Chapter 20. Exchange Rate Regimes
I. MOTIVATING QUESTION
How does the exchange rate regime affect macroeconomic adjustment?
Under a fixed nominal exchange rate regime, there are two methods of adjustment: relatively slow,
medium-run adjustment through the movement of prices and the real exchange rate, or relatively fast
adjustment through devaluation, often induced by a speculative attack on the currency. Under a flexible
exchange rate regime, policymakers can use monetary policy to stimulate output during a recession. In
choosing between exchange rate regimes, the apparently superior adjustment mechanism offered by a
flexible exchange rate has to be weighed against the potential benefits offered by offered by fixed
exchange rates. The relative costs and benefits of exchange rate regimes will depend on a country’s
specific circumstances.
II. WHY THE ANSWER MATTERS
The choice of exchange rate regime is a perennial and fundamental issue in international
macroeconomics. Moreover, currency crisis remains a topical and intriguing phenomenon. This chapter
provides students a basis to understand and think about these issues within the framework developed in
the previous three chapters.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1. Tools and Concepts
i. Following Mundell, the chapter defines an optimal currency area as a group of countries that
satisfy at least one of two conditions: similar economic shocks or high factor mobility within the group.
IV. SUMMARY OF THE MATERIAL
1. The Medium Run
Suppose a country operates under a fixed exchange rate,
´
E .
Perfect capital mobility implies that the
domestic nominal interest rate equals the world nominal interest rate, i.e., i=i*. To simplify, take expected
inflation and foreign output as fixed. These assumptions imply that the goods market equilibrium
condition can be expressed as follows:
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This chapter focuses on the role of the real exchange rate (
´
E
P/P*) in equation (20.1). A real
depreciation (a decrease in the real exchange rate) increases output by increasing net exports. An increase
in G also increases output; an increase in T reduces output. The export effect is given by Y* while the
domestic real interest rate is given by i* – πe. The time subscripts indicate that the domestic price level and
domestic output can change over time. For convenience, the text assumes that G, T, and P* are constant.
Assuming countries are operating at potential output there should be no difference in inflation rates across
countries and therefore no pressure on exchange rates.
Now suppose that the economy starts from a position in which output is below the natural level (Yn) and
unemployment is above the natural rate. If policymakers maintain a commitment to the fixed exchange
rate, the relatively high unemployment rate will tend to drive down wages, prices, and expected prices.
Although eventually the economy returns to the natural level of output, the process takes some time.
Output adjustment is limited by the speed of price adjustment.
If policymakers want to speed up adjustment, they can devalue the currency (decrease the level of
´
E
).
A devaluation creates a real depreciation in the short run and shifts the IS curve to the right. In principle,
a devaluation of the right size can return the economy to its natural level of output almost immediately. In
practice, however, the immediate effect of a devaluation will be to increase the price of imported goods
(in terms of domestic goods), which has two implications. First, it will take time for a devaluation to
improve the trade balance (the J-curve effect), and second, devaluation will lead to an immediate increase
in the cost of living (since some goods are imported), which will tend to increase wages and slow down
price adjustment. These effects suggest that devaluation will not eliminate adjustment and that it may be
difficult to determine the size of the devaluation required to restore output to its natural level.
2. Exchange Rate Crises under Fixed Exchange Rates
The analysis in Section 20.1 assumed that international investors believed that policymakers would
maintain a fixed exchange rate of
´
E
. In fact, as was demonstrated in Section 20.1, policymakers have
the option of devaluing the currency or, in the extreme, abandoning fixed exchange rates altogether. If
international investors believe a devaluation is possible, the expected future exchange rate will rise above
the current exchange rate, and by uncovered interest parity, the domestic interest rate will rise above the
world rate by the amount of the expected devaluation (in percentage terms). Thus, in the face of an
expected devaluation, policymakers will be required to raise the interest rate if they wish to maintain the
fixed exchange rate. Since raising the interest rate reduces domestic output and increases home
unemployment, policymakers may find this course too painful and may abandon the current fixed rate,
either through a devaluation (which validates the original expectation) or by adopting a flexible exchange
rate regime.
