Agenda

• Fixed Exchange Rates

Exchange Rates, Business Cycles, • Macroeconomic Policy in an Open Economy
and Macroeconomic Policy in the with Fixed Exchange Rates
Open Economy,
Part 3 • Fixed versus Flexible Exchange Rates

27-1 27-2

Fixed Exchange Rates Fixed Exchange Rates

• Fixed-exchange-rate systems are historically • Two key questions:

important.
¾ How does the use of a fixed-exchange-rate system
¾ The U.S. was on a fixed exchange rate system affect an economy and macroeconomic policy?
before the early 1970s.
¾ Which is the better system, flexible or fixed
¾ Fixed exchange rates are still used by many exchange rates?
countries.

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1
Fixed Exchange Rates Fixing the exchange rate

• Fixing the exchange rate: • An overvalued currency:

¾ The government sets the exchange rate. ¾ When the official rate is above its fundamental
• Either unilaterally or in agreement with other countries. value, the currency is said to be overvalued.
• The “official rate” is the rate set by the government.

¾ What happens if the official rate differs from the

fundamental rate determined by the supply and
demand of the currency?

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An overvalued exchange rate Fixing the exchange rate

P$ or enom
S$
• An overvalued currency:

¾ The government has three choices for dealing

with an overvalued currency.
P$
• First, the government could devalue the currency,
reducing the official rate to the fundamental value.

D$

Q$

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2
Devaluing the currency Fixing the exchange rate
P$ or enom
S$
• An overvalued currency:
¾ The government has three choices for dealing
with an overvalued currency.
P$
• Second, the country could restrict international
transactions.

– This would reduce the supply of its currency to the foreign

exchange market and raise the fundamental value of the
D$ currency.

– If a country prohibits people from trading the currency at all,

Q$ the currency is said to be inconvertible.

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Restricting international transactions Fixing the exchange rate

P$ or enom
S$
• An overvalued currency:
¾ The government has three choices for dealing
with an overvalued currency.
P$
• Third, the central bank can buy (or demand) its own
currency to make the fundamental value equal to the
official rate.

– The central bank buys the domestic currency in the foreign

D$ exchange market using its official reserve assets.

– The decline in official reserve assets equals the country’s

Q$ balance of payments deficit.
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3
Foreign exchange market intervention Fixing the exchange rate
P$ or enom
S$
• An overvalued currency:

¾ An overvalued currency cannot be maintained

forever.
P$
• The country will eventually run out of official reserve
assets and have to devalue its currency.

D$

Q$

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Fixing the exchange rate A speculative run on an overvalued currency

• An overvalued currency: P$ or enom

S$

¾ A speculative run (or attack) may end the attempt

to support an overvalued currency.
P$
• If investors think a currency may soon be devalued, they
may sell assets denominated in the overvalued currency,
increasing the supply of that currency on the foreign
exchange market.
D$

Q$

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4
Fixing the exchange rate Fixing the exchange rate

• An overvalued currency: • An undervalued currency:

¾ A speculative run (or attack) may end the attempt ¾ When the official rate is below its fundamental
to support an overvalued currency. value, the currency is said to be undervalued.

• This causes even bigger losses of official reserves from

the central bank and speeds up the likelihood of
devaluation.

– This happened in Mexico in 1994 and Asia in 1997–1998.

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An undervalued exchange rate Fixing the exchange rate

P$ or enom
S$
• An undervalued currency:

¾ The government has three choices for dealing

with an undervalued currency.
P$
• First, the government could revalue the currency,
increasing the official rate to the fundamental value.

D$

Q$

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Revaluing the currency Fixing the exchange rate
P$ or enom
S$
• An undervalued currency:

¾ The government has three choices for dealing

with an undervalued currency.
P$
• Second, the government could ease restrictions on
international transactions.

– This would increase the supply of its currency to the foreign

D$ exchange market and raise the fundamental value of the
currency.

Q$

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Easing restrictions on int’l transactions Fixing the exchange rate

P$ or enom
S$
• An undervalued currency:
¾ The government has three choices for dealing
with an undervalued currency.
P$
• Third, the central bank can continue to acquire official
reserve assets.

– The central bank sells the domestic currency in the foreign

exchange market to buy official reserve assets.
D$
– The increase in official reserve assets equals the country’s
balance of payments surplus.
Q$

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6
Foreign exchange market intervention Fixing the exchange rate
P$ or enom
S$
• An undervalued currency:

¾ An overvalued currency can seemingly be

maintained forever, except …
P$
• If the domestic central bank is gaining official reserve
assets, foreign central banks must be losing them.
– Or the foreign country is selling assets.

D$
• So the undervalued currency cannot be maintained for
forever.
Q$

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Macro policy with fixed exchange rates Macro policy with fixed exchange rates

• Monetary policy and the fixed exchange rate: • Monetary policy and the fixed exchange rate:

¾ The best way for a country to make the
fundamental value of a currency equal the official
rate is through the use of monetary policy.
¾The nominal exchange rate is given by:
enom = ePFor/P
¾ For an overvalued currency, a monetary
contraction is desirable.
• In a Keynesian model, a monetary contraction causes:
– Nominal exchange rate appreciation in the short-run,
– Real exchange rate appreciation in the short-run,
– Nominal exchange rate appreciation in the long-run, and
– No real exchange rate effect in the long-run.

