Macro Unit 7 Flashcards
What is a flexible and fixed exchange rate regime?
Flexible: an exchange rate that is entirely determined by supply and demand for the currency on foreign exchange markets, rather than being held constant by the gov or central bank
Using the policy interest rate to target inflation means it cannot be used to target a specific exchange rate. The country controls monetary policy but not its exchange rate
Fixed: an exchange rate that is held constant or within a narrow range over time
Fixing the exchange rate means that the interest rate cannot be used to manage AD because changing the interest rate to raise or lower AD will usually cause a change in the exchange rate.
Countries with a fixed exchange rate cannot use monetary policy to stabilise the economy following a shock
What is a FlexIT monetary regime?
FlexIT: flexible exchange rate regime with a stable and credible inflation target. The central bank is given operational independence to set monetary policy in pursuit of target inflation. Interest rate changes affect inflation by:
1. Via AD. The central bank tightens policy (raising policy rate), anticipating this will cause nominal and real exchange rate appreciation, dampening exports and hence output. Conversely, a relaxation of monetary policy causes exchange rate depreciation, stimulating AD.
2. Directly affecting inflation. Changes in the exchange rate have a direct effect on cpi inflation through import prices.
What is a FlexNIT monetary regime?
A flexible exchange rate regime with no stable and credible inflation target. In these regimes, authority over monetary policy has not been delegated to an independent central bank with a stable inflation target.
In such countries, high and volatile inflation leads to frequent exchange rate depreciations. Rather than stabilising inflation by reinforcing the interest rate channel of monetary policy, movements in the exchange rate reinforce inflationary shocks.
What is a Fix monetary regime?
A fixed exchange rate regime in which the nominal exchange rate is either completely fixed or moves by relatively small amounts.
In such countries, even when the exchange rate is not completely fixed it is much more stable than in other countries with flexible exchange rates.
We model the case where the nominal exchange rate does not change at all and for as long as the home country maintains a fixed exchange rate, it cannot use the interest rate to target inflation.
In a FlexIT regime, how does a country respond to a demand shock?
Suppose the country begins at SSE with actual inflation of 2% equal to expected inflation and the target rate.
A positive demand shock occurs shifting AD up.
Output increases fromY0 to Y1.
The rise in output causes employment to rise, causing a rightward movement along the Phillips curve.
Inflation increases to 4%.
The central bank will raise interest rates.
They will expect the nominal exchange rate to appreciate in response to the rise in the policy rate.
Wages and prices are slower to adjust so the nominal exchange rate appreciates by more than prices have increased, so the real exchange rate appreciates.
This reduces competitiveness, causing a fall in exports and a rise in imports.
A a result, AD shifts back down, offsetting the impact of the initial shift in demand.
How is the real exchange rate determined in a FlexIT v FlexNIT regime?
In a flexIT regime, the real exchange rate, c = e x P/P where P is domestic prices and P foreign prices
The real exchange rate depends on domestic inflation and the nominal exchange rate.
In a flexNIT regime, the central bank does not have an inflation target. We rewrite the expression for the real exchange rate, dividing the top and bottom of the fraction by the foreign prices level P: c = e/P/P
Thus, real exchange rate, c = nominal exchange rate/price ratio
So a rise in e (depreciation) will translate to a rise in c (improved competitiveness), but will be offset by any increase in the price ratio P/P*, which occurs when domestic inflation is higher than foreign inflation.
In a FlexNIT regime, how do countries respond to a demand shock?
Suppose the country starts at SSE with actual and expected inflation at 2%.
There is a positive demand shock shifting AD up.
This increases output from Y0 to Y1, causing employment to increase and hence a rightward movement along the Phillips curve.
This increases output inflation to 4%.
In this economy, there is a flexible exchange rate but without an inflation target. So the economy stays at Y1.
Without anchoring of inflationary expectations, the new higher inflation rate will become embedded in inflation expectations, meaning the Phillips curve will shift upwards, such that last year’s inflation becomes the new expected inflation.
If output remains at Y1 with employment above the SSE, inflation will rise further. Without the discipline imposed by an inflation target, there is nothing stopping inflation drifting upwards.
How can we model the affect of inflation and depreciation on competitiveness, c?
The formula for c shows that it changes if the nominal exchange rate changes or if the home and foreign inflation rates differ.
With a flexible exchange rate, it is possible for the exchange rate to adjust to keep competitiveness constant. When inflation rates differ.
If home inflation>foreign inflation, competitiveness can remain constant as long as its nominal exchange rate depreciates enough.
Delta represents the rate of depreciation of the nominal exchange rate. If e changes from e0 to e1, the depreciation rate is: delta = e1-e0/e0 and delta>0 implies the nominal exchange rate is depreciating. So:
- Depreciation, delta, increases e, raising c
- Domestic inflation, pi, increases P, reducing c
- Foreign inflation, pi, increases P, raising c
So rate of change of competitiveness ~ delta + pi* - pi
Constant competitiveness (rate of change of c is 0), delta = pi-pi*
So for the real exchange rate to be stable, the rate of depreciation of the nominal exchange rate must exactly offset the difference between home and foreign inflation expectations
How may changes in the exchange rate make inflation worse in a FlexNIT regime?
The initial impact of the positive demand shock on employment causes inflation to rise form 2-4%.
