1. Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Why Exchange Rates Matter in a Crisis: Latvia vs. Czech Republic Posting prepared May 24, 2010 http://dolanecon.blogspot.com/ Terms of Use: You are free to use these slides in your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers. Check it out at http://www.bvtpublishing.com/disciplines.php?Economics

2. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Economic Crisis in Europe  The 27 countries of the European Union, like the United States, have been hit hard by the global economic crisis  But average figures for the EU tell only part of the story  We need also to ask what has caused the impact of the crisis to vary from country to country within the EU

3. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Fixed and Flexible Exchange Rates  Exchange rate policy is one factor that has made a big difference  16 EU countries are members of the euro area, and several others have currencies that are firmly pegged to the euro  Other EU countries have exchange rates that vary from day to day depending on supply and demand Source: Europa.eu

4. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ A Comparison: Latvia and the Czech Republic  The Czech Republic has a flexible exchange rate, while the Latvian exchange rate is firmly fixed to the euro  In the first years after joining the EU (2004-2007), both countries enjoyed a boom  The crisis caused a sharp recession in both countries, but the recession in Latvia was more severe  Why the difference?

5. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Exchange Rates in Latvia and the Czech Republic  After 2004, rapid growth and a strong inflow of capital caused appreciation of the Czech koruna.  In 2004, it took 33 koruna to buy one euro; by 2008, the koruna had strengthened to 23 per euro.  After 2008, the koruna depreciated sharply, back to almost 30 per euro at one point  During the whole period, the Latvian currency, the lats, remained firmly fixed at an exchange rate of.71 lats per euro Stronger Koruna

6. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Rapid Inflation in Latvia  In Latvia, the boom years after 2004 brought rapid inflation, the fastest in the EU  The fixed exchange rate kept interest rates low and helped fuel a housing bubble  Central bank actions to hold the exchange rate steady led to rapid growth of the money supply, further fueling inflation  Wages rose and the country lost competitiveness

7. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Low Inflation in the Czech Republic  In contrast, inflation in the Czech Republic remained low in the boom years, barely higher than the EU average  A stengthening exchange rate kept import prices low, holding average price increases down  Not needing to hold the exchange rate fixed, the Czech central bank was able to use monetary policy to avoid overheating of the economy

8. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ In Czech Republic, Exchange Rate Helps Absorb Impact of Crisis  When the global financial crisis hit, the Czech koruna depreciated sharply, from 23 per euro to almost 30 per euro  The depreciation absorbed much of the impact of the crisis by quickly improving the country’s competitiveness relative to its EU trading partners  Inflation slowed moderately, but there was no threat of deflation Weaker Koruna

9. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Crisis in Latvia Forces Adjustment through “Internal Devaluation”  The crisis hit Latvia much harder  With no change in the exchange rate, Latvia could restore competitiveness only through deflation  Restoring competitiveness through a fall in prices and wages is sometimes called a strategy of “internal devaluation”

10. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Consequences for Unemployment  “Internal devaluation” through deflation has been very painful to Latvia, and has brought soaring unemployment  The extra flexibility of a floating exchange rate has helped the Czech Republic adjust more smoothly to the crisis  Unemployment in Latvia is the highest in the EU, but in the Czech Republic, it has stayed below the EU average

11. Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Bottom Line  During good times, a fixed exchange rate is beneficial in promoting trade and economic integration  However, during a boom, a fixed exchange rate can contribute to overheating  When there is a sharp downturn, a flexible exchange rate can speed adjustment compared with the painful process of “internal devaluation” that a fixed-rate country must undergo