Feb 10 2004

Lesson 3

By

John Kennes

International Monetary Economics

Feb 10 2004

Class cancelled on Feb 12, 2004.

Neil Thygesen is giving a talk at the end of the month. Feb 27

Announcements

Feb 10 2004

Grading formula: Percentage score = .3 (project) + .7 (exam)

0-30%: 0031-40%: 0341-50%: 0551-60%: 0661-70%: 0771-80%: 0881-88%: 0989-93%: 1094-98%: 1199-100%: 13 Additional 11’s and 13’s will be given on a

discretionary basis.

Announcements

Feb 10 2004

What are the choices?What theory is relevant to understanding the choicesWhat are the policy implications?

The Choice of an Exchange Rate Regime

Feb 10 2004

Denmark: fixed exchange rate

Canada: flexible exchange rate

Why?

Two regimes

Feb 10 2004

Long-Run: real and monetary sphere separated

Neutrality of moneyPurchasing power parity

Short-Run: real and monetary spheres interfere

The interest and exchange rate connection(Money and exchange rate policy can deal with undesirable

fluctuations)

Exchange rates and Monetary Policy

Feb 10 2004

Money, the price level and te exchange rate tend to move

proportionately in the long run

Feb 10 2004

Long-run neutrality of money

Feb 10 2004

AD: inflation erodes purchasing power of money and therefore discourages consumption and investment

AS: Price setting – In boom times prices are jacked up, more workers hired, wages go up

In the long run W/P settles back down.

How the AD-AS model works

Feb 10 2004

The real exchange rate:

– Defined as EP/P*– PPP: E offsets changes in P/P*– So is constant

Many caveats though

Neutrality of Money implication: PPP

PPP asserts itself in the long-run

Feb 10 2004

Japan versus US, 1953-2002

Inflation difference: 0.2% US-JapanAppreciation rate: 1.7%

Why?

Explanation: Japan produced higher quality goods that could be sold

at higher prices – (a measurement issue)

Caveat: Balsa-Samuelson Effect

Feb 10 2004

Nominal exchange rate volatilePrices are much more sticky

What about the real interest rate?

Volatile fluctuations in the real exchange rate

Implication of sticky prices

Feb 10 2004

M increases -> credit abundant - > i falls

Domestic

Households take advantage of lower interest rates to borrow and spend

Firms step up investment (Stock prices also typically increase)

International

Investors move assets out of the country where yields are more appealing

Capital outflow results in a depreciation -> high competitiveness

Interest and exchange rate connection - effects

Feb 10 2004

1. The interest rate channel2. The credit channel3. Stock market channel4. Exchange rate channel

Expansion fuels inflation (lags of 2 years of more, because prices are

sticky)

4 Channels

Feb 10 2004

Price increases -> real appreciation -> competiveness declines – trade

deficit

Central bank is intervening: Selling part of its reserves and buying

back its own currency -> reducing (reabsorbing) the money supply

Efforts by Central bank to expand the money supply are thwarted by

the need to conduct off-setting foreign exchange rate operations

Effects are radically altered under fixed exchange rates

Feb 10 2004

IS curve: goods market equilibrium

A decline in the interest rate results in more output

LM curve: money market equilibrium

Higher output gap raises demand for money

IS-LM

Feb 10 2004

Interest rates initially lower because LM curve shifts out

Capital is flowing out, because of lower interest rates

What happens next depends on the exchange rate regime

IS-LM: An increase in the money supply

Feb 10 2004

IS-LM: An increase in the money supply

Feb 10 2004

Fiscal policy: cut taxesIS curve shifts upDomestic assets become attractive

If the exchange rate is fixed, CB finds capital inflow creates pressure

towards appreciation: To counteract must buy for foreign currency

and increase the money supply.

If the exchange rate is flexible, CB does not intervene. IS curve starts

shifting left again.

IS-LM: An increase in fiscal policy

Feb 10 2004

Fixed exchange rates

No independent monetary policy

Flexible exchange rates

No effects of fiscal policyThe exchange rate offsets fiscal policy effects

Exchange rate regimes and policy effectiveness

Feb 10 2004

Exchange rate regimes and policy effectiveness

Feb 10 2004

Most European countries prefer fixed exchange rates

Only exception is UK

Canada prefers a flexible exchange rate.

Preferences

Feb 10 2004

Free floating (Euro, US dollar, British Pound)Managed floating (Japan)Target zones (current ERM +/- 15%)Crawling pegs (regular slide)Fixed and Adjustable (The Snake, Bretton Woods)Currency Boards (Fixed with a 1 to 1 relationship between

monetary policy and exchange rate) Hong Kong, Argentina

(collapsed in 2002)Currency Union (Euro)

The range of exchange rate regimes

Feb 10 2004

1) Regime effects the transmission of shocks. (Box 11.3) Increase in world wide interest rates

Expansion under flexibleContraction under fixed

A foreign BoomExpansion under fixedContraction under flexible

What drives the choices of exchange rate regime?

Feb 10 2004

Monetary Policy

Can be used to deal with cyclical disturbancesCan be misused inflation (time inconsistency problems)

Fiscal Policy

Can be used to deal with fluctuations, but is highly politicized.Can be misused (public debts, political cycles)

Some Criteria

Feb 10 2004

Exchange rate stability:

Free floating exchange rates move around too much

Fixed exchange rates eventually become misaligned

More Criteria

Feb 10 2004

The Case for Fixed Exchange Rates

Flexible rates moved too much (financial markets are often hectic)

Exchange rate volatility: A source of uncertaintyA way of discplining monetary policyIn presence of shock, always possible to realign

Old Debate: Fixed versus Float

Feb 10 2004

Only pure floats or hard pegs are robust

• Intermediate arrangements invite government manipulations under speculative attacks

• Pure floats remove exchange rates from public policy domain

• Hard pegs are unassailable (oops Argentina)

New Debate: The Two Corner Solution

Feb 10 2004

In line with theory of time inconsistency

• Soft pegs are half hearted monetary commitments, so they ultimately fail.

New Debate: The Two Corner Solution

Feb 10 2004

Fear of Floating:

Many countries officially float but in fact intervene quite a bit

Fear of Fixing:

Many countries declare a peg but let the exchange rate move out of

the official bounds.

The Two Corner Solution and the real world

Feb 10 2004

The Two Corner Solution and the real world

80.00

90.00

100.00

110.00

120.00

130.00

140.00

1999M1 1999M7 2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7

Denmark (vis a vis €)Sweden (vis a vis €)Switzerland (vis a vis €)Korea (vis a vis $)

Feb 10 2004

Fear of Floating is deeply ingrained in many European countries

Fear of fixing explains disenchantment with the EMS and some

reluctance towards the monetary union.

The Two Corner Solution and the real world

Feb 10 2004

• A menu is hard to pick: Tradeoffs are everywhere• All of this takes the view of a single county• Systems involve many countries and rest on agreed

rules, including mutual support• Since the end of the Bretton Woods, there is no world

monetary system• This leaves room for regional monetary systems.

Enters Europe’s experience.

Conclusions