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Exporting US Inflation: 1966–1972. Effect on Internal and External Balance of a Rise in the Foreign (US) Price Level, P*. The “simple” solution for the £, M, ¥, FF, … Revalue against the $ Let the $ depreciate. The Case for Floating Exchange Rates.

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effect on internal and external balance of a rise in the foreign us price level p
Effect on Internal and External Balance of a Rise in the Foreign (US) Price Level, P*
  • The “simple” solution for the £, M,
  • ¥, FF, …
  • Revalue against the $
  • Let the $ depreciate
the case for floating exchange rates
The Case for Floating Exchange Rates
  • Monetary policy autonomy…w/o capital controls
    • Each country can choose “appropriate” long-run inflation rate
  • Symmetry
    • $ can “devalue” as necessary…not constrained as leader
  • Exchange rates as automatic stabilizers
    • Floating cushions output against real shocks
      • Something’s gotta adjust…if not E, then Y
    • Temporary reduction in demand for country’s exports

 depreciation attenuates output reduction

slide4

Exchange rate, E

2

E2

DD2

DD2

(a) Floating

exchange rate

DD1

DD1

Y1

Y1

Y2

Output, Y

Exchange rate, E

(b) Fixed

exchange rate

3

1

1

E1

E1

AA1

AA1

AA2

Y2

Y3

Output, Y

Effects of a Temporary Fall in Export Demand

Depreciation

leads to higher

demand for and

output of

domestic products

Fixed exchange

rates mean output

falls as much as

the initial fall in aggregate demand

the case for floating exchange rates1
The Case for Floating Exchange Rates
  • Monetary policy autonomy…w/o capital controls
    • Each country can choose “appropriate” long-run inflation rate
  • Symmetry
    • $ can “devalue” as necessary…not constrained as leader
  • Exchange rates as automatic stabilizers
    • Floating cushions output against real shocks
      • Something’s gotta adjust…if not E, then Y
    • Temporary reduction in demand for country’s exports

 depreciation attenuates output reduction

    • Permanent reduction in demand for country’s exports

 depreciation restores equilibrium automatically

the case against floating exchange rates
The Case Against Floating Exchange Rates
  • Lack of discipline
  • Destabilizing speculation
    • Hot money

…but “fundamental disequilibrium”  one-way bet under fixed rates

    • A “vicious circle” of depreciation and inflation.

E deprec Pim up CoL up W up P up  E deprec

    • Floating exchange rates make a country more vulnerable to money market disturbances…that’s the tradeoff:

L up  R up  E-apprec.  CA & Y down

slide7

Exchange

rate, E

DD

1

E1

2

E2

AA2

AA1

Output, Y

Y2

Y1

A Rise in Money Demand Under a Floating Exchange Rate

the case against floating exchange rates1
The Case Against Floating Exchange Rates
  • Lack of discipline
  • Destabilizing speculation
    • Hot money

…but “fundamental disequilibrium”  one-way bet under fixed rates

    • A “vicious circle” of depreciation and inflation.

E deprec Pim up CoL up W up P up  E deprec

    • Floating exchange rates make a country more vulnerable to money market disturbances…that’s the tradeoff:

L up  R up  E-apprec.  CA & Y down

      • Recall: fixed rates cushion output against monetary shocks

L up  M up  nothing shifts under fixed rates

the case against floating exchange rates2
The Case Against Floating Exchange Rates
  • Injury to International Trade and Investment
    • Exchange rate risk
        • But forward markets can protect traders against foreign exchange risk.
        • International investments face greater uncertainty about payoffs denominated in home country currency.
  • Uncoordinated Economic Policies
    • Countries can engage in competitive currency depreciations.
    • A large country’s fiscal and monetary policies affect other economies

…aggregate demand, output, and prices become more volatile across countries if policies diverge.

macroeconomic interdependence under floating rate the large country case
Macroeconomic Interdependence Under Floating RateThe Large Country Case
  • Effect of a permanent monetary expansion by US
    • $ depreciates, US output rises
    • Small country’s output may rise or fall.

Its currency appreciates  Its CA and output decrease

US economy expands It sells more to US  Its output rises

  • Effect of a permanent fiscal expansion by US
    • US output rises, US currency appreciates
    • Small country’s output rises

Its currency depreciates  Its CA and output rise

US economy expands  It sells more to US  Its output rises

Large Country => Locomotive

the case against floating exchange rates3
The Case Against Floating Exchange Rates
  • Injury to International Trade and Investment
    • Exchange rate risk
        • But forward markets can protect traders against foreign exchange risk.
        • International investments face greater uncertainty about payoffs denominated in home country currency.
  • Uncoordinated Economic Policies
    • Countries can engage in competitive currency depreciations.
    • A large country’s fiscal and monetary policies affect other economies

…aggregate demand, output, and prices become more volatile across countries if policies diverge.

  • Free Float Really Managed Float
    • Fear of depreciation – inflation spiral  intervention
more case against floating exchange rates
More Case Against Floating Exchange Rates
  • Speculation and volatility in the foreign exchange market
    • Expectation of depreciation in short-run
    •  Rush to sell currency
    •  Depreciation in short-run
    • … and recovery to fundamental value in long-run
    • High nominal and real exchange rate volatility under floating
    • Violation of Purchasing Power Parity
    • Disruption of trade ???
nominal and real effective dollar exchange rate indexes 1975 2010 purchasing power parity
Nominal and Real Effective Dollar Exchange Rate Indexes, 1975–2010Purchasing Power Parity???

Source: International Monetary Fund, International Financial Studies.

milestones a floating
Milestones ‘a Floating

Plaza Accord

Louvre Accord

  • Black Monday
  • Japan Bubble
  • S & L Debacle

Berlin Wall Down

  • Maastricht
  • ERM Crisis

Tequila Crisis

Emerging Mkt Boom

East Asia Crisis

  • Contagion
  • LTCM

Dot.com bubble

  • US Capital Inflow
  • US CA Deficit
  • Greenspan Put

Global Savings Glut

  • China rising
  • Developed country aging
  • Reserve buildup
  • Tech slowdown

GlobalHousing

Bubble

  • Leveraging
    • US Saving down

C R I S I S

  • Deleveraging

The Great Recession

Rush to safety

Vietnam Expansion

  • Inflation
  • Commodity price boom

F L O A T I N G

Yom Kippur War

O i l S h o c k

Stop – Go Inflation

  • Recycling petrodollars

America Held Hostage

2nd O i l S h o c k

Volcker Disinflation

  • Twin Deficits
  • Rust Belt
  • Lost Decade