Chapter 8 Floating versus Fixed Exchange Rate Regimes · 2017. 11. 14. · advantages and disadvantages of alternative exchange rate regimes. 8.1 The Tradeoff between Inflation and

George Alogoskoufis, International Macroeconomics and Finance

Chapter 8 Floating versus Fixed Exchange Rate Regimes

In a floating exchange rate regime a monetary expansion can lead to higher output and employment, causing a depreciation of the exchange rate and to a temporary improvement in the current account.

In contrast, in a system of fixed exchange rates, monetary policy cannot be used to achieve internal and external balance, as it has to remain geared to the objective of stabilizing the exchange rate.

Fiscal policy could substitute for monetary policy under a fixed exchange rate regime, but fiscal policy has a number of weaknesses as a short-run macroeconomic policy instrument: First and foremost, it implies a conflict between the objectives of internal and external balance. Second, it is rather inflexible, in the sense that changes in fiscal policy require long and variable design, decision and implementation lags, as changes in national budgets, lengthy and uncertain legislative procedures and so on. Third, as we shall see below, too frequent a recourse to fiscal policy has adverse implications for both the evolution of government debt and the external debt of a country. Finally, fiscal expansions may crowd out private investment and have adverse long run implications for an economy’s capital stock and per capita income.

When the conflict between internal and external balance is acute, then the only solution in a fixed exchange rate regime is a devaluation of the exchange rate, which can be seen as a form of one off monetary policy.

The question that arises then is why would a country want to abandon the short-term instrument of monetary policy, by choosing a fixed exchange rate regime? Taken to the world level, why would so many countries choose to participate in international monetary regimes that imply fixed exchange rates, such as the international gold standard, or the Bretton Woods system, or the European Monetary System. Even more importantly, why would a country want to to join a currency area, like the euro area, in which the possibility of devaluation of the exchange rate does not even exist?

In order to provide a comprehensive answer to these questions, we must go beyond the limitations of short-term analysis, and analyze the pros and cons of systems of fixed and floating exchange rates, both for the medium run and the long run. Only then shall we have a complete picture of the advantages and disadvantages of alternative exchange rate regimes.

8.1 The Tradeoff between Inflation and Unemployment and the Exchange Rate Regime

Under floating exchange rates, monetary policy can be used to expand output and employment in the short run. In addition, an expansionary monetary policy results in an improvement in the current account, because it causes a depreciation of the exchange rate. Hence, there is no short run tradeoff between internal and external balance. However, there is a catch. The systematic use of monetary

George Alogoskoufis, International Macroeconomics and Finance Chapter 8

policy to expand output and employment may lead to high and rising inflation, without securing high output and employment in the medium run.

In this case, the advantage of floating exchange rates, in that they allow monetary policy to pursue the short run objectives of internal and external balance, loses much of its attractiveness.

To see how this may happen, we must go beyond the short run analysis. Our analysis so far, based on the short run keynesian model, has not discussed the determination of inflation in the short run, or the medium run. When this is accounted for, the arguments in favor of the use of monetary policy to achieve the objective of high employment loses much of its power.

8.1.1 The Expectations Augmented Phillips Curve

We have assumed until now that prices are fixed in the short run. In fact, this was a simplifying assumption which does not fully conform with reality. Wages and prices may not be perfectly flexible in the short run, but they do adjust in response to excess demand for labor and goods and services.

Since the early 1960s, it has been widely assumed that inflation in the short run is negatively related to unemployment. This negative relation between inflation and unemployment was first highlighted in an empirical study by Phillips (1960), and was subsequently given a consistent theoretical interpretation by Phelps (1967) and Friedman (1968).

In accordance with the Phelps-Friedman interpretation, the Phillips curve can by written as,

! (8.1)

where π is inflation, πe is expected inflation, u is the rate of unemployment, and a,b>0 are constant parameters. a measures the strength of the response of inflation to unemployment.

The interpretation of this relation was the following: Wage inflation depends on expected price inflation, as wage setters aim to maintain the purchasing power of their wages. However, when there is an excess supply of labor, and unemployment is high, wage setters are prepared to accept a real wage cut, and accept wage changes that are lower than expected inflation. When wages are set, firms set prices so as to cover the increase in their wage costs. Hence, price inflation is equal to wage inflation (minus productivity growth). As a result, price inflation is equal to expected inflation and depends negatively on the unemployment rate, which, induces lower wage inflation, and, hence, lower price inflation.

