Forward Exchange and International Financial Investment

Assume you are an American importer who must pay 500,000 Euros at the end of 90 days when you receive 1,000 cases of French wine at your warehouse in New York. Suppose that you have not covered this transaction in the forward market. In which of the following cases will you suffer the largest loss?

The euro spot exchange rate value vis-à-vis the dollar does not change

The euro (spot) initially appreciates by 2 percent, and then depreciates by 1 percent

The euro (spot) initially depreciates by 3 percent, and then appreciates by 2 percent

The euro (spot) initially appreciates by 3 percent, and then depreciates by 2.9 percent


Forward Exchange and International Financial Investment

Assume you are an American importer who must pay 500,000 euros at the end of 60 days when you receive 1,000 cases of French wine at your warehouse in New York. If you do not hedge this transaction, you face exchange-rate risk. The best way to remove the risk of loss due to currency fluctuations is to

buy 500,000 euros in the forward exchange market for delivery in 60 days.

invest the dollar equivalent of 500,000 euros in a dollar-denominated deposit at a French bank.

sell 500,000 euros in the forward exchange market for delivery after 60 days.

sell 500,000 euros now in the spot market.


Forward Exchange and International Financial Investment

An import-export business that finds itself in a "short" foreign-currency position risks a financial loss if

it pays attention to exchange-rate forecasts.

foreign demand for its product rises (more than expected).

the domestic currency depreciates (more than expected).

the foreign currency depreciates (more than expected).


Forward Exchange and International Financial Investment

In a ________ contract you can effectively lock in the price at which you buy or sell a foreign currency at a set date in the future.


Forward Exchange and International Financial Investment

A ________ gives the holder the right (but not the obligation) to sell a foreign currency at some time in the future at a price set today.


Forward Exchange and International Financial Investment

Which of the following financial instruments provides a buyer the right (but not the obligation) to purchase or sell a fixed amount of currency at a prearranged price, within a few days to a few years?


Forward Exchange and International Financial Investment

An investment exposed to exchange-rate risk is a(n) ________ international investment.


What Determines Exchange Rates?

A Road Map
What Determines Exchange Rates?


What Determines Exchange Rates?

Exchange Rates in the Short Run
Since the general shift to floating exchange rates in the early 1970s, exchange rates between the U.S. dollar and other major currencies have been variable or volatile. The charts at the beginning of the chapter suggest three types of variability. First, there are long-term trends in which some currencies tend to appreciate against the dollar, and others tend to depreciate.

Pressures on exchange rates in the short run can be best understood in terms of the demands and supplies of assets denominated in different currencies

Foreign exchange markets seems sensitive to movements in interest rates

Expectations of future exchange rates can have a powerful impact on international financial positioning, and thus on the value of the current exchange rate


What Determines Exchange Rates?

The Long Run: The Monetary Approach
Combining PPP and the quantity theory equations for two countries, we obtain a basis for the monetary approach to explaining or predicting exchange rates in the long run: e = P/Pf = (Ms/Msf)(kf /k)(Yf /Y). If the ratio of the k's is steady, then the exchange rate will change over the long run as the money supplies change and as real GDPs grow, with elasticities of one.

Emphasizes the importance of money supplies and demands as keys to understanding the determinants of exchange rates, through the link of money to price levels and inflation rates.

The exchange-rate value of a foreign currency (

) is raised in the long run by the following:


What Determines Exchange Rates?

The Long Run: Purchasing Power Parity (PPP)
The chapter then examines long trends in exchange rates. Our understanding of exchange rates in the long run is based on the purchasing power parity (PPP) hypothesis. Three versions of PPP are presented: the law of one price for a single product, absolute PPP, and relative PPP.

Exchange rates over time
Long-term trends
Medium-term trends


What Determines Exchange Rates?

Exchange-Rate Overshooting
During class discussion of the short-run pressures on exchange rates, inquisitive students may ask if both the interest rate (say, the domestic interest rate) and the expected future spot exchange rate change at the same time. Here is one possible way to respond. If the increase in the nominal domestic interest rate is caused by a higher expected rate of inflation, then it may also be accompanied by an expectation (based on PPP) that the domestic currency will depreciate in the future.

International investors can react
rationally
to news by driving the exchange rate


What Determines Exchange Rates?

How Well Can We Predict Exchange Rates?
The chapter next discusses how difficult it is to predict exchange rate movements in the short run. Generally, economic models (like the asset market approach or the monetary approach) cannot beat the naive model of a random walk, which predicts that the exchange rate in the future will simply be the same as the exchange rate today.

The naïve model: the spot exchange rate follows a

, so we have no ability to predict whether it will go up or down


What Determines Exchange Rates?

Introduction
What Determines Exchange Rates?


What Determines Exchange Rates?

Asset Market Approach to Exchange Rates
The chapter first examines short-run movements in exchange rates. It presents the version of the asset market approach to exchange rates that focuses on debt securities and the uncovered interest parity relationship developed in Chapter 18, presuming that this relationship holds approximately if not exactly. The basic discussion examines the pressure on the current spot exchange rate if one of the other three rates (the domestic interest rate, the foreign interest rate, and the expected future spot exchange rate) changes, with the other two held constant.


What Determines Exchange Rates?

2.Calculate and report the real bilateral exchange rate values (annual averages) of your country's currency since 1990, relative to the U.S. dollar. If possible, use price indexes called “Producer Prices,” “Wholesale Prices,” or a similar name, even if the names are somewhat different between your country and the United States. If there is more than one price index of this type for your country, choose the one that is most suitable. If your country does not have full data for this type of price index, then use the price index that is usually called the “Consumer Price Index” for both your country and the United States. In reporting the values of the real exchange rates, use a base year of 1990=100. [Please attach an appendix in which the methods of calculating the real exchange rates are documented.]


What Determines Exchange Rates?

Price Gaps and International Income Comparisons: The list of countries is ordered by national income per capita using common prices (sometimes called national income per capita at PPP exchange rates), as shown in the middle column of numbers. Singapore is at the top of the list because it has the highest value for this common-price income per capita. Yes, national income per capita for Singapore is lower than the United States (and a number of other countries) using market exchange rates to convert national income values into the same currency, as shown in the first column. But, at those market exchange rates, Singapore has surprising low average prices for goods and services, as shown in the third column. For example, average Singapore prices are only 62 percent of the prices for the same bundle of goods and services in the United States. After we adjust for the remarkably low Singapore


What Determines Exchange Rates?

11. a.If we use 1995 as the base year, the nominal exchange rate of $1/pnut corresponds to a ratio of U.S. prices to Pugelovian prices of 100/100. According to PPP, this relationship should be maintained over time. If the price level ratio changes to 260/390 in 2018, then the nominal exchange rate should change to $0.67/pnut. The pnut should depreciate during this time period because of the higher Pugelovian inflation rate (the reason why Pugelovia’s price level increased by more than the U.S. price level increased).


What Determines Exchange Rates?

b.For the United States, the quantity theory of money with a constant k means that the quantity equation with k = 0.25 should hold in 2018: 65,000 = 0.25 260 1,000. It does. Because the quantity equation holds for both years with the same k, the change in the price level from 1995 to 2018 is consistent with the quantity theory of money with a constant k. Similarly, for Pugelovia, the quantity equation with k = 0.5 should hold for 2018, and it does (58,500 = 0.5 390 300).


What Determines Exchange Rates?

