Macroeconomics I

Prof. Isaac Baley and Davide Debortoli

Open Economy
Mod.7: Exchange Rate Regimes
Outline

• Pros and Cons of Fixed Exchange Rates

• Real World Examples:

• German Reunification
• The Euro
• Hyperfinflation in Latin America
Implications of Fixed Exchange Rates
UIP 1+ i *
1+ i = E
Ee

➢ Fixed exchange rate

E = Ee = E ⇒ i =i *=i *

LOSS OF MONETARY INDEPENDENCE

The domestic interest rate must follow
the foreign interest rate!
Fixed Exchange Rates
PROS AND CONS, relatively to Flexible Exchange Rate

PROS: CONS:

• No independence of monetary policy

– Higher costs of recession
– Slower transition to Medium-Run
An Economic Crisis under Fixed Exchange Rate
In the Short Run

i i UIP0

Step 1: Drop in Demand

B A
iA=i* LM

IS
IS’
YB YA Y EA E

Step 1: Due to crisis (from A to B): Y↓, E=, i=

Step 2: The Central Bank CANNOT do anything!

With FIXED Exchange Rate, Monetary Policy

CANNOT be used to stimulate demand
An Economic Crisis with Fixed Exchange Rate
From the Short-Run to the Medium Run

i i UIP0

Short-Run

To Medium-Run
NX↑
iA=i* LM

IS
IS’
YB YA=Yn Y EA E

Starting Point: YA=Yn

Short-Run:
• Drop in demand, the IS shifts to the LEFT
• New equilibrium: YB<Yn, iA=i*
From the Short-Run to the Medium Run
P↓ à the real exchange rate ε↓ (since E is fixed) à NX ↑, IS shifts to RIGHT

Final outcome: Y=Yn, i=i*

From the Short-Run to the Medium Run

Fixed exchange rate Flexible exchange rate

E remains constant E adjusts to a new level
ε adjusts because P adjust ε adjusts because both P and E adjust
SLOWER Transition FASTER Transition
Loss of Monetary Independence:
The European Monetary System & the German Reunification
The Main Concern: Loss of Monetary Independence

A problem if:

1. Large heterogeneity among members of the union

How similar are the 19 countries in the Euro zone (e.g. compared with with US or Spain)?
… in the Euro-Area, large heterogeneity in fiscal policies

2. Low labor mobility

– Relative wages do not adjust
– High unemployment regions coexist with low unemployment ones
(i.e. slow adjustment towards medium-run equilibrium)
Heterogeneity in Fiscal Policy: Euro vs US
Evolution of Debt in Euro Area US Gov’t Debt Composition (2016)

Debt/GDP Ratio in Euro Area Debt/GDP Ratio in US states (2016)

read more
Labor Mobility: Euro vs. US
US: High mobility,
Cross-border mobility Small unemployment differentials

Euro: Low mobility,

Large unemployment differentials
Fixed Exchange Rates
PROS AND CONS, relatively to Flexible Exchange Rate

PROS: CONS:

• Build Reputation • No independence of monetary policy

Delegate monetary policy to countries – Higher costs of recession
with better reputation (otherwise
– Slower transition to Medium-Run
reputation only based on Central Bank’s
own actions
Fixed Exchange Rate and Reputation (1)
Interest Rate on 10-year Bonds in Europe

Germany France Italy Spain

Euro Conversion
Rates Fixed
14.00
Introduction of the EURO

12.00

10.00

8.00

6.00

4.00

2.00

0.00
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
-2.00

Source: Eurostat, October 2020

Fixed Exchange Rate & Reputation (2)
Latin America in 1980 - 2000
Fixed Exchange Rates
PROS AND CONS, relatively to Flexible Exchange Rate

PROS: CONS:

• Build Reputation • No independence of monetary policy

Delegate monetary policy to countries – Higher costs of recession
with better reputation (otherwise
– Slower transition to Medium-Run
reputation only based on Central Bank’s
own actions
• Self-fulfilling crisis
(Speculative Attacks)
Self-fulfilling Currency Crisis
• Suppose financial markets, even if there is no fundamental reason to do so, start
expecting a devaluation of the domestic currency, i.e. Ee<E.
•à i.e. even if i=i*, investors sell domestic currency (from UIP)

What can the central bank do?

Self-fulfilling Currency Crisis
• Suppose financial markets, even if there is no fundamental reason to do so, start
expecting a devaluation of the domestic currency, i.e. Ee<E.
•à i.e. even if i=i*, investors sell domestic currency (from UIP)

What can the central bank do?

