Monetary and Exchange-Rate Policies
READING ASSIGNMENT: Oatley – Chapter 13
1
Plan for today
1.
2.
Review electoral models. Especially…
The “Sectoral model” of voter-preferences:
 export-oriented prefers weak, fixed
 import-competing prefers weak, float
 non-tradable prefers strong, float
 finance prefers float (strength doesn’t matter
3.
Commitment problem
4.
Phillips curve
5.
A solution: independent central banks
2
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 rate stability
• So, how do governments make the
decision?
• “Society-based” approach says it’s interest
groups that pressure the government…
3
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
4
What will governments choose?
Society-based models of monetary & XR politics
1. Electoral models
2. Partisan models
3. Sectoral models
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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
8
Consider, however,
The Median Voter Model
• Maybe left and right parties will adopt the
same policies!
9
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
• Obviously (given the name of the model) the interest
groups are based on *sector*
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NIKE
Domestic
Employment
economic
concerns
autonomy
PUMA
XR
stability
Inflation
concerns
13
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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Strong currency
Domestic
economic
autonomy
XR stability
Weak currency
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Oatley’s “state centered” approach
to Monetary and XR politics
It’s all about commitment!
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Show me the money!
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Show me the money!
• It’s all about commitment
• Insulate policy-makers from short-term political pressures
• Time 1: beginning of your term in office
• Time 2: right before elections
• Option A: sound monetary policy
• Option B: drop interest rates
• Time 1: U(A2)>U(B2)
• Time 2: U(A2)<U(B2)
• The “sirens”: electoral pressures
• The commitment: Independent central banks
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First – the “sirens” policy mechanism:
Monetary & Unemployment
• Assume there’s a “natural rate of unemployment”
– New entrants, labor unions, minimum wages, hiring & firing
practices, unemployment compensation… (raise the wage, lower the
demand for labor)
• Workers care about their REAL wage (purchasing power),
but paid a NOMINAL wage
• An unanticipated reduction of the interest rate 
unexpected increase in inflation  lower REAL wage 
reduce unemployment 
• (An unanticipated increase of the interest rate 
unexpected decrease in inflation  increase REAL wage 
increase unemployment )
• In the long-run, labor market adjusts and changes are
reversed  return to the “natural rate of unemployment”
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But is there a cost???...
• If a government continually uses monetary
policy to keep unemployment below the
natural rate, it must continually increase
the rate of inflation (accelerationist
principle)
• The Phillips curve illustrates this
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http://www.andrew.cmu.edu/course/88-301/phillips/phillips_curve.gif
Courtesy of Peter Thompson Intermediate Macroeconomics, Carnegie Mellon. Also see Oatley, p289, fig 13.2
1.
Over the past 40 years, the Phillips curve has shifted first out then in again, as changes
in the natural rate of unemployment and in expected inflation have altered the terms of
the short-run trade-off between inflation & unemployment
2.
In the early 1960s, the Phillips curve trade-off was favorable: low unemployment with low
inflation
3.
The “new economics” of the 1960s led to an attempt to move to the upper right end of the
Phillips curve, in the hope of exploiting a presumed permanent – not just a short-run –
trade-off between inflation & unemployment
4.
By 1971, the short-run Phillips curve had shifted out! Too many years of creeping
inflation had destroyed the Federal Reserve’s credibility as an inflation fighter, and had
raised expected inflation
5.
The 1973 tripling of of world oil prices caused a further outward shift in the Phillips curve
6.
By 1975, the short-term inflation-unemployment trade-off had become unfavorable – to
keep unemployment down at 5% would require 12% inflation, to reduce inflation to 3%
would require 10% unemployment
7.
In the early 1980s, Federal Reserve Chair Paul Volker decided to attempt to reestablish
the Federal Reserve’s inflation-fighting credibility by doing whatever was necessary to
reduce inflation
8.
By 1985, it was clear that Volcker disinflation had “succeeded.” At the price of a few
years of high unemployment, Federal Reserve’s inflation-fighting credibility had been
restored and the short-run Phillips curve had shifted inward
9.
But even so, the Phillips curve of the late 1980s & early 1990s was not as favorable as
that of the 1960s
10.
The mid-1990s, however, saw a further inward shift of the Phillips curve: an apparent
fall in the natural rate of unemployment (welfare reform?)
What is the real cost?
• P290*** Oatley:
– Inflation raises uncertainty among firms & unions
– This uncertainty can *reduce* investment & *economic growth*
– This, in turn, raises the natural rate of unemployment
– Consider Oatley, p291***, fig 13.3
• How do we solve this problem?
• We “commit” to low inflation with independent central banks
(more on that next slides…)
• However, also consider p298***:
– Countries with more independent central banks have
experienced *lower* rates of *economic growth*
– Consider Oatley, p298***, fig 13.6
• Conclusion: Governments can impact/control inflation. Not
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so much influence on economic growth
Commitment mechanisms
• 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!)
– Then current account deficit widens (after Brazil’s 1998/9 crisis)
– And deficit spending ultimately undermined confidence
– Tied hands prevented the government from acting
– Commitment was, perhaps, too strong…
– Run on the currency in 2002  disaster!!
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Commitment mechanisms
•
Central bank independence measured:
1.
2.
3.
•
CB’s freedom to decide which economic objectives to pursue
CB’s freedom to decide how to set monetary policy (in pursuit of
the above objective)
Whether CB decisions can be reversed by other branches of the
government
Examples:
–
Swiss National Bank – highly independent
•
–
Reserve Bank of Australia – highly subordinate
•
•
No provision whatsoever for the government to influence monetary
policy
Secretary of the Treasure has final authority over monetary-policy
decisions & must approve any interest-rate changes proposed by the
Reserve Bank
Does it work? Consider Oatley p296*** fig 13.5 (where’s
Switzerland?)
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Time-inconsistent preference problem
• Exams force students to study – solves their time-consistent
preference problem
• But the prof has a time-consistency problem too!
• The day of the exam, my optimal strategy is to cancel the exam
– I can use my time for other things
– Students are also better off – they did their studying, but are
spared the exam-anxiety
• But if I cancelled all my exams, my reputation would suffer
• Imagine you had heard that I often cancel my mid-term, would you
have studied?
• Then the exam would not have worked to solve your timeconsistency problem
• So my “campus reputation” encourages me to be credible
• Summer campus problem? A one-shot game! Forget grades!
• KU Institutional solution to force me to give you a final exam?
– KU won’t pay me!
– My commitment was credible after all…
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Take aways
1.
Sectoral models:




export-oriented prefers weak, fixed
import-competing prefers weak, float
non-tradable prefers strong, float
finance prefers float (strength doesn’t matter
2. Phillips curve
3. Commitment problem
4. A solution: independent central banks
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Thank you
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