[00:16] So today uh my plan is to finish the
[00:19] open economy part of the course and uh
[00:21] we will talk about exchange regimes but
[00:24] but before I do that, I need to finish
[00:27] uh
[00:28] a few things that we didn't in the
[00:29] previous lecture
[00:31] and that will help us an introduction
[00:32] for the kind of things I want to talk
[00:34] about today.
[00:35] And uh
[00:37] let me start just reviewing that last uh
[00:40] slide with that we discussed
[00:43] uh which is the Mundell-Fleming model.
[00:45] And the Mundell-Fleming model
[00:46] essentially is our old IS-LM model in
[00:49] which the IS is a little different
[00:51] because now we have a net exports term
[00:54] uh
[00:54] which is a function of new things like
[00:57] uh foreign output foreign income and
[01:01] uh and most importantly the real
[01:03] exchange rate and the real exchange rate
[01:05] in itself because of the UIP uncovered
[01:08] interest parity condition is a function
[01:09] of expected exchange rate
[01:11] the the
[01:14] internal foreign in- interest rate
[01:17] and it also gives us yet another reason
[01:19] for why
[01:20] uh the interest rate affects uh domestic
[01:23] aggregate demand. Okay? There's a
[01:25] There's a There's a the traditional
[01:27] investment effect of a increase in
[01:29] interest rate but we also get um the
[01:32] appreciation effect of an increase in
[01:34] the interest rate which is
[01:35] contractionary from the point of view of
[01:37] aggregate demand. So but this is like
[01:39] that with uh this extra net export term
[01:42] and and in this diagram, you know, for
[01:45] this we have the same interest rate here
[01:47] uh from this diagram which which
[01:50] portrays the
[01:52] uh uncovered interest parity condition,
[01:54] we can get for any given international
[01:56] interest rate and expected exchange rate
[01:59] for next period uh
[02:01] we can get the current exchange rate.
[02:03] Okay? So
[02:04] that was our model and we did a few
[02:07] experiments here. The first one was
[02:10] well, what happens if the expected
[02:11] exchange rate goes up?
[02:13] The first thing is which curves move?
[02:15] Well, if the expected exchange rate goes
[02:16] up, then I know that for any given
[02:20] interest rate
[02:21] uh the current exchange rate will go up.
[02:24] Okay?
[02:25] I know that this curve, in other words,
[02:27] will shift to the right.
[02:29] Why do I know that? Well, because if the
[02:31] current exchange rate doesn't move by
[02:32] the same amount of expected exchange
[02:34] rate, now I'm on a expected
[02:36] I'm going to have a expected capital
[02:37] gain or loss which will be inconsistent
[02:39] with the previous uh parity of interest
[02:42] rate, you know? So we had agreed that
[02:45] uh you know, that we had certain
[02:47] expected appreciation. So let's make it
[02:48] very simple. Suppose that this interest
[02:50] rate happens to be equal to the
[02:51] international interest rate then we know
[02:53] that this exchange rate has to be equal
[02:55] to the expected exchange rate because
[02:56] you cannot expect an appreciation or
[02:57] depreciation of the currency if the
[02:59] interest rates are the same.
[03:00] But if now the expected exchange in the
[03:02] next period goes up and if the exchange
[03:04] rate today doesn't move, that would mean
[03:06] that you expect also capital uh uh
[03:08] an appreciation of the currency which
[03:10] means that investing in domestic bonds
[03:12] would give you a higher return because
[03:13] of the same interest rate plus expected
[03:15] appreciation. So we know that the
[03:17] uncovered interest parity condition will
[03:19] move to the right. You know, as a result
[03:21] of the increase in expected exchange
[03:22] rate. But it also means that at any
[03:24] given interest rate you get a higher an
[03:27] appreciated exchange rate relative to
[03:29] the previous one before the increase in
[03:31] expected exchange rate which means that
[03:33] the IS will shift to the left.
[03:35] Okay.
[03:36] So if the expected exchange rate goes
[03:38] up, that leads to an appreciation and
[03:40] that leads to
[03:41] contraction in aggregate demand.
[03:44] Okay.
[03:44] Good.
[03:46] Next experiment was well, what happens
[03:48] if foreign output comes down? Well, if
[03:50] foreign output comes down, then that has
[03:52] nothing to do with the interest parity
[03:53] condition. It's not
[03:55] doesn't show up in this expression. But
[03:57] it does shift this, you know, because it
[03:59] reduces our exports for any given level
[04:01] of interest rate and output and so the
[04:03] IS shifts to the left. So that's
[04:05] contractionary. That's a way you import
[04:07] a recession from the rest of the world.
[04:09] Okay? Uh as I said before
[04:12] people around Asia and and Latin America
[04:14] very very worried about the Chinese
[04:16] actually the Europeans as well because
[04:18] Germany exports a lot to China are very
[04:21] worried about contractions in China and
[04:22] so on because through that channel it's
[04:24] contractionary as well. Now we're in the
[04:27] other part of the
[04:29] of the cycle because China is reopening
[04:31] uh and and that sort of gives lots of
[04:33] hope to Europe and so on.
[04:36] And that's one of the reasons why the
[04:37] euro has appreciated vis-à-vis the the
[04:39] dollar recently.
[04:41] Okay.
[04:42] Um
[04:43] and then the the last experiment that I
[04:45] don't remember whether we finished or
[04:47] not, I think I said it very quickly is
[04:49] well, what happens if the international
[04:50] interest rate goes up?
[04:53] What moves? Well, the first thing that
[04:54] will move is this. This was a parameter,
[04:56] okay? So
[04:58] what do I know that if I keep the
[05:00] interest rate constant and the
[05:02] international interest rate went up what
[05:04] has to happen to the exchange and the
[05:05] expected exchange rate hasn't changed?
[05:07] What has to happen to the exchange rate
[05:09] today to be indifferent between the two
[05:10] things?
[05:11] The the two bonds.
[05:14] So this is experiment. Suppose that
[05:16] we're at any domestic interest rate, we
[05:18] don't touch that. Now I increase
[05:20] international interest rate
[05:22] and I say the expected exchange rate
[05:25] is the same as it used to be, what has
[05:27] to happen to the current exchange rate
[05:29] in order to be indifferent between
[05:30] investing in the US bond or the other
[05:32] foreign bond?
[05:36] Exactly, it has to depreciate. Why?
[05:42] That's correct but but why is it that
[05:44] you need an
[05:45] that the exchange rate falls today in
[05:47] order to restore to have the the
[05:50] interest parity condition
[05:52] holding?
[05:55] Okay. So remember what happened is that
[05:58] you had the same interest rate and now
[05:59] that the international interest rate
[06:01] went up.
[06:02] That means if nothing moves, now you
[06:04] preferred you were indifferent before.
[06:06] Now you would prefer to invest in the
[06:07] international bond.
[06:09] If I don't change the the the US rate,
[06:11] then I have to compensate you by some
[06:13] other mean.
