copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 15-1 chapter 15...

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.15-1

CHAPTER 15

International Economic Policy


Questions• How has the world organized its

international monetary system?• What is a fixed exchange rate

system?• What is a floating exchange rate

system?• What are the costs and benefits of

fixed exchange rates vis-à-vis floating exchange rates?


Questions• Why do most countries today have

floating exchange rates?• Why has western Europe recently

created a “monetary union”--an irrevocable commitment to fixed exchange rates within western Europe?

• What were the causes of the three major currency crises of the 1990s?


The Gold Standard• Before World War I, nearly all of the

world economy was on the gold standard– a government would define a unit of its

currency as worth a particular amount of gold

– the currency was convertible• could be converted into gold freely

– the currency’s price in terms of gold was its parity


Figure 15.2 - Growth of the Gold Standard


The Gold Standard• When two countries were on the gold

standard, their nominal exchange rate was fixed at the ratio of their gold parities– at World War II parities

• the U.S. dollar was equal to 1/35 of an ounce of gold

• the British pound sterling was set to equal 1/15.58333 ounces of gold

• the exchange rate of the dollar for the pound was £1.00=$2.40


The Gold Standard• Example of currency arbitrage

– the U.S. government is willing to buy gold at $35 per ounce

– the British government is willing to buy gold at £15.58333 per ounce

– the pound trades for $2.64 (10% higher than the ratio of the gold parities - $2.40)


The Gold Standard• Someone with an ounce of gold could

– trade it to the British Treasury for £15.58333

– trade those pounds for dollars in the foreign exchange market and get $38.50

– trade the $38.50 to the U.S. Treasury for 1.1 ounces of gold

– repeat the process as quickly as possible, making a 10% profit each time the circle is completed


Figure 15.1 - How to Profit in the Foreign-Exchange Market


Weaknesses of theGold Standard

• The gold standard tended to be deflationary– under some circumstances, it pushed

countries to raise their interest rates which reduced output and increased unemployment

– it never provided a countervailing push to other countries to lower their interest rates



• If the exchange rate is floating, foreigners’ domestic currency earnings must be used to buy exports or to invest in the home country

• The exchange rate moves up or down in response to the supply and demand for foreign exchange in order to make it so

0NFINX



• Under a gold standard, foreign-currency earnings can also be used to purchase gold from the foreign country’s Treasury

0FG-NFINX • If a country’s net exports plus net

foreign investment are less than zero, its Treasury will find itself losing gold– the country’s gold reserves shrink



• If a country’s gold reserves are shrinking, it has a choice– abandon the fixed exchange rate system– make it more attractive for foreigners to

invest by raising domestic interest rates• puts contractionary pressure on the economy

• Countries gaining gold face no incentive to lower interest rates in order to stay on the gold standard


Collapse of the Gold Standard

• The gold standard was suspended during World War I

• After the war ended, politicians and central bankers sought to restore it– they believed it was an important step in

restoring prosperity

• After the Great Depression began, the gold standard broke apart



• Four factors made the gold standard a less secure monetary system– everyone knew that governments could

abandon their gold parities in an emergency

– everyone knew that governments were trying to keep interest rates low enough to produce full employment



• Four factors made the gold standard a less secure monetary system– after World War I, countries held their

reserves in foreign currencies rather than gold

– the post-war surplus economies did not lower interest rates as gold flowed in



• As soon as a recession hit, governments found themselves under pressure to raise interest rates and lower output– could either stay on the gold standard

and face a deep depression or abandon the gold standard

– the further countries moved away from their gold-standard rates, the faster they recovered from the Great Depression


Figure 15.3 - Economic Performance and Degree of Exchange Rate Depreciation

During the Great Depression


The Bretton Woods System• The Bretton Woods System was the

result of an international monetary conference that took place in 1944

• Three principles guided this system– in ordinary times, exchange rates should

be fixed– in extraordinary times, exchange rates

should be changed– an institution was needed to watch over

the international financial system• the International Monetary Fund (IMF)