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Macro policy with fixed exchange rates
• Monetary policy and the fixed exchange rate:
¾ For an overvalued currency, a monetary
contraction is desirable:
• The relationship between the money supply and the
nominal exchange rate determines the level of the
money supply for which the fundamental value of the
exchange rate equals the official rate.
27-29
Macro policy with fixed exchange rates
• Monetary policy and the fixed exchange rate:
¾A large money supply yields an overvalued
currency.
• Larger than the level of the money supply for which the
fundamental value of the exchange rate equals the
official rate.
27-31
The money supply and fixed exchange rates
enom
Ms
27-30
Macro policy with fixed exchange rates
• Monetary policy and the fixed exchange rate:
¾ IMPLICATION: Countries cannot both maintain
a fixed exchange rate and use monetary policy to
affect output.
• Expansionary monetary policy to fight a recession
would lead to an overvalued currency.
• Contractionary monetary policy to fight rising inflation
would lead to an undervalued currency.
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 Macro policy with fixed exchange rates Macro policy with fixed exchange rates

• Monetary policy and the fixed exchange rate: • Monetary policy and the fixed exchange rate:

¾ A group of countries may be able to coordinate ¾ A group of countries may be able to coordinate
their use of monetary policy. their use of monetary policy.

• If two countries that have fixed their exchange rates
both increase their money supplies to fight joint
recessions, there need not be an overvaluation.
• If only the first country increases its money supply it
would lead to a depreciation of its currency.
• Meanwhile, the second country would experience an
appreciation of its currency.

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Macro policy with fixed exchange rates Macro policy with fixed exchange rates
enom enom • Monetary policy and the fixed exchange rate:
S S

¾ A group of countries may be able to coordinate

their use of monetary policy.
enom enom
• However, if the second country also increases its money
supply, it provides an offsetting effect.

• If the money supplies expand in both country, they

D
D offset each other, so their exchange rate need not
change.

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9
Coordinated monetary expansion Fixed versus flexible exchange rates
enom
• Currency unions:

¾ Under a currency union, countries agree to share

a common currency:
Fixed enom
• They often agree to cooperate economically and
politically as well.

Ms

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Fixed versus flexible exchange rates Fixed versus flexible exchange rates

• Currency unions: • Currency unions:

¾ To work effectively, a currency union must have
just one central bank.
• Because countries do not usually want to give up
control over their own monetary policy, currency unions
are very rare.
¾ Major advantages of currency unions:
• Reduces the costs of trading goods and assets across
countries.
• Speculative attacks on a national currency can no longer
occur.

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Fixed versus flexible exchange rates Fixed versus flexible exchange rates
• Currency unions: • Which is better?
¾ Major disadvantages of currency unions: ¾ Both fixed and flexible exchange rate systems
have benefits and disadvantages.
• All countries share a common monetary policy.

– A problem that also arises with fixed exchange rates. ¾ Which exchange rate system is better for an
individual countries depends on its economic and
– If one country is in recession while another is concerned about
inflation, monetary policy cannot help both. political circumstances and those of its major
trading partners.
– With flexible exchange rates, the countries could have
independent monetary policies to help their particular situation.

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Fixed versus flexible exchange rates Fixed versus flexible exchange rates

• Major benefits of fixed exchange rates: • Major disadvantages to fixed exchange rates:

¾ First, stable exchange rates make international ¾ First, they take away a country’s ability to use
trades easier and less costly. expansionary monetary policy to combat
recessions.
¾ Second, fixed exchange rates help discipline
monetary policy, making it impossible for a ¾ Second, disagreement among countries about the
country to engage in expansionary policy. conduct of monetary policy may lead to the
breakdown of the system.
– Which may result in lower inflation in the long run.

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Fixed versus flexible exchange rates
• Major benefits of flexible exchange rates:
¾ First, flexible exchange rates allow countries to
use monetary policy to combat recessions and
inflations.
¾ Second, flexible exchange rates permit countries
follow independent monetary and fiscal policies.
27-45
Fixed versus flexible exchange rates
• Which is better?
¾ Which is better depends on the circumstances.
• Fixed exchange rates are more desirable:
– If there are large benefits to be gained from increased trade and
economic integration, AND
– If countries can coordinate their monetary policies closely.
27-47
Fixed versus flexible exchange rates
• Major disadvantages to flexible exchange rates:
¾ First, exchange rate volatility introduces uncertainty
into international transactions, making them more
costly.
¾ Second, there is no independent restraint on
expansionary monetary and fiscal policies.
27-46
Fixed versus flexible exchange rates
• Which is better?
¾ Which is better depends on the circumstances.
• Flexible exchange rates are more desirable:
– If countries value having independent monetary policies.
» Either because they face different macroeconomic shocks or hold
different views about the costs of unemployment and inflation
than other countries.
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