Lecture 9 International Finance

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Lecture 9

  • International Finance

  • ECON 243 – Summer I, 2005

  • Prof. Steve Cunningham

Exchange Rate Policy

  • What exchange rate policy should a country use? Is there a “best” exchange rate policy?

    • Clean Float
    • Fixed (never change)
    • Dirty Float
    • Adjustable Peg
  • Each approach has its strengths and weaknesses.

  • Different countries might do well to choose different policies. There is no one right chose that is correct for every country for all time.

Five Major Issues in Choosing

  • The effects of macroeconomic shocks;

  • The effectiveness of government monetary and fiscal policies;

  • Differences in macroeconomic goals, priorities, and policies;

  • Controlling inflation;

  • The real effects of exchange rate variability.


  • Generally countries prefer exchange rate policies that minimize shocks because this results in a more stable economy.

  • Types of shocks to consider:

  • The effects of shocks vary with exchange rate regime and with type of shock.

Shocks (Overview)

  • Monetary and fiscal shocks operate like any (deliberate) expansionary or contractionary monetary or fiscal policy.

    • The analysis previously given applies.
  • An adverse international trade shock reduces both the current account and GDP, causing the country’s currency to depreciate.

    • The depreciation makes the country’s exports more desirable, and exports improve, reversing the deterioration in the current account balance. GDP improves.
  • The adjusting exchange rate always restores external balance after a shock. It does not always restore internal balance.

Choosing an Exchange Rate Regime: Internal Shocks

  • Internal (domestic) shocks are generally less of a problem for a country under fixed exchange rates.

  • Monetary Shock:

    • Domestic interest rate changes trigger capital flows and pressure on exchange rates.
    • Under a fixed rate, domestic monetary shocks create a need for intervention which tends to reverse and offset the shock.
    • Under a floating rate, the resulting change in the exchange rate magnifies the effect of the shock.

Choosing an Exchange Rate Regime: Internal Shocks (2)

  • Domestic Spending Shock

    • This may be an unexpected change in C, I or G.
    • Result depends upon how responsive international capital flows are to interest rate changes.
    • Under a fixed exchange rate, if capital is not responsive, then it is less disruptive than under floating rates.
      • E.g., a decline in spending reduces imports, improving the trade balance. The intervention required expands the domestic money supply, lowering interest rates, and restoring aggregate demand.
    • Under a fixed exchange rate, if capital is responsive, then domestic spending shocks are more disruptive than under floating rates.

Choosing an Exchange Rate Regime: Internal Shocks (3)

  • Domestic Spending Shock, continued

    • Under floating rates, the changes in exchange rates tend to magnify changes in domestic production and demand even more.
    • The floating rate makes things worse.

Choosing an Exchange Rate Regime: External Shocks

  • Foreign trade shocks are a major way in which business cycles are transmitted from country to country.

  • Incomes fall in one country, resulting in declines in purchases of exports from another, which reduces the incomes in the second country.

  • Consider a foreign trade shock:

    • Example: demand for our exports fall.
    • Under a float, the currency depreciates, making our exports cheaper in other countries.
    • Demand for exports rise.
    •  Better under floating exchange rates.
  • (Floating) Exchange rate changes insulate economies from foreign trade shocks.

Choosing an Exchange Rate Regime: External Shocks (2)

  • International Capital Shocks

    • Under a float, adverse effects of capital outflows result in exchange rate changes that cause offsetting improvements in trade.
    • Under a fixed exchange rate, the intervention required tends to exacerbate the negative effects of the int’l capital shock.
    •  Floating rates are generally better.

Choosing an Exchange Rate Regime: Domestic Policy Effectiveness

  • Fixed Exchange Rates:

    • Monetary policy is useless.
    • Fiscal policy is made stronger.
  • Floating Exchange Rates:

    • Monetary policy is reinforced by the exchange rate change.
    • The effectiveness of fiscal policy depends upon how responsive capital is (capital mobility).
      • If capital is highly mobile, then fiscal policy is made stronger. If capital is not mobile, then fiscal policy is made weaker.
  • One thing is clear: if a country wants to use monetary policy to conduct domestic policy, it will favor a floating exchange rate.

