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CHAPTER 15International Economic Policy1Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Questions How has the world organized its international monetary system?What is a fixed exchange rate system?What is a floating exchange rate system?What are the costs and benefits of fixed exchange rates vis-vis floating exchange rates?2Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Questions Why do most countries today have floating exchange rates?Why has western Europe recently created a“monetary union”-an irrevocable commitment to fixed exchange rates within western Europe?What were the causes of the three major currency crises of the 1990s?3Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Gold Standard Before World War I,nearly all of the world economy was on the gold standarda government would define a unit of its currency as worth a particular amount of goldthe currency was convertible could be converted into gold freelythe currencys price in terms of gold was its parity4Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.2-Growth of the Gold Standard5Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Gold Standard When two countries were on the gold standard,their nominal exchange rate was fixed at the ratio of their gold paritiesat World War II parities the U.S.dollar was equal to 1/35 of an ounce of gold the British pound sterling was set to equal 1/15.58333 ounces of gold the exchange rate of the dollar for the pound was 1.00=$2.406Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Gold Standard Example of currency arbitragethe U.S.government is willing to buy gold at$35 per ouncethe British government is willing to buy gold at 15.58333 per ouncethe pound trades for$2.64(10%higher than the ratio of the gold parities-$2.40)7Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Gold Standard Someone with an ounce of gold couldtrade it to the British Treasury for 15.58333 trade those pounds for dollars in the foreign exchange market and get$38.50trade the$38.50 to the U.S.Treasury for 1.1 ounces of goldrepeat the process as quickly as possible,making a 10%profit each time the circle is completed8Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.1-How to Profit in the Foreign-Exchange Market9Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Weaknesses of theGold Standard The gold standard tended to be deflationaryunder some circumstances,it pushed countries to raise their interest rates which reduced output and increased unemploymentit never provided a countervailing push to other countries to lower their interest rates10Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Weaknesses of theGold Standard If the exchange rate is floating,foreigners domestic currency earnings must be used to buy exports or to invest in the home country The exchange rate moves up or down in response to the supply and demand for foreign exchange in order to make it so0NFINX11Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Weaknesses of theGold Standard Under a gold standard,foreign-currency earnings can also be used to purchase gold from the foreign countrys Treasury0FG-NFINX If a countrys net exports plus net foreign investment are less than zero,its Treasury will find itself losing goldthe countrys gold reserves shrink12Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Weaknesses of theGold Standard If a countrys gold reserves are shrinking,it has a choiceabandon the fixed exchange rate systemmake it more attractive for foreigners to invest by raising domestic interest rates puts contractionary pressure on the economy Countries gaining gold face no incentive to lower interest rates in order to stay on the gold standard13Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Collapse of the Gold Standard The gold standard was suspended during World War I After the war ended,politicians and central bankers sought to restore itthey believed it was an important step in restoring prosperity After the Great Depression began,the gold standard broke apart14Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Collapse of the Gold Standard Four factors made the gold standard a less secure monetary systemeveryone knew that governments could abandon their gold parities in an emergencyeveryone knew that governments were trying to keep interest rates low enough to produce full employment15Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Collapse of the Gold Standard Four factors made the gold standard a less secure monetary systemafter World War I,countries held their reserves in foreign currencies rather than goldthe post-war surplus economies did not lower interest rates as gold flowed in16Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Collapse of the Gold Standard As soon as a recession hit,governments found themselves under pressure to raise interest rates and lower outputcould either stay on the gold standard and face a deep depression or abandon the gold standardthe further countries moved away from their gold-standard rates,the faster they recovered from the Great Depression17Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.3-Economic Performance and Degree of Exchange Rate Depreciation During the Great Depression18Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Bretton Woods System The Bretton Woods System was the result of an international monetary conference that took place in 1944 Three principles guided this systemin ordinary times,exchange rates should be fixedin extraordinary times,exchange rates should be changedan institution was needed to watch over the international financial system the International Monetary Fund(IMF)19Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Bretton Woods System The Bretton Woods System broke down in the early 1970sthe U.S.found itself with a large trade deficit and sought to devalue its currency Since then,the exchange rates of the major industrial powers have been floating exchange ratesfluctuate according to supply and demand20Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How a Fixed Exchange Rate System Works A fixed exchange rate is a commitment by a country to buy and sell its currency at fixed,unchanging