15 Fixed versus Floating: International Monetary Experience Notes to Instructor Chapter Summary Chapter 15 examines the choice of fixed versus floating exchange rate regimes in more detail. We consider the potential benefits of a fixed exchange rate regime, such as efficiency gains from reduced transactions costs, fiscal discipline, and reducing valuation effects, and the costs, such as loss of stabilization policy. We study exchange rate systems that involve cooperative and noncooperative adjustments. The chapter concludes with an overview of two key exchange rate systems: the gold standard and the Bretton Woods system. Comments The majority of this chapter is dedicated to weighing the costs and benefits of fixing the exchange rate. Fixed versus floating exchange rate regimes were briefly examined in the previous chapter. Here we devote more attention to the trade-offs facing a country when it chooses an exchange rate regime. This is a useful precursor to the theory of optimum currency area, which is presented in more detail in Chapter 20. The chapter concludes with a historical overview of exchange rate systems from the gold standard to the present. 317 318 Chapter 15 ■ Fixed versus Floating: International Monetary Experience Lecture Notes This chapter considers the costs and benefits associated with maintaining an exchange rate peg. As described by the historical overview of the international monetary experience at the end of this chapter, the choice to fix versus float is not straightforward. In addition to using the IS-LM-FX model from the previous chapter, this chapter introduces a new model to examine these trade-offs: the symmetry-integration diagram. This allows us to better understand the benefits and costs of fixing and to examine a variety of fixed exchange rate systems. 1 Exchange Rate Regime Choice: Key Issues Historically, fixed exchange rates were the preferred exchange rate regime among economists and policy makers. Most countries adopted the gold standard, a system in which the value of a country’s currency was pegged to an ounce of gold. Because most countries adopted the gold standard, their currencies were fixed relative to each other. Figure 15-1 shows a timeline of exchange rate regimes. The years 1914–1917 and 1940–1944 were World Wars and, as such, are omitted from the textbook figure and this discussion. ■ 1870–1913: Metallic standards, especially the gold standard (peak: 70% of countries in 1913) ■ 1918–1939: Gold standard returned, then declined during the Great Depression ■ 1945–1970s: Fixed exchange rate regimes common (Bretton Woods), with most currencies pegged to the U. S. dollar and British pound ■ 1970s–present: Floating exchange rate regimes more common, especially among the world’s wealthiest countries APPLICATION Britain and Europe: The Big Issues This application examines Great Britain’s 1992 decision to move from a fixed to a floating exchange rate regime, highlighting key issues in the exchange rate regime debate. As countries in the European Union (EU) moved toward a single currency unit in the 1980s and 1990s, they adopted exchange rate pegs relative to each other, called the Exchange Rate Mechanism (ERM). It was believed the adoption of a common currency in Europe would promote trade by lowering transactions costs. In addition, from Britain’s perspective, the ERM would help anchor inflation to Germany’s low inflation rate. It joined the ERM in 1990. In practice, ERM members were pegged to the German deutschmark (DM) because the Bundesbank had monetary autonomy and pursued antiinflationary policies. The DM served as the base currency or center currency. In the analysis, we treat Britain as the home country and Germany as the foreign country. As countries in Eastern Europe moved away from communism, the Berlin Wall fell in 1989, reunifying East Germany and West Germany. East Germany lagged behind West Germany and required significant public spending for social programs and to modernize infrastructure. A Shock in Germany Chapter 15 ■ Fixed versus Floating: International Monetary Experience 319 This fiscal expansion led to an increase in output, creating inflationary pressure and an increase in Germany’s interest rate. The Bundesbank responded by cutting the money supply to stabilize output, further raising Germany’s interest rate. This is illustrated in Figure 15-2, panel (a). Choices for the Other ERM Countries An increase in Germany’s interest rate had two effects on ERM countries, illustrated in panels (b) and (c) of Figure 15-2. ■ IS curve shifts to the right. Higher German interest rates leads to expenditure switching in favor of home-country goods, so the trade balance rises, increasing external demand in the home country. This happens in both a floating and a fixed exchange rate regime. ■ LM curve shifts to the left. To prevent depreciation against the DM, interest rates must be increased elsewhere in the ERM. Central banks must follow Germany’s lead, cutting the money supply and raising the nominal interest rate to keep the exchange rate fixed. Choice 1: Float and Prosper Option 1: Britain chooses to keep its inter- est rate unchanged (Point 4) ■ IS curve shifts to the right. ■ LM curve shifts to the right. ■ To keep the interest rate unchanged, the Bank of England would need to expand the money supply, shifting LM to the right. ■ To keep the home interest rate unchanged, the new equilibrium is at point 4, where output increases and the pound depreciates relative to the DM. Choice 2: Peg and Suffer Option 2: Britain remains part of the ERM (Point 2) ■ IS curve shifts to the right. ■ LM curve shifts to the left. ■ To remain part of the ERM, Britain would reach a new equilibrium at point 2, suffering a decrease in output, while the exchange rate is unchanged. Option 3: Britain stabilizes output (Point 3) ■ IS curve shifts to the right. ■ LM curve shifts to the left (by a smaller amount than is required to maintain peg). ■ Bank of England contracts the money supply only by the amount needed to stabilize output. ■ To stabilize output, Britain reaches a new equilibrium at point 3, at which the pound depreciates relative to the DM. What Happened Next? Britain opted out of the ERM, not wanting German-specific events to dictate domestic policy. Figure 15-3 compares Britain with France, a country that opted to remain part of the ERM. The British economy boomed (Point 4), whereas France suffered a recession (Point 2). The benefits of integration into the Eurozone are longer term, so it is difficult to determine whether the costs outweighed the benefits for Britain. ■ 320 Chapter 15 ■ Fixed versus Floating: International Monetary Experience Key Factors in Exchange Rate Regime Choice: Integration and Similarity Measuring the costs and benefits of a fixed exchange rate regime usually means examining the degree of economic integration and economic similarity. Economic integration is measured by the volume of trade among the countries as well as the amount of other cross-border transactions. Economic similarity means that the countries experience similar shocks at similar times. Each country will face a different set of costs and benefits. Like Britain and France, they will reach different conclusions about whether to fix or float. Economic Integration and the Gains in Efficiency Economic integration refers to the growth of market linkages in goods, capital, and labor markets between countries. Lowering transactions costs through a fixed exchange rate will help promote economic integration. Because exchange