Econ 141 Spring 2017
Exchange rate regimes: Fixed vs. Floating
Fixed vs. Floating Rates
• Example: Britain and the ERM
• In September 1992, Britain left the European Exchange Rate
Mechanism (ERM) and floated the pound.
• The ERM was a fixed exchange rate system created in 1979 that
allowed adjustable bands.
• The Deutsche mark served as the base currency (center currency) in
the ERM.
Britain and Europe in the 1990s
• The UK joined the ERM in October 1990.
• After a rise in unemployment in 1991-92, the British government
decided (in September 1992) that he benefits of being in ERM and
the euro project were smaller than costs. The UK left.
• The proximate cause was a monetary contraction by Germany
following German reunification in 1990.
• Let’s see how Britain did compared with France (which remained
pegged to the DM).
Maybe a good decision?
Key Factors in Exchange Rate Regime Choice: Integration and Similarity
• The fundamental source of this divergence between what Britain
wanted and what Germany wanted was that each country faced
different shocks.
• The fiscal shock that Germany experienced after reunification was
not felt in Britain or any other ERM country.
• The issues that are at the heart of this decision are: economic
integration as measured by trade and other transactions, and
economic similarity, as measured by the similarity of shocks.
Economic Integration and the Gains in Efficiency
• “Economic integration” refers to the growth of market linkages in
goods, capital, and labor markets among regions and countries.
• By lowering transaction costs, a fixed exchange rate might promote
integration and hence increase economic efficiency. Why?
The greater the degree of economic integration between markets in
the home country and the base country,
1. the greater the volume of transactions between the two,
2. the greater the benefits the home country gains from fixing its
exchange rate with the base country.
Economic Similarity and the Costs of Asymmetric Shocks
• A fixed exchange rate can lead to costs when a country-specific shock
or asymmetric shock is not shared by the other country: the shocks
are dissimilar.
• In 1991-92, German policy makers wanted to tighten monetary
policy, but British policy makers did not because they had not
experienced the same shock.
Economic Similarity and the Costs of Asymmetric Shocks
If there more economic similarity between the home country and the
base country, then the economic stabilization costs to home of fixing its
exchange rate to the base are smaller.
Countries are more similar if they face symmetric shocks more
frequently than asymmetric shocks.
As economic similarity rises, the stability costs of common currency
decrease.
Simple Criteria for Fixed Exchange Rates
• The benefits of integration depend upon economic similarity:
As integration rises, the efficiency benefits of a common currency
increase.
As symmetry rises, the stability costs of a common currency
decrease.
• The key prediction of the theory is:
pairs of countries above the FIX line (more integrated, more
similar shocks) will gain economically from adopting a fixed exchange
rate. Those below the FIX line (less integrated, less similar shocks) will
not.
Price Levels and Exchange Rates in the Long Run: PPP
Fixed Exchange Rates and Trade
• Best argument in favor of fixed exchange rates is that they increase
trade by eliminating exchange rate risk.
Benefits Measured by Trade Levels
• Adopting the gold standard raised bilateral trade by 30% to 100%
compared with countries that were off the gold standard.
• What about fixed exchange rates today? Do they promote trade?
Fixed Exchange Rates and Trade
Price Convergence
• The effect of the exchange rate regime on prices can be estimated
using purchasing power parity (PPP) as a benchmark for a fully
integrated market.
• If fixed exchange rates promote trade, then differences between
prices (measured in a common currency) should be smaller between
countries with pegged.
• That is, PPP are more likely to hold under a fixed exchange rate than
under a floating regime.
Fixed Exchange Rates and Trade
• In the study reported in the text, country pairs A–B were classified in four
different ways:
• a. The two countries are using a common currency (i.e., A and B are in a
currency union or A has unilaterally adopted B’s currency).
• b. The two countries are linked by a direct exchange rate peg (i.e., A’s
currency is pegged to B’s).
• c. The two countries are linked by an indirect exchange rate peg, via a
third currency (i.e., A and B have currencies pegged to C but not directly to
each other).
• d. The two countries are not linked by any type of peg (i.e., their
currencies float against one another, even if one or both might be pegged
to some other third currency).
Fixed Exchange Rates and Trade: comparing fixed to floating
Fixed Exchange Rates and Monetary Autonomy
• When a country pegs, it gives up its independent monetary policy:
It’s money supply M must adjust to keep the home interest rate i
equal to the foreign interest rate i* (plus any risk premium).
