1. A summary (and a small extension) of M-F model.

2. Fixed or floating exchange rates? The choice of an exchange rate

regime

Dr hab. Gabriela Grotkowska & dr hab. Joanna Siwińska-Gorzelak

WNE UW

Real-Income Effects of Economic Policies for a Small Open Economy with Perfect Capital Mobility under Fixed versus Floating Exchange

Rates

Fixed exchange rates.Fiscal & monetary policies (for different levels of

capital mobility)

FISCAL POLICY MONETARY POLICY

k 0 + ++ ∞ 0 + ++ ∞

Y 0 + ++ +++ 0 0 0 0

CA 0 - -- - - - 0 0 0 0

FA 0 + + + +++ 0 0 0 0

E 0 0 0 0 0 0 0 0

The effects of policies on current accountunder floating exchange rates

• Expansionary fiscal policy increases Y and causes an appreciation (under big and perfect capital mobility)

• Hence, NX deteriorates (lower exports, higher imports)

• An increase in G (or a decrease in T) crowds out NX

• An increase in M (expansionary monetary policy) causes an increase in Y and a depreciation. The overall effect is an increase in NX

• Note that the reverse to NX happens to financial account

Floating exchange rates.Fiscal & monetary policies

FISCAL POLICY MONETARY POLICY

k 0 + ++ ++++++ 0 + ++ +++++

Y +++ ++ + 0 + ++ +++ ++++

CA 0 - -- - - - 0 + ++ +++

FA 0 + + + +++ 0 - -- ---

E ++ (Home depr.)

+ - - - + ++ +++ ++++

The effects of an increase in country risk

Why domestic interest rate(s) may differ from international interest rate(s) (under perfect capital mobility)

– country risk (ϴ): The risk that the country’s borrowers will default on their loan repayments (or foreign investors will loose their money due to other factors), because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk.

– expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation

Country risk in M-F model

•We haven’t discussed the changes in

country risk yet.

•An increase in country risk makes holding

the country’s currency less attractive;

hence the BoP requires an increase in the

country’s interest rate

•An increase in country’s risk (risk

premium) shifts the BP line up and to

the left (see graph)

•Under a floating exchange rate: a

depreciation

•Under a fixed exchange rate: Central

Bank’s intervention.

r

Y

LM

IS

r* BP

BP’r*+θ

Fixed or floating?• The single most important aspect of an exchange rate regime is the degree of

flexibility. • The matter is of course more complicated than a simple choice between fixed

exchange rate and floating:

• I. Floating:– Free float– Managed float

• II. Intermediate regimes– Target zone or band– Basket peg– Crawling peg– Adjustable peg

• III. Institutionally fixed – Currency board– Dollarization (unilaterally adopting a foreign currency – for example Kosovo &

euro) – Monetary Union.

Fixed Versus Floating Exchange Rates

• The fundamental trade-offs between fixed versus floating exchange rates cut across two dimensions: economic efficiency and economic stability.

• The most efficient exchange-rate system may or may not be the one that attains greater stability of an economy’s overall real-income performance.

• This is what makes the choice of the “best” exchange-rate system potentially very difficult.

Costs Stemming from Foreign Exchange Risks

• If rates of exchange are fixed, then volatility of exchange rateis not a problem, as it should be significantly muted, if not eliminated.

• As a result, there is little incentive to undertake foreign exchange hedging activities, and so the associated costs are minimized. A system of fixed exchange rates thereby would be most efficient.

• “Fixed” exchange rates are never permanently fixed, however. In a system of fixed rates, people face the possibility of exchange-rate realignments (REALIGNMENT - a change in an official exchange-rate target)

Costs Stemming from Foreign Exchange Risks

• Under floating exchange rates, the volatility of exchange rate might be significant

• Hedging activities entail expenditures of resources.

• In addition, holding and trading derivatives exposes banks and other firms to risks.

• Furthermore, governmental concerns about the potential for systemic risks. The costs incurred by governments in examining and supervising financial institutions represent further costs that stem from hedging activities in the face of foreign exchange risks.