[06:15] The only way I can compensate you in
[06:16] this model, the only thing that's
[06:17] endogenous is by an expected
[06:20] appreciation of the exchange rate
[06:22] because that would give you a capital
[06:23] gain from holding the bond the US bond,
[06:27] a currency capital gain. Now
[06:29] since the expected exchange rate is
[06:31] given, the only way I can give you that
[06:32] is depreciating the currency today so
[06:34] then you can expect an appreciation
[06:36] tomorrow.
[06:36] From today to tomorrow. Okay, that's
[06:38] that's the mechanism.
[06:39] Okay, so that means that this
[06:42] uh curve here will shift to the right.
[06:45] Okay? For any given interest rate you
[06:46] need a sorry, to the left. For any given
[06:49] I made that mistake in the previous
[06:50] lecture as well. So for any given level
[06:52] of interest rate, this curve will have
[06:54] to move to the left.
[06:55] Okay? So if the interest rate doesn't
[06:57] change and international interest rate
[06:58] is up, you need an exchange rate today
[07:00] that is lower than it used to be so you
[07:02] can expect an appreciation from now to
[07:04] the next period.
[07:05] Okay?
[07:07] So that's what moves to the left. Now
[07:09] what happens? What else moves in that
[07:10] case?
[07:15] I remember when I'm I'm asking the
[07:17] question, what else moves?
[07:19] Uh I mean what other curve moves? What
[07:22] you need to do is just take something as
[07:23] given and then see what whether we get
[07:25] the same equilibrium output or not or
[07:27] not. So I'll take an interest rate as
[07:28] given as IS
[07:30] and then ask the question, well, will I
[07:32] get the same equilibrium output or not?
[07:34] If I get the same equilibrium output,
[07:36] that means the IS hasn't moved.
[07:38] But if I get a different equilibrium
[07:39] output, it means the IS has moved
[07:40] because for the same interest rate I'm
[07:42] getting a different equilibrium output.
[07:44] So what happens in this case?
[07:48] Does the IS move or not?
[07:51] When I star goes up?
[08:05] Going to simplify the question. Yes, it
[08:07] does. Which way?
[08:15] Will I get more or less output?
[08:18] When the international interest rate
[08:19] goes up?
[08:20] And I'm taking Look the kind of things
[08:22] I'm taking as given. I'm also taking as
[08:24] given international output.
[08:26] So I I'm not moving Y star.
[08:29] I'm not moving expected exchange rate.
[08:31] Uh
[08:33] and I'm asking the question
[08:34] is the domestic
[08:36] central bank, the Fed in the case of the
[08:38] US, does not change the interest rate,
[08:40] what happens to equilibrium output? Does
[08:41] it go down or up?
[08:45] If the other if the international
[08:46] interest rate goes up, the domestic
[08:48] interest does not
[08:50] what has to happen to exchange rate?
[08:55] You answered it before.
[08:57] Has to go down. That means it has to
[08:58] depreciate. What happens to net exports
[09:01] when the exchange rate depreciates?
[09:06] What does it mean that the exchange rate
[09:07] depreciates? Especially if you have the
[09:09] In this case we have the prices
[09:11] completely fixed. So now if the nominal
[09:13] exchange rate depreciates, means that
[09:14] the real exchange rate depreciates.
[09:16] What does that mean?
[09:21] What got cheaper?
[09:26] Okay, you need a lot of to study for the
[09:28] quiz. Uh
[09:30] domestic goods are cheaper. So so that
[09:33] means that the
[09:34] and
[09:35] equivalently foreign goods got more
[09:37] expensive.
[09:38] That means for any given level of
[09:39] domestic interest rate, now there will
[09:41] be less imports and more exports. That
[09:43] means net exports will be more which
[09:45] means the IS will shift to the right.
[09:48] Okay.
[09:56] Good. So these things you you need to
[09:58] control. I understand that this is a
[10:00] little confusing to think about exchange
[10:02] rate and so on, but
[10:03] but uh
[10:08] So, anything that happens here with
[10:09] exchange rate is just a relative price.
[10:12] The more expensive are your goods,
[10:15] the harder it will be to sell them, you
[10:18] And and the more tempted you will be to
[10:19] buy foreign goods. That's That's That's
[10:21] what it does. So, it's
[10:23] So, that's contraction. Appreciation of
[10:24] contraction here or not. Here, the story
[10:27] is a little different. It's all about
[10:29] equalizing expected returns. So, you
[10:31] need to have an equal movement in the
[10:32] exchange rate today so that you are
[10:34] always indifferent between investing in
[10:36] one side or the other. It's about the
[10:38] return, the expected exchange in the
[10:39] exchange rate.
[10:41] So, okay, good.
[10:46] Okay, I got it. It's a little unclear,
[10:48] but
[10:49] we'll keep trying.
[10:54] Is there anything particularly unclear?
[10:56] Or is all a blur here?
[11:00] Okay, got it.
[11:03] Um
[11:06] Well, let me So, all that is I describe
[11:08] here
[11:09] is is um
[11:13] is allowing the exchange rate to move.
[11:14] We're saying, "Look, if we move
[11:17] something or the foreign foreigners move
[11:19] something, then we ask the question,
[11:20] "Well, what does exchange rate has to do
[11:22] here?"
[11:24] Okay? And typically when when when
[11:27] that's done,
[11:29] we call those regimes floating exchange
[11:31] rate systems, meaning exchange rate can
[11:34] float, can move around. As interest
[11:36] rates in different parts of the world
[11:37] change, then the exchange rate moves
[11:40] around. Okay?
[11:41] Typically call that flexible exchange
[11:43] rate. I think the distinction is a lot
[11:44] harder to make in practice, but for
[11:47] reasons I'll explain later, but but
[11:50] that's what is meant as a as a floating
[11:52] exchange rate system, one in which
[11:54] really you're doing your Each country is
[11:56] doing its own policies and so on, and
[11:58] the exchange rate does what it needs to
[11:59] do so so so the financial markets clear.
[12:05] Many countries, however, do something
[12:07] which is a the polar opposite of that,
[12:09] which is called a fixed exchange rate
[12:11] regime. Okay?
[12:12] So, some countries really peg their
[12:15] currencies to a major currency.
[12:18] An extreme case is the Eurozone, where
[12:21] they gave up their individual currencies
[12:24] and they have a common currency. Okay?
[12:26] So, so Germany and and and and and and
[12:30] Italy have a
[12:31] ultra pegged exchange rate because they
[12:33] have the same currency. Okay?
[12:35] Now,
[12:36] most of the times fixed exchange rates
[12:38] are
[12:39] are a little weaker than that.
[12:41] For example, the Hong Kong dollar has
[12:42] been pegged to the dollar for a long
[12:44] time, for the US dollar for a long time.
[12:46] Okay? And we'll show you a few others.
[12:48] Many countries go through some phase
[12:50] where they try to peg the currency
[12:52] and it typically fails at some point,
[12:54] but but they have periods in which the
[12:56] currency is pegged.
[12:58] But so, let me
[12:59] Suppose that you have a pegged exchange
[13:01] rate, let me show you
[13:02] some features of it. Suppose you are in
[13:05] a peg in a peg or a fixed exchange rate
[13:08] regime pegged to another currency, and
[13:10] suppose it's credible. That's a big
[13:12] issue with fixed exchange rate, but
[13:14] suppose it's credible. There are some
[13:15] countries that have credible fixed
[13:16] exchange rate.
