16 Fixed versus Floating Exchange Rates

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16 Fixed versus Floating

Exchange Rates

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Econ 340, Deardorff, Lecture 16: 2

Outline: Fixed versus Floating

Exchange Rates

• Both Systems Are Used

• What the “Experts” Recommend

• Pros and Cons of Floating

– Disruption When Rates Move

– Automatic Adjustment

• Pros and Cons of Pegging

– Stability

– Instability

• Alternatives

– Crawling Peg

– Monetary Unification

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Who Uses Fixed and Float

• Lessons from the list of exchange arrangements

(below)

– Floating rates are used by many countries

• Rich & poor

• Large & small

• All over the world

– Pegged rates are used today mostly by small countries

– Many countries are between fixed and floating (Source of table below: IMF, “Annual Report on

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Exchange Arrangements

of Sample Countries, as of 2013

Floating Exchange Rates 48 countries + euro 17

Australia Mexico

Canada Sweden

India United Kingdom

Japan United States

Pegged Exchange Rates 45 countries

Belize Latvia

Denmark Nepal

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Exchange Arrangements

of Sample Countries, as of 2013

Stabilized Arrangement 19 countries

Costa Rica Ukraine

Lebanon Vietnam

Crawling Peg or Crawl-like Arrangement 17 countries

Argentina China

Other Managed Arrangement 19 countries

Bangladesh Russia

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Exchange Arrangements

of Sample Countries, as of 2013

Currency Board 12 countries

Hong Kong Lithuania

No Separate Legal Tender 13 countries

Ecuador ($) Montenegro (€)

More Fixed than Pegged:

• Currency Board

– Peg to another currency

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Country Distribution of Currency Arrangements 2013

Pegged Float

More Fixed

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Outline: Fixed versus Floating

Exchange Rates

– Stability

– Instability • Alternatives

– Crawling Peg

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What “Experts” Recommend

• Some favor freely floating rates

– Let exchange rate adjust to fix imbalances

– “Let the market work”

• Others favor perfectly fixed rates

– Define currency rigidly in terms of something you can’t control

• Gold

• Foreign currency (“Currency Board”)

– AND give up control of the money supply

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What “Experts” Recommend

• Advocates of floating rates

–

Milton Friedman (Nobel Prize 1976):

“A country that enters into a hard-fixed rate bears an economic cost. The cost is discarding a means—a flexible

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What “Experts” Recommend

• Advocates of floating rates

–

Jeffrey Sachs:

“Once reserves are gone, investors panic. The worst mistake is for

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What “Experts” Recommend

• Advocates of fixed rates

–

Robert Mundell (Nobel Prize 1999):

“A world currency of some sort has existed for most of the past 2,500

years. Two thousand years ago, in the age of Caesar Augustus, it was the

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What “Experts” Recommend

–

Milton Friedman:

“If [over the last 30 years] the Canadian dollar had been rigidly tied to the US

dollar, those differences would have required Canada to deflate relative to the United States, with unfortunate consequences for Canada that would have strained, to put it mildly, the trade relations between the two countries, and have put strong pressure on

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What “Experts” Recommend

–

Robert Mundell:

“Exchange rate uncertainty imposes a cost of trade much like a tariff ... If

Canada and the United States shared a stable common currency or an

irrevocably fixed exchange rate, Canada’s real income would soar,

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What “Experts” Recommend

• “Bradford DeLong, an economic historian at the

University of California at Berkeley, explains the

debate to his students this way:

” (WSJ)

To Mr. Friedman, an exchange rate is a

price; therefore, it is an infringement on human freedom to peg it. To Mr.

Mundell, an exchange rate is a

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What “Experts” Recommend

• Allan Meltzer (Carnegie-Mellon): “The

best you can say of what economic

research has produced is:

– You can make a case for freely floating

exchange rates if you’re willing to live with the consequences.

– You can make a case for fixed exchange rates if you’re willing to live with the

consequences.

– You can’t make much of a case for anything in between.”