Assume now a country that has a floating exchange rate regime, and in which the government instructs the central bank to use monetary policy in order to maintain unemployment at a low level, say, u0. Initial, inflationary expectations are equal to π0. Then, inflation in the first period that the central bank follows this policy successfully will be equal to,

" (8.2)

If the government’s unemployment target is so low that u0<b/a, the expression on the right hand side will be positive, and inflation in period 1 will turn out to be higher than π0, the initially

π = π e − au + b

π1 = π 0 − au0 + b = π 0 + a((b / a)− u0 )

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expected inflation rate. We shall have that π1 > π0, i.e. the actual inflation rate will be higher than the inflation rate expected by wage setters.

Phelps and Friedman suggested that in a case such as this, inflationary expectations will not remain constant, but that they will start adapting upwards.

8.1.2 The Adaptation of Expectations and the Rise in Inflation

Assuming adaptive expectations, i.e. that inflationary expectations in each period adapt to the most recent inflation rate, in period 2, inflationary expectations will rise to π1. As a result, if the central bank keeps pursuing the unemployment target u0<b/a, inflation in period 2 will rise again, as it will be determined by,

! (8.3)

Again, we shall have π2 > π1, i.e. the actual inflation rate being higher than the expected inflation rate, which is equal to period 1’s inflation rate.

In period 3, the expected inflation rate will be π2, in period 4 in will be π3, and so on. Inflation and inflationary expectations will keep rising continuously. After T periods, inflation will be equal to,

! (8.4)

As a result of the central bank using monetary policy to maintain unemployment at the low rate u0, inflation will be rising continuously.

This situation is depicted diagrammatically in Figure 8.1. The original Phillips curve (indicated by PC0) crosses the horizontal axis at π0, the initial inflationary expectations at the unemployment rate uN=b/a. The government however considers this unemployment rate as too high, and the central bank uses monetary policy to reduce it to u0. The result is that inflation rises to π1, which is higher than the inflation rate π0, which was originally expected.

In period 2 inflationary expectations adapt to π1> π0. As a result, the Phillips curve shifts upwards, to PC1. The central bank again uses monetary policy to keep the unemployment rate at u0. The result is that inflation rises to π2, which is higher than the inflation rate π1, to which inflationary expectations had adapted.

As a result of the government using monetary policy to keep unemployment low at u0, the Phillips curve keeps shifting upwards, and inflation is on an ever rising path. The only way for the government to stabilize inflation, is to adopt an unemployment target of uN=b/a. If monetary policy targets unemployment at uN, then inflation will stop rising and will in fact be stabilized.

Friedman (1968) termed an unemployment rate such as uN the “natural rate” of unemployment. According to his definition, “The “natural rate of unemployment”, … is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.” (p. 8).

π 2 = π1 + a((b / a)− u0 ) = π 0 + 2a((b / a)− u0 )

πT == π 0 +Ta((b / a)− u0 )

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Phelps (1967) and Friedman (1968) argued that trying to reduce the unemployment rate below the “natural” rate, by increasing aggregate demand and inflation, would only meet with temporary success. As inflationary expectations will adjust to the higher inflation, unemployment will tend to return to its “natural” rate. One would need continuous increases in aggregate demand and inflation in order to keep unemployment below its “natural” rate. If at some point the central bank stopped increasing aggregate demand and inflation, then the unemployment rate would return to the “natural” rate, and the economy would be saddled with high inflation.

Thus, while in the short run monetary policy can respond to shocks that temporarily raise unemployment, in the medium run, monetary policy cannot reduce unemployment below the “natural” rate, and it has to be addressed to the problem of inflation.

The adjustment of expectations to a given government policy will be even quicker if agents do not have backward looking adaptive expectations, but forward looking rational expectations. The rational expectations hypothesis was introduced to macroeconomics by Lucas (1972), who adapted it from a earlier paper by Muth (1961). The rational expectations hypothesis implies that agents make use of all the available information in forming their expectations about the future, including information and knowledge on the intentions of governments and central banks, and on how the economy functions.

Thus, in the context of our Phillips curve example, expectations about inflation may adjust much more quickly that implied by the adaptive expectations hypothesis, and the government may have very little scope for using monetary policy to affect unemployment even in the short run.

What is the significance of this argument for exchange rate regimes? If in a floating exchange rate regime, the government and the central bank of a country have been using monetary policy in a way that has led to high and rising inflation, then, one way in which they can affect inflationary expectations downwards, in order to quickly reduce inflation, is to fix the exchange rate with a low inflation international currency, as this would be a strong signal of their determination to reduce inflation, and may lead to a quicker downward adjustment of inflationary expectations, especially if expectations are formed rationally.

