Chapter19MacroeconomicPolicyandCoordination

UnderFloatingExchangeRatesPreviewArgumentsforflexibleexchangeratesArgumentsagainstflexibleexchangeratesForeignexchangemarketssince1973InterdependenceoflargecountriesTheChaingMaiInitiativeforEast

Asiancountries2Copyright?2009PearsonAddison-Wesley.Allrightsreserved.IntroductionTheBrettonWoodssystemcollapsedin1973becausecentralbankswereunwillingtocontinue

tobuyover-valueddollardenominatedassetsandtosellundervaluedforeigncurrencydenominatedassets.In1973,centralbanksthoughttheywouldtemporarilystoptradingintheforeignexchangemarket,andwould

let

exchange

rates

adjust

to

supply

and

demand,andthenwouldreimposefixedexchangeratessoon.Butnonewglobalsystemoffixedrateswasstartedagain.3Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsforFlexibleExchangeRatesMonetarypolicyautonomyWithoutaneedtotradecurrencyinforeignexchangemarkets,centralbanksaremorefreetoinfluencethedomesticmoneysupply,interestrates,andinflation.Centralbankscanmorefreelyreacttochangesinaggregatedemand,output,andpricesinordertoachieveinternalbalance.4Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Argumentsfor

FlexibleExchangeRates(cont.)AutomaticstabilizationFlexibleexchangerateschangethepricesofacountry’sproductsandhelpreduce“fundamentaldisequilibria”.Onefundamentaldisequilibriumiscausedbyanexcessiveincreaseinmoneysupplyandgovernmentpurchases,leadingtoinflation,aswesawintheUSduring1965–1972.Inflationcausesthecurrency’spurchasingpowertofall,bothdomesticallyandinternationally,andflexibleexchangeratescanautomaticallyadjusttoaccountforthisfallinvalue,aspurchasingpowerparitypredicts.5Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Argumentsfor

FlexibleExchangeRates(cont.)Anotherfundamentaldisequilibriumcouldbecausedbyachangeinaggregatedemandofacountry’sproducts.Flexibleexchangerateswouldautomaticallyadjusttostabilizehighorlowaggregatedemandandoutput,therebykeepingoutputclosertoitsnormallevelandalsostabilizingpricechangesinthelongrun.6Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Fig.19-1:EffectsofaFallinExportDemandReductioninaggregatedemandDepreciationleadstohigherdemandforandoutputofdomesticproductsFixedexchangeratesmeanoutputfallsasmuchastheinitialfallin

aggregatedemand7Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Argumentsfor

FlexibleExchangeRates(cont.)Inthelongrun,arealdepreciationofdomesticproductsoccursaspricesfall(duetolowaggregatedemand,outputandemployment)underfixedexchangerates.Intheshortrunandlongrun,arealdepreciationofdomesticproductsoccursthroughanominaldepreciationunderflexibleexchangerates.Fixedexchangeratescannotsurviveforlonginaworldwithdivergentmacroeconomicpoliciesandotherchangeswhichaffectnationalaggregatedemandandnationalincomedifferently.8Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Argumentsfor

FlexibleExchangeRates(cont.)Flexibleexchangeratesmayalsopreventspeculationinsomecases.Fixedexchangeratesareunsustainableifmarketsbelievethatthecentralbankdoesnothaveenoughofficialinternationalreserves.9Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

BrettonWoodsSystemSymmetry(notpossibleunderBrettonWoods)TheU.S.isnowallowedtoadjustitsexchangerate,likeothercountries.Othercountriesareallowedtoadjusttheirmoneysuppliesformacroeconomicgoals,liketheU.S.could.10Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRatesUncoordinatedmacroeconomicpoliciesFlexibleexchangerateslosethecoordinationofmonetarypolicesthroughfixedexchangerates.Lackofcoordinationmaycause“expenditureswitching”policies:eachcountrymaywanttomaintainalow-valuedcurrency,sothataggregatedemandisswitchedtodomesticproductsattheexpenseofothereconomies

