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Chapter 10

Fixed,floating Fixed,floating and managed and managed

exchange ratesexchange rates

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10.1 IntroductionThe main contents of this chapter:1.The traditional debate→10.2,10.3;2.The more modern model→10.4-

10.10;3.The managed floating→10.11;4.Conclusions→10.12.

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10.2 The Case for Fixed Exchange Rates

Be careful: The case for fixed exchange rates

usually has two sides to it: both the positive arguments in favour of fixed exchange rates and the arguments against floating rates. The arguments against floating exchange rates do not necessarily constitute the arguments for completely fixed exchange rates.

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Fixed Exchange Rates Promote International Trade and Investment

Fixed parities provide the best environment for the conduct of international trade and investment, exchange-rate fluctuations cause additional uncertainty and risk in international economic transactions and inhibit the growth and development of such transactions.

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Fixed Exchange Rates Provide Discipline for Macroeconomic Policies

The pursuit of reckless macroeconomic policies(excessive monetary growth)—pressure for devaluation—intervene—reserve fall—pressure continue—have to devalue—a sign of mismanagement—encourage to resist adopting unsound expansionary macroeconomic policies.

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Fixed Exchange Rates Promote International Cooperation

Countries that agree to peg generally have to agree on measures to be undertaken when the agreed exchange-rate parity comes under pressure. At a minimum to avoid conflicting exchange-rate targets and competitive devaluation, provide a more stable environment.

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Speculation Under Floating Rates is Likely to be Destabilizing

Destabilizing private speculation produce the “wrong”(sub-optimal rate from the viewpoint of resource allocation) exchange rate.

Several ways to bring about the wrong exchange rate:

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1.Irrational speculationOne example: foreign exchange market

participants can be too risk-aversion.They attach too high a probability to

the possibility of a depreciation of a ‘weak’ currency, or conversely, even when this is not justified by the fundamentals Excessive selling of the ‘weak’ currency excessive depreciation the ‘weak’ currency under-valued.

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Another example:the ‘band-wagon’ effect.There is too much self-generating

speculation detached from the fundamentals, ‘speculation feeding upon speculation’ rather than the fundamentals.

News hits the market the even greater increase in the eventual monetary growth rate and unduly inflation forecast set off unjustified speculation the depreciation of the currency will be greater than was justified by the news.

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2. Exchange-rate uncertaintyOne reason:in a world of uncertainty

they do not know the correct exchange-rate model.

Use a seriously defective model be impressed by a plausible but relatively unimportant fundamental variable make expectation basing on this variable the wrong exchange rate.

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Another reason:the ‘Peso Problem’.Exchange rates are determined not

only by what is held to be the underlying fundamentals today, but by what is expected to happen to those fundamentals in the future.

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Even if speculator’s models are correct, their perceptions about the future can prove to be seriously wrong the exchange rate moves immediately in anticipation of events that do not materialize seriously interfere with the conduct of macroeconomic policy and with it macroeconomic stability.

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Another reason:the ‘rational bubble’.An rational bubble exists when

holders of a currency realise that it is overvalued but they are nevertheless willing to hold it expect to be able to sell eventually at an higher exchange rate

prolongs an exchange overvaluation and aggravates the macroeconomic costs associated with it.

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10.3 The Case for Floating Exchange Rates

Caution: The arguments against fixed

exchange rates do not necessarily constitute arguments for completely floating exchange rates.

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Floating Exchange Rates Ensure Balance-of-Payments Equilibrium

In a floating regime the exchange rate autonomously adjusts to ensure continues equilibrium between the demand for, and supply of a currency.

Run an unsustainable current account deficit depreciate reduce import and increase export balance-of-payments restored to a sustainable level.

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In a fixed regime, exchange rate is fixed, the authorities can only keep BOP equilibrium through changing reserves or taking fiscal and monetary policies or resorting to capital control.

Exchange-rate adjustments by taking care of the BOP deficits relieve the authorities of having to adopt unpopular alternatives such as deflation or a resort to protectionism which could then provoke a damaging trade war.

