© 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando Quijano and Yvonn Quijano 21 C H A P T E R Exchange Rate Regimes

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Fixed Exchange Rates and the Adjustment of the Real Exchange Rate in the Medium Run 21-1  In the medium run, the economy reaches the same real exchange rate and the same level of output, whether it operates under fixed exchange rates or under flexible exchange rates.  Under fixed exchange rates, the adjustment takes place through the price level rather than through the nominal exchange rate.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Aggregate Demand Under Fixed Exchange Rates  The equilibrium condition in the goods market is:  The real interest rate and real exchange rate equal:  Under fixed exchange rates:  Then, the equilibrium condition becomes:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Aggregate Demand Under Fixed Exchange Rates  The focus of this chapter is on the real exchange rate, government spending, and taxes. Therefore, we simplify the relation above as follows:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Aggregate Demand Under Fixed Exchange Rates  In a closed economy, the price level affects output through its effect on the real money stock:  In an open economy, the price level affects output through its effects on the real exchange rate.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium in the Short Run and in the Medium Run Aggregate Demand and Aggregate Supply in an Open Economy Under Fixed Exchange Rates An increase in the price level leads to a real appreciation and a decrease in output: The aggregate demand curve is downward sloping. An increase in output leads to an increase in the price level: The aggregate supply curve is upward sloping. The aggregate supply relation is:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium in the Short Run and in the Medium Run Adjustment Under Fixed Exchange Rates The aggregate supply shifts down over time, leading to a decrease in the price level, to a real depreciation, and to an increase in output. The process ends when output has returned to the natural level of output.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium in the Short Run and in the Medium Run  So long as output is below the natural level of output, the price level decreases, leading to a steady real depreciation.  In the short run, a fixed nominal exchange rate implies a fixed real exchange rate.  In the medium run, a fixed nominal exchange rate is consistent with an adjustment of the real exchange rate through movements in the price level.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Case For and Against a Devaluation  The case for devaluation is that, in a fixed exchange rate regime, a devaluation (an increase in the nominal exchange rate) leads to a real depreciation (an increase in the real exchange rate), and thus to an increase in output.  A devaluation of the right size can return an economy in recession back to the natural level of output.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Case For and Against a Devaluation Adjustment with a Devaluation The right size devaluation can shift aggregate demand to the right, leading the economy to go to point C. At point C, output is back to the natural level of output, and the real exchange rate is the same as at point B.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Case For and Against a Devaluation  The case against devaluation points out that:  In reality, it is difficult to achieve the “right size” devaluation.  The initial effects of a depreciation may be contractionary.  The price of imported goods increases, making consumers worse off. This may lead workers to ask for higher nominal wages, and firms to increase their prices as well.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Return of Britain to the Gold Standard: Keynes Versus Churchill  The gold standard was a system in which each country fixed the price of its currency in terms of gold. This system implied fixed nominal exchange rates between countries.  Britain decided to return to the gold standard in This required a large real appreciation of the pound. Overvaluation of the pound among the reasons for Britain’s poor economic performance after World War I.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Exchange Rate Crises Under Fixed Exchange Rates  Higher inflation, or the steady increase in the prices of domestic goods, leads to a steady real appreciation and worsening of a country’s trade position.  Lowering the domestic interest rate triggers an increase in the nominal exchange rate, or nominal depreciation.  The size of the devaluation can be estimated using the interest parity condition. 21-2

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Exchange Rate Crises Under Fixed Exchange Rates  Under fixed exchange rates, if markets expect that parity will be maintained, then they believe that the interest parity condition will hold; therefore, the domestic and the foreign interest rates will be equal.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Exchange Rate Crises Under Fixed Exchange Rates  Expectations that a devaluation may be coming can trigger an exchange rate crisis. The government has two options:  Give in and devalue, or  Fight and maintain the parity, at the cost of very high interest rates and a potential recession.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The 1992 EMS Crisis  Realignments are adjustments of parities between currencies.  The September 1992 EMS (European Monetary System) Crisis was the belief that several countries were soon going to devaluate. Some countries defended themselves by increasing the overnight interest rate by up to 500%.  In the end, some countries devalued, others dropped out of the EMS, and others remained.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Exchange Rate Movements Under Flexible Exchange Rates  The current exchange rate depends on:  Current and expected domestic and foreign interest rates for each year over a given period.  The expected exchange rate at the end of the period. 21-3

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Exchange Rate Movements Under Flexible Exchange Rates  Factors that influence the current exchange rate include:  Any factor which moves the expected future exchange rate. For example, forecasts of the current account balance. Trade deficits may lead to a depreciation.  Any factor that moves current or expected future domestic or foreign interest rates. For example, anticipations of high short-term interest rates in the future.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Choosing Between Exchange Rate Regimes  In the short run, under fixed exchange rates, a country gives up its control of the interest rate and the exchange rate.  Also, anticipation that a country may be about to devalue its currency may lead investors to ask for very high interest rates.  An argument against flexible exchange rates is that they may move a lot and may be difficult to control them through monetary policy. 21-4

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Choosing Between Exchange Rate Regimes  In general, flexible exchange rates are preferable except when:  A group of countries is tightly integrated  A central bank cannot be trusted.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Common Currency Areas  For countries to constitute an optimal currency area, two conditions must be satisfied:  The countries experience similar shocks; thus, can choose roughly the same monetary policy.  Countries have high factor mobility, which allow countries to adjust to shocks.  A common currency, such as the Euro, allows countries to lower the transaction costs of trade.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Euro: A Short Story  The European Monetary Union (EMU) was consolidated under the Maastricht Treaty.  In January 1999, parities between the currencies of 11 countries and the Euro were “irrevocably” fixed.  The new European Central Bank (ECB), based in Frankfurt, became responsible for monetary policy for the Euro area.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Hard Pegs, Currency Boards, and Dollarization  One way of convincing financial markets that a country is serious about reducing money growth is a pledge to fix its exchange rate, now and in the future.  A hard peg is the symbolic or technical mechanism by which a country plans to maintain exchange rate parity.  Dollarization is an extreme form of a hard peg. A less extreme way is the use of a currency board involving the central bank.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Key Terms  gold standard, gold standard, gold standard,  realignments, realignments,  overnight interest rate, overnight interest rate, overnight interest rate,  optimal currency area, optimal currency area, optimal currency area,  Euro, Euro,  Maastricht Treaty Maastricht Treaty Maastricht Treaty  European Central Bank (ECB), European Central Bank (ECB), European Central Bank (ECB),  hard peg, hard peg, hard peg,  dollarization, dollarization,  currency board, currency board, currency board,