Choice of exchange rate regimes by leader6

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									                     Choice of exchange rate regimes

                                    Ester Faia

                            Goethe University Frankfurt


                                    June 2009




Ester Faia (Institute)       Choice of exchange rate regimes   June 2009   1 / 14
Fixed versus ‡oating exchange rates




    Two fallacies:
       1   Floating exchange rates are not necessarily associated with periods of
           turbulence and disruption
       2   Fixed exchange rates is not a price control or the opposite of free
           markets. As exchange rates are the price of money, even if they are
           …xed, money can adjust (unless there are sticky prices)




   Ester Faia (Institute)      Choice of exchange rate regimes        June 2009   2 / 14
Choosing between …xed and ‡oating exchange rates




   Micro-economic considerations involving e¢ ciency
   Macroeconomic considerations involving short run policy
   Policy discipline, concerning credibility




   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009   3 / 14
Micro-economic considerations




   If two regions engage in trading there are some gains by having a
   single currency (it reduces trade costs as it reduces uncertainty in
   exchange rate movements)
   Perfectly credible …xed exchange rates can be considered as single
   currency




   Ester Faia (Institute)   Choice of exchange rate regimes    June 2009   4 / 14
Macroeconomic considerations



   Floating exchange rates insulate against foreign shocks
   Suppose a shock to foreign demand, exports fall and domestic
   demand fall as well. Output falls below the Pareto e¢ cient level. If
   nominal exchange rates adjust, then the real exchange rate adjusts
   too and exports go back to previous equilibrium (Pareto e¢ cient).
   Friedman 1953 (”The Case for Flexible Exchange Rates”) argues: if
   there is a change in foreign demand it is better to adjust the
   exchange rate. If exchange rates are …xed, prices have to adjust to
   equilibrate exports but this might bring about a recession




   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009    5 / 14
Rules versus discretion



    Suppose monetary authority follows a rule:

                             ∆mt = 0.01 + 0.5 (unt                  1   0.05)

    or:
                                           ∆mt = 0.01
    Rule 1 is activist while rule 2 is not but both could be rules imposed
    ex-ante or be the ex-post outcome of discretionary policy (Kydland
    and Prescott 1977)




    Ester Faia (Institute)        Choice of exchange rate regimes               June 2009   6 / 14
Rules versus discretion (continued)




    Discretionary policy prevails when the ,monetary authority selects each
    period the value of ∆mt on the basis of new optimization solution
    Rules: policy maker merely implements in each period a rule or
    formula that has been chose to be applicable for a large number of
    periods




   Ester Faia (Institute)   Choice of exchange rate regimes    June 2009   7 / 14
Example from Kydland and Prescott 1980

   Policy objective function: keep in‡ation, π, close to zero and
   unemployment very low
       s
   Let’ assume that π is determined by money supply and that:

                                      unu = ∆mt               ∆mt
                                                                e


   where ∆mt is expected money growth.
           e

   Monetary policy instrument is set to minimize the following objective:
                                    a
                            zt =      (∆mt )2           b (∆mt          ∆mt )
                                                                          e
                                    2
   Assume rational expectations: ∆mt = Et
                                   e
                                                                     1 ∆mt   so that the second
   term goes to zero
   Minimization delivers: ∆mt = 0. Under commitment the monetary
   authority maintains this decision for a large number of periods

   Ester Faia (Institute)          Choice of exchange rate regimes                    June 2009   8 / 14
Discretionary policy

    The monetary authority re-optimizes in every period. Suppose t = 4:
                                     a
                             z4 =      (∆m4 )2           b (∆m4         ∆m4 )
                                                                          e
                                     2
    ∆m4 = E3 ∆m4 but in every period ∆m4
       e                                                              ∆m4 is not necessarily
                                                                        e

    equal to zero
    FOC:
                                     ∂z4
                                         = a∆m4                  b=0
                                    ∂∆m4
                                                            b
                                               ∆m4 =
                                                            a
    In subsequent periods the policy maker will also choose ∆mt = b ,
                                                                  a
    time-consistent policy


    Ester Faia (Institute)          Choice of exchange rate regimes                 June 2009   9 / 14
Discipline and exchange rates

    Timeless perspective: assume to consider zt on average, over a large
    number of periods
    If agents are rational they set on average ∆mt = Et 1 ∆mt , thus the
                                                  e

    impact of monetary policy on unemployment will be zero on average
    and rules versus discretion will only make a di¤erence for the in‡ation
    rate
    From the perspective of the period at end the monetary authority
    considers expectations of money supply as given and believes that by
    increasing the actual money supply it can decrease unemployment
    But ∆mt depends on the ongoing process so under discretion agents
              e

    will set it equal to b , which implies that unemployment will not fall
                         a
    but in‡ation will be higher
    Under …xed exchange rates the monetary authority follows a rule:
    with EMS the monetary authorities were borrowing credibility (an
    alternative is the currency board)
   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009   10 / 14
Intermediate arrangements (pegged)




   Par value: the exchange rate remains within some bands
   Bands are worst than …xed or ‡oating because they are subject to
   speculative attacks (hence often lead to crisis)




   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009   11 / 14
Optimal currency area


   This is an extreme form of cooperation with credibly …xed exchange
   rates
   Mundell 1961 analyzes the desiderability of …xed versus ‡oating but
   now from a global perspective (not only a single country)
   How many country an optimal currency area involves from a global
   perspective? One or all?
   The answer depends on labour mobility: if labour markets have sticky
   wages and sticky prices asymmetric shocks lead to asymmetries in
   output across countries unless workers can migrate
   Another consideration is the extent of trade across regions; higher
   trade gives higher bene…ts of currency areas



   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009   12 / 14
Monetary policy cooperation




   Two types: the one involving macroeconomic policies (taxes, money
   supply, in‡ation) and the one involving international institutions (…xed
   rates arrangements, agreements on tari¤s like GATT, IMF, EMS)
   Cooperation versus coordination: the second requires higher sacri…ces
   as the policy maker, when setting the instrument, must consider also
   the e¤ects for the other country




   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009   13 / 14
Advantages of monetary policy coordination




   Consider two large economies that can a¤ect each other
   Suppose that the home …scal authorities can increase government
   expenditure, this will change net exports and change the real
   exchange rate
   Any policy action has e¤ects on other countries unless they are done
   in a coordinated fashion




   Ester Faia (Institute)   Choice of exchange rate regimes   June 2009   14 / 14

								
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