To resolve the trilemma, a country can do the following:
1. Choose open capital markets, with fixed exchange rates (an “open
peg”).
2. Choose to open its capital market but allow the currency to float
(an “open nonpeg”).
3. Choose to close its capital markets (“closed”).
The Trilemma again
Fixed Exchange Rates and Monetary Autonomy
Measuring the costs of fixing the exchange rate: output volatility
• An increase in the base-country interest rate should lead output to
fall in a country that fixes its exchange rate to the base country.
• Under floating, the home country need not follow the base country’s
rate increase. It can keep its interest rate where it is.
• A cost of fixed a exchange rate regime is a more volatile level of
output.
Costs of Fixing Measured in Output Volatility
Fixed rates, fiscal discipline and inflation
• A common argument in favor of fixed exchange rate regimes in
developing countries is that an exchange rate peg prevents the
government from printing money to finance government
expenditure.
• Often, central banks are called upon to monetize the government’s
deficit (i.e., buy government debt with fresh money). Persistent
increases the money supply lead to inflation.
• This is a source of government revenue. It is an inflation tax
(seigniorage) levied on the holders of money.
Inflation tax
• At any instant, money grows at a rate ΔM/M = ΔP/P = π.
• Real money balances, M/P, lose a fraction π of their real value when
prices rise by π. The inflation tax is π × M/P.
• The amount that the inflation tax transfers from money holders to
the government is called seigniorage, and can be written
M
*
Seigniorage = p ´ = p ´ L(r + p )Y
P
Fixed rates, fiscal discipline and inflation
• If a country’s currency floats, its central bank chooses how much
money to print, hence, inflation.
• If a country’s currency is pegged, the central bank might manage the
peg well keeping inflation equal to foreign inflation. Or, it can
mismanage the peg badly enough to force the currency off the peg.
• Nominal anchors—whether money targets, exchange rate targets, or
inflation targets—imply a “promise” by the government to ensure
certain monetary policy outcomes in the long run.
• Promises do not always turn out right.
Fixed rates, fiscal discipline and inflation
Inflation and the exchange rate regime
Liability dollarization, national wealth and contractionary depreciations
• The Home country’s total external wealth is the sum total of assets
minus liabilities expressed in local currency:
W  ( AH  EAF )  ( LH  ELF )
• A change ΔE in the exchange rate affects the values of EAF and ELF
expressed in local currency. The resulting change in national wealth
is
W  E  AF  LF 
Destabilizing wealth shocks
• In a more complex short-run model of the economy, wealth affects
the demand for goods. For example,
• Consumers might spend more when they have more wealth. In this
case, the consumption function would become C(Y − T, Total
wealth).
• Firms might find it easier to borrow if their wealth increases. The
investment function would then become I(i, Total wealth).
Destabilizing wealth shocks
• If foreign currency external assets do not equal foreign currency
external liabilities, the country is said to have a currency mismatch
on its external balance sheet. Exchange rate changes will affect
national wealth.
• If foreign currency assets exceed foreign currency liabilities, then
the country experiences an increase in wealth when the exchange
rate depreciates.
• If foreign currency liabilities exceed foreign currency assets, then
the country experiences a decrease in wealth when the exchange
rate depreciates.
• In principle, if the valuation effects are large enough, the overall
effect of a depreciation can be contractionary.
Evidence of wealth changes with depreciation
• These countries
experienced crises
and large
depreciations of
between 50% and
75% against the U.S.
dollar and other
major currencies
from 1993 to 2003.
• A large fraction of
the external debt for
each of these was
denominated in
foreign currencies.
Evidence of output contractions following real depreciations
Original Sin
• A constant feature of international finance has been the inability of
most countries (especially poorer countries) to borrow from abroad
in their own currencies.
• The term “original sin” is used to refer to a country’s inability to
borrow in its own currency.
• Governments that have or might create high inflation rates cannot
borrow in their own currencies. Foreign creditors and domestic
residents will lend only in foreign currency.
Original Sin
Foreign currency debt and the exchange rate regime
• Often the only way for developing countries to avoid adverse
valuation effects is by pegging the exchange rate.
• For countries that borrow in foreign currencies, floating exchange
rates are less useful as a stabilization tool, or can even be
destabilizing.