Incontrast,“expenditurechanging”fiscalpoliciesarethoughttochangethelevelofaggregatedemandintheshortrunforbothdomesticandforeignproducts.11Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRates(cont.)Lackofcoordinationmaycausevolatilityinnationaleconomies:becausealargecountry’sfiscalandmonetarypoliciesaffectothereconomies;aggregatedemand,output,and

pricesbecomemorevolatileacrosscountriesifpoliciesdiverge.Volatileaggregatedemandandoutput,especiallyinexportsectorsandimport-competingsectors,leadtovolatileemployment.Volatility,notstabilization,mayoccur.12Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRates(cont.)Speculationandvolatilityintheforeignexchangemarketmaybecomeworse,notbetter.Iftradersexpectacurrencytodepreciateintheshortrun,theymayquicklysellthecurrencytomakeaprofit,evenifitisnotexpectedtodepreciateinthelongrun.Expectationsofdepreciationleadtoactualdepreciationintheshortrun.Earlierweassumedthatexpectationsdonotchangewhentemporaryeconomicchangesoccur,butthisassumptionisnotvalidifexpectationschangequicklyinanticipationofeventemporaryeconomicchanges.13Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRates(cont.)Suchspeculationtendstoincreasethefluctuationsofexchangeratesaroundtheirlongrunvalues,ascurrencytradersquicklyreacttochanging(interpretationsof)economicnews.Infact,volatilityofexchangeratessince1973hasbecomelarger.Buthowbigofaproblemisthis?14Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRates(cont.)Reductionoftradeandinternationalinvestmentcausedbyuncertaintyaboutexchangerates.Butpreciselybecauseofadesiretoreducethisuncertainty,forwardexchangeratesandderivativeassetswerecreatedtoinsureagainstexchangeratevolatility.AndinternationalinvestmentandtradehaveexpandedsincetheBrettonWoodssystemwasabandoned.Andcontrolsonflowsoffinancialassetflowsareoftennecessaryunderfixedexchangeratesystems,inordertopreventcapitalflightandspeculation.15Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRates(cont.)Discipline:ifcentralbanksaretemptedtoenactinflationarymonetarypolicies,adherencetoafixedexchangeratesmayforcethemnottoprintso

muchmoney.Butthetemptationmaynotgoaway:devaluationduetoinflationarymonetarypolicymaystilloccur.Andinflationiscontainedinthecountrythatcreatesitunderflexibleexchangerates:theU.S.couldnolonger“export”inflationafter1973.Andinflationtargetsmaybebetterdisciplinethanexchangeratetargets.16Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ArgumentsAgainst

