Lecture 14

Expectations and Exchange Rate Dynamics; the British

Devaluation of 1992; the Mexican Devaluation of 1994

Mundell-Fleming in (Y, r) Diagram

Uncovered Interest Parity
Exchange Rate Volatility
Collapse of the European "Exchange Rate Mechanism": increase in r*
Collapse of the Mexican Peso in 1994
What Is To Be DoneWhen the Peso Collapses?

Mundell-Fleming in (Y, r) Diagram

Note that the Mundell-Fleming model is, in sense, just our old IS-LM model with an
extra NX(e) term in the IS equation, and an extra restriction--r=r*--imposed by world
capital markets.

So what happens to force r = r*? Suppose that, at current exchange rates, the IS curve
(augmented by NX(e), but note: no *: IS, not IS*) and the LM curve intersect at r > r*?

M interest rates exceed world interest rates; money flows in; people bid up the price of M
assets--which is the same thing as the exchange rate rising. And as the exchange rate
rises, the IS curve shifts in and to the left because the trade balance deteriorates.
Equilibrium? When the exchange rate has risen enough to move IS back far enough that
there is no desired short-term speculative capital inflow. (Distinguish between
"speculative" and "fundamental" capital inflows).
Uncovered Interest Parity

Exchange rates, since the early-1970s breakdown of the Bretton Woods fixed exchange
rate system, have been much more volatile than anyone had predicted. Why? A bunch of
reasons--one that governments were let loose to pursue independent monetary policies.
But here I want to focus on expectations and exchange rate dynamics.

Begin by noting that so far we have assumed a fixed exchange rate that sometimes jumps
in response to shocks. This seems inconsistent. Suppose that people have a pretty good
idea about what the long-run exchange rate is going to be--call it e*--and notice
differences beween e, the current exchange rate, and e*.expected exchange rate
movements:

Invest in the foreign country, and earn r*

Invest in the home country, and earn r plus or minus the expected exchange rate
movement: e*- e

So that the right equation to go alongside of:

Y = C(Y-T) + I(r) + G + NX(e)

and

M/P = L(i, Y)

isn't r=r*, but is instead:

r = r* + (e - e*)

When e is above e*, the exchange rate is expected to depreciate, and so domestic real
(and nominal) interest rates will be higher than world market values. When e is below e*,
the exchange rate is expected to appreciate.
Implications?

The higher is the exchange rate e, the higher are domestic interest rates--and so the LM*
curve is upward sloping... It rotates clockwise around its intersection with the e=e* line...
Call this curve--allowing for expected exchange rate changes and their effects on
domestic interest rates--LM**

The higher is the exchange rate e, the higher are domestic interest rates--and the lower is
investment. So the IS* curve also rotates, in this case counterclockwise, around its
intersection with the e=e* line. Call this curve--allowing for expected exchange rate
changes and their effects on domestic interest rates--IS**

If the current exchange rate is above e*, then domestic interest rates will be somewhat
higher--and the exchange rate somewhat lower--than in the static expectations case. If the
current exchange rate is below e*, then the exchange rate will be somewhat higher--and
the domestic interest rate somewhat lower--than in the static expectations case.

Exchange Rate Volatility

So let's take a look back at the case we considered at the end of last week: sudden
increase in foreign interest rates r*; giving the government a choice between recession (as
they pull LM curve back to keep exchange rate from falling) or decline in the exchange
rate. And suppose everyone expects that in the long run the exchange rate will decline.

So the rise in foreign interest rates pulls the IS* curve down and to the left, and also
pushes the e* curve, the equilibrium long-run exchange rate line, downward. Then we
move to the IS** curves and LM** curves by rotating the IS* and LM* curves
counterclockwise and clockwise, respectively, around their intersections with the new e*
line.

We find that the current exchange rate e falls, and falls by a lot--by more than the decline
in e*. Why? Well look back at your new foreign exchange market equilibrium condition:
r = r* + (e - e*)

If r were equal to or greater than r*--that would mean that the government had responded
to the increase in r* by inflicting equal or greater degrees of monetary contraction on the
domestic economy. In which case the LM* curve would have shifted in by enough (or
more than enough) to maintain the previous exchange rate. Hence no expectations of LR
devaluation--and no fall in the e* line.

