Exchange Rate Regimes: © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard
Prepared by:
Fernando Quijano and Yvonn Quijano
21
C H A P T E R
Exchange Rate
Regimes
Fixed Exchange Rates and the Adjustment of
the Real Exchange Rate in the Medium Run
21-1
In the medium run, the economy reaches the
same real exchange rate and the same level
of output, whether it operates under fixed
exchange rates or under flexible exchange
rates.
Under fixed exchange rates, the adjustment
takes place through the price level rather than
through the nominal exchange rate.
Aggregate Demand Under
Fixed Exchange Rates
The equilibrium condition in the goods market is:
Y C Y T I Y r G NX Y Y = + + + ( ) ( , ) ( , , )
*
c
The real interest rate and real exchange rate
equal:
r i
e
t
Under fixed exchange rates:
E E =
i i =
*
Then, the equilibrium condition becomes:
Y C Y T I Y i G NX Y Y
EP
P
e
= + + +
|
\
|
.
| ( ) ( , ) , ,
* *
*
t
c =
EP
P
*
The focus of this chapter is on the real
exchange rate, government spending, and
taxes. Therefore, we simplify the relation
above as follows:
Y C Y T I Y i G NX Y Y
EP
P
e
= + + +
|
\
|
.
| ( ) ( , ) , ,
* *
*
t
Y Y
EP
P
G T =
|
\
|
.
|
*
, ,
( , , ) + +
In a closed economy, the price level affects
output through its effect on the real money
stock:
P
M
P
i Y |
|
\
|
.
| + | +
In an open economy, the price level affects
output through its effects on the real exchange
rate.
P
EP
P
NX Y |
|
\
|
.
| + + +
*
Equilibrium in the Short Run
and in the Medium Run
Aggregate Demand and
Aggregate Supply in an
Open Economy Under
An increase in the price
level leads to a real
appreciation and a
decrease in output: The
aggregate demand curve
is downward sloping. An
increase in output leads
to an increase in the price
level: The aggregate
supply curve is upward
sloping.
P P F
Y
L
z
e
= +
|
\
|
.
| ( ) , 1 1
The aggregate supply relation is:
Adjustment Under Fixed
Exchange Rates
The aggregate supply
shifts down over time,
leading to a decrease in
the price level, to a real
depreciation, and to an
increase in output. The
process ends when
output has returned to the
natural level of output.
So long as output is below the natural level of
output, the price level decreases, leading to a
steady real depreciation.
In the short run, a fixed nominal exchange
rate implies a fixed real exchange rate.
In the medium run, a fixed nominal exchange
rate is consistent with an adjustment of the
real exchange rate through movements in the
price level.
The Case For and
Against a Devaluation
The case for devaluation is that, in a fixed
exchange rate regime, a devaluation (an
increase in the nominal exchange rate) leads
to a real depreciation (an increase in the real
exchange rate), and thus to an increase in
output.
A devaluation of the right size can return an
economy in recession back to the natural level
of output.
The Case For and
Adjustment with a
Devaluation
The right size
devaluation can shift
aggregate demand to the
right, leading the
economy to go to point
C. At point C, output is
back to the natural level
of output, and the real
exchange rate is the
same as at point B.
The Case For and
The case against devaluation points out that:
In reality, it is difficult to achieve the right size
devaluation.
The initial effects of a depreciation may be
contractionary.
The price of imported goods increases, making
consumers worse off. This may lead workers to
ask for higher nominal wages, and firms to
increase their prices as well.

The Return of Britain to the Gold
Standard: Keynes Versus Churchill
The gold standard was a system in which
each country fixed the price of its currency in
terms of gold. This system implied fixed
nominal exchange rates between countries.
Britain decided to return to the gold standard in
1925. This required a large real appreciation of
the pound. Overvaluation of the pound among
the reasons for Britains poor economic
performance after World War I.
Exchange Rate Crises
Under Fixed Exchange Rates
Higher inflation, or the steady increase in the
prices of domestic goods, leads to a steady
real appreciation and worsening of a countrys
trade position.
Lowering the domestic interest rate triggers
an increase in the nominal exchange rate, or
nominal depreciation.
The size of the devaluation can be estimated
using the interest parity condition.
21-2
Under fixed exchange rates, if markets expect
that parity will be maintained, then they
believe that the interest parity condition will
hold; therefore, the domestic and the foreign
interest rates will be equal.
i i
E E
E
t
t
e
t
t
t
= +