The Bretton Woods System• The Bretton Woods System broke

down in the early 1970s– the U.S. found itself with a large trade

deficit and sought to devalue its currency• Since then, the exchange rates of the

major industrial powers have been floating exchange rates– fluctuate according to supply and

demand


How a Fixed Exchange Rate System Works

• A fixed exchange rate is a commitment by a country to buy and sell its currency at fixed, unchanging prices (in terms of other currencies)– the central bank or Treasury must

maintain foreign exchange reserves– these reserves are limited



• If there is a high degree of capital mobility, the real exchange rate is set by

)r-(r- fr0

• The higher the interest rate differential in favor of the home country, the lower is the exchange rate


Figure 15.4 - The Real Exchange Rate,Long-Run Expectations, andInterest Rate Differentials



• If capital is highly mobile and the fixed exchange rate (*) is lower than – foreign exchange speculators will want to

sell the home currency for foreign currency• the government spends down its reserves

– to keep the exchange rate at *, the central bank must lower interest rates• monetary policy no longer can play a role in

domestic stabilization


Figure 15.5 - Domestic Interest Rates Are Set by Foreign-Exchange Speculators

and the Exchange Rate Target



• The central bank must set the domestic real interest rate equal to

r

0f *-rr

– an increase in foreign interest rates (rf) requires a point-for-point increase in domestic interest rates

– an increase in foreign exchange speculators’ views of the long-run value of the exchange rate (0) requires an increase in domestic interest rates


Figure 15.6 - Effect of Foreign Shocks under Fixed Exchange Rates



• If capital mobility is low– the exchange rate is also affected by the

speed at which the government is accumulating or spending its foreign exchange reserves (R)

R)r-(r- Rf

r0 – when the government is accumulating

reserves, the value of foreign currency is higher than it would otherwise be• it is increasing foreign currency demand


Figure 15.7 - With Limited Capital Mobility a Central Bank Can Shift the

Exchange Rate by Spending Reserves



• If capital mobility is low– the central bank can use monetary policy for domestic

disturbances• this is limited by the sensitivity of exchange rates to the

magnitude of foreign-exchange market interventions performed by the central bank and by the amount of reserves

– the domestic real interest rate will be

R*-

rrr

R

r

0f


Benefits of Fixed Exchange Rates

• Floating exchange rate systems add risk– discourages international trade– makes the international division of labor

less sophisticated

• This is an important reason behind the decision of most of western Europe to form a monetary union– fix their exchange rates against each other

irrevocably


Costs of Fixed Exchange Rates

• Under fixed exchange rates, monetary policy is tightly constrained by the requirement of maintaining the exchange rate at its fixed parity

• Fixed exchange rates also have the disadvantage of rapidly transmitting monetary of confidence shocks– interest rates move in tandem all across

the world in response• Fixed exchange rates also make large-

scale currency crises more likely


Fixed or Floating Exchange Rates?

• Is it more important to preserve the ability to use monetary policy to stabilize the domestic economy rather than dedicating monetary policy to a constant exchange rate?

• Is it more important to preserve the constancy of international prices and thus expand the volume of trade and the scope for the international division of labor?


Fixed or Floating Exchange Rates?

• Economist Robert Mundell argued that the major reason to have floating exchange rates is that they allow adjustment to shocks that affect two countries differently– this benefit would be worth little if two

countries suffered the same shocks and reacted to them in the same way

– this benefit would also be worth little if factors of production are highly mobile


The European Currency Crisis of 1992

• After reunification with East Germany, the West German government undertook a program of massive public investment– this shifted the IS curve out– the German central bank raised interest

rates to keep inflation under control


Figure 15.8 - German Fiscal Policy and Monetary Response in the Early 1990s



• The increase in interest rates generated a rise in the German exchange rate vis-à-vis the dollar and the yen– exports fell

• Other countries in western Europe had fixed their exchange rates to the German mark as part of the European Exchange Rate Mechanism



• The rise in German interest rates meant that these western European countries were required to raise interest rates as well– the required interest rate increase

threatened to send the other European countries into a recession


Figure 15.9 - Effect of German Policy on Other European Countries



• Foreign exchange speculators did not believe that these western European governments would keep this promise to maintain the fixed exchange rate parity when unemployment began to rise 0 rose which caused an additional rise in

the domestic real interest rate required to maintain exchange rate parity

r

0f

ε*ε-ε

rr



• Different governments in western Europe undertook different strategies– some spent reserves in the hope that it

demonstrated their commitment to maintaining the exchange rate parity

– some tried to demonstrate that they would defend the parity no matter how high the interest rate needed to be

