; Chapter 19 The Case for Floating Exchange Rates The Case for Floating Exchange Rates The Case for Floating Exchange Rates The Case for Floating Exchange Rates
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Chapter 19 The Case for Floating Exchange Rates The Case for Floating Exchange Rates The Case for Floating Exchange Rates The Case for Floating Exchange Rates


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									                                                                             The Case for
              Chapter 19                                               Floating Exchange Rates
The Case for Floating Exchange Rates                              There are three arguments in favor of floating
The Case Against Floating Exchange Rates                          exchange rates:
Macroeconomic Interdependence Under a Floating Rate                • Monetary policy autonomy
                                                                   • Symmetry
                                                                   • Exchange rates as automatic stabilizers

         The Case for                                                        The Case for
   Floating Exchange Rates                                             Floating Exchange Rates
Monetary Policy Autonomy                                          Symmetry
• Floating exchange rates:                                         • Floating exchange rates remove two main asymmetries
   – Restore monetary control to central banks                        of the Bretton Woods system and allow:
   – Allow each country to choose its own desired long-run             – Central banks abroad to be able to determine their own
     inflation rate                                                      domestic money supplies
                                                                       – The U.S. to have the same opportunity as other
                                                                         countries to influence its exchange rate against foreign

         The Case for
   Floating Exchange Rates                                                    Effects of a Fall in Export Demand

Exchange Rates as Automatic Stabilizers                                       Exchange rate, E
• Floating exchange rates quickly eliminate the                                   E2

  “fundamental disequilibrium” that had led to parity                                                      1
                                                              (a) Floating        E1
  changes and speculative attacks under fixed rates.              exchange rate
   – Next figure shows that a temporary fall in a country’s
     export demand reduces that country’s output more                                                 Y2 Y1               Output, Y
     under a fixed rate than a floating rate.                                 Exchange rate, E

                                                              (b) Fixed                          3
                                                                  exchange rate E1                              1

                                                                                                 Y3   Y2   Y1             Output, Y

      The Case Against                                                  The Case Against
   Floating Exchange Rates                                           Floating Exchange Rates
There are five arguments against floating rates:                  Discipline
• Discipline                                                      • Floating exchange rates do not provide discipline for
• Destabilizing speculation and money market                        central banks.
  disturbances                                                        – Central banks might embark on inflationary policies
• Injury to international trade and investment                          (e.g., the German hyperinflation of the 1920s).

• Uncoordinated economic policies                                 • The pro-floaters’ response was that a floating exchange
                                                                    rate would bottle up inflationary disturbances within
• The illusion of greater autonomy                                  the country whose government was misbehaving.

      The Case Against
                                                              A Rise in Money Demand Under a Floating Exchange Rate
   Floating Exchange Rates
Destabilizing Speculation and Money Market
Disturbances                                                         rate, E
• Floating exchange rates allow destabilizing
    – Countries can be caught in a “vicious circle” of                 E1
      depreciation and inflation.                                                          2
• Floating exchange rates make a country more
  vulnerable to money market disturbances.


                                                                                           Y2   Y1          Output, Y

      The Case Against                                                  The Case Against
   Floating Exchange Rates                                           Floating Exchange Rates
Injury to International Trade and Investment                      Uncoordinated Economic Policies
• Floating rates hurt international trade and investment          • Floating exchange rates leave countries free to engage
  because they make relative international prices more              in competitive currency depreciations.
  unpredictable:                                                      – Countries might adopt policies without considering their
• Supporters of floating exchange rates argue that                      possible beggar-thy-neighbor aspects.
  forward markets can be used to protect traders against
  foreign exchange risk.
    – The skeptics replied to this argument by pointing out
      that forward exchange markets would be expensive.

           The Case Against                                           Inflation Rates in Major Industrialized Countries,
                                                                      1973-1980 (percent per year)
        Floating Exchange Rates
     The Illusion of Greater Autonomy
     • Floating exchange rates increase the uncertainty in the
       economy without really giving macroeconomic policy
       greater freedom.
        – A currency depreciation raises domestic inflation due to
          higher wage settlements.

Nominal and Real Effective Dollar Exchange Rates                       Macroeconomic Interdependence
Indexes, 1975-2000                                                         Under a Floating Rate
                                                                         Assume that there are two large countries, Home and
                                                                         Macroeconomic interdependence between Home and
                                                                          • Effect of a permanent monetary expansion by Home
                                                                             – Home output rises, Home’s currency depreciates, and
                                                                               Foreign output may rise or fall.
                                                                          • Effect of a permanent fiscal expansion by Home
                                                                             – Home output rises, Home’s currency appreciates, and
                                                                               Foreign output rises.

