International_Economics_Tenth_Edition (1)

revaluations) of its currency to restore payments balance. Developing nations suffering from high inflation rates have been major users of this mechanism.

9.A currency crisis, also called a speculative attack, is a situation in which a weak currency experiences heavy selling pressure. Among the causes of currency crises are budget deficits financed by inflation, weak financial systems, political uncertainty, and changes in interest rates on world markets. Although a fixed exchange-rate system has the advantage of promoting low inflation, it is especially vulnerable to speculative attacks.

10.Capital controls are sometimes used by governments in an attempt to support fixed exchange rates and prevent speculative attacks on currencies. However, capital controls are hindered by the private sector's finding ways to evade them and move funds into or out of a country.

11.Currency boards and dollarization are explicitly intended to maintain fixed exchange rates and thus prevent currency crises. A currency board is a monetary authority that issues notes and coins convertible into a foreign currency at a fixed exchange rate. The most vital contribution a currency board can make to exchange-rate stability is to impose discipline on the process of money creation. This results in greater stability on domestic prices which, in turn, stabilizes the value of the domestic currency. Dollarization occurs when residents of a country use the U.S. dollar alongside or instead of their own currency. Dollarization is seen as a way to protect a country's growth and prosperity from bouts of inflation, currency depreciation, and speculative attacks against the local currency.

•Adjustable pegged exchange rates (page 448)

•Bretton Woods system

(page 448)

•Capital controls (page 462)

•Clean float (page 453)

•Crawling peg (page 457)

•Currency board (page 464)

•Currency crashes (page 458)

•Currency crisis (page 458)

•Devaluation (page 447)

•Dirty float (page 453)

•Dollarization (page 466)

•Exchange controls (page 462)

•Exchange-stabilization fund (page 446)

•Fixed exchange rates

(page 442)

•Floating exchange rates

(page 449)

•Fundamental disequilibrium

(page 447)

•Key currency (page 442)

•Leaning against the wind

(page 453)

•Managed floating system

(page 452)

•Official exchange rate

(page 445)

•Par value (page 445)

•Revaluation (page 447)

•Seigniorage (page 467)

•Special drawing right (SDR) (page 444)

•Speculative attack

(page 458)

•Target exchange rates

(page 453)

1.What factors underlie a nation's decision to adopt floating exchange rates or fixed exchange rates?

2.How do managed floating exchange rates operate? Why were they adopted by the industrialized nations in 1973?

3.Why do some developing countries adopt currency boards? Why do others dollarize their monetary systems?

4.Discuss the philosophy and operation of the Bretton Woods system of adjustable pegged exchange rates.

470Exchange-Rate Systems and Currency Crises

5.Why do nations use a crawling-peg exchangerate system?

6.What is the purpose of capital controls?

7.What factors contribute to currency crises?

8.Why do small nations adopt currency baskets against which to peg their exchange rates?

9.What advantage does the SDR offer to small nations seeking to peg their exchange rates?

15.1 The Federal Reserve Bank of New York regularly reports on its intervention in foreign-exchange markets. Set your browser to this URL:

http://www.ny.frb.org/markets/

foreignex.htm

15.2 Throughout the world, central banks intervene in the foreign market. For a quick link to numerous central banks, go to the Bank for International Settlements Web page at this URL:

http://www.bis.org/cbanks.htm

10.Present the case for and the case against a system of floating exchange rates.

11.What techniques can a central bank use to stabilize the exchange value of its currency?

12.What is the purpose of a currency devaluation? What about a currency revaluation?

15.3 The International Monetary Fund (IMF) provides loans, technical assistance, and policy guidance to developing members in order to reduce poverty, improve living standards, and safeguard the stability of the international monetary system. Learn about exchange-rate practices by setting your browser to this URL:

http://www.imf.org

Currency devaluations and revaluations are used in conjunction with a fixed exchangerate system. The monetary authority changes a currency's exchange rate by decree, usually by a sizable amount at one time. How is such a policy implemented?

Recall that under a fixed exchange-rate system, the home currency is assigned a par value by the nation'smonetary authorities.

The par value is the amount of a nation'scurrency that is required to purchase a fixed amount of gold, a key currency, or the special drawing right. These assets represent the legal numeraire, or the unit of contractual obligations. By comparing various national currency prices of the numeraire, monetary authorities determine the official rate of exchange for the currencies.

In the legal sense, a devaluation or revaluation occurs when the home country redefines its currency price of the official numeraire, changing the par value. The eco- nomic effect of the par value'sredefinition is the impact on the market rate of exchange. Assuming that other trading nations retain their existing par values, one would expect

(1) a devaluation to result in a depreciation in the currency's exchange value; (2) a revaluation to result in an appreciation in the currency's exchange value.

