International Business Chapter 19 This Was The Case The Shock Created German Reunification Asymmetric Shocks Create

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19 Fixed Versus Floating: International Monetary Experience

Notes to Instructor

Chapter Summary

This chapter 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

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

1. Exchange Rate Regime Choice: Key Issues

a. Application: Britain and Europe: The Big Issues

i. A Shock in Germany

ii. Choices for the Other ERM Countries

iii. Choice 1: Float and Prosper?

b. Key Factors in Exchange Rate Regime Choice: Integration and Similarity

c. Economic Integration and the Gains in Efficiency

f. Application: Do Fixed Exchange Rates Promote Trade?

i. Benefits Measured by Trade Levels

ii. Benefits Measured by Price Convergence

g. Application: Do Fixed Exchange Rates Diminish Monetary Autonomy and

Stability?

2. Other Benefits of Fixing

a. Fiscal Discipline, Seigniorage, and Inflation

b. Side Bar: The Inflation Tax

3. Fixed Exchange Rate Systems

a. Cooperative and Noncooperative Adjustments to Interest Rates

4. International Monetary Experience

5. Conclusions

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

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 19-1 shows a timeline of exchange rate regimes. World War I and II occurred

during 1914–1917 and 1940–1944 and, as such, these years 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

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

A Shock in Germany 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.

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 19-2.

■ IS curve shifts to the right. Higher German interest rates lead 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

Choice 1: Float and Prosper Option 1: Britain chooses to keep its interest rate

unchanged (point 4).

■ IS curve shifts to the right since a rise in foreign interest rates always leads to

expenditure switching at home.

Choice 2: Peg and Suffer Option 2: Britain remains part of the ERM (point 2).

■ IS curve shifts to the right.

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

but enough to stabilize output).

■

What Happened Next? Britain opted out of the ERM, not wanting German-specific

events to dictate domestic policy. Figure 19-3 compares Britain with France, a country

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

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

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

Simple Criteria for a Fixed Exchange Rate

Now that we have identified the efficiency benefits and stability costs, we can define a

19-4 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.

In 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 →

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

Benefits Measured by Trade Levels Economic historians found that pairs of countries

that adopted the gold standard in the late nineteenth and early twentieth 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)

Figure 19-5 suggests a strong relationship between currency regimes and trade.

Countries with a common currency have a 38% higher trade volume than a floating rate.

Benefits Measured by Price Convergence 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,

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

The Trilemma, Policy Constraints, and Interest Rate Correlations Solutions to the

trilemma:

1. Open capital markets with fixed exchange rate (“open peg”)

Note that case 1 implies that monetary policy is not autonomous, so interest rates in the

monetary policy so that changes in interest rates across countries are independent.

Figure 19-6 shows interest rate movements in home countries relative to a base

country. In case 1, the estimated slope of the line should be equal to 1. The data support

this observation:

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.

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

S I D E B A R

The Inflation Tax

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

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

The extra money printed to purchase goods and services is worth ∆M/P = (∆M/M) ×

(M/P) = π × (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:

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:

■ Home external assets

● AH denominated in home currency (pesos)

● AF denominated in foreign currency ($) = EAF measured in home currency

(pesos)

■ Home external liabilities

Home country’s total external wealth is the sum of total assets less the liabilities

expressed in home currency:

Suppose the exchange rate changes by ∆E. The change in wealth is (valuation effect)

From the expression, there are two possible cases following a depreciation, ∆E > 0:

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.

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 19-8 reports data on the cumulative

change in external wealth associated with valuation effects during currency crises from

Evidence Based on Output Contractions Do these wealth effects matter for output?

Figure 19-9 plots the relationship between the percentage change in output against the

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 19-2 reports data on the percentage of external liabilities denominated in

Options for Redemption?

■ Another perspective argues that the real source of the problem is global 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.

Practical Limitations

■ Government borrowing denominated in foreign currency is still a problem.

■ Also, currency mismatch in private sectors is a problem, compounded by moral

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.

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 (see Application: Britain and Europe: The Big Issues). At that

time, the German Deutsch Mark (DM) was the base currency. Germany, as the center

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 19-11.

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

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

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.