Transcript Fixed regime

Chapter 10
Fixed,floating and
managed
exchange rates
1
10.1 Introduction
The main contents of this chapter:
1.The traditional debate→10.2,10.3;
2.The more modern model→10.4-10.10;
3.The managed floating→10.11;
4.Conclusions→10.12.
2
10.2 The Case for Fixed
Exchange Rates
Be careful:
The case for fixed exchange rates usually
has two sides to it: both the positive
arguments in favour of fixed exchange rates
and the arguments against floating rates. The
arguments against floating exchange rates do
not necessarily constitute the arguments for
completely fixed exchange rates.
3
Fixed Exchange Rates Promote
International Trade and Investment
Fixed parities provide the best
environment for the conduct of
international trade and investment,
exchange-rate fluctuations cause
additional uncertainty and risk in
international economic transactions and
inhibit the growth and development of
such transactions.

4
Fixed Exchange Rates Provide Discipline
for Macroeconomic Policies
The pursuit of reckless macroeconomic
policies(excessive monetary growth)—
pressure for devaluation—intervene—
reserve fall—pressure continue—have to
devalue—a sign of mismanagement—
encourage to resist adopting unsound
expansionary macroeconomic policies.

5
Fixed Exchange Rates Promote
International Cooperation
Countries that agree to peg generally
have to agree on measures to be
undertaken when the agreed exchangerate parity comes under pressure. At a
minimum to avoid conflicting exchangerate targets and competitive devaluation,
provide a more stable environment.

6
Speculation Under Floating Rates is
Likely to be Destabilizing
Destabilizing private speculation produce
the “wrong”(sub-optimal rate from the
viewpoint of resource allocation)
exchange rate.
Several ways to bring about the wrong
exchange rate:

7
1.Irrational speculation
One example: foreign exchange market
participants can be too risk-aversion.
They attach too high a probability to the
possibility of a depreciation of a ‘weak’
currency, or conversely, even when this
is not justified by the fundamentals
Excessive selling of the ‘weak’ currency
excessive depreciation
the ‘weak’
currency under-valued.
8
Another example:the ‘band-wagon’ effect.
There is too much self-generating
speculation detached from the
fundamentals, ‘speculation feeding upon
speculation’ rather than the fundamentals.
News hits the market
the even greater
increase in the eventual monetary growth
rate and unduly inflation forecast
set
off unjustified speculation
the
depreciation of the currency will be
greater than was justified by the news.
9
2. Exchange-rate uncertainty
One reason:in a world of uncertainty they
do not know the correct exchange-rate
model.
Use a seriously defective model
be
impressed by a plausible but relatively
unimportant fundamental variable
make expectation basing on this
variable
the wrong exchange rate.
10
Another reason:the ‘Peso Problem’.
Exchange rates are determined not only
by what is held to be the underlying
fundamentals today, but by what is
expected to happen to those
fundamentals in the future.
11
Even if speculator’s models are correct,
their perceptions about the future can
prove to be seriously wrong
the
exchange rate moves immediately in
anticipation of events that do not
materialize
seriously interfere with
the conduct of macroeconomic policy
and with it macroeconomic stability.
12
Another reason:the ‘rational bubble’.
An rational bubble exists when holders of
a currency realise that it is overvalued
but they are nevertheless willing to hold
it
expect to be able to sell
eventually at an higher exchange rate
prolongs an exchange
overvaluation and aggravates the
macroeconomic costs associated with it.
13
10.3 The Case for Floating
Exchange Rates
Caution:
The arguments against fixed
exchange rates do not necessarily
constitute arguments for completely
floating exchange rates.
14
Floating Exchange Rates Ensure
Balance-of-Payments Equilibrium
In a floating regime the exchange rate
autonomously adjusts to ensure
continues equilibrium between the
demand for, and supply of a currency.
Run an unsustainable current account
deficit
depreciate
reduce
import and increase export
balance-of-payments restored to a
sustainable level.

15
In a fixed regime, exchange rate is fixed,
the authorities can only keep BOP
equilibrium through changing reserves
or taking fiscal and monetary policies or
resorting to capital control.
Exchange-rate adjustments by taking care
of the BOP deficits relieve the
authorities of having to adopt unpopular
alternatives such as deflation or a resort
to protectionism which could then
provoke a damaging trade war.
16
Floating Exchange Rates Ensure
Monetary Autonomy
Floating regime enable each country to
operate an independent monetary policy;
that is, monetary autonomy enabling
each country to determine its own
inflation rate.
Countries prefer low rates
tight
macroeconomic policy
currency
appreciation.