Figure 15.5 on page 472 illustrates the legal and economic implications of devaluationl

revaluation policies. Assume that the SDR serves as the numeraire by which the value of individual currencies can be defined relative to each other-Burundi'sfranc and Uganda's shilling. The diagram's vertical axis denotesthe shilling price of an SDR, and the horizontal axis depicts the franc price of an SDR. Three price ratios are illustrated by each point in the figure: (1) the shilling price of the SDR, (2) the franc price of the SDR, and (3) the shilling price of the franc, indicated by the slope of a ray connecting the origin with any point in the figure.

Referring to Figure 15.5(a), suppose Uganda sets its par value at 700 shillings per SDR, whereas Burundi's par value equals 350 francs perSDR. Connecting these two pricesyields point A in the diagram. Relativeto each other, the official exchange rate between the shilling and the franc is2 shillings:::: 1 franc, denoted by the slope of the ray OA (700/350 :::: 2.0).

Assume that Uganda wishes to devalue the shilling by, say, 10 percent to correct a payments deficit. Starting at point A, Uganda would raise the shilling price of the SDR from 700 to 770 shillings per SDR, a 10 percent increase. This results in a movement from point A to point B in the figure. Corresponding to the slope of ray DB, the new exchange rate is 2.2 shillinqs « 1 franc (770/350 :::: 2.2). Uganda's devaluation results in a depreciation in the shilling's exchange valuefrom 2 shillings ::::

1 franc to 2.2 shillings:::: 1 franc, a 10 percent

change. Conversely, suppose that Uganda revalues the shilling by 10 percent to reverse a payments surplus. Starting at point A in Figure 15.5(b), Uganda would lower the official price of the SDR from 700 shillings to 630 shillings, a 10 percent decrease. The exchange value of the

shilling would increase from 2 shillings = 1 franc to 1.8 shillings = 1 franc, a 10 percent change.

To change the shilling/franc exchange rate, it is not sufficient for Uganda to redefine the shilling'spar value. It is also necessary that the par value of the Burundi franc

remain constant or be altered by a smaller fraction. In Figure 15.5(a), a change in the shillinglfranc exchange rate requires a change in the slope of ray GA. Acting by itself, Uganda can establish only the vertical position in the diagram. Because Burundi determines the horizontal position, any redefinition of Uganda's par value can beneutralized by an equivalent change in Burundi'spar value. In other words, Burundi can offset any change in the slope of the ray that Uganda may wish to undertake.

Let us start again at point A in Figure 15.5(a), where the exchange rate is set at

2 shillings = 1 franc. Facing a payments deficit, suppose Uganda devalues the shilling 10 percent by increasing the official price of the SDR from 700 to 770 shillings. This would cause a movement from point A to point B, where the exchange rate is 2.2 shillings = 1 franc. But what if Burundi determines that the shilling'sdevaluation gives Uganda an unfair competitive advantage? Suppose Burundi retaliates by devaluing the franc 10 percent, thus increasing the official price of the SDR from 350 to 385 francs. A movement from

point B to point C in the diagram would result. Although both currencies have been officially devalued by 10 percent, the exchange rate between them remains constant at 2 shillings = 1 franc. The conclusion is that a devaluation in the legal sense does not necessarily ensure a devaluation in the economic sense-that is, a depreciation in the exchange rate. This occurs only if other nations do not retaliate by initiating offsetting devaluations of their own.

Currency devaluations do have foreign repercussions similar to those of domestic economic policies. The larger and more significant the devaluing nation, the greater the economic effects transmitted abroad. A nation that devalues to initiate an export-led economic recovery may be the cause of recession in its trading partners. This was often the case during the Great Depression of the 1930s, when competitive devaluations were widespread. It is no wonder that when currency realignments involving devaluations and revaluations are called for, they usually require intense negotiations and the harmonization of economic interests among participating nations.

Policy makers are also aware of a nation's balance-of-payments (BOP) position. A nation is said to be in external balance when it realizes neither BOP deficits nor BOP surpluses.' In practice, policy makers usually express external balance in terms of a BOP subaccount, such as the current account. In this context, external balance occurs when the current account is neither so deeply in deficit that the home nation is incapable of repaying its foreign debts in the future nor so strongly in surplus that foreign nations cannot repay their debts to it. Although nations usually consider internal balance to be the highest priority, they are sometimes forced to modify priorities when confronted with large and persistent external imbalances.

Nations have economic targets other than internal balance and external balance, such as long-run economic development and a reasonably equitable distribution of national income. Although these and other commitments may influence international economic policies, the discussion in this chapter is confined to the pursuit of internal balance and external balance.

