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Exchange Rate Politics

Exchange Rate Politics. Mundell-Fleming Model (a.k.a. The Unholy Trinity). Main point of the Frieden article:. Economic integration makes exchange rates more politically salient because it exacerbates their distributional consequences. Uses the Mundell-Fleming model to build his argument.

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Exchange Rate Politics

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  1. Exchange Rate Politics Mundell-Fleming Model (a.k.a. The Unholy Trinity)

  2. Main point of the Frieden article: • Economic integration makes exchange rates more politically salient because it exacerbates their distributional consequences. • Uses the Mundell-Fleming model to build his argument.

  3. Main point of the Mundell-Fleming model: • No country can have more than two of the following three conditions: • Fixed exchange rate (or pegged exchange rate) • Independent monetary policy • Capital mobility

  4. (1) Fixed exchange rate • Fixed (pegged) exchange rate = the value of the currency is matched to the values of another currency or basket of currencies • As the reference currency appreciates or depreciates, so does the value of the pegged currency • The alternative to a fixed rate is a floating (flexible) exchange rate = the value of the currency is set based on the foreign exchange market • Which type of exchange rate do you think is preferable?

  5. (2) Monetary policy • Monetary policy = the actions taken by a central bank to influence the supply (and, therefore, price) of money • The price of money in the domestic market is the interest rate: • How much you pay your bank to borrow (buy) money • How much your bank pays you when you deposit (sell) it money • How do interest rates affect our day to day life? • The price of money in the global market is the exchange rate: • How much of her currency a foreigner pays to buy your currency • How do exchange rates affect our day to day life?

  6. (2) Monetary policy • Tools of monetary policy: • Open markets operations (buying and selling government bonds). • Which of buying and selling of government bonds increases the price of money? • The discount rate = interest rate charged to banks on loans they receive from the central bank. • An increase in the discount rate is equivalent to an increase or decrease in the money supply? • Reserve requirements = amount of funds that a bank must hold in reserve, as a percentage of its checkable deposits. • What happens to the money supply if the reserve requirements increase?

  7. (3) Capital mobility • We are now talking about cross-border capital mobility =how easily financial capital moves from one country to another • Do not confuse with domestic capital mobility (the cost of capital switching industries in the domestic economy) • Capital is mobile = can move across national borders without restriction • What are some factors that render financial capital mobile? • What are factors that make financial capital immobile?

  8. Why only two of the three conditions? • Remember that the Mundell-Fleming model says we can only have TWO of these three conditions be true simultaneously. • And the conditions are: • Capital mobility • Fixed exchange rate • Autonomous monetary policy

  9. Set up 1 (traditional):Capital is immobileMonetary policies workExchange rates are fixed • The government decides to stimulate the economy. • What does “stimulate the economy” mean?

  10. Set up 1 (traditional): Capital is immobileMonetary policies work Exchange rates are fixed • The government decides to stimulate the economy. • What does “stimulate the economy” mean? • Increase investment, production, and consumer spending • The government uses monetary policy to do this. • Will they use expansionary or contractionary policy?

  11. Set up 1 (traditional): Capital is immobileMonetary policies work Exchange rates are fixed • The government decides to stimulate the economy. • What does “stimulate the economy” mean? • Increase investment, production, and consumer spending • The government uses monetary policy to do this. • Will they use expansionary or contractionary policy? • Expansionary policy: will increase the money supply.

  12. Set up 1 (traditional): Capital is immobileMonetary policies work Exchange rates are fixed • What does an increase in money supply do to the price of money?

  13. Set up 1 (traditional): Capital is immobileMonetary policies work Exchange rates are fixed • What does an increase in money supply do to the price of money? • It lowers it. • What is the price of money in the domestic economy?

  14. Set up 1 (traditional): Capital is immobileMonetary policies work Exchange rates are fixed • What does an increase in money supply do to the price of money? • It lowers it. • What is the price of money in the domestic economy? • Interest rates • So the government increases the money supply and interest rates goes down. This leads to: • Increased borrowing because it’s cheaper; • Reduced savings because they yield lower revenues • Reduces the nominal price level; ALL goods in the domestic market are affected

  15. Set up 1 (traditional): Capital is immobileMonetary policies work Exchange rates are fixed • With expansionary monetary policy, we have: • Increased borrowing because it’s cheaper; • Reduced savings because they yield lower revenues • Reduces the nominal price level; ALL goods in the domestic market are affected • In this case, what are the domestic groups affected by the expansionary monetary policy? Who benefits? Who suffers? • What type of political activity are we likely to see?