The ________ approach to exchange rates emphasizes the role of portfolio repositioning by international financial investors.


What Determines Exchange Rates?

The asset market approach to exchange rate determination seeks to predict

the possibility of retaining a pegged exchange rate by the government.

the short-term pressures on exchange rates.


What Determines Exchange Rates?

The exchange rate value of a foreign currency is ________ in the short run by a rise in its expected future spot exchange rate value.


What Determines Exchange Rates?

A decrease in the foreign interest rate relative to the domestic interest rate ________ the exchange rate value of a foreign currency in the short run.


What Determines Exchange Rates?

Other things equal, a broad shift to expecting depreciation of the euro will lead to

an increase in official exchange market intervention by the euro area monetary authorities.

a lowering of exports of European goods and services.

a decrease in the demand for euro-denominated financial assets.


What Determines Exchange Rates?

If the domestic interest rate decreases, with the foreign interest rate and the expected future spot rate remaining unchanged, the value of the domestic currency vis-à-vis the foreign currency is expected to

converge to its purchasing power parity (PPP) value.


What Determines Exchange Rates?

If the expected future spot exchange rate value of the foreign currency decreases, with the interest rate differential unchanged, the current spot exchange-rate value of the domestic currency


What Determines Exchange Rates?

Which of the following statements is true?

If the domestic interest rate rises, there will be international financial repositioning toward domestic-currency assets, thereby causing the domestic currency to appreciate.

If the expected future spot exchange rate value of the foreign currency decreases, there will be international financial repositioning toward foreign-currency assets, thereby causing the domestic currency to depreciate.

If foreign interest rates increase, the domestic interest rate remaining unchanged, there will be international financial repositioning toward domestic-currency assets and the domestic currency will appreciate.

If the expected future spot dollar per euro exchange rate increases, there will be international financial repositioning toward the dollar-denominated assets thereby causing the euro to depreciate.


What Determines Exchange Rates?

Everything else remaining unchanged, an increase in interest rates in the United States is most likely to result in

outflows of capital from the United States.

a decrease in the demand for dollar-denominated financial assets.


What Determines Exchange Rates?

Which of the following is NOT linked together by uncovered interest parity?


What Determines Exchange Rates?

If investors begin to expect a decrease in the value of the Thai baht vis-à-vis other currencies, their actions will cause

the actual depreciation to occur much faster.

the Thai baht to appreciate immediately.

a large inflow of foreign capital into Thailand.


What Determines Exchange Rates?

The ________ effect suggests that speculations can sometimes be destabilizing as the actions of international investors move the exchange rate away from the long-run equilibrium value consistent with fundamental economic influences.


Government Policies toward the Foreign Exchange Market

Two Aspects: Rate Flexibility and Restrictions on Use
Government policies toward the foreign exchange market exist for a variety of reasons, including to reduce variability in exchange rates, to keep the exchange value of its currency either high or low, or to raise national pride in a steady or strong currency. The two major aspects of government policies toward the foreign exchange market are policies toward the exchange rate itself and policies that permit or restrict access to the foreign exchange market.

Policy toward the level and variability of the (nominal spot) exchange rate. In simple terms, it is the choice between a floating exchange rate and a fixed exchange rate.

Restrictions (if any) on the use of the foreign exchange market. These restrictions are generally called


Floating Exchange Rate
The basic choice that a government faces with its policy toward the exchange rate itself is between an exchange rate that is floating and one that is set or fixed by the government. In the polar case of a clean float the government permits private market demand and supply to set the exchange rate with no direct involvement by government officials.


Fixed Exchange Rate
The basic choice that a government faces with its policy toward the exchange rate itself is between an exchange rate that is floating and one that is set or fixed by the government. In the polar case of a clean float the government permits private market demand and supply to set the exchange rate with no direct involvement by government officials.


Defense Through Official Intervention
The first line of defense is often official intervention. If the country's currency is experiencing pressure toward depreciation, the country's monetary authority can defend the fixed rate by entering the foreign exchange market to buy domestic currency and sell foreign currency. The intervention is financing the country's official settlements balance deficit and preventing this excess private demand for foreign currency from driving the foreign currency's value above the top of the band.

Defending against depreciation
Defending against appreciation
Temporary disequilibrium


Exchange Controls
The first half of this chapter examines types of government policies toward the foreign exchange market and provides analysis of government intervention and exchange controls. The second half examines the actual policies that governments have adopted during the past 150 years.


International Currency Experience
11.Key features of the interwar currency experience were that exchange rates were highly variable, especially during the first years after World War I and during the early 1930s. Speculation seemed to add to the instability, and governments sometimes appeared to manipulate the exchange-rate values of their currencies to gain competitive advantage.

Gold Standard, 1870-1914
Gold value of each currency was fixed.
Britain was the central country.


What to Fix To?
If the government chooses to impose a fixed exchange rate, there are three additional choices that the government faces. First, what to fix to? Answers could include gold (or some other commodity), the U.S. dollar or some other single currency, or a basket of currencies. (With the exception of the specific examination of the gold standard, subsequent discussion assumes that a fix is to one or several foreign currencies.) Second, when to change the fixed exchange rate?

A fixed rate means that the value of a country’s currency is fixed to something else, but what is this something else?

A single currency (e.g. dollar or euro)?


When to Change the Fixed Rate?
If the government chooses to impose a fixed exchange rate, there are three additional choices that the government faces. First, what to fix to? Answers could include gold (or some other commodity), the U.S. dollar or some other single currency, or a basket of currencies. (With the exception of the specific examination of the gold standard, subsequent discussion assumes that a fix is to one or several foreign currencies.) Second, when to change the fixed exchange rate?

Never
: Permanently fixed rate. Not credible.
Occasionally


A compromise between the United States and Britain led to an agreement in 1944 that established the Bretton Woods System, a regime of adjustable pegged exchange rates. While this system looked successful for almost two decades, it also had two defects. One was that it set up one-way speculative gambles when currencies were in trouble. The second arose from the role of the U.S. dollar in the system. As the system developed, other countries pegged their currencies to the dollar, and the U. S. government was committed to buy or sell gold for dollars with other central banks. Continuing U.S. payments deficits in the 1960s led some other countries to amass large holdings of U.S. dollar-denominated assets as official reserves. Confidence that the U.S. government could continue to honor the official gold price dwindled. The U.S. government was unwilling to contract the U.S. economy to reduce th


The U.S. government probably could have maintained the system, at least for longer than it actually lasted, if it had been willing to change its domestic policies, tightening up on government spending to contract the economy and cool off its inflation. The United States instead reacted by changing the rules of Bretton Woods, severing the link between the private gold market and the official gold price in 1968 and suspending gold convertibility and forcing other countries to revalue their currencies in 1971. An agreement in late 1971 reestablished fixed exchange rates after a short period in which some currencies floated, but most major currencies shifted to floating in 1973.


The current system is often described as a system of managed floating exchange rates, and the trend is generally in this direction. But there is also much official resistance to market-driven exchange rates. Some of the resistance is seen in the active management of floating exchange rates. More dramatically, the countries of the European Union have attempted to create a zone of stability in Europe, first by using the snake within the tunnel, then through the Exchange Rate Mechanism of the European Monetary System, and now with European Monetary Union and the euro. A goodly number of countries maintain fixed or heavily managed exchange rates. However, the series of exchange rate crises during the 1990s and early 2000s show how difficult it is for a government to defend a fixed or a heavily managed exchange rate in the face of wide swings in speculative international financial flows.