FlexibleExchangeRates(cont.)IllusionofgreatermonetarypolicyautonomyCentralbanksstillneedtointerveneintheforeignexchangemarketbecausetheexchangerate,likeinflation,affectstheeconomyagreatdeal.ButfortheU.S.,exchangeratestabilityisusuallyconsideredlessimportantbytheFederalReservethanpricestabilityandlowunemployment.17Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Since1973In1975,IMFmembersmetinRambouillet,Francetoallowflexibleexchangerates,buttoprevent“erraticfluctuations”.In1976inKingston,Jamaica,theyamendedthearticlesofagreementforIMFmembershiptoformallyendorseflexiblerates,butpreventedmembersfrom“manipulatingexchangerates…togainanunfaircompetitiveadvantage”:noexpenditureswitchingpolicieswereallowed.Thearticlesallowed“surveillance”ofmembersbyothermemberstobesuretheywereactingfairly.18Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Since1973DuetocontractionarymonetarypolicyandexpansivefiscalpolicyintheU.S.,thedollarappreciatedbyabout50%relativeto15currenciesfrom1980–1985.ThiscontributedtoagrowingcurrentaccountdeficitbymakingimportscheaperandU.S.goodsmoreexpensive.19Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Fig.19-3:NominalandRealEffectiveDollarExchangeRateIndexes,1975–2006Source:InternationalMonetaryFund,InternationalFinancialStudies.20Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Since1973(cont.)ToreducethevalueoftheU.S.$,theU.S.,Germany,Japan,Britain,andFranceannouncedin1985thattheircentralbankswouldjointlyinterveneintheforeignexchangemarketsinordertoreducethevalueofthedollar.ThedollardroppedsharplythenextdayandcontinuedtodropastheU.S.continuedamoreexpansionarymonetarypolicy,pushingdowninterestrates.AnnouncementwascalledthePlazaAccords,becauseitwasmadeatthePlazaHotelinNewYork.21Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Since1973(cont.)Afterthevalueofthedollarfell,countrieswereinterestedinstabilizingexchangerates.U.S.,Germany,Japan,Britain,France,andCanadaannouncedrenewedcooperationin1987,pledgingtostabilizeexchangerates.Theycalculatedzonesofabout+/-5%aroundwhichcurrentexchangerateswereallowedtofluctuate.AnnouncementwascalledtheLouvreAccords,becauseitwasmadeattheLouvreinParis.22Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Since1973(cont.)ItisnotatallapparentthattheLouvreaccordsucceededinstabilizingexchangerates.ThestockmarketcrashinOctober1987madeproduction,employmentandpricestabilitytheprimarygoalsfortheU.S.centralbank,andexchangeratestabilitybecamelessimportant.Newtargetswere(secretly)madeafterOctober1987,butcentralbankshadabandonedthesetargetsbytheearly1990s.23Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Since1973(cont.)Manyfixedexchangeratesystemshavenonethelessdevelopedsince1973.Europeanmonetarysystemandeurozone(studiedinchapter20).TheChinesecentralbankcurrentlyfixesthevalueofitscurrency.ASEANcountrieshaveconsideredafixedexchangeratesandpolicycoordination.Nosystemisrightforallcountriesatalltimes.24Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Interdependenceof“Large”CountriesPreviously,weassumedthatcountriesare“small”inthattheirpoliciesdonotaffectworldmarkets.Forexample,adepreciationofthedomesticcurrencywasassumedtohavenosignificantinfluenceonaggregatedemand,outputandpricesinforeigncountries.ForcountrieslikeCostaRica,thismaybeanaccuratedescription.However,largeeconomiesliketheU.S.,EU,Japan,andChinaareinterdependentbecausepoliciesinonecountryaffectothereconomies.25Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Interdependence

of“Large”Countries(cont.)IftheUSpermanentlyincreasesthemoneysupply,theDD-AAmodelpredictsfortheshortrun:anincreaseinU.S.outputandincomeadepreciationoftheU.S.dollar.WhatwouldbetheeffectsforJapan?anincreaseinU.S.outputandincomewouldraisedemandofJapaneseproducts,therebyincreasingaggregatedemandandoutputinJapan.adepreciationoftheU.S.dollarmeansanappreciationoftheyen,loweringdemandofJapaneseproducts,therebydecreasingaggregatedemandandoutputinJapan.Thetotaleffectof(1)and(2)isambiguous.26Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Interdependence

of“Large”Countries(cont.)IftheU.S.permanentlyincreasesgovernmentpurchases,theDD-AAmodelpredicts:anappreciationoftheU.S.dollar.WhatwouldbetheeffectsforJapan?anappreciationoftheU.S.dollarmeansandepreciationoftheyen,raisingdemandofJapaneseproducts,therebyincreasingaggregatedemandandoutputinJapan.WhatwouldbethesubsequenteffectsfortheU.S.?HigherJapaneseoutputandincomemeansthatmoreincomeisspentonU.S.products,increasingaggregatedemandandoutputintheU.S.intheshortrun.27Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Interdependence