17
Countries pursue expansionary
macroeconomic policies
suffer
higher inflation
currency
depreciation
Under fixed regime, the need to have
common inflation rates constrains
countries to pursue similar monetary
policies.
18
Floating Exchange Rates Insulate
Economies
Floating regime can insulate the domestic
economy from foreign price shocks.
An increase in foreign prices
foreign
competitiveness decrease
domestic
BOP surplus
domestic currency
appreciate
prevent the country
importing foreign inflation.

19
Fixed regime lead to the importing of
foreign price inflation/deflation.
A foreign price rise
home economy
overcompetitive
home economy
BOP surplus
fixed rate undervalued
necessitate purchase of foreign currency
with newly-created domestic currency to
peg the exchange rate
an
accompanying rise in domestic prices
ending the surplus.
20
Floating Exchange Rates Promote
Economic Stability
It is better to let exchange rates adjust in
response to shocks to an economy than
fix them and force the adjustment onto
other economic variables, because
floating regime is more conductive to
economic stability since exchange rate
is easy to adjust whereas domestic
prices tend to be very difficult to reduce.

21
Floating regime: A loss of international
competitiveness
currency
depreciation
restore international
competitiveness.
Fixed regime: A loss of international
competitiveness
require severe
deflationary policies
induce the fall
in domestic wages and prices
restore international competitiveness.
22
Private Speculation is Stabilizing
Private speculators are a stabilizing rather
than destabilizing force because it is in
the interests of speculators.
Speculators attempt to buy at a low rate
and sell at a high value
reduce the
gap between the low and high values
move the exchange rate towards its
fundamental equilibrium value.

23
Box 10.1 The Optimum Currency Area
Literature
Put simply, an optimum currency area is a
region for which it is optimal to have a
common currency and a common
monetary policy.
Determining a set of criteria to determine
which countries should participate in a
monetary union has been the subject
matter of optimum currency area theory.
24
In the literature on the subject there is no
single set of criteria which is generally
agreed upon. Nonetheless, it is
worthwhile to briefly review some of the
criteria that have been suggested for
determining which countries should join
a monetary union.
25
Degree of factor mobility internationally.
Mundell(1961) proposed that the higher
the degree of factor mobility between
countries, then the more beneficial a
monetary union would be between
them.

26
The rationale:
Bop in deficit(a fall in demand for its goods),
high capital mobility will enable it to
finance its deficit more easily;
high labor mobility will mean that deficit
regions can deflate their economies without
fear of a large increase in unemployment.
Without the need for an exchange rate
depreciation.
Conversely, a monetary union would be
undesirable.
27
Degree of financial integration.
If a country has a high degree of financial
integration with other countries, then it
will be more able to finance its deficits
and less dependent on exchange rate
changes, then a single currency is a
more feasible option.

28
Degree of openness.
McKinnon(1963) has argued that the
more open, the more profitable it is to
join a currency union.
The rationale is that if the economy has a
large tradables sector it will be much
more vulnerable to inflation from a
depreciation currency and
unemployment from an appreciation
currency and therefore the less
desirable exchange rate changes are.

29
Degree of product diversification.
Kenen(1969) has suggested that the more
diversified a country’s range of exports
and imports, the more it will benefit
from monetary union.
A diversified economy means less
variability in its export earnings and
import expenditure and more stability
for its BOP. Accordingly, the less will be
the need to resort to exchange rate
changes.

30
Degree of similarity of inflation rates.
If countries have similar inflation rates
then PPP theory suggests that there is
no need for exchange rate changes and
hence a monetary union is more
feasible.

31
Even if we ignore numerous criticisms
that can be made of the individual
criteria, it is clear that emphasizing one
particular factor is hardly sufficient
grounds for justifying monetary union.
In sum, the optimal currency area
literature addresses an interesting
question but the various criteria that
have been suggested are far from
conclusive.
32
10.4 The Modern Evaluation of Fixed
and Flexible Exchange-Rate Regimes


The modern approach evaluates by
seeing which regime best stabilizes the
domestic economy in the face of various
shocks to the economy.
The literature does not provide an
unambiguous answer.
33
It shows that the choice is crucially
dependent upon a multiplicity of
factors.
These factors are:
1.the specification of the objective
function of the authorities as between
price and output stability;
2.the type of the shock impinging upon
the economy;
3.the structural parameters of the
economy.