The whole point of letting e fall was to keep r from having to rise as much as r*--and to
avoid the recession that would come when it did.

Hence the exchange rate "overshoots" its long-run value: falls more than its long-run
value falls, and then slowly climbs back up.

Under a floating rate system, not only do exchange rates shift because governments
follow inconsistent monetary policies, but exchange rates fluctuate much more than do
"LR equilibrium" rates because of overshooting.

Rudiger Dornbusch saw this in the early 1970s, before our current experience with
flexible exchange rates more than a couple of years old. Rudiger Dornbusch really
smart...

Collapse of the European "Exchange Rate Mechanism": increase in r*

All this applies very neatly to the collapse of the ERM in Britain in late 1992: Britain
wound up with (a) an undervalued exchange rate (expected to appreciate), low domestic
interest rates, and something of a small boom...

All this does not apply neatly to Mexico at the end of 1994--even though the analogies
with Britain appear quite close...

Collapse of the Mexican Peso in 1994

But things can get more complicated and more difficult very quickly. Suppose, for
example, that we have:

r = r* + (e - e*) + (risk premium); and suppose that the risk premium = s(e(1) - e(2))--that
people are scared of the fall in the exchange rate
possibly because they are irrational "positive feedback" traders
possibly because large moves in exchange rates bankrupt lots of people in the domestic
economy
possibly because they fear that--even if it is irrational--that others will stampede out and
make it impossible to get their money...
If the risk premium turns out to move faster and stronger in response to devaluation, then
you have Stanley Fischer's nightmare...

There is No Exit

Stanley Fischer's moment of terror

What Is To Be Done When the Peso Collapses?

So what do you do? You calm people down. You point out that there is a perfectly good
equilibrium out there in which the economy is fine--that in large part the risk premium
has risen so far for no reason other than the fact of its rise.

When worse comes to worst, you provide liquidity--and hope that it is a liquidity crisis,
not a solvency crisis, and that the high real interest rates reflect fear of the crisis itself and
panic and not knowledge by the market of bad news that you do not yet know.

When it works, it is one of the few free lunches out there that economists can actually
help the world obtain...

Economics 100b; Spring 1996; Brad DeLong

1. Why, in the Mundell-Fleming model, is the LM* curve a vertical line?

2. Suppose that, in the Mundell-Fleming model, the equilibrium exchange rate is above
the level e' at which the central bank wishes to keep the currency. Suppose that the
central bank takes steps to peg the exchange rate to e'. Which curves shift--the IS*, the
LM*, or both--and why?

3. What must be true about elasticity of demand for imports and exports, if net exports
are to be a decreasing function of the real exchange rate?

4. Suppose exchange rates are fixed: is the imposition of a tariff expansionary or

contractionary? Suppose exchange rates are flexible. Is the answer the same? Why or
why not?

5. In the Mundell-Fleming model under flexible exchange rates, what happens to

production, the exchange rate, and the trade balance if the world interest rate r* suddenly
rises?

6. In the Mundell-Fleming model under fixed exchange rates, what happens to

production, the exchange rate, and the trade balance if the world interest rate r* suddenly
falls?

The Mundell-Fleming model can be used to analyze California's relationship with the rest
of the country--if we consider California to be a "small open economy" with a fixed
exchange rate to the rest of the U.S.:

7. Suppose that the state government had used "fiscal policy" to try to alleviate the
depression of 1991-1993 in California by cutting state taxes and expanding spending.
Does the Mundell-Fleming model predict that such a policy would have been a successful
anti-California depression policy? Why or why not?

8. Suppose that the state government has used "monetary policy" to try to alleviate the
depression of 1991-1993 in California by reducing reserve requirements of state-
chartered banks--so that such banks would be able to support a larger supply of deposits
and loans. Does the Mundell-Fleming model predict that such a policy would have been a
successful anti-California depression policy? Why or why not?