[13:18] Well, if if you have a fixed exchange
[13:20] rate with respect to some other currency
[13:23] and it's credible, then you know that
[13:25] the expected exchange rate is equal to
[13:26] exchange rate and equal to a constant.
[13:28] That's what it means to have a fixed
[13:29] exchange rate. Okay? It's constant.
[13:33] But if this is constant, means you never
[13:35] can expect an appreciation or
[13:36] depreciation
[13:38] because it's constant. It's fixed.
[13:41] And if you can't expect an appreciation
[13:43] or depreciation, the uncovered interest
[13:45] parity condition tells you that you
[13:48] know, what does it tell you?
[13:50] That your interest rate has to be the
[13:51] same as the foreign interest rate.
[13:56] Why?
[13:58] What would happen in a credible
[14:01] uh peg in a credible fixed exchange rate
[14:03] if the domestic interest rate is higher
[14:05] than the international
[14:06] than the currency the interest rate
[14:08] of the country you're pegging to?
[14:12] What would happen? Suppose that
[14:14] I'm in a fixed exchange rate and and we
[14:15] have the same interest rate and now I
[14:17] unilaterally decide to raise interest
[14:19] rates.
[14:21] What do you think would happen with
[14:22] capital flows?
[14:24] How would What would you do to your
[14:25] portfolio?
[14:28] If the currency is exchange rate is
[14:29] pegged
[14:31] and it's credible,
[14:32] it is as if they were issuing the same
[14:35] currency because it's the same It's a
[14:36] different currency, different name, but
[14:38] it has a constant in front of it. Okay?
[14:41] So, it's as if it was issuing the same
[14:42] currency. Two bonds that are identical
[14:45] and issued in the same currency cannot
[14:47] be paying different interest rate
[14:48] because you would go invest all your
[14:51] money, you know, in the in the bond that
[14:53] is paying a higher interest rate.
[14:55] And that's what happens here. So, it's
[14:58] Mechanically, what would happen is for
[15:00] some crazy reason a country has a fixed
[15:01] exchange rate, credible fixed exchange
[15:03] rate, decides to have an interest rate
[15:04] higher than the currency the the the
[15:07] interest rate in the currency it's it's
[15:09] being pegged to,
[15:10] then you would see massive capital flows
[15:12] to that country. So, there would be an
[15:14] enormous pressure for an appreciation of
[15:16] that currency.
[15:18] Okay?
[15:19] But but the And what the central bank
[15:21] would have to do is start buying massive
[15:23] amounts of the of the supplying massive
[15:25] amounts of this currency for those that
[15:27] want to buy it
[15:29] because there will be an infinite demand
[15:31] for that. Okay?
[15:33] So, in practice, what that means And And
[15:36] sometimes
[15:38] you can do that for a little while, but
[15:40] but but but not in in a sustained
[15:43] manner. So, what happens in practice is
[15:45] that if you really have a a a a pegged
[15:48] exchange rate and you have free capital
[15:50] mobility, which is people can move in
[15:53] and out of your bonds, China does them,
[15:55] for example, so it can allow itself to
[15:58] both control a little bit the currency
[16:00] and uh uh
[16:02] uh
[16:03] mean be semi semi pegged and it still
[16:06] can move its domestic interest rate
[16:07] because they have capital controls, but
[16:09] but if you don't have capital controls
[16:10] and people can move money in and out, it
[16:12] can do portfolio investment as it
[16:14] happened with most of the advanced
[16:15] economies,
[16:16] then effectively uh
[16:19] you give up domestic monetary policy.
[16:22] Okay? Because whatever the other country
[16:24] does, the country you're pegging to
[16:26] does, you have to follow.
[16:29] So, that's what it means. You peg, you
[16:31] give up your domestic monetary policy if
[16:35] you choose to peg to another country.
[16:37] I'll I'll a little later I'm going to
[16:39] tell you why countries may choose to do
[16:40] that, but that's what you do.
[16:43] Okay? And the the uncovered interest
[16:45] parity tells you that's what you do.
[16:47] You're not going to be able to deviate
[16:48] there significantly from the interest
[16:50] rate that the other country is setting
[16:53] if you want to maintain your fixed
[16:54] exchange rate.
[16:56] Now, in practice, there are many hybrid
[16:58] regimes. There There are very very few
[17:01] pure float regimes.
[17:03] Uh
[17:04] few. I mean, maybe five or something
[17:06] like that. But but but but so, there are
[17:09] all sorts of degrees
[17:10] of exchange rate regimes and and which
[17:13] are hybrids between fixed exchange rates
[17:15] and and fully flexible exchange rates.
[17:19] Let me show you just a few just
[17:21] randomly more or less randomly selected
[17:24] in Bloomberg. Uh so, there you have in
[17:26] in in in in white is the US euro.
[17:31] That's a float. That's a That's a
[17:33] cleanest float you can imagine. I mean,
[17:34] there's no
[17:36] Then, another which is a very clean
[17:38] float is the dollar yen,
[17:41] Japanese yen.
[17:43] Now, that's a currency that has that
[17:46] freely floats, but if there's a major
[17:48] dislocations, central banks do intervene
[17:51] to money So,
[17:52] it means
[17:53] in normal circumstances, they float. And
[17:56] the same is true with the euro. But if
[17:57] there's big dislocations, a major bank
[17:59] collapses or something like that, then
[18:02] there major dislocations in in financial
[18:04] markets. They become very segmented.
[18:06] Arbitrage is not that easy and so on.
[18:08] Then then then central banks intervene.
[18:10] But but for the normal business cycle
[18:12] and so on, they do not.
[18:14] They do not intervene in the currency
[18:16] market. They intervene in different ways
[18:17] and that's the reason I'll get there.
[18:20] And the other one is the the pound, not
[18:22] the US dollar versus the British pound.
[18:25] Uh then then it's also that's a pure
[18:28] float.
[18:30] This is also pure float. This is the
[18:33] US versus the Aussie dollar
[18:36] So, and against the Canadian dollar and
[18:39] against the the Swedish krona.
[18:43] Okay? Those are pretty floating
[18:47] regimes. They are a little different
[18:48] from the previous ones I showed you
[18:51] because these are currencies that are
[18:52] much more prone to sell off
[18:56] during risk-off environments. And that's
[18:58] the reason you see these spikes here.
[19:01] Okay? This was COVID.
[19:03] Biggest spike. You didn't see it in the
[19:05] in the dollar euro and so on and so
[19:07] forth. So, these are currencies that are
[19:08] free floaters, but they're very exposed
[19:10] to to risk the risk environment in the
[19:14] market. But they're still they're free
[19:15] floaters.
[19:16] Um
[19:18] The Swiss are a little bit more of
[19:20] independent minded than and but they do
[19:22] control a bit more the currency, but
[19:23] they're still I I consider those
[19:27] a free floaters.
[19:30] These are currencies that are a little
[19:31] different. This is the Brazilian real.
[19:34] Uh
[19:35] the zar is the South African rand.