rate fluctuations create uncertainty about prices, they create a barrier to cross-border exchange of goods, capital, and labor. The more countries engage in these transactions, the higher the costs of exchange rate fluctuations. A greater degree of economic integration between the home and base countries means a larger volume of transactions. This implies greater benefits from fixed exchange rate regimes and increased efficiency benefits from adopting a common currency. Economic Similarity and the Costs of Asymmetric Shocks An asymmetric shock is a shock that affects one country, leaving others unaffected. This was the case of the shock created by German reunification. Asymmetric shocks create conflicts in policy objectives of the countries with fixed exchange rates. In contrast, symmetric shocks are those that are common to all countries that are part of the fixed exchange rate regime. If countries experience the same shock, they will have the same policy response to stabilize output, leaving the exchange rate unchanged. A greater degree of economic similarity between the home and base countries means the countries face more symmetric shocks and fewer asymmetric shocks. That implies lower costs from the fixed exchange rate regime and decreased stability costs of a common currency Simple Criteria for a Fixed Exchange Rate Now that we have identified the efficiency benefits and stability costs, we can define a net benefit of fixed versus float. Two conclusions emerge from the previous discussion: ■ As integration rises, the efficiency benefits of a common currency increase. ■ As symmetry rises, the stability costs of a common currency decrease. Figure 15-4 illustrates the symmetry-integration diagram, showing these trade-offs in terms of symmetry of shocks (lower stability costs) and market integration (higher efficiency gains). The examples given on the graph are based on a geographic sense of economic integration and market integration. Instructors may find it useful to discuss this from the perspective of a campus location in the city, state or province, country, or region among a group of countries nearby. Chapter 15 ■ Fixed versus Floating: International Monetary Experience 321 On the diagram, the FIX line indicates where the net benefit of a fixed exchange rate regime is equal to zero. ■ Above the FIX line → high degree of economic integration, symmetric shocks → net benefit 0 → fixed exchange rate regime ■ Below the FIX line → low degree of economic integration, asymmetric shocks → net benefit 0 → floating exchange rate regime The following two applications consider empirical evidence about whether fixed exchange rate regimes in fact promote efficiency gains and hinder output stability. APPLICATION Do Fixed Exchange Rates Promote Trade? A fixed exchange rate regime eliminates exchange rate volatility, reducing the transactions costs associated with cross-border exchange. Specifically, under a pure fixed exchange rate, there is no exchange rate risk. Our hypothesis is that removing this risk will increase the volume of trade. Economic historians found that pairs of countries that adopted the gold standard in the late 19th and early 20th centuries enjoyed trade levels 30% to 100% higher than those with floating exchange rates. Today, there are several versions of a fixed exchange rate regime, making this a challenging question to answer empirically. We can classify countries in four ways: ■ Common currency (A and B use the same currency unit) ■ Direct exchange rate peg (A’s currency is fixed to B’s) ■ Indirect exchange rate peg (A and B have an exchange rate peg with a third country, C) ■ Floating exchange rate regime (A and B’s currencies are not linked directly or indirectly) Figure 15-5 tells the story. Countries with a common currency have a 38% higher trade volume than a floating rate. Countries that directly peg their exchange rates to each other have a 21% higher trade volume. There is no significant benefit for countries with indirect pegs Benefits Measured by Price Convergence Benefits Measured by Trade Levels If fixed exchange rates lower transactions costs, differences in prices should be smaller among countries with fixed exchange rates. Earlier, we examined how nominal exchange rates are linked through relative prices, using the law of one price (LOOP) and purchasing power parity (PPP). LOOP and PPP are more likely to hold in a fixed exchange rate regime if the argument posited previously is true. Research on prices of baskets of goods shows that as exchange rate volatility rises, price differences widen, and the speed of convergence in the prices (toward PPP) decreases. For individual goods, as exchange rate volatility rises, there are larger price differences across locations. In the case of Europe, the price gaps have narrowed among ERM/euro countries and widened for those countries that left the ERM. ■ 322 Chapter 15 ■ Fixed versus Floating: International Monetary Experience APPLICATION Do Fixed Exchange Rates Diminish Monetary Autonomy and Stability? If capital markets are unrestricted, then uncovered interest parity (UIP) holds, and the home interest rate must be equal to the foreign interest rate. Therefore, policy in the base country dictates economic conditions in the countries pegged to the base currency. This application examines to what extent fixed exchange rate regimes imply interest rate parity (e. g. , no monetary policy autonomy) and affect output stability. The Trilemma, Policy Constraints, and Interest Rate Correlations Solutions to the trilemma: 1. Open capital markets with fixed exchange rate (“open peg”) 2. Open capital markets with a floating exchange rate (“open nonpeg”) 3. Closed capital markets (“closed”) Note that case 1 implies that monetary policy is not autonomous, so interest rates in the home country move one-for-one with the base country. Cases 2 and 3 imply autonomous monetary policy, so that changes in interest rates across countries are independent. Figure 15-6 shows interest rate movements in home countries relative to a base country. The estimated slope of the line should be equal to 1 in case 1. The data support this observation: 1. Panel (a): slope 0. 88 (close to 1) 2. Panel (b): slope 0. 58 3. Panel (c): slope 0. 39 Costs Measured by Output Volatility Loss of monetary policy autonomy may not be a bad thing if central bankers are irresponsible or unable to achieve macroeconomic objectives. In some sense, the costs of a fixed exchange rate regime hinge more on output stability than monetary policy autonomy. As shown in Figure 15-7, output volatility is higher for countries with a fixed exchange rate regime relative to float. The data show the instability is higher for poorer countries. This suggests that loss of monetary policy autonomy is costly in terms of output stability. From the figure, countries using intermediate exchange rate regimes experience roughly the same volatility as float. ■ 2 Other Benefits of Fixing This section extends the discussion of costs and benefits of fixed exchange rate regimes beyond economic integration and output stability. Fiscal Discipline, Seigniorage, and Inflation A fixed exchange rate regime prevents the government from financing a budget deficit by printing money. Since monetary policy must be dedicated to maintaining the exchange rate, the central bank cannot simply create money for the government to spend. In a floating exchange rate regime, the government may opt to monetize a deficit by printing money. This expansion of the Chapter 15 ■ Fixed versus