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Exchange Rate Regimes Notes

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THE CHOICE OF EXCHANGE RATE REGIMES


Policy trilemma o Fixed exchange rate o Capital controls o Monetary policy


MDC's might choose to adapt capital controls as well o Don't just focus on LDC's


Flexible ER - insulate economy from shocks (insulating hypothesis)


Hollowing out of the middle - 'bipolar view' o Movement away from the middle ground between flexible and fixed o Many of the major financial crises - soft pegs suffered from speculation o Bank credibility - decrease uncertainty
 If fixed but not fixed to e.g. US$, central bank can just revalue/devalue ER


Credibility problem o Revalue/devalue ER rather than change IR which is more painful o Middle ground between flexible and fixed - aim to get positive bits from both but just get negative
 Monetary policy dependent on country that is extremely different to you
 And don't get credibility
 Lose on both fronts 'ER regimes. Is there a third way?' Joshi 'Currency unions: a survey of the issues' Masson & Taylor


'A currency union may be defined as a geographical area throughout which a single currency circulates as the principal medium of exchange'


Monetary policy issues o Facilitating transactions and ensuring price stability
 'social benefit derived from money is, moreover, enhanced by stability in its value, that is, by price stability.'
 'The widest possible use of a single money that exhibits such stability would miminise transactions costs and maximise its informational role' - 'call for a single world money, or global currency area' - i.e. joining a currency union can reduce unfavourable effects of ER uncertainty on trade and investment provided price stability
 Also, a country may join a monetary union with a low inflation country in order to 'enhance the anti-inflationary credibility of its own monetary policy.'


'tying the hands of the domestic monetary authority in this fashion may enhance its anti-inflationary credibility.' o Monetary policy institutions in a currency union
 If there is a dominant country 'its CB would to some degree set monetary policy for the union as a whole.'


Advantages for other countries if that currency were the most stable in its prices
 Monetary policy could alternatively be set by a supra-national institution


Room for manoeuvre of monetary policy is slight


Ensure an effective commitment to price stability o Seigniorage
 Goal of price stability may conflict with an attempt to use monetary expansion to finance government expenditure, as an alternative to raising revenue by conventional forms
 But 'in many cases, inflation is an unintended consequence of undisciplined policies.'


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Traditional criteria for successful currency unions Factor mobility
 Mundell argued that unless factors of production can freely move between regions, shifts in demand facing one region relative to another may lead to unemployment in the absence of flexibility of the nominal ER


Relatively low mobility of labour is thus a potential handicap for the EC as it progresses towards monetary union
 Expected returns to financial capital tend to be equalised across countries, but not the same for physical capital.


'lack of such arbitrage may explain the observed close correlation of savings and investment in industrial countries.'


'high mobility of financial capital allows, in principal, for financing differences between national saving and investment.' - but if adjustment requires private sector investment, issue of mobility of physical capital comes into play


ER stability tends to enhance capital mobility
 'It is therefore doubtful that formation of a currency union can, in and of itself, lead to a sufficient mobility of physical capital either to cushion shocks completely or to lead to quick elimination of underdevelopment.' Openness and regional interdependence
 Reduction in transaction costs - increase in trade
 EC countries have a high proportion of internal, relative to external trade


On this criterion, EC would seem to have the makings of a natural common currency area Industrial and portfolio diversification
 If a country exports a wide variety of goods, and shocks are primarily either to supply or to consumer preferences, then the effect of a shock on output in the whole economy will be less than the effect on individual industries


A diversified economy has less need to retain ER flexibility in the face of shocks
 Do currency unions increase inter or intra industry trade?


If intra industry trade, specialisation may occur but with countries remaining diversified so a shock to one industry should not affect countries asymmetrically Wage/price flexibility
 In some countries, response of wages and prices to nominal ER changes could be large enough to limit the usefulness of it as an instrument An overview of the traditional criteria
 No single overriding criterion
 Are shocks symmetric or asymmetric (affect countries differently)?


Similar industrial structures may imply symmetric
 Are shocks temporary or permanent?
 EC Commission highlights the following potential positive effects of currency union:


Intra-EMS ER shocks disappear


Elimination of expected devaluations dampens inflationary pressures


By enforcing coordination of monetary policies, monetary union would reduce costs related to the attempt to use the ER within the EC in a beggar-thy-neighbour fashion Fiscal policy within currency areas:

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