[19:38] And this is the
[19:40] Colombian peso.
[19:42] And you see several things here. They
[19:43] They do move. So, so they have a big
[19:45] component of flexible exchange rate.
[19:48] Uh
[19:49] They do intervene a lot more, though. Uh
[19:52] because they're exposed to much more
[19:54] risk off type environment and so on and
[19:56] they need to intervene fairly frequently
[19:59] to control movements in the exchange
[20:00] rate.
[20:01] But but you also see a trend
[20:04] in these things.
[20:05] So, their currencies are becoming
[20:07] chronically weaker relative to the
[20:09] dollar.
[20:12] And the reason for that
[20:13] is because they're countries that have
[20:15] higher inflation.
[20:17] So, if you want to maintain the real
[20:18] exchange rate constant and you have high
[20:20] inflation than the other country, then
[20:22] your nominal exchange rate has to be
[20:23] depreciating.
[20:24] Okay?
[20:25] Because your prices are rising at a
[20:27] faster pace than the other one,
[20:29] well,
[20:30] if the exchange rate was not
[20:31] appreciating on average depreciating on
[20:33] average, then it would mean that you
[20:35] would be coming more and more expensive.
[20:36] Okay? So, that's the reason. Countries
[20:38] that have higher inflation, they tend to
[20:40] have these trends as well.
[20:42] Okay?
[20:43] But they're still fairly floating.
[20:45] Here, these are all
[20:47] currencies that are
[20:49] uh, to a different degree
[20:52] uh,
[20:53] um,
[20:54] targeted in the sense that they're
[20:56] contained in in terms of they're not
[20:58] free to float at will.
[21:00] Uh, the scale here will mislead you. If
[21:03] I had put it in the same scale as the
[21:05] the euro dollar or the the euro yen and
[21:07] the the dollar yen or the euro yen as
[21:09] well,
[21:10] then these things would have been looked
[21:12] very small. Okay? So, so I should have
[21:15] put a a real floater there so you would
[21:16] have seen that these guys are moving a
[21:18] lot less.
[21:19] And these are different kind of
[21:20] countries. This is the Hong Kong dollar
[21:22] that for all practical purposes pegged.
[21:25] Okay? These little wiggles is just
[21:27] technical things that happen overnight
[21:29] and stuff like that.
[21:30] But they're pegged to the dollar.
[21:32] Okay? So, the Hong Kong dollar is pegged
[21:34] to the dollar.
[21:35] Uh,
[21:37] that means they really don't have
[21:38] independent monetary policy relative to
[21:40] the US vis-a-vis the US.
[21:43] The This is the CNH. This is the the the
[21:47] um,
[21:48] the Chinese
[21:49] renminbi
[21:50] and and and it's a currency again. I
[21:52] should have put it with a floated real
[21:54] floater there. It's a lot more
[21:56] controlled. Okay? So, it moves around
[21:59] but but in a much tighter range and and
[22:02] and they're thinking about exchange rate
[22:04] when part of their policy program and so
[22:06] on, the exchange rate is something
[22:08] they're thinking about.
[22:11] This one here, the blue one is is an
[22:13] interesting one.
[22:14] Uh,
[22:16] um,
[22:18] that's the the the the Singaporean
[22:21] Okay?
[22:22] And the Singaporean dollar, they have a
[22:24] very interesting regime.
[22:26] They have a a a um,
[22:28] a target zone, meaning they let the
[22:30] exchange rate move within a range only.
[22:34] But it's not pegged against a
[22:36] single currency, it's pegged against a
[22:38] basket
[22:39] of of currencies.
[22:41] Okay? And the the recipe is secret.
[22:44] So, everyone is always guessing what
[22:46] they're doing and so on. They do change
[22:48] the weights a little bit to keep the
[22:49] markets confused. But but their currency
[22:51] is very stable. It's well understood.
[22:54] It's a It's a weighted average of the
[22:55] euro, the renminbi and the and the
[22:57] dollar. But but they they don't disclose
[23:00] exactly the thing, but you know, you can
[23:02] filter out what they're doing and and
[23:04] they they keep things in a range
[23:06] uh, and they occasionally change the
[23:07] slope of that range, but but it's very
[23:10] regulated in that country. And they in
[23:12] fact they state their monetary policy in
[23:15] terms of the effects. They say, "That's
[23:17] our policy."
[23:18] Interest rate is what everything needs
[23:20] to be so the exchange rate remains in
[23:21] that range. That's that's that's the way
[23:23] they state the monetary policy. They
[23:24] don't even think about
[23:26] So, I let the markets determine the
[23:28] interest rate, we determine the exchange
[23:30] rate here in that range. And it's a
[23:31] narrow range.
[23:35] Again,
[23:36] I should have put
[23:38] um,
[23:40] a real floater there so you would have
[23:41] seen that. Okay? So,
[23:43] so the the point is that
[23:45] everything goes. They're all sort of
[23:47] arrangements happening around the world.
[23:50] This is These are different kind of
[23:51] currencies, you know?
[23:53] Uh, this is the the
[23:55] the
[23:58] the Turkish lira
[24:00] Okay?
[24:00] and the Argentinian peso.
[24:04] I think through this sample it's been
[24:05] called peso since since they have this
[24:07] very high inflation, they keep changing
[24:08] the name of the currency and so on
[24:10] because they have to remove zeros from
[24:12] things. So, but but I think through all
[24:14] that period it's still the Argentinian
[24:15] peso.
[24:16] And uh,
[24:18] so I mean, look at the scale.
[24:21] So,
[24:23] you cannot see it, but but all these two
[24:25] countries are all the time fighting
[24:28] against the exchange rate. In fact,
[24:30] Argentina today has like five different
[24:31] exchange rates.
[24:33] There is the official exchange rate,
[24:34] there is the blue exchange rate, there
[24:36] is the purple exchange rate, there are
[24:37] all sorts of things.
[24:39] You should never pay with a credit card
[24:40] if you go to Argentina if you do tourism
[24:42] because you don't want to pay the
[24:43] official exchange rate. You can get
[24:45] three times that in the in the blue
[24:47] market.
[24:48] They don't call it the black market.
[24:50] It's Since everyone does it, I think
[24:51] it's blue is fine. But but so there are
[24:53] all sorts of exchange rates.
[24:55] Uh,
[24:56] and but it's still This is the official
[24:58] one. And even the official one you see
[25:00] sort of has completely exploded.
[25:03] The Turkish lira looks pretty good here
[25:05] just because I put it next to Argentina
[25:06] the Argentinian peso. Otherwise, it also
[25:08] would look pretty bad.
[25:10] Okay? But most of the these countries
[25:12] are all the time pegging the exchange
[25:13] rate because they use that to stabilize
[25:15] inflation, the whole thing breaks up,
[25:17] and then they boom, they go through big
[25:19] spikes. You see this one here. They're
[25:20] trying to stabilize. There you see that
[25:22] they're trying to stabilize the
[25:23] currency.
[25:24] They're not floating there in that
[25:26] range.
[25:28] And they were a little successful and
[25:31] And and and and that's happens all the
[25:33] time to them.