At times, international investors may have good reason to expect devaluation or abandonment of a fixed
exchange rate. A country’s currency may be overvalued, implying that a real depreciation is necessary to
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improve output, the trade balance, or both. The quickest way to achieve a real depreciation is through a
nominal depreciation. Likewise, a country may want to reduce its interest rate to get out of a recession. A
fixed exchange rate precludes this option, but a flexible exchange rate permits an interest rate reduction
through monetary expansion and concomitant nominal depreciation. Although there may be reasons to
expect devaluation in some circumstances, an expected devaluation can trigger a crisis even if the initial
fear of devaluation is groundless.
An increase in the expected future exchange rate, for whatever reason, requires policymakers to raise the
interest rate and suffer a fall in output to maintain the fixed exchange rate. If policymakers are unwilling
to pay this cost, then a fear of devaluation can become self-fulfilling.
3. Exchange Rate Movements under Flexible Exchange Rates
Chapter 20 assumed that the expected exchange rate next period was fixed. This assumption generated a
simple relationship between the interest rate and the exchange rate: the lower the interest rate, the more
depreciated the exchange rate. In fact, the expected future exchange rate is not fixed, but can vary, with
implications for the current exchange rate.
Rewrite the uncovered interest parity condition as follows:
Et= [(1+it)/(1+i*t)]Eet+1. (20.4)
Applying equation (20.4) to time t+1 implies that the exchange rate at time t+1will depend on the
domestic and foreign interest rates at time t+1 and the expected exchange rate at time t+2. Thus, the
expected exchange rate at time t+1 will depend on expected interest rates at time t+1and the expected
exchange rate at time t+2. In other words,
Eet+1 = [(1+iet+1)/(1+i*et+1)] Eet+2.
Substituting this equation into equation (20.4) gives
Et = [[(1+it)(1+iet+1)]/[(1+i*t)(1+i*et+1)]]Eet+2.
Carrying this calculation n years into the future gives
Et = [[(1+it)(1+iet+1)...(1+iet+n)]/[(1+i*t)(1+i*et+1)…(1+i*et+n)]]Eet+n+1. (20.5)
Equation (20.5) makes clear that the current exchange rate depends on expected interest rates and the
expected exchange rate far into the future. In particular, there are three implications.
First, the current exchange rate will be affected by any factor that affects the future expected exchange
rate. Over a long enough horizon, it is reasonable to assume that the exchange rate will have to be
consistent with current account balance, since countries cannot borrow—and will not want to lend—
forever. Thus, economic news that affects forecasts of the current account balance may affect the future
expected exchange rate, which in turn will affect the current exchange rate.
Second, the current exchange rate will be affected by any factor that affects current or expected future
domestic or foreign interest rates.
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Third, as a result of the first two implications, the relationship between the home interest rate and the
exchange rate is not straightforward. Suppose the home central bank cuts the domestic interest rate.
Financial market participants will make some judgement about whether the cut is temporary or signals the
start of a series of interest rate cuts, and will then revise their expectations about future domestic interest
rates accordingly. They will also assess the likely response of foreign central banks and revise their
expectations of future foreign interest rates. These changes in expectations will affect the current
exchange rate.
The bottom line is that exchange rates can fluctuate greatly even in the absence of large changes in
current economic variables. As a result, countries that operate under flexible exchange rate regimes must
be prepared to accept substantial exchange rate fluctuations.
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4. Choosing between Exchange Rate Regimes
Countries that operate under fixed exchange rates with one another are constrained to have the same
interest rates. Therefore, fixed exchange rates eliminate discretionary monetary policy and nominal
depreciation as methods of adjustment during recession. In normal times, adjustment happens slowly—
through price adjustment and changes in the real exchange rate over the medium run. In emergency
situations, adjustment happens through devaluation, often forced on policymakers through currency crisis.
Thus, the adjustment mechanism of fixed exchange rates does not appear terribly attractive.
On the other hand, as Robert Mundell pointed out in the 1960s, the loss of discretionary monetary policy
is less important to the extent that countries operating under fixed exchange rates face one of two
conditions: similar economic shocks or high factor mobility with one another. If countries face similar
shocks, they would tend to choose the same monetary policies even in the absence of fixed exchange
rates. If countries have high factor mobility, movements of workers can substitute for real depreciation as
a method of economic adjustment. In other words, workers will move from areas that require real
depreciation to avoid high unemployment. A group of countries that satisfy at least one of Mundell’s
conditions is said to constitute an optimal currency area. As the name implies, it makes sense
economically for such a group of countries to adopt a single currency. As the text argues, many
economists believe that the countries of the Euro zone do not constitute an optimal currency area, since
they satisfy neither of Mundell’s conditions.
