Exchange rates and Currency Unions Flashcards
What are the four exchange rate regimes
-Pure fixed rate
-Adjustable peg
-Managed float
-Pure flexible rate
How do you fix exchange rates (e.x Denmark)
-Denmark’s national bank stabilizes krone by buying and selling foreign currency
-When Denmark buys euro –> increase krone on market (depreciation of krone)
-When Denmark sells euro –> decreases krone on market (appreciation of krone)
Why does a fixed exchange rate limit financial autonomy
-The dependent country must employ other policy changes to prevent exchange rate fluctuation (e.x increasing or decreasing money supply)
What are the three corners of Mundell’s impossible trinity
-Independent monetary policy
-Free capital movements
-Fixed exchange rate
What are features of policies under fixed exchange rate
-Loss of monetary autonomy if capital mobility
-Fiscal policy becomes more efficient under fixed
exchange rates if capital mobility
-Loose fiscal policy can threaten the peg and lead to speculative attacks and currency crisis
Reasons for fixed exchange rate
-Discipline on price stabilization
-Reduces speculation and money market disturbances
-Promotes international trade and investment
Reasons against fixed exchange rate
-Loss of monetary policy autonomy
-Exchange rate movements act as an automatic stabilizer
-Fixed exchange rate regimes can be subject to large adjustments
Why join a Currency Union
-Lose monetary policy autonomy but you get say at table
What is Mundell’s theory of Optimum Currency Area
When two regions have:
-Transaction cost are low and trade is high
-Macroeconomic shocks can be absorbed by high labour mobility and large fiscal transfers
-Similar business cycles and production
When is a Currency Union especially costly
-When wages and prices are rigid
-Macroeconomic shocks are asymmetric
-Business cycles are not synchronized across regions
- Low labour and fiscal mobility
What is a speculative attack
-large devaluation (sudden loss of confidence in peg)
->Run on the central bank’s foreign reserves to defend
-> Central bank sells its reserves to defend exchange rate peg
What are the assumptions of the fundamental balance of payments crises by Krugman (1979)
-The fixed exchange rate is fundamentally inconsistent with the macro policy
-Monetary policy too expansionary for the peg to be sustainable
What occurs under Krugman’s 1979 fundamental crisis
-Central bank sells reserves at the same time it buys T-bills –>Central Bank will eventually run out of reserves –> crisis happens before central bank runs out of reserve due to expectations of collapse
What is a speculative attack
-A run on CB reserves (all speculators want to
sell domestic currency and buy reserves of the CB).
What are the assumptions of Krugman’s 1999 self-fulfilling crisis
Attack is self-fulfilling because speculators speculate a collapse –> causing a run onreserves –> leading to the expected collapse