34
10.5 The Specification of the
Objective Function
For simplicity we shall deal with an
economy where the authorities have
two objectives------price and output
stability------the minimization of
fluctuations of the price and output
level around their target values.
35

The authorities will wish to minimize the
value of the following objective function:
O( P, y )  w(Y  Yn )  (1  w)( P  Pn )
2
2
Where:
w------the relative weight attached
to each of the two objectives;
Yn------the natural/target value for
domestic real income;
Pn------the natural/target value for
domestic price level.
36

The idea of incorporating a weighted
objective function: there may be a
trade-off for the authorities between
income and price stability.
w=1, domestic income stability;
w=0, domestic price stability.
37
10.6 The Model


Now investigate an economy buffeted
by various transitory shocks.
Transitory: self-reversing, the economy
is always expected to return to its
natural price(Pn) and output level(Yn).
38
Make some simple rules concerning
expectations:
 Exchange rate: depreciate today,
appreciate back to its normal level in
the next period;
 The price and output levels: rise today,
go back to its normal level in the next
period.
39
Three types of transitory shocks:
 money demand;
 aggregate demand;
 aggregate supply.
40
1.money demand
Md t  Pit  Yt  rt  Ut1
(10.1)
Where:
Mdt: money demand;
Yt: real domestic income;
rt: domestic nominal interest rate;
Ut1: a transitory money demand shock
term with zero mean and normal
distribution.
41
Pit: aggregate price index made up of a
weighted average of the domestic and
foreign price levels;
The idea of incorporating Pit:monetarist
proposition--------the demand to hold
money is a demand for real balances
related to the purchasing power of
money.
*
Pit  Pt  (1   )( st  Pt ) ,0<α<1 (10.1a)
42
2.aggregate demand
Yd t   ( st  Pt  Pt )   (rt  Pt  Pt 1/ t )  Yn  Ut2
*
(10.2)
Where:
Pt 1 / t :the expected price level one
period hence;
Yn :the natural level of output;
Ut2 :a transitory aggregate demand
shock term with zero mean and normal
distribution.
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3.aggregate supply
Ys t   ( Pt  Wt )  Ut3
Ys t  Ys t (Lt )
(10.3)
Where: Ys t / Lt  0  2,Ys t /  2 Lt  0(10.3a)
Where:
Ys t :the supply of domestic output;
Wt :wage rate pre unit of labour;
LT :labour input;
Ut3 :a transitory aggregate supply
shock term with zero mean and normal
distribution.
44

Uncovered interest parity condition is
assumed to hold continuously:
rt  rt  ( st 1 / t  st )
*
Where:
rt :the foreign interest rate;
*
st 1/ t
:the expected exchange rate in
period t+1;
(st 1/ t  st ) :the expected rate of
depreciation of the currency.
45
The setting of nominal wages:
The contracts have a duration of one
period;
Wt is set at the level of required to
generate an expected output at the
natural level Yn:
Wt =Wt*

Where:
Wt*:is the wage rate will lead to full
employment at the natural rate of output.
46
Require the simultaneous fulfillment of
two equations: Mst=Mdt , Yst=Ydt
Under fixed exchange rates:
 rt=rt*
 Mst is endogenously determined.
Under floating exchange rates:
 Mst is exogenously determined,
 rt and st are endogenously determined
and tied together via the uncovered
interest parity.

47
10.7 Determining Equilibrium
Aggregate demand schedule(Yd):
Downward-sloping, P↑Yd↓.
1.P↑ →(s+P*-P)↓ →competitiveness↓ →
net export ↓ → Yd↓；
2. P↑ →Pt+1/t ↓ →(r+P-Pt+1/t)↑ →Yd↓.
The absolute slop=1 /(   ) .

