Exporting US Inflation: 1966–1972

Effect on Internal and External Balance of a Rise in the Foreign (US) Price Level, P* The “simple” solution for the £, M, ¥, FF, … Revalue against the $ Let the $ depreciate

The Case for Floating Exchange Rates – Monetary policy autonomy…w/o capital controls Each country can choose “appropriate” long-run inflation rate – Symmetry $ can “devalue” as necessary…not constrained as leader – Exchange rates as automatic stabilizers Floating cushions output against real shocks – Something’s gotta adjust…if not E, then Y Temporary reduction in demand for country’s exports  depreciation attenuates output reduction

AA 1 DD 1 Effects of a Temporary Fall in Export Demand AA 2 DD 2 AA 1 DD 2 DD 1 E2E2 2 Y2Y2 Y2Y2 Output, Y Exchange rate, E (a) Floating exchange rate Output, Y Exchange rate, E (b) Fixed exchange rate Y1Y1 E1E1 1 Y1Y1 E 1 1 Y3Y3 3 Depreciation leads to higher demand for and output of domestic products Fixed exchange rates mean output falls as much as the initial fall in aggregate demand

The Case for Floating Exchange Rates – Monetary policy autonomy…w/o capital controls Each country can choose “appropriate” long-run inflation rate – Symmetry $ can “devalue” as necessary…not constrained as leader – Exchange rates as automatic stabilizers Floating cushions output against real shocks – Something’s gotta adjust…if not E, then Y Temporary reduction in demand for country’s exports  depreciation attenuates output reduction Permanent reduction in demand for country’s exports  depreciation restores equilibrium automatically

The Case Against Floating Exchange Rates Lack of discipline Destabilizing speculation – Hot money …but “fundamental disequilibrium”  one-way bet under fixed rates – A “vicious circle” of depreciation and inflation. E deprec  P im up  CoL up  W up  P up  E deprec – Floating exchange rates make a country more vulnerable to money market disturbances…that’s the tradeoff: L up  R up  E-apprec.  CA & Y down

AA 1 DD Output, Y Exchange rate, E E1E1 Y1Y1 1 A Rise in Money Demand Under a Floating Exchange Rate AA 2 E2E2 Y2Y2 2

The Case Against Floating Exchange Rates Lack of discipline Destabilizing speculation – Hot money …but “fundamental disequilibrium”  one-way bet under fixed rates – A “vicious circle” of depreciation and inflation. E deprec  P im up  CoL up  W up  P up  E deprec – Floating exchange rates make a country more vulnerable to money market disturbances…that’s the tradeoff: L up  R up  E-apprec.  CA & Y down Recall: fixed rates cushion output against monetary shocks L up  M up  nothing shifts under fixed rates

Injury to International Trade and Investment – Exchange rate risk – But forward markets can protect traders against foreign exchange risk. – International investments face greater uncertainty about payoffs denominated in home country currency. Uncoordinated Economic Policies – Countries can engage in competitive currency depreciations. – A large country’s fiscal and monetary policies affect other economies …aggregate demand, output, and prices become more volatile across countries if policies diverge. The Case Against Floating Exchange Rates

Macroeconomic Interdependence Under Floating Rate The Large Country Case – Effect of a permanent monetary expansion by US $ depreciates, US output rises Small country’s output may rise or fall. Its currency appreciates  Its CA and output decrease US economy expands  It sells more to US  Its output rises – Effect of a permanent fiscal expansion by US US output rises, US currency appreciates Small country’s output rises Its currency depreciates  Its CA and output rise US economy expands  It sells more to US  Its output rises Large Country => Locomotive

Injury to International Trade and Investment – Exchange rate risk – But forward markets can protect traders against foreign exchange risk. – International investments face greater uncertainty about payoffs denominated in home country currency. Uncoordinated Economic Policies – Countries can engage in competitive currency depreciations. – A large country’s fiscal and monetary policies affect other economies …aggregate demand, output, and prices become more volatile across countries if policies diverge. Free Float Really Managed Float – Fear of depreciation – inflation spiral  intervention The Case Against Floating Exchange Rates

More Case Against Floating Exchange Rates Speculation and volatility in the foreign exchange market Expectation of depreciation in short-run  Rush to sell currency  Depreciation in short-run … and recovery to fundamental value in long-run  High nominal and real exchange rate volatility under floating  Violation of Purchasing Power Parity  Disruption of trade ???

Nominal and Real Effective Dollar Exchange Rate Indexes, 1975–2010 Purchasing Power Parity??? Source: International Monetary Fund, International Financial Studies.

Milestones ‘a Floating Vietnam Expansion – Inflation – Commodity price boom F L O A T I N G Yom Kippur War O i l S h o c k Stop – Go Inflation – Recycling petrodollars America Held Hostage 2 nd O i l S h o c k Volcker Disinflation – Twin Deficits – Rust Belt – Lost Decade Plaza Accord Louvre Accord – Black Monday – Japan Bubble – S & L Debacle Berlin Wall Down – Maastricht – ERM Crisis Tequila Crisis Emerging Mkt Boom East Asia Crisis – Contagion – LTCM Dot.com bubble – US Capital Inflow – US CA Deficit – Greenspan Put Global Savings Glut – China rising – Developed country aging – Reserve buildup – Tech slowdown Global HousingGlobal Housing B u b b l e – Leveraging US Saving down C R I S I S – Deleveraging The Great Recession Rush to safety