Central Bank Balance Sheet
Assets Liabilities

Domestic Bonds B Money Supply Ms

Foreign Reserves F

1) Resists against the “attack” and keep exchange rate constant …

i.e. sell foreign reserves: F↓ and reduce money supply Ms↓… as a result i ↑and Y↓ (LM shifts up)

à Recession (… and reserves might not be enough!)

Case 1: The Central Bank Resists
UIP1
i i Ee↓ UIP0
Step 1: Expectations of Devaluations

Step 2: Monetary Contraction

LM1
i1
LM0
i0=i*

IS0
Y1 Y0
Y E0=E1=Ee0 E

Step 1: Financial markets expect devaluation: Ee↓(UIP shifts up)

Step 2: Central bank increases interest rate (LM shifts up)

Final outcome Y↓, i↑ , E=

Practice question (M7)

1+ i *
1+ i = E
Ee
Case 2: Central Bank Devaluates
UIP1
i i Ee↓ UIP0

LM0
i0=i* i0

IS1
IS0
Y0 Y1
Y E1=Ee1 E0=Ee0 E

Step 1: Financial markets expect devaluation: Ee↓(UIP shifts up)

Step 2: Central bank devaluate the currency, setting a new peg at E1=Ee1
Step 3: NX↑ and thus IS shifts to the right.

Final outcome: Y↑, i = , E↓

Self-fulfilling Currency Crisis
• Suppose financial markets, even if there is no fundamental reason to do so, start
expecting a devaluation of the domestic currency, i.e. Ee<E.
•à i.e. even if i=i*, investors sell domestic currency (from UIP)

What can the central bank do?

Central Bank Balance Sheet

Assets Liabilities

Domestic Bonds B Money Supply Ms

Foreign Reserves F

1) Resists against the “attack” and keep exchange rate constant …

i.e. sell foreign reserves: F↓ and reduce money supply Ms↓… as a result i ↑and Y↓ (LM shifts up)

à Recession (… and reserves might not be enough!)

2) Validate expectations, and devaluate

… even if there was no reason to do so initially
Speculative Attacks in the Real World
The European Monetary System (EMS) in September 1992
—> Fears of devaluations cause actual devaluations
Italy and UK exit EMS
Spain devalued
France resisted

22
Fixed Exchange Rates
PROS AND CONS, relatively to Flexible Exchange Rate

PROS: CONS:

• Build Reputation • No independence of monetary policy

Delegate monetary policy to countries – Higher costs of recession
with better reputation (otherwise
– Slower transition to Medium-Run
reputation only based on Central Bank’s
own actions

• Self-fulfilling crisis
(Speculative Attacks)

The Euro is a currency UNION!

à No need to defend the parity using reserves
à Speculative Attacks unlikely to succeed
Fixed Exchange Rates
PROS AND CONS, relatively to Flexible Exchange Rate

PROS: CONS:

• Build Reputation • No independence of monetary policy

Delegate monetary policy to countries – Higher costs of recession
with better reputation (otherwise
– Slower transition to Medium-Run
reputation only based on Central Bank’s
own actions

• Reduce Uncertainty
in International Trade • Self-fulfilling crisis
(Speculative Attacks)
Uncertainty in International Trade
(1 + i1t ) e (1 + i1t )(1 + ite+1 )(1 + ite+ 2 )..... (1 + ite+ n )
UIP : Et = Et +1 = Ete+ n +1
( 1t )
1 + i *
( 1t )( 1t +1 )( 1t +2 ) ( 1t +n )
1 + i *
1 + i * e
1 + i * e
...... 1 + i * e

FLEXIBLE EXCHANGE RATE: HIGH UNCERTAINTY

• Uncertainty about future interest rates and exchange rates

FIXED EXCHANGE RATE: LOW UNCERTAINTY

• No uncertainty about future exchange rates Et=Eet+1=…=Eet+n

Because of uncertainty, exchange rates can be very volatile, and thus

making it difficult for exporting and importing firms to operate (e.g.
decide how much to produce, how much to invest, etc.)
Fixed Exchange Rates
PROS AND CONS, relatively to Flexible Exchange Rate

PROS: CONS:

• Reduce Uncertainty • No independence of monetary policy

in International Trade – Higher costs of recession
– Slower transition to Medium-Run

• Self-fulfilling crisis
• Build Reputation (Speculative Attacks)
Delegate monetary policy to
countries with better reputation

No Advantage or Disadvantage in the Medium-Run

Real Exchange Rate is Flexible Anyway