+
*
1
Expectations that a devaluation may be
coming can trigger an exchange rate crisis.
The government has two options:
Give in and devalue, or
Fight and maintain the parity, at the cost of very
high interest rates and a potential recession.
The 1992 EMS Crisis
Realignments are adjustments of parities
between currencies.
The September 1992 EMS (European
Monetary System) Crisis was the belief that
several countries were soon going to
devaluate. Some countries defended
themselves by increasing the overnight
interest rate by up to 500%.
In the end, some countries devalued, others
dropped out of the EMS, and others remained.
Exchange Rate Movements
Under Flexible Exchange Rates
The current exchange rate depends on:
Current and expected domestic and foreign
interest rates for each year over a given period.
The expected exchange rate at the end of the
period.
21-3
1
1
1
1
+ =
|
\
|
.
| +
+
i
E
i E
t
t
t
e
t
( )( )
*
E
i
i
E
t
t
t
e
t
=
+
+
+
1
1
1
*
E
i
i
E
t
t
t
e
t
+
+
+
+
=
+
+
1
1
1
2
1
1
*
E
i
i
E
e
t
e
t
e
t
e
t +
+
+
+
=
+
+
1
1
1
2
1
1
*
E
i i
i i
E
t
t
e
t
t
e
t
e
t
=
+ +
+ +
+
+
+
( )( )
( )( )
* *
*
1 1
1 1
1
1
2
E
i i i
i i i
E
t
t
e
t
e
t n
t
e
t
e
t n
e
t n
=
+ + +
+ + +
+ +
+ +
+
( )( )...( )
( )( )...( )
* * *
*
1 1 1
1 1 1
1
1
Exchange Rate Movements
Under Flexible Exchange Rates
Factors that influence the current exchange
rate include:
Any factor which moves the expected future
exchange rate. For example, forecasts of the
current account balance. Trade deficits may lead
to a depreciation.
Any factor that moves current or expected future
domestic or foreign interest rates. For example,
anticipations of high short-term interest rates in the
future.
Choosing Between
Exchange Rate Regimes
In the short run, under fixed exchange rates, a
country gives up its control of the interest rate
and the exchange rate.
Also, anticipation that a country may be about
to devalue its currency may lead investors to
ask for very high interest rates.
An argument against flexible exchange rates
is that they may move a lot and may be
difficult to control them through monetary
policy.
21-4
Choosing Between
Exchange Rate Regimes
In general, flexible exchange rates are
preferable except when:
A group of countries is tightly integrated
A central bank cannot be trusted.
Common Currency Areas
For countries to constitute an optimal
currency area, two conditions must be
satisfied:
The countries experience similar shocks; thus, can
choose roughly the same monetary policy.
Countries have high factor mobility, which allow
countries to adjust to shocks.
A common currency, such as the Euro, allows
countries to lower the transaction costs of
trade.
The Euro: A Short Story
The European Monetary Union (EMU) was
consolidated under the Maastricht Treaty.
In January 1999, parities between the
currencies of 11 countries and the Euro were
irrevocably fixed.
The new European Central Bank (ECB),
based in Frankfurt, became responsible for
monetary policy for the Euro area.
Hard Pegs, Currency Boards,
and Dollarization
One way of convincing financial markets that
a country is serious about reducing money
growth is a pledge to fix its exchange rate,
now and in the future.
A hard peg is the symbolic or technical
mechanism by which a country plans to
maintain exchange rate parity.
Dollarization is an extreme form of a hard
peg. A less extreme way is the use of a
currency board involving the central bank.
Key Terms
gold standard,
realignments,
overnight interest rate,
optimal currency area,
Euro,
Maastricht Treaty
European Central Bank (ECB),
hard peg,
dollarization,
currency board,

Exchange Rate Regimes: © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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