Efficiency of fixed versus floating regimes

What is the basic economic efficiency trade-off faced in choosing between fixed and floating exchange rates?

•There are large resource costs to hedge against foreign exchange market risks in a system of floating exchange rates, but with fixed exchange rates there can be significant risks of un-hedged losses stemming from unanticipated currency devaluations.

•Because these latter risks depend on many factors, including the behavior of governments, a fixed-exchange-rate system is not necessarily preferable, on efficiency grounds, to a system of floating exchange rates.

Stability Arguments for Fixed versus Floating Exchange Rates

• Another potentially important consideration in choosing between fixed and floating exchange rates is economic stability.

• Important variables for which stability is a concern include real income, the inflation rate, and the unemployment rate.

Autonomous Expenditure Volatility and Fixed versus Floating Exchange Rates

• One possible source of real income instability that any nation faces is variability in aggregate autonomous expenditures (demand shocks).

• Volatility in real income in the rest of the world results in domestic income instability, holding all other factors unchanged.

• Equilibrium real income is more stable in the face of variations in aggregate autonomous expenditures under a floating exchange rate.

Monetary Policy Autonomy and Fixed versus Floating Exchange Rates

• One other factor that can influence a nation’s choice to fix or float:

• MONETARY POLICY AUTONOMY The capability of a central bank to engage in monetary policy actions independent of the actions of other central banks.

• Under a fixed exchange rate, a central bank’s actions to keep the value of its nation’s currency unchanged preclude the potential for any efforts to vary the quantity of money for purposes of domestic real-income stabilization. This makes a nation’s monetary policy a “slave” to events in other nations.

Advantages of a fixed regime

• On the other hand, fixed rates provide a nominal anchor to monetary policy.

• Monetary policy: there can be an inflationary bias when monetary policy is set with full discretion.

• A central bank that wants to fight inflation, it can commit more credibly by fixing the exchange rate, or even giving up its currency altogether. Workers, firm managers, and others who set wages and prices then perceive that inflation will be low in the future because the currency peg will prevent the central bank from expanding even if it wanted to.

Stability stemming from exchange rate regimes

• Flexible e.r - national independence for monetary policy retaining seigniorage, retaining lender-of-last-resort capability, and avoiding speculative attacks.

• Flexible e.r - allowing for automatic adjustment to trade shocks,• Fixed e.r. – a monetary anchor, keeping inflation under control. • Which dominate: the advantages of fixing or the advantages of

floating? • Empirical attempts to evaluate performance are hampered by the fact

that de facto exchange rate regimes frequently differ from de jure: countries do not in practice follow the regime that they have officially declared.

• Some studies have attempted to classify countries according to their de facto exchange rate regime and then to test which categories have superior economic performance, judged by growth and other measures.

• It seems that there are no simple answers….

More on exchange rate regimes …

• https://voxeu.org/article/managing-exchange-rate

Atish R. Ghosh, Jonathan D. Ostry, Mahvash S. Qureshi 02 April 2014

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7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S

. C

ents

per

Mexic

an P

eso

A case study: exchange rate stability (?) under a fixed rate…The Mexican peso crisis

Understanding the crisis

• In the early 1990s, Mexico was an attractive place for foreign investment.

• During 1994, political developments caused an

increase in Mexico’s risk premium ( ):

– Serious political & social unrest

– assassination of leading presidential candidate

• Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (r* > 0)

Understanding the crisis

• These events put downward pressure on the peso.

• Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate.

• Doing this requires that Mexico’s central bank have adequate reserves of dollars. Did it?

Dollar reserves of Mexico’s central bank

December 1993 ……………… $28 billion

August 17, 1994 ……………… $17 billion

December 1, 1994 …………… $ 9 billion

December 15, 1994 ………… $ 7 billion

During 1994, Mexico’s central bank hid the fact

that its reserves were being depleted.

Conclusions from the Mexican case

• Fixed exchange rates may sometimes become very unstable…

• … and their security & stability may be illusionary