Lecture 16 Fixed versus Floating Exchange Rates Econ 340

Outline: International Macroeconomics Recall Macro from Econ 102 –Aggregate Supply and Demand –Policies Effects ON the Exchange Market –Expansion –Interest Rate Effects OF the Exchange Market –Depreciation via Trade –Depreciation via Net Wealth Effects THOUGH the Exchange Market 2Econ 340, Deardorff, Lecture 15: Int Macro Left over from Last Time

Effects THROUGH the Exchange Market The issue here: –Do macroeconomic effects get transmitted to other countries, and if so how? –i.e., does an expansion, for example, in one country cause an expansion or a contraction in other countries? 3Econ 340, Deardorff, Lecture 15: Int Macro

Effects THROUGH the Exchange Market –The answer: Although many exceptions are possible, it is usually true that changes in one country cause changes in the same direction in others: Expansion here → expansion there Inflation here → inflation there High interest rates here → high interest rates there 4Econ 340, Deardorff, Lecture 15: Int Macro

Effects THROUGH the Exchange Market Example: How a recession in US can cause recession Canada –Fall in aggregate demand in US (due to non- monetary contraction such as a fall in investment) leads to Fall in US income, leads to Fall in Canadian exports to US, leads to Fall in Canadian income –To see these links in more detail… 5Econ 340, Deardorff, Lecture 15: Int Macro

US Investment Falls US Income Falls US Interest Rate FallsUS Imports Fall US Dollar Depreciates US Imports Fall More Canadian Exports Fall Canadian AD Falls Canadian Income Falls 6Econ 340, Deardorff, Lecture 15: Int Macro

Effects THROUGH the Exchange Market We’ve seen some of this dramatically during the last few years: –Crisis started in US –Effects were transmitted to the world –Exception: US dollar did not depreciate immediately; it appreciated at first. (Due to flight to safety.) 7Econ 340, Deardorff, Lecture 15: Int Macro

Econ 340, Deardorff, Lecture 16: Fixed/Float 8 Outline: Fixed versus Floating Exchange Rates Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating –Disruption When Rates Move –Automatic Adjustment Pros and Cons of Pegging –Stability –Instability Alternatives –Crawling Peg –Monetary Unification The Problem of Undervalued Currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 9 Who Uses Fixed and Float Lessons from the list of exchange arrangements (below) –Floating rates are used by many countries Rich & poor Large & small All over the world –Pegged rates are used today mostly by small countries –Many countries are between fixed and floating (Source of table below: IMF, “Annual Report on Exchange Arrangements and Exchange Restrictions 2014”)

Econ 340, Deardorff, Lecture 16: Fixed/Float 10 Exchange Arrangements of Sample Countries, as of 2014 Floating Exchange Rates47 countries + euro 18 AustraliaMexico CanadaSweden IndiaUnited Kingdom JapanUnited States Pegged Exchange Rates44 countries BelizeMorocco DenmarkNepal JordanSaudi Arabia

Econ 340, Deardorff, Lecture 16: Fixed/Float 11 Exchange Arrangements of Sample Countries, as of 2014 Stabilized Arrangement21 countries IraqSingapore LebanonVietnam Crawling Peg or Crawl-like Arrangement17 countries NicaraguaChina Other Managed Arrangement19 countries BangladeshRussia MalaysiaSwitzerland Between Floating and Pegged: 57 countries

Econ 340, Deardorff, Lecture 16: Fixed/Float 12 Exchange Arrangements of Sample Countries, as of 2014 Currency Board12 countries Hong KongLithuania No Separate Legal Tender12 countries Ecuador ($)Montenegro (€) More Fixed than Pegged: Currency Board –Peg to another currency –Vary money supply automatically with changes in international reserves (= forced nonsterilization)

Econ 340, Deardorff, Lecture 16: Fixed/Float 13 PeggedFloat More Fixed More Flexible

Econ 340, Deardorff, Lecture 16: Fixed/Float 14 Outline: Fixed versus Floating Exchange Rates Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating –Disruption When Rates Move –Automatic Adjustment Pros and Cons of Pegging –Stability –Instability Alternatives –Crawling Peg –Monetary Unification The Problem of Undervalued Currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 15 What “Experts” Recommend Some favor freely floating rates –Let exchange rate adjust to fix imbalances –“Let the market work” Others favor perfectly fixed rates –Define currency rigidly in terms of something you can’t control Gold Foreign currency (“Currency Board”) –AND give up control of the money supply Let flows of money fix imbalances i.e., do not sterilize!

Econ 340, Deardorff, Lecture 16: Fixed/Float 16 What “Experts” Recommend Advocates of floating rates –Milton Friedman (Nobel Prize 1976): “A country that enters into a hard-fixed rate bears an economic cost. The cost is discarding a means—a flexible exchange rate—of adjusting to external forces that impinge on it differently than on the other country or countries whose currency it shares.”

