International Adjustment & Interdependence

Exchange Rate Fluctuations and Interdependence

Collapse of the Bretton Woods System Is the system of flexible exchange rates among the major currencies of the period since 1973 any better ?

Foreign Exchange Market Intervention

Governments intervene in the foreign exchange market to a lesser or greater extent Dirty floating is the practice of using substantial intervention to try to maintain an exchange rate against the pressure of market forces

Why Governments Intervene?

Movements in exchange rates cause unnecessary changes in domestic output
Central Banks attempt to move the real exchange rate in order to affect trade flows To prevent the exchange rate from depreciating in order to control inflation To smooth out fluctuations in exchange rates

Sterilized vs. Nonsterilized Intervention

Sterilized intervention:

Central bank buys foreign exchange, issuing domestic currency

The increase in home money is reversed by an open market sale of bonds The home money supply, therefore, is kept unchanged Nonsterilization : There is a change in money stock This will affect exchange rates since it changes the money supply

Interdependence

U.S. Monetary Contraction

United States Exchange rate Output Inflation $ appreciates -

Rest of World

+ +

Interdependence
U.S. Fiscal Expansion

United States Exchange rate Output Inflation $ appreciates + -

Rest of World

+ +

Policy Synchronization
Under flexible exchange rates there is as much interdependence as there is under fixed rates Exchange rate overshooting causes sharp changes in competitiveness Flexible rates are far from being a perfect system

The Choice of Exchange Rate Regimes

Target Zones : Target zones allow exchange rates to float within limited bands and provide for government intervention if the exchange rate passes outside the band

Dollarization and Currency Boards