Exchange rate regimes Many countries have some control on the exchange rate Completely flexible exchange rates would means that the rate is left to the market without governments’ interventions Monetary policy of central banks implicitly aim at certain exchange rate targets

Exchange rate regimes No exchange rate targets: US and Japan –Flexible exchange rate movements –Fed and BOJ do not ignore exchange rates but are willing to let them fluctuate (a lot) Fixed exchange rates: keep the same exchange with another foreign currency Peg: fixing the exchange rate –To a single currency (Argentina to the $ 91-01) –To a basket of currencies (with weights depending on trade)

Exchange rate regimes Fixed exchange rates “change” (devaluate or revaluate) at different frequencies Crawling Peg: predetermined rate of devaluation –If inflation is much higher at home than in the pegged currency’s country –Need to periodically devaluate to avoid real appreciation and lose competitiveness.

Exchange rate regimes European Monetary System (EMS): let exchange rates fluctuate within “bands” (lasted from 1978 to 1998) Central parity: the reference exchange rate within the bands –Changes in parity or bands may occur depending on circumstances Common currency area: different countries sharing one currency (one central bank)

Monetary Policy when pegging A government may announce a peg and: –Either control the official exchange rate (no currency “market”, but a black market) –Intervene in the exchange market to “defend” the peg value Interest parity condition: (1 + i) = (1 + i*)*(E/E e )

Monetary policy when pegging If the exchange rate is not expected to change then i=i* (approximately) –Assuming perfect capital mobility –Assuming expected E equals actual E By fixing the exchange rate a country forgoes its monetary policy as i must adjust to keep E fixed. Money demand: M/P = Y*L(i)

Monetary Policy when pegging Example: Y increases leading to an increase demand for money –In a flexible exchange rate the central bank can let i adjust –In a fixed exchange rate the central bank must increase M in order to keep i at par with i* Monetary policy as M adjusts depending on what happens to E, which depends on M*

Fiscal policy when pegging An increase in G (or cut in T) leads to an increase in nominal output (Y) Monetary policy needs to adjust (and expand) to keep i unchanged. Fiscal policy has accomodating monetary policy under fixed exchange rate Ho about the impact on prices?

The Central Bank Central Bank’s Liabilities: Money Base Central Bank’s Assets: Domestic Bonds and Foreign exchange reserves (foreign currency and foreign bonds) Changes in money supply can be met by either buying/selling: –Domestic bonds –Foreign reserves

Central Bank Open market operation: central bank buys gov. bonds in exchange of money Bond purchase leads to interest decrease Investors will now prefer foreign bonds To buy foreign bonds they exchange currency Currency depreciates Central bank sells foreign currency to keep fixed exchange rate

Fixed vs. Flexible With fixed exchange rate a country forgoes exchange rate policy and monetary policy. Why some countries opt for fixed rates? In the medium run prices adjust  = E (P/P*) Fixed exchange rate help stabilize domestic prices

Price adjustment with Fixed rates AD => Y = f[E(P/P*);G;T] –As the real exchange rate falls, output increases –Increase in G increases AD –Decrease in T increases AD In a closed economy monetary policy affects prices (interest rate channel) In an open economy the channel is the real exchange rate

Equilibrium in the medium run Short-Run: Aggregate Demand = Aggregate Supply Medium-Run: depends on real exchange rate  = E(P/P*) –With flexible rates E (nominal exch. rate) adjusts –With fixed rates E is fixed and P adjusts If P > P* (for a given E) then inflation will fall If P < P* (for a given E) then inflationary pressurs

Equilibrium in the medium run With a low “real” exchange rate Aggregate Supply will shift out (hence medium-run) As shifting out reduces prices which leads to a real exchange rate readjustment Flexible vs. Fixed exchange rate: –Flexible gives short-run adjustment in nom. E –Fixed gives medium-run adjustment in prices

Devaluations: Good or Bad? Medium run may be far away and this leads to devaluation pressures Devaluation spurs Aggregate Demand AD shifts out increasing output (and prices) Tradeoff: –Devaluation: short-run increase in output (P  ) –No Devaluation: medium run output increase (P  )