Floating: International Monetary Experience 323 money supply inevitably leads to high inflation and imposes an inflation tax (seigniorage) on the public. In this way, the fixed exchange rate regime can, in theory, serve as a nominal anchor. Table 15-1 shows that fixed exchange rate regimes do not prevent inflation. However, when we examine subgroups, we observe that the adoption of a fixed exchange rate regime does eventually reduce inflation in emerging markets and developing countries. In general, fixed exchange rate regimes are neither necessary nor sufficient to ensure low inflation. Developing countries suffering from high inflation rates are an exception, as exchange rates may serve as the only viable nominal anchor for these countries. S I D E The Inflation Tax B A R The extra money printed to purchase goods and services is worth M / P ( M / M) (M / P) (M / P). In the example above, the $1 tax borne by the public is “paid” to the government. We can see how this relates to the interest rate by using the money market equilibrium condition: Seigniorage (M / P) L(r* )Y This section considers why monetizing the deficit imposes an inflation tax (seigniorage) on the public. Assume output is fixed, prices are flexible, and inflation and the nominal interest rate are constant. In this case, the growth rate of the money supply is equal to the inflation rate, M / M . From the Fisher effect, we know i r* . The inflation created from monetizing the deficit erodes the purchasing power of money. When the public holds money balances M / P, as prices rise, the value of real money balances outstanding falls. For example, if you hold $100 and P 1, when the government expands M by 1%, P grows by 1%, so your real money balances fall to $99 ($100 / 1.01). Therefore, this acts as an inflation tax, transferring resources from the public to the government. Note that the revenue generated by monetizing the deficit is offset partially by a decrease in real money demand. In the extreme case of a hyperinflation, money demand collapses to zero, eliminating potential seigniorage for the government. Liability Dollarization, National Wealth, and Contractionary Depreciations Many developing countries and emerging markets suffer from liability dollarization, in which a large portion of foreign investment from abroad is denominated in another currency. This creates the potential for large destabilizing wealth effects when the exchange rate changes. Assumptions: ■ Two countries, home (pesos) and foreign ($). ■ Nominal exchange rate, Epesos/$ ■ Home external assets ● AH denominated in home currency (pesos) ● AF denominated in foreign currency ($) EAF measured in home currency (pesos) ■ Home external liabilities ● LH denominated in home currency (pesos) ● LF denominated in foreign currency ($) ELF measured in home currency (pesos) 324 Chapter 15 ■ Fixed versus Floating: International Monetary Experience Home country’s total external wealth is the sum of total assets less the liabilities expressed in home currency: W (AH EAF) (LH ELF) Suppose the exchange rate changes by E. The change in wealth is (valuation effect): W E (AF LF) From the expression, there are two possible cases following a depreciation, E 0: ■ If AF LF, then external wealth increases ■ If AF LF, then external wealth decreases (liability dollarization) Destabilizing Wealth Shocks Note that wealth effects may offset or magnify the effects of a depreciation on aggregate demand. Although a depreciation increases the trade balance, it also affects wealth because: ■ Consumption may be a function of wealth if households save or borrow. ■ Investment may be a function of wealth if the ability of firms to obtain credit depends on their net worth. When a country’s foreign currency assets do not equal foreign currency liabilities, it has a currency mismatch on its external balance sheet. Now consider how stabilization policy (a monetary expansion) affects the economy differently in the presence of wealth effects. ■ If AF LF, then external wealth increases → C and I increase → policy effect on output magnified ■ If AF LF, then external wealth decreases → C and I decrease → policy effect on output dampened In theory, a currency depreciation could actually be contractionary if the valuation effects are large enough! And this is important for developing countries, whose external liabilities are often nearly completely dollarized. Evidence Based on Changes in Wealth Figure 15-8 reports data on the cumulative change in external wealth associated with valuation effects during currency crises from 1993 to 2003. From the figure, these valuation effects can be quite large, although they depend on the percent depreciation in the currency. Countries with a larger fraction of liabilities denominated in another currency (dollars or yen in these cases) or those experiencing larger depreciations suffered larger losses in wealth. Evidence Based on Output Contractions Do these wealth effects matter for output? Figure 15-9 plots the relationship between the percentage change in output against the wealth losses associated with valuation effects. The figure shows a clear relationship: countries suffering larger wealth losses experienced more severe contractions in output. Original Sin Historically, most countries—especially those less-developed countries operating on the fringes of the global capital market—were forced to borrow in gold or in a “hard currency,” such as the British pound or the U. S. dollar. This created a currency mismatch. Table 15-2 reports data on the percentage of external liabilities denominated in foreign currency across groups of countries. Wealthier countries have a relatively small percentage of Chapter 15 ■ Fixed versus Floating: International Monetary Experience 325 their external liabilities denominated in foreign currency. But the rest of the countries have between 72% and 100% of external debt denominated in foreign currency. “Original sin” refers to a country’s inability to borrow in its own currency. This problem arises partly from a country’s historical macroeconomic policies. As the value of domestic currency debts was eroded by inflation, creditors required the debts be denominated in a foreign hard currency. Options for Redemption? ■ ■ ■ Another perspective argues that the real source of the problem is golbal capital market failure. Because small countries have a small pool of liabilities traded, investors benefit little from diversification into these liabilities. These liabilities are more appealing when they are bundled with others in the form of a security denominated in a single currency. Another prescription involves improving institutional quality and designing better macroeconomic policy to achieve low inflation. Finally, countries can reduce currency mismatch through the central bank’s acquisition of foreign currency and sovereign wealth funds (increasing AF). Practical Limitations Government borrowing denominated in foreign currency is still a problem. ■ Also, currency mismatch in private sectors is a problem, compounded by moral hazard (excessive risk-taking with the expectation of a government bailout). ■ The private sector is unable to hedge against exchange rate risk because their capital markets are underdeveloped. What does this mean for the fixed versus floating debate? Among countries that cannot borrow in their own currency, floating exchange rates are less useful as a stabilization tool and may be destabilizing. This is particularly true of developing countries, so these countries