prices(in terms of other currencies)the central bank or Treasury must maintain foreign exchange reservesthese reserves are limited21Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How a Fixed Exchange Rate System Works If there is a high degree of capital mobility,the real exchange rate is set by)r-(r-fr0 The higher the interest rate differential in favor of the home country,the lower is the exchange rate22Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.4-The Real Exchange Rate,Long-Run Expectations,andInterest Rate Differentials23Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How a Fixed Exchange Rate System Works If capital is highly mobile and the fixed exchange rate(*)is lower than foreign exchange speculators will want to sell the home currency for foreign currency the government spends down its reservesto keep the exchange rate at*,the central bank must lower interest rates monetary policy no longer can play a role in domestic stabilization24Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.5-Domestic Interest Rates Are Set by Foreign-Exchange Speculatorsand the Exchange Rate Target25Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How a Fixed Exchange Rate System Works The central bank must set the domestic real interest rate equal tor0f*-rran increase in foreign interest rates(rf)requires a point-for-point increase in domestic interest ratesan increase in foreign exchange speculators views of the long-run value of the exchange rate(0)requires an increase in domestic interest rates26Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.6-Effect of Foreign Shocks under Fixed Exchange Rates27Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How a Fixed Exchange Rate System Works If capital mobility is lowthe exchange rate is also affected by the speed at which the government is accumulating or spending its foreign exchange reserves(R)R)r-(r-Rfr0when the government is accumulating reserves,the value of foreign currency is higher than it would otherwise be it is increasing foreign currency demand28Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.7-With Limited Capital Mobility a Central Bank Can Shift theExchange Rate by Spending Reserves29Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.How a Fixed Exchange Rate System Works If capital mobility is lowthe central bank can use monetary policy for domestic disturbances this is limited by the sensitivity of exchange rates to the magnitude of foreign-exchange market interventions performed by the central bank and by the amount of reservesthe domestic real interest rate will beR*-rrrRr0f30Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Benefits of Fixed Exchange Rates Floating exchange rate systems add riskdiscourages international trademakes the international division of labor less sophisticated This is an important reason behind the decision of most of western Europe to form a monetary unionfix their exchange rates against each other irrevocably31Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Costs of Fixed Exchange Rates Under fixed exchange rates,monetary policy is tightly constrained by the requirement of maintaining the exchange rate at its fixed parity Fixed exchange rates also have the disadvantage of rapidly transmitting monetary of confidence shocksinterest rates move in tandem all across the world in response Fixed exchange rates also make large-scale currency crises more likely32Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Fixed or Floating Exchange Rates?Is it more important to preserve the ability to use monetary policy to stabilize the domestic economy rather than dedicating monetary policy to a constant exchange rate?Is it more important to preserve the constancy of international prices and thus expand the volume of trade and the scope for the international division of labor?33Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Fixed or Floating Exchange Rates?Economist Robert Mundell argued that the major reason to have floating exchange rates is that they allow adjustment to shocks that affect two countries differentlythis benefit would be worth little if two countries suffered the same shocks and reacted to them in the same waythis benefit would also be worth little if factors of production are highly mobile34Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The European Currency Crisis of 1992 After reunification with East Germany,the West German government undertook a program of massive public investmentthis shifted the IS curve outthe German central bank raised interest rates to keep inflation under control35Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.8-German Fiscal Policy and Monetary Response in the Early 1990s36Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The European Currency Crisis of 1992 The increase in interest rates generated a rise in the German exchange rate vis-vis the dollar and the yenexports fell Other countries in western Europe had fixed their exchange rates to the German mark as part of the European Exchange Rate Mechanism37Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The European Currency Crisis of 1992 The rise in German interest rates meant that these western European countries were required to raise interest rates as wellthe required interest rate increase threatened to send the other European countries into a recession38Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.9-Effect of German Policy on Other European Countries39Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The European Currency Crisis of 1992 Foreign exchange speculators did not believe that these western European governments would keep this promise to maintain the fixed exchange rate parity when unemployment began to rise0 rose which caused an additional rise in the domestic real interest rate required to maintain exchange rate parityr0f*-rr40Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The European Currency Crisis of 1992 Different governments in western Europe undertook different strategiessome spent reserves in the hope that it demonstrated their commitment to maintaining the exchange rate paritysome tried to demonstrate that they would defend the parity no matter how high