Choosing an Exchange Rate Regime: Goals, Priorities, and Policies

  • Culture, history, exigencies, among other things, may result in countries having different goals and priorities. These lead to different policies.

    • Economic growth
    • Low unemployment
    • Low inflation
    • External balance
    • Income distribution equality or inequality

Choosing an Exchange Rate Regime: Goals, Priorities, and Policies (2)

  • To be successful, fixed exchange rates require consistency or coordination in these areas.

    • Multiple objectives within a country may require conflicting policies, so priorities may be critically important.
    • Independent monetary policies are not possible.
    • Tax, interest rate, or inflation rate differences will lead to capital flows that will undermine the currency fix.
    • Productivity and productivity growth differences affect relative inflation rates.
  • Recently the French complained that the British should reduce the length of their workweek, and Italy has complained that the level of the euro has hurt them in international markets.

Choosing an Exchange Rate Regime: Goals, Priorities, and Policies (3)

  • Floating exchange rates are tolerant of diversity in countries’ goals, priorities, and policies.

  • Changes in the exchange rates keep external balance while internal changes occur.

  • The exchange rates insulate each country from internal policies and shocks of other countries.

  • Int’l policy coordination is still possible, but not necessary.

  • This freedom only exists as long as the countries involved do not care what exchange rate eventuates.

Choosing an Exchange Rate Regime: Goals, Priorities, and Policies (4)

  • For example, in the early 1980s, unemployment rates were very high in many European countries, but they did not attempt expansionary policies because their currencies were already weak against the dollar.

    • They actually tightened monetary policy to raise their interest rates to prevent their currencies from weakening further.

Choosing an Exchange Rate Regime: Inflation

  • An implication of PPP is that relative stable prices is a requirement for a fixed exchange rate.

    • The countries involved must have similar inflation rates over the long run.
  • Thus, fixed exchange rates may create a necessary price discipline on domestic policy to maintain low, stable inflation rates.

    • Argentina’s inflation rate dropped from 3000% to 4% per year after they fixed their peso to the U.S. dollar.
    • Inflationary expectations also lowered because of the credibility of the fixed-rate discipline.

Choosing an Exchange Rate Regime: Inflation (2)

  • This price discipline forces countries under fixed exchange rates to:

    • Keep their deficits small and similar,
    • Keep their money supply growth rates low and steady
    • This is the logic behind certain actions required of nations joining the European Union.
  • The result may be that a world under fixed exchange rates might enjoy lower global inflation rates.

  • Under a fixed system with a “lead country”, like the U.S. under Bretton Woods, all countries will have to match the inflation rate of the lead country.

  • When one country inflates, they all must inflate, which means that inflation can be “exported”.

Choosing an Exchange Rate Regime: Inflation (3)

  • No such pressures exist under floating exchange rates. Countries are free to conduct any domestic policies they wish.

  • Budget deficits may be financed by money creation.

  • This may lead to higher average global inflation rates.

  • Average inflation rates were higher after 1973 than before.

  • The real keys to lower inflation rates are policy discipline, resolve, and credibility of the monetary authorities in each country.

Choosing an Exchange Rate Regime: Exchange Rate Volatility

  • Floating exchange rates do float!

  • High variability of exchange rates can be a deterrent to trade and international investment because it raises exchange rate risk, affecting total expected returns. (Exchange rate risk is exchange rate variability.)

    • Exchange rate variability has real effects.
  • Those who favor fixed exchange rates claim that it reduces this variability, hence improves int’l trade and investment.

Choosing an Exchange Rate Regime: Exchange Rate Volatility (2)

  • Does exchange rate risk/variability actually reduce trade?

    • Early studies typically found no effect on the volume of international trade.
    • More recent studies found that exchange rate variability may affect trade volume, but the change is mostly negligible.
    • There is some concern that the dramatic swings due to overshooting may lead to significant long-term effects as capital formation is affected.

