monetary policies are not possible.
Tax, interest rate, or inflation rate differences will lead to
capital flows that will undermine the currency fix.
Productivity and productivity growth differences affect
relative inflation rates.
Recently the French complained that the British
should reduce the length of their workweek, and
Italy has complained that the level of the euro has
hurt them in international markets.
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Choosing an Exchange Rate Regime:
Goals, Priorities, and Policies (3)
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Floating exchange rates are tolerant of diversity in
countries’ goals, priorities, and policies.
Changes in the exchange rates keep external
balance while internal changes occur.
The exchange rates insulate each country from
internal policies and shocks of other countries.
Int’l policy coordination is still possible, but not
necessary.
This freedom only exists as long as the countries
involved do not care what exchange rate
eventuates.
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Choosing an Exchange Rate Regime:
Goals, Priorities, and Policies (4)
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For example, in the early 1980s,
unemployment rates were very high in
many European countries, but they did not
attempt expansionary policies because their
currencies were already weak against the
dollar.
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They actually tightened monetary policy to raise
their interest rates to prevent their currencies
from weakening further.
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Choosing an Exchange Rate Regime:
Inflation
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An implication of PPP is that relative stable
prices is a requirement for a fixed exchange rate.
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The countries involved must have similar inflation rates
over the long run.
Thus, fixed exchange rates may create a
necessary price discipline on domestic policy to
maintain low, stable inflation rates.
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Argentina’s inflation rate dropped from 3000% to 4%
per year after they fixed their peso to the U.S. dollar.
Inflationary expectations also lowered because of the
credibility of the fixed-rate discipline.
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Choosing an Exchange Rate Regime:
Inflation (2)
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This price discipline forces countries under fixed exchange
rates to:
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Keep their deficits small and similar,
Keep their money supply growth rates low and steady
This is the logic behind certain actions required of nations joining
the European Union.
The result may be that a world under fixed exchange
rates might enjoy lower global inflation rates.
Under a fixed system with a “lead country”, like the U.S.
under Bretton Woods, all countries will have to match the
inflation rate of the lead country.
When one country inflates, they all must inflate, which
means that inflation can be “exported”.
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Choosing an Exchange Rate Regime:
Inflation (3)
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No such pressures exist under floating exchange rates.
Countries are free to conduct any domestic policies
they wish.
Budget deficits may be financed by money creation.
This may lead to higher average global inflation
rates.
Average inflation rates were higher after 1973 than
before.
The real keys to lower inflation rates are policy
discipline, resolve, and credibility of the monetary
authorities in each country.
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Choosing an Exchange Rate Regime:
Exchange Rate Volatility
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Floating exchange rates do float!
High variability of exchange rates can be a
deterrent to trade and international investment
because it raises exchange rate risk, affecting total
expected returns. (Exchange rate risk is exchange
rate variability.)
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Exchange rate variability has real effects.
Those who favor fixed exchange rates claim that it
reduces this variability, hence improves int’l trade
and investment.
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Choosing an Exchange Rate Regime:
Exchange Rate Volatility (2)
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Does exchange rate risk/variability actually
reduce trade?
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Early studies typically found no effect on the
volume of international trade.
More recent studies found that exchange rate
variability may affect trade volume, but the
change is mostly negligible.
There is some concern that the dramatic swings
due to overshooting may lead to significant
long-term effects as capital formation is
affected.
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Choosing an Exchange Rate Regime:
Exchange Rate Volatility (3)
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Those who favor floating exchange rates argue that fixed
exchange rates are just another form of price fixing or price
controls. The market is not being allowed to work.
As with all markets, equilibrium exchange rates are prices
that provide information (“send signals”) about the relative
values of currencies. The question is whether or not the
market might send “false signals” for some reason.
Price controls have been shown to be generally inefficient,
while equilibrium rates are by definition optimal if they result
from full information and full adjustment.
Those who argue against floating exchange rates argue that
market exchange rates may be distorted by speculation,
speculative bandwagons and bubbles, informational
problems, and adjustment problems.
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Extreme Fixes:
Currency Boards
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An “exchange rate only” monetary authority.
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The board holds only foreign currency assets as official
reserves.
It issues domestic currency liabilities only in exchange for
foreign currency assets.
It holds no domestic currency assets, so cannot sterilize
actions.
Because it focuses entirely on maintaining the fix, and
not on domestic policy, and cannot sterilize, it has great
credibility in terms of its commitment to the fixed
exchange rate.
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Extreme Fixes:
Currency Boards (2)
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Hong Kong established a currency board in 1973.
In the 1990s, Estonia, Lithuania, Bulgaria, and
Bosnia/Herzegovina established currency boards.
Argentina set up a currency board in 1991, which it
abandoned in 2002.
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The creation of the board in 1991 was intended to increase the
credibility of their anti-inflation stance.
Inflation fell dramatically, interest rates fell, and economic growth
increased. Real growth was nearly 4% from 1992-1998.
But the fix made Argentina vulnerable to external shocks.
Following the Mexico peso crisis hit in 1995, int’l investors started
pulling out of Argentina. Defending its fix, Its money supply shrank
and interest rates rose. This ultimately threw the country into
recession in 1998.
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Extreme Fixes:
Currency Boards (3)
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The Argentine government ultimately had to allow
the exchange rate to float.
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The currency board does not force a country to follow
sensible fiscal and regulatory policies.
The fixed exchange rate leaves the country more exposed
to adverse foreign shocks.
It is difficult to find a “graceful” exit strategy that allows
the country to abandon the fix and allow rates to float.
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Extreme Fixes:
Dollarization
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An extreme form of a fixed exchange rate is
for a country to abolish its own currency and
use the currency of some other country.