The actual current system is in many ways a nonsystem—countries can choose almost any exchange rate policies that they want, and there is much variety. Two major blocs of currencies exist—one is the U.S. dollar and the currencies fixed to it, and the other is the countries adopting the euro and other currencies fixed to the euro. A growing number of countries have floating exchange rates for their currencies, with a greater or lesser degree of “management.” Yet other countries use a fixed exchange rate to another currency, a fixed exchange rate to a basket of currencies, or a crawling pegged exchange rate. A few countries are “dollarized”—each simply uses the currency of some other country as its own.
Tips


Government Policies toward the Foreign Exchange Market

________ are in place when a country's government places restrictions on the conversion of the domestic currency into foreign currency or vice versa.

Two Aspects: Rate Flexibility and Restrictions on Use


Government Policies toward the Foreign Exchange Market

Which of the following are in place when government imposes limits on or requires approvals for payments related to some (or all) international financial investment activities?


Government Policies toward the Foreign Exchange Market

With a(n) ________, the government allows the market to determine the exchange rate of a currency.


Government Policies toward the Foreign Exchange Market

Under which of the following policies does the government enter the foreign exchange market and buy or sell foreign currency to influence the exchange rate of the domestic currency?


Government Policies toward the Foreign Exchange Market

Which of the following terms describes an exchange rate regime in which the government intervenes in the foreign exchange market to influence the market-determined exchange rate?


Government Policies toward the Foreign Exchange Market

Which of the following statements is true?

The special drawing right (SDR) is a basket of currencies made up of U.S. dollars, euros, and Japanese yen.

Today, South Africa is a country that has a currency fixed to gold.

Currencies whose prices are fixed to the same commodity would have currency exchange rates that are also fixed.

A country maintains a cleanly floating exchange rate value to neutralize the international value of its currency.


Government Policies toward the Foreign Exchange Market

Which of the following terms is used to describe an exchange rate regime in which the rate is fixed to a currency or basket of currencies?


Government Policies toward the Foreign Exchange Market

An exchange rate regime in which the government may change the fixed rate in the face of a significant disequilibrium in the country's international position is called a(n)


Government Policies toward the Foreign Exchange Market

If a country with a relatively high inflation rate maintains a pegged exchange rate against the currency of a relatively low inflation country

its exports will become more competitive in the international market.

its exports will become less competitive in the international market.


Government Policies toward the Foreign Exchange Market

For a country which has a relatively high rate of inflation and wants some form of pegged exchange rate, which of the following exchange-rate regimes is the best choice?


Government Policies toward the Foreign Exchange Market

Which of the following mechanisms would not be used by a country to defend a fixed exchange rate?

The government can buy or sell foreign currency to influence the actual exchange rate.

The government can threaten to shift to a floating exchange rate.

The government can impose a form of exchange control.

The government can alter domestic interest rates to influence short-term international capital flows.


Government Policies toward the Foreign Exchange Market

Consider that Britain is trying to maintain a fixed exchange rate with respect to the U.S. dollar. However, the present situation in the foreign exchange market is conducive for the British pound to depreciate with respect to the U.S. dollar. Which of the following interventions will stem the pressures for depreciation of the pound?

The government of Britain should sell pounds and buy dollars.

The government of Britain should do nothing, as a fixed rate cannot change.

The government of Britain should buy pounds and sell dollars.

The government of Britain should increase the country's money supply.


International Lending and Financial Crises

Gains and Losses from Well-Behaved International Lending
International capital movements can bring major gains both to the lending or investing countries and to the borrowing countries, through intertemporal trade and through portfolio diversification for the lenders/investors. But international lending and borrowing sometimes is not well-behaved—financial crises are recurrent.


International Lending to Developing Countries
International lending and borrowing often is well-behaved, but not always. The chapter next examines financial crises in developing countries during 1982 to 2002. Following defaults in the 1930s, lending from industrialized countries to developing countries was low for four decades. Such lending dramatically increased in the 1970s for four reasons.

Sometimes international lending is not well- behaved.


Reducing the Frequency of Financial Crises
We now are paying more attention to finding ways to reduce the likelihood or frequency of financial crises in developing countries. Some proposals for improved practices in borrowing countries, including better macroeconomic policies, better disclosure of information and data, avoiding government short-term borrowing denominated in foreign currencies, and better regulation of banks, enjoy widespread support.

Avoiding short-term borrowing denominated in foreign currencies


Financial Crises: What Can and Does Go Wrong
International capital movements can bring major gains both to the lending or investing countries and to the borrowing countries, through intertemporal trade and through portfolio diversification for the lenders/investors. But international lending and borrowing sometimes is not well-behaved—financial crises are recurrent.

2.  Exogenous negative international shocks


Resolving Financial Crises
International Lending and Financial Crises

May include loans that compensate for the lack of private lending during the crisis.

Restore investor confidence by replenishing official reserve holdings.


International Lending Benefits
International Lending and Financial Crises

, in which the lender gives up resources today in order to get more in the future, and the borrower gets resources today but must be willing to pay back more in the future.


Taxes on International Lending
6. With free international lending Japan lends 1,800 (= 6,000 − 4,200) to America, at point T. If Japan and America each impose a 2 percent tax on international lending, the total tax is 4 percent. The gap WZ restores equilibrium, and the amount lent internationally declines to 600 (= 6,000 − 5,400). The interest rate in Japan (and the one received net of taxes by Japan’s international lenders) is 3 percent and the interest rate in America (and the one paid including taxes by America’s international borrowers) is 7 percent.

We have compared free international lending with no international lending and have found the orthodox result: Freedom raises world product and national incomes.

Another standard result also carries over from trade analysis: the


Crisis struck in 1982, when first Mexico and then many other developing countries declared that they could not repay. The crisis was brought on by rising interest rates in the United States, which raised the cost of servicing the loans, and declining export earnings for the debtor developing countries, as the industrialized countries endured a deep recession. This debt crisis wore on through the 1980s. Beginning in 1989, the Brady Plan led to reductions in debt and conversion to bonds. By 1994, the 1980s debt crisis was finally over.


Argentina pegged its peso to the U.S. dollar and succeeded in ending its hyperinflation in the early 1990s. However, the peso experienced an increase in its real effective exchange rate value, and an extended recession began in 1998. The fiscal deficit widened, and the IMF stopped lending to it in late 2001. In early 2002 the government ended the pegged exchange rate and the peso lost three-fourths of its value relative to the U.S. dollar. The banking system largely ceased to function and the economy went into a severe recession. After a few months delay Argentina’s crisis spread to neighboring countries, especially Uruguay.


