Exchange Rate
Regimes
Fixed Exchange Rates and the Adjustment of
the Real Exchange Rate
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In the medium run, the economy reaches the
same real exchange rate and the same level of
output
(whether it operates under fixed exchange rates or
under flexible exchange rates.)
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Under fixed exchange rates, the adjustment
takes place through the price level rather than
through the nominal exchange rate.
Equilibrium in the Short Run and in the
Medium Run
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In the short run, a fixed nominal exchange rate
implies a fixed real exchange rate.
In the medium run, a fixed nominal exchange
rate will not prevent an adjustment of the real
exchange rate through movements in the price
level.
The Case For and Against a Devaluation in
the Short Run
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The case for devaluation is that, in a fixed
exchange rate regime, a devaluation leads to a
real depreciation (an increase in the real
exchange rate), and thus to an increase in
output.
A devaluation of the right size can return an
economy in recession back to the natural level
of output.
The Case For and Against a Devaluation
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The case against devaluation points out that:
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In reality, it is difficult to achieve the “right size”
devaluation.
The initial effects of a depreciation may be
contractionary (the J-curve effect).
The price of imported goods increases, making
consumers worse off temporarily. This may lead
workers to ask for higher nominal wages, and
firms to increase their prices as well.
The Return of Britain to the Gold
Standard: Keynes Vs. Churchill
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The gold standard was a system in which
each country fixed the price of its currency in
terms of gold. This system implied fixed
nominal exchange rates between countries.
Britain decided to return to the gold standard
in 1925. This required a large real
appreciation of the pound.
As a result, the overvaluation of the pound
was among the reasons for Britain’s poor
economic performance in the late 1920’s.
Exchange Rate Crises
Under Fixed Exchange Rates
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Higher inflation, or the steady increase in the
prices of domestic goods, leads to a steady real
appreciation and worsening of a country’s
trade position.
Lowering the domestic interest rate triggers an
decrease in the nominal exchange rate, or
nominal depreciation.
The size of the devaluation can be estimated
using the interest parity condition.
Exchange Rate Crises
Under Fixed Exchange Rates

Under fixed exchange rates, if markets expect
that parity will be maintained, then they
believe that the interest parity condition will
hold; therefore, the domestic and the foreign
interest rates will be equal.
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Exchange Rate Crises
Under Fixed Exchange Rates
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Expectations that a devaluation may be coming
can trigger an exchange rate crisis. The
government has two options:
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Give in and devalue, or
Fight and maintain the parity, at the cost of very
high interest rates and a potential recession.
The 1992 EMS Crisis
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Realignments are adjustments of parities between
currencies.
The September 1992 EMS (European Monetary
System) Crisis was caused by the belief that several
countries were soon going to devalue. Some
countries defended themselves by increasing the
overnight interest rate up to 500%.
In the end, some countries devalued, others dropped
out of the EMS, and others remained.
Roughly the same happened in Korea and Thailand
in 1997.
International Reserves –
Insuring against financial crises
Choosing Between Exchange Rate
Regimes
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In the short run, under fixed exchange rates, a country
gives up its control of the interest rate and the
exchange rate.
Also, anticipation that a country may be about to
devalue its currency may lead investors to ask for
very high interest rates.
An argument against flexible exchange rates is that
they may move a lot, may be difficult to control and
lead to a volatile macroeconomic environment.
The Euro: A Short Story
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The European Monetary Union (EMU) was
consolidated under the Maastricht Treaty (1991).
In January 1999, parities between the currencies of
11 countries and the Euro were “irrevocably” fixed.
In January 2001, the Euro replaced national
currencies.
The new European Central Bank (ECB), based in
Frankfurt, became responsible for monetary policy
for the Euro area.
Advantages of a Common Currency

Reduction in exchange rate risk
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Reduction in transactions costs
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Eliminates the risk of exchange rate variability, which
increases capital market stability
There is no exchange of currencies among members,
so transaction costs are reduced
Economies of scale

Along with the dollar, the euro may serve as a reserve
currency, so the EU gets interest free loans
Disadvantages of a Common Currency

Loss of independent monetary policy
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With a common currency monetary
policy is the same in all countries because
there is one money supply and one
central bank
Loss of national symbol

Losing a national currency may be a loss
of national identity or heritage
Optimal Currency Areas
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An optimal currency area is a group of
countries suitable to adopt a common
currency without significantly jeopardizing
domestic policy goals.
Criteria for optimal currency areas
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Similar composition of industries
Significant mobility for factors of production
(labor and capital)
Diversified economies
Diverse demand shocks
People Changing Region of Residence in the 1990s
(percent of total population)
Optimal Currency Areas
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Are the American States an optimal currency area?
Is the European Union an optimal currency area?
Should Britain join the EMU (the Euro)?
Did Ecuador do wisely in dollarizing its economy?
What should Argentina do?
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Endogenous Optimal Currency Areas
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