Question

Describe the movement of each line in the context of what’s happening in the economy.

Suppose a country with a fixed exchange rate attempted to fix their rate at too strong a level. Analyze what effect this would have using the monetary model. What reasons may a country have to decide to do this?

Answer 1

Monetary policy ineffective under fixed exchange rates With a fixed exchange rate, you give up on an independent monetary policy.

The effective exchange rate measures a currency against a basket of other currencies. This is usually trade-weighted. When looking at the effective Sterling exchange rate, we will compare the value of Sterling against our main trading partners – The Euro, the Dollar, the Yen e.t.c and give a weighting depending on how much we trade with that country, e.g. Eurozone 60%. A weighting will be given to different trading countries depending on how significant they are.

The effective exchange rate is good for looking at the overall performance of a currency. For example, the Pound may appreciate against the Dollar – but this may be due to just temporary weakness in the Dollar. However, if the overall effective exchange rate increases, it suggests the Pound is becoming stronger.

If a country experiences rapid productivity growth, then it can enable lower costs and lower price level, this will help to reduce the real exchange rate.

Suppose that prices in country A increase, this decreases the real exchange rate. However, if the nominal exchange rate is kept constant, then we can see a misalignment between the exchange rate, and it’s ‘real value.’

A good example is the Pound Sterling in the ERM crisis. In 1990, the UK entered the ERM – a semi-fixed exchange rate mechanism. This tried to keep the value of the Pound at a fixed rate against the German D-Mark. However, in the late 1980s, the UK experience high inflation and then a recession. The market value of the Pound started to fall, to reflect the real changes in the exchange rate.

However, the government (rather artificially) were trying to keep the value of the Pound high and constant in the ERM. Therefore, they intervened in the foreign exchange markets buying Pounds and increasing interest rates to keep the value of the Pound high. Therefore, the nominal exchange rate became overvalued against the real exchange rate. But, eventually, the attempt to keep the nominal value of the Pound high failed. Markets correctly predicted that the Pound was overvalued. Intense selling of the Pound eventually forced the UK government to leave the ERM and allow the Pound to devalue – coming closer to its real exchange rate.

Floating the exchange rate addressed this problem. It meant that one of the final prerequisites for effective domestic monetary policy had been achieved (the other, namely that the government fully finance any budget deficit in the market at market interest rates, had been achieved in the early 1980s when the Australian Government adopted a tender system for issuing bonds). While the ability to gain greater control of domestic monetary conditions was well understood at the time as one of the key benefits of floating the exchange rate, the decision to float in late 1983 occurred largely as a result of speculative pressure on the exchange rate. That is, in the lead-up to the float, there were very large capital inflows coming into Australia from speculators betting on an appreciation of the Australian dollar. This was not sustainable and the government had the choice of either tightening capital controls or floating the exchange rate. The latter was chosen as the more desirable course of action.

Consistent with obtaining better control over domestic monetary conditions, the choice of exchange rate regime can also influence the way in which economies cope with external shocks. Take for example, a sharp rise in the terms of trade (the ratio of export prices to import prices), as experienced in Australia's recent mining boom. The combination of a flexible exchange rate and independent monetary policy led to a high exchange rate and high interest rates relative to the rest of the world during that period, both of which played an important role in preserving overall macroeconomic stability. This is in contrast to previous resources booms, which typically ended with an episode of significant inflation.

In summary, the floating exchange rate regime that has been in place since 1983 is widely accepted as having been beneficial for Australia. The floating exchange rate has provided a buffer against external shocks – particularly shifts in the terms of trade – allowing the economy to absorb them without generating the large inflationary or deflationary pressures that tended to result under the previous fixed exchange rate regimes. While discretionary changes were made to the value of the Australian dollar under previous regimes in response to developing pressures, it was extremely difficult to calibrate the adjustments to provide an effective buffer against the shocks. The shift to a floating exchange rate has therefore contributed to a reduction in output volatility over the past two decades or so. Importantly, it has also enabled the Reserve Bank to set monetary policy that is best suited to domestic conditions (rather than needing to meet a certain target level for the exchange rate).