Choosing an Exchange Rate Regime: Exchange Rate Volatility (3)

  • Those who favor floating exchange rates argue that fixed exchange rates are just another form of price fixing or price controls. The market is not being allowed to work.

  • As with all markets, equilibrium exchange rates are prices that provide information (“send signals”) about the relative values of currencies. The question is whether or not the market might send “false signals” for some reason.

  • Price controls have been shown to be generally inefficient, while equilibrium rates are by definition optimal if they result from full information and full adjustment.

  • Those who argue against floating exchange rates argue that market exchange rates may be distorted by speculation, speculative bandwagons and bubbles, informational problems, and adjustment problems.

Extreme Fixes: Currency Boards

  • An “exchange rate only” monetary authority.

    • The board holds only foreign currency assets as official reserves.
    • It issues domestic currency liabilities only in exchange for foreign currency assets.
    • It holds no domestic currency assets, so cannot sterilize actions.
    • Because it focuses entirely on maintaining the fix, and not on domestic policy, and cannot sterilize, it has great credibility in terms of its commitment to the fixed exchange rate.

Extreme Fixes: Currency Boards (2)

  • Hong Kong established a currency board in 1973.

  • In the 1990s, Estonia, Lithuania, Bulgaria, and Bosnia/Herzegovina established currency boards.

  • Argentina set up a currency board in 1991, which it abandoned in 2002.

    • The creation of the board in 1991 was intended to increase the credibility of their anti-inflation stance.
    • Inflation fell dramatically, interest rates fell, and economic growth increased. Real growth was nearly 4% from 1992-1998.
    • But the fix made Argentina vulnerable to external shocks. Following the Mexico peso crisis hit in 1995, int’l investors started pulling out of Argentina. Defending its fix, Its money supply shrank and interest rates rose. This ultimately threw the country into recession in 1998.

Extreme Fixes: Currency Boards (3)

  • The Argentine government ultimately had to allow the exchange rate to float.

    • The currency board does not force a country to follow sensible fiscal and regulatory policies.
    • The fixed exchange rate leaves the country more exposed to adverse foreign shocks.
    • It is difficult to find a “graceful” exit strategy that allows the country to abandon the fix and allow rates to float.

Extreme Fixes: Dollarization

  • An extreme form of a fixed exchange rate is for a country to abolish its own currency and use the currency of some other country.

  • Because the “other currency” is often the U.S. dollar, this is called dollarization.

  • The government can still “de-dollarize” and reintroduce local currency.

Extreme Fixes: Dollarization (2)

  • In 1999, the president of Argentina talked about adopting the dollar, but did not follow through.

  • In 2000, Ecuador dollarized.

  • In 2001 El Salvador dollarized.

  • Dollarization makes it much harder for a country to retake control of its currency and devalue, so adds to its credibility.

  • It removes exchange rate risk, especially in terms of trade with the U.S.

Extreme Fixes: Dollarization (3)

  • What is the cost of dollarization?

    • The country gives up control over all monetary policy, leaving it in the hands of the U.S. Federal Reserve.
    • It sells its U.S. bonds to buy the dollars, which means that it no longer collects bond interest. This can be a large income for some countries. (It loses seigniorage.)

Precursors to the EU

  • Benelux (1944): Belgium, Netherlands, and Luxembourg established a customs union.

  • May, 1952: the six-nation European Coal and Steel Community (ECSC) was created. (The Benelux nations with Germany, France, and Italy.)

  • March 1957: The Treaty of Rome established the European Economic Community (EEC) and the European Atomic Energy Commission (Euratom).

Objectives of the EEC

  • To gradually phase out all tariffs among the member nations.

  • Replace the old tariff system with a single external tariff system.

  • Create a system that allowed for the free movement of goods, labor, and capital among the six.

  • Charles de Gaulle (France) pushed for agricultural integration to parallel the industrial integration.

More History

  • In 1958, Britain called for the EEC to be expanded into an Atlantic free-trade zone.

  • France vetoed the proposal.

