Lecture 19
FIXED VS. FLOATING EXCHANGE RATES

1. Conduct of monetary policy

• Central bank cannot use monetary policy to affect output
• Money supply becomes endogenous

• Central bank can increase money supply to reduce unemployment

2. Inflation from abroad

• Higher inflation in other countries translates into higher inflation at home (foreign inflation is "imported)
• Use PPP to show this

• If P* rises, domestic price level does not have to rise
• Adjustment can occur in the exchange rate
• Inflation from abroad is not "imported"

• But, but... is this a mirage?
  • If the domestic currency depreciates...
    ...import prices will rise
  • In order to maintain their purchasing power, workers will demand wage increases...
    ...causing final goods prices to rise

3. Exchange Rates as Automatic Stabilizers

• Suppose demand for Home exports falls...
  ... causing aggregate expenditure to fall
• Output falls ...
  ... causing money demand to decrease
• Domestic interest rate falls ...
  ... leading to capital outflows and...
  ... a depreciation of the domestic currency
• The currency depreciation makes domestic goods cheaper for foreign consumers ...
  ... thus offsetting the initial drop in Home exports

• In order to arrest the currency depreciation, the central bank will sell forex reserves...
  ... causing the money supply to decrease
• Result: Output will fall by a larger amount than in the floating case

4. Monetary discipline

• Central banks may use monetary policy too freely
• Result: Higher inflation

• Money supply cannot be altered at will by the central bank
• If domestic currency is tied to a stable foreign currency (say, the euro), Home country's inflation will equal that of the Foreign country (Use PPP to show this)

5. Currency movements as impediments to trade and capital flows

• International prices of goods and assets are more unpredictable
• Discourages trade and foreign investment

• But, but... how about using hedging techniques - forward contracts, futures?

• Exchange-rate risk to traders and investors is eliminated
• Or, is it? Think of the Asian Crisis of 1997

6. Money market shocks

• Suppose real money demand rises
• Interest rates will rise...
  ... causing the currency to appreciate and...
  ... domestic investment to decrease
• With the fall in AE, output will decrease

• In order to prevent the currency from appreciating, the central bank will buy forex reserves
• Money supply will increase
• Result: Interest rate and GNP are unaffected