will prefer fixed to floating exchange rates, all else equal. Summary In addition to economic integration and economic similarity, there are several factors that influence a country’s decision to adopt a fixed exchange rate regime: ■ Fixed exchange rates impose fiscal discipline by preventing the imposition of an inflation tax (seigniorage) on the public. ■ Fixed exchange rates avoid large changes in external wealth among countries with assets and liabilities denominated in a foreign currency. These factors are more compelling for poorer countries, leading to a fear of floating. These additional considerations influence the symmetry-integration diagram as illustrated in Figure 15-10. The benefits of fiscal discipline and avoidance of wealth effects shift the FIX line down because they add to the net benefit a country receives from adopting a fixed exchange rate regime. ■ 326 Chapter 15 ■ Fixed versus Floating: International Monetary Experience 3 Fixed Exchange Rate Systems In reality, there are several types of fixed exchange rate systems, often involving multiple countries, such as the Bretton Woods system and the European Exchange Rate Mechanism (ERM). These are examples of reserve currency systems in which N countries participate. The center (or base) country, usually assigned the number N, is the currency to which all other countries peg. And the base country supplies the reserve currency for the rest of the world. At the beginning of this chapter, we studied Britain’s decision to leave the ERM and allow the pound to float (Application: Britain and Europe: The Big Issues). At that time, the German Deutschmark (DM) was the base currency. Germany, as the center country, had monetary policy autonomy. The German central bank had the luxury of choosing i*. ERM countries had to set their interest rates equal to i* to maintain the peg. This fundamental asymmetry is known as the Nth currency problem. An alternative to the approach studied earlier is for countries to reach cooperative arrangements. There are two kinds of agreements studied in this chapter: ■ Mutual agreement and compromise between the center and noncenter countries through the adjustment of interest rates. ■ Mutual agreement to change the exchange rate peg. Cooperative and Noncooperative Adjustments to Interest Rates In the following examples, the home country is the noncenter country and the foreign country is the center country. Suppose the noncenter country experiences an adverse demand shock but the center country does not. This is shown as a leftward shift in the home country’s IS curve in Figure 15-11. Noncooperative (Point 1) ■ To maintain the exchange rate peg, the home country must reduce the money supply, shifting LM to the left to keep the interest rate unchanged. ■ With no response from the center country, each country’s equilibrium is at Point 1. The noncenter country’s Y is below the desired level, whereas the center country’s Y* is equal to the desired level. Cooperative (Point 2) ■ The center country agrees to allow its output to expand, lowering interest rates by shifting the LM* curve to the right. ■ The noncenter country follows, shifting the LM curve to the right, reducing the loss in output. ■ Because the home country’s interest rate falls, the IS* curve shifts to the left (all else equal, the center country’s trade balance improves when the noncenter country’s interest rate falls). Similarly, IS shifts left because i* falls. ■ Point 2 is the cooperative equilibrium, with the center country experiencing a small increase in Y* and the noncenter country experiencing a small decrease in Y. Caveats Cooperative arrangements may arise if the countries seek to limit exchange rate volatility without a hard peg. In this way, the countries can achieve most of the benefits of fixing without high stability costs. Chapter 15 ■ Fixed versus Floating: International Monetary Experience 327 In practice, these cooperative arrangements are rarely credible. The shocks that hit a group of countries are often asymmetric, and it may be difficult for one country to allow output to deviate from the desired level to help out another country. In the end, these asymmetric shocks should average out, but this requires a long-term commitment. For example, in the ERM, countries pleaded with Germany to ease its monetary policy, which would to reduce the contraction in output felt elsewhere in Europe. As demonstrated in the case of the ERM and Germany, the center country has a great deal of autonomy and may be unwilling to give it up, making cooperative agreements difficult to achieve. Cooperative and Noncooperative Adjustments to Exchange Rates Instead of adjusting interest rates, suppose that countries agree to reset their exchange rate pegs following a shock. Countries that previously had an exchange rate peg at E1 announce that the new peg is E2 E1. ■ E E1: devaluation (in the home currency) 2 ■ E E1: revaluation (in the home currency) 2 In the following examples, both the home and foreign countries are the noncenter. Devaluation and revaluation are analogous to depreciation and appreciation, except these terms are used only to describe changes in exchange rate pegs. Figure 15-2 shows the effects of a home-country devaluation relative to the other countries. The devaluation is achieved through a monetary expansion (LM shifts right), leading to a devaluation in the home currency that boosts the trade balance and increases demand (IS shifts right) such that interest rates are unchanged. Cooperative (Point 2) ■ The devaluation in the home country leads to a decrease in demand in the foreign noncenter country. ■ The foreign noncenter country’s IS* curve shifts to the left. The foreign central bank shifts LM* to the left to maintain interest rate parity (this is a one-time change in the exchange rate). ■ The foreign country agrees to let output Y* fall to bring the home country closer to the desired output. Noncooperative (Point 3) ■ Here, the home country implements a larger devaluation, causing a large increase in the demand for home goods and a large decrease in the demand for foreign goods. LM shifts to the right. ■ IS shifts to the right and IS* shifts to the left by larger magnitudes than under a cooperative agreement. ■ The foreign country must implement a large decrease in money supply, shifting LM* to the left to maintain interest rate parity. ■ The foreign country suffers a larger decrease in Y*—the home country essentially exports its recession to the foreign country. We can use the same logic to analyze the effects of a home-country revaluation. Suppose the home country’s economy is “overheating” with Y higher than the desired level. The analysis can be expanded to consider a center country’s choice to devalue or revalue. 