[25:36] And now obviously,
[25:38] I mean, look at this the size of this.
[25:40] This is an appreciation of the dollar
[25:42] relative So, it's a depreciation of the
[25:43] Argentinian peso.
[25:45] What do you think is happening here?
[25:49] Looks very smooth, by the way.
[25:51] It's not that it's moving around. It's
[25:52] just
[25:55] What do you think is happening?
[26:01] Very high inflation in the thousands,
[26:03] you know?
[26:04] And that's what that's what is happening
[26:05] here. But but again, this is a hybrid
[26:08] system. They They try to stabilize
[26:10] frequently the exchange rate. The thing
[26:12] goes and then they stabilize it again
[26:13] and and so on and so forth. But you
[26:15] can't fight
[26:17] just having much higher inflation than
[26:18] the rest of the world. You have higher
[26:19] inflation, then there's no way around
[26:21] that your currency is going to
[26:22] depreciate. They try to,
[26:24] but they can't.
[26:27] Anyways,
[26:28] uh,
[26:31] so let me let me go back to this model
[26:32] and and and and think a little bit more
[26:35] about the decision to
[26:37] have one kind of exchange rate or the
[26:38] other one and therefore everything that
[26:40] goes in between.
[26:42] So, remember I just to remind you that's
[26:44] that's the model we have.
[26:46] Um,
[26:48] so let me think about policy first and
[26:49] then then let's think how
[26:51] how how do you deal with policy in the
[26:53] different exchange rate regimes.
[26:55] And and then we'll see why would
[26:56] countries would want thing or the other.
[26:59] So, suppose a country's in a recession.
[27:01] We're in this model.
[27:02] Uh,
[27:04] and suppose that we are in the flexible
[27:06] exchange rate regime.
[27:08] So, what should the fis- fiscal policy
[27:10] do?
[27:11] Suppose you're in a recession.
[27:13] What what should fiscal fiscal policy
[27:15] do?
[27:18] There's nothing unique of closed economy
[27:20] here.
[27:21] You know,
[27:22] of open economy. In closed economy you
[27:24] would have given me the same answer.
[27:25] You're in a recession, what will you do
[27:27] with fiscal policy?
[27:29] Have expansionary fiscal policy.
[27:31] Increase G. So, that means you move the
[27:33] IS to the right.
[27:35] Nothing changes in the open economy. You
[27:36] keep doing that.
[27:38] The only thing that you get is a little
[27:39] smaller multiplier because part of that
[27:41] will go to imports.
[27:43] But but it still it moves in the right
[27:45] direction. Okay?
[27:47] And and and yes, if countries rely on
[27:49] other countries doing also their own
[27:50] expansionary fiscal policy, but suppose
[27:52] we're talking about a recession that is
[27:54] unique to this country. Then you're
[27:55] going to do an expansionary fiscal
[27:57] policy.
[27:59] What would the central bank do?
[28:02] In closed economy.
[28:04] What?
[28:06] Drop interest rate. Well, in open
[28:07] economy does the same.
[28:09] You you just drop interest rate.
[28:12] It turns out that that will depreciate
[28:13] your currency,
[28:15] uh,
[28:15] which will help you
[28:17] as well. So, it's very expansionary
[28:19] because of that. You know, because it
[28:20] your currency depreciates, so net export
[28:22] goes up as a result of that. So, you get
[28:24] the investment kick. You lose a little
[28:26] bit because part of it goes to import,
[28:28] but then you also get the effect of net
[28:31] exports that come from the exchange
[28:32] rate. Okay?
[28:33] So, monetary policy is a great policy
[28:36] in open economy because it gets
[28:37] reinforced by the exchange rate.
[28:40] It's even better than fiscal other
[28:41] things equal when you compare the two.
[28:44] The two policies lose power relative to
[28:46] the closed economy because the
[28:48] multiplier is smaller.
[28:49] But the difference is that the interest
[28:51] rate policy gets the extra kick that
[28:53] comes from the depreciation of the
[28:54] currency.
[28:55] Okay? So, it's a very powerful tool.
[29:00] Okay.
[29:02] So, that's what you would do if you have
[29:03] a
[29:04] uh, flexible exchange rate.
[29:07] And that's what countries do in practice
[29:09] when they are free floaters.
[29:11] Suppose you have a fixed exchange rate
[29:13] regime.
[29:14] Okay?
[29:16] So, and it's a credible fixed exchange
[29:17] rate regime.
[29:19] Then I asked you again the question.
[29:21] What
[29:23] uh, what kind of fiscal policy would you
[29:24] run in that country?
[29:29] The same.
[29:30] Expansionary. That's what you would do.
[29:32] And it's effective as it was in closed
[29:34] economy. A little less because the
[29:36] multiplier is a little less. That's it.
[29:38] But no difference in the analysis.
[29:41] In fact,
[29:42] fiscal policy has exactly the same
[29:43] effect as as as fiscal policy in the
[29:45] flexible exchange rate in this case
[29:47] because I haven't moved the exchange
[29:48] rate in any event in either of the two
[29:50] cases. Okay?
[29:52] What should the central bank do?
[29:58] That's a tricky question.
[30:05] Hm? Yes, if the central bank knows. So,
[30:07] it would have to match. Yeah, exactly.
[30:09] Uh so, the central bank cannot do
[30:11] anything. I'm saying suppose this is a
[30:12] neo-Keynesian recession. This country's
[30:14] in recession.
[30:15] Now, now it wants to use its policy
[30:18] tools to deal with that. It has fiscal,
[30:21] but it doesn't have monetary policy.
[30:23] Unless
[30:24] the cycle of the other country coincides
[30:26] with your cycle. So, if it's a global
[30:27] recession or something like that, then
[30:30] then you're doomed because the other
[30:31] country's doing the monetary policy for
[30:32] what they're doing, what they need, not
[30:34] for what you need. And therefore, you
[30:36] don't have monetary policy. So, that's a
[30:37] costly thing of a fixed exchange rate.
[30:40] We already said it, but you now we're
[30:42] making it very concrete because we are
[30:43] in a recession,
[30:45] and you realize now that you don't have
[30:46] a tool that you had before.
[30:48] Okay?
[30:49] So, that's a cost
[30:50] of a fixed exchange rate.
[30:54] Here's an example. Uh here what I'm
[30:56] plotting
[30:57] is the the policy rate in the US.
[31:01] That's the blue one.
[31:02] And that's the policy rate in Hong Kong.
[31:04] There's a small difference, but you can
[31:05] see that the
[31:06] These are technical things. But you can
[31:08] see that that Hong Kong has to follow
[31:10] the US essentially. It's exactly the
[31:12] same shape.
[31:14] So, Hong Kong doesn't have independent
[31:16] policy.
[31:18] Okay?
[31:19] It Again, those are technical gaps.
[31:20] They're not really
[31:22] But just look at the shape. It's exactly
[31:24] the same, moving around. So, Hong Kong
[31:26] doesn't have monetary policy.
[31:28] Period.
