L14 - Exchange Rate Regimes

Question 1

Currency pegs can be more or less ‘official’ - what are the two types?

Answer 1

1. Currency board- CB can only issue as many pesos as it has dollars
2. Managed float/crawl- official commitment limited, goes in a band

Question 2

Random fluctuations in domestic demand should ensure e adjusts, inconsistent with pegging. SO WE CANNOT HAVE TWO OF THE FOLLOWING FIXED

Answer 2

e and M

Question 3

What can we tell from IS equation:

Y = 1/(1-c) { Č + I(r) + G + NX(e) }

Answer 3

C, G fixed
I(r*) fixed
NX(ē) fixed

EVERYTHING IS FIXED, Y ENTIRELY DETERMINED BY THE GOODS MARKET!

Question 4

So if Y is entirely determined by the goods market, what are implications for the money market?

Answer 4

M/P = L(i, Y)

M is the only thing that can vary to accommodate Y, it’s as if it’s a classical eq’m only here it’s SR cuz e=ē
P fixed
i fixed
Y fixed

SO we’re giving up monetary policy control

Question 5

Diagram needed to illustrate this

Answer 5

See (1)

THREE IS’s,
THREE LM’s
ONE i=i*

Question 6

Suppose CB wants to expand M under fixed e regime

Hint: money market

Answer 6

Shifts M/P right, downward pressure on i, capital flows out, CB buys more to maintain peg, but that contracts the money supply

BACK TO ORIGINAL POSITION

Question 7

Benefits of fixing ē

Answer 7

• Imported inflation-fighting credibility

- Stable prices -> increased trade

Question 8

Costs of fixing ē

How can you show it in a diagram?(2)

Answer 8

• Devaluation of ę=eP/P* can come through price cuts alone, requires constant NOG engineering

Important if ę is high when peg initiated

Diagram- IS in (e, Y) space with ē>e

Question 9

How can we fix the problem of overvalued e? And what’s the problem with the solution?

Answer 9

Stimulate G to increase IS to that level

Problem:
Only a temporary fix, might reduce pressure on p to fall (requires some AS story, but distance of Y from Y_fe usually matters for price adjustment)*** think of this

Underlying problem- overvalued ę, NX<0, internal balance but no external

Question 10

Risk of overvaluation - sustained CA deficit requires NCF surplus , what if investors think will have devaluation

Answer 10

Will require higher return at home to compensate

Devaluation fears can worsen NOG

I( r+ ø) in the IS relationship so I lower

And that worsened NOG:

1. Politicians forced to devalue
2. Income tax revenues, G can’t sustain?

“Markets can influence the events they anticipate” -George Soros