The quick adjustment of expectations will ensure that the reduction in inflation will be associated with a lower rise in unemployment than otherwise, as expectations will adjust more quickly to the low inflation policy of the government and the central bank.

8.1.3 The Costs of Disinflation and Government Credibility

Assume an economy that had adopted a flexible exchange rate regime, and used monetary policy in the way that we have just described, ending up with high inflationary expectations, high inflation, and an unemployment rate that returned to the “natural rate”. Inflation is no longer rising, as the government does no longer attempt to reduce it below the “natural rate”. Yet, inflation is high, and the government wishes to reduce it.

The speed at which expectations adapt, depends on the credibility of the switch in government policy. If the government has lost credibility, by having used monetary policy to continuously reduce unemployment below the “natural rate” and thus by continuously creating higher inflation

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than what was expected, the private sector will not be prone to believe government pronouncements that from now on inflation will be kept low. Thus inflationary expectations will remain high and will adjust only gradually. How can inflation be reduced in the absence of government credibility?

One way is to reduce inflation taking the opposite path. By adopting a restrictive monetary policy that reduces aggregate demand and causes an increase in unemployment above its “natural rate”, a central bank can gradually induce inflationary expectations to adapt downwards, and thus it can gradually induce a reduction in inflation.

The process is shown diagrammatically in Figure 8.2. Starting from high inflation and high inflationary expectations πΕ, the central bank initiates a restrictive monetary policy, that induces unemployment above its natural rate, say to u1. By maintaining unemployment at u1, through a restrictive monetary policy, the central bank keeps inflation below expected inflation, and gradually forces expected inflation down. As inflationary expectations adapt downwards, so does actual inflation. The process can stop when the Phillips curve has shifted back to PC0, and inflation and inflationary expectations have returned to π0. Then unemployment can be reduced to uN as no further fall in inflation is required.

However, this process is socially costly, as the economy has to go through a period of high unemployment, in order for the central bank to convince the private sector to reduce its inflationary expectations.

The cost of disinflation can be reduced if the government and the central bank can gain credibility more quickly than through the lengthy disinflation process described above. Credibility can be acquired more quickly if the government changes the regime that led to high inflation in the first place. For example, if the government grants political independence to a central bank with a single minded inflation objective, or if it abandons the floating exchange rate regime that led to high inflation in the first place, then a rational private sector will see through the regime change, and expectations will adapt more quickly, even immediately if the regime change is fully understood and is credible.

8.1.4 Anti-inflationary Credibility and Fixed Exchange Rate Regimes

This anti-inflationary credibility argument may explain the appeal of fixed exchange rate regimes such as the international gold standard in the 19th century, or the Bretton Woods system from the end of World War II until the early 1970s.

This type of solution to the high inflation problem is also behind the decisions of many governments, after the high inflation of the 1970s, to grant independence to their central banks, or to adopt fixed or managed exchange rate regimes, with a low inflation currency as the US dollar or the Deutsche mark. We shall analyse these cases when we discuss the evolution of the international monetary system and the European monetary arrangements that led to the creation of the euro.

The rationale was that by granting away the flexibility afforded by discretionary monetary policy, in favor of a monetary policy chosen by a conservative central bank, even if that central bank was a foreign central bank, credibility would be restored more quickly, and inflation would fall more quickly and at a lower cost.

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Thus, the appointment of an independent central banker, or a fixed exchange rate regime with a low inflation currency were seen as solutions to the high inflation problem faced by a number of countries in the 1970s. After the rise in inflation in the 1970s, in 1979 US President Carter appointed Paul Volcker as Chairman of the independent Federal Reserve Board, with the express objective of reducing inflation. A number of countries of the European Economic Community, chose a fixed exchange rate regime among their currencies after 1978, and ended up reducing inflation by borrowing the anti-inflationary credibility of the politically independent Bundesbank. Countries such as Argentina and Brazil adopted monetary reforms and fixed exchange rate regimes in the 1990s, in order to reign in on the problem of chronic inflation. The same choice was made by a number of transition economies in Eastern Europe in the 1990s, such as Poland and Czechoslovakia. In all those cases, the monetary policy flexibility afforded by floating exchange rates had resulted in high inflation, and fixed exchange rates were seen as a way of gaining anti-inflationary credibility.

