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Lecture 16 Fixed versus Floating Exchange Rates

Lecture 16 Fixed versus Floating Exchange Rates. Econ 340. Outline: Fixed versus Floating Exchange Rates. Both Systems Are Used What the “Experts” Recommend Pros and Cons of Floating Disruption When Rates Move Automatic Adjustment Pros and Cons of Pegging Stability Instability

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Lecture 16 Fixed versus Floating Exchange Rates

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  1. Lecture 16 Fixed versus Floating Exchange Rates Econ 340

  2. Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating • Disruption When Rates Move • Automatic Adjustment • Pros and Cons of Pegging • Stability • Instability • Alternatives • Crawling Peg • Monetary Unification • The Problem of Undervalued Currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  3. Who Uses Fixed and Float • Lessons from the list of exchange arrangements (below) • Floating rates are used by many countries • Rich & poor • Large & small • All over the world • Pegged rates are used today mostly by small countries • Many countries are between fixed and floating (Source of table below: IMF, “Annual Report on Exchange Arrangements and Exchange Restrictions 2013”) Econ 340, Deardorff, Lecture 16: Fixed/Float

  4. Exchange Arrangementsof Sample Countries, as of 2013 Econ 340, Deardorff, Lecture 16: Fixed/Float

  5. Exchange Arrangementsof Sample Countries, as of 2013 Between Floating and Pegged: Econ 340, Deardorff, Lecture 16: Fixed/Float

  6. Exchange Arrangementsof Sample Countries, as of 2013 More Fixed than Pegged: • Currency Board • Peg to another currency • Vary money supply automatically with changes in international reserves (= forced nonsterilization) Econ 340, Deardorff, Lecture 16: Fixed/Float

  7. Pegged Float More Fixed More Flexible Econ 340, Deardorff, Lecture 16: Fixed/Float

  8. Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating • Disruption When Rates Move • Automatic Adjustment • Pros and Cons of Pegging • Stability • Instability • Alternatives • Crawling Peg • Monetary Unification • The Problem of Undervalued Currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  9. What “Experts” Recommend • Some favor freely floating rates • Let exchange rate adjust to fix imbalances • “Let the market work” • Others favor perfectly fixed rates • Define currency rigidly in terms of something you can’t control • Gold • Foreign currency (“Currency Board”) • AND give up control of the money supply • Let flows of money fix imbalances i.e., do not sterilize! Econ 340, Deardorff, Lecture 16: Fixed/Float

  10. What “Experts” Recommend • Advocates of floating rates • Milton Friedman (Nobel Prize 1976): “A country that enters into a hard-fixed rate bears an economic cost. The cost is discarding a means—a flexible exchange rate—of adjusting to external forces that impinge on it differently than on the other country or countries whose currency it shares.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  11. What “Experts” Recommend • Advocates of floating rates • Jeffrey Sachs: “Once reserves are gone, investors panic. The worst mistake is for countries to wait too long to float their currencies.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  12. What “Experts” Recommend • Advocates of fixed rates • Robert Mundell (Nobel Prize 1999): “A world currency of some sort has existed for most of the past 2,500 years. Two thousand years ago, in the age of Caesar Augustus, it was the Roman aureus... A hundred years ago it was the gold sovereign. Less than thirty years ago it was the 1944 gold dollar. The world has been without a universal currency for only a tiny fraction of its history.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  13. What “Experts” Recommend • Milton Friedman: “If [over the last 30 years] the Canadian dollar had been rigidly tied to the US dollar, those differences would have required Canada to deflate relative to the United States, with unfortunate consequences for Canada that would have strained, to put it mildly, the trade relations between the two countries, and have put strong pressure on Canada to devalue or float.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  14. What “Experts” Recommend • Robert Mundell: “Exchange rate uncertainty imposes a cost of trade much like a tariff ... If Canada and the United States shared a stable common currency or an irrevocably fixed exchange rate, Canada’s real income would soar, closing a large part of the gap between the two countries’ GDP per capita.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  15. What “Experts” Recommend • “Bradford DeLong, an economic historian at the University of California at Berkeley, explains the debate to his students this way: ” (WSJ) To Mr. Friedman, an exchange rate is a price; therefore, it is an infringement on human freedom to peg it. To Mr. Mundell, an exchange rate is a promise; to change it is to default on a commitment. Econ 340, Deardorff, Lecture 16: Fixed/Float

