Exchange rate regimes - short + medium run (topic 9) Flashcards
Focus: interactions between a country and the rest of the world considering the medium run price fluctuations Prices affect the real exchange rate i.e., when the economy is above or below its natural level, prices tend to increase/decrease and these fluctuations will push the exchange rate up/down affects net exports and output.
How does prices affect the real exchange rate?
when the economy is above or below its natural level, prices tend to increase/decrease and these fluctuations will push the exchange rate up/down => affects net exports and output.
Where do we see price fluctuations?
In the medium run.
What changes can be seen in the real exchange rate when output is below potential? Explain graphically.
Assuming, π^e = π-bar
Therefore:
PC = π - π-bar = (α / L)(Y - Y_n)
So,
π^* = π -bar
If output is below potential in point A (equilibrium), and inflation is below π-bar => P increase less than P*.
The real exchange rate decreases (even if the nominal exchange rate remains constant).
- The mechanism relies on the fact that the real exchange rate can change even if the nominal exchange rate is fixed.
- This is a sign that shows us we’re in the medium run.
- It means that output will be low for a while and unemployment will be high.
- Adjustment in prices => change in the real exchange rate (which allows the economy to return to its natural level) i.e., in medium run, level of output is the same independently of exchange rate regime and with or without fiscal or monetary policy.
NX will increase => output increases (i.e., the IS curve shifts to the right) => the economy moves along the PC curve back to its medium run equilibrium.
LM is not affected (r = i - π-bar)
What should be done to decrease trade deficit while keeping output at its natural level (to avoid overheating/inflation)?
A decrease in the nominal policy rate i (depreciation) will reduce the trade deficit => i decreases = I and NX increase => movement to the right along the IS curve, i.e., output increase
To prevent changes in output: the government will implement a contractionary fiscal policy (making the IS curve shift left).
In a flexible exchange rate regime:
What can be done by the government and central bank in order to bring an economy below its natural level and back to medium run equilibrium?
Expansionary fiscal policy (government)
Expansionary monetary policy (CB)
Wait for the adjustment in prices to boost output (through real depreciation which affects NX positively – but it takes time)
In a fixed exchange rate regime:
What can be done by the government and central bank in order to bring an economy below its natural level and back to medium run equilibrium?
Expansionary fiscal policy (government)
Wait for the adjustment in prices to boost output (through real depreciation which affects NX positively – but it takes time)
Devalue = decrease the fixed nominal exchange rate. A devaluation can bring an economy that is below its potential back to its medium run equilibrium (similar effects as waiting for prices to adjust and affect the real exchange rate, but quicker).
Can members of a common currency devalue?
No.
When does mundell believe that it is optimal to join a common currency?
Mundell believes it is optimal to join a common currency when satisfying one of the following criteria:
- Countries must experience similar shocks (to have common monetary policy)
- If shocks are dissimilar, prices and wages must be very flexible (a country hit by a negative shock can regain competitiveness by decreasing prices relative to other members (real depreciation)).
- If shocks are dissimilar there must be a high factor (i.e., worker) mobility (free movement of people to balance unemployment rates) .
What happens when devaluing?
By decreasing the demand for the domestic currency (selling domestic currency/decreasing the interest rate) the central bank can decrease the nominal exchange rate => real depreciation i.e., pushing NX up => the IS curve shifts right i.e., output increases.
What can start an exchange rate crisis?
investors believe that the currency is overvalued the fixed exchange rate will not be maintained for long (because the central bank needs to foreign reserves to buy domestic currency to maintain its value, but the foreign reserve stock is limited).
There’s a rumor on the foreign exchange market that a county is considering/will devaluate (not necessarily true).
A country is going through severe recession and investors can think that the country will devaluate to boost NX and output.
What happens when investors think there is a risk of devaluation?
When investors think there is a risk of devaluation (or a risk of an exit from the fixed exchange regime) => increase in expected returns of foreign investments (as it increases the number of units of domestic currency when converting from foreign currency in the end of the period) => investors will invest in foreign currency => decrease in demand for domestic currency => risk of depreciation.
The central bank will need to increase the domestic interest rate to maintain the fixed exchange rate and bring the expected return of domestic investments = expected return of foreign investments.
The increase in interest rate will:
• Decrease investment => demand and output decreases.
• If investors demand a high interest rate, the effect on output will be substantial.
If the interest rate is not increased:
• Domestic and foreign investors will prefer foreign bonds => selling domestic bonds (speculative attack + capital outflow.)
• Demand for domestic bonds and currency decreases => the central bank must buy domestic currency by selling foreign bonds => low foreign bond reserves = the country must devalue or let the currency float.
What happens in a speculative attack?
Speculative attack = the fear of devaluation leads to a decrease in Ee => the IPC line (i = ( 1 + i^*) / (E^e) E-1) rotates/the slope increases, the central bank must either,
Give in and devaluate:
* Devaluation will push NX up and the IS curve shifts right.
or maintain the parity by setting a high interest rate.
- Selling bonds or intervene on the foreign exchange market (buying domestic currency and sell foreign bonds/reserves).
- LM curve shifts upwards.
- ICP is maintained by the increase in interest rate.
- The increase brings the economy to point B where output is lower due to the increased interest rate (as it decreases investment and thereby output).