In conclusion, if a government cannot use monetary policy in a restrained way, and ends up losing credibility and inducing high and rising inflation, then it is probably preferable to opt for either an independent central bank, with a low inflation mandate, or, a fixed exchange rate regime with a low inflation international currency. A fixed exchange rate regime, if it can be maintained, allows a national government to borrow the anti-inflationary credibility of the low inflation currency.

8.2 Confidence Crises and the Collapse of Fixed Exchange Rate Regimes

One of the greatest weaknesses of a fixed exchange rate regime is that it may collapse under the weight of a crisis of confidence in the ability of the central bank to maintain a constant nominal exchange rate. Such a collapse may imply important economic and social costs not only during the period that a central bank tries to defend the fixed exchange rate, but also afterwards.

A crisis of confidence can take place either because of fundamental reasons, for example because the foreign reserves of the central bank are not sufficient for it to engage in the necessary interventions in the foreign exchange market, or because of non fundamental reasons, such as sudden shifts in expectations in international currency markets that are not necessarily related to the economic fundamentals of the country itself.

8.2.1 A Confidence Crisis in a Fixed Exchange Rate Regime

If for any reason expectations of an imminent devaluation of the exchange rate take hold, this will require an increase in domestic interest rates in order to maintain the fixed exchange rate. At the same time, the central bank will be forced to make interventions in the foreign exchange market, something that would lead to a reduction in its foreign reserves.

To see how a confidence crisis may destabilize a fixed exchange rate regime, consider a country which maintains a fixed exchange rate under perfect capital mobility. For equilibrium in the forex market, uncovered interest parity must hold. Thus,

! (8.5) S_= Se 1+ i

1+ i*

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where is the fixed exchange rate (units of foreign currency per unit of domestic currency), Se is the expected future exchange rate, i is the domestic interest rate and i* is the foreign interest rate.

As long as the expected future exchange rate is equal to the current fixed exchange rate, i.e as long as the fixed exchange rate is credible, the domestic interest rate will be equal to the foreign interest rate.

Assume now that, for whatever reason, participants in forex markets believe that the will be a depreciation of the exchange rate, and the future exchange rate will be lower than the current exchange rate.

A shift in expectations leads to speculation against the domestic currency. Forex traders that believe there will be a depreciation within their time horizon, take bets against the domestic currency, by borrowing in the domestic money market and using the proceeds in order to buy foreign exchange from the central bank. They do this in the belief that when the time comes to repay their domestic loans, they will do that in a depreciated currency.

In order to maintain the current exchange rate at its fixed value, the central bank raises domestic interest rates relative to foreign interest rates. This is a direct consequence of (8.5), which implies that,

! (8.6)

Thus, an expectation of a future depreciation of the exchange rate (devaluation) will cause domestic interest rates to rise. As the central bank intervenes to support the exchange rate, it loses foreign exchange reserves, the monetary base and the money supply are reduced, and domestic interest rates rise. Of course, the central bank may chose to increase interest rates by even more than what would be required by the reduction in its foreign exchange reserves, in order to reduce the incentives of traders to speculate against the domestic currency.

Thus, when a confidence crisis breaks out, the central bank has two options. The first is to raise domestic interest rates, without abandoning the fixed exchange rate. The required hike in interest rates may be quite high if market participants expect a significant imminent depreciation of the exchange rate. The second option is to succumb to the pressure and either proceed to a one off devaluation of the exchange rate, or choose to move from fixed to floating exchange rates. In both cases, the fixed exchange rate regime is destabilized.

The option of maintaining sufficiently high interest rates, makes it unattractive for dealers in the foreign exchange market to borrow in domestic currency at the domestic interest rate i, and convert the proceeds in foreign currency, which has the lower yield i *. In this way the central bank limits the currency outflows and the pressure on the exchange rate. However, being forced to raise domestic interest rates significantly, in order to maintain the fixed exchange rate, entails costs for domestic households and firms, and reduces aggregate demand, output and employment. Thus, the defense of a fixed parity, when market participants have lost confidence in the ability of the central bank to defend it, entails significant economic and, therefore, political costs.

S_

S_> Se ⇒ i > i*

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The second option, is to devalue, or to abandon the fixed exchange rate regime, in favor of floating exchange rates. A devaluation may or may not work, depending on whether it triggers expectations of a further devaluation or not. Resorting to floating exchange rates means that the fixed exchange rate regime has collapsed, and the exchange rate may depreciate significantly in the short run.