Financial crises also hit industrialized countries, and the chapter concludes with an examination of the global financial and economic crisis. The crisis began in the United States, which had experienced a credit boom and a bubble in house prices. As the house price bubble began to deflate in 2006, an increasing number of mortgages went into default. In August 2007 problems at BNP Paribas signaled the depth of losses on securities backed by these mortgages. Furthermore, financial institutions became reluctant to lend to each other, because potential lenders became worried that the borrowing institutions may hold dodgy assets that made it more likely that they could not service their debts in the future. With the failure of Lehman Brothers in September 2008, short-term financial markets and lending among financial institutions froze, and the crisis entered a much worse phase. The U.S. Fed


The first explanation is overlending and overborrowing. This can occur when the government borrows and guarantees private borrowing, and lenders view this as low risk. The box on “The Special Case of Sovereign Debt” uses a benefit-cost analysis to show when a sovereign debtor would default. The Asian crisis showed that overlending and overborrowing could occur with private borrowers as well, especially if rising stock and land prices show high returns until the bubble bursts. The second explanation is exogenous shocks—for instance, a decline in export prices or a rise in foreign (often U.S.) interest rates—that make it more difficult for the borrower to service its debt. The third is exchange rate risk. This can be acute if private borrowers use liabilities denominated in foreign currency to fund assets denominated in local currency, betting that the exchange rate value of the local curr


International Lending and Financial Crises

________ refer(s) to purchasing shares in a foreign enterprise largely owned and controlled by the investor.

Gains and Losses from Well-Behaved International Lending


International Lending and Financial Crises

Official lending and investing are usually done by

private individuals when purchasing government bonds.

governments or multilateral institutions.


International Lending and Financial Crises

From pre-World War II years to the early 1980s, which one of the following countries was the principal lender in the world?


International Lending and Financial Crises

The largest net international lenders since 1980 have been


International Lending and Financial Crises

From the early 1980s through today, the largest net borrower in the world has been


International Lending and Financial Crises

Since 2000, developing countries received large net capital inflows in the form of

official loans from foreign governments and the International Monetary Fund (IMF).


International Lending and Financial Crises

Which of the following is a major benefit of international lending?

It eliminates exchange rate risk in financial activities.

It requires reducing restrictive international trade practices in the lending and the borrowing countries.

It allows both small countries and large countries to apply similar levels of optimal taxes on the international loans.

It allows some lenders to shift their lending to foreign borrowers who are willing to pay higher interest rates on the loans..


International Lending and Financial Crises

If international financial transactions are prohibited

lenders in the richer countries will probably earn high rates of return.

borrowers in poorer countries will probably pay low interest rates.

lenders in the richer countries will probably earn low rates of return.


International Lending and Financial Crises

Borrowers in wealthy countries that have few domestic investment opportunities would gain if

all restrictions on capital flows between nations were removed.

capital flows between nations are prohibited.

governments set allowable interest rates.


International Lending and Financial Crises

Assume that investment opportunities are less in high-wealth countries and more in low-wealth countries. Now, if all barriers to international financial transactions are removed, borrowers in ________ countries lose and lenders in ________ countries gain.


International Lending and Financial Crises

International financial freedom

helps all citizens in both poor and wealthy countries.


International Lending and Financial Crises

By restricting foreign lending, a country with sufficient market power can

bid up the rate that domestic lenders get after taxes.

bid up the rate that foreign borrowers have to pay.


How Does the Open Macroeconomy Work?

The Performance of a National Economy
This chapter provides a framework and model for analyzing international macroeconomics. We judge the performance of a national economy against two objectives. Internal balance involves both full employment and price stability or an acceptable rate of inflation. External balance involves a reasonable and sustainable makeup of the country's international payments, taken to be approximately an official settlements balance that is zero.

Actual domestic production close to the economy’s potential, often summarized as full employment (an acceptably low unemployment rate)

Price stability (an acceptably low inflation rate)


How Does the Open Macroeconomy Work?

Domestic Production Depends on Aggregate Demand
In the short run (and within the economy's supply capabilities), domestic production is determined by aggregate demand: Y = AD = C + Id + G + (X - M) = E + (X - M), where Y is both domestic production and national income, and E is national expenditure on goods and services. Consumption C is a positive function of Y (inclusive of the effects of taxes T), and real domestic investment Id is a negative function of the interest rate i.

In the short run, domestic production (producers’ willingness to produce) is determined by demand.

Equilibrium occurs when domestic production (Y, or real GDP) equals desired aggregate demand (AD) for domestically produced goods and services:


How Does the Open Macroeconomy Work?

Equilibrium GDP and Spending Multipliers
If the interest rate and price level are constant, then the equilibrium is the level of real GDP (and income) that equals desired aggregate demand at that level of income, or, equivalently, the level of real GDP for which desired national saving S equals desired domestic and foreign investment Id + If, given that X - M is (approximately) equal to If.


How Does the Open Macroeconomy Work?

Trade Depends on Income
In the short run (and within the economy's supply capabilities), domestic production is determined by aggregate demand: Y = AD = C + Id + G + (X - M) = E + (X - M), where Y is both domestic production and national income, and E is national expenditure on goods and services. Consumption C is a positive function of Y (inclusive of the effects of taxes T), and real domestic investment Id is a negative function of the interest rate i.

Consumption expenditure depends on domestic income (Y):

Real private domestic investment is negatively related to the level of interest rates, i, in the economy:


How Does the Open Macroeconomy Work?

A More Complete Framework: Three Markets
The IS-LM-FE model provides a more complete framework for analyzing the open macroeconomy. It shows the determination of the short-run equilibrium levels of the country's real GDP and interest rate while also indicating the state of the country's official settlements balance (or, equivalently, the pressure on the exchange rate value of the country's currency).

Three types of markets:
Domestic product market
Money market


How Does the Open Macroeconomy Work?

A Framework for Macroeconomic Analysis
This chapter provides a framework and model for analyzing international macroeconomics. We judge the performance of a national economy against two objectives. Internal balance involves both full employment and price stability or an acceptable rate of inflation. External balance involves a reasonable and sustainable makeup of the country's international payments, taken to be approximately an official settlements balance that is zero.

Our model analyzes the economy in the short run, when prices are “sticky” and slow to respond to various demand shocks, such as changes in the money supply.

Beyond the short run, the price level does respond to demand and supply shocks. This means that the amount of inflation the country experiences eventually depends on the rate of growth of the country’s money supply.

In addition, the economy tends toward full employment in the long run.


How Does the Open Macroeconomy Work?

Domestic Production and Unemployment
5.The intersection of the IS and LM curves indicates a short-run equilibrium in the country’s market for goods and services (the IS curve) and a short-run equilibrium in the country’s market for money (the LM curve). The intersection indicates the equilibrium level of the country’s real domestic product and income (its real GDP) and the equilibrium level of its interest rate.


How Does the Open Macroeconomy Work?

2.Disagree. The recession in the United States reduces U.S. national income, so U.S. residents reduce spending on all kinds of things, including spending on imports. The decrease in U.S. imports is a decrease in the exports of other countries, including Europe’s exports to the United States. The reduction in European exports reduces production in Europe, so the growth of real GDP in Europe declines. A recession in the United States is likely to lower the growth of European real GDP.


How Does the Open Macroeconomy Work?

11.The real exchange rate value of the dollar increased from 90 to 100, so the U.S. dollar had a real appreciation. The United States lost international price competitiveness. (For the import and export functions shown in equations 22.13 and 22.14, the ratio (Pf e/P) is an indicator of the U.S. international price competitiveness. Stated this way, the real exchange rate is measuring the real exchange-rate value of the foreign (rest of the world) currency—the nominal exchange rate e is valuing foreign currency and the foreign currency product price index Pf is in the numerator. The rest of the world experienced a real depreciation (from 111 to 100), so the rest of the world gained international price competitiveness.) A change in international price competitiveness drives a change in the country’s net exports and current account, so the IS and FE curves shift. A decline in international p


How Does the Open Macroeconomy Work?

