Transcript powerpoint file.

Chapter 20
Exchange Rate Regimes and Crises
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Exchange Rate Regimes
• A nation essentially has three options for
controlling its exchange rate.
– Floating rate regime: exchange rates with other
currencies are set by forces of supply and demand
– Fixed rate regime: the exchange rate is set and
maintained at that price
– Crawling peg: the exchange rate varies within in a
relatively narrow pre-defined range in the short run.
The pre-defined range can vary over the long run.
– What are the advantages and disadvantages of these
policies?
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Flexible Exchange Rate Regimes
• Flexible exchange
rate regimes let
the forces of
supply and
demand for
foreign exchange
determine
currency values.
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Flexible Exchange Rate Regimes
• Advantages:
– Trade imbalances are corrected automatically with
no need for government intervention.
• Example: U.S. exports decline because Japan's economy
enters a recession. The supply curve for foreign
exchange shifts to the left, increasing the U.S. exchange
rate, thereby weakening the U.S. dollar.
– Stabilization policy can be conducted without
concern for the impact on exchange rates.
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Flexible Exchange Rate Regimes
• Disadvantages:
– Exchange rates can fluctuate wildly in short time
intervals. Such fluctuations make international
transactions more risky.
– Some countries forego inflation-fighting credibility.
In particular, economies with present or historically
high inflation rates may need externally generated
credibility to lower domestic inflation.
• Most wealthy nations adopt a flexible regime
because these disadvantages are minimal.
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Fixed Exchange Rates
• With a fixed exchange rate regime, the
government and the central bank essentially
commit themselves to pegging (fixing) the
value of the domestic currency to a foreign
currency.
• The countries most likely to adopt fixed
exchange rates are the ones that need external
validation to contain inflation.
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Fixed Exchange Rates
•Usually the exchange
rate is pegged (fixed)
at a rate below the
equilibrium exchange
rate, which means that
the currency is
overvalued.
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Supporting Overvalued Exchange Rates
•A government can
support an overvalued
currency by drawing
down its foreign
reserves—the stock of
foreign currency and
foreign liquid assets
that it owns—by
purchasing the
domestic currency.
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Supporting Overvalued Exchange Rates
•A government can also
support an overvalued
currency by adjusting
(raising) domestic
interest rates to attract
a sufficient amount of
capital inflows.
•The supply curve for
FE shifts right.
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Supporting Undervalued Exchange Rates
•A government
sometimes promotes
an undervalued
exchange rate to
promote exports.
•It can do this by either
purchasing foreign
currency or lowering
domestic interest rates.
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Fixed Exchange Rate Regimes
• Advantages
– Exchange rate risk is eliminated.
• The Bretton Woods System that collapsed between 1971
and 1973 was designed to foster international trade by
diminishing exchange rate risk.
– The domestic government gains a measure of
external credibility in fighting inflation.
• By pegging the domestic currency to a stable foreign
currency, the government is committing itself to longterm inflation rates similar to inflation rates in the nation
for which the currency is pegged.
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Fixed Exchange Rate Regimes
• Disadvantages
– the domestic country relinquishes control of its
domestic monetary policy.
• Interest rates must be adjusted primarily to control
international capital flows.
– the domestic government traps itself into an
inflexible policy in which one devaluation can ruin
the government's credibility.
• Devaluations become self-fulfilling prophecies: if
private investors sense that a devaluation is inevitable,
they send their assets abroad until devaluation occurs.
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The Crawling Peg
• A crawling peg is a hybrid between fixed and
flexible exchange rate regimes.
– The government typically announces a range of
exchange rates in which it will allow the currency
to trade.
– If the exchange rate moves outside one of the
predefined bounds, the government intervenes to
move the currency back into the acceptable range.
– The trading ranges can change through time.
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The Crawling Peg
• Advantages and Disadvantages
– Exchange rate risk is reduced but not eliminated.
– The government gains some credibility in fighting
inflation, but less credibility than under a fixed
exchange rate regime.
– Gives the government an "out" in that one
devaluation does not ruin the government's
credibility.
– The country retains partial control over domestic
monetary policy.
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Exchange Rate Crises
• Typical scenario:
– A government supports an overvalued currency.
– A confidence crisis emerges in the ability of the
government to continue to support the currency.
– Capital flight occurs (Demand for foreign exchange
shifts to the right).
– The government raises domestic interest rates to
instill confidence in the currency.
– Currency is devalued.
– Inflation spikes upward as import prices surge.
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The Mexican Peso Crisis
• Background:
– After debt default in 1982, high inflation, and
massive unemployment, President Salinas in 1988
implemented a series of economic reforms, one of
which included pegging the exchange rate at about
3 pesos to the U.S. dollar.
– Goal was to borrow inflation credibility from the
U.S. by promising to keep Mexican inflation in line
with U.S. inflation.
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The Mexican Peso Crisis
• Signs that the peso was severely overvalued
emerged:
– trade deficit widened sharply in the early 1990s
– Mexican inflation rates were consistently higher
than those in the United States.
• In December of 1994, just four months after
Salinas' successor (Zedillo) took office, the
peso was suddenly and sharply devalued from
3.4 pesos to nearly 6 pesos to the dollar.
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The Mexican Peso Crisis
• The devaluation led
to a depression-like
year in 1995.
– GDP contracted by
6.2 percent
– Inflation rose from
7.1 percent in 1994 to
52 percent in 1995.
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The Mexican Peso Crisis
• Output declined for three reasons:
– Import prices increased, reducing purchasing
power of Mexican consumers.
– Many business debts were denominated in foreign
currencies, which essentially doubled their debts
leading to bankruptcies.