48
The money demand schedule(Md):
Downward-sloping, P↑Y↓.
P↑→Md↑→Y↓→Md↓→to maintain money
demand equilibrium.
The absolute slop=  / 
 For most of analysis, assume:

 (   )  
That is: Yd is flatter than Md.
 In the case of an aggregate supply
shock both cases are examined.
49
The aggregate supply schedule(Ys):
Positive slop, P↑Ys↑.
P↑→real wage↓ → producers take on
more workers→ Ys↑.
The absolute slop= 1 / 

50
Determining equilibrium:
Simultaneous interaction of all three
schedule through a common point.
Equilibrium price:Pn
the optimal
Equilibrium output:Yn target value

51
Price level
Ys1
Pn
Yd1
Md1
Yn
Real income
Figure 10.1 Equilibrium of the model
52
10.8 Money Demand Shock
An unanticipated rise in money demand.
Md shift to the left(Md1→Md2)(Ms⇕)
1.under fixed exchange rates
Excess demand for money a tendency for the
currency to appreciate authorities have to
purchase the foreign currency expand the
domestic money stock till Md2 shifts back to
Md1 short-term equilibrium remains at point
A no disturbance to price and output fixed
is optimal.
53
2.under floating exchange rates
Excess demand for currency currency appreciating
A loss in competitiveness net export decrease
demand for domestic output decrease
Expected future depreciation of the currency
domestic interest rate rise demand for
domestic output decrease
Yd shift to the left(Yd1→Yd2) ;
Domestic interest rate rise demand for money fall
Md shift back to the left(Md2→Md3);
Temporary equilibrium point C a fall in both price
and output.
54
Price level
Pn
P2
Ys1
A
C
B
Yd1
Yd2
Md1
Md3
Md2
0
Y2 Yn
real income
Figure 10.2 money demand shock
55
10.9 Aggregate Demand Shock
An unanticipated increase in aggregate
demand. Yd shift to the right(Yd1→Yd2)
1.under fixed exchange rates
Real income
demand for money
currency tend to appreciate purchase
foreign currency expand money stock
Md1→Md2,excess money demand is
eliminated short-term equilibrium at
point B both the price and output
56
2.under floating exchange rates
Real income
demand for money
competitiveness
currency appreciate
Yd2→Yd3
Yd
expected future depreciation
domestic interest rate
Md
Md1→Md3
Equilibrium at point C
both the price and
output higher than initial equilibrium but lower
than fixed exchange rates.
57
Price level
Ys1
P2
B
C
P3
Pn
Md2
Md3 Yd2
A
Yd3
Md1
Yd1
0
Yn Y3 Y2
real income
Figure 10.3 Aggregate demand shock
58
10.10 Aggregate Supply Shock
An unanticipated fall in aggregate supply.
Ys shift to the left(Ys1→Ys2)
Ys
P
Md
Md>Ms or
Yd
Y
Md
Md<Ms
59
Case 1: Md schedule is steeper than Yd
schedule, i.e.  (   )  
Excess supply of money at point B
currency tend to depreciate
1.under fixed exchange rates
buy domestic currency money supply
=money demand Md1→Md2
equilibrium at point B P Y
60
2.under floating exchange rates
Currency depreciate
export increase Yd
Yd1→Yd2
expected future appreciate
domestic interest rate
Money demand
Md1→Md3
Equilibrium at point C P Y
61
Price level
P3
P2
Pn
Ys2
C
Ys1
B
A
Yd2
Yd1
Md2 Md3 Md1
0 Y2 Y3 Yn
Real income
Figure 10.4 Aggregate supply shock(case 1)
62


the choice would depend primarily
upon the objectives of the authorities:
If biased towards price stability fixed
exchange rates;
If biased towards output stability
floating exchange rates.
63
Case 2: Yd schedule is steeper than Md
schedule, i.e.  (   )  
Excess demand for money at point
Bcurrency tend to appreciate
1.under fixed exchange rates
buy foreign currency money supply
=money demand
Md1→Md2
equilibrium at point B P Y
64
2.under floating exchange rates
Currency appreciate
export decrease Yd
Yd1→Yd2
expected future depreciate
domestic interest rate
Money demand
Md1→Md3
Equilibrium at point C P Y
65
Price level
P2
P3
Pn
Ys2
B
Ys1
C
Md2
Md3
Md1
A
Yd1
Yd2
0
Y3 Y2 Y1
Real income
Figure 10.5 Aggregate supply shock(case 2)
66
the choice would depend primarily upon
the objectives of the authorities:
 If biased towards price stability
floating
exchange rates;
 If biased towards output stability
fixed
exchange rates.
Note:
The choice of exchange rates is very closely
related to the structural parameters of
the economy.(  (   )   or  (   )   )
67
Table 10.1 summary of the results under
fixed and floating rates
Transitory shock
Floating rates
Fixed rates
Price
stability
Output
stability
Price
stability
Output
stability
Money demand
Χ
Χ
√
√
Aggregate demand
√
√
Χ
Χ
Aggregate supply
Md steeper than Yd
Χ
√
√
Χ
Aggregate supply
Yd steeper than Md
√
Χ
Χ
√
68
It reveals:
the choice between the two regimes
is seen to depend crucially upon:
 The type of shock impinging upon the
economy;
 The objectives of the authorities;
 The structural parameters of the
particular economy considered.
69
Reminding readers:
The model set out is extremely
simple. In practice, the choice will be
even more complex.
 Transitory and permanent shocks;
 Wage indexation;
 The problem of interdependence.
70
10.11 Managed Floating
Rationales for intervention:
 The authorities can choose an exchange
rate more in line with economic
fundamentals than the market;
 Intervention is required to mitigate the
costs of exchange-rate ‘over-shooting’;
 Intervention is an appropriate
instrument for smoothing necessary
economic adjustments.
71
Note:



It is necessary to assume that the authorities
can influence the nominal and/or real
exchange rate in their desired direction;
It is necessary to compare exchange market
intervention with alternative policies;
It should be remembered that exchange-rate
management by the authorities can vary in
degree from occasional intervention to
influence the exchange rate to a permanent
pegging.
72
1.Authorities might be able to produce a
more appropriate exchange rate
Case 1:The authorities are in possession
of superior relevant information.
Case 2:The authorities know better and
sooner what they themselves are about
to do.
73
2.Intervention needed to mitigate costs of
exchange-rate overshooting
According to the Dornbusch(1976)
overshooting model, changes in
monetary policy will lead to short-term
real depreciation or appreciation. These
real-exchange rate movements(over and
undervaluations in relation to PPP) will
exert effects on the real economy.
74



Misaligned exchange rates distort the
allocation of resources between
tradables and non-tradables as well as
consumption patterns between the two;
Misalignment complicates and inhibits
investment decisions;
Misalignments almost certainly exert a
ratchet effect on protectionism.
75
Since an under/overvaluation must
necessarily eventually be corrected, this
will involve the various adjustment costs.
Foreign exchange intervention
designed to reduce the costs and extent
of exchange-arte overshooting could be
justified.
76
Alternatively, misalignment can be
reduced by increasing flexibility in the
goods and labor markets because
misalignment is induced by ‘sticky’
goods price not due to inefficiency in
the foreign exchange market.
77
The measures increasing flexibility in the
goods and labour market would include
anti-trust legislation, reductions in trade
union power, and the reduction of social
security benefits
likely to bring
about resistance and turmoil
exchange market intervention can prove
a superior policy tool.
78
3.Intervention to smooth the economic
adjustment process
 Exchange market intervention
(‘exchange rate protection’) can slow
down the necessary adjustment between
the traded and non-traded sectors or
within the tradables sector.
79
For example:
Persistent BOP surplus a tendency to
appreciate large transitional
unemployment
if intervention, moderate the appreciation
allow time for transition avoid
excessive transitional unemployment
costs.
80

Exchange market intervention can
compare favourably to other methods of
protection such as tariff protection.
Exchange-rate protection must necessarily
be a temporary method of protection;
Tariffs and subsidies have a habit of
becoming permanent features and tend
to invite retaliation.
81
Intervention may exist if the economy is
caught in a ‘vicious circle’.
For example:
Current account deficit depreciation
price and wages increase offset
depreciation further depreciation
‘vicious circle’;
If intervention slow down or even avoid
the spiral allow time to reduce the real
wage or to await productivity
improvements.

82
10.12 Conclusions

Neither the traditional advantages/
disadvantages approach or modern
literature provide a clear-cut reason to
prefer fixed to floating exchange rates,
or vice versa.
83


The lack of decisive arguments in favor
of either fixed or floating exchange
rates has frequently been taken as a
rationale for some degree of exchangerate management between the two
regimes;
The interdependence between different
countries when determining the choice
of exchange rates is an issue that merits
further attention.
84
Further reading:
 郝振飞、金发奇，《从“扩展三角”到
人民币汇率制度的选择》，《财经界》
(下旬刊), 2008年02期。
 王高华，《经济冲击与汇率制度选择探
讨》，《江西金融职工大学学报》，
2008/03。
 宿玉海，《20世纪90年代以来的汇率制
度选择理论及评介》，《山东财政学院
学报》，2008/01。
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