– some abandoned the fixed exchange rate and let their currencies float

• The end result was the formation of the European Monetary Union


The Mexican Currency Crisis of 1994-1995

• The Mexican currency crisis was a surprise to most economic analysts– the government’s budget was balanced– the government’s willingness to raise

interest rates was not in question– the Mexican peso was not overvalued

• The peso lost half of its value in four months starting in December of 1994



• Concerns about political stability reduced foreign exchange speculators’ estimates of the long-run value of the peso and raised their assessment of 0

– the Mexican government spent $50 billion in foreign reserves and eventually ran out• it devalued the peso and let it float against the

U.S. dollar• the rise in caused a further increase in 0

• the value of the Mexican government’s debt also increased, which led to further increases in 0



• The Mexican government had two options– it could raise interest rates

• the level of interest rates required would produce a Great Depression in Mexico

– it could keep interest rates low and let the value of foreign currency rise much further• Mexican companies and the Mexican

government would be unable to pay their dollar-denominated debts

• Mexico’s foreign trade would fall drastically



• The U.S. made direct loans to Mexico– these loans built Mexico’s foreign-

exchange reserves back to a comfortable level• this allowed domestic interest rates to remain

relatively low

– the Mexican government was also able to refinance its debt• confidence was restored that the Mexican

government would not be forced to resort to default or hyperinflation


Figure 15.10 - Mexico’s Nominal Exchange Rate: The Value of the U.S. Dollar

in Mexican Pesos


The East Asian Currency Crisis of 1997-1998

• In mid-1997, foreign investors began to worry about the long-run sustainability of growth in East Asia– they began to change their opinions of

the fundamental long-term value of East Asia’s exchange rates (0)• the value of the currencies fell causing a

further change in 0



• It also became clear that many of East Asia’s banks and companies had borrowed heavily abroad in amounts denominated in dollars or yen– these loans had been used to make non-

profitable investments

– this lead to further decreases in 0



• There was a vicious cycle created– each decline in the exchange rate raised

the burden of foreign-denominated debt and raised the probability of bankruptcy

– each rise in the perceived burden of foreign-denominated debt caused a further loss in the value of the exchange rate

• The IMF stepped in with loans to boost foreign exchange reserves– promises to improve banking regulation

were made in return


Figure 15.11 - Exchange Rates During the Asian Currency Crisis


Managing Crises• The exchange rate equation offers a

country a menu of choices for its value of the real exchange rate () and its value of the domestic real interest rate (r)

– the higher the domestic real interest rate, the more appreciated is the exchange rate

)r-(r-εε f0


Managing Crises• If international investors suddenly lose

confidence in the future of the country’s economy, the menu of choices that the country has deteriorates– if the domestic real interest rate is to

remain unchanged, the exchange rate must depreciate

– if the exchange rate is to remain unchanged, the domestic real interest rate must rise


Managing Crises• Because a large rise in domestic real

interest rates will likely create a recession, letting the exchange rate depreciate seems like the logical policy choice– throughout the 1990s, investors reacted

negatively when the exchange rate depreciates

– this seems especially dangerous when businesses and governments have borrowed abroad in foreign-denominated debt


Chapter Summary• For most of the past century, the world

has operated with fixed exchange rates--not, as today, with floating exchange rates

• Under fixed exchange rates monetary policy has only very limited freedom to respond to domestic conditions– the main goal of monetary policy is that of

adjusting interest rates to maintain the fixed exchange rate


Chapter Summary• A country would adopt fixed exchange

rates to make it easier to trade by making foreign prices more predictable and less volatile– fixed exchange rate systems increase the

volume of trade and encourage the international division of labor


Chapter Summary• In the past generation, most countries

have concluded that the freedom to set their own monetary policies to satisfy domestic concerns is more important than the international integration benefits of fixed exchange rates– an exception is western Europe, which is

in the process of permanently fixing its exchange rates via a monetary union


Chapter Summary• Wide swings in foreign exchange

speculators’ views of countries’ future prospects have caused three major currency crises in the 1990s– such currency crises were greatly

worsened by poor bank regulation and other policies that threatened to send economies subject to capital flight into a vicious spiral ending in depression and hyperinflation

copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 15-1 chapter 15...

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