International Economics Lecture 7 Fixed v. Floating Exchange rates
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1 Intenational Economics Lectue 7 Fixed v. Floating Exchange ates How should a govenment manage its exchange ates. In geneal, we distinguish between two opposing policies: fixed exchange ates and floating exchange ates. Unde fixed exchange ates, govenments decide to fix thei ates to some othe standad, eithe a dominant cuency such as the dolla, o a basket of cuencies o gold. Unde floating exchange ates, the maket detemines the outcomes of ates. Histoy: Fom , the wolds finances wee dominated by the Betton Woods system. All cuencies wee pegged in tems of the dolla which in tun was linked to gold. Ealie in the 20 th centuy, the pound steling played a simila ole. Since 1971, we have had a mixed system in which the main cuencies, the dolla, DM and Yen float against each othe. Many mino cuencies ae linked to the dolla o othe cuencies. In addition, many Euopean cuencies ae linked in the Euopean monetay system. Hee, cuencies ae allowed to move in a band, but not outside the band. In fact, we can talk about a ange of altenatives between a puely fixed exchange ate system and a pue floating system. Even unde pue floating, govenments geneally intevene, cajole, etc., to move cuencies in the desied way. Even unde a fixed exchange ate system, devaluations occu that is, govenments ae foced by cicumstances to lowe the value of thei cuencies. fixed managed taget zone dity float float What ae the advantages and disadvantages of each? Thee ae at least two schools of thought on exchange ate policy. The Chicago school geneally agues that floating ates ae the best. This is not supising since floating ates epesent a pomaket appoach. Keynes was a chief achitect of Betton Woods and a stong poponent of fixed ates. Many Keynesians agee that govenment intevention is necessay to pomote exchange ate stability. If fixed exchange ates pomote stability and pedictability, then what ae the aguments fo floating? Fiedman and othes ague that fixed ate egimes do not pomote stability but in fact pomote instability. They would cite the collapse of a tight EMS o the fall of the peso as pefect examples of the flaws in a fixed system. Poblems with fixed system (Chicago appoach: 1. Speculation will dive exchange ates to thei tue equilibium level, govenments cannot alte the tue equilibium. 2. Speculatos who do not stabilize will be diven out of the maket. 3. Govenments, in paticula cental banks subsidize ich speculatos when they fix exchange ates atificially high. 4. The best way to pomote stability is to keep the money supply gowing at a steady ate.
2 Keynesian esponse: 1. Thee is a geat deal of evidence that speculation can be destabilizing. Witness the gyations of the dolla in the mid-1980 s 2. Exchange ates may not settle at thei equilibium values o it may take a long time to do so (in the long un we e all dead.) 3. A fixed exchange ate system may impose the discipline necessay fo exchange ate stability; in paticula monetay policy must be coodinated. Note that no one debates the meit of a stable exchange ate system. The question is how to attain one. The ecod: Since 1971, exchange ate fluctuations have been wild. This would seem to indicate that the Keynesian have the edge. Fiedman would point out that the instability has been caused by the inability o unwillingness of counties to follow sound policies. Howeve, in ecent yeas most counties have followed moe esponsible monetay policies, yet fluctuations continue. Is a fixed ate system feasible today? Pobably not. It would take moe coopeation than we ae likely to see. And which cuency would dominate? Fixed exchange ates systems tend to wok when one county is dominant. Exchange ates and BOP- If the cuent account is negative, then what happens to exchange ates? They should fall. A dop in exchange ates should incease expots and decease impots. This may, howeve, occu with a lag. This effect is sometimes efeed to as the j-cuve effect. In the case of the US afte the devaluation of the dolla in the mid-eighties, it took quite a while (we still have a substantial tade deficit!) In Mexico, we saw an effect within a yea. Tade suplus Devaluation Tade deficit Maco Policy with fixed and floating exchange ates Monetaist view: Recall that the monetaists essentially see exchange ates an outcome of monetay policy and oppose fixed exchange ates. Fiscal policy has no effect on exchange ates (though they admit it may in the shot un.) Excessive gowth in the money supply leads to inflation and devaluation unde fixed o floating exchange ates. Keynesian view: Pices don t adjust instantaneously, so quantities adjust. Fiscal and monetay policy cam be used to suppot an exchange ate. Note that if a county is committed to exchange ate stability, it has fewe degees of feedom in adjusting domestic maco-policy. Simple Keynesian model: Closed Economy: Open Economy: Y = C + I + G = E(Y) Y = C + I + G + (X - M) = E(Y) + X - M
3 Now we assume that M, impots, ae a function of Y, that is, M = M(Y). Why? We get: Y = E(Y) + X - M(Y) Aggegate Expenditue E(Y) + X - M(Y) Aggegate Income The spending multiplie in a small open economy: Y = C + I + G + (X - M) C = a + by M = my Note that b is the maginal popensity to consume and m is the maginal popensity to impot. Y = a + by + I + G + X - my Y = a + by + I + G + X - my G = Y(1 - b + m) so, we get the familia multiplie: Y / G =1/(1 - b + m) Finally, Lindet notes that (1-b), one minus the MPC, is just the MPS, the maginal popensity to save. So: Y / G =1/(s + m) As usual, one can think of impots, like savings as a leakage, that is, they syphon of funds fom the cicula flow. Example. Suppose the govenment cuts taxes. Some of the incease in $$$ that people get that would have been spent on US goods will now be spent on foeign goods. Instead of buying a Chevy, you buy a Toyota (like me.) What about foeign demand fo Ameican poducts? An incease in impots will actually have a small (multiplie like effct in othe economies. Example: If Ameicans buy bee made in Canada (Molson) then this inceases Canadian income. Some of this is spent on Ameican goods which stimulates the US economy, so now all of these impots ae leakeges.