Because the “other currency” is often the U.S.
dollar, this is called dollarization.
The government can still “de-dollarize” and
reintroduce local currency.
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Extreme Fixes:
Dollarization (2)
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In 1999, the president of Argentina talked
about adopting the dollar, but did not follow
through.
In 2000, Ecuador dollarized.
In 2001 El Salvador dollarized.
Dollarization makes it much harder for a
country to retake control of its currency and
devalue, so adds to its credibility.
It removes exchange rate risk, especially in
terms of trade with the U.S.
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Extreme Fixes:
Dollarization (3)
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What is the cost of dollarization?
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The country gives up control over all monetary
policy, leaving it in the hands of the U.S. Federal
Reserve.
It sells its U.S. bonds to buy the dollars, which
means that it no longer collects bond interest. This
can be a large income for some countries. (It loses
seigniorage.)
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Precursors to the EU
• Benelux (1944): Belgium, Netherlands, and
Luxembourg established a customs union.
• May, 1952: the six-nation European Coal and Steel
Community (ECSC) was created. (The Benelux
nations with Germany, France, and Italy.)
• March 1957: The Treaty of Rome established the
European Economic Community (EEC) and the
European Atomic Energy Commission (Euratom).
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Objectives of the EEC
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To gradually phase out all tariffs among the
member nations.
Replace the old tariff system with a single
external tariff system.
Create a system that allowed for the free
movement of goods, labor, and capital
among the six.
Charles de Gaulle (France) pushed for
agricultural integration to parallel the
industrial integration.
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More History
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In 1958, Britain called for the EEC to be expanded into an
Atlantic free-trade zone.
France vetoed the proposal.
Rejected, in 1959 Britain, Portugal, Switzerland, Austria,
Sweden, Norway, and Finland formed the European Free
Trade Association (EFTA).
In 1961, Britain again asked for EEC membership, but de
Gaulle of France again vetoed the admission.
In 1962, a Dutch proposal (the “Mansholt”) was accepted,
leading to a common agricultural policy among the EEC
nations.
1965—the “Second Treaty of Rome”.
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Second Treaty of Rome
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This, the second Brussels Treaty, created the European
Community (EC).
The ECSC, the EEC, and Euratom were all merged together.
A four-part governing body, consisting of a Commission,
Council, Parliament, and Court.
In 1967, Britain was AGAIN rejected for member by a French
veto.
1973—Britain, Denmark, and Ireland were admitted to the
EC.
In 1981, Greece was admitted.
In 1986, Spain and Portugal were admitted.
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Treaty of Maastricht
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In December 1991, the Treaty of Maastricht
was approved by the EC.
This Treaty had three “pillars”:
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Monetary Union
Common Foreign and Security Policies
Cooperation in Justice and Home Affairs.
Believing that a single market requires a
single currency, the Maastricht Treaty called
for the creation of the European Monetary
Union (EMU) in three stages.
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European Monetary Union (EMU)
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Stage 1 (1991). Convergence in 5 ways:
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Inflation rates
Interest rates
Currency exchange
Rate stability
Debt-to-GDP ratio of less than 60%
Stage 2 (1994). Creation of a European Central
Bank (ECB).
Stage 3 (1997).The ECB would be responsible for
monetary policy and the euro would circulate as
bank money.
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Convergence Criteria
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Each country’s inflation rate must be no higher than 1.5
percentage points above the average of the inflation rates
of the three countries with the lowest rates.
Each country’s exchange rates must be maintained within
the prescribed trading band with no realignments during
the preceding two years.
Each country’s long-term interest rates (gov’t bonds) must
be no higher than 2 percentage points above the average
of the three lowest.
Each country’s budget deficit must be no more than 3% of
its GDP, and its gross gov’t debt no larger than 60% of its
GDP.
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European Monetary Union
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Exchange Rate Mechanism (ERM) established to create a
monetary union and eventually a single currency—the
euro.
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In a monetary union, exchange rates are permanently fixed, with a
single monetary authority (central bank) conducting monetary
policy for the entire union.
The ERM was an adjustable-peg system, used as the
entering nations brought their monetary and fiscal policies
into line with one another.
Eleven EU countries joined in 1999 with one more joining in
2001.
With its low inflation rates, economic size and prestige of its
central bank, Germany was generally regarded as the lead
country.
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European Monetary Union
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In May 1998, there was a summit of EU
leaders to decide which countries met the
five criteria.
They decided that 11 countries had met the
criteria and could be admitted to the
monetary union. (Other countries could join
later when they met the criteria.)
Britain, Denmark, and Sweden qualified
but chose not to join.
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European Central Bank (ECB)
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Center of the European System of Central Banks.
On January 1, 1999, the ECB assumed responsibility
for the union-wide monetary policy.
Each country gives up (independent) monetary
policy, and, because of potential effects on deficits,
has limited access to fiscal policy.
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Can these countries function solely on limited fiscal policy?
The anticipated gains are the elimination of all
exchange rate concerns within the union, eliminating
all foreign exchange transactions costs.
It was a centerpiece toward larger-scale economic
integration.
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Floating the Euro
 On January 1, 1999, the European Monetary Union
(EMU) was inaugurated, leading to the
introduction of a new currency, called the euro.
 On January 1, 2002, euro currency began to
circulate in Europe.
 On February 28, 2003, all other currencies were
withdrawn from circulation.
 By July 2002, the euro was trading evenly with the
U.S. dollar.
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European Union
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Under a single currency, with a common
commercial code, labor laws, etc., product and
labor mobility should be extremely high and
costless.
This allows Europe to operate economically
like one very large nation.
A European Constitution?
Recent problems.
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