Brief Answers to Problems and Questions for Review

Brief answers to problems and questions for review

An inconvertible currency is one that cannot be freely traded for another country’s currency among domestic consumers and businesses.Under this system, the government or the central bank becomes a monopolist with respect to holding all foreign exchange and all residents and firms of the country are legally obligated to sell any foreign exchange to the government at a fixed price.Likewise, any resident or firm that needs foreign exchange must purchase it from the government at the same fixed price.

Under a system of exchange controls, it becomes relatively easy for the government to “fix” the price of foreign exchange.This exchange-rate system almost always requires the government to seriously control the flow of capital into and out of the country.

As a practical matter, exchange controls tend to cause a number of economic difficulties.First, there is the simple annoyance of dealing with a government bureaucracy.The government must sell or buy all foreign exchange earned and requested by residents and firms within the country.A more serious difficulty arises with respect to the difference between the nominal exchange rate and the real exchange rate.When a country fixes the exchange rate, this usually means that the exchange rate is fixed in nominal terms.So long as the nominal exchange rate is close to its purchasing power parity value, then a nominal peg may be sustainable over time.A common problem in this regard is that a country’s domestic inflation may not be equal to the foreign rate of inflation.In this case, the country’s real exchange rate is depreciating and the nominal exchange rate is becoming overvalued.To balance the demand for foreign exchange with the supply of foreign exchange, the government can use one of three options.First, the government could allow the currency to depreciate.Second, the government could implement restrictive macroeconomic policies (contractionary fiscal and/or monetary policy) that would reduce the demand for foreign exchange.The third and most common option available to the government is to ration the available supply of foreign exchange in the domestic markets.

Figure 18.2 shows how an inconvertible currency could lead to a shortage of foreign exchange.The demand and supply of foreign exchange would only balance at E.If the demand for foreign exchange increases at all from D, then there is going to be a shortage of foreign exchange at the fixed exchange rate, XRe.

Intervention in the foreign exchange market occurs when the government or the central bank tries to change the supply of foreign exchange in order to influence the exchange rate.If the government buys foreign exchange this would shift the supply curve to the left and tend to cause a depreciation of the exchange rate.If the government sells foreign exchange this would tend to shift the supply curve to the right and cause an appreciation of the exchange rate.

Many countries “fix” their currency to the currency of another country using intervention in the foreign exchange market.Intervention simply refers to the government buying and selling foreign exchange to influence the value of the exchange rate.A country’s central bank usually conducts intervention in the foreign exchange market.The government can maintain the exchange rate in the short run by either selling or buying foreign exchange.In the long run, the country can maintain the exchange rate so long as it can sell or buy foreign exchange.In theory, a country can buy foreign exchange (sell domestic currency) forever and keep its exchange rate from appreciating.However, a country can only sell foreign exchange for a limited period of time before it runs out of foreign exchange.In order for a country to maintain the “fixed” exchange rate over time, internal balance must be adjusted to be consistent with the fixed exchange rate.In this case, the government intervention has two major effects.First, in the short run the government intervention stabilizes the exchange rate.Second, the intervention has set into motion an automatic adjustment process that virtually guarantees that the private sector balance of payments deficit will not persist in the long run.The government intervention causes the domestic money supply to fall. As the money supply falls, aggregate demand also falls and the equilibrium levels of output and the price level both decline.As this occurs, the government’s need to intervene in the foreign-exchange market would also diminish.In this case, the government has maintained the fixed exchange rate by reducing the equilibrium level of output or the rate of economic growth.A fixed exchange rate arrangement has the advantage of not only “fixing” the exchange rate, but it also automatically adjusts the economy to a sustainable external equilibrium.Maintaining a fixed exchange rate through intervention means that a country cannot use discretionary monetary policy to influence the economy.This loss of monetary policy occurs because in order to maintain a fixed exchange rate, the monetary base and the money supply become a function of the country’s external balance.

A current account deficit would cause a leftward shift of the aggregate demand curve that could contribute to a recession.With a fixed exchange rate, it might be necessary for the government to sell foreign exchange in order to maintain the exchange rate.This sort of intervention could lead to a falling money supply as the selling of foreign exchange leads to the withdrawal of domestic currency from the banking system.A falling money supply would definitely lower aggregate demand.