Assuming foreign inflation stays at 2%, the price ratio P/P* will increase
Suppose e, the nominal exchange rate, remained constant
The real exchange rate, c, would fall (appreciate), dampening the impact of the demand shock
To prevent a real exchange rate appreciation, policymakers will loosen monetary policy by maintaining or potentially cutting nominal interest rates, thus lowering real interest rates
A fall in real interest rates causes the nominal exchange rate to depreciate immediately, implying a real depreciation
If e stays constant, the impact on the demand shock will be progressively unwound by domestic inflation
Import prices rise, directly raising inflation, accentuating the impact of higher inflation expectations
Higher domestic inflation causes the price ratio, P/P*, to rise more rapidly, worsening competitiveness
For as long as the policymaker continues to attempt to offset the impact of inflation on the real exchange rate, the process will continue
Why may a policymaker allow an inflation-depreciation spiral to take hold?
The government faces a trade off between controlling unemployment and inflation.
In a FlexNIT exchange rate economy, if the policymaker tries to keep unemployment below equilibrium, it will result in inflation at home rising above inflation abroad.
To prevent competitiveness from worsening, with the associated decline in exports and rise in unemployment, the government must keep monetary policy loose and allow the exchange rate to depreciate, but this will raise inflation further.
The only way to keep unemployment below equilibrium is to have a process of rising inflation and an ever more rapidly depreciating nominal exchange rate.
Explain the features of a country under a monetary union
Monetary union: common currency area where all countries use the same currency, eg eurozone
A country within a common currency area does not have its own monetary policy. Base money (reserves and currency) is issued by the shared central bank, which controls the policy interest rate.
The exchange rate for any given member country against countries outside the currency union is the same, and it is determined by the exchange rate of the common currency against other global currencies.
There is still an exchange rate between member countries, but for all member countries the nominal exchange rate, e=1 and this cannot change
So the economy of a country that belongs to a monetary union is a fix economy with a fixed exchange rate, and interest rates entirely dependent on monetary policy set elsewhere (ie the ECB)
But this one’s not fix the real exchange rate. Since e=1, the real exchange rate becomes c = P*/P, ie the price of foreign goods to domestic goods
How do countries under a fix regime respond to a demand shock?
Suppose the country is in SSE with actual inflation and expected inflation at 2%.
The positive demand shock causes AD to shift up. Consequently output increases from Y0 to Y1.
This causes employment to rise which causes a rightward movement along the Phillips curve and inflation increases to 4%.
Since inflation has only risen in one member of the monetary union, the central bank does not respond by raising interest rates.
Assuming the inflation rate in foreign countries remains constant, P/P* rises, thus causing the real exchange rate, c=eP*/P to fall and worsen competitiveness.
This causes a fall in exports and rise in imports.
As competitiveness worsens further over time, AD will shift downwards. As long as the economy stays away from SSE and inflation stays above the foreign inflation rate, competitiveness will worsen and AD will progressively shift backwards, the boost in demand will be ultimately offset by the loss of competitiveness and so AD returns to initial.
Note, this offset in AD is slower than in a FlexIT regime where the nominal exchange rate can be appreciated immediately thru raising interest rates.
What determines long run inflation in a common currency area?
Each member’s inflation rate is ultimately determined by the inflation target of the central bank.
An economy can only be at SSE if its real exchange rate is constant.
Constant competitiveness requires that delta = pi - pi* holds.
Fixing the nominal exchange rate means that by definition, delta must be 0. Therefore: constant competitiveness in a common currency area: pi=pi*
To reach long run equilibrium, the inflation of a member must converge to the average inflation in the eurozone, pi*, which, if the central bank is doing its job, will converge to the target inflation rate, pi T
Why do countries join a common currency area?
Long run inflation is stable, ie converges to the central bank’s target rate, unlike in a FlexNIT regime where inflation can drift upwards in the absence an independent central bank with a stable inflation target.
But this target inflation is not chosen by the government.
Movements in the real exchange rate have stabilising affects on the fix economy, albeit more slowly than in a FlexIT regime.
Unlike a FlexIT regime where governments are not always committed to the independent of the central bank, a flex regime allows convergence to stable inflation without the government’s intervention.
Apply the different exchange rate regimes to real life
Many countries have adopted the dollar as currency (dollarisation), including Ecuador, Zimbabwe etc
Many non EU countries have adopted the euro, eg Andorra, Monaco, San Marino etc
Countries that adopt a foreign currency lack monetary control.
Following the Breton woods agreement, many countries adopted fixed exchange rate regimes where countries kept their own currency but pegged it to other currencies, ie Denmark to the euro. This eliminates monetary policy autonomy. The most extreme example of this is a common currency like eurozone.
Shadow/managed exchange rate regimes are where countries attempt to limit exchange rate changes by choosing a shadow/target regime, ie china fixed the renminbi to usd loosely, this retains come monetary autonomy
What is the real life impact of countries abandoning monetary policy autonomy by fixing or managing exchange rates?
Fixing the exchange rate is often used to stabilise inflation. There is strong correlation between exchange rate depreciation, delta, and inflation.
Countries with fixed exchange rates have low inflation, close to us levels.
FlexNIT economies show high depreciation and high inflation
Successful examples include Spain and uk, Spain joined erm then eurozone and inflation dropped to ecb target rate but at the expense of high unemployment and low growth. Uk joined erm briefly then shifted to an independent central bank with a 2% inflation target (FlexIT) which achieved stable inflation without fixing the exchange rate.
Argentina are an unsuccessful example, they fixed the peso to the dollar but higher domestic inflation than us inflation caused a real appreciation and hence loss of competitiveness and recession. This fixed regime collapsed causing a sharp depreciation and hyperinflation.
Inflation control can occur in fixed or flexible exchange rate regimes, a fixed exchange rate does not guarantee stable inflation.
