Fixed Exchange Rates and Currency Unions

Introduction Why would a government buy or sell foreign

exchange? How does the overall economy and

economic policy change when the exchange rate is not allowed to float freely?

How do fixed exchange rate systems work? How do countries with fixed exchange rates

affect the world economy?

Inconvertible Currencies To fix a currency can make it an

inconvertible currency One that cannot be freely traded for another

country’s currency among domestic consumers and businesses

Common term for this system is exchange controls

Government or central bank becomes a monopolist controlling all sales of foreign currency at set price

Easy to “fix” the price of foreign exchange Common among developing countries

Inconvertible Currencies Foreign exchange market

Downward sloping demand Perfectly inelastic supply

One seller of foreign exchange - government

Equilibrium at intersection determines fixed exchange rate

Government balances available supply of foreign exchange with demand to achieve set exchange rate

Inconvertible Currencies

Inconvertible Currencies To keep exchange rate fixed, total

outflows and inflows must be equal at all times

Requires government to control flow of capital into and out of the country Domestic individuals and companies’

ability to purchase foreign financial assets is severely limited.

Difficulties & Exchange Controls Exchange controls lead to

Government initially balancing demand and supply for foreign exchange

Eliminated wide swings in exchange rate Difficulties with exchange controls

1. Must deal with government bureaucracy Government sole source of foreign exchange Less quality than free market Efficiency losses with only one provider

Difficulties & Exchange Controls

2. Difference between nominal and real exchange rates

If nominal rate close to PPP rate, then relatively sustainable

Money supplies in developing countries difficult to control

Domestic inflation rate can likely be greater than foreign inflation rate

Country’s real exchange rate is depreciating and nominal rate is becoming over valued


2. Difference between nominal and real exchange rates (cont.)

Assume expansionary policies - economy expands and price level increases

Real exchange rate depreciates and nominal rate is fixed

Imports relatively cheaper and domestic demand increasing – rising demand for foreign exchange

Excess demand at fixed exchange rate

Difficulties & Exchange Controls Balancing demand leaves 3 options

1. Allow currency to depreciate Large depreciation can cause higher

inflation and lower GDP

2. Government could implement contractionary policies to reduce demand for foreign exchange Sacrifice domestic demand to maintain

exchange rate

Difficulties & Exchange Controls Balancing demand leaves 3

options3. Ration available supply of foreign

exchange Government decides who gets the foreign

exchange Should provide for necessary imports and

deny for unnecessary What is considered necessary?

Obviously gives way to large incentives for government corruption

Difficulties & Exchange Controls Additional problems for economy

Depreciation of real exchange rate makes exports more expensive

Supply for foreign exchange available to country coming from exports decreases

Shortage of foreign exchange increases Rationing problem is more severe May cause product and input shortages

in domestic markets

Intervention: Foreign Exchange Government may choose to peg

their currency to that of another currency Mexico might peg peso to US dollar Mexico uses intervention – buying and

selling of foreign exchange to influence value of exchange rate

Mexico selling foreign exchange increases supply and Mexico buying dollars increases demand

Intervention: Foreign Exchange

I. Foreign exchange market in equilibrium with Mexico pegging rate of XRP

Economic growth – increase demand for foreign exchange

To maintain XRP, government sells foreign exchange to increase supply

Maintains exchange rate and prevents depreciation of currency


II. Assume Mexico’s interest rates increase relative to US

Capital flows to Mexico increasing supply of foreign exchange

To peg rate, Mexico purchases foreign exchange increasing demand

Maintains exchange rate and prevents appreciation of currency


III. Long run can hold rate as long as can buy or sell foreign exchange

Mobile portfolio capital can be a good or bad thing for a country with fixed rate

Inflows create additional supply of foreign exchange for country

Capital flows volatile in short run and create problems when outflow from domestic markets

If cannot maintain peg, can lead to “currency crisis” causing severe depreciation of currency

Macro Adjustment – Fixed Rates I Internal balance must be adjusted to

stay in line with a fixed exchange rate over time

Example: Assume domestic economy growing quickly Domestic demand for foreign exchange

increases as demand for imports increases

Private sector has balance of payments deficit

Macro Adjustment – Fixed Rates I Example (cont.)