A current account surplus and a fixed exchange rate would lead to the buying of foreign exchange.This buying of foreign exchange would mean an injection of money into the domestic banking system that could lead to an expansion of the money supply.These factors would lead to a significant increase in aggregate demand that might put severe upward pressure on the price level (P).

Under a fixed exchange-rate system, there are two cases where monetary policy is consistent with both internal and external balance.For example, if an external deficit occurs when the economy has inflation, the response of monetary policy (contraction of the money supply) that automatically occurs will move the economy towards full employment and lower inflation.Also, if an external surplus occurs when the economy is at less than full employment, the response of monetary policy (expansion of the money supply) that automatically occurs will move the economy closer to full employment.

Under a fixed exchange-rate system, there are two cases that require the country to sacrifice the interests of internal balance in order to maintain the country’s external balance.For example, if an external deficit occurs when the economy is at less than full employment, the response of monetary policy (contraction of the money supply) that automatically occurs will move the economy further away from full employment.In this situation, the automatic adjustment requires the country to suffer a recession to maintain the fixed exchange rate.Also, if a country has an external surplus coupled with a period of inflation or a rapid period of economic growth, the response of monetary policy (expansion of the money supply) that automatically occurs will move the economy to even higher inflation or even more rapid economic growth.

The effects of expansionary fiscal policy lead to a government budget deficit that must be financed.In this case, the government’s extra borrowing causes interest rates to rise.In an open economy with freely flowing international capital, the rise in interest rates causes an inflow of foreign capital.As foreign capital moves into the domestic market, the supply of loanable funds is augmented by foreign capital.The inflow of foreign capital lowers interest rates.When the government adopts an expansionary fiscal policy, the inflow of foreign capital requires that foreign investors first sell foreign currency (i.e., buy domestic currency).The effect of the capital flows is clear.In this case, the government must intervene in the foreign-exchange market and buy foreign currency.This intervention in the foreign exchange market maintains the “fixed” or “pegged” exchange rate.The secondary effect of the government intervention is that the money supply changes.In this case, when the government buys foreign exchange it also sells currency and the money supply increases.The effect of the increase in the money supply is to increase the amount of loanable funds available and interest rates decline.Also, as the government adopts an expansionary fiscal policy, aggregate demand increases.The initial effect of this expansionary fiscal policy is to increase both domestic output and the price level.In addition to this initial effect, the intervention in the foreign exchange market and the resulting increase in the money supply cause aggregate demand to increase even further.The net result is that in an open economy with capital mobility and fixed exchange rates, the effects of expansionary fiscal policy are more pronounced.

Fiscal policy is effective in achieving internal balance when the exchange rate is fixed because as the government adopts an expansionary fiscal policy, aggregate demand increases.The initial effect of this expansionary fiscal policy is to increase both domestic output and the price level.In addition to this initial effect, the intervention in the foreign exchange market and the resulting increase in the money supply causes aggregate demand to increase even further.The net result is that in an open economy with capital mobility and fixed exchange rates, the effects of expansionary fiscal policy are more pronounced.

Technically, it is possible to separate monetary policy from intervention in the foreign exchange market.This separation is known as sterilization. For example, if the government is selling foreign exchange (international reserves) to maintain the exchange rate, this causes a decrease in the monetary base and the money supply.A government (central bank) can easily offset this effect through open market operations.The government knows exactly how much the intervention has reduced the monetary base, i.e., the government knows how much foreign currency it sold and how much domestic currency it bought in the foreign exchange market.In response to this intervention, the government could conduct open market operations in the domestic bond market by purchasing a like amount of bonds.The intervention in the foreign exchange market reduces the monetary base.However, this reduction in the monetary base can be sterilized by purchasing the equivalent amount of bonds.The net effect of intervention and sterilization on the domestic supply of money is therefore zero.In this way a government can keep the domestic money supply insulated from the intervention in the foreign exchange market.

