1. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard1 of 28 CHAPTERS IN ECONOMIC POLICY Part. II Unit 6 Exchange Rate Regimes

2. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 28 Exchange Rate Crises Under Fixed Exchange Rates Exchange rate crises Let’s assume that a country is operating under a fixed exchange rate, and that its domestic currency is overvalued (because domestic inflation rate is higher than foreign inflation rate) Higher relative inflation implies a steady real appreciation and a steady worsening of NX 21-2

3. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 28 Exchange Rate Crises Under Fixed Exchange Rates Financial markets start believing that the monetary authorities will be forced to devalue domestic currency 21-2

4. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 28 Exchange Rate Crises Under Fixed Exchange Rates Expectations that a devaluation may be coming can trigger an exchange rate crisis The government and the Central bank have a few options: i) They can try to convince markets that they have no intention of devaluing

5. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 28 ii) The Central bank can increase the domestic interest rate However, to fully compensate the risk of a depreciation, usually substantial increases are needed Let us consider the following equation which provides a good approximation of the interest parity condition: i t = i t *  (E e t+1  E t )/E t

6. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 28 In other words, in equilibrium the domestic interest rate must be (approximately ) equal to the foreign interest rate minus the expected appreciation rate of the domestic currency, or (alternatively) equal to the foreign interest rate minus the expected depreciation rate of the foreign currency

7. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 28 Tipically, increases in domestic interest rate only partially compensate the market for the risk of a depreciation: large outflow of capital and loss of Central bank reserves ensue Eventually, the choice for the central bank becomes either to increase further the interest rate or to validate the market’s expectations and devalue

8. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 28 Case study: The 1992 EMS Crisis Started in 1979, the EMS was an exchange rate system based on fixed parities with bands Each member (among them France, Germany, Italy and starting from 1990, UK) had to maintain its exchange rate within narrow bands Although no currency was designated as an anchor, the Deutsche Mark and the German Central bank were the centre of the EMS

9. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 28 At the very beginning the EMS was characterized by many realignments (adjustment of parities) among member countries From 1987 to 1992, on the contrary, it worked well, with only two realignments In 1992, however, financial markets became convinced that more realignments were due Main reason: the reunification process in Germany had brought a substantial increase in demand and inflation in that country

10. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 28 In order to check inflation, the Bundesbank adopted a restrictionary monetary policy Germany’s EMS partner, however, needed lower interest rates to reduce increasing unemployment To financial markets, the position of these countries looked increasingly untenable This belief led in early September 1992 to speculative attacks on a number of currencies (financial investors started selling in anticipation of devaluation)

11. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 28 The monetary authorities of the countries under attack reacted by increasing interest rates This move did not prevent large capital outflows and large losses of foreign exchange reserves After a few weeks Italy and UK had to suspend their participation in the EMS. Spain devalued its currency

12. Chapter 21: Exchange Rate Regimes German Unification, Interest Rates, and the EMS Table 1 German Unification, Interest Rates, and Output Growth: Germany, France, and Belgium, 1990-1992 Nominal Interest Rates (%)Inflation (%) 199019911992199019911992 Germany8.59.29.52.73.74.7 France10.39.610.32.93.02.4 Belgium9.69.4 2.92.72.4 Real Interest Rates (%)GDP Growth (%) 199019911992199019911992 Germany5.75.54.85.74.52.1 France7.46.67.92.50.71.4 Belgium6.7 7.03.32.10.8 The nominal interest rate is the short-term nominal interest rate. The real interest rate is the realized real interest rate over the year – that is, the nominal interest rate minus actual inflation over the year. All rates are annual.

13. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 28 Choosing Between Exchange Rate Regimes The pros and cons of flexible vs. fixed exchange rates On the whole, flexible exchange rates appear to be preferable to fixed exchange rates: i) In the short run, under flexible exchange rates, monetary authorities are able to control the interest rate and the exchange rate ii) Also, under flexible exchange rates, a country is less vulnerable to speculative attacks 21-4

14. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 28 However: flexible exchange rates are characte- rized by high volatility and this has negative effects on the international trade and on domestic production In some circumstances (high economic integration, the need to enforce a disinflationary process) fixed exchange rates appear to be the right solution

15. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 28 The case for a common currency: when a group of countries is already highly integrated and aims at fostering the integration process, a common currency may be the right solution A common currency: i) reduces the transactions costs of trade ii) enhances competition iii) bring economic convergence

16. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 28 Common Currency Areas Properties of an optimal currency area (R. Mundell): A set of countries is an optimal currency area when one of these two conditions is satisfied: i) symmetric shocks Countries have to experience similar fluctuations of their economic activity

17. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 28 ii) High factor mobility Internal mobility of factors (particularly of labour) allows countries to adjust to shocks

18. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 28 A smooth functioning of a optimal currency area requires also a coordination of fiscal policies Furthermore, following asymmetric shocks (shocks affecting regions within a common currency area in a different way), substantial transfers of fiscal resources from the relatively prosperous regions towards the adversely affected regions are desirable to mitigate the burden of real adjustment

19. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 28 In the US: asymmetric shocks are quite common. However, US economy is characterized by an high factor mobility and by substantial interregional transfers of fiscal resources Euro zone: asymmetric shocks are quite common and, at the same time, the EU labour market is characterized by a low degree of mobility. Furthermore, interregional transfers of fiscal resources are not satisfactory

20. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 28 The Euro: a short history 1991-93: the Maastricht treaty. This treaty set several main convergence criteria for joining the EMU: i) The ratio of the annual government deficit to GDP must not exceed 3% ii) The ratio of gross government debt to GDP must not exceed 60% (if the target could not be achieved due to specific conditions, the ratio had to be approaching the reference value at a satisfactory pace).

21. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 28 iii) The inflation rate must be no more than 1.5% higher than the average of the three best performing (lowest inflation) member states of the EU iv) The nominal long-term interest rate must not be more than 2% higher than in the three lowest inflation member states. May 1998: 11 countries qualified (Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, the <netherlands, Portugal, Spain)

22. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 28 May 1998: 11 countries qualified (Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxembourg, the Netherlands, Portugal, Spain); 3 decided to stay out (UK, Denmark, Sweden); 1 did not qualify (Greece) January 1999: the parities between the 11 currencies and the euro were “irrevocably” fixed and the European Central Bank became responsible for monetary policy in the Euro zone 2001: Greece qualifies January 2002: euro coins and banknotes are introduced

23. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard23 of 28 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.

24. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard24 of 28 Dollarization is an extreme form of a “hard peg”: it is enacted by replacing the domestic currency with the dollar A less extreme way is the use of a currency board involving the central bank: under a currency board, i) the central bank is ready to buy and to sell any amount of foreign currency at the official exchange rate; ii) the central bank cannot engage in open market operations and anticipate any resource to the government

25. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard25 of 28 Currency boards are required to hold realizable financial assets in the reserve currency at least equal to the value of domestic currency

26. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard26 of 28 A case study: Argentina’s currency board: During the ’70s and early ’80s Argentina was characterized by hyperinflation and recession Early ’90s: in order to reduce inflation, the government decided to peg Argentina’s currency to the dollar (nominal exchange rate peso/dollar = 1) The currency board was at the beginning very successful: in 1994 Argentina was characterized by substantial price stability and by a strong output growth

27. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard27 of 28 However, in the second half of the ’90s: Substantial appreciation of the dollar (and of the peso) This brought a loss of competitiveness for Argentina  trade deficit  recession  worsening of fiscal deficit and of government debt As a consequence of an increasing default risk and exchange rate risk, financial investors asked very high interest rates  this increased the risk of default (self-fulfilling expectation)

28. Chapter 21: Exchange Rate Regimes © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard28 of 28 December 2001: default January 2002: the government let the peso fluctuate Substantial depreciation of the peso (3.75 pesos for dollar)  increase of the burden of debt  bankrupcies  severe recession (GDP growth rate in 2002 =  11%)