Week 7 - Fixed vs Floating exchange rates

Question 1

Nominal exchange rate vs Real exchange rate

Answer 1

Nominal
- rate at which a person can trade the currency of one country for the currency of another (the foreign price of domestic currency)
Real
- rate at which a person can trade the goods of one country for the goods of another,
ie. relative price of domestic goods in terms of foreign goods

Question 2

Floating exchange rate system vs Fixed exchange rate system

Answer 2

Floating
- exchange rate adjusts freely in response to changing MARKET CONDITIONS (to balance supply and demand)
- determined by market forces & not regulated by central bank

Fixed
- central bank announces a target for the exchange rate, and “defends” it by INTERVENING in the foreign exchange (FX) market
- usually country fixes currency against one specific foreign currency
» not allowed to fluctuate from the pre-specified TARGET
» however, the fix can be changed infrequently - devaluation (decrease) / revaluation (increase)

Question 3

The Mundell-Fleming (M-F) model
Assumption + 2 similarities with IS-LM

Answer 3

M-F model extends IS-LM to the case of the open economy, assuming a SMALL OPEN ECONOMY with PERFECT CAPITAL MOBILITY

Similarities
1. Assumes price level is fixed (short-run; means exchange rate doesn’t matter)
2. Focuses on aggregate demand (supply adjusts automatically; NO supply shocks)

Question 4

Perfect capital mobility

Answer 4

1. Capital flows freely between countries
2. No restrictions / transaction costs on borrowing/investing abroad
3. Domestic & foreign financial assets are considered PERFECT SUBSTITUTES
   » Hence no one will invest in UK bank accounts/bonds if the interest rate is lower than on US bank accounts/bonds

Question 5

World interest rate, r*

Answer 5

1. Perfect capital mobility implies that interest rates are the same across all countries -> r* is the common interest rate
2. World int rate is determined at the intersection of world supply & demand FOR MONEY
3. PCM implies that domestic interest rate must equal world interest rate, r = r*
   » The domestic interest rate in a small, open economy is fixed in equilibrium

Question 6

What is the key driver of exchange rate movements?

What are the effects of an increase in UK interest rates, relative to the rest of the world?

Answer 6

CAPITAL FLOWS
- are driven by INTEREST RATE DIFFERENTIALS relative to rest of world

An increase in UK int rates,
1. induces capital INFLOWS
2. leading to APPRECIATION of the sterling exchange rate

Question 7

Axes of the graph for the M-F model

*Requires both goods & money markets simultaneously in eqm.

Answer 7

Exchange rate, e against Income, Y
(no longer interest rate, r at y-axis)

Question 8

2 differences of the IS* curve from IS-LM

Note: IS* curve represents goods market equilibrium (at all points) & is DOWNWARD-SLOPING

Answer 8

1. Aggregate demand includes NET EXPORTS
   - In IS-LM, AD didn’t include net exports
   **Net exports are DECREASING in the exchange rate
   eg. If UK sterling depreciates, UK goods are cheaper to American consumers hence UK exports go up.
2. Investment depends on the WORLD INTEREST RATE & is therefore CONSTANT
   - since domestic int rate always = world int rate & world int rate is fixed

Question 9

Why is the LM* curve in M-F model vertical when the LM curve in IS-LM is upward-sloping?

Note: LM* curve represents money market equilibrium

Answer 9

1. In the OPEN economy, domestic interest rates are FIXED
2. Therefore, money market eqm can only happen at 1 int rate - WORLD interest rate
3. There is a UNIQUE level of income Y* for money market eqm at the intersection of the LM curve & world r*
4. Changes in exchange rate don’t affect money supply/demand, hence LM* curve is vertical.

Question 10

Effect of fiscal policy under a FLOATING exchange rate system

Note: r’ is supposed to be r*. I can’t use the asterisk due to italics feature

Answer 10

In an open economy, fiscal policy is completely INEFFECTIVE under a floating exchange rate system
- Increase in income implies increase in demand for money
- Domestic interest rate increases to choke off the excess demand for money
- as r > r’, this causes CAPITAL INFLOWS into UK economy b/c investors can get a higher return
2 effects:
- r falls back to r’
- higher DEMAND for domestic currency causes the exchange rate to APPRECIATE -> domestic goods are more $$ relative to foreign goods → net exports FALLS
- The fall in net exports exactly OFFSETS the effects of the expansionary fiscal policy on income, i.e. there is total CROWDING-OUT
» No overall change in output.

Question 11

Effect of monetary policy under a FLOATING exchange rate system (Exchange rate channel of monetary policy)

Note: r’ is supposed to be r*. I can’t use the asterisk due to italics feature

Answer 11

In a small open economy with floating exchange rates, monetary policy is EFFECTIVE in stimulating the economy.
- Suppose BoE expands money supply.
- LM* curve shifts to the right, exchange rate has DEPRECIATED & income has increased. Increase in money supply causes excess money supply.
- Domestic interest rate falls to restore money market eqm
- As r < r’, this induces CAPITAL OUTFLOWS -> investors move money out of UK into US to get a higher return
2 effects:
- r reverts to r’
- decreased DEMAND for domestic currency causes the exchange rate to DEPRECIATE
- SUPPLY OF LOANABLE FUNDS shifts to the left. Converges back to eqm, ie. world r*.
- Domestic goods becomes INEXPENSIVE relative to foreign goods → boosts NET EXPORTS, which is a component of AD, hence AD and INCOME increase.