[31:30] Not something they have. So, if they get
[31:31] a recession that has to do with their
[31:32] own cycle,
[31:33] and that is not a result of something
[31:35] that's happening in the US,
[31:37] they don't have that that tool to deal
[31:39] with that.
[31:41] Of course, during COVID and and during
[31:43] the global financial crisis, they were
[31:45] aligned. So, they you know,
[31:47] they would have moved it in the same
[31:48] direction. That worked.
[31:50] But if there's a shock that is
[31:51] Chinese-centric, that is affecting Hong
[31:53] Kong,
[31:55] the US monetary policy is not going to
[31:56] react to that.
[31:58] And that that's a problem for Hong Kong
[32:00] Hong Kong.
[32:01] And still, they choose to do it. And the
[32:03] good question is why?
[32:06] Always there's politics that is more
[32:07] than than the kind of thing, but there
[32:09] are also economic arguments for why you
[32:11] may want to do these things.
[32:13] Another situation that I mentioned
[32:16] happens all the time every other day in
[32:18] Argentina, for example,
[32:20] is speculative attacks on the currency.
[32:22] So, you want to have a fixed exchange
[32:23] rate, but the markets don't believe you
[32:25] that you're going to be able to keep it
[32:26] there.
[32:27] And uh
[32:29] And so, what happens? So, look at this
[32:31] equation here. Suppose that that
[32:33] that you have a fixed exchange rate, but
[32:36] now the markets think you're not going
[32:37] to be able to sustain it.
[32:39] Okay?
[32:40] So, that means suppose that this guy is
[32:42] just going down.
[32:44] That happens again in Argentina every
[32:45] other day.
[32:47] Probably today, every single day. No?
[32:49] They want to say that they want to sign
[32:50] the exchange rate, but the markets don't
[32:52] believe you, and they expect your
[32:53] currency to lose value in the next few
[32:56] hours in the case of Argentina.
[32:58] So, this guy is going down.
[33:03] What happens to the current to the to
[33:04] the current exchange rate? So, expected
[33:06] exchange rate goes down. Big
[33:08] The The everyone expects your currency
[33:10] to drop.
[33:13] What What will tend to happen to
[33:16] the
[33:17] currency today?
[33:18] To the Argentinian peso today?
[33:23] It drops, but you have a fixed exchange
[33:25] rate, you can't let it drop.
[33:28] I I'm So, if you're going to maintain an
[33:30] exchange a fixed exchange rate, and now
[33:32] you have a speculative attack, people
[33:33] think your currency is going to drop,
[33:35] and you want to maintain your peg,
[33:36] that's called defending the peg. If you
[33:39] want to defend the peg, then the only
[33:41] option you have if this guy is dropping
[33:42] to keep the exchange rate is to raise
[33:44] interest rates a lot.
[33:46] That's the way you fight the main way
[33:47] you fight it. I mean, you fight it by
[33:49] closing capital accounts and so on, but
[33:52] that's the last resort. You first try to
[33:54] fight it with monetary policy. So, if
[33:56] this thing is dropping, you fight it by
[33:58] increasing interest rate a lot.
[34:00] And that's the way you stabilize the
[34:01] currency.
[34:03] But what happens when you raise interest
[34:04] rate a lot to defend the parity, the
[34:06] peg?
[34:08] What is the problem of that?
[34:17] Yeah, you generate a domestic recession.
[34:19] Okay? Because just to defend your
[34:21] currency, your peg,
[34:23] you had to raise interest rate a lot.
[34:25] No?
[34:26] So, it means you're going to have a
[34:27] recession at home.
[34:29] Okay?
[34:31] So, that's another problem of fixed
[34:32] exchange. It's a problem That's not a
[34:34] problem for Hong Kong. It was in 1997.
[34:37] They did have a speculative attack
[34:38] despite the fact that they had
[34:40] twice the number of reserves relative to
[34:42] their money base, but still they had
[34:44] speculative problem there. But it rarely
[34:46] happens in Hong Kong. In Argentina,
[34:47] again, every other day, but but in
[34:51] same in Turkey.
[34:52] In Turkey, it's every 15 days, but but
[34:55] but
[34:56] but it's happening all the time.
[34:59] So, that's a problem as well, because if
[35:01] you have
[35:02] to spend a lot of energy defending your
[35:04] peg, then you're going to be causing
[35:06] lots of recessions at home just to
[35:08] stabilize the currency. Okay?
[35:13] That's That's bigger economies. They
[35:15] were okay. Well, Argentina, Turkey, and
[35:16] so on, no? But these are
[35:19] bigger boys, no? Here we have a
[35:21] a
[35:23] This is the ERM crisis. So, before the
[35:25] euro,
[35:26] uh
[35:27] more or less the Eurozone plus the UK
[35:30] uh
[35:30] had a system called the ERM.
[35:33] The EM EMS ERM ERM is the Well, anyway.
[35:37] EMS is European Monetary System. ERM is
[35:40] Exchange Rate Mechanism or something
[35:42] like that. And they're both linked. But
[35:45] let's call it the
[35:46] European Monetary System. And the basic
[35:49] idea of the European Monetary System
[35:52] was that that
[35:54] they behave very much like Singapore
[35:56] with respect to each other. Meaning,
[35:58] they allow themselves to
[36:00] move around, but only in narrow bands.
[36:03] The The countries that had the more
[36:05] stable
[36:09] domestic monetary position, like France
[36:11] vis-à-vis the
[36:12] Germany, the Deutschmark, and the French
[36:15] franc, but they had these bands of 2 and
[36:18] 1/2% up and down, and they moved within
[36:20] those those ranges. They didn't have a
[36:22] full peg, but they allowed themselves to
[36:24] move a little bit. Portugal, which it
[36:26] was a little bit had a little bit less
[36:27] discipline, they had 5% for each side
[36:30] and stuff like that. But the point is,
[36:32] they would have narrow bands. Okay? And
[36:34] they moved around in those narrow bands,
[36:36] and they kept their
[36:38] uh
[36:39] kept it for quite a while
[36:41] before the euro.
[36:43] Now, here the whole system came under a
[36:46] speculative attack.
[36:50] What happened around there?
[36:52] You You probably have no idea.
[36:58] Well, it's really linked to that, yes.
[37:02] Yeah. It's the German re- reunification.
[37:04] So, what happened is
[37:06] when
[37:07] East Germany and and West Germany unify,
[37:10] they had to have a massive fiscal
[37:12] policy, massive expansionary fiscal
[37:13] policy.
[37:15] And that big expansion put lots of
[37:17] upward pressure on the on on on
[37:20] on German interest rates.
[37:22] And And that led to big appreciations
[37:25] uh of the Deutschmark.
[37:27] And And the other countries tried to
[37:28] fight it because they had to be in this
[37:30] very narrow band.
[37:32] But they were experiencing these big
[37:33] speculative attacks.
[37:35] And so, they had to raise their interest
[37:36] rate enormously.
[37:38] Uh
[37:39] the UK tried to do it for a while, and
[37:40] they essentially said, "I we give up."
[37:42] And then they they they they abandoned
[37:44] the the system.
[37:45] The French tried to stay in there for
[37:47] quite a bit. Okay? You can see the
[37:49] French franc. They didn't move. They
[37:50] didn't move.
