A Society-Centered Approach to Monetary and Exchange-Rate Policies READING ASSIGNMENT: Oatley – Chapter 12 1

Killing me softly Song about a song Multivocality Expression over content (content is in the “ear” of the beholder) Recalls: –Ad campaigns (cola wars) –Political campaigns 2

Plan for today 1.The Trilemma 2.France vs. Germany in the 1980s 3.How to deal with imbalances: fix vs. float 4.Electoral models 5.Partisan models 6.Sectoral models 3

The story of the contemporary international monetary system is the story about the search for the elusive ideal-balance between domestic economic autonomy and exchange rate stability. 4 The saga continues…

The Unholy Trinity Fixed Exchange Rate Autonomy of Monetary Policy Capital Mobility Mundell-Fleming: Only 2 out of 3 are possible 5

The Trilemma Fixed Exchange Rate Open Capital Flows Sovereign Monetary Policy Switzerland PRC Eurozone countries 6

The point of the unholy trinity – you can’t have it all… “The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).” – Paul Krugman 7

The European Monetary System 1979 Fixed but adjustable The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark 8

French-German fight in

Or: François tests the Adele-hypothesis Is the trilemma wrong? Can we have it all? 10

French-German fight in Mitterand – socialist president – believed German monetary policy was strangling Expansionist monetary policy (e.g., lowered interest rates) French inflation began to rise Called on Germany to lower their interest rates 18 month stand-off… the French backed down 11

: Monetary Union 1988: Planning begins Gradually moved towards fixing their currency XR’s (1999 – “permanently” fixed) Jan 2002: The Euro! Why union? High degree of economic openness across Europe  Sacrificed monetary autonomy for XR stability 12

Fixed XR Also may act as a kind of commitment To avoid SPECULATATION governments try to make a credible commitment to a fixed XR If the commitment is not credible, speculation can be disastrous Argentine Currency Board ( ) –Pegged the Argentine peso to the U.S. dollar in an attempt to eliminate hyperinflation –Credibility? Required legislative vote to change the value of the currency (public discussion undermines the point of a devaluation!) –But deficit spending ultimately undermined confidence –And tied hands prevented the government from acting –Run on the currency in 2002  disaster!! 13

To fix or to float? 14

Trade & international capital flows lead to imbalances How do governments deal with these imbalances?  Fixed exchange rate  sacrifice monetary policy OR:  Floating exchange rate  sacrifice certainty in international exhanges Trade-off between  exchange rate stability versus  domestic price stability with monetary policy autonomy 15

What will governments choose? Society-based models of monetary & XR politics 1.Electoral models 2.Partisan models 3.Sectoral models 16

The triangle behind the scenes of all these models: r 17

Assuming free capital flows… Governments must choose between –monetary policy autonomy –XR stability 18

1. Electoral models Prediction: Democracies choose floating XR  –monetary autonomy used to manipulate political- business cycles If there is a fixed XR  –commitment may not be credible before elections (elections like the Sirens!) Pocketbook voter model – people vote according to changes in their income – Sociotropic model – voters consider macro performance (economic growth, unemployment, inflation) – 19

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2. Partisan models Left-wing parties are “pro-employment” –Tied to organized labor Right-wing parties are “anti-inflation” –Tied to business interests Prediction: –Right-wing governments more likely than left-wing governments to establish & maintain a fixed XR It is possible to connect this to the electoral model: –Voters choose left-wing parties during recessions & right-wing parties under inflation Some partisan models suggest, however, *convergence* of party positions (specifically in 2 party systems) 21

Downs offers a “spatial” model of party competition. Based on Hotelling’s (1929) model –Where should PUMA locate if people shop at stores closest to their house? NIKEPUMA Employment concerns Inflation concerns Vote single-peaked preferences In a 2-party system, where will the left & right parties locate? Dems 민주당 Reps 한나라당 What happens when somebody decides not to vote? Median preference shifts away from the absent voter 22

Final thought on “partisan” models As we move into “sectoral models,” Consider that in the “partisan” model, we have –Left – labor-oriented – parties –VS –Right – business oriented – parties What does this “ontology” recall from our trade models? What model is based on labor & owners of capital? FACTOR MODEL So, you can think of the “partisan model” as analogous to the “factor model” 23

3. Sectoral models Interest groups have different preferences on the trade-off between domestic economic autonomy & XR stability Some groups prefer XR stability Others groups prefer domestic economic autonomy (sovereign monetary policy) Obviously (given the name of the model) the interest groups are based on *sector* 24