We have chosen to focus more on the complete model, and to reduce the treatment of spending multipliers by presenting the explicit formula for only the small, open-economy multiplier. Foreign income repercussions are covered intuitively and with examples. An instructor who wants to cover more on multipliers may want to prepare a class handout of a few pages that works through multipliers with foreign income repercussions.
Suggested answers to end of chapter questions and problems
1.Mexico. The United States and Mexico have close trading ties, with most of Mexico’s exports destined for the United States. If national production and income increase in the United States, the relatively large increase in Mexican exports to the United States increases Mexico’s domestic product by a substantial amount. For countries other than Mexico and Canada, the shares of their exports that go to the United


How Does the Open Macroeconomy Work?

The final piece of the framework that we develop in the text is that the country's exports and imports depend on international price competitiveness, in addition to depending on national incomes. The price of foreign-produced traded products relative to the price of home-produced substitute products is Pf e/P, where e is measured as units of domestic currency per unit of foreign currency. This ratio is essentially the (inverse of the country’s) real exchange rate introduced in Chapter 19. The country's demand for imports is a negative function of this price ratio, while demand for the country's exports is a positive function. A change in price competitiveness causes a change in net exports, so that both the IS and the FE curves shift.
Tips


How Does the Open Macroeconomy Work?

Which of the following is NOT a fundamental objective for the performance of a country's macroeconomy?

A reasonable and sustainable balance of payments with the rest of the world


How Does the Open Macroeconomy Work?

The goal of internal balance includes

a reasonable and sustainable balance of payments with the rest of the world.


How Does the Open Macroeconomy Work?

If C represents aggregate consumption, Id represents domestic investments, G represents government expenditures, E represents national expenditures on goods and services, X represents foreign demands for exports, and M represents domestic demand for imports, then aggregate demand for this country equals

Domestic Production Depends on Aggregate Demand


How Does the Open Macroeconomy Work?

Equilibrium gross domestic product (GDP) in the short run is determined at the point where

gross domestic production equals aggregate demand.

domestic production equals domestic consumption.

Equilibrium GDP and Spending Multipliers


How Does the Open Macroeconomy Work?

Real domestic investment spending is

positively related to the marginal propensity to consume.

negatively related to the level of interest rates in the economy.

positively related to government spending.

negatively related to the exchange rate.


How Does the Open Macroeconomy Work?

The amount by which imports increase when income goes up by one dollar is called


How Does the Open Macroeconomy Work?

If the marginal propensity to save is 0.3 and the marginal propensity to import is 0.2, then value of the simple spending multiplier is


How Does the Open Macroeconomy Work?

The greater the marginal propensity to import, the


How Does the Open Macroeconomy Work?

For a small open economy, assume that the marginal propensity to import is 0.3, and that interest rates, exchange rates, and the price level are all constant. If an increase of $10 billion in government spending results in an increase of $6 billion in imports, then

real gross domestic product (GDP) increases by $4 billion.

real domestic investment decreases by $4 billion.


How Does the Open Macroeconomy Work?

Fiscal policy consists of

changes in money supply and interest rates.

changes in government expenditures and taxes.

changes in the official settlements balance.


How Does the Open Macroeconomy Work?

If the marginal propensity to save is 0.3, the marginal propensity to import is 0.1, and the government increases expenditures by $10 billion, ignoring foreign-income repercussions, how much will gross domestic product (GDP) rise?


How Does the Open Macroeconomy Work?

When considering foreign-income repercussions, the spending multiplier is

smaller because an increase in domestic imports causes a current account deficit.

larger because an increase in domestic imports causes foreign income to rise and thus boosts domestic exports.

smaller because an increase in domestic imports lowers the growth in domestic exports.

larger because an increase in domestic imports causes a surplus in the official settlements balance.


Internal and External Balance with Fixed Exchange Rates

From the Balance of Payments to the Money Supply
When the country has an official settlements balance surplus, and its central bank intervenes to prevent its currency from appreciating, the central bank must sell domestic currency and buy foreign currency. This increases the central bank's holdings of official reserves and increases its liabilities as the domestic currency is added to the economy.

If the country has an official settlement balance surplus, so that the exchange-rate value of the country’s currency is experiencing upward pressure, the central bank must intervene to buy foreign currency and sell domestic currency. This will have the following effects on the central bank’s balance sheet:

Official international reserve holdings increase so that R will rise.

Liabilities increase, probably an increase in bank deposits at the central bank.


From Money Supply Back to the Balance of Payments
A Tale of Three Countries: (a) If Germany had raised taxes in 1991, then the story probably would have turned out better. If Germany raised taxes, then more of the effort to restrain the excessive growth and overheating of the German economy would have been driven by a shift to the left of Germany’s IS curve (from IS2 back toward IS1), so less of the restraint would have come from the tightening of German monetary policy (Germany’s new LM3 would be to the right of the LM3 shown in the box).

If the country begins with a surplus in its overall balance, the surplus requires the central bank to buy foreign currency and sell domestic currency.

As the central bank increases the monetary base (bank reserves), it tends to reduce interest rates.

The lower interest rates will have several effects on the country’s balance of payments.


Sterilization
Rather than allowing these automatic adjustments toward external balance, the monetary authority can resist by sterilization—taking an offsetting domestic action (like an open market operation) to reduce or eliminate the effect of the intervention on the domestic money supply. This is a wait-and-see strategy. There are limits to how long the country can continue to run an overall payments imbalance.

The central bank can keep the external surplus or deficit from having an impact on the domestic money supply by taking offsetting actions.

is action by the central bank to reverse the effects of official intervention on the domestic money supply.


Monetary Policy with Fixed Exchange Rates
A Tale of Three Countries: (a) If Germany had raised taxes in 1991, then the story probably would have turned out better. If Germany raised taxes, then more of the effort to restrain the excessive growth and overheating of the German economy would have been driven by a shift to the left of Germany’s IS curve (from IS2 back toward IS1), so less of the restraint would have come from the tightening of German monetary policy (Germany’s new LM3 would be to the right of the LM3 shown in the box).

Under a fixed exchange-rate regime, the government must defend that rate.

The first line of defense is official intervention: The monetary authority (the central bank) buys or sells foreign currency in the foreign exchange market as necessary to keep the exchange rate within the allowable band around the pegged exchange-rate value.


Fiscal Policy with Fixed Exchange Rates
A change in fiscal policy has two opposing effects on the country's overall payments balance. For instance, a shift to expansionary fiscal policy tends to increase both interest rates and real GDP, so the financial account tends to improve while the current account tends to deteriorate. If the former predominates, then the country's overall payments tend to go into surplus.

The effectiveness of fiscal policy will depend on the responsiveness of capital flows to the interest rate changes following a fiscal policy.

If capital flows are very sensitive to interest rate changes (high capital mobility), then the capital flows will be very large, and the official settlements balance will go into surplus.

If capital flows are unresponsive (low capital mobility), then the financial account will only improve a little, and the overall balance will go into deficit.


Perfect Capital Mobility
In the extreme case of perfect capital mobility (with investors expecting the fixed rate to be maintained), monetary policy has no independent effectiveness even in the short run, while fiscal policy has a strong (full spending multiplier) effect on real GDP. The FE curve is a flat line, and the LM curve is effectively this same flat line.

A practically unlimited amount of international financial capital flows in response to the slightest change in one country’s interest rates.

Perfect capital mobility with fixed exchange rates:

Makes it impossible for monetary policy to influence interest rates or the domestic economy.