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Floating Exchange Rates Ensure Monetary Autonomy

Floating regime enable each country to operate an independent monetary policy; that is, monetary autonomy enabling each country to determine its own inflation rate.

Countries prefer low rates tight macroeconomic policy currency appreciation.

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Countries pursue expansionary macroeconomic policies suffer higher inflation currency depreciation

Under fixed regime, the need to have common inflation rates constrains countries to pursue similar monetary policies.

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Floating Exchange Rates Insulate Economies

Floating regime can insulate the domestic economy from foreign price shocks.

An increase in foreign prices foreign competitiveness decrease domestic BOP surplus domestic currency appreciate prevent the country importing foreign inflation.

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Fixed regime lead to the importing of foreign price inflation/deflation.

A foreign price rise home economy overcompetitive home economy BOP surplus fixed rate undervalued necessitate purchase of foreign currency with newly-created domestic currency to peg the exchange rate an accompanying rise in domestic prices ending the surplus.

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Floating Exchange Rates Promote Economic Stability

It is better to let exchange rates adjust in response to shocks to an economy than fix them and force the adjustment onto other economic variables, because floating regime is more conductive to economic stability since exchange rate is easy to adjust whereas domestic prices tend to be very difficult to reduce.

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Floating regime: A loss of international competitiveness currency depreciation restore international competitiveness.

Fixed regime: A loss of international competitiveness require severe deflationary policies induce the fall in domestic wages and prices restore international competitiveness.

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Private Speculation is StabilizingPrivate speculators are a stabilizing

rather than destabilizing force because it is in the interests of speculators.

Speculators attempt to buy at a low rate and sell at a high value reduce the gap between the low and high values move the exchange rate towards its fundamental equilibrium value.

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Box 10.1 The Optimum Currency Area Literature

Put simply, an optimum currency area is a region for which it is optimal to have a common currency and a common monetary policy.

Determining a set of criteria to determine which countries should participate in a monetary union has been the subject matter of optimum currency area theory.

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In the literature on the subject there is no single set of criteria which is generally agreed upon. Nonetheless, it is worthwhile to briefly review some of the criteria that have been suggested for determining which countries should join a monetary union.

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Degree of factor mobility internationally.

Mundell(1961) proposed that the higher the degree of factor mobility between countries, then the more beneficial a monetary union would be between them.

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The rationale:Bop in deficit(a fall in demand for its goods), high capital mobility will enable it to

finance its deficit more easily; high labor mobility will mean that

deficit regions can deflate their economies without fear of a large increase in unemployment.

Without the need for an exchange rate depreciation.

Conversely, a monetary union would be undesirable.

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Degree of financial integration.If a country has a high degree of

financial integration with other countries, then it will be more able to finance its deficits and less dependent on exchange rate changes, then a single currency is a more feasible option.

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Degree of openness.McKinnon(1963) has argued that the

more open, the more profitable it is to join a currency union.

The rationale is that if the economy has a large tradables sector it will be much more vulnerable to inflation from a depreciation currency and unemployment from an appreciation currency and therefore the less desirable exchange rate changes are.

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Degree of product diversification.Kenen(1969) has suggested that the

more diversified a country’s range of exports and imports, the more it will benefit from monetary union.

A diversified economy means less variability in its export earnings and import expenditure and more stability for its BOP. Accordingly, the less will be the need to resort to exchange rate changes.

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Degree of similarity of inflation rates.

If countries have similar inflation rates then PPP theory suggests that there is no need for exchange rate changes and hence a monetary union is more feasible.

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Even if we ignore numerous criticisms that can be made of the individual criteria, it is clear that emphasizing one particular factor is hardly sufficient grounds for justifying monetary union.

In sum, the optimal currency area literature addresses an interesting question but the various criteria that have been suggested are far from conclusive.

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10.4 The Modern Evaluation of Fixed and Flexible Exchange-Rate

Regimes

The modern approach evaluates by seeing which regime best stabilizes the domestic economy in the face of various shocks to the economy.

The literature does not provide an unambiguous answer.

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It shows that the choice is crucially dependent upon a multiplicity of factors.