328 Chapter 15 ■ Fixed versus Floating: International Monetary Experience Caveats A noncooperative adjustment in the exchange rate peg (especially a devaluation) is known as a beggar-thy-neighbor policy. The home country improves its output at the expense of the foreign country’s output. This highlights a key problem with noncooperative agreements: they can lead to retaliation in which the peg is constantly adjusted, eliminating the potential gains from a fixed exchange rate regime. Successful exchange rate systems involve some degree of cooperation. APPLICATION The Gold Standard Is it possible to avoid the problem of asymmetric shocks in an exchange rate system? This would require that all countries are noncenter, avoiding the Nth currency problem, so that one country is unable to dominate the others with autonomous monetary policy. The gold standard is an example of such a system. Because all countries pegged to gold, no single country could act as a center country with its own currency. Mechanics of the gold standard: Britain (home) and France (foreign): ■ Gold and money are seamlessly interchangeable. The money supply, M, equals the combined value of gold and money in the hands of the public. (Under the pure gold standard, the only acceptable money was gold coins. ). ● Each country’s currency is pegged to a gold local currency price: Pg, P*. Thus one pound costs 1/Pg ounces of gold and one ounce of gold g costs P* francs. In other words, an ounce of gold costs Pg pounds in g Britain and P* frances in France g ● The par exchange rate (British pounds per French franc): Epar Pg/P* g ● The gold standard depends heavily on maintaining free convertibility: central banks must be willing and able to buy or sell gold in exchange for their domestic currency. The prices are Pg, P* . g ■ Arbitrage keeps exchange rates fixed. Consider what happens when the French franc appreciates against the British pound: ● If E Epar, then Epar/E P* /EPg < 1. This means that an ounce of g gold costs fewer pounds in Britain (Pg) than it does in France (EP* ). g Buy one ounce of gold in Britain for (Pg) pounds Sell gold in France for P* francs g Convert the francs to EPg P* 1 pounds g ● Gold flows out of Britain and into France, expanding France’s money supply and contracting Britain’s money supply. These flows lead to a decrease in E (the franc depreciates and the pound appreciates) until the par exchange rate is achieved. Considerations and limitations: ■ The arbitrage process is not without cost. If the exchange rate deviates from the par value by a very small amount, it will not be worthwhile to exploit the difference. This means there is effectively an exchange rate band within which the currency can appreciate or depreciate, roughly 1%. ■ The arbitrage process works in reverse if the exchange rate is below its par value. Gold flows out of France and into Britain, expanding Chapter 15 ■ Fixed versus Floating: International Monetary Experience 329 Britain’s money supply and contracting France’s. These flows lead to an increase in E until the par exchange rate is achieved. ■ Gold arbitrage implies interest rate parity across countries because the expected depreciation is zero. The approach to fixed exchange rate regimes from earlier applies to the gold standard. ■ Under the gold standard, there is no center country. All countries cooperate without explicit policy intervention. ■ The gold standard has one major advantage: it is inherently symmetrical. All countries share in the adjustment process. And, since there is no reserve currency, no country has the privilege of an independent monetary policy. In reality, though, the gold standard did not operate smoothly. 4 International Monetary Experience This section provides a historical overview of exchange rate systems, beginning in 1870 and continuing through the present. The following text summarizes this information in a timeline and key points. The Rise and Fall of the Gold Standard 1870–1918: The first era of globalization and World War I ■ Origins ● A combination of technological developments in transport and communications plus policy changes increased economic integration, increasing the benefits associated with a fixed exchange rate regime. ● A stabilization policy was politically irrelevant and price stability was the primary goal. ■ Experience on the gold standard ● A few countries adopted a gold peg, increasing the benefits to others adopting a fixed exchange rate regime thereafter (network externality). ● Many countries joined the gold standard only to leave during a domestic economic crisis. U. S. 1890 deflation and recession—William Jennings Bryan “cross of gold. ” Gold Standard Act of 1900—economic growth and gold discovery meant higher output and prices. ■ Collapse and World War I ● During World War I, the inflation tax became an important source of revenue, leading to several countries leaving the gold standard. ● Conflict reduced trade. Close to 100% reduction among warring countries. 50% reduction among these countries and neutral states. 1918–1945: The Great Depression and World War II ■ 1920s ● Protectionism and beggar-thy-neighbor policies further reduced trade. ● By the 1930s, world trade was half of the 1914 levels. 330 Chapter 15 ■ Fixed versus Floating: International Monetary Experience The Great Depression (1930s) ● More severe output fluctuations caused stabilization policies to be increasingly popular. ● Remaining on gold standard meant continued deflation because of slow growth in the world’s gold supply. ● Developing countries experienced recession earlier; some devalued as early as 1929 and increasingly relied on major currencies because gold reserves were not available. ● Weakened confidence and credibility of gold pegs indicated by currency traders. In 1931, Austria and Germany imposed capital controls. The major currencies abandon the gold standard: Britain in 1931, the United States in 1933. ■ The trilemma revisited (Figure 15-13) ● Option 1: remain on the gold standard and forgo monetary policy autonomy (France). ● Option 2: remain on the gold standard and impose capital controls (Austria, Germany, several countries in South America). ● Option 3: abandon the gold standard (Britain and the United States). In the end, the system collapsed because: ■ the efficiency gains from trade were diminished as the results of war and poor macroeconomic policy ■ stability costs became more important ■ lack of cooperation among countries in that they did not commit to maintaining the gold peg ■ slow growth in the world’s gold supply led to a worldwide deflation Bretton Woods to the Present ■ Background and design ● In 1944, economic policy makers gathered at Bretton Woods, NH to establish a cooperative international monetary system. ● Their objective was to maintain a system of fixed exchange rates to rebuild trade among countries. All countries that signed the Bretton Woods agreement pegged their currencies to the U. S. dollar. The dollar, in turn, was pegged to gold. The Bretton Woods agreement included capital controls. Since speculators were blamed for destabilizing the gold standard, controlling the movements of capital was believed to reduce speculation. ■ Bretton Woods performance and collapse ● Market pressures and the trilemma: To trade, some system of international credit was needed. Countries wanted to liberalize financial transactions but limit speculation. By the 1960s, controls were leaky, with businesses using accounting tricks to move currency across countries or using unregulated offshore accounts. ■ Chapter 15 ■ Fixed versus Floating: International Monetary Experience 331 ● ■ From the trilemma, the deterioration of capital controls meant a loss of monetary policy autonomy to remain part of the Bretton Woods system. Countries compromised on a “fixed but adjustable” system in which countries devalued as a means of stabilizing output. This made the system unstable, creating beggar-thy-neighbor policies that encouraged speculation. ● In the 1960s, the United States experienced inflation as the result of fiscal expansion during the Vietnam War era. Countries pegged to the dollar would be forced to follow by expanding their money supplies, increasing inflation abroad. Gradually, countries abandoned the dollar peg. ● In 1971, the U. S. dollar was no longer convertible to gold. Aftermath and options ● Countries faced several options after the collapse of the Bretton Woods system: Most advanced countries have moved to a floating exchange rate regime, preferring monetary policy autonomy over fixed exchange rates. A group of European countries attempted to preserve fixed exchange rates through the ERM. Today a subset of those countries is “irrevocably” committed to the euro. This group of countries is at the top corner of the trilemma diagram. Some developing countries have maintained capital controls, but most have opened capital markets. There is a fear of floating (benefits greater than costs) for these countries. Some countries have adopted intermediate regimes, dirty floats, or pegs with limited flexibility (India). A small number of countries still rely on capital controls today (China), but this is changing. ● Today, there is no real international monetary system in the sense of cooperative systems between countries. There are some notable exceptions, such as the establishment of the ERM and the Eurozone. 