of“Large”Countries(cont.)Infact,theU.S.hasdependedonsavedfundsfrommanycountries,whileithasborrowedheavily.TheU.S.hasrunacurrentaccountdeficitformanyyearsduetoitslowsavingandhighinvestmentexpenditure.28Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Fig.19-5:GlobalExternalImbalances,1999–2006Source:InternationalMonetaryFund,WorldEconomicOutlook,April2007.29Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Interdependenceof“Large”Countries(cont.)ButasforeigncountriesspendmoreandlendlesstotheU.S.,interestratesarerisingslightlytheU.S.dollarisdepreciatingtheU.S.currentaccountisincreasing(becominglessnegative).30Copyright?2009PearsonAddison-Wesley.Allrightsreserved.Fig.19-4:U.S.RealInterestRate,1997–2007Source:GlobalFinancialData.Realinterestratesaredefinedasten-yeargovernmentbondrateslessaverageinflationovertheprecedingtwelvemonths.Thedataaretwelve-monthmovingaveragesofmonthlyrealinterestratessodefined.31Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ChiangMaiInitiativeInMay2000,ASEANcountries(Thailand,Brunei,Singapore,Philippines,Malaysia,Indonesia)plusChina,SouthKorea,andJapanmetinChiangMai,Thailand.Theyagreedtoestablishanetworkoffinancingforcountrieswithbalanceofpaymentsdeficits.Theyalsoconsideredcoordinatingmonetarypoliciestofixtheircurrencies,ortocreateacommoncurrency,inthefuture.32Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ChiangMaiInitiative(cont.)ASEAN+3countrieswantedtoavertanothercrisisliketheonethatoccurredin1997.Banksdidnotinsure(hedge)againstadeclineinthevalueofdomesticassets,andwhenvalueofthoseassetsdroppedbelowthevalueofforeigncurrencyliabilitiesafterdevaluationsoccurred,manywentbankrupt.Banksexpectedthatthattheexchangeratewouldbefixed,butsince1997bankshaveinsuredagainstthisexchangeraterisk.Thus,oneofthereasonsforhavingafixedexchangerate(toavoidabankingcrisis)hasbeenalreadyreducedbybanks.33Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ChiangMaiInitiative(cont.)Somecountriesareinterestedindevelopingexportgoodssectors(ex.,clothing,toys,computers).Thesesectorswouldbenefitfromalowvalueddomesticcurrencybecauseexportswouldbecheapinforeignmarkets.SomebelievethatChinacurrentlyhasanundervaluedcurrencyforthisreason.Butcontrolsonassetflowsarenecessarytokeepinvestorsfrombuyingdomesticassetsatthefixedexchangerate,therebydrivingupthedemandofdomesticcurrencyandthreateningthestabilityofthefixedexchangerate.34Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ChiangMaiInitiative(cont.)Butnotallcountriesmaywanttofollowafixedexchangerate:centralbanksmayinsteadtargetaninflationrate,dependingonmacroeconomicpolicyanddevelopmentgoals.Andcentralbankscandirectlyrespondtoexchangeratefluctuationscausedbyrapidchangesflowsoffinancialassets,ifnecessary.Also,longrunchangesinthedemandofexports(ex.,Koreantoys)orinsupplyfactors(ex.,productivityoflaborinKorea)maymakefixedexchangeratesoutdated.35Copyright?2009PearsonAddison-Wesley.Allrightsreserved.ChiangMaiInitiative(cont.)EachmajorASEANmembercontributed$150milliontoafundforbalanceofpaymentsproblems,andmaywithdrawupto2timestheircontributioninU.S.dollars,eurosoryeniftheneedarises.Inaddition,bilateralloansmaybemadebetweenASEANandotherparticipatingcountries.Butitisunclearwhetherthetotalfundofabout

U.S.$1billionissufficienttomaintainafixedcurrencyrate.36Copyright?2009Pear