L8: Fixed Exchange Rates and Currency Unions

Question 1

fixed exchange rate

Answer 1

where the central bank stabilises the currency with respect to another currency

Question 2

how is the exchange rate fixed?

Answer 2

central bank has to offset any form of market forces by buying/selling foreign currency in the market

effectively what they do when they intervene to stabilise the exchange rate is to change the supply of local currency on the market

Question 3

what happens to monetary policy when fixing the exchange rate?

Answer 3

loss of monetary policy autonomy and this can be costly

forced to adopt the monetary policy of the country you fix exchange rates to

Question 4

non-fully credible fixed exchange rates

Answer 4

market expectations for the future mean that fixed exchange rates are not always rigid

interest rate of the country that fixes the exchange rate has to be higher to compensate for possible depreciation

Question 5

impossible trinity of Mundell

Answer 5

independent monetary policy

fixed exchange rate

free capital movements

Question 6

what happens to fiscal policy when we fix exchange rates?

Answer 6

restore partly the efficiency of fiscal policy
- when you run a fiscal stimulus under flexible exchange rates, part of it is offset by an appreciation of the currency and reduces the size of the fiscal multiplier

however, loose fiscal policy can threaten the peg and lead to speculative attacks and a currency crisis
- at some point people will worry about the credibility of the pegged currency so it might be threatened by the market and people believing that the peg will be abandoned and thus speculate against the currency

Question 7

benefits of fixed exchange rates

Answer 7

discipline on price stabilisation
- developing countries adopt pegged exchange rates since they suffer from a lack of credibility on monetary policy (hard to implement and takes time)

reduction of speculation and money market disturbances

promotion of international trade and investment

• generates confidence in the currency
• promotes formal international investment into the economy

Question 8

why do we commit to currency unions?

Answer 8

fully integrated markets and potentially erratic movements of currency can be costly
- generation of more inflation and currency wars than there would be with a currency union

costs are not so large because there are similar business cycles

• having the same monetary policy is not so bad
• limits uncoordinated policies

potentially promotes trade in goods and assets

Question 9

currency union: optimum currency area by Mundell

Answer 9

two regions constitute an optimum currency area if:

• transaction cost considerations are important
• there is a lot of trade between regions
• there are macroeconomic shock absorbers other than the exchange rate like high labour mobility and large fiscal transfers
• the two regions have a similar production structure so there is little need for macroeconomic shock absorbers

guidelines to assess whether countries should have a currency union or not

Question 10

currency crises

Answer 10

often seen as a large devaluation of the currency

what happens in practice is that there is suddenly a speculative attack where people start to distrust a given currency and sell it massively in the market in exchange for other currencies

Question 11

run on central bank foreign reserves

Answer 11

to defend a fixed exchange rate, the central bank sells its reserves

but there are a limited amount of reserves and this limits the ability to go against the market

Question 12

generations of currency crisis models

Answer 12

fundamental balance of payments crises (Krugman)

crises with self-fulfilling expectations (Obstfield and Krugman)

Question 13

fundamental balance of payments crises

Answer 13

fixed exchange rate is fundamentally inconsistent with macro policy (some sort of fiscal issues where governments have a hard time financing the deficit and rely on the central bank)

monetary policy is too expansionary for the peg to be sustainable

exchange rate collapses before reserves run out - if the market expects the currency to lose value, they start to sell now rather than wait

Question 14

crises with self-fulfilling expectations

Answer 14

beyond fundamentals, it can be a self-fulfilling equilibrium by just the fact of the anticipation of the devaluation of currency where it becomes devalued

multiple equilibria based on expectations of the market - either good where nothing happens or bad when the currency collapses

Question 15

sovereign debt crisis

Answer 15

governments forced to default if they cannot pay back and they have been borrowing in foreign currencies

Question 16

cost of sovereign default

Answer 16

cost of debt as the interest rate

reputation costs

other broader macroeconomic costs

• triggers or worsens banking/financial crisis
• triggers currency crisis
• trade disruption

Question 17

when is debt sustainable?

Answer 17

if debt/GDP is not changing