  16. What “Experts” Recommend • Allan Meltzer (Carnegie-Mellon): “The best you can say of what economic research has produced is: • You can make a case for freely floating exchange rates if you’re willing to live with the consequences. • You can make a case for fixed exchange rates if you’re willing to live with the consequences. • You can’t make much of a case for anything in between.” (WSJ) Econ 340, Deardorff, Lecture 16: Fixed/Float

  17. What “Experts” Recommend • Where they agree: An “adjustable peg” is worse than both fixed and floating rates • Friedman: “The reasons why a pegged exchange rate is a ticking bomb are well known.” • Mundell: “I have never nor ever would advocate a general system of “pegged” rates. Pegged rate systems always break down.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  18. Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating • Disruption When Rates Move • Automatic Adjustment • Pros and Cons of Pegging • Stability • Instability • Alternatives • Crawling Peg • Monetary Unification • The Problem of Undervalued Currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  19. Pros and Cons of Floating • Con: Exchange rates DO MOVE; And when they do, they cause • Macro effects (as we saw last time) • Depreciation • Stimulates aggregate demand, but not necessarily when needed: may just cause inflation • Changes values of assets and liabilities • Appreciation • Reduces aggregate demand, may cause recession Econ 340, Deardorff, Lecture 16: Fixed/Float

  20. Pros and Cons of Floating • Con: Exchange rates DO MOVE; when they do, they cause • Micro effects: exports and imports subject to • Uncertainty • Instability Costly for traders Like trade barrier Reduces trade Econ 340, Deardorff, Lecture 16: Fixed/Float

  21. Pros and Cons of Floating • Example: The US dollar rose 50% during 1980-1985 • Caused US auto and other industries to contract • Major dislocation in middle US • Ended in 1985 when in “Plaza Accord” major central banks agreed to intervene Econ 340, Deardorff, Lecture 16: Fixed/Float

  22. Pros and Cons of Floating • Pro: Exchange rate provides efficient and automatic across-the-board adjustment • Suppose that, due to inflation, our prices are too high, causing our imports to rise and exports to fall • Exchange depreciation fixes this for all sectors • With fixed rates, individual prices and wages would have to fall to become competitive: much more painful • That’s what Greece and other weak countries in the EU are have had to do recently. • Called “internal devaluation” • Floating Permits countries to have independent monetary policies to deal with macroeconomic shocks Econ 340, Deardorff, Lecture 16: Fixed/Float

  23. Pros and Cons of Floating • Experience with exchange rates in the 1930s (not really floating, but they moved a lot) made governments prefer fixed rates • After WWII, IMF was created, based on Pegged Exchange Rates • Most currencies pegged to US $ • IMF helped countries manage this • When in trouble, countries devalued Econ 340, Deardorff, Lecture 16: Fixed/Float

  24. Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating • Disruption When Rates Move • Automatic Adjustment • Pros and Cons of Pegging • Stability • Instability • Alternatives • Crawling Peg • Monetary Unification • The Problem of Undervalued Currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  25. Pros and Cons of Pegging • Pro: If it succeeds, exchange rate is stable, avoiding disruptions • Con: If it fails, • devaluation causes instability, • just like floating rates, only worse • The Problem: Pegged Rates are Prone to Crisis Econ 340, Deardorff, Lecture 16: Fixed/Float

