ECON3315 International Economic Issues Instructor: Patrick M. Crowley Issue 15: To fix or to float?

Overview Some history Some history Fixed rates – what do they entail? Fixed rates – what do they entail? Floating rates – what do they entail? Floating rates – what do they entail? Other variations on a theme…. Other variations on a theme…. Intervention Intervention Economic policy and exchange rate regimes Economic policy and exchange rate regimes

Some history Before WWI: Gold standard Inter-war years: Flexible exchange rates – led to “competitive depreciation/devaluations” or “beggar thy neighbor” policies Post WWII: Bretton Woods system – based on dollar, which in turn was pegged to price of gold (at $35/oz) Canadian episode: 1950s-60s – Canada floated – not a disaster Vietnam war: late 1960s – US increased spending, threatening US$ gold peg, so in 1971, Smithsonian agreement, whereby US$ gold peg was maintained, but greater fluctuation allowed 1973: Germans complained that Bretton Woods was unsustainable, and Nixon cut US$ link to gold Post 1973: Floating rates the norm – except in Europe where “the Snake” used 1984 – Plaza agreement: central banks agreed to coordinated intervention to depreciate the US$ 1987 – Louvre accord: central banks agreed to stabilize the US$ within a certain range against DM and Yen

Fixed exchange rates Fixed exchange rates still popular today – e.g. HK$, many smaller developing countries, CEECs Fixed exchange rates entail making sure that the exchange rate remains fixed against another currency This means that the central bank has to be ready to sell or buy the domestic currency in the forex market so as to keep the price fixed – it means that foreign exchange reserves become key But as the value of currency depends on how much there is in circulation, what does this tell us about how monetary policy and exchange rate policy? So here, exchange rate often used as a means of “anchoring” economic policy

Fixed exchange rates Pros: Pros: - more certainty for exporters and importers - more certainty for exporters and importers - potentially anchors monetary policy - potentially anchors monetary policy - can always devalue/revalue to another rate - can always devalue/revalue to another rate - can bestow credibility - can bestow credibility Cons: Cons: - can lead to crises if policy not credible - can lead to crises if policy not credible - ties monetary policy to anchor country - ties monetary policy to anchor country - could choose inappropriate rate to peg at - could choose inappropriate rate to peg at - choice of currency might not be obvious - choice of currency might not be obvious

Flexible exchange rates With a fully flexible exchange rate regime, market forces fully determine the value of a country’s currency. Economic policy can be independent of another country’s policies Foreign exchange markets though can be unstable in 2 ways: - misalignment: pushing currencies far away from their “equilibrium” values – e.g. US$ in ‘84 - misalignment: pushing currencies far away from their “equilibrium” values – e.g. US$ in ‘84 - volatility: causing currencies to move around a lot, creating market “nervousness” and erratic currency movements – e.g. US$ in ‘87 - volatility: causing currencies to move around a lot, creating market “nervousness” and erratic currency movements – e.g. US$ in ‘87 Central banks often “intervene” if forex markets are thought to be unstable

Flexible exchange rates  Pros: - economic policy can focus on internal economic situation - forex market movements can be seen as indication of quality of economic policy  Cons: - exchange rate movements create shocks in the economy - exporters and importers have little certainty - can encourage bad economic policy as no “anchor”

Other variations on a theme… Other intermediate exchange rate regimes: Dirty/managed floating - intervention Shadow target zone – specific zone for currency known by policymakers only, e.g. UK pound before ERM Explicit target zone – e.g. ERM Crawling peg Currency boards Dollarization/Euroization

Intervention Unsterilized intervention Unsterilized intervention Sterilized intervention Sterilized intervention Efficacy – “leaning against the wind”… Efficacy – “leaning against the wind”… Short-term vs long term effects Short-term vs long term effects

Economic policy and exchange rate regimes Many developed countries use floating rate policies Many developed countries use floating rate policies Many developing countries still use fixed rate policies Many developing countries still use fixed rate policies The line has become blurred though, as the EU now essentially has gone to a one (fixed) currency regime The line has become blurred though, as the EU now essentially has gone to a one (fixed) currency regime Credibility matters but it is a 2-way street… Credibility matters but it is a 2-way street…