the interest rate needed to besome abandoned the fixed exchange rate and let their currencies float The end result was the formation of the European Monetary Union41Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Mexican Currency Crisis of 1994-1995 The Mexican currency crisis was a surprise to most economic analyststhe governments budget was balancedthe governments willingness to raise interest rates was not in questionthe Mexican peso was not overvalued The peso lost half of its value in four months starting in December of 199442Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Mexican Currency Crisis of 1994-1995 Concerns about political stability reduced foreign exchange speculators estimates of the long-run value of the peso and raised their assessment of 0the Mexican government spent$50 billion in foreign reserves and eventually ran out it devalued the peso and let it float against the U.S.dollar the rise in caused a further increase in 0 the value of the Mexican governments debt also increased,which led to further increases in 043Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Mexican Currency Crisis of 1994-1995 The Mexican government had two optionsit could raise interest rates the level of interest rates required would produce a Great Depression in Mexicoit could keep interest rates low and let the value of foreign currency rise much further Mexican companies and the Mexican government would be unable to pay their dollar-denominated debts Mexicos foreign trade would fall drastically44Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Mexican Currency Crisis of 1994-1995 The U.S.made direct loans to Mexicothese loans built Mexicos foreign-exchange reserves back to a comfortable level this allowed domestic interest rates to remain relatively lowthe Mexican government was also able to refinance its debt confidence was restored that the Mexican government would not be forced to resort to default or hyperinflation45Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.10-Mexicos Nominal Exchange Rate:The Value of the U.S.Dollarin Mexican Pesos46Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The East Asian Currency Crisis of 1997-1998 In mid-1997,foreign investors began to worry about the long-run sustainability of growth in East Asiathey began to change their opinions of the fundamental long-term value of East Asias exchange rates(0)the value of the currencies fell causing a further change in 047Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The East Asian Currency Crisis of 1997-1998 It also became clear that many of East Asias banks and companies had borrowed heavily abroad in amounts denominated in dollars or yenthese loans had been used to make non-profitable investmentsthis lead to further decreases in 048Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The East Asian Currency Crisis of 1997-1998 There was a vicious cycle createdeach decline in the exchange rate raised the burden of foreign-denominated debt and raised the probability of bankruptcyeach rise in the perceived burden of foreign-denominated debt caused a further loss in the value of the exchange rate The IMF stepped in with loans to boost foreign exchange reservespromises to improve banking regulation were made in return49Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.11-Exchange Rates During the Asian Currency Crisis50Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 15.11-Exchange Rates During the Asian Currency Crisis51Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Managing Crises The exchange rate equation offers a country a menu of choices for its value of the real exchange rate()and its value of the domestic real interest rate(r)the higher the domestic real interest rate,the more appreciated is the exchange rate)r-(r-f052Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Managing Crises If international investors suddenly lose confidence in the future of the countrys economy,the menu of choices that the country has deterioratesif the domestic real interest rate is to remain unchanged,the exchange rate must depreciateif the exchange rate is to remain unchanged,the domestic real interest rate must rise53Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Managing Crises Because a large rise in domestic real interest rates will likely create a recession,letting the exchange rate depreciate seems like the logical policy choicethroughout the 1990s,investors reacted negatively when the exchange rate depreciatesthis seems especially dangerous when businesses and governments have borrowed abroad in foreign-denominated debt54Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter Summary For most of the past century,the world has operated with fixed exchange rates-not,as today,with floating exchange rates Under fixed exchange rates monetary policy has only very limited freedom to respond to domestic conditionsthe main goal of monetary policy is that of adjusting interest rates to maintain the fixed exchange rate55Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter Summary A country would adopt fixed exchange rates to make it easier to trade by making foreign prices more predictable and less volatilefixed exchange rate systems increase the volume of trade and encourage the international division of labor56Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter Summary In the past generation,most countries have concluded that the freedom to set their own monetary policies to satisfy domestic concerns is more important than the international integration benefits of fixed exchange ratesan exception is western Europe,which is in the process of permanently fixing its exchange rates via a monetary union57Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Chapter Summary Wide swings in foreign exchange speculators views of countries future prospects have caused three major currency crises in the 1990ssuch currency crises were greatly worsened by poor bank regulation and other policies that threatened to send economies subject to capital flight into a vicious spiral ending in depression and hyperinflation58Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.
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