• Emerging market and developing countries very often pegged to the
US dollar in the 1980s and 1990s for exactly this reason.
Developing countries and fixed rates
• A fixed exchange rate may be the only way to maintain a nominal
anchor, when institutions are weak, the central bank lacks
independence, or the government has resorted to inflation taxes.
• Fixed exchange rates help avoid large fluctuations in external wealth
for countries with high levels of liability dollarization.
• Such countries exhibit a “fear of floating.”
Floating rates and policy interdependence
Floating Exchange Rates: Fiscal expansion by Home
i
LM
FR
DR’
DR
IS
i*
IS’
Y
LM
IS’
IS
Y*
Ec
Ee
E
Floating Exchange Rates: Fiscal expansion by Home
• In the short run, fiscal expansion at home crowds out investment and
reduces the CA surplus for Home. Investment in ROW rises.
• In the long run, output is at potential and the nominal interest rates
are higher at home and abroad.
• The world real interest rate is higher in the long run.
• In the long run, home government expenditure crowds out of
investment globally.
Floating Exchange Rates: Monetary expansion by Home
i
FR
MP
DR
DR’
MP’
IS
E
Y
Ee
i*
MP
IS
IS’
Y*
E
Case 1: the increase in E and increase in Y
have a negative net effect on the foreign
trade balance.
Floating Exchange Rates: Monetary expansion by Home
i
FR
MP
DR
DR’
MP’
IS
E
Y
Ee
i*
MP
IS’
IS
Y*
E
Case 2: the increase in E and increase in Y
have a positive net effect on the foreign
trade balance.
Floating Exchange Rates: Monetary expansion by Home
• In the short run, a home monetary expansion increases output and
investment at home.
• For the ROW, output can fall (case 1) or rise (case 2). This depends the
relative impact of the home currency depreciation and the increase in
home income on demand for goods and services from the ROW.
•
æE P
æ
F/H Home
TBForeign = TBæ
,Y Foreign - TForeign,YHome - THome æ
æ P
æ
æ Foreignexpansion by home has æan ambiguous
In the short run, monetary
effect on foreign trade balances.
• In the long run, output is at potential and the nominal and real
interest rates are unchanged at home and abroad.
Fixed exchange rate systems
• A fixed exchange rate system involves multiple countries.
• Examples are the global Bretton Woods system in the 1950s and
1960s and the European Exchange Rate Mechanism (ERM) through
which all potential euro members must pass.
• These systems were based on a reserve currency system in which
there are N countries (1, 2, . . . , N) participating.
• One of the countries, the center country (the Nth country), provides
the reserve currency, which is the base or center currency to which
all the other countries peg.
Fixed exchange rate systems
• When the center country has monetary policy autonomy it can set its
own interest rate i *.
• Another, noncenter, country, which is pegging, then has to adjust its
own interest rate so that i equals i * in order to maintain the peg.
• The noncenter country loses its ability to conduct stabilization policy,
but the center country keeps that power.
• The asymmetry can be a recipe for political conflict and is known as
the “Nth currency problem.”
• Cooperation is needed to avoid this problem.
Cooperative and Noncooperative Adjustments to Interest Rates
Noncooperative equilibrium
Cooperative and Noncooperative Adjustments to Interest Rates
Cooperative equilibrium
Cooperative and Noncooperative Adjustments to Interest Rates
• A unilateral peg gives the benefits of fixing to both countries but
imposes a stability cost on the noncenter country only.
• Historically, countries don’t even try to cooperate under fixed rates.
• A major problem is that the shocks that hit a group of economies are
typically asymmetric.
• The center country in a reserve currency system has tremendous
autonomy, which it may be unwilling to give up, thus making
cooperative outcomes hard to achieve consistently.
Cooperative and Noncooperative Adjustments to Interest Rates
• Suppose a (noncenter) country was pegging at a rate E1 and
announces that it will now peg at a new rate, E2 ≠ E1.
• If E2 > E1, the home currency is devalued. If E2 < E1, the home
currency is revalued.
• The center (eg, U.S.) is a large country with monetary policy
autonomy. Its interest rate is set at i$. Home is pegged to the U.S.
dollar at Ehome/$ and Foreign is pegged at E*foreign/$.
