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