What Has Been Learned Since 1973?                                    What Has Been Learned Since 1973?
                                                                        Figure 19-5: Exchange Rate Trends and Inflation Differentials,
     Monetary Policy Autonomy                                                        1973-2000
     • Floating exchange rates allowed a much larger
       international divergence in inflation rates.
     • High-inflation countries have tended to have weaker
       currencies than their low-inflation neighbors.
     • In the short run, the effects of monetary and fiscal
       changes are transmitted across national borders under
       floating rates.

What Has Been Learned Since 1973?                               What Has Been Learned Since 1973?
   • After 1973 central banks intervened repeatedly in the         Symmetry
     foreign exchange market to alter currency values.             • The international monetary system did not become
   • Why did central banks continue to intervene even in             symmetric until after 1973.
     the absence of any formal obligation to do so?                   – Central banks continued to hold dollar reserves and
      – To stabilize output and the price level when certain            intervene.
        disturbances occur                                         • The current floating-rate system is similar in some
      – To prevent sharp changes in the international                ways to the asymmetric reserve currency system
        competitiveness of tradable goods sectors                    underlying the Bretton Woods arrangements
   • Monetary changes had a much greater short-run effect            (McKinnon).
     on the real exchange rate under a floating nominal
     exchange rate than under a fixed one.

What Has Been Learned Since 1973?                               What Has Been Learned Since 1973?
   The Exchange Rate as an Automatic Stabilizer                    Discipline
   • Experience with the two oil shocks favors floating            • Inflation rates accelerated after 1973 and remained
     exchange rates.                                                 high through the second oil shock.
   • The effects of the U.S. fiscal expansion after 1981           • The system placed fewer obvious restraints on
     provide mixed evidence on the success of floating               unbalanced fiscal policies.
     exchange rates.                                                  – Example: The high U.S. government budget deficits of
                                                                        the 1980s.

What Has Been Learned Since 1973?                               What Has Been Learned Since 1973?
   Destabilizing Speculation                                       International Trade and Investment
   • Floating exchange rates have exhibited much more              • International financial intermediation expanded
     day-to-day volatility.                                          strongly after 1973 as countries lowered barriers to
      – The question of whether exchange rate volatility has         capital movement.
        been excessive is controversial.                           • For most countries, the extent of their international
   • In the longer term, exchange rates have roughly                 trade shows a rising trend after the move to floating.
     reflected fundamental changes in monetary and fiscal
     policies and not destabilizing speculation.
   • Experience with floating exchange rates contradicts
     the idea that arbitrary exchange rate movements can
     lead to “vicious circles” of inflation and depreciation.

                                                                    Are Fixed Exchange Rates
What Has Been Learned Since 1973?                               Even an Option for Most Countries?
   Policy Coordination                                            Maintaining fixed exchange rates in the long-run
   • Floating exchange rates have not promoted                    requires strict controls over capital movements.
     international policy coordination.                            • Attempts to fix exchange rates will necessarily lack
   • Critics of floating have not made a strong case that the        credibility and be relatively short-lived.
     problem of beggar-thy-neighbor policies would                    – Fixed rates will not deliver the benefits promised by
     disappear under an alternative currency regime.                    their proponents.

        Directions for Reform                                                     Summary
   The experience of floating does not fully support              The weaknesses of the Bretton Woods system led
   either the early advocates of that exchange rate               many economists to advocate floating exchange rates
   system or its critics.                                         before 1973 based on three arguments:
   One unambiguous lesson of experience is that no                 • Floating rates would give countries greater autonomy
   exchange rate system functions well when                          in managing their economies.
   international economic cooperation breaks down.
                                                                   • Floating rates would remove the asymmetries of the
   Severe limits on exchange rate flexibility are unlikely           Bretton Woods system.
   to be reinstated in the near future.
                                                                   • Floating rates would quickly eliminate the
   Increased consultation among policymakers in the
                                                                     “fundamental disequilibriums.”
   industrial countries should improve the performance
   of floating rates.

   Critics of floating rates advanced several
   • Floating would encourage monetary and fiscal
     excesses and beggar-thy-neighbor policies.
   • Floating rates would be subject to destabilizing
     speculation and retard international trade and


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