Cooperative and Noncooperative Adjustments to Interest Rates
The home country in recession
Cooperative and Noncooperative Adjustments to Interest Rates
The home country devalues but its interest rate still equals i$
Cooperative and Noncooperative Adjustments to Interest Rates
The foreign country cooperates by taking its real appreciation.
Cooperative and Noncooperative Adjustments to Interest Rates
Devaluing bad: beggar-thy-neighbor.
The Gold Standard
• Example: Britain pegs to gold at Pg (pounds per ounce of gold) and
France pegs to gold at P*g (francs per ounce of gold).
• One pound cost 1/Pg ounces of gold, and an ounce of gold cost P*g
francs.
• Thus, one pound costs Epar = P*g /Pg francs. This ratio is called the
par exchange rate implied by the gold prices in each currency.
• The gold standard rested on the principle of free convertibility. This
meant that central banks in both countries stood ready to buy and
sell gold in exchange for paper money at these mint prices, and the
export and import of gold were unrestricted.
Under the gold standard
• Between 1870 and 1913, the number of countries on the gold
standard rose from 15% of all countries to 70%.
• From 1870-1914 (“the first great globalization”), transport costs fell
and protectionism declined, and world trade grew.
• Also, the costs of asymmetry in aggregate demands were politically
unimportant.
• Price stability was the goal of most governments, unemployment
reduction was not.
Under the gold standard
• Not everyone was pleased. William Jennings Bryan in 1896:
“Having behind us the commercial interests and the laboring interests and all
the toiling masses, we shall answer their demands for a gold standard by
saying to them, you shall not press down upon the brow of labor this crown
of thorns. You shall not crucify mankind upon a cross of gold.”
• At the start of 20th century, expansion of gold supplies eased U.S. and
European deflations.
• World War I reduced trade (almost entirely for the U.K., France,
Germany and Russia) (substantially for the US due to U-boats)
• High government deficits required inflationary financing, forcing
countries to float.
The end of the gold standard
• The re-adoption of gold after World War I reached 90% by the end of the
1920s and then fell to 25% by 1939.
• The return to gold in the 1920s followed the great hyperinflations occurred
between 1922 and 1924.
• Re-pegging to gold was used to devalue currencies (called “Beggar-thyneighbor policies”).
• Gold supplies grew more slowly than income leading to deflation.
• In 1931, Britain left gold (floated) and imposed capital controls. Germany
and Austria just imposed capital controls.
• The US devalued on January 31, 1934 (Gold Reserve Act of 1934).
• France, Switzerland, and Italy finally left gold in 1936.
The end of the gold standard
• The U.K. and U.S. chose floating with open capital markets.
• Germany and much of South America chose capital controls and
pegged exchange rates.
• France stayed on gold because it had accumulated large reserves
from the mid-1920s on (and did not expand the franc supply).
• Countries that floated grew 26% more between 1935 and 1929 than
countries that remained on gold (and 5% more than countries that
adopted capital controls).
Gold and per capita GNI
The rise and fall of the gold standard
• As the volume of trade and other economic transactions between
nations increase, the gain from adopting a fixed exchange rate rises.
• As 19th-century globalization proceeded, it is likely that more
countries crossed the FIX line and met the economic criteria for
fixing.
• But the benefits were often less apparent than the costs, particularly
in times of deflation or in recessions.
• As world trade fell by half, the rationale for fixing based on gains
from trade weakened.
The Gold Standard
• Before World War I
Bretton Woods and after
The end of Bretton Woods
• Capital mobility rose and controls failed to hold by late 1960s. As this
happened, countries pegged to the dollar lost monetary autonomy.
• Devaluations became the most important way of achieving policy
compromise in a “fixed but adjustable” system. Eventually, frequent
devaluations (and some revaluations) made the system unstable.
• Rising inflation in the U.S. and Europe meant that U.S. would
eventually quit fixing the dollar price of gold. Gold convertibility
ended in August 1971.
The end of Bretton Woods
• Responses to the collapse of the Bretton Woods system:
Most advanced countries chose to float and preserve monetary policy
autonomy.
A group of European countries decided to try to preserve a fixed
exchange rate system among themselves (the ERM).
Some developing countries have maintained capital controls, but
many of them (especially the emerging markets) have opened their capital
markets. More and more float and pursue inflation targeting.
Some countries, both developed and developing, chose a middle
ground and attempted to maintain intermediate regimes, such as “dirty
floats” or pegs with “limited flexibility.”