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Fixed Exchange Rates

Fixed Exchange Rates. CHAPTER 15. Introduction. Chapter defines a number of alternative exchange rate regimes Places them on a continuum between “fixed” and “flexible” Focuses on the case of fixed exchange rates

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Fixed Exchange Rates

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  1. Fixed Exchange Rates CHAPTER 15

  2. Introduction • Chapter defines a number of alternative exchange rate regimes • Places them on a continuum between “fixed” and “flexible” • Focuses on the case of fixed exchange rates • Examines various ways that balance of payments adjustment can occur under this regime • Considers the policy trilemma in international finance

  3. Alternative Exchange Rate Regimes • Menu of exchange rate arrangements from which a country can choose—in 2001 • 41 countries pursued a floating or flexible exchange rate regime • Monetary authority did not intervene to influence market value of nominal exchange rate • 42 countries maintained a managed floating regime • Monetary authority may have intervened to influence the nominal exchange rate in some way • 6 countries used crawling bands • Monetary authorities intervened to maintain nominal exchange rate in a band around a central rate, and these bands were periodically adjusted • 4 countries employed crawling pegs • Nominal exchange rate was fixed in value to another currency or to a “basket” of other currencies, but adjusted periodically by small amounts • 45 countries pursued fixed exchange rates or fixed pegs • Monetary authorities adopted a policy goal of keeping the nominal exchange rate at a fixed value in terms of another currency or in terms of a “basket” of other currencies • 8 countries pursued an extreme form of fixed exchange rate known as a currency board • Monetary authority is required to fully back up the domestic currency with reserves of foreign currency to which domestic currency is pegged • Relatively large number of (usually very small) countries maintained no independent currency whatsoever

  4. Table 15.1 Exchange Rate Arrangements, 2001

  5. A Model of Fixed Exchange Rates • In contrast to flexible or floating exchange rate regime, we will consider the polar opposite case of a fixed exchange rate regime • Mexico will be our home country • United States will be our foreign country • Although peso began floating in 1995, in previous years, it was fixed against US dollar • Under a fixed exchange rate regime, when Mexican government raises (lowers) e and thereby decreases (increases) value of peso • Called a devaluation (revaluation) of peso • Contrasts with a market-driven, upward movement in e under a flexible exchange rate regime known as a(n) depreciation (appreciation) • In practice, devaluations are more common than revaluations

  6. Table 15.2. Mexican Balance of Payments, 1993 (billions of US dollars)

  7. Table 15.3. Exchange Rate Terminology Revisited

  8. A Model of Fixed Exchange Rates • Suppose an overvaluation of peso exists (1/e1 > 1/e0) • Implies an excess supply of pesos or an excess demand for dollars • How can this be sustained? • Must be some additional demand for pesos or supply of dollars which can come from • Positive net factor receipts • Positive net transfers (e.g. inflows of foreign aid) • Positive net official reserve transactions • Mexico’s central bank can sell its holdings of dollars (buying pesos) which draws down foreign reserves • Helps eliminate excess supply of pesos or demand for dollars

  9. Figure 15.1 The Peso Market

  10. A Model of Fixed Exchange Rates • Suppose an undervaluation of the peso exists (1/e2 < 1/e0) • Implies an excess demand for pesos or an excess supply of dollars • Situation can be sustained via additional supply of pesos or demand for dollars which can come from • Negative net factor receipts • Negative net transfers • Negative net official reserve transactions • Mexico’s central bank can buy dollars (sell pesos) which builds up foreign reserves • Conclusion: Central banks in countries with overvalued currencies tend to draw down foreign exchange reserves • While central banks in countries with overvalued currencies tend to build up foreign reserves

  11. Interest Rates and Exchange Rates • Suppose Mexican government successfully ensures that a fixed rate e3 is an equilibrium rate • What must be the relationship between e3 and ee? • If e3 is both a fixed and an equilibrium rate, then e3 must equal ee • Causes a change in interest rate parity condition • ee – e = 0 therefore: rM = rUS

  12. Interest Rates and Exchange Rates • For the Mexican government to maintain a fixed, equilibrium exchange rate, it must ensure that its interest rate equals that in United States • By increasing or decreasing rM into equality with rUS, the Mexican government can move SF graph to left or right until equilibrium e and e3 are identical • Complexities of real world cause fixed exchange rates to be maintained with combinations of net factor receipts, net transfers, official reserve transactions, and interest rates • However, one principle is always operable • The farther a fixed exchange rate is from the equilibrium exchange rate, the more difficult it is to maintain for an extended period of time

  13. Figure 15.2 An Equilibrium Fixed Exchange Rate

  14. The Policy Trilemma • “Dilemma” refers to a necessary choice between two undesirable alternatives • “Trilemma” refers to a necessary choice among three undesirable alternatives • Policy trilemma recognizes countries would ideally like to pursue three desired objectives • Monetary independence • Ability to conduct an independent monetary policy with an eye to stabilizing the domestic macroeconomic policy • Exchange rate stability • Ability to avoid destabilizing volatility in nominal exchange rate • Capital mobility • Ability to take advantage of flows on direct and portfolio capital accounts from foreign savings • However, countries must sacrifice one of above desired objectives in order to achieve other two

  15. Figure 15.3. The Policy Trilemma

  16. The Policy Trilemma • Suppose a country wants to maintain both capital mobility and exchange rate stability • Must pursue a fixed exchange rate regime • Must give up monetary independence • If a country wants to maintain its fixed exchange rate as an equilibrium rate, it must adjust its interest rate to that in country to which its currency is pegged • Since interest rates are set via monetary policy, in maintaining capital mobility and exchange rate stability, country must sacrifice its independent monetary policy

  17. The Policy Trilemma • Suppose a country wants to maintain both capital mobility and monetary independence • Must allow currency to float • Must give up exchange rate stability

  18. The Policy Trilemma • Suppose a country wants to maintain both monetary independence and exchange rate stability • Must restrict transactions on capital account of the balance of payments in order to suppress portfolio considerations • Must give up capital mobility

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