Question 12

If the exchange rate increases above target, how does the BoE intervene in the EXCHANGE RATE MARKET?

Answer 12

BoE must buy foreign currency / sell pounds in exchange for dollars, to boost supply so that the price of pounds falls.
- Paid through MONEY CREATION; BoE creates additional reserves, which expands its liabilities = monetary base, which automatically expands the money supply (1:1 ratio)

Question 13

Effect of fiscal policy under a FIXED exchange rate system

Answer 13

An increase in govt spending leads to an increase in INCOME. Fiscal policy under Fixed exchange rate is EFFECTIVE at stabilising the economy.
- IS* curve shifts right
- Increase in int rate induces CAPITAL INFLOWS
- Higher DEMAND for domestic currency causes exchange rate APPRECIATION
- CB intervenes by creating money & buying foreign currency (/sell pounds in exchange for dollars)
- Money supply increases & LM* shifts right
- (Exchange rate unchanged,) OUTPUT increases

Question 14

Effect of monetary policy under a FIXED exchange rate system

Answer 14

Under a fixed exchange rate, Monetary policy is completely INEFFECTIVE at stabilising the economy - NO effect on OUTPUT.
- Expansion of money supply causes LM* curve to shift right, exchange rate DEPRECIATES
- CB intervenes by selling foreign currency (buying pounds in exchange for dollars), to increase demand for pounds, which drives up sterling exchange rate.
- Money supply contracts & LM* shifts back left
- Exchange rate & output both unchanged

B/c under a fixed exchange rate, the role of the monetary policy is stabilising exchange rate instead of output - Problem of 2 targets & 1 instrument

Question 15

Short-selling

Answer 15

Selling a borrowed asset you don’t own when the price is high, and buying it back when the price subsequently falls

Question 16

UK’s fixed exchange rate experience - SELF-FULFILLING currency crisis

Answer 16

1. During 1989-92, Britain entered a FIXED EXCHANGE RATE regime called the European Exchange Rate Mechanism.
2. Sterling was pegged to the German deutschmark
3. UK economy was in recession, but the govt was unable to provide monetary stimulus.
4. Britain became the victim of a “self-fulfilling currency crisis”
   - the weakness of the economy led market speculators to believe that the BoE would be forced to abandon the fixed exchange rate regime, hence they launched a SPECULATIVE ATTACK (investors realised they could make huge profits by BETTING on the DEPRECIATION of the pound sterling)

so…
1. Speculators engaged in a wave of short-selling of sterling.
- By short-selling pounds in the market, price of pounds fell, STERLING EXCHANGE RATE FELL. Traders through their actions drove down value of the sterling (self-fulling)
2. The UK govt tried to DEFEND the fixed exchange rate by intervening in the FX market, by selling deutschmarks to boost value of sterling. But the BoE’s reserves depleted rapidly & had to take even more extreme measures:
3. INCREASING INTEREST RATES to 15% (during a time of deep recession), to try to attract capital flows back into UK economy so that SUPPLY OF FUNDS would shift back. But speculators believed it was only a temporary ploy & kept short-selling.
4. Eventually, BoE was out of reserves & had no choice but to ABANDON the fixed exchange rate regime, ie. self-fulfilling.
» Britain could pursue an independent monetary policy/exchange rate & lift the economy out of recession, no longer tied to an overvalued fixed world r*

Question 17

Effects of monetary policy on output, in an open economy vs closed economy, under a fixed & floating exchange rate

Answer 17

Fixed
- monetary policy loses effectiveness, as role of monetary policy is to stabilise the exchange rate instead of output {for both open & closed economies}

Floating
- monetary policy remains effective, but operates through a different channel: the EXCHANGE RATE CHANNEL of monetary policy.
- This is different to the transmission mechanism in the CLOSED economy: the INTEREST RATE CHANNEL of monetary policy
^an increase in the money supply increases output by decreasing the interest rate and stimulating investment spending
- Interest rate channel does not work in the small open economy with PCM, because the domestic interest rate is ANCHORED to the world interest rate.

Question 18

Would a system of fixed or floating exchange rates be better at promoting output stability in the face of shocks to money demand? (from PS6)

Answer 18

• Consider a positive money demand shock, i.e. an increase for the demand for money which is UNRELATED to income and the interest rate. The money market is no longer in equilibrium, hence LM* curve needs to shift left to a lower level of income to restore money market equilibrium (given that the interest rate cannot change as it is fixed at r*).
• Under a floating exchange rate, equilibrium output falls.
• Under a fixed exchange rate, equilibrium output is unchanged.
• Hence, FIXED exchange rates are better at promoting output stability, by acting as a “SHOCK ABSORBER” against money market volatility.