  26. Pros and Cons of Pegging • Why Crisis? • Pegged rate does not respond to market changes • Some currencies become undervalued, others overvalued • Inevitable unless all countries have exactly the same rate of inflation • Crisis eventually erupts for overvalued currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  27. Pros and Cons of Pegging • Why Crisis for Overvalued Currency? $/€ • Central bank must sell foreign currency • Since reserves are finite, they eventually run out • Market knows that when they do… S€ E0 E* Fed sells € D€ Q€ Econ 340, Deardorff, Lecture 16: Fixed/Float

  28. Pros and Cons of Pegging • Why Crisis for Overvalued Currency $/€ • Intervention will stop • Currency will depreciate • Knowing this, people don’t want to hold the overvalued currency, so… S€ E0 E* D€ Q€ Econ 340, Deardorff, Lecture 16: Fixed/Float

  29. Pros and Cons of Pegging • Why Crisis for Overvalued Currency $/€ • Before reserves run out, capital outflow increases demand • And reserves fall faster • “Speculative Attack” S€ E0 E* D€1 Fed sells more € D€ Q€ Econ 340, Deardorff, Lecture 16: Fixed/Float

  30. Pros and Cons of Pegging • Pegged rates offer speculators a “one-way bet” • Once they see that reserves are falling… • … they bet on a devaluation by selling the country’s currency • If they are right, they win • If they are wrong, they break even (since the exchange rate doesn’t change) • They can’t lose, so they bet a lot Econ 340, Deardorff, Lecture 16: Fixed/Float

  31. Pros and Cons of Pegging • Crisis even without Overvaluation • Crisis only requires expectation of devaluation • The expectation doesn’t have to be justified; it only has to be believed • Can happen even to a currency that is not overvalued • How? By “contagion”. • If one country has a crisis, for whatever reason • Other countries that are near it, or similar to it, may become suspect • That’s part of what happened in the Asian Crisis that started in 1997 • Some countries fear contagion today Econ 340, Deardorff, Lecture 16: Fixed/Float

  32. Pros and Cons of Pegging • Result: “Pegged Rates” are not Fixed • In a world of pegged exchange rates, over time • Some currencies become undervalued • Other currencies become overvalued • Why? Many reasons (see Makin) • Bretton Woods: US inflation caused dollar to become overvalued • Europe in the 1990s: German tight money after reunification, caused others to become overvalued Econ 340, Deardorff, Lecture 16: Fixed/Float

  33. Pros and Cons of Pegging • Result: “Pegged Rates” are not Fixed • Overvalued currencies are subject to speculative attacks • When they do devalue, they do it • Suddenly • By large amounts • This is just as disruptive as changes in a floating rate, perhaps more so Econ 340, Deardorff, Lecture 16: Fixed/Float

  34. Pros and Cons of Pegging • The choice is not between fixed and floating: E Time Econ 340, Deardorff, Lecture 16: Fixed/Float

  35. Pros and Cons of Pegging • The choice is between pegged and floating: E Which is more stable? Time Econ 340, Deardorff, Lecture 16: Fixed/Float

  36. Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating • Disruption When Rates Move • Automatic Adjustment • Pros and Cons of Pegging • Stability • Instability • Alternatives • Crawling Peg • Monetary Unification • The Problem of Undervalued Currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  37. Alternatives • Mixtures of pegged and floating rates • Crawling peg • Change the pegged rate slowly and predictably in response to a fall or rise in reserves • Slow movement of the peg is supposed to stop the loss of reserves before crisis hits • Still subject to speculative attack Econ 340, Deardorff, Lecture 16: Fixed/Float

  38. Alternatives • Mixtures of pegged and floating rates • Wider band • Let the rate move freely in a large band around the official pegged rate • Less intervention should be needed • Does not help if country has, say, higher inflation than others: crisis still inevitable Econ 340, Deardorff, Lecture 16: Fixed/Float