5 Conclusions This chapter considered the choice of whether to adopt a fixed or a floating exchange rate regime. The primary factors are economic integration and stability costs, with other factors such as fiscal discipline and liability dollarization playing an important role in emerging markets and developing countries. We considered the mechanics of a fixed exchange rate regime with cooperation and noncooperation in terms of interest rate parity and exchange rate adjustments. The chapter concluded with a summary of exchange rate systems in practice, focusing on the gold standard and the Bretton Woods systems. 332 Chapter 15 ■ Fixed versus Floating: International Monetary Experience Teaching Tips 1. Teaching Tip 1: Rep. Ron Paul (R-Texas) advocates returning the United States to the gold standard, eliminating the Federal Reserve, and allowing privately issued currency to compete with the dollar (http://www. ronpaul. com/2010-01-26/ron-paul-legalize-competingcurrencies/ and http://www. ronpaul. com/2009-02-01/going-back-tothe-gold-standard/ for example). Ask your students whether a return to the gold standard would be a good idea. Point out that most of the rest of the world would probably not follow our lead on this issue. Then ask them whether privately issued currencies are allowed in the United States. Give them a few days to do some research. You, luckily, have this resource. The E. F. Schumacher Society (Small Is Beautiful, Blond & Briggs, 1973) maintains a list of current and “retired” local currency experiments at http://www. smallisbeautiful. org/local_currencies/retired_in-planning. htm. So there is competition for the dollar. Have the class discuss why the dollar has maintained its monopoly position as U. S. currency in the face of this competition. 2. Teaching Tip 2: German reunification was one of the biggest news stories of 1990. Twenty years later, the shockwaves continue. As we saw in this chapter, reunification imposed large fiscal costs on the West German government, ultimately resulting in the United Kingdom’s decision to leave the ERM. As of July, 2010, unemployment in eastern Germany was 11. 5%, almost double the 6. 5% rate in the west. And government subsidies of € 80 billion flowed into the east, half of which paid for social benefits and welfare. The roots of this lay in the exchange rate between the West German Deutschmark (DM) and the East German ostmark (OM). Before reunification, the official exchange rate was 1 to 1. But the black market rate was between five and ten OM/DM. But, for political reasons, the West German government agreed to an exchange rate between 1 and 3 OM/DM, with prices and wages converted at a 1:1 ratio. The problem was that East German productivity was less than half that of West German workers. In effect, East German labor was priced out of the market, resulting in the large flow of subsidies that continues today. West Germany financed the increased government spending with debt, pushing up interest rates. The rest of the story is told in the textbook. So here’s the question for your students: what, if anything, should the West German government have done differently? 3. Sources: http://www. dw-world. de/dw/article/0,,6025610,00. html and http://www. sjsu. edu/faculty/watkins/germancurrency. htm Chapter 15 ■ Fixed versus Floating: International Monetary Experience 333 IN-CLASS PROBLEMS 1. Examine the empirical evidence on the benefits and costs of currency pegs. First, identify the potential costs and benefits, then evaluate each based on the empirical analysis presented in the chapter. Answer: The potential benefits of a fixed exchange rate regime are: efficiency gains from the reduction of transactions costs and convergence in prices, fiscal discipline in the form of lower inflation tax (seigniorage), and reduction in losses from valuation effects arising from currency mismatch in external wealth. The costs of a fixed exchange rate rest mainly on lack of policy autonomy, which could otherwise be used to stabilize output. The empirical evidence is summarized as follows: ■ Benefits Countries with a common currency and direct exchange rate peg have a higher volume of trade relative to those with floating exchange rates. There is no significant benefit for countries with indirect pegs. ● Evidence testing in both baskets of goods (PPP) and individual goods indicate price convergence is faster among countries with lower exchange rate volatility. ● Fixed exchange rate regimes do not prevent inflation in general. However, ● ■ the adoption of a fixed exchange rate regime does eventually reduce inflation in emerging markets and developing countries. ● Losses in external wealth associated with valuation effects (from depreciation) can be quite large, although they depend on the percent depreciation in the currency. Countries with a larger fraction of liabilities denominated in another currency such as dollars or yen or those experiencing larger depreciations suffered larger losses in wealth. The empirical evidence indicates these losses have a significant effect on output. Costs ● Interest rate movements in home countries relative to a base country. The estimated slope of the line should be equal to 1 in case 1. The data support this observation. ● Output volatility is higher for countries with a fixed exchange rate regime relative to float. The data show the instability is higher for poorer countries. This suggests that loss of monetary policy autonomy is costly in terms of output stability. 