Econ 340, Deardorff, Lecture 16: Fixed/Float 17 What “Experts” Recommend Advocates of floating rates –Jeffrey Sachs: “Once reserves are gone, investors panic. The worst mistake is for countries to wait too long to float their currencies.”

Econ 340, Deardorff, Lecture 16: Fixed/Float 18 What “Experts” Recommend Advocates of fixed rates –Robert Mundell (Nobel Prize 1999): “A world currency of some sort has existed for most of the past 2,500 years. Two thousand years ago, in the age of Caesar Augustus, it was the Roman aureus... A hundred years ago it was the gold sovereign. Less than thirty years ago it was the 1944 gold dollar. The world has been without a universal currency for only a tiny fraction of its history.”

Econ 340, Deardorff, Lecture 16: Fixed/Float 19 What “Experts” Recommend –Milton Friedman: “If [over the last 30 years] the Canadian dollar had been rigidly tied to the US dollar, those differences would have required Canada to deflate relative to the United States, with unfortunate consequences for Canada that would have strained, to put it mildly, the trade relations between the two countries, and have put strong pressure on Canada to devalue or float.”

Econ 340, Deardorff, Lecture 16: Fixed/Float 20 What “Experts” Recommend –Robert Mundell: “Exchange rate uncertainty imposes a cost of trade much like a tariff... If Canada and the United States shared a stable common currency or an irrevocably fixed exchange rate, Canada’s real income would soar, closing a large part of the gap between the two countries’ GDP per capita.”

Econ 340, Deardorff, Lecture 16: Fixed/Float 21 What “Experts” Recommend “Bradford DeLong, an economic historian at the University of California at Berkeley, explains the debate to his students this way: ” (WSJ) To Mr. Friedman, an exchange rate is a price; therefore, it is an infringement on human freedom to peg it. To Mr. Mundell, an exchange rate is a promise; to change it is to default on a commitment.

Econ 340, Deardorff, Lecture 16: Fixed/Float 22 What “Experts” Recommend Allan Meltzer (Carnegie-Mellon): “The best you can say of what economic research has produced is: –You can make a case for freely floating exchange rates if you’re willing to live with the consequences. –You can make a case for fixed exchange rates if you’re willing to live with the consequences. –You can’t make much of a case for anything in between.” (WSJ)

Econ 340, Deardorff, Lecture 16: Fixed/Float 23 What “Experts” Recommend Where they agree: An “adjustable peg” is worse than both fixed and floating rates –Friedman: “The reasons why a pegged exchange rate is a ticking bomb are well known.” –Mundell: “I have never nor ever would advocate a general system of “pegged” rates. Pegged rate systems always break down.”

Econ 340, Deardorff, Lecture 16: Fixed/Float 24 Outline: Fixed versus Floating Exchange Rates Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating –Disruption When Rates Move –Automatic Adjustment Pros and Cons of Pegging –Stability –Instability Alternatives –Crawling Peg –Monetary Unification The Problem of Undervalued Currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 25 Pros and Cons of Floating Con: Exchange rates DO MOVE; And when they do, they cause –Macro effects (as we saw last time) Depreciation –Stimulates aggregate demand, but not necessarily when needed: may just cause inflation –Changes values of assets and liabilities Appreciation –Reduces aggregate demand, may cause recession or deflaton

Econ 340, Deardorff, Lecture 16: Fixed/Float 26 Pros and Cons of Floating Con: Exchange rates DO MOVE; when they do, they cause –Micro effects: exports and imports subject to Uncertainty Instability Costly for traders Like trade barrier Reduces trade

Econ 340, Deardorff, Lecture 16: Fixed/Float 27 Pros and Cons of Floating Example: The US dollar rose 50% during –Caused US auto and other industries to contract –Major dislocation in middle US –Ended in 1985 when in “Plaza Accord” major central banks agreed to intervene

Econ 340, Deardorff, Lecture 16: Fixed/Float 28 Pros and Cons of Floating Pro: Exchange rate provides efficient and automatic across-the-board adjustment –Suppose that, due to inflation, our prices are too high, causing our imports to rise and exports to fall Exchange depreciation fixes this for all sectors With fixed rates, individual prices and wages would have to fall to become competitive: much more painful –That’s what Greece and other weak countries in the EU have had to do recently. –Called “internal devaluation” –Floating Permits countries to have independent monetary policies to deal with macroeconomic shocks

Econ 340, Deardorff, Lecture 16: Fixed/Float 29 Pros and Cons of Floating Experience with exchange rates in the 1930s (not really floating, but they moved a lot) made governments prefer fixed rates After WWII, IMF was created, based on Pegged Exchange Rates –Most currencies pegged to US $ –IMF helped countries manage this –When in trouble, countries devalued

