feb 10 2004 lesson 3 by john kennes international monetary economics
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Feb 10 2004
Class cancelled on Feb 12, 2004.
Neil Thygesen is giving a talk at the end of the month. Feb 27
Announcements
Feb 10 2004
Grading formula: Percentage score = .3 (project) + .7 (exam)
0-30%: 0031-40%: 0341-50%: 0551-60%: 0661-70%: 0771-80%: 0881-88%: 0989-93%: 1094-98%: 1199-100%: 13 Additional 11’s and 13’s will be given on a
discretionary basis.
Announcements
Feb 10 2004
What are the choices?What theory is relevant to understanding the choicesWhat are the policy implications?
The Choice of an Exchange Rate Regime
Feb 10 2004
Long-Run: real and monetary sphere separated
Neutrality of moneyPurchasing power parity
Short-Run: real and monetary spheres interfere
The interest and exchange rate connection(Money and exchange rate policy can deal with undesirable
fluctuations)
Exchange rates and Monetary Policy
Feb 10 2004
Money, the price level and te exchange rate tend to move
proportionately in the long run
Feb 10 2004
AD: inflation erodes purchasing power of money and therefore discourages consumption and investment
AS: Price setting – In boom times prices are jacked up, more workers hired, wages go up
In the long run W/P settles back down.
How the AD-AS model works
Feb 10 2004
The real exchange rate:
– Defined as EP/P*– PPP: E offsets changes in P/P*– So is constant
Many caveats though
Neutrality of Money implication: PPP
Feb 10 2004
Japan versus US, 1953-2002
Inflation difference: 0.2% US-JapanAppreciation rate: 1.7%
Why?
Explanation: Japan produced higher quality goods that could be sold
at higher prices – (a measurement issue)
Caveat: Balsa-Samuelson Effect
Feb 10 2004
Nominal exchange rate volatilePrices are much more sticky
What about the real interest rate?
Volatile fluctuations in the real exchange rate
Implication of sticky prices
Feb 10 2004
M increases -> credit abundant - > i falls
Domestic
Households take advantage of lower interest rates to borrow and spend
Firms step up investment (Stock prices also typically increase)
International
Investors move assets out of the country where yields are more appealing
Capital outflow results in a depreciation -> high competitiveness
Interest and exchange rate connection - effects
Feb 10 2004
1. The interest rate channel2. The credit channel3. Stock market channel4. Exchange rate channel
Expansion fuels inflation (lags of 2 years of more, because prices are
sticky)
4 Channels
Feb 10 2004
Price increases -> real appreciation -> competiveness declines – trade
deficit
Central bank is intervening: Selling part of its reserves and buying
back its own currency -> reducing (reabsorbing) the money supply
Efforts by Central bank to expand the money supply are thwarted by
the need to conduct off-setting foreign exchange rate operations
Effects are radically altered under fixed exchange rates
Feb 10 2004
IS curve: goods market equilibrium
A decline in the interest rate results in more output
LM curve: money market equilibrium
Higher output gap raises demand for money
IS-LM
Feb 10 2004
Interest rates initially lower because LM curve shifts out
Capital is flowing out, because of lower interest rates
What happens next depends on the exchange rate regime
IS-LM: An increase in the money supply
Feb 10 2004
Fiscal policy: cut taxesIS curve shifts upDomestic assets become attractive
If the exchange rate is fixed, CB finds capital inflow creates pressure
towards appreciation: To counteract must buy for foreign currency
and increase the money supply.
If the exchange rate is flexible, CB does not intervene. IS curve starts
shifting left again.
IS-LM: An increase in fiscal policy
Feb 10 2004
Fixed exchange rates
No independent monetary policy
Flexible exchange rates
No effects of fiscal policyThe exchange rate offsets fiscal policy effects
Exchange rate regimes and policy effectiveness
Feb 10 2004
Most European countries prefer fixed exchange rates
Only exception is UK
Canada prefers a flexible exchange rate.
Preferences
Feb 10 2004
Free floating (Euro, US dollar, British Pound)Managed floating (Japan)Target zones (current ERM +/- 15%)Crawling pegs (regular slide)Fixed and Adjustable (The Snake, Bretton Woods)Currency Boards (Fixed with a 1 to 1 relationship between
monetary policy and exchange rate) Hong Kong, Argentina
(collapsed in 2002)Currency Union (Euro)
The range of exchange rate regimes
Feb 10 2004
1) Regime effects the transmission of shocks. (Box 11.3) Increase in world wide interest rates
Expansion under flexibleContraction under fixed
A foreign BoomExpansion under fixedContraction under flexible
What drives the choices of exchange rate regime?
Feb 10 2004
Monetary Policy
Can be used to deal with cyclical disturbancesCan be misused inflation (time inconsistency problems)
Fiscal Policy
Can be used to deal with fluctuations, but is highly politicized.Can be misused (public debts, political cycles)
Some Criteria
Feb 10 2004
Exchange rate stability:
Free floating exchange rates move around too much
Fixed exchange rates eventually become misaligned
More Criteria
Feb 10 2004
The Case for Fixed Exchange Rates
Flexible rates moved too much (financial markets are often hectic)
Exchange rate volatility: A source of uncertaintyA way of discplining monetary policyIn presence of shock, always possible to realign
Old Debate: Fixed versus Float
Feb 10 2004
Only pure floats or hard pegs are robust
• Intermediate arrangements invite government manipulations under speculative attacks
• Pure floats remove exchange rates from public policy domain
• Hard pegs are unassailable (oops Argentina)
New Debate: The Two Corner Solution
Feb 10 2004
In line with theory of time inconsistency
• Soft pegs are half hearted monetary commitments, so they ultimately fail.
New Debate: The Two Corner Solution
Feb 10 2004
Fear of Floating:
Many countries officially float but in fact intervene quite a bit
Fear of Fixing:
Many countries declare a peg but let the exchange rate move out of
the official bounds.
The Two Corner Solution and the real world
Feb 10 2004
The Two Corner Solution and the real world
80.00
90.00
100.00
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120.00
130.00
140.00
1999M1 1999M7 2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7
Denmark (vis a vis €)Sweden (vis a vis €)Switzerland (vis a vis €)Korea (vis a vis $)
Feb 10 2004
Fear of Floating is deeply ingrained in many European countries
Fear of fixing explains disenchantment with the EMS and some
reluctance towards the monetary union.
The Two Corner Solution and the real world
Feb 10 2004
• A menu is hard to pick: Tradeoffs are everywhere• All of this takes the view of a single county• Systems involve many countries and rest on agreed
rules, including mutual support• Since the end of the Bretton Woods, there is no world
monetary system• This leaves room for regional monetary systems.
Enters Europe’s experience.
Conclusions
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