NIKEPUMA Domestic economic autonomy XR stability 25

Domestic economic autonomy XR stability Weak currency Strong currency 26

Four domestic interest groups 1.Export-oriented producers 2.Import-competing producers 3.Nontraded-goods producers 4.Financial services industry 27

Fixed or Float / Strong or Weak? Export-oriented producers prefer… –Fixed XR: stability for their international transactions –Weak XR: keeps the price of their products world markets low (keeps demand high) Import-competing producers prefer… –Floating XR: prefers monetary policy to address recessions/inflation –Weak XR: keeps the price of imports high! This spurs domestic demand Nontraded-goods producers prefer… –Floating XR: prefers monetary policy to address recessions/inflation –Strong XR: consume more traded goods, travel more, pay for tuition 28

Fixed or Float / Strong or Weak? Financial services industry prefer… –XR stability leads to more international transactions… –But XR volatility leads to XR-risk business… –And monetary autonomy helps maintain a stable domestic banking system, low inflation, and more stable interest rates –So: A weak preference for Floating XR –As for currency strength: buy foreign assets when XR is strong, repatriate returns when the XR is weak –So: No preference on XR strength 29

Sectoral XR preferences summary XR stability preference High/fixed low/float/ monetary autonomy XR strength preference Strong currency Nontradable Weak currency Export-orientedImport-competing Financial services ??? Exporters in other countries – keep them out of our elections! Imperialist colonial powers? Get them out of our countries! 30

Take aways 1.The Trilemma 2.France vs. Germany in the 1980s 3.Floating XR allows for flexibility in monetary policy 4.Electoral models – democracies prefer floating XR 5.Partisan models – left prefers float, right prefers fixed 6.Sectoral models:  export-oriented prefers weak, fixed  import-competing prefers weak, float  non-tradable prefers strong, float  finance prefers float (strength doesn’t matter 31

Thank you 32

Political-business cycles (PBC)? Governments may be less willing to accept monetary policy constraints before an election Problem 1: empirical – debate over whether we really observe PBCs Problem 2: theoretical – if voters are rational, they shouldn’t be fooled by a PBC (short-run employment eaten up by eventual inflation) Kaplan: Lately in Latin America, we see COUNTER- PBCs! –International explanation: lack of international finance since Latin American Debt Crisis –Domestic explanation: Hyper-inflation history makes voters “inflation-averse” 33

Connecting monetary policy to unemployment: The Phillips curve Governments can reduce unemployment only by causing more rapid inflation & can reduce inflation only by causing higher unemployment More on this tomorrow… 34

Thought… If poor voters have more trouble solving their collective action problem to “rock the vote,” What effect should mandatory voting laws (which provide all voters selective incentives to vote) have on politics? Answer: Move policy platforms of parties to the LEFT 35

Why are there imbalances? These days, foreign exchange markets conduct between $1 trillion and $1.5 trillion worth of business… PER DAY!!  Exchange rate volatility!  Exchange rate misalignments 36

Consequences of XR volatility? Uncertainty hurts international transactions? Suppose you work on a profit margin of 5%-9% and the XR changes 5% between the time you ship an export and the time it arrives… But businesses can purchase options to buy a foreign currency 30, 60, or 90 days in the future at today’s XR, thereby insuring themselves against short-term XR volatility Nevertheless, a reduction in investment is one possible consequence of currency misalignments 37

Free Capital Flow Fixed Exchange RateSovereign Monetary Policy Inconsistent/Unholy Trinity Or “Trilemma”: a country can only have 2 out of 3 of these USA PRC 38

Why is the US dollar special? 39

Overvaluation of the Dollar International reserve currency Early 1980s: Reagan’s fiscal expansion – cut taxes, increased spending  Current account deficit  Increased interest rates and capital inflows (from, e.g., Japan)  Value of the dollar goes up! Plaza Accord (fall 1985): G5 agreed to reduce the value of the dollar against the yen & mark by 10-12% – sell dollars if it appeared the value was going to increase By early 1987, dollar had depreciated 40% 40

Similar situation today US twin deficits: fiscal & current account Japan, Europe, China, current account surpluses  Finance the American deficit –US absorbs about 6% of the world’s savings US international investment position: –foreign-owned assets in 2007: $17.8 trillion –US residents’ foreign assets in 2007: $15.4 trillion –international investment position: –$2.4 trillion 41

What’s the worry? Catastrophe! Doubts about the solvency of American financial institutions & American assets  Foreign lenders reluctant to continue to accumulate dollar-denominated assets  Trigger massive sales of current holdings? 42

Hope? Competition for scarce resources pressures China to revalue? Forces the United States to tighten the belt? 43