Shocks to the Economy
We can examine how shocks affect the economy of a country with a fixed exchange rate. A domestic monetary shock has a limited effect. A change in fiscal policy is an example of a domestic spending shock. An international capital flow shock shifts the FE curve. The intervention to defend the fixed exchange rate results in effects on the domestic economy.

Internal shocks
Domestic monetary shocks
Domestic spending shocks


Imbalances and Policy Responses
We can examine how shocks affect the economy of a country with a fixed exchange rate. A domestic monetary shock has a limited effect. A change in fiscal policy is an example of a domestic spending shock. An international capital flow shock shifts the FE curve. The intervention to defend the fixed exchange rate results in effects on the domestic economy.

A country wants to achieve both internal balance and external balance. Yet, its actual performance often falls short of these goals.

The government of a country in one of the two dilemma cases (deficit and high unemployment, or surplus and rapid inflation) has three basic choices:

Abandon the goal of external balance (abandon the fixed exchange rate).


c.The rightward shift of the IS curve results in a new IS'-LM intersection with some increase in the level of domestic product. The increase in domestic product and income also increases the country's imports. To proceed, let's examine the "normal" case in which the country then has a current account and overall payments surplus, because the increase in exports is larger than the initial increase in imports. This means that the intersection of the original LM curve and the new IS' curve at E' is to the left of the new FE' curve. If the country's official settlements balance goes into surplus, then the country's central bank must intervene to defend the fixed exchange rate by buying foreign currency and selling domestic currency.


The effect of a large, abrupt change in the exchange rate on the value of the country's current account (or trade) balance is not so straightforward. The value of the country's current account, measured in foreign currency (superscript fc), is CA = Pfcx X Pfcm M. The effects of a devaluation of the country's currency are: (1) no change or decrease in the foreign currency price of its exports (Pfcx), (2) no change or increase in the volume of exports (X), (3) no change or decrease in the foreign currency price of its imports (Pfcm), and (4) no change or decrease in the volume of imports (M). The response of the trade balance could be unstable (that is, the value of the balance could decline rather that improve) if the decrease in the foreign currency price of exports is large relative to the other changes—an extreme example is perfectly inelastic demands for exports and imports. The respo


A Tale of Three Countries: (a) If Germany had raised taxes in 1991, then the story probably would have turned out better. If Germany raised taxes, then more of the effort to restrain the excessive growth and overheating of the German economy would have been driven by a shift to the left of Germany’s IS curve (from IS2 back toward IS1), so less of the restraint would have come from the tightening of German monetary policy (Germany’s new LM3 would be to the right of the LM3 shown in the box). German interest rates would not have risen so much (maybe not at all). There would have been less (or no) pressure on France and Britain to tighten their monetary policies to try to match rising German interest rates. (b) If, instead, France had reduced taxes in 1991, the story also probably would have turned out better (at least for France). France could have used the assignment rule. Direct monetary


This chapter presents the analysis of the macroeconomy of a country that has a fixed exchange rate. As noted in the introduction, this analysis is important because some countries currently have fixed exchange rates or floating rates that are so heavily managed that they resemble fixed rates, and because there are ongoing discussions of proposals to return to a system of fixed rates among the world's major currencies. We focus on defense of the fixed exchange rate through official intervention in the foreign exchange market.


Internal and External Balance with Fixed Exchange Rates

Which of the following can be considered as domestic assets of a country's central bank?

The country's government bonds owned by the central bank

Foreign currency assets held by the central bank

From the Balance of Payments to the Money Supply


Internal and External Balance with Fixed Exchange Rates

The sum of currency issued by the central bank and bank deposits at the central bank is called


Internal and External Balance with Fixed Exchange Rates

Official intervention in the foreign exchange market to defend a fixed-exchange rate when the value of the country's currency is under downward pressure causes

a downward pressure on the country's interest rates.

no change in the liabilities of the central bank.


Internal and External Balance with Fixed Exchange Rates

Consider a country that has an official settlements balance surplus and is experiencing upward pressure on the exchange-rate value of its currency. Which of the following will NOT be true in this context?

The central bank of this country must intervene to buy foreign currency and sell domestic currency.

Its balance sheet will show an increase in official international reserve holdings.

Its balance sheet will show an increase in its liabilities.

For the regular bank that is involved in the intervention transaction, the central bank decreases the bank's deposits at the central bank.

From Money Supply Back to the Balance of Payments


Internal and External Balance with Fixed Exchange Rates

A(n) ________ of the money supply in a country ________ the domestic interest rates.


Internal and External Balance with Fixed Exchange Rates

A(n) ________ in a country's money supply causes international capital


Internal and External Balance with Fixed Exchange Rates

The initial impact of ________ the money supply ________ the balance of payments.


Internal and External Balance with Fixed Exchange Rates

Assuming no effect on exchange rates, which of the following is likely to happen if the money supply in a country contracts?

Decline in the international price competitiveness


Internal and External Balance with Fixed Exchange Rates

Following an expansion of the money supply, a government committed to maintaining a fixed exchange rate must

accept a surplus in its current account.

increase its level of government expenditure and autonomous investments.

intervene in the foreign exchange market to sell foreign currency and buy domestic currency.


Internal and External Balance with Fixed Exchange Rates

Which of the following indicates taking an action to reverse the effect of official intervention on the domestic money supply?


Internal and External Balance with Fixed Exchange Rates

If a country starts with a surplus in its official settlements balance, intervention to defend a fixed exchange rate will cause

the money supply to expand and the economy to grow.

both the money supply and the economy to contract.

the money supply to grow and the economy to contract.

the money supply to contract and the economy to grow.


Internal and External Balance with Fixed Exchange Rates

There are limits to the ability of monetary authorities to use sterilized intervention in the case of a deficit because

the central bank may be unwilling to increase its holdings of foreign currency beyond a certain limit.

the pressure from foreign countries to allow the domestic currency to appreciate will lead to large losses.

the central bank's ability to constantly obtain foreign currency for the sterilized intervention is constrained.

the export level is fixed and it cannot be allowed to drop.


Floating Exchange Rates and Internal Balance

Monetary Policy with Flexible Exchange Rates
With floating exchange rates monetary policy exerts strong influence on domestic product and income. A change in monetary policy results in a change in the country's interest rates. Both the current account and the financial account tend to change in the same direction. To keep the overall payments in balance, the exchange rate must change.

Shocks to the economy alter both the international performance of the country’s economy and its domestic performance.

With floating exchange rates, a change in the exchange rate takes care of achieving external balance following a shock.

If the country’s overall payments tend to go into deficit, then the country’s currency depreciates, reversing the tendency toward deficit.


Fiscal Policy with Flexible Exchange Rates
With floating exchange rates the effect of a change in fiscal policy depends on how responsive international capital flows are to changes in interest rates. If capital flows are sufficiently responsive, then the exchange rate changes in the direction that counters the thrust of the fiscal policy change—an effect sometimes called international crowding out.


International Macroeconomic Policy Coordination
Changes in government policies adopted by one country can have spillover effects on other countries. International macroeconomic policy coordination involves some degree of joint determination of several countries' macroeconomic policies to improve joint performance. Efforts at policy coordination in the late 1970s and 1980s include the agreement at the Bonn Summit of 1978, the Plaza Agreement of 1985, and the Louvre Accord of 1987, but major efforts at coordination are infrequent.

The policies adopted by one country have effects on other countries.