[37:51] But it was extremely costly for them
[37:53] because the interest rate has to go up a
[37:54] lot, and sort of like got into a big
[37:56] recession and so on. Eventually, the
[37:58] whole system broke up broke down. I
[38:00] mean, everyone left. And eventually,
[38:02] they rejoined, but now in the euro. And
[38:05] the euro is a little different because
[38:06] in the euro, you give up There's no
[38:08] space for the speculative attacks
[38:11] because there's a single currency.
[38:13] Okay?
[38:14] So, that's the that's the most extreme
[38:15] form.
[38:17] Speculative attacks nowadays in Europe
[38:18] happen through different means. It's
[38:20] It's It's the
[38:22] Well, anyways, let me not get into that
[38:24] for
[38:24] But but
[38:26] But here you have So, what I'm saying,
[38:28] having a fixed exchange rate is not
[38:29] easy, even for countries that have sort
[38:31] of very well-developed financial
[38:33] markets, and so on and so forth.
[38:37] Now, it would seem,
[38:39] given all that I said,
[38:41] that
[38:42] I mean, there's no reason to have a
[38:43] fixed exchange rate. It's something you
[38:45] you give up an an instrument, and on top
[38:48] of that,
[38:49] you're subject to speculative attacks
[38:50] all the time. Okay? Not all the time.
[38:53] Well, it depends on how bad you are. But
[38:55] but you know, you have to be very
[38:57] well-behaved because otherwise, you're
[38:59] subject to speculative attacks all the
[39:00] time.
[39:01] So,
[39:03] So, why not do flexible exchange rate?
[39:05] Why Why What is wrong with flexible
[39:07] exchange rate?
[39:08] Well, I think the main problem of
[39:10] flexible exchange rate
[39:11] is that it tends to move a lot.
[39:13] I mean, we know that it moves a lot more
[39:15] than fundamentals, meaning
[39:17] you know, productivity is a little
[39:18] higher in one country than the other,
[39:20] demand is a little higher in the other
[39:21] in the other country, but the exchange
[39:23] rate moves a lot more than those little
[39:25] differences justify.
[39:28] And the reason one way of understanding
[39:29] this is the following.
[39:31] And this it will serve as an
[39:32] introduction to the next topic of the
[39:34] course, which will be asset pricing and
[39:36] things like that.
[39:37] So, let's look at revisit our interest
[39:39] parity condition, but now let's not
[39:41] assume
[39:42] that that that the next the the the
[39:46] expected exchange rate is fixed.
[39:48] I mean, that was an assumption just to
[39:49] make our life simple, but but it it's
[39:51] not be. So, that's a that's a then
[39:53] covered interest rate condition is this.
[39:56] Well, you see, I can replace this guy
[39:58] here for what will happen next period.
[40:00] It's the same thing shifted by a period
[40:02] with an expectation there.
[40:04] So, ET + 1 expected, this guy here is
[40:07] equal to 1 +
[40:09] expected domestic interest rate 1 period
[40:12] from now
[40:13] divided by 1 + international interest
[40:15] rate expected 1 period from now
[40:17] times the expected exchange rate for T +
[40:20] 2
[40:20] 2 years from now.
[40:22] And I can keep doing this. I can replace
[40:23] this by something equivalent to that
[40:25] with all the sub index shifted by 1
[40:27] year, blah blah blah blah blah blah.
[40:29] And so, I can end up writing this
[40:30] exchange rate
[40:32] as
[40:33] this product of lots of things that can
[40:35] happen in the future. The the monetary
[40:37] policy path
[40:38] at home, the monetary policy path, not
[40:41] the next period, the path for years to
[40:43] come
[40:44] of
[40:45] monetary policy in the other country,
[40:47] and there's always an expected exchange
[40:49] rate at the end there
[40:51] that is free. It can move around.
[40:55] So, the problem of this exchange is that
[40:57] the future matters too much
[41:00] in a sense. And you know, people have
[41:02] lots of imagination, so
[41:03] all sorts of weird things they imagine.
[41:05] And and when you people have lots of
[41:07] imagination, then these things are
[41:08] moving a lot. And that's the reason do
[41:10] you see enormous fluctuations in nominal
[41:12] exchange rate.
[41:13] Now,
[41:15] uh
[41:17] And that's the problem. It's a problem
[41:18] to have a very volatile exchange rate
[41:20] because it it makes transactions more
[41:22] difficult. I mean, you know, if you the
[41:24] price of things are ready price of
[41:26] things are changing all the time, it's a
[41:27] little bit more difficult to plan.
[41:29] Uh
[41:30] financial investments become more
[41:31] because you get all this exchange rate
[41:33] volatility in between. So, that's one of
[41:35] the main reasons
[41:37] uh
[41:38] you would prefer, if you could to have a
[41:41] more
[41:42] managed exchange rate. It's because you
[41:44] don't want this all this artificial
[41:46] volatility that comes from behavioral
[41:48] traits and things of that kind. Okay?
[41:50] That's the main reason.
[41:53] Uh
[41:54] Look at this example, for example.
[41:57] Example, for example, sorry about that.
[41:58] But
[41:59] this is Russia during the the the war.
[42:03] This was the the the the ruble, the the
[42:06] the the Russian currency.
[42:09] And
[42:10] when they invaded, of course, this thing
[42:12] collapsed.
[42:13] The currency collapsed. Okay?
[42:16] Uh
[42:16] this period is a is a little longer than
[42:18] you think, but but it collapsed for for
[42:20] quite a while.
[42:21] And then it recovered a lot, actually
[42:23] overshot and came down.
[42:25] So, this is not because the Central Bank
[42:27] said, you know,
[42:29] we're going to
[42:31] devalue the currency. It's just people
[42:34] said, "Wow, this a country going into
[42:35] war. It's going to be a mess, blah blah
[42:37] blah blah."
[42:38] So, all that future I talk about
[42:40] uh
[42:43] essentially destroyed the currency.
[42:45] Okay?
[42:46] Now, a lot of that recovery happened
[42:48] there not because people now
[42:50] began to see the future as a better
[42:52] future or anything like that.
[42:53] It's because
[42:54] they had to hike interest rate
[42:56] massively. They were around 4 or 5% and
[42:58] they had to go to 20% interest rate to
[43:00] defend the exchange rate. Remember I
[43:01] told you have a speculative attack and
[43:03] you have enormous pressure on your
[43:04] currency. Well, the main tool you have
[43:06] to offset that is to raise interest
[43:08] rate.
[43:09] They had they had interest rate
[43:11] massively. They did a lot of other
[43:12] things as well. They
[43:14] put capital controls and lots of things.
[43:16] But but but this was the main thing they
[43:17] did. And so, they dragged the recession
[43:19] the economy into recession for war
[43:21] related reasons and because of the
[43:23] monetary policy response they had to do
[43:25] with that.
[43:25] Okay? So, that's an extreme case of a
[43:28] war. But but that's the kind of things
[43:29] that can happen. Uh
[43:32] in in in in an in a floating exchange
[43:35] rate.