IPolicy Instruments

To attain the objectives of external balance and internal balance, policy makers enact expenditurechanging policies, expenditure-switching policies, and direct controls. Expenditure-changing policies alter the level of aggregate demand for goods and services, including those produced domestically and those imported. They include fiscal policy, which refers to changes in government spending and taxes,

'Recall from Chapter 10 that BOP transactions are grouped into two categories: the current account and the capital and financial account. Private-sector transactions and official (central bank) transactions are included in the capital and financial account. With double-entry accounting, total debits equal total credits in the BOP statement. This implies that a current account deficit (surplus) will equal a capital and financial account surplus (deficit).

In this chapter, we assume that BOP equilibrium occurs when the current-account delicit (surplus) is equal to tlie surplus (deficit) on private-sector financial and capital transactions; the balance on official financial and capital transactions thus equals zero. This measure is known as the official reserve transaction balance; it emphasizes the role of all private-sector transactions in a nation's international payments position. It follows that a BOP deficit (surplus) occurs if the deficit (surplus) on current-account transactions exceeds the surplus (deficit) on private-sector financial and capital transactions.

and monetary policy, which refers to changes in the money supply by a nation's central bank (such as the Federal Reserve). Depending on the direction of change, expenditure-changing policies are either expenditure increasing or expenditure reducing.

If inflation is a problem, it is likely to be because the level of aggregate demand (total spending) is too high for the level of output that can be sustained by the nation's resources at constant prices. The standard recommendation in this case is for policy makers to reduce aggregate demand by implementing expenditure-decreasing policies such as reductions in government expenditures, tax increases, or decreases in the money supply; these policies offset the upward pressure on prices resulting from excess aggregate demand. If unemployment is excessive, the standard recommendation is for policy makers to increase aggregate demand for goods and services by initiating expenditure-increasing policies.

Expenditure-switching policies modify the direction of demand, shifting it between domestic output and imports. Under a system of fixed exchange rates, a trade-deficit nation could devalue its currency to increase the international competitiveness of its industries, thus diverting spending from foreign goods to domestic goods. To increase its competitiveness under a managed floating exchange-rate system, the nation could purchase other currencies with its currency, thereby causing the exchange value of its currency to depreciate. The success of these policies in promoting trade balance largely depends on switching demand in the proper direction and amount, as well as on the capacity of the home economy to meet the additional demand by supplying more goods. Exchange-rate adjustments are general switching policies that influence the balance of payments indirectly, through their effects on the price mechanism and national income.

Direct controls consist of government restrictions on the market economy. They are selective expenditure-switching policies whose objective is to control particular items in the balance of payments. Direct controls, such as automobile tariffs and dairy quotas, are levied on imports in an attempt to switch domestic spending away from foreign goods to domestic goods. Similarly, the object of an export subsidy is to enhance exports

476 Macroeconomic Policy in an Open Economy

by switching foreign spending to domestic output. When a government wishes to limit the volume of its overseas sales, it may impose an export quota (such as Japan's automobile export quotas of the 1980s). Direct controls may also be levied on capital flows so as to either restrain excessive capital outflows or stimulate capital inflows.

Economic-policy formation is subject to institutional constraints that involve considerations of fairness and equity.' Policy makers are aware of the needs of groups they represent, such as labor

'See A.C. Day, "Institutional Constraints and the International Monetary System:' in R, Mundell and A, Swoboda, eds.. Monetary Problems of the InternationalEconomy (Chicago: University of Chicago Press, 19691, pp, 333-342,

and business, especially when pursuing conflicting economic objectives. For example, to what extent are policy makers willing to permit reductions in national income, output, and employment at the cost of restoring BOP equilibrium? The outcry of adversely affected groups within the nation may be more than sufficient to convince policy makers not to pursue external balance as a goal. During election years, government officials tend to be especially sensitive to domestic economic problems. Reflecting perceptions of fairness and equi- ty, policy formation tends to be characterized by negotiation and compromise.

Figure 16.1 illustrates the two basic policy dimensions of internal balance and external bal-

ance. The vertical axis of the diagram depicts the size of a nation's BOP deficit or surplus. External balance is reached at the diagram's origin, with neither BOP surplus nor BOP deficit. The horizontal axis indicates the extent of domestic recession or inflation. Full employment (zero recession) without inflation, or internal balance, is also achieved at the diagram's origin. An economy reaches overall balance when it attains internal balance and external balance.

Exchange-Rate Policies

and Overall Balance

As noted previously, expenditure-switching policies can help a nation attain overall balance. Although these measures are designed primarily to influence the nation's external sector, they have secondary impacts on its internal sector. Let us examine one expenditure-switching instrument, the exchange rate, and its impact on a nation's external sector and internal sector.