8.2.2 Stages in a Typical Exchange Rate Crisis

A typical confidence crisis in a fixed exchange rate regime unfolds in stages. At first, the government and the central bank seek to assure in all tones that they will defend the fixed exchange rate and will not devalue. Statements are made at a high, even the highest political level. During this stage, the central bank begins to raise short-term interest rates and engages in foreign exchange market interventions to support the exchange rate. This first line of defense usually proves ineffective, especially if the interest rate increase is insufficient to persuade speculators to stop betting on a devaluation.

Then, in a second stage, after a few hours, or days, or weeks, the central bank resorts either to a very large increase in interest rates, in order to convince markets that it does not intend to devalue or succumbs and devalues the currency either through a one off devaluation or through a switch to a system of floating exchange rates. In the latter case, the fixed exchange rate regime collapses, and both the central bank and the government lose out. If the rise in interest rates is successful, it may have to be sustained for some time.

8.2.3 Winners and Losers from an Exchange Rate Crisis

What is the economic cost of a successful defense of a fixed exchange rate? Mainly the costs imposed on households, firms and domestic banks, who have debt obligations in domestic currency, by the high interest rate policy. In addition, if the defense period is lengthy, this may lead to a recession. These costs are mitigated by the gains made by domestic lenders, including the central bank, which lend at high interest rates for the period of the crisis. In the event a successful defense, speculators in the foreign exchange market are among the losers. They have lost the difference between the high domestic interest rates they paid in order to borrow in domestic currency, and the low interest rate they received by investing in foreign currency, while they maintained their speculative positions against the domestic currency.

What is the economic cost of an unsuccessful defense of a fixed exchange rate? The costs of high interest rates for the period that the central bank was trying to defend the exchange rate, plus the loss to the central bank of selling its foreign exchange reserves cheaply, and buying them back dearly, in terms of domestic currency. The cost to the central bank is the gain to speculators in the forex market.

In addition, an unsuccessful defense of a fixed exchange rate regimes implies costs for domestic consumers, and benefits for domestic producers, as the price of imports goes up in domestic currency. In addition, an unsuccessful defense implies costs for domestic borrowers in foreign currency, who, believing that the exchange rate will have remained fixed, borrowed in foreign currency, although their income stream was in domestic currency. These may include domestic households and firms, as well as domestic banks. If the exchange rate is devalued, either through a one off devaluation, or through reverting to a floating exchange rate regime, the nominal value of their debt in domestic currency goes up, and so does the cost of servicing this increased debt.

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Thus, fixed exchange rate regimes, not only preclude the use of monetary policy to stabilize the economy, but are also subject to potential exchange rate crises, which, when they occur, generally entail high economic costs for domestic households and firms.

8.3 Fluctuations and Volatility in Floating Exchange Rate Regimes

Floating exchange rate regimes may not be characterized by acute crises, but they are characterized by significant fluctuations and volatility in nominal and real exchange rates.

Fluctuations and volatility in nominal and real exchange rates are caused by changes in expectations about the future path of interest rates. Due to the gradual adjustment of the prices of goods and services, these fluctuations in nominal exchange rates are translated into fluctuations in real exchange rates, affecting exports and imports, and the path output, employment and the current account. In addition, as nominal exchange rates are determined in order to satisfy interest parity, they are not conducive to the attainment of internal and external balance. In fact, they are often destabilizing and may imply significant real costs.

In order to see how the whole path of current and expected future interest rates at home and abroad affects exchange rates, let us start with our familiar uncovered interest parity condition. At time t, the spot exchange rate is determined by,

! (8.6)

where S is the spot exchange rate in period t (units of foreign currency per unit of domestic currency), Se is the expected future spot exchange rate in period t+1, based on information available at time t, i is the domestic interest rate and i* is the foreign interest rate, both at time t.

From (8.6), the expected future spot exchange rate in period t+1 will be determined by,

! (8.7)

The expected spot exchange rate for period t+1 will be equal to the expected spot exchange rate for period t+2 times the ratio of expected domestic and foreign interest rates at time t+1. This is based on the assumption of rational expectations, which essentially suggests that agents will form expectations about the future value of a variable taking into account the economic process that actually determines the variable concerned. Since foreign exchange traders know that spot exchange rates are determined by (8.6), it is rational on their part to assume that the future spot rate will be determined by a similar process, and, thus, their expectations will be formed on the basis of (8.7).

Substituting (8.7) in (8.6), we then get,

! (8.8)

St = St+1e 1+ it1+ it

*

St+1e = St+2

e 1+ it+1e

1+ i*t+1e

St = St+2e 1+ it+1

e

1+ i*t+1e1+ it1+ i*t

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Thus, the current spot rate, can be seen to depend on the expected spot rate two periods into the future, times the product of the ratio of current interest rates and the ratio of expected interest rates one period from now.