[43:36] Even when
[43:38] uh
[43:41] I mean, the main constraint in Argentina
[43:43] and Turkey and so on is reserves. They
[43:44] don't have enough reserves. So, if you
[43:46] have to defend your currency
[43:48] by intervening in the in the in the
[43:50] FX market
[43:52] if you don't have enough, then you're
[43:53] not credible. I mean,
[43:54] if you have massive capital outflows and
[43:56] you have a few billion dollars there,
[43:59] it's not going to work.
[44:01] That's not the case of Russia. They had
[44:02] massive amount of reserves. So, that
[44:04] that was not the issue. It was all about
[44:05] expectations of things that happen in
[44:07] the future. It was all about
[44:09] this kind of terms. Okay?
[44:14] Anyway, so so that added to the cost
[44:16] they had.
[44:18] So,
[44:20] so how do we choose these things then in
[44:22] practice?
[44:23] Again, there are lots of things and
[44:24] politics plays play role and so on.
[44:27] Uh
[44:28] but this this a case to so so again
[44:32] I would put it even the other way
[44:33] around. I think that if you could, you
[44:35] would like to have a fixed exchange
[44:37] rate.
[44:38] If you could,
[44:40] you would like to have a fixed exchange
[44:41] rate because then you remove all this
[44:42] spurious noise that happens every single
[44:44] day because of exchange rate volatility
[44:46] that complicates your life.
[44:49] Uh
[44:51] But so, when can you do that?
[44:53] Well, first, you can do it with respect
[44:54] to some other country
[44:56] where the shocks are very similar.
[44:59] You know, because
[45:00] you you know, if you know that that that
[45:03] say you're Mexico, but
[45:05] or the north of Mexico, something like
[45:06] that, and you know that all your shocks
[45:08] are really shocks to the US.
[45:10] Then the US can do the monetary policy
[45:11] for you.
[45:13] You know, because you have the same
[45:14] shocks.
[45:15] I'm exaggerating. So, if you're very
[45:17] similar
[45:19] then it makes sense to have a fixed
[45:20] exchange rate because why pay for all
[45:22] that volatility when you're going to be
[45:23] doing the same policies
[45:25] in both countries more or less at the
[45:26] same time because you're exposed to the
[45:27] same shocks.
[45:29] So, that's one thing. That's one reason
[45:30] why the Eurozone is a Eurozone because
[45:33] they're European countries that have
[45:35] very similar business cycles and so on.
[45:37] Germany is a little different. That's
[45:38] the reason they always have some
[45:39] problem. I mean, the north and the
[45:41] south, they're a little different. But
[45:43] but but they're much more similar
[45:46] than than other countries. Uh
[45:50] Uh so so that's that's what they have
[45:53] want.
[45:55] Another option is is is when you have
[45:59] lots of fiscal capacity.
[46:01] Because if you have lots of fiscal
[46:02] capacity, then the cost of not having
[46:04] monetary policy is not that large
[46:05] because you can fight your business
[46:06] cycle with fiscal policy.
[46:09] That's the case of Hong Kong, for
[46:10] example. Hong Kong
[46:12] Hong Kong, first of all, is not subject
[46:13] to speculative attack because they have
[46:14] massive amount of reserves. So, anyone
[46:16] that dares attacking them is going to
[46:18] lose their shirt. So, so they're safe.
[46:21] Uh
[46:22] uh
[46:23] Soros tried many years back and he
[46:25] didn't do as well as he did attacking
[46:26] the British pound.
[46:28] Uh
[46:29] um
[46:29] then then but they also have lots of
[46:32] fiscal resources, so they can
[46:33] fight their domestic recessions and so
[46:35] on with fiscal policy.
[46:37] The other factor, which also applies to
[46:39] Hong Kong
[46:41] if you have very flexible factor
[46:43] markets. So, if wages move very easily,
[46:45] if prices move very easily domestically
[46:48] then you don't care about
[46:50] having a fixed nominal exchange rate
[46:51] because a fixed nominal exchange rate is
[46:53] not the same as a fixed real exchange
[46:55] rate, which is what you really need to
[46:56] move around.
[46:57] If your prices are flexible
[46:59] doesn't matter that nominal exchange
[47:00] doesn't move because the prices are
[47:01] moving around.
[47:02] And so, you you still have lots of
[47:04] flexibility in the real exchange rate.
[47:06] And that's the reason I would say is one
[47:08] of the reasons uh political reasons as
[47:09] well, but but why they can afford it.
[47:11] Why I think in the case of Hong Kong
[47:12] it's the other way around. It was some
[47:13] political reasons
[47:15] uh and and and the and then they build a
[47:18] system so that
[47:20] is is a is a coherent system because
[47:22] they have lots of fiscal capacity, can
[47:24] defend the currency well
[47:26] and they have very flexible markets.
[47:30] Uh
[47:33] This is
[47:34] Well, this again, this is what I said
[47:36] before. If you if you
[47:38] if this is what I said before. If you if
[47:40] you have you don't like that noise. If
[47:42] you especially you're going to be
[47:42] trading a lot with people and so on.
[47:45] You know,
[47:46] in Europe, many people cross the border
[47:48] many times a day and then you want to go
[47:50] shopping one way or the other. It's a
[47:52] it's a pain if the exchange rate is
[47:54] moving all the time. You know? It's much
[47:55] easier if things are stable. And the
[47:57] same apply to financial transactions.
[47:59] People have deposits in different banks
[48:00] and stuff like that.
[48:02] It's it's better if you don't have all
[48:04] that fluctuation. And the case of the
[48:06] Euro area, they decided that
[48:08] uh
[48:10] that the advantage of having a very
[48:11] fixed exchange rate
[48:13] uh
[48:14] uh were more than the cost for
[48:16] individual countries of not having
[48:17] independent monetary policy.
[48:20] It's still a work in progress. They're
[48:21] building that is not finished.
[48:24] But but but they're working at it.
[48:26] The other reason why
[48:28] uh countries fix exchange rate
[48:30] uh and that's the Argentinian reason and
[48:32] so on
[48:33] is is when when they have no control in
[48:35] inflation.
[48:37] They have no credibility.
[48:38] And so, if you peg to another currency
[48:40] that has credibility, then the idea, the
[48:42] hope at least, is that you will inherit
[48:45] the credibility of the other currency.
[48:47] And that's what they tried to
[48:49] uh Ar- Argentina had a currency board
[48:51] like Hong Kong for a while. The whole
[48:53] idea was to control inflation. Well,
[48:56] let's peg to someone.
[48:58] Uh and and and if they if the markets
[49:00] believe you, then it will work because
[49:02] then you inherit the the credibility of
[49:04] the You're saying, when you take a fixed
[49:06] exchange rate, I'm not going to run
[49:07] monetary policy, which is the main
[49:08] source of inflation.
[49:10] So, I'm going to let the credible
[49:11] country run the monetary policy for me.
[49:13] That's what gives you credibility.
[49:15] As long as somebody believes that you're
[49:16] not going to
[49:18] quit the thing.
[49:19] But but but that's the reason countries
[49:21] do it, often to stabilize inflation as
[49:24] well.
[49:25] Okay.