Intermediate Macroeconomics

Lecture 22: exchange rate regimes

1
 This lecture

1- Adjustment of real exchange rate when nominal exchange rate fixed

2- Exchange rate crises under fixed exchange rates

3- Flexible exchange rates

4- Choosing between exchange rate regimes

5- Reading: Blanchard, chapter 20

2
 Aggregate demand under fixed exchange rates

Main points:

• In the long run, the economy reaches the same real exchange rate and the same level
of output, whether it operates under fixed exchange rates or under flexible exchange
rates

• Under fixed exchange rates, the adjustment takes place through the price level rather
than through the nominal exchange rate

3
 Aggregate demand under fixed exchange rates
• Equilibrium in the goods market

Y = C(Y, T ) + I(Y, i) + G + N X (Y, Y ∗ , ε)

• Real exchange rate defined by

EP
ε≡
P∗
• With fixed nominal exchange rate

E = Ē, i = i∗

so now write equilibrium in the goods market

 
∗ ∗ ĒP
Y = C(Y, T ) + I(Y, i ) + G + N X Y, Y , ∗
P

4
 Adjustment under fixed exchange rates

• Suppose an economy is in a recession, where Y < Ȳ

• How does the economy recover from the recession?

• In the short run, fixed nominal exchange rate also implies fixed real exchange rate

• But in the long run, real exchange rate can adjust

• Recall the aggregate supply (AS) relation

W P e F (Y )
P = =
A F (Ȳ )

5
 Equilibrium in the long run

• So long as output Y is below its natural level Ȳ , P < P e and the price level keeps
decreasing (adaptive expectation)

– the lower price leads to a real depreciation

– output slowly recovers

• In the long run, real exchange rate and real output are independent of nominal
exchange rate regime (a version of “monetary neutrality ”): output returns to Ȳ and
real exchange rate returns to ε̄

Ȳ = C(Ȳ , T ) + I(Ȳ , i∗ ) + G + N X Ȳ , Y ∗ , ε̄

6
 Real exchange rate in Spain

There was a real appreciation associated with a boom until 2008. Since 2008, the real exchange rate has
depreciated, but the adjustment is far from complete. The unemployment rate in Spain was still as high as
21% in 2016.
7
 An alternative way to recover: devaluation

• To recover from a recession, the adjustment through prices is usually long and painful

• Alternatively, the government can achieve a real depreciation by devaluing the

currency, a one-time decrease in E
EP
ε≡
P∗
• A devaluation can quickly lead to a real depreciation

8
 For and against devaluation

For:

• With a fixed exchange rate, a devaluation (a decrease in the nominal exchange rate)
leads to a real depreciation (a decrease in the real exchange rate), and a short run
increase in output

• A devaluation of the correct size can return an economy in recession back to the
natural level of output

9
 For and against devaluation

Against:

• In practice, it is difficult to achieve the “correct” devaluation

• Initial effects of a depreciation may be contractionary

• The price of imported goods increases, making consumers worse off. This may lead
workers to ask for higher nominal wages, and firms to increase their prices as well

10
 Exchange rate crises under fixed exchange rates

• Higher domestic prices leads to a steady real appreciation, a worsening of a country’s

trade position, lower net exports which reduce aggregate demand and reduce output

• But if the country would instead devalue (or let the exchange rate float), the real
appreciation could be mitigated, cushioning the effects on aggregate demand

⇒ Financial markets may come to expect a devaluation soon to resolve the growing
problem

11
 Exchange rate crises under fixed exchange rates
• If fixed exchange rate is credible, then
e
Et+1 = Ē, it = i∗t

• But if foreign exchange markets expect devaluation in future (current rate is not
credible), then
e
Et+1 < Ē

• Implies domestic interest rates must rise to compensate for expected depreciation.
From interest parity
e
Et+1 − Ē
it ≈ i∗t − > i∗t
Ē

12
 Exchange rate crises under fixed exchange rates

e
Et+1 − Ē
it ≈ i∗t − > i∗t
Ē

Expectations that a devaluation is imminent may trigger an exchange rate crisis. The
government then has two options

(i) give in and devalue, or

(ii) try to maintain fixed rate, probably at the cost of very high interest rates and a
potential recession

e.g., assume expected devaluation by 3% in 1 month, then the (annualised) 1 month interest
rate has to rise by 3% × 12 = 36% to prevent massive capital outflows, otherwise a crisis
occurs

13
 EMS crisis

The September 1992 EMS (European Monetary System) crisis was the belief that several countries were
soon going to devalue. Some countries defended themselves by increasing the overnight interest rate by up
to 500%. In the end, some countries devalued, others dropped out of the EMS, and others remained.
14
 Flexible exchange rates

• With flexible nominal exchange rate, interest parity implies

1 + it e
Et = E
1 + i∗t t+1
• So Et depends on

– current domestic and foreign interest rates

– expected exchange rate at the end of the period

• Iterating forward, Et depends on path of future domestic and foreign interest rates and
expectations of exchange rates far into the future

15
 Factors that influence the exchange rate

• Anything that moves current and/or expected future domestic or foreign interest rates!

⇒ not surprising that Et may change even if current it does not

• When interest rates are cut, investors have to assess whether this is first of many cuts,
or whether it is just a temporary change movement in interest rates. Effect on Et
much greater if the cut is first of many

• Anything which moves expected future exchange rates

– forecasts of the current account balance

– commodity prices (for a country like Austalia)

16
 Choosing between exchange rate regimes
Fixed rates:

• May severely constrain domestic monetary policy (e.g., i = i∗ )

• Can be difficult to maintain credibility of a given fixed rate

• Fiscal policy may be more powerful

Flexible rates:

• May be excessively volatile, difficult to control via monetary policy

• Volatility in nominal exchange rate implies short run volatility in real exchange rate,
fluctuations in trade balance and real output

17
 Choosing between exchange rate regimes

• Consensus opinion amongst economists is that flexible exchange rates are generally
preferable

• Exceptions?

– if countries tightly integrated (e.g., experience similar real shocks, have high factor
mobility between them, etc)

– central bank cannot credibly control domestic inflation

18
 Common currency areas

• A common currency (extreme form of fixed exchange rate), such as the euro, lowers
transaction costs in trade and finance

• For countries to benefit from a common currency, probably need:

(i) experience similar shocks; thus, so roughly the same monetary policy is suitable for all

(ii) high factor mobility, helps adjust to shocks

19
 The Euro: a short history

• The European Monetary Union (EMU) was consolidated under the Maastricht Treaty

• In January 1999, parities between the currencies of 11 countries and the Euro were
‘irrevocably’ fixed

• From 1999 to 2002, the Euro existed as a unit of account but Euro coins and bank
notes did not exist

• After 2002, only the Euro circulate in the Euro area. The European Central Bank
(ECB), based in Frankfurt became responsible for monetary policy for the Euro area

• In 2022, 19 countries were in the Euro area

20
 Next

• Rules vs. discretion in macroeconomic policy making

(an applications of game theory in macroeconomics)

21
 Example #11: problem

Setup: Consider an open-economy IS-LM model. The domestic economy is small

relative to the world economy. To begin with, suppose the exchange rate is flexible.

(a) What are the effects of expansionary monetary policy on output and the exchange
rate? Do net exports increase or decrease?
(b) What are the effects of contractionary fiscal policy on output, the exchange rate,
and net exports?
(c) Now suppose the country pursues a fixed exchange rate regime. Can the economy
still engage in expansionary monetary policy? What are the effects of an exchange
rate devaluation?