Government sells foreign currency in foreign exchange market to maintain exchange rate

AD increases and hope current account deficit keeps it from going past full employment level

With sufficient reserves, government can intervene until economic growth slows

Macro Adjustment – Fixed Rates I


Example (cont.) With government intervention in

foreign exchange market, economic situation will correct itself

When government sells foreign currency they are getting domestic currency in exchange

This leads to decrease in domestic money supply (similar to selling government bonds)


Example (cont.) Foreign exchange is not part of

country’s money supply The country’s monetary base is

reduced by amount of intervention Domestic money supply contracts by

multiple of amount of intervention


Example (cont.) Effects of intervention1. The exchange rate is stabilized in

the short run as shown earlier2. Begun automatic adjustment almost

guaranteeing balance of payments deficit will not continue in long run

Macro Adjustment – Fixed Rates I Effects of intervention

AD falls with fall in money supply Equilibrium levels of output and price

level fall Maintained fixed exchange rate by

reducing rate of economic growth Allows not only exchange rate to be

fixed, but automatically adjusts economy for sustainable external equilibrium

Macro Adjustment – Fixed Rates I Maintaining fixed exchange rate takes

away governments ability to use discretionary monetary policy to influence the economy

Money supply becomes a function of country’s external balance based on how much government must intervene in foreign exchange market

Macro Adjustment – Fixed Rates II Along with benefits, there is a cost

associated with fixed exchange rates Automatic changes from intervention

occur without considering the state of the domestic economy

Assume external balance is in deficit and economy is producing less than full employment

Macro Adjustment – Fixed Rates II

Money supply declines and country’s external balance is balanced

Internal balance would change decreasing output and unemployment would increase

Intervention in this case is inconsistent with internal balances

However, some cases it can be consistent

Macro Adjustment – Fixed Rates II Table 17.1 summarizes effects of

intervention on external and internal balances

First column – state of internal balance Second column – position of external balance Third & fourth – appropriate government

response to solve internal and external balance respectively

Last column – lists consistency

Macro Adjustment – Fixed Rates II Two cases where monetary policy

solves internal and external balances – consistent

Two case where internal and external balances conflict – inconsistent

These two cases of inconsistency make fixing exchange rates a problem for some countries

Macro Adjustment – Fixed Rates II Inconsistencies

1. External deficit when at less than full employment, adjustment leads to recession to maintain fixed exchange rates

2. External surplus with high inflation or rapid economic growth, adjustment leads to higher inflation or more rapid economic growth


Most participants in international trade prefer fixed exchange rates as it decreases risk of transactions

But, fixed exchange rates mean that on occasion internal and external balances will be mismatched with policy

Fiscal Policy & Internal Balance

In the short run, there are solutions to the dilemma between internal and external balances

1. Government can assign roles Monetary policy for external balance Fiscal policy for internal balance Example: government adopts

expansionary fiscal policy

Fiscal Policy & Internal Balance Example (cont.) -

Government budget deficit financed through borrowing

Demand for loanable funds increases raising interest rates (D to D’)

Open economy, rise in interest rates creates inflow of foreign capital

Domestic supply of loanable funds increases (S to S+f)

Fiscal Policy & Internal Balance Example (cont.)

Inflow of capital requires foreign investors to sell foreign currency or buy domestic currency

Supply of foreign exchange increases Exchange rate to appreciate, but with

fixed rate government intervenes Demand for foreign exchange

increases maintaining pegged or fixed rate


Example (cont.) Secondary effect on market for loanable

funds Government purchases of foreign

exchange increases domestic money supply

Increase in money supply leads to increase in supply of loanable funds (S+f to S’+f)

Equilibrium interest rate moves back toward ie

Effects of Fiscal Policy - Domestic Expansionary fiscal policy

Increases AD, increasing output and price level

Intervention in foreign exchange increases money supply

AD increases even more with increase in money supply

With open economy and fixed exchange rates, effect of policy are more pronounced

Effects of Fiscal Policy - Domestic

Effects of Fiscal Policy - Domestic Contractionary Fiscal Policy

Demand for loanable funds decreases Lowers interest rate Investment in domestic country

decreases – capital outflows Supply of loanable funds decreases

(S to S-f) Interest rates increase towards

original equilibrium


Contractionary Fiscal Policy (cont.) Capital outflow causes demand for

foreign exchange to increase Pressure for currency to depreciate Intervention in foreign exchange

market leads to increase in supply of foreign exchange to maintain fixed rate


Contractionary Fiscal Policy (cont.) Secondary effect from change in

money supply Selling foreign exchange buys

domestic currency decreasing money supply

Supply of loanable funds decreases even further moving equilibrium interest rate back toward original rate

Effects of Fiscal Policy - Domestic Contractionary Fiscal Policy (cont.)