These factors are: 1.the specification of the objective

function of the authorities as between price and output stability;

2.the type of the shock impinging upon the economy;

3.the structural parameters of the economy.

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10.5 The Specification of the Objective Function

For simplicity we shall deal with an economy where the authorities have two objectives------price and output stability------the minimization of fluctuations of the price and output level around their target values.

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The authorities will wish to minimize the value of the following objective function:

Where: w------the relative weight attached

to each of the two objectives; Yn------the natural/target value for

domestic real income; Pn------the natural/target value for

domestic price level.

22 ))(1()(),( nn PPwYYwyPO

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The idea of incorporating a weighted objective function: there may be a trade-off for the authorities between income and price stability.

w=1, domestic income stability; w=0, domestic price stability.

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10.6 The Model Now investigate an economy

buffeted by various transitory shocks.

Transitory: self-reversing, the economy is always expected to return to its natural price(Pn) and output level(Yn).

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Make some simple rules concerning expectations:

Exchange rate: depreciate today, appreciate back to its normal level in the next period;

The price and output levels: rise today, go back to its normal level in the next period.

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Three types of transitory shocks: money demand; aggregate demand; aggregate supply.

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1.money demand (10.1)Where: Mdt: money demand;

Yt: real domestic income;

rt: domestic nominal interest rate;

Ut1: a transitory money demand shock term with zero mean and normal distribution.

1UtrYPiMd tttt

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Pit: aggregate price index made up of a weighted average of the domestic and foreign price levels;

The idea of incorporating Pit:monetarist proposition--------the demand to hold money is a demand for real balances related to the purchasing power of money.

,0<α<1 (10.1a)))(1( *tttt PsPPi

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2.aggregate demand

(10.2)

Where: :the expected price level one

period hence; :the natural level of output; :a transitory aggregate demand

shock term with zero mean and normal distribution.

2/1* )()( UtYPPrPPsYd ntttttttt

ttP /1

nY

2Ut

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3.aggregate supply (10.3) Where: , (10.3a)Where: :the supply of domestic output; :wage rate pre unit of labour; :labour input; :a transitory aggregate supply shock

term with zero mean and normal distribution.

3)( UtWPYs ttt )(LtYsYs tt

0/ tt LYs 0/ 22 tt LYs

tYs

tW

3UtTL

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Uncovered interest parity condition is assumed to hold continuously:

Where: :the foreign interest rate; :the expected exchange

rate in period t+1; :the expected rate of

depreciation of the currency.

)( /1*

ttttt ssrr

*tr

tts /1

)( /1 ttt ss

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The setting of nominal wages:The contracts have a duration of one

period;Wt is set at the level of required to

generate an expected output at the natural level Yn:

Wt =Wt*

Where: Wt*:is the wage rate will lead to full

employment at the natural rate of output.

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Require the simultaneous fulfillment of two equations: Mst=Mdt , Yst=Ydt

Under fixed exchange rates: rt=rt* Mst is endogenously determined.

Under floating exchange rates: Mst is exogenously determined, rt and st are endogenously determined

and tied together via the uncovered interest parity.

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10.7 Determining Equilibrium

Aggregate demand schedule(Yd): Downward-sloping, P↑Yd↓.1.P↑ → (s+P*-P)↓

→ competitiveness↓ → net export ↓ → Yd↓ ；

2. P↑ → Pt+1/t ↓ → (r+P-Pt+1/t)↑ → Yd↓.

The absolute slop= .)/(1

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The money demand schedule(Md): Downward-sloping, P↑Y↓.P↑→ Md↑→ Y↓→ Md↓→ to maintain

money demand equilibrium.The absolute slop= For most of analysis, assume:

That is: Yd is flatter than Md. In the case of an aggregate supply

shock both cases are examined.

/

)(

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The aggregate supply schedule(Ys):

Positive slop, P↑Ys↑.P↑→ real wage↓ → producers take

on more workers→ Ys↑.The absolute slop=

/1

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Determining equilibrium: Simultaneous interaction of all

three schedule through a common point.