  39. Alternatives • Truly Fixed Exchange Rate • Use another country’s currency “Dollarization” • Form a monetary union The Eurozone (we’ll look more at this next week) Econ 340, Deardorff, Lecture 16: Fixed/Float

  40. Alternatives • Truly Fixed Exchange Rate • Currency Board • Peg to another currency • Replace central bank with “board” that automatically varies money supply one-for-one with international reserves • If reserves fall, so does money supply, forcing adjustment • This mimics the Gold Standard, where gold flowed among countries Econ 340, Deardorff, Lecture 16: Fixed/Float

  41. Alternatives • Truly Fixed Exchange Rate • Currency Board • How it’s supposed to work • If exchange rate is over-valued (excess demand for foreign currency) • Currency board sells reserves • This reduces the domestic money supply 1-for-1 • Falling money causes falling income and prices • Imports fall, exports rise, and excess demand for foreign currency disappears • If exchange rate is under-valued: Opposite Econ 340, Deardorff, Lecture 16: Fixed/Float

  42. Alternatives • Truly Fixed Exchange Rate • Currency Board • Didn’t work for Argentina, which had a crisis anyway • Must not have followed the rules Econ 340, Deardorff, Lecture 16: Fixed/Float

  43. Alternatives • Pegged Rate with Capital Controls • Why did pegged rates work in the 1950s & 60s? • Most countries had capital controls • In spite of that, the system of pegged rates didn’t work perfectly: there were some crises • Capital controls prevent inflow and outflow of capital, and thus limit speculation • Today, most countries see capital controls as too costly • But not all: China, Malaysia Econ 340, Deardorff, Lecture 16: Fixed/Float

  44. Alternatives The Impossible Trinity Policy: Full Capital Controls See Frankel (This is the Missing Figure 3) Goal: Monetary Independence Increased Capital Mobility Goal: Exchange Rate Stability Policy: Pure Float Policy: Monetary Union Goal: Full Financial Integration Econ 340, Deardorff, Lecture 16: Fixed/Float

  45. Exchange Rates Since 1945 • See reading by Buttonwood (column in The Economist) • Bretton-Woods System, 1945-1971 • Overseen by IMF • Currencies were pegged, mostly to US $ • Capital mobility was restricted, but gradually liberalized over time • Frequent crises, as currencies became overvalued due to inflation Econ 340, Deardorff, Lecture 16: Fixed/Float

  46. Exchange Rates Since 1945 • August 15, 1971: • Nixon cut the link of US $ to gold, signaling the end of pegged rates • Countries stopped pegging, then restarted at different rates, but by 1973 they had given up Econ 340, Deardorff, Lecture 16: Fixed/Float

  47. Exchange Rates Since 1945 • Since 1973, major currencies have floated • Exchange rates moved more than expected • Crises did not disappear • Monetary policy became more free: • “ ‘the Greenspan put’: the use of interest-rate cuts to rescue financial markets, in effect underwriting asset prices.” Econ 340, Deardorff, Lecture 16: Fixed/Float

  48. Outline: Fixed versus Floating Exchange Rates • Both Systems Are Used • What the “Experts” Recommend • Pros and Cons of Floating • Disruption When Rates Move • Automatic Adjustment • Pros and Cons of Pegging • Stability • Instability • Alternatives • Crawling Peg • Monetary Unification • The Problem of Undervalued Currencies Econ 340, Deardorff, Lecture 16: Fixed/Float

  49. The Problem of Undervalued Currencies • Overvalued currencies lead to crisis • In that sense they are self correcting, since countries are forced, eventually, to devalue or float • Undervalued currencies • Do not lead to crisis, but only to accumulation of reserves • May be viewed as harmful to trading partners Econ 340, Deardorff, Lecture 16: Fixed/Float

  50. The Problem of Undervalued Currencies • Today, the Chinese yuan is considered undervalued • US administration puts pressure on China to appreciate • US Congress threatens to restrict imports Econ 340, Deardorff, Lecture 16: Fixed/Float

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