334 Chapter 15 ■ Fixed versus Floating: International Monetary Experience 2. The Bulgarian lev is currently pegged to the euro. Using the IS/LM diagrams for home (Bulgarian lev) and foreign (Eurozone) illustrate how each of the following scenarios affects the Bulgarian lev. Assume that this fixed exchange rate regime involves noncooperative adjustments to interest rates and that the Eurozone is the center “country. ” a. Bulgaria increases government spending to finance social welfare programs. Answer: The increase in government spending leads to a rightward shift in the IS curve. This leads to an increase in home country’s interest rate and an implied appreciation in the home currency, shifting IS* to the left. In a fixed exchange rate regime, the home country’s central bank shifts LM to the right to offset the increase in the home interest rate and IS* does not shift. Floating (B): Y ↑, i ↑, E ↓ Fixed (C): Y ↑; i and E unchanged i LM1 LM2 i* LM*1 i2 i1 A B C i*1 i*2 IS2 B A C IS1 IS*1 IS*2 Y Y*2 Y*1 Y* Y1 Y2 Y3 b. The Eurozone countries decrease the money supply. Answer: The decrease in foreign money supply leads to a leftward shift in the LM* curve. This leads to an increase in foreign country’s interest rate, i*, and an implied appreciation in the foreign currency, shifting IS to the right. In a fixed exchange rate LM2 i C i3 i2 i1 B A i*3 i*2 i*1 i* LM1 regime, the home country’s central bank shifts LM to the left to align home interest rate i with the foreign interest rate i*, shifting IS* to the right. Floating (B): Y ↑, i ↑, E ↑ Fixed (C): Y ↓, i ↑, E unchanged LM*2 LM*1 C B A IS2 IS1 IS*2 IS*1 Y3 Y1 Y2 Y Y*2 Y*3 Y*1 Y* Chapter 15 ■ Fixed versus Floating: International Monetary Experience 335 c. Investors expect a depreciation in the Bulgarian lev relative to the euro. Answer: This increases the return on foreign deposits, leading to a depreciation in the home currency, shifting IS to the right. The result is an increase in home interest rates, which shifts IS* to the left. In a fixed exchange rate regime, the home country’s central bank shifts LM to the left to prevent the depreciation and the home interest rate, i, rises, shifting IS* further to the right. Note that the interest rates may not be equal as long as investors expect a depreciation, i i*. Floating (B): Y ↑, i ↑, E ↑ Fixed (C): Y ↓, i ↑, E unchanged LM2 i C i3 B i2 i1 A i*1 i*2 IS2 IS1 IS*2 Y3 Y1 Y2 Y Y*2 Y*1 Y*3 IS*1 Y* B IS*3 i*3 A C LM1 i* LM*1 3. The Chinese government manages the value of the Chinese yuan relative to the U. S. dollar. Between 1995 and 2005, the yuan was pegged to the dollar at a rate of roughly 8. 28 yuan per dollar. China’s central bank, the People’s Bank of China (PBC), is responsible for using monetary policy to defend the fixed exchange rate. As a result of government policy geared toward spurring capital investment, China experienced a significant increase in investment demand. a. Using the IS/LM diagram for home (China) and foreign (the United States) illustrate the impact of this policy, assuming the PBC responds to maintain a fixed exchange rate. Answer: See the following diagram. i LM1 LM2 i* LM*1 i3 i1 A C B i*3 i*1 A B C IS2 IS*3 IS1 Y1 Y3 Y2 Y Y*1 Y*3 IS*1 Y* 336 Chapter 15 ■ Fixed versus Floating: International Monetary Experience b. How would this policy and central bank response affect the government budget, current account, domestic interest rates, and output? Answer: The government budget, trade balance, and home interest rate are unaffected by this policy. China’s output increases. c. How would China’s experience be different if the PBC allowed the yuan to float against the U. S. dollar? What would be the implications for China’s exports to the United States? For China’s imports from the United States? Answer: If the yuan floats against the dollar, the increase in investment demand will lead to an appreciation in the yuan by increasing the domestic return on China’s deposits. China’s output increases by a smaller amount and its trade balance decreases because of the increase in China’s interest rate and the appreciation in the yuan. This would cause a decrease in China’s exports and an increase in China’s imports from the United States, as shown by the rightward shift in IS* in the previous figure. d. In practice, China uses capital controls to fix its exchange rate. How does this affect the previous answers? In the case of capital controls, is the outcome more similar to the fixed case in (a) or the floating case in (c)? Answer: In the case of capital controls, China can allow the interest rate in China to deviate from the U. S. interest rate through eliminating capital market arbitrage. This will result in a situation similar to the floating case mentioned previously; because interest rates need not be equal, China’s central bank does not need to expand the money supply to prevent the appreciation in the yuan. 4. During the mid-1990s, Mexico maintained an exchange rate peg against the U. S. dollar. When President Zedillo took office in December 1994, he faced several challenges. A combination of the assassination of a presidential candidate (Luis Donald Colosio) and the rebellion in Chiapas had led to an increase in the expected future exchange rate, Eepeso/$. a. Using the IS/LM diagram for home (Mexico) and foreign (the United States) illustrate the impact of this change in investor expectations, assuming the Banco de Mexico responds to maintain a fixed exchange rate. Answer: See the following diagram. Point B shows the floating exchange rate outcome (for comparison); point C shows the fixed exchange rate output. LM2 i i3 i2 i1 C i*3 i*1 i*2 IS2 IS*1 IS*2 Y3 Y1 Y2 Y Y*2 Y*1 Y*3 Y* A B IS*3 C LM1 i* LM*1 B A IS1 Chapter 15 ■ Fixed versus Floating: International Monetary Experience 337 b. How would the change in exchange rate expectations and the subsequent central bank response affect the government budget, trade balance, domestic interest rates, and output? Answer: Mexico’s central bank is forced to cut the money supply to prevent an actual depreciation in the peso because investors shift deposits out of Mexico, expecting a higher return on U. S. deposits. Also, the expected depreciation leads to a rightward shift in IS because the demand for Mexico’s goods rises. The increase in Mexico’s interest rate leads to an increase in demand for U. S. goods, shifting IS* to the right and offsetting gains in Mexico’s trade balance. c. When president-elect Ernesto Zedillo took office, he was forced to make a decision between either establishing an exchange rate band (effectively floating the peso against the dollar) or continuing the monetary policy mentioned previously. President Zedillo decided to establish an exchange rate band. The former President Salinas referred to Zedillo’s policies as “el error de diciembre,” or “the December mistake. ” Do you believe this decision was a mistake? Explain, considering the trade-offs between output stabilization and exchange rate stability. Answer: Based on the previous diagram, we can see why President Zedillo may have opted to float the peso against the dollar. In this case, Mexico does not suffer a contraction in output and its trade balance improves. This highlights the trade-off be- tween exchange rate stability and output stability. In the case of a fixed exchange rate, Mexico suffers a contraction in output. In the floating case, it experiences an expansion. d. Suppose that a large share of Mexico’s external debt is denominated in U. S. dollars. How does this affect your answer to (c)? Answer: If a large share of Mexico’s external debt is denominated in U. S. dollars, then a depreciation in the peso could have added costs in terms of valuation effects. The depreciation in the peso would reduce Mexico’s external wealth, potentially contracting demand through reducing consumption and/or investment demand. In this case, it might be more beneficial to maintain the exchange rate peg. 5. Consider a noncenter home country that is part of a fixed exchange rate regime. The home country currently has output higher than its desired level. Concerned about inflationary pressures, central bankers want to contract the money supply. Using the IS/LM diagrams for a home and a foreign country, show how each of the following would affect home and foreign output. In which cases are the monetary policy objectives inconsistent with the home country remaining in the fixed exchange rate regime? a. The foreign country is a center country. Compare a cooperative versus a