Sterilization works best when the intervention in the foreign exchange market is used to correct relatively small deviations from purchasing power parity. In this case interventions are sufficiently small that the exchange rate policy will not badly distort the focus of monetary policy on the price level and real GDP.

If a country has a high rate of inflation then the amount of intervention necessary to fix the exchange rate may be large.If the constant selling of foreign exchange is sterilized, then the money supply will not fall and neither will the rate of inflation.This policy can continue only so long as the government has access to foreign exchange.If the supply of foreign exchange for intervention is interrupted, then the intervention would cease and the exchange rate would rapidly depreciate.

A useful variation on a fixed exchange rate is to fix (peg) the real exchange rate.In this case the nominal exchange rate would be allowed to change fairly frequently.What is held constant is the real exchange rate.The common term for this system is a crawling peg.The difficulty with maintaining an exchange rate that is pegged in nominal terms is that it requires that the ratio of changes in domestic prices to changes in foreign prices be constant. The difficulty with a pegged nominal exchange rate is that the real exchange rate may be fluctuating.A preferable policy with respect to the exchange rate is to peg the exchange rate in real terms.In practice, the country may set a preannounced rate of change in the nominal exchange rate based on inflation rate differences.Although participants in the foreign exchange market are facing an exchange rate that is changing, the amount of change is known in advance.Usually, the rate is changed on a preannounced schedule such as daily or weekly.Even though the nominal exchange rate is changing, the real exchange rate is being held steady.

In some cases, a country may be willing to sacrifice domestic monetary policy in the interest of maintaining a fixed exchange rate.Suppose that two countries trade extensively with one another because of a combination of location, language, and similarity of business environments.In addition, if the relationship is truly close, then the correlation between changes in the GDPs of the two countries may be rather high.In many cases, this occurs because one country’s GDP may be substantially larger than the other.In these circumstances, the smaller country might choose to fix its exchange rate in nominal terms to the currency of the larger country.Citizens in both countries benefit from the security of a fixed exchange rate that makes trade and investment less risky as a fixed exchange rate eliminates exchange rate risk.The smaller country’s monetary policy may have to be sacrificed to keep the exchange rate fixed.The smaller country will have a growth rate of the money supply and an inflation rate that is nearly identical to that of the larger country.

There are a number of benefits and costs associated with a currency union.A benefit of a currency union is the monetary efficiency gain.Monetary efficiency gains are the gains that are derived from not having to change currencies in order to buy or sell goods or services across national borders. A cost of a currency union is the loss of an autonomous monetary policy.If either country wished to pursue an independent monetary policy, it could not do so with a currency union.Whether or not a currency union is a good idea depends on the magnitude of the monetary efficiency gains versus the potential losses in terms of economic stability.A country’s monetary efficiency gains are influenced by a number of factors.The greater the amount of trade between the countries, the larger the monetary efficiency gains will be. However, there is not some type of precise cutoff point where a currency union is a good idea on one side and not a good idea on the other.The gains of a monetary union can be extrapolated to the movement of factors of production between the countries joining the union.If capital is mobile between countries there will be additional gains for both currency traders and investors.Likewise, there are several factors that influence the losses in terms of economic stability of each of the countries joining the union.If labor can (and most importantly does) freely migrate between the countries the losses associated with economic stability are reduced.Second, the more similar the two countries’ average rates of inflation, the smaller the economic stability losses in both countries.Third, the economic stability losses are smaller if there is some form of common fiscal policy within the countries joining the union.The final factor is the most important in determining the size of the economic stability losses.The economic stability losses will be smaller the higher the correlation of GDP between the two countries.

There are three conditions for an optimum currency area.First, there needs to be a substantial amount of trade.Second, a currency area will work better if there is free mobility of resources.Third, a currency union works best if there is a high correlation in economic conditions across the region.In the case of the United States, the first two conditions are obviously met.The third condition is more questionable as all regions of the US do not grow at the same rate at all times.

If the exchange rate is fixed and capital is mobile, monetary policy is not effective.If the exchange rate floats and capital is mobile, monetary policy is effective.A country can accomplish two out of the three but not all three together.