In some cases, the loss of policymaking flexibility under fixed exchange rates may also provide benefits.
If countries have a reputation for undisciplined monetary policy, international investors may fear that a
flexible exchange rate system will allow too much latitude for inflationary policy. To the extent that such
countries can commit to a fixed rate system, they eliminate the potential for discretionary monetary
policy. Since a fixed exchange rate can always be abandoned, however, it is not always a simple matter to
demonstrate commitment to a fixed rate system. One method is to enter into a common currency with a
set of other countries, as much of Europe has done. Another is to supplement fixed exchange rates with
legislative or technical measures that limit or prohibit discretionary monetary policymaking. The latter
arrangements—called currency boards—generated much interest in the 1990s. Argentina adopted a
currency board in 1991, but abandoned it in crisis in 2001. Some economists argue that Argentina’s
currency board was not tight enough, since an exchange rate crisis was not prevented. These economists
argue that a country that wants a fixed exchange rate should simply adopt the U.S. dollar as its currency.
Other economists argue that fixed exchange rates are a bad idea, and that currency boards should be used
for only short periods of time, if at all. A box in the text describes Argentina’s crisis.
Finally, the policy flexibility seemingly offered by flexible exchange rates may be illusory. In practice,
flexible exchange rates vary greatly. Large and unpredictable movements in the nominal exchange rate
make life more complicated for firms and consumers and have real effects in the short run since prices
(and hence the real exchange rate) adjust slowly. As described above, movements in the exchange rate
are driven by expectations, which are not well understood, and the relationship between monetary policy
and the nominal exchange rate is a bit more complicated than it seemed in Chapter 19. Moreover, to the
extent that changes in the nominal exchange rate have real effects, monetary policymakers may be
required to use policy to respond to unpredictable (and sometimes difficult to understand) movements in
the nominal exchange rate. Thus, flexible exchange rates do not allow policymakers complete
independence: to some extent, policymakers are at the mercy of the foreign exchange market.
The choice of exchange rate regime requires weighing the costs of highly variable nominal exchange rates
against the potentially poor adjustment properties of fixed exchange rates. The choice will depend on the
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circumstances of a given country—in particular, whether it is part of a group of countries that satisfy one
of Mundell’s two conditions and whether it needs to establish a reputation for monetary discipline.
V. PEDAGOGY
The discussion in this chapter is relatively sophisticated for students just coming to terms with
open-economy macroeconomics. It is important to review carefully the adjustment mechanisms under
fixed and flexible exchange rates before tossing around terms cavalierly. It may also be helpful to discuss
the role of the nominal exchange rate (under flexible rates) as an automatic stabilizer. Under a fixed
exchange rate, a shock to the goods market will affect output by the full amount of the horizontal shift of
the IS curve (since the interest rate is fixed). Under a flexible rate, the same shock to the IS curve will
have a smaller effect on output (since the interest rate and exchange rate can vary). In other words,
flexible exchange rate systems tend to dampen IS shocks.
VI. EXTENSIONS
An appendix to the chapter introduces real interest parity (uncovered interest parity with real interest rates
and exchange rates substituted for nominal interest rates and exchange rates) and extends it to a long-run
relation. With this in mind, the current real exchange rate is influenced by two factors—domestic and
foreign long-term real interest rates and the expected long-run real exchange rate. In the long run, the real
exchange rate should adjust to a level consistent with current account balance. If there is a large current
account deficit today, then presumably the expected long-run real exchange rate will be lower (more
depreciated) than the current real exchange rate, other things equal.
VII. OBSERVATIONS
The real exchange rate drives adjustment in an open economy. In the short run, with prices fixed,
movements in the nominal exchange rate create movements in the real exchange rate. Thus, in the short
run, fixed exchange rate regimes have no avenue for adjustment, and shocks translate into changes in
output. In the medium run, the real exchange rate can adjust through prices, and the flexibility of the
nominal exchange rate is irrelevant.
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