Referring to Figure 16.1, suppose a nation is located in the disequilibrium zone of BOP deficit with recession, indicated by point C in the figure. A depreciation (devaluation) of the nation's currency increases the international competitiveness of its goods; this leads to rising exports and a reduction in the BOP deficit. Additional export sales provide an injection of spending into the economy, which encourages additional production and thus reduces the level of unemployment. In terms of the figure, the currency depreciation induces movement in a northeasterly direction, promoting both internal balance and external balance.

Conversely, suppose that a nation experiences

BOP surplus with inflation, indicated by point A in Figure 16.1. If this nation permits an appreciation (revaluation) of its currency, the international competitiveness of its goods will decline, causing exports to fall. Falling export sales decrease the level of spending in the economy, thus reducing its inflation rate. By promoting internal balance and external balance, the currency's appreciation induces a southwesterly movement in the figure.

As these examples suggest, the ability to implement exchange-rate policies is subject to interna-

tiona1 policy cooperation for several reasons. A depreciation of one nation's currency implies an appreciation for its trading partners. If the dollar depreciates by 30 percent, this can be equivalent to a 30 percent subsidy on U.S. exports and a 30 percent tax on U.S. imports. Furthermore, changes in the exchange rate influence the external sectors and internal sectors of both the home country and its trading partners. In a global system, one nation cannot achieve overall balance single-handedly by means of its own policy tools. Other nations can implement retaliatory policies-such as tariffs and currency devaluations-that offset the nation's pursuit of overall balance, as occurred during the Great Depression of the 1930s.

Monetary Policy and

Fiscal Policy: Effects

on Internal Balance

The previous section suggested that exchange-rate policies primarily affect the economy's external sector, while having secondary effects on its internal sector. Let us now consider monetary policy and fiscal policy as stabilization tools. These tools are generally used to stabilize the economy's internal sector, while having secondary effects on its external sector. How successful are monetary policy and fiscal policy in achieving full employment and price stability?

Let us assume that the mobility of international capital is high. This suggests that a small change in the relative interest rate across nations induces a large international flow of capital (investment funds). This assumption is consistent with capital movements among many industrial nations, such as the United States and Germany, and the conclusions of many analysts that capital mobility is increasing as national financial markets have become internationalized.

Two conclusions will emerge from our discussion: (1) Under a fixed exchange-rate system, fiscal policy is successful in promoting internal balance, whereas monetary policy is unsuccessful. (2) Under a floating rate system, monetary policy is successful in promoting internal balance, whereas fiscal

478 Macroeconomic Policy in an Open Economy

policy is unsuccessful. These conclusions are summarized in Table 16.1.

In practice, most industrial nations maintain neither rigidly fixed exchange rates nor freely floating exchange rates. Rather, they maintain managed floating exchange rates in which central banks buy and sell currencies in an attempt to prevent exchange-rate movements from becoming disorderly. Heavier exchange-rate intervention moves a nation closer to our fixed exchange-rate conclusions for monetary and fiscal policy; less intervention moves a nation closer to our floating exchange-rate conclusions.

Fiscal Policy with Fixed

Exchange Rates and Floating

Exchange Rates

Assume that a nation operates under a fixed exchange-rate system and encounters high unemployment. Let us follow the case of an expansionary fiscal policy-say, an increase in government purchases of goods and services. The rise in government spending increases aggregate demand, which leads to higher output, employment, and income, as seen in the upper portion of Figure 16.2(a).

Now refer to the lower portion of Figure 16.2(a). As total spending rises, so does the demand for money. Given the supply of money, interest rates increase; this encourages foreigners to invest more in the home nation and discourages its residents from investing abroad. The resulting net capital inflows push the nation's capital account into surplus. Concurrently, the increase in spending results

in higher imports and a trade deficit. If investment flows are highly mobile, it is likely that the capitalaccount surplus will exceed the trade-account deficit; the overall BOP thus moves into surplus. Because the nation is committed to fixed exchange rates, its central bank buys foreign currency, thus preventing an appreciation of the home currency. This increases the money supply, which leads to additional spending, output, and employment. In this manner, the expansionary fiscal policy promotes internal balance.

If capital mobility is low, however, the tradeaccount deficit may more than offset the capitalaccount surplus, pulling the overall BOP into deficit. To prevent the home currency from depreciating, central bankers would purchase it on the foreign-exchange market. This would cause a decrease in the money supply, an increase in interest rates, a decline in investment spending, and a decrease in output. The attempt to use expansionary fiscal policy to jumpstart the economy could backfire.

The result is different if the country has floating exchange rates. As before, fiscal expansion leads to higher output and income as well as higher interest rates. Higher income induces rising imports, which push the trade account into deficit. Higher interest rates lead to net investment inflows and a surplus in the capital account. With highly mobile capital, it is likely that the surplus in the capital account will exceed the deficit in the trade account, so that the overall BOP moves into surplus. This leads to an appreciation in the home currency's exchange value. With a