Equilibrium price:Pn the optimalEquilibrium output:Yn target value

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Price level Ys1Pn Yd1 Md1

Yn Real incomeFigure 10.1 Equilibrium of the model

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10.8 Money Demand Shock

An unanticipated rise in money demand. Md shift to the left(Md1→Md2)(Ms⇕)1.under fixed exchange ratesExcess demand for money a tendency for the

currency to appreciate authorities have to purchase the foreign currency expand the domestic money stock till Md2 shifts back to Md1 short-term equilibrium remains at point A no disturbance to price and output fixed is optimal.

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2.under floating exchange ratesExcess demand for currency currency

appreciating A loss in competitiveness net export decrease demand for domestic output decrease Expected future depreciation of the currency domestic interest rate rise demand for domestic output decrease

Yd shift to the left(Yd1→Yd2) ;Domestic interest rate rise demand for money

fall Md shift back to the left(Md2→Md3);Temporary equilibrium point C a fall in both

price and output.

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Price level Ys1

Pn A P2 C Yd1 B Yd2

Md3 Md1 Md2 0 Y2 Yn real income

Figure 10.2 money demand shock

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10.9 Aggregate Demand Shock

An unanticipated increase in aggregate demand. Yd shift to the right(Yd1→Yd2)

1.under fixed exchange ratesReal income demand for money

currency tend to appreciate purchase foreign currency expand money stock Md1→Md2,excess money demand is eliminated short-term equilibrium at point B both the price and output

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2.under floating exchange ratesReal income demand for money competitiveness Ydcurrency appreciate Yd2→Yd3 expected future depreciation

domestic interest rate Md Md1→Md3 Equilibrium at point C both the price and

output higher than initial equilibrium but lower than fixed exchange rates.

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Price level Ys1 P2 B C Md2 P3 Md3 Yd2 Pn A Yd3 Md1 Yd1 0 Yn Y3 Y2 real income

Figure 10.3 Aggregate demand shock

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10.10 Aggregate Supply Shock

An unanticipated fall in aggregate supply.

Ys shift to the left(Ys1→Ys2)Ys P Md Md>Ms orYd Y Md Md<Ms

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Case 1: Md schedule is steeper than Yd schedule, i.e.

Excess supply of money at point B currency tend to depreciate

1.under fixed exchange rates buy domestic currency money

supply =money demand Md1→Md2 equilibrium at point B P Y

)(

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2.under floating exchange ratesCurrency depreciate export increase Yd

Yd1→Yd2 expected future appreciate domestic interest rate Money demand Md1→Md3Equilibrium at point C P Y

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Price level Ys2

P3 C Ys1 P2 B Pn A Yd2 Yd1 Md2 Md3 Md1 0 Y2 Y3 Yn Real incomeFigure 10.4 Aggregate supply shock(case

1)

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the choice would depend primarily upon the objectives of the authorities:

If biased towards price stability fixed exchange rates;

If biased towards output stability floating exchange rates.

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Case 2: Yd schedule is steeper than Md schedule, i.e.

Excess demand for money at point Bcurrency tend to appreciate

1.under fixed exchange rates buy foreign currency money

supply =money demand Md1→Md2 equilibrium at point B P Y

)(

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2.under floating exchange ratesCurrency appreciate export decrease Yd

Yd1→Yd2 expected future depreciate domestic interest rate Money demand Md1→Md3Equilibrium at point C P Y

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Price level Ys2

P2 B Ys1 P3 C Md2Pn A Md3 Md1 Yd1 Yd2 0 Y3 Y2 Y1 Real incomeFigure 10.5 Aggregate supply shock(case

2)

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the choice would depend primarily upon the objectives of the authorities:

If biased towards price stability floating exchange rates;

If biased towards output stability fixed exchange rates.