noncooperative adjustment in interest rates. Answer: See the following diagram. In the noncooperative case, there is little the home country can do. It remains at point A, un- 338 Chapter 15 ■ Fixed versus Floating: International Monetary Experience able to use monetary policy to achieve output stability. In the case of a cooperative agreement, the foreign country and the home country agree to raise interest rates, reducing output in both countries. This pushes output below its desired level in the foreign country and brings home country output closer to its desired level. This cooperative agreement is similar to how autonomous monetary policy would respond, except the home country must compromise and not contract the money supply as much as what is needed to achieve desired output (otherwise the foreign country might not LM*2 LM2 i i2 B LM1 i* i*2 B LM*1 i1 A i*1 IS2 IS1 IS*2 IS*1 Y0 Y2 Y1 Y Y*2 Y*0 Y* A agree to raise interest rate, i*). b. The foreign country is a noncenter country. Compare a cooperative versus a noncooperative adjustment in exchange rates. Answer: See the following diagram. In this case, the home country wants to implement a currency revaluation to reduce the trade balance and contract output. In the cooperative case, the foreign country agrees to the revaluation, compromising to let its output rise above the desired level by a small amount. In the noncooperative case, the home country revalues by a larger amount, leading to a bigger boom in output in the foreign country. Essentially, the home country “exports” its economic boom to the foreign country in part (in a cooperative agreement) or in full (noncooperative). i LM3 i* LM2 LM1 i*2 LM*1 LM*2 LM*3 C i1 B A A i*1 B C IS1 IS2 IS3 IS*2 IS*1 Y Y*0 Y*2 Y*3 Y* IS*3 Y0 Y2 Y1 Chapter 15 ■ Fixed versus Floating: International Monetary Experience 339 6. During the 1980s, several Latin American countries had currencies pegged to the U. S. dollar. Consider three such countries: Belize, Bolivia, and Mexico. A larger share of Mexico’s exports was/is sold in the United States relative to Belizean and Bolivian exports to the United States. In addition, Mexico shares a large geographic border with the United States, whereas Belize is located further south in Central America, with coastal access to the United States through the Caribbean Sea. Bolivia is located in South America and is landlocked. Compare and contrast these three countries in terms of their likely degree of integration symmetry with the United States. Plot Belize, Bolivia, and Mexico on the symmetry-integration diagram relative to the United States. Answer: See the following diagram. Although it is not possible to determine the position of the FIX line without more information, we know that Mexico is in the upper right and Bolivia is in the lower left. Sharing a geographic border with the United States and trading heavily means Mexico’s efficiency gains are larger than those in Bolivia and Belize. Because Belize has coastal access to the United States and is located closer than Bolivia, it lies above and to the right of Bolivia, but below and to the left of Mexico. 7. Several countries that have experienced political and economic stability adopt a fixed exchange rate regime to draw on the potential benefits, such as fiscal discipline, seigniorage, and expected future inflation. To what extent do you believe these potential benefits differ in cooperative versus noncooperative fixed exchange rate systems? Answer: Cooperative exchange rate systems are generally more successful than noncooperative regimes. Countries can compromise on adjusting interest rates or exchange rates, preventing countries from being forced off of a fixed exchange rate regime. With cooperation, the costs of asymmetric shocks are shared by members of the fixed exchange rate regime, reducing stability costs. In practice, however, cooperative arrangements often break down because it is difficult for a country to let another country’s economic conditions dictate those at home, especially if the home country happens to be a center country. In terms of the benefits, to the extent that cooperative arrangements last longer, the efficiency gains from trade are higher because these take some time for the economy to realize. Also, cooperative arrangements may help impose fiscal discipline by providing a nominal anchor that is generally agreed upon. 8. Symmetry of shocks Mexico Belize Bolivia FIX Market integration In the context of the trilemma, compare and contrast the dissolution of the gold standard during the 1920s and 1930s to the collapse of the Bretton Woods system during the 1960s and early 1970s. In what sense did the Bretton Woods system attempt to address the problems associated with the gold standard? To what extent did the Bretton Woods system strengthen or weaken a country’s ability to maintain a fixed exchange rate? Answer: The gold standard collapsed for a combination of reasons: ■ ■ ■ ■ the efficiency gains from trade were diminished as the results of war and poor macroeconomic policy stability costs became more important to policy makers politically lack of cooperation between countries in that they did not commit to maintaining the gold peg slow growth in the world gold supply led to deflation 340 Chapter 15 ■ Fixed versus Floating: International Monetary Experience In comparison, the Bretton Wood’s collapse stemmed from: ■ 9. market forces against capital controls (in addition to being at odds with financial liberalization) ■ changes in U. S. domestic monetary policy affecting world economic conditions ■ breakdown in cooperation and frequent devaluations, leading to a loss of credibility in the system In the context of the trilemma, the gold standard eliminated monetary policy autonomy as an option because it was premised on free convertibility between gold and money, leaving speculators free to arbitrage. The Bretton Woods system addressed this through capital controls, leaving countries free to pursue domestic monetary policy. In addition, the Bretton Woods system pegged currencies to the U. S. dollar, rather than gold, so that the base currency could be adjusted as world economic conditions changed. In this sense, the Bretton Woods system could be successful as it offered some flexibility through cooperation. The breakdown of the system stemmed from the U. S. expansion of its money supply in the 1960s (exporting its high inflation rates worldwide) and the de facto deterioration of capital controls. The International Monetary Fund (IMF) is often viewed as an international lender of last resort. When countries seek out loans from the IMF to alleviate banking and economic crises, the IMF often requires countries to maintain a fixed exchange rate. Why do you suspect the IMF pressures countries with large levels of foreigndenominated debt to maintain fixed exchange rates? Do you believe this is a good policy? Discuss possible alternatives. Answer: The IMF might require a fixed exchange rate regime as a condition of lending to dissuade countries from defaulting on their external debt denominated in a foreign currency, such as the country’s loans from the IMF. As we have seen in this chapter, there is considerable debate about whether fixed exchange rates are beneficial. However, it is clear that a fixed exchange rate regime does reduce the probability of default. An alternative would be to lend in the country’s local currency. Even if this requires higher interest rates, it would help to develop local capital markets through increased liquidity.