4 Effect of a 1% incease in US spending on Economy US 1.3 Japan 1.0 Gemany 0.9 UK 0.5 Canada 0.8 Summay: The effect of Fiscal policy on the tade balance: 1. Inceases in income will likely wosen the tade balance by inceasing impots. 2. An incease in foeign aggegate demand will help ou tade balance. 3. Anything on the supply side will likely help ou tade balance. - famewok: Recall that a moe sophisticated way of analyzing Maco policy is to use the - famewok. The cuve epesents the locus of points whee the eal maket is in equilibium. The key hee is the equilibium between savings and investment. Both ae influenced by income (Y) and inteest ates (i). Fo equilibium: S(Y,i) = I(Y,i) I=I[] G G+I I+G Y G+I=S+T S(Y)+T In the above, the investment function in the uppe left hand cone is a function of the inteest ate. Intuitively, the cuve slopes downwad because as income inceases, savings incease; in ode to bing equilibium (S=I o S+T=G=I), we must have lowe inteest ates (which lowe saving and incease the demand fo investment.)
5 Now, let us deive the cuve: Speculative Money demand M=M[] Ms Y Md M=M(Y) Combining the two, we get: Y Now, suppose we add expots and impots, and assume, again, that M=M(Y). What happens to the slope of the cuve? (Hint: Think about what happens to the effectiveness of fiscal policy and the multiplie when impots ae added.) The cuve is flatte. Example. Suppose the govenment cuts taxes. Some of the incease in $$$ that people get that would have been spent on US goods will now be spent on foeign goods. Instead of buying a Calistoga, you buy Peie.
6 Go ove the basics of - Expansionay fiscal policy: Y* Y** Y In the above a tax cut o incease in govenment spending will move equilibium income fom Y* to Y** and shift inteest ates up. Again, fiscal policy is less effective. Y* Y** Y Again income shifts fom Y* to Y**. This time inteest ates fall. Fixed Exchange ates: With fixed exchange ates, we must add anothe constaint: B = C(Y) + K[i] In the above constaint, the cuent account must offset the capital account fo BOP to be in equilibium. Recall that impots ae a function of income, so C(Y) and foeign investment should depend on domestic inteest ates.
7 What ae the signs of the above? C(Y) is negative with espect to Y; as income inceases, impots go up, wosening the cuent account. K[i] is positive with espect to i; as inteest ates ise, mae capital is dawn in. So, as income ises, in ode to offset the cuent account deficit, inteest ates must ise to attact capital. The U.S. was in this situation in the ealy 80 s. The FE cuve is positive sloping, and may have a slope highe o lowe than the cuve. Q: A vetical FE cuve means what? That inteest ates don t daw in capital vey much so income is the main deteminant of BOP. R FE Y CASES: Suppose that the US cuts govenment spending o inceases taxes- a contactionay fiscal policy. Then you ae no longe on the FE cuve. One eithe needs to devalue OR expand the money supply to get back on FE. Fiscal policy and monetay policy must be coodinated to achieve a stable exchange ate. R FE Y** Y* Y In the above, the new equilibium Y** is not consistent with a fixed exchange ate and will ceate a balance of payments suplus which should tend to push up the value of the county s cuency. Example 2: Geat Bitain 1992 Bitain was then a membe of the EMS which was tantamount to a fixed exchange ate system. By 1992, it was clea that the pound was ovevalued and eithe Bitain must devalue dastically OR un a vey contactionay fiscal and/o monetay policy.
8 R FE Y Note: Devaluation would shift the cuve to the ight. (Why?) In sum, with fixed exchange ates: Y inceases impots M, Y, deceases capital inflows Both of the above tend to wosen BOP and put downwad pessue on the exchange ates. Note that the monetaists and eveyone agee that an incease in the money supply lowes value of the exchange ate. Fiscal Policy: Ambiguous. An expansionay fiscal policy will incease Y and theefoe incease impots and wosen BOP. But an expansionay policy will also incease which will suck in capital boosting BOP. Some ague that in the shot un, the inteest ate effect is the moe significant, in the long un the income effect will dominate. In tems of --FE, it depends on the slope of the FE cuve. If FE steepe than, then an expansionay fiscal policy will push the county to the ight of FE. This will push impots up and lowe capital inflows. To offset, the county will eventually have to devalue. FE
9 Y* Y** Y If FE is less steep than, then an expansionay fiscal policy will leave the county above (and to the left of) FE. This will push impots down and incease capital inflows. To offset, the county will eventually have to devalue. FE Y* Y** Y Pefect Capital Mobility: In this case, the FE cuve is flat at the wold inteest ate. A county effectively has no contol ove inteest ates and hence ove monetay policy. Fiscal policy is extemely effective. FE = Y
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