Initially AD decreases, lowering equilibrium output and price level

Intervention in foreign exchange market decreasing money supply has additional effect of decreasing AD further

Net result in open economy, effects on output and price level are more pronounced

Sterilization The separation of monetary policy

from intervention in foreign exchange market

Allows achieving external balance to not affect the money supply of the country

Can solve mismatch between external and internal balance under fixed exchange rate in short run

Sterilization Assume private demand foreign

exchange increases Balance of payments deficit Government must sell foreign exchange

to maintain exchange rate Decrease in domestic money supply A central bank in developed country

with active government bond market can use open market operations

Sterilization Government knows how much

domestic currency it purchased Government can purchase like

amount of government bonds Net effect of intervention and

sterilization on domestic money supply is zero

Sterilization Problems

Best used when there are small short run deviations in exchange rate from PPP

Necessary exchange rate is kept fairly close to PPP or policy likely to fail

Example If domestic inflation is higher than foreign

inflation (usual case), intervention and sterilization result in overvalued real currency

Sterilization Example (cont.)

Supply of foreign reserves held by government not enough to maintain exchange rate and currency must be devalued

Sharp devaluations have consequences discussed in chapter 15

Sterilization Sterilization can work if we vary what we

mean by fixed exchange rate We can fix or peg the real exchange rate

instead of nominal rate Nominal rate is allowed to change while real

rate is held constant – crawling peg Remember equation for real exchange rate

Sterilization

Maintaining nominal rate requires ratio of prices to be constant

To maintain real exchange rate, calculate change in price ratio and change nominal rate to account for difference

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Sterilization Country may set pre-announced rate of

change in nominal rate based on differences Although exchange rate is changing,

participants know by how much Real exchange rate is held steady Still a need for intervention to smooth out

changes from announced rate Monetary policy can now focus on domestic

economic conditions and exchange rate in real sense is stable

Pegging w/Monetary Policy A country may be willing to sacrifice

domestic monetary policy for fixed rate

Could have two countries very closely related Larger and smaller country with high level

of trade May have high correlation between

changes in GDP (one in larger than other)

Pegging w/Monetary Policy These circumstances may lead to

smaller country fixing its exchange rate to larger country

Monetary policy is sacrificed, but smaller country may not have any influence with domestic monetary policy to begin with b/c of connection with larger country

Pegging w/Monetary Policy Recession in larger country most likely

leads to recession in smaller country If monetary policy does not matter, smaller

country may feel makes sense to forgo monetary policy in exchange for fixed exchange rates

May require some intervention, but does not matter if sterilized or not

Smaller country’s monetary and price level growth rate almost identical to larger country

Currency Unions If maintaining fixed rate has so many

problems, then why continue to try? If really want to keep exchange rate

stability between two countries, then more logical to merge two currencies into one – currency union

Obviously benefits and costs associate with this decision

Currency Unions Consider Germany and Austria before

the formation of the euro Benefit from monetary efficiency gains

Gains derived from not having to change currencies when conduction trade between the countries

Cost from economic stability loss Countries no longer have ability to conduct

independent monetary policy

Currency Unions Must weigh the size of gains and

losses for each country The greater the trade between the

countries, the greater the monetary efficiency gains

There is not, however, a precise cutoff point where common currency is good or bad

Currency Unions Common currency will ease transaction

of capital flows across countries Not changing currency will increase

efficiency of financial markets in both countries

Similarly, would be easier to make direct investments (FDI) if did not have to convert currency

Some uncertainty with investing across boarders would be eliminated as well

Currency Unions

1. Ability of labor to move across boarders when one country has a recession can reduce losses of recession

2. If two countries have similar average rate of inflation, less change joint monetary policy is undesirable

3. Economic stability losses smaller if common fiscal policy – similar taxation and spending systems

Currency Unions

4. Smaller economic stability losses the more correlated the GDP’s of the countries

Recession in one country means recession in another so joint policies appropriate for both countries

Using these measure of gains and losses, can better determine if common currency is best choice

Fixed Exchange Rates and Currency Unions

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