  • Rejected, in 1959 Britain, Portugal, Switzerland, Austria, Sweden, Norway, and Finland formed the European Free Trade Association (EFTA).

  • In 1961, Britain again asked for EEC membership, but de Gaulle of France again vetoed the admission.

  • In 1962, a Dutch proposal (the “Mansholt”) was accepted, leading to a common agricultural policy among the EEC nations.

  • 1965—the “Second Treaty of Rome”.

Second Treaty of Rome

  • This, the second Brussels Treaty, created the European Community (EC).

  • The ECSC, the EEC, and Euratom were all merged together.

  • A four-part governing body, consisting of a Commission, Council, Parliament, and Court.

  • In 1967, Britain was AGAIN rejected for member by a French veto.

  • 1973—Britain, Denmark, and Ireland were admitted to the EC.

  • In 1981, Greece was admitted.

  • In 1986, Spain and Portugal were admitted.

Treaty of Maastricht

  • In December 1991, the Treaty of Maastricht was approved by the EC.

  • This Treaty had three “pillars”:

    • Monetary Union
    • Common Foreign and Security Policies
    • Cooperation in Justice and Home Affairs.
  • Believing that a single market requires a single currency, the Maastricht Treaty called for the creation of the European Monetary Union (EMU) in three stages.

European Monetary Union (EMU)

  • Stage 1 (1991). Convergence in 5 ways:

    • Inflation rates
    • Interest rates
    • Currency exchange
    • Rate stability
    • Debt-to-GDP ratio of less than 60%
  • Stage 2 (1994). Creation of a European Central Bank (ECB).

  • Stage 3 (1997).The ECB would be responsible for monetary policy and the euro would circulate as bank money.

Convergence Criteria

  • Each country’s inflation rate must be no higher than 1.5 percentage points above the average of the inflation rates of the three countries with the lowest rates.

  • Each country’s exchange rates must be maintained within the prescribed trading band with no realignments during the preceding two years.

  • Each country’s long-term interest rates (gov’t bonds) must be no higher than 2 percentage points above the average of the three lowest.

  • Each country’s budget deficit must be no more than 3% of its GDP, and its gross gov’t debt no larger than 60% of its GDP.

European Monetary Union

  • Exchange Rate Mechanism (ERM) established to create a monetary union and eventually a single currency—the euro.

    • In a monetary union, exchange rates are permanently fixed, with a single monetary authority (central bank) conducting monetary policy for the entire union.
  • The ERM was an adjustable-peg system, used as the entering nations brought their monetary and fiscal policies into line with one another.

  • Eleven EU countries joined in 1999 with one more joining in 2001.

  • With its low inflation rates, economic size and prestige of its central bank, Germany was generally regarded as the lead country.

European Monetary Union

  • In May 1998, there was a summit of EU leaders to decide which countries met the five criteria.

  • They decided that 11 countries had met the criteria and could be admitted to the monetary union. (Other countries could join later when they met the criteria.)

  • Britain, Denmark, and Sweden qualified but chose not to join.

European Central Bank (ECB)

  • Center of the European System of Central Banks.

  • On January 1, 1999, the ECB assumed responsibility for the union-wide monetary policy.

  • Each country gives up (independent) monetary policy, and, because of potential effects on deficits, has limited access to fiscal policy.

    • Can these countries function solely on limited fiscal policy?
  • The anticipated gains are the elimination of all exchange rate concerns within the union, eliminating all foreign exchange transactions costs.

  • It was a centerpiece toward larger-scale economic integration.

Floating the Euro

  • On January 1, 1999, the European Monetary Union (EMU) was inaugurated, leading to the introduction of a new currency, called the euro.

  • On January 1, 2002, euro currency began to circulate in Europe.

  • On February 28, 2003, all other currencies were withdrawn from circulation.

  • By July 2002, the euro was trading evenly with the U.S. dollar.

European Union

  • Under a single currency, with a common commercial code, labor laws, etc., product and labor mobility should be extremely high and costless.

  • This allows Europe to operate economically like one very large nation.

  • A European Constitution?

  • Recent problems.

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