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What “Experts” Recommend

• Where they agree: An “adjustable peg” is

worse than both fixed and floating rates

–

Friedman: “The reasons why a

pegged

exchange rate is a ticking bomb

are well

known.”

–

Mundell: “I have

never

nor ever would

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Outline: Fixed versus Floating

Exchange Rates

– Stability

– Crawling Peg

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Pros and Cons of Floating

• Con: Exchange rates DO MOVE;

And when they do, they cause

–

Macro effects (as we saw last time)

• Depreciation

– Stimulates aggregate demand, but not necessarily when needed: may just cause inflation

– Changes values of assets and liabilities

• Appreciation

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Pros and Cons of Floating

• Con: Exchange rates DO MOVE; when

they do, they cause

–

Micro effects: exports and imports subject to

• Uncertainty

• Instability Costly for traders

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Pros and Cons of Floating

• Example: The US dollar rose 50% during

1980-1985

– Caused US auto and other industries to contract

– Major dislocation in middle US

– Ended in 1985 when in “Plaza Accord”

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Pros and Cons of Floating

• Pro: Exchange rate provides efficient and

automatic across-the-board adjustment

– Suppose that, due to inflation, our prices are too high, causing our imports to rise and exports to fall

• Exchange depreciation fixes this for all sectors

• With fixed rates, individual prices and wages would have to fall to become competitive: much more painful

– That’s what Greece and other weak countries in the EU are have had to do recently.

– Called “internal devaluation”

– Floating Permits countries to have independent

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Pros and Cons of Floating

• Experience with exchange rates in the

1930s (not really floating, but they moved

a lot) made governments prefer fixed rates

• After WWII, IMF was created, based on

Pegged Exchange Rates

–

Most currencies pegged to US $

–

IMF helped countries manage this

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Outline: Fixed versus Floating

Exchange Rates

• What the “Experts” Recommend • Pros and Cons of Floating

– Stability

– Crawling Peg

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Pros and Cons of Pegging

• Pro: If it succeeds, exchange rate is

stable, avoiding disruptions

• Con: If it fails,

–

devaluation causes instability,

–

just like floating rates, only worse

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Pros and Cons of Pegging

• Why Crisis?

–

Pegged rate does not respond to market

changes

–

Some currencies become undervalued, others

overvalued

• Inevitable unless all countries have exactly the same rate of inflation

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Pros and Cons of Pegging

• Why Crisis for Overvalued Currency?

–

Central bank

must sell foreign

currency

–

Since reserves

are finite, they

eventually run out

–

Market knows

that when they

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Pros and Cons of Pegging

• Why Crisis for Overvalued Currency

–

Intervention will

stop

–

Currency will

depreciate

–

Knowing this,

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Pros and Cons of Pegging

• Why Crisis for Overvalued Currency

–

Before reserves

run out, capital

outflow increases

demand

–

And reserves fall

faster

–

“Speculative

Attack”

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Pros and Cons of Pegging

• Pegged rates offer speculators a “one-way

bet”

–

Once they see that reserves are falling…

–

… they bet on a devaluation by selling the

country’s currency

• If they are right, they win

• If they are wrong, they break even

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Pros and Cons of Pegging

• Crisis even without Overvaluation

– Crisis only requires expectation of devaluation

• The expectation doesn’t have to be justified; it only has to be believed

• Can happen even to a currency that is not overvalued

– How? By “contagion”.

• If one country has a crisis, for whatever reason

• Other countries that are near it, or similar to it, may become suspect

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Pros and Cons of Pegging

• Result: “Pegged Rates” are not Fixed

–

In a world of pegged exchange rates, over

time

• Some currencies become undervalued

• Other currencies become overvalued

–

Why? Many reasons (see Makin)

• Bretton Woods: US inflation caused dollar to become overvalued

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Pros and Cons of Pegging

• Result: “Pegged Rates” are not Fixed

–

Overvalued currencies are subject to

speculative attacks

–

When they do devalue, they do it

• Suddenly

• By large amounts

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Pros and Cons of Pegging

• The choice is not between

fixed

and

floating

:

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Pros and Cons of Pegging

• The choice is between

pegged

and

floating

:

E

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Outline: Fixed versus Floating

Exchange Rates

– Stability

– Instability

• Alternatives

– Crawling Peg

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Alternatives

• Mixtures of pegged and floating rates

–

Crawling peg

• Change the pegged rate slowly and predictably in response to a fall or rise in reserves

• Slow movement of the peg is supposed to stop the loss of reserves before crisis hits

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Alternatives

• Mixtures of pegged and floating rates

–

Wider band

• Let the rate move freely in a large band around the official pegged rate

• Less intervention should be needed

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Alternatives

• Truly Fixed Exchange Rate

–

Use another country’s currency

“Dollarization”

–

Form a monetary union

The Eurozone

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Alternatives

• Truly Fixed Exchange Rate

–

Currency Board

• Peg to another currency

• Replace central bank with “board” that

automatically varies money supply one-for-one with international reserves

– If reserves fall, so does money supply, forcing adjustment

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Alternatives

• Truly Fixed Exchange Rate

–

Currency Board

• How it’s supposed to work

– If exchange rate is over-valued (excess demand for foreign currency)

» Currency board sells reserves

» This reduces the domestic money supply 1-for-1

» Falling money causes falling income and prices

» Imports fall, exports rise, and excess demand for foreign currency disappears

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Alternatives

• Truly Fixed Exchange Rate

–

Currency Board

• Didn’t work for Argentina, which had a crisis anyway

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Alternatives

• Pegged Rate with Capital Controls

–

Why did pegged rates work in the 1950s &

60s?

• Most countries had capital controls

• In spite of that, the system of pegged rates didn’t work perfectly: there were some crises

–

Capital controls prevent inflow and outflow of

capital, and thus limit speculation

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Alternatives

The

Impossible

Trinity

See Frankel (This is the Missing

Figure 3)

Goal: Exchange Rate Stability Goal: Monetary

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Exchange Rates Since 1945

• See reading by Buttonwood (column in

The Economist

₎

• Bretton-Woods System, 1945-1971

–

Overseen by IMF

–

Currencies were pegged, mostly to US $

–

Capital mobility was restricted, but gradually

liberalized over time

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Exchange Rates Since 1945

• August 15, 1971:

–

Nixon cut the link of US $ to gold, signaling

the end of pegged rates

–

Countries stopped pegging, then restarted at

different rates, but by 1973 they had given up

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Exchange Rates Since 1945

• Since 1973, major currencies have floated

–

Exchange rates moved more than expected

–

Crises did not disappear

–

Monetary policy became more free:

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Outline: Fixed versus Floating

Exchange Rates

– Stability

– Crawling Peg

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The Problem of

Undervalued Currencies

• Overvalued currencies lead to crisis

–

In that sense they are self correcting, since

countries are forced, eventually, to devalue or

float

• Undervalued currencies

–

Do not lead to crisis, but only to accumulation

of reserves

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The Problem of

Undervalued Currencies

• Today, the Chinese yuan is considered

undervalued

–

US administration puts pressure on China to

appreciate

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0.020 0.040 0.060 0.080 0.100 0.120 0.140 0.160 0.180

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Recent Pronouncements

• Obama: "As I've said before, China

moving to a more market-oriented

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Recent Pronouncements

• Wen Jiabao:

–

“The Chinese currency is not undervalued.” “We

oppose all countries engaging in mutual

finger-pointing or taking strong measures to force other

nations to appreciate their currencies.”

–

“What I don’t understand is depreciating one’s

own currency, and attempting to pressure others

to appreciate, for the purpose of increasing

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Krugman’s Argument

(From NYT, Mar 15, 2010)

• China’s current account surplus in 2010 will be over $450 billion

• US should declare China a “currency manipulator” in next report, Apr 15

– (US did not, and hasn’t since.)

• China does not have US “over a barrel.” We have China over a barrel.

• We should repeat what we did in 1971:

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