  16. How realistic is the capital immobility assumption? • We just saw that, in a world with capital immobility, monetary policy is a very powerful tool for the government. • Is financial capital in the world today mobile or immobile?

  17. Set up 2 (our world): Capital is mobileMonetary policies don’t workExchange rates are fixed • Again, the government tries to stimulate the economy through monetary policy. • Does it use expansionary or contractionary policy?

  18. Set up 2 (our world): Capital is mobileMonetary policies don’t workExchange rates are fixed • Again, the government tries to stimulate the economy through monetary policy. • Does it use expansionary or contractionary policy? • Expansionary • We already saw that this lowers interest rates because the supply of money increases. So it should work as before and we should see a stimulated economy. But does it work as before?

  19. Set up 2 (our world): Capital is mobileMonetary policies don’t work Exchange rates are fixed • In this setting, monetary policy DOES NOTHING. Why? Because: • As interest rates decrease, those who own capital are hurt. Why? • Now capital is mobile and they don’t have to accept lower prices. What do they do? • They move their assets to countries with higher interest rates. What does this do to the money supply in our country? • So the government’s efforts amount to nothing. Why? • Does this mean that governments are powerless in a world with capital mobility? We’ll find out next…

  20. How can governments regain control of the economy? • Monetary policy stimulates or slows down the economy by affecting the price of money • We said that the price of money is: • Interest rate in the domestic markets • Exchange rate in the global market • We saw that, with capital mobility, governments can’t influence interest rates (the domestic price of money) • So all they have to work with is the exchange rate.

  21. How can governments regain control of the economy? • To influence the economy through the exchange rate, the government must be able to directly affect the exchange rate. • But if the exchange rate is fixed, as in the previous scenario, the government can’t do much to change it. • So the solution is flexible exchange rates. What does this mean?

  22. Set up 3 (our world with a twist): Capital is mobileMonetary policies workExchange rates are flexible • What happens in this set up if the government enacts expansionary monetary policy? • Domestic money supply increases • As a result, interest rates go down • Domestic capital again looks for better interest rates abroad • Domestic money supply goes down • Interest rates go up again • So far, it’s all like before… But here comes the twist:

  23. Set up 3 (our world with a twist): Capital is mobileMonetary policies workExchange rates are flexible • In order to invest in foreign markets with better interest rates, domestic firms must buy foreign currency • So, globally, the supply of domestic currency increases, as does the demand for foreign currency • What does this do the cost of the domestic currency relative to the foreign currency?

  24. Set up 3 (our world with a twist): Capital is mobileMonetary policies workExchange rates are flexible • In order to invest in foreign markets with better interest rates, domestic firms must buy foreign currency • So, globally, the supply of domestic currency increases, as does the demand for foreign currency • What does this do the cost of the domestic currency relative to the foreign currency, now that the price of the currency is set by the market rather than the domestic government? Decreases. • So we observe currency devaluation.

  25. Set up 3 (our world with a twist): Capital is mobileMonetary policies workExchange rates are flexible • What does currency devaluation do to the domestic economy? • Increases the relative price of imports • Reduces the price of exports • Does devaluation stimulate the economy? • Are the distributional effects of devaluation the same as those of reduced interest rates? Who benefits? Who suffers? • What type of political action are we likely to see in this case?

  26. What does this all mean for political action? • As financial integration increases, the domestic effects of monetary policy change. • As trade integration increases, domestic sensitivity to the effects of monetary policy increase. Why is this? • The result: with increased financial and commercial integration, exchange rates become more politicized.

  27. What does this all mean for political action? • Two issues related to exchange rates matter: • The choice between independent monetary policy and fixed exchange rates. • To have independent monetary policy, we must have floating exchange rates (given that capital is mobile) • Which scenario do you think is preferable? • The choice of the appropriate level of currency, if exchange rates are flexible

  28. What does this all mean for political action? • Which groups prefer independent monetary policy? Why? • Which groups prefer higher exchange rates? Why?

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