Econ 340, Deardorff, Lecture 16: Fixed/Float 30 Outline: Fixed versus Floating Exchange Rates Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating –Disruption When Rates Move –Automatic Adjustment Pros and Cons of Pegging –Stability –Instability Alternatives –Crawling Peg –Monetary Unification The Problem of Undervalued Currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 31 Pros and Cons of Pegging Pro: If it succeeds, exchange rate is stable, avoiding disruptions Con: If it fails, –devaluation causes instability, –just like floating rates, only worse The Problem: Pegged Rates are Prone to Crisis

Econ 340, Deardorff, Lecture 16: Fixed/Float 32 Pros and Cons of Pegging Why Crisis? –Pegged rate does not respond to market changes –Some currencies become undervalued, others overvalued Inevitable unless all countries have exactly the same rate of inflation –Crisis eventually erupts for overvalued currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 33 Pros and Cons of Pegging Why Crisis for Overvalued Currency? –Central bank must sell foreign currency –Since reserves are finite, they eventually run out –Market knows that when they do… S€S€ D€D€ Q€Q€ $/€ E* Fed sells € E0E0

Econ 340, Deardorff, Lecture 16: Fixed/Float 34 Pros and Cons of Pegging Why Crisis for Overvalued Currency –Intervention will stop –Currency will depreciate –Knowing this, people don’t want to hold the overvalued currency, so… S€S€ D€D€ Q€Q€ $/€ E* E0E0

Econ 340, Deardorff, Lecture 16: Fixed/Float 35 Pros and Cons of Pegging Why Crisis for Overvalued Currency –Before reserves run out, capital outflow increases demand –And reserves fall faster –“Speculative Attack” S€S€ D€D€ Q€Q€ $/€ E* E0E0 D€1D€1 Fed sells more €

Econ 340, Deardorff, Lecture 16: Fixed/Float 36 Pros and Cons of Pegging Pegged rates offer speculators a “one-way bet” –Once they see that reserves are falling… –… they bet on a devaluation by selling the country’s currency If they are right, they win If they are wrong, they break even (since the exchange rate doesn’t change) –They can’t lose, so they bet a lot

Econ 340, Deardorff, Lecture 16: Fixed/Float 37 Pros and Cons of Pegging Crisis even without Overvaluation –Crisis only requires expectation of devaluation The expectation doesn’t have to be justified; it only has to be believed Can happen even to a currency that is not overvalued –How? By “contagion”. If one country has a crisis, for whatever reason Other countries that are near it, or similar to it, may become suspect That’s part of what happened in the Asian Crisis that started in 1997 Some countries fear contagion today

Econ 340, Deardorff, Lecture 16: Fixed/Float 38 Pros and Cons of Pegging Result: “Pegged Rates” are not Fixed –In a world of pegged exchange rates, over time Some currencies become undervalued Other currencies become overvalued –Why? Many reasons (see Makin) Bretton Woods: US inflation caused dollar to become overvalued Europe in the 1990s: German tight money after reunification, caused others to become overvalued

Econ 340, Deardorff, Lecture 16: Fixed/Float 39 Pros and Cons of Pegging Result: “Pegged Rates” are not Fixed –Overvalued currencies are subject to speculative attacks –When they do devalue, they do it Suddenly By large amounts –This is just as disruptive as changes in a floating rate, perhaps more so

Econ 340, Deardorff, Lecture 16: Fixed/Float 40 Pros and Cons of Pegging The choice is not between fixed and floating: Time E

Econ 340, Deardorff, Lecture 16: Fixed/Float 41 Pros and Cons of Pegging The choice is between pegged and floating: Time E Which is more stable?

Econ 340, Deardorff, Lecture 16: Fixed/Float 42 Outline: Fixed versus Floating Exchange Rates Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating –Disruption When Rates Move –Automatic Adjustment Pros and Cons of Pegging –Stability –Instability Alternatives –Crawling Peg –Monetary Unification The Problem of Undervalued Currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 43 Alternatives Mixtures of pegged and floating rates –Crawling peg Change the pegged rate slowly and predictably in response to a fall or rise in reserves Slow movement of the peg is supposed to stop the loss of reserves before crisis hits Still subject to speculative attack

Econ 340, Deardorff, Lecture 16: Fixed/Float 44 Alternatives Mixtures of pegged and floating rates –Wider band Let the rate move freely in a large band around the official pegged rate Less intervention should be needed Does not help if country has, say, higher inflation than others: crisis still inevitable

Econ 340, Deardorff, Lecture 16: Fixed/Float 45 Alternatives Truly Fixed Exchange Rate –Use another country’s currency “Dollarization” –Form a monetary union The Eurozone (we’ll look more at this next week)