Note:The choice of exchange rates is very

closely related to the structural parameters of the economy.( or ) )( )(

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Table 10.1 summary of the results under fixed and floating rates

Transitory shock Floating rates Fixed rates

Price stability

Output stability

Price stability

Output stabilit

y

Money demand Χ Χ √ √

Aggregate demand √ √ Χ Χ

Aggregate supply Md steeper than Yd

Χ √ √ Χ

Aggregate supply Yd steeper than Md

√ Χ Χ √

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It reveals: the choice between the two

regimes is seen to depend crucially upon:

The type of shock impinging upon the economy;

The objectives of the authorities; The structural parameters of the

particular economy considered.

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Reminding readers: The model set out is extremely

simple. In practice, the choice will be even more complex.

Transitory and permanent shocks; Wage indexation; The problem of interdependence.

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10.11 Managed FloatingRationales for intervention: The authorities can choose an

exchange rate more in line with economic fundamentals than the market;

Intervention is required to mitigate the costs of exchange-rate ‘over-shooting’;

Intervention is an appropriate instrument for smoothing necessary economic adjustments.

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Note: It is necessary to assume that the

authorities can influence the nominal and/or real exchange rate in their desired direction;

It is necessary to compare exchange market intervention with alternative policies;

It should be remembered that exchange-rate management by the authorities can vary in degree from occasional intervention to influence the exchange rate to a permanent pegging.

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1.Authorities might be able to produce a more appropriate exchange rate

Case 1:The authorities are in possession of superior relevant information.

Case 2:The authorities know better and sooner what they themselves are about to do.

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2.Intervention needed to mitigate costs of exchange-rate overshooting

According to the Dornbusch(1976) overshooting model, changes in monetary policy will lead to short-term real depreciation or appreciation. These real-exchange rate movements(over and undervaluations in relation to PPP) will exert effects on the real economy.

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Misaligned exchange rates distort the allocation of resources between tradables and non-tradables as well as consumption patterns between the two;

Misalignment complicates and inhibits investment decisions;

Misalignments almost certainly exert a ratchet effect on protectionism.

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Since an under/overvaluation must necessarily eventually be corrected, this will involve the various adjustment costs.

Foreign exchange intervention designed to reduce the costs and extent of exchange-arte overshooting could be justified.

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Alternatively, misalignment can be reduced by increasing flexibility in the goods and labor markets because misalignment is induced by ‘sticky’ goods price not due to inefficiency in the foreign exchange market.

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The measures increasing flexibility in the goods and labour market would include anti-trust legislation, reductions in trade union power, and the reduction of social security benefits likely to bring about resistance and turmoil exchange market intervention can prove a superior policy tool.

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3.Intervention to smooth the economic adjustment process

Exchange market intervention (‘exchange rate protection’) can slow down the necessary adjustment between the traded and non-traded sectors or within the tradables sector.

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For example: Persistent BOP surplus a tendency

to appreciate large transitional unemployment

if intervention, moderate the appreciation allow time for transition avoid excessive transitional unemployment costs.

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Exchange market intervention can compare favourably to other methods of protection such as tariff protection.

Exchange-rate protection must necessarily be a temporary method of protection;

Tariffs and subsidies have a habit of becoming permanent features and tend to invite retaliation.

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Intervention may exist if the economy is caught in a ‘vicious circle’.

For example:Current account deficit depreciation

price and wages increase offset depreciation further depreciation ‘vicious circle’;

If intervention slow down or even avoid the spiral allow time to reduce the real wage or to await productivity improvements.

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10.12 Conclusions Neither the traditional advantages/

disadvantages approach or modern literature provide a clear-cut reason to prefer fixed to floating exchange rates, or vice versa.

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The lack of decisive arguments in favor of either fixed or floating exchange rates has frequently been taken as a rationale for some degree of exchange-rate management between the two regimes;

The interdependence between different countries when determining the choice of exchange rates is an issue that merits further attention.

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Further reading: 郝振飞、金发奇，《从“扩展三角”到人民币汇率制度的选择》，《财经界》(下旬刊 ), 2008 年 02 期。

王高华，《经济冲击与汇率制度选择探讨》，《江西金融职工大学学报》， 2008/03 。

宿玉海，《 20 世纪 90 年代以来的汇率制度选择理论及评介》，《山东财政学院学报》， 2008/01 。