– Mexico raised interest rates to slow capital outflow.
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The Asian Crisis
• The Asian Crisis refers to the collapse of the
values of many Asian currencies in 1997 and
1998.
– Affected Indonesia, South Korea, Thailand,
Malaysia, and to a lesser extent Hong Kong and
Taiwan.
– Generally driven by a surge of capital inflows, not
policies of sustaining overvalued exchange rates.
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The Asian Crisis
• The Asian Crisis is a like a play with two acts
(Fortune, March 2, 1998):
– Act I: A bubble in real-estate and asset prices.
• Over time, prices of real estate and other assets soared,
driven in part by large amounts of foreign investment.
– Act II: The bursting of the bubble.
• A slump in the semiconductor market and a
strengthening of the U.S. dollar probably triggered the
crisis.
• Foreign and domestic investors pulled their funds out of
Asia, which caused asset prices to plunge.
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The Asian Crisis
• Devaluation:
– The flow of funds out of the country (capital
outflow) put downward pressure on Asian
currencies.
– The real debt-load of Asian firms that held foreign
debt surged.
– Many banks went bankrupt.
– The International Monetary Fund lent funds to
some of these governments to avert a wider crisis.
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The Argentine Peso Crisis
• Background:
– Because of high debt levels and irresponsible fiscal
policy in the 1970s and 1980s, the Argentine
government printed money to pay off debts, which
resulted in hyperinflation. Inflation reached absurd
levels, exceeding 3,000 percent in 1989.
– To reduce that inflation, the government adopted a
currency board and pegged the Argentine peso at
US $1.
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The Argentine Peso Crisis
• Currency Board
– a monetary authority that issues money convertible
into a foreign anchor currency.
– A currency board is an even stronger commitment
to a fixed exchange rate system because the
currency board is forbidden by law to print money.
– The Argentine currency board was to hold roughly
one U.S. dollar in reserve for every peso in
circulation, reducing a run on the peso because the
currency board had dollars to back up the currency.
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The Argentine Peso Crisis
• The currency board
eradicated inflation in
Argentina throughout
the 1990s, actually
leading to deflation in
1999.
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The Argentine Peso Crisis
• Signs of trouble:
– The U.S. dollar strengthened throughout the 1990s,
simultaneously strengthening the peso.
– The unemployment rate surged in the late 1990s as
the economy failed to increase exports.
– Capital flight surged as people believed that the
peso had to be devalued.
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The Argentine Peso Crisis
• The government reaction:
– To prevent capital flight, the government froze
bank accounts in late 2001 and allowed only small
amounts of funds to be withdrawn each month.
– Riots forced the President to resign in late 2001.
– The peso was devalued in January 2002, initially at
1.4 pesos to the dollar. By January 2003, it took
3.25 pesos to purchase a dollar.
– Many bank accounts were still frozen in early
2003, but restrictions were gradually loosening.
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Stabilization Policy with Flexible
Exchange Rates
• Expansionary
monetary policy
has a larger effect
on output in an
open economy
than in a closed
economy.
• The AD curve
shifts to ADO
rather than ADC,
the closed
economy result.
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Stabilization Policy with Flexible
Exchange Rates
• Why the added benefit to output in the openeconomy scenario?
– An increase in the money supply reduces domestic
interest rates, which makes domestic assets less
attractive to foreigners.
– The supply of foreign exchange shifts to the left,
increasing the equilibrium exchange.
– Net exports increase in response, boosting
Aggregate Demand.
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Stabilization Policy with Flexible
Exchange Rates
• Why the reduced output effect from fiscal
policy in the open-economy scenario?
– Expansionary fiscal policy simultaneously
increases the demand for loanable funds, driving up
interest rates and crowding out private investment.
– Higher interest rates attract foreign investment,
shifting the supply curve of foreign exchange to the
right. The exchange rate falls, strengthening the
domestic currency.
– The strong currency reduces net exports.
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Stabilization Policy with Flexible
Exchange Rates
• Expansionary
fiscal policy has a
smaller effect on
output in an open
economy than in
a closed
economy.
• The AD curve
shifts to ADO
rather than ADC,
the closed
economy result.
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The European Monetary Union
• On January 1, 2002 twelve members of the
European Union began the process of
destroying their local currencies and jointly
floated a new paper currency called the euro.
• By July 1, 2002 the euro was the only currency
in circulation.
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The European Monetary Union
• The 12 nations that comprise the European
Monetary Union (EMU) include
–
–
–
–
Austria, Belgium, Finland,
France, Germany, Greece,
Ireland, Italy, Luxembourg,
the Netherlands, Portugal and Spain.
• Each of these nations abandoned their domestic
monetary policy, leaving it under the control of
the European Central Bank (ECB).
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The European Monetary Union
• Advantages to EMU membership:
– Reduced transactions costs in purchasing products
across nations.
– Eliminates exchange rate risk
– Creates an integrated economic area comparable in
size to the U.S.
– Forces external discipline on certain governments
such as Spain and Italy.
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The European Monetary Union
• Disadvantages to EMU membership:
– Requires countries to adhere to strict budget
guidelines and inflation limits.
– Each nation had to give up complete control over
its monetary policy.
• Thought question: Would the U.S. ever
abandon the dollar and create a North
American Monetary Union?
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The European Monetary Union
• Disadvantages to EMU membership:
– Leaves countries more vulnerable to interest rate
policies that do not reflect current economic
conditions
• Equivalent to California experiencing a recession while
the rest of the states in the Union enjoy strong growth.
The Federal Reserve may not cut interest rates just to
ease the pain in California.
• Moreover labor mobility within the EMU is low
compared with the U.S. so recessions may linger in
certain nations for some time.
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