Econ 340, Deardorff, Lecture 16: Fixed/Float 46 Alternatives Truly Fixed Exchange Rate –Currency Board Peg to another currency Replace central bank with “board” that automatically varies money supply one-for-one with international reserves –If reserves fall, so does money supply, forcing adjustment –This mimics the Gold Standard, where gold flowed among countries

Econ 340, Deardorff, Lecture 16: Fixed/Float 47 Alternatives Truly Fixed Exchange Rate –Currency Board How it’s supposed to work –If exchange rate is over-valued (excess demand for foreign currency) »Currency board sells reserves »This reduces the domestic money supply 1-for-1 »Falling money causes falling income and prices »Imports fall, exports rise, and excess demand for foreign currency disappears –If exchange rate is under-valued: Opposite

Econ 340, Deardorff, Lecture 16: Fixed/Float 48 Alternatives Truly Fixed Exchange Rate –Currency Board Didn’t work for Argentina, which had a crisis anyway –Must not have followed the rules

Econ 340, Deardorff, Lecture 16: Fixed/Float 49 Alternatives Pegged Rate with Capital Controls –Why did pegged rates work in the 1950s & 60s? Most countries had capital controls In spite of that, the system of pegged rates didn’t work perfectly: there were some crises –Capital controls prevent inflow and outflow of capital, and thus limit speculation –Today, most countries see capital controls as too costly But not all: China, Malaysia

Econ 340, Deardorff, Lecture 16: Fixed/Float 50 Alternatives The Impossible Trinity See Frankel (This is the Missing Figure 3) Goal: Exchange Rate Stability Goal: Monetary Independence Goal: Full Financial Integration Policy: Full Capital Controls Policy: Pure Float Policy: Monetary Union Increased Capital Mobility

Exchange Rates Since 1945 See reading by Buttonwood (column in The Economist) Bretton-Woods System, –Overseen by IMF –Currencies were pegged, mostly to US $ –Capital mobility was restricted, but gradually liberalized over time –Frequent crises, as currencies became overvalued due to inflation Econ 340, Deardorff, Lecture 16: Fixed/Float 51

Exchange Rates Since 1945 August 15, 1971: –Nixon cut the link of US $ to gold, signaling the end of pegged rates –Countries stopped pegging, then restarted at different rates, but by 1973 they had given up Econ 340, Deardorff, Lecture 16: Fixed/Float 52

Exchange Rates Since 1945 Since 1973, major currencies have floated –Exchange rates moved more than expected –Crises did not disappear –Monetary policy became more free: “ ‘the Greenspan put’: the use of interest-rate cuts to rescue financial markets, in effect underwriting asset prices.” Econ 340, Deardorff, Lecture 16: Fixed/Float 53

Econ 340, Deardorff, Lecture 16: Fixed/Float 54 Outline: Fixed versus Floating Exchange Rates Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating –Disruption When Rates Move –Automatic Adjustment Pros and Cons of Pegging –Stability –Instability Alternatives –Crawling Peg –Monetary Unification The Problem of Undervalued Currencies

Econ 340, Deardorff, Lecture 16: Fixed/Float 55 The Problem of Undervalued Currencies Overvalued currencies lead to crisis –In that sense they are self correcting, since countries are forced, eventually, to devalue or float Undervalued currencies –Do not lead to crisis, but only to accumulation of reserves –May be viewed as harmful to trading partners

Econ 340, Deardorff, Lecture 16: Fixed/Float 56 The Problem of Undervalued Currencies Today, the Chinese yuan is considered undervalued –US administration puts pressure on China to appreciate –US Congress threatens to restrict imports

Econ 340, Deardorff, Lecture 14: Pegging 57 US$/yuan Exchange Rate

Recent Pronouncements Obama: "As I've said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort.”

Recent Pronouncements Wen Jiabao: –“The Chinese currency is not undervalued.” “We oppose all countries engaging in mutual finger- pointing or taking strong measures to force other nations to appreciate their currencies.” –“What I don’t understand is depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is protectionism.”

Krugman’s Argument (From NYT, Mar 15, 2010) China’s current account surplus in 2010 will be over $450 billion US should declare China a “currency manipulator” in next report, Apr 15 –(US did not, and hasn’t since.) China does not have US “over a barrel.” We have China over a barrel. We should repeat what we did in 1971: –Then Nixon used a 10% surcharge on imports, so as to prod Japan, Germany, and others to appreciate –We should use (or threaten) a 25% surcharge on Chinese exports.

Econ 340, Deardorff, Lecture 16: Fixed/Float 62 Next Time The Euro –What is it? –History of European monetary integration –Pros and cons of currency unification –Effects on US –What happened?