A policy change that benefits the country making it may harm other countries.

A country may fail to make a policy change that benefits other countries.


Shocks to the Economy
Domestic monetary shocks have strong effects on domestic product, with the exchange rate change reinforcing the thrust of the shock. The effects of domestic spending shocks depend on how responsive international capital flows are to changes in interest rates. International capital flow shocks affect the domestic economy by changing the exchange rate and the country's international price competitiveness.

Internal Shocks
Domestic monetary shocks
Domestic spending shocks


Internal Imbalance and Policy Responses
While a cleanly floating exchange rate ensures external balance, it does not ensure internal balance, and changes in the floating exchange rate to achieve external balance can exacerbate an internal imbalance. Government monetary or fiscal policies may be used to address internal imbalances.


International Microeconomic Policy Coordination
Changes in government policies adopted by one country can have spillover effects on other countries. International macroeconomic policy coordination involves some degree of joint determination of several countries' macroeconomic policies to improve joint performance. Efforts at policy coordination in the late 1970s and 1980s include the agreement at the Bonn Summit of 1978, the Plaza Agreement of 1985, and the Louvre Accord of 1987, but major efforts at coordination are infrequent.


Floating Exchange Rates
Floating Exchange Rates and Internal Balance


This is what did happen. On March 18, the monetary authorities of Japan, the United States, Britain, Canada, and the euro area conducted a coordinated intervention totaling about $10.4 billion. Within an hour of the announcement of the impending intervention, the yen depreciated 3 to 4 percent and then stayed at the lower exchange rate values for the next week.
Suggested answers to end of chapter questions and problems
1.Agree. The change in the exchange rate that occurs when there is a change in monetary policy is the basis for the enhanced effectiveness of monetary policy under floating exchange rates. For instance, when monetary policy shifts to be more expansionary, the decrease in the country’s interest rate results in a depreciation of the country’s currency. This is essentially overshooting (although overshooting also emphasizes that this depreciation is very large). It is oversho


The box on “Why Are U.S. Trade Deficits So Big?” provides an application of the floating-rate analysis to the macroeconomic experience of the United States since 1980. The box shows that changes in the real exchange rate and changes in the trade deficit (with the expected lag) have been closely correlated. Digging behind this relationship to examine saving and real investment, it appears that the large U.S. trade deficits were the result of the government budget deficit in the 1980s, and were the result of a real investment boom in the late 1990s, with the fiscal deficit again becoming important in the early 2000s.


c.If the dollar depreciates, then the United States gains international price competitiveness. U.S. exports increase and imports decrease. The current account improves further. The increase in exports and shift of domestic spending from imports to domestic products add some aggregate demand, so domestic product and income rebound somewhat (or do not decline by as much).


Changes in government policies adopted by one country can have spillover effects on other countries. International macroeconomic policy coordination involves some degree of joint determination of several countries' macroeconomic policies to improve joint performance. Efforts at policy coordination in the late 1970s and 1980s include the agreement at the Bonn Summit of 1978, the Plaza Agreement of 1985, and the Louvre Accord of 1987, but major efforts at coordination are infrequent. Countries disagree about goals and about how the macroeconomy works, and the benefits of coordination often are probably rather small.


Floating Exchange Rates and Internal Balance

Under a floating exchange-rate regime

only fiscal policy should be used to reconcile the goals of internal and external balance.

the changes in the exchange rate can take care of external balance, leaving macroeconomic policy to take care of internal balance.

deficits and surpluses in the official settlements balance will be the primary concern of policy makers.

monetary policy must be used to manage the exchange rate.

Monetary Policy with Flexible Exchange Rates


Floating Exchange Rates and Internal Balance

Changes in floating exchange rates move a country's economy to:

a zero value for its official settlements balance.


Floating Exchange Rates and Internal Balance

Other fundamental things equal, an increase in the exchange-rate value of the domestic currency will make domestic goods

less competitive in the international markets.


Floating Exchange Rates and Internal Balance

Other fundamental things being equal, a decrease in the exchange rate value of the domestic currency will make domestic goods


Floating Exchange Rates and Internal Balance

Other fundamental things being equal, an increase in the exchange-rate value of the domestic currency will cause the current account to

become smaller than the (nonofficial) financial account.


Floating Exchange Rates and Internal Balance

Other fundamental things being equal, a decrease in the exchange rate value of domestic currency will cause the current account to


Floating Exchange Rates and Internal Balance

An expansion of the money supply by the country's central bank

decreases the willingness of banks to lend money.

increases the level of international capital inflows.


Floating Exchange Rates and Internal Balance

Under a floating exchange-rate regime, an expansion in the money supply will

induce financial capital to leave the country.

attract speculative capital into the country.

have no effect on financial account balance.

cause a surplus in the official settlement balance.


Floating Exchange Rates and Internal Balance

Under a floating exchange-rate regime, following an expansion in the country's money supply, the country's monetary authority

must buy foreign currency in the foreign exchange market.

must buy domestic currency in the foreign exchange market.

may not intervene in the foreign exchange market.

will be forced to reverse the monetary expansion.


Floating Exchange Rates and Internal Balance

Under a floating exchange-rate regime, the domestic currency will normally depreciate if the money supply

does not change with the change in the exchange rates.

is managed to keep the country's inflation rate steady.


Floating Exchange Rates and Internal Balance

With perfect capital mobility, uncovered interest parity always holds because

almost unlimited flows of capital can occur if there is any deviation from the parity.

lower domestic interest rates trigger hedging to avoid exchange-rate risks.

capital flows out at a much faster rate than it flows in if the interest rate changes.

the no-arbitrage condition cannot be satisfied without using forward contracts.


Floating Exchange Rates and Internal Balance

Under a floating exchange-rate regime with a low degree of capital mobility, if the domestic government uses an expansionary fiscal policy

foreign capital outflows decrease domestic product.

the financial account balance deteriorates.

the official settlements balance tends to go into surplus.

Fiscal Policy with Flexible Exchange Rates


National and Global Choices: Floating Rates and the Alternatives

Key Issues in the Choice of Exchange-Rate Policy
The text examines five key issues that can influence a country's choice. Figure 25.1 presents a summary of implications of the key issues for the advantages of each policy choice.

The effectiveness of government policies


National Choices
National and Global Choices: Floating Rates and the Alternatives


Extreme Fixes
If the only relevant national goal is to defend the fixed rate, then the currency board is probably better. Because the currency board holds no domestic-currency assets, the currency board cannot sterilize its foreign exchange intervention. The domestic money supply must change with the intervention, and the adjustments to eliminate the payments imbalance takes place.

attempts to establish a fixed exchange rate that is long-lived by mandating that the board, acting as the country’s monetary authority, should focus almost exclusively on maintaining the fixed rate.


The International Fix – Monetary Union
The members of the European Union (EU) are pursuing an international fix—a monetary union in which exchange rates are permanently fixed among the currencies of the countries in the union and a single monetary authority conducts a unionwide monetary policy. As mentioned previously in Chapter 20, in 1979 the EU countries established the European Monetary System, and most became members of its Exchange Rate Mechanism (ERM), an adjustable pegged rate system among its members' currencies.

exchange rates are permanently fixed and a single monetary authority conducts a single, unionwide monetary policy.

In 1999, a subset of countries in the European Union implemented a monetary union with a single currency, the euro, and the European Central Bank as the monetary authority.