Repeating the substitution T times, one can see that the current spot rate is determined by,

! (8.9)

Thus, the current spot exchange rate is affected not only by current interest rate differentials, but also by expectations about the future evolution of domestic and international interest rates for the next T-1 periods, and the expectation about the future spot exchange rate T periods from today. Anything affecting these expectations, whether relevant or irrelevant, affects the current value of the spot nominal exchange rate, and causes fluctuations and volatility.

In addition, because the prices of goods and services only adjust gradually, these fluctuations and volatility in the spot nominal exchange rate cause fluctuations and volatility in the real exchange rate as well. Fluctuations and volatility in real exchange rates then affect exports, imports, the current account and output and employment.

When, following the collapse of the Bretton Woods system of fixed exchange rates, the main industrial economies moved to a regime of floating exchange rates, proponents of this transition did not expect that exchange rates would fluctuate excessively, as they expected them to be determined by slow moving economic fundamentals, including monetary and fiscal policy. A similar experience with floating in the 1920s, which had been highlighted by Nurkse (1944), had either been forgotten, or dismissed, as it was attributed to the volatile macroeconomic policies of the period (see Friedman 1953).

The fluctuations and volatility that materialized initially surprised many economists. However, when it was realized that exchange rates are determined just like other financial variables, and depend on expectations about the future, economists came up with the current theories of floating exchange rates.

Yet, excessive fluctuations and volatility remain an unwelcome by product of regime of floating exchange rates in a world of high capital mobility.

8.4 Some Preliminary Conclusions

Having reviewed the arguments above, we can draw some preliminary conclusions with regard to the choice between a regime of floating versus fixed exchange rates.

In a floating exchange rate regime a country has the ability to use monetary policy to address short-term shocks to output, employment and external balance. This feature is a major advantage of a floating exchange rate regime.

In contrast, in a system of fixed exchange rates, monetary policy cannot be used when there is free capital mobility, as in this case monetary policy becomes subservient to the task of stabilizing the exchange rate.

St = St+Te 1+ it+T −1

e

1+ i*t+T −1e

1+ it+T −2e

1+ i*t+T −2e ... 1+ it+1

e

1+ i*t+1e1+ it1+ i*t

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However, if a government or central bank over-exploits the freedom it has under floating exchange rates to set its own monetary policy, and ends up losing its credibility and causing high and rising inflation, then it is probably preferable to stabilize the exchange rate vis-a-vis a low inflation international currency. This way, the problem of high inflation can be addressed, by importing the anti-inflationary credibility of the low inflation currency.

In any case, a fixed exchange rate regime runs the risk of a currency crisis, which can cause significant economic costs and destabilize not only the exchange rate but also the economy in general. One of the reasons is that it is much harder to resolve the conflict between internal and external balance in a fixed exchange rate regime, with the result being a gradual buildup of external imbalances that, in time, tends to undermine the credibility of the fixed exchange rate regime. Such a danger of a currency crisis does not threaten floating exchange rate regimes, but, in such regimes, there are large short and medium run fluctuations and volatility in nominal and real exchange rates.

Many economists today believe that floating rate regimes are a better option than fixed exchange rates, especially if a country can acquire anti-inflationary credibility through other means, such as appointing an independent central banker that does not allow inflation to rise out of control.

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Figure 8.1 Inflationary Expectations and the Phillips Curve

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Figure 8.2 The Costs of Disinflation without Government Credibility

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References

Friedman M. (1968), “The Role of Monetary Policy”, American Economic Review, 58, pp. 1-17. Lucas R.E. Jr (1972), “Expectations and the Neutrality of Money”, Journal of Economic Theory, 4,

pp. 103-124. Muth J.F. (1961), “Rational Expectations and the Theory of Price Movements”, Econometrica, 29,

pp. 315-335. Phelps E.S. (1967), “Phillips Curves, Expectations of Inflation and Optimal Unemployment over

Time”, Economica, 34, pp. 254-281. Phillips A.W. (1958), “The Relationship between Unemployment and the Rate of Change of Money

Wages in the United Kingdom, 1861-1957”, Economica, 25, pp. 283-299.

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Chapter 8 Floating versus Fixed Exchange Rate Regimes · 2017. 11. 14. · advantages and disadvantages of alternative exchange rate regimes. 8.1 The Tradeoff between Inflation and