Effects of Macroeconomic Shocks
Key gains from European Monetary Union are the elimination of exchange rate risk and the elimination of the transaction costs of exchanging currencies. Key risks include the loss of national use of exchange rate changes and monetary policy to address shortcomings in national economic performance. The ECB’s monetary policy can address union-wide macroeconomic performance shortcomings, as it did starting in 2015 when the ECB began an aggressive quantitative easing to address very low euro area inflation rates, slow real GDP growth, and high unemployment rates.


The Effectiveness of Government Policies
Each country must make its own decision about its exchange rate policy. Several of these key issues seem to be important for most countries. Strong arguments in favor of a country's choosing a floating exchange rate are the use of changes in the floating exchange rate to achieve external balance, so that monetary policy can be used to pursue domestic objectives, the ability to set its own goals and policies, and the reduced need to hold official international reserves to defend against speculative attacks on the fixed rate.


Differences in Macroeconomic Goals, Priorities, and Policies
Third, countries that have their currencies linked through fixed exchange rates must achieve consistency in their macroeconomic policies, so that the fixed rate can be defended and maintained. If countries have different goals, priorities, and policies, then they will favor floating exchange rates.


The members of the European Union (EU) are pursuing an international fix—a monetary union in which exchange rates are permanently fixed among the currencies of the countries in the union and a single monetary authority conducts a unionwide monetary policy. As mentioned previously in Chapter 20, in 1979 the EU countries established the European Monetary System, and most became members of its Exchange Rate Mechanism (ERM), an adjustable pegged rate system among its members' currencies. By mid-1992 all EU members except Greece were members of the ERM. Then a series of speculative attacks weakened the ERM—Britain and Italy left it in 1992, realignments were necessary for the central rates of the currencies of some other countries, and the bands for nearly all currencies were widened to plus or minus 15 percent in 1993. After 1993 the exchange rates within the ERM were generally steady, and a


Fiscal policy has become a flash point for the euro area. In the absence of national monetary policy and national exchange rate policy, national fiscal policy should be valuable as the key tool for national macroeconomic stabilization. But national governments may sometimes run excessive fiscal deficits and build up excessive government debt. The Stability and Growth Pact attempted to impose limits on the size of national government budget deficits, but the pact was weakened in 2005. Then the global financial and economic crisis led to ballooning deficits in some euro-area countries. Greece had to be rescued from a government debt crisis in 2010, followed by Ireland and Portugal. In mid-2011 the government debts of Spain and Italy came under market pressures. National fiscal policies and national government debt were central to the crisis that threatened the viability of the euro. The eu


Key gains from European Monetary Union are the elimination of exchange rate risk and the elimination of the transaction costs of exchanging currencies. Key risks include the loss of national use of exchange rate changes and monetary policy to address shortcomings in national economic performance. The ECB’s monetary policy can address union-wide macroeconomic performance shortcomings, as it did starting in 2015 when the ECB began an aggressive quantitative easing to address very low euro area inflation rates, slow real GDP growth, and high unemployment rates. But, a major challenge for the member countries is finding effective mechanisms for national adjustments when adverse economic shocks affect different countries in different ways (for instance, Germany and Ireland during the early 2000s). Labor mobility between member countries is low. “Internal devaluation” to improve international


Given the importance of having and maintaining similar inflation rates for the success of fixed exchange rates, the most important criterion is probably that related to the country's inflation rate. The criteria related to government budget deficits and debt seem to be more debatable. A country that shifts to completely fixed exchange rates has given up the ability to use national monetary policy and exchange rate changes in seeking to address imbalances. This country may need to use fiscal policy more actively, including sometimes running large budget deficits. If the criteria also restrain the independence of fiscal policy, the country's government is left with little in the way of policy tools to address national imbalance. However, the series of government debt crises that hit Greece, Ireland, and Portugal beginning in 2010 show that excessive fiscal deficits and government debts can


National and Global Choices: Floating Rates and the Alternatives

Which of the following is most likely to happen if the demand for money decreases in the domestic economy under floating exchange rates and free capital mobility?

The domestic interest rate will increase.

The financial account of the country's balance of payments will deteriorate.

The average price level in the domestic economy will decrease.

Key Issues in the Choice of Exchange-Rate Policy


National and Global Choices: Floating Rates and the Alternatives

Monetary policy is most effective in influencing aggregate demand

under a freely floating exchange-rate system.

under a fixed exchange-rate system with sterilization.

under a fixed exchange-rate system without sterilization.


National and Global Choices: Floating Rates and the Alternatives

Fiscal policy is most effective in influencing aggregate demand

under a floating exchange-rate system with a low degree of capital mobility.

under a floating exchange-rate system with a high degree of capital mobility.


National and Global Choices: Floating Rates and the Alternatives

Those who advocate a return to a real gold standard believe that doing so would

force countries to pursue sustainable fiscal policies.

allow countries to earn a higher rate of  interest on their holdings of international reserve assets.

reduce unemployment rates by allowing countries to have independent monetary policies.

reduce inflation rates by imposing strong discipline on national monetary authorities.


National and Global Choices: Floating Rates and the Alternatives

Under a gold standard, a major discovery of a new gold deposit would


National and Global Choices: Floating Rates and the Alternatives

A domestic monetary shock is least disruptive

under both fixed and floating exchange rates.


National and Global Choices: Floating Rates and the Alternatives

The process of "demonetization of gold" involves

the purchase of gold and supply of money into the market by the central banks to defend the fixed gold prices.

a sudden fall in private demand for gold in a country due to discovery of a minable gold deposit.

gold sales into the private market in recent decades by central banks and the International Monetary Fund (IMF).

a sudden increase in the private demand for gold in a country, forcing its central bank to sell off gold.


National and Global Choices: Floating Rates and the Alternatives

A domestic spending shock is likely to be least disruptive under a

floating exchange-rate system when there is high capital mobility.

fixed exchange-rate system when there is high capital mobility.

fixed exchange-rate system without sterilization.

floating exchange-rate system when there is low capital mobility.


National and Global Choices: Floating Rates and the Alternatives

For an international capital-flow shock in which foreign investors lose confidence in a country

the country's real domestic product is affected if the country has a fixed exchange rate but is not affected if the country has a floating exchange rate.

the country's real gross domestic product (GDP) decreases regardless of whether the country has a fixed or floating exchange rate, but the country's real GDP declines less if the country has a floating exchange rate.

the country's real domestic product is affected if the country has a floating exchange rate but not affected if the country has a fixed exchange rate.

the country's real GDP tends to decline if the country has a fixed exchange rate, but the country's real GDP tends to increase if the country has a floating exchange rate.


National and Global Choices: Floating Rates and the Alternatives

Export demand shocks are likely to be least disruptive to a country with

a fixed exchange-rate system with sterilization.

a fixed exchange-rate system without sterilization.


National and Global Choices: Floating Rates and the Alternatives

An international trade shock arising from a sudden increase in import demand is likely to be least disruptive to a country with

a surplus in the overall payment balance.


National and Global Choices: Floating Rates and the Alternatives

Which of the following statements is true?

A domestic monetary shock is less disruptive with floating exchange rates.

If foreign capital is highly responsive to changes in interest rates, then domestic spending shocks are less disruptive with fixed exchange rates.

With floating exchange rates, the transmission of business cycles through foreign trade and repercussion is less than with fixed exchange rates.

International capital-flow shocks have domestic effects under fixed exchange rates but not under floating exchange rates.