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# What difference does a flexible exchange rate make to an optimal policy mix available to government? How, if at all, does this question relate to the EU's "single currency" question?

There are two different exchange rate policies available to the government - fixed and flexible rates. Both have their advantages and disadvantages. When trade in goods occurs between two different money-using (not barter) countries, there must also be an exchange of currencies taking place. The fixed exchange rate was the old system used until the middle of this century. But it is making a comeback now. At present we live in the flexible rate system. This system was historically less stable and led to inflation and current account deficit, but nowadays the futures market is invented and widely used (one can buy currencies forward), so the uncertainty about the exchange rate can be elliminated (or "hedged"). However, with the introduction of the European Union, European governments are planning to fix their exchange rates with each other permanently and then go on to a common currency to achieve greater stability, more certainty and lower the transaction cost associated with converting the currencies. In this essay I am trying to confront the two exchange rate systems. I will also explore how governments can use their monetary and fiscal policy instruments to maintain a fixed exchange rate or to manipulate the exchange rate in the floating rate system (the dirty float).

But let me first explain the theory behind the exchange rate. The exchange rate in a free market is the result of the interaction of demand and supply of different currencies. Demand for a particular currency is, from tangible (or "real") view point, the export of the country, because people want to buy English exports need pounds to do so. On the other hand the supply for pounds is determined by the amount that England imports as the England importers need to change their pounds to other currencies to do so. Where the demand and supply intersect the equilibrium is formed:

In the current example the equilibrium occurs at a rate of 1.60 where q units (e.g. pounds) are demanded and q units are supplied. Similar analysis applies to every currency. The demand for sterling is also the supply of dollars if the pounds are exchanged to dollars.

This is a very simplified view of real life, because only demand for tangible reasons is included (trade, tourism etc.) In the reality the changing of currencies because of these reasons only account for 5% of the total volume of the trade. Most of the exchange are money flows - portfolio or direct investments abroad. There is also much speculation going on with the currencies. The capital flows affect the exchange rate much more than the trade in goods. They are themselves affected mostly by interest rates  not by the actual trade. Interest affects especially the very volatile short term flows, the "hot money". Thus it is tempting for a country who wants to keep its currency "strong" (i.e. highly valued in terms of other currencies) to raise its interest rates. However this decreases the investment and ultimately the growth of economy. If interest rates are high, people want to hold their money in the banks in this country. That increases demand for that particular currency. Diagrammatically:

As seen in the diagram, the new equilibrium is reached at E1 and the exchange rate has risen. Sometimes the changes are more complex, because the supply of pounds can contract at the same time, because people want to hold their money in the home country (due to these high interest rates). That will increase the exchange rate even further.

There is a problem with measuring the exchange rate, because there are many countries with different currencies and when one exchange rate changes it is hard to tell which country was the cause (i.e. did the demand or the supply change). That is why a system of trade weighted indices was set up to take account of all the changes. This is a common measure - either SDR or now ECU to which the countries exchange rate is compared to obtain an effective exchange rate.

Floating exchange rates were only first introduced in the 1970s. In this system the actual exchange rate will partly depend on the relative inflation levels of the different countries as well. When one country has higher inflation, people wil lose out by changing money into that  currency as their money will gradually become worth less. So the exhange will change at the rate of inflation in favour of country with lower inflation, the currency of the high-inlation country will depreciate. An appreciation, in floating rates, is a situation when the price of foreign currency rises, depreciation is when the price falls.

The main advantage of the floating exchange rate are the automatic stabilisation of country's trade with others when the situation changes (i.e. economic growth stops). As seen from the previous example the floating exhange also helps to equalise the prices in countries with different inflation rates.

Floating rates also free the internal policies from unnecessary constraints. Government can concentrate on domestic issues like inflation and unemployment instead of using monetary and fiscal policy to defend the  exchange rate. With fixed rates interest might have to be raised quite often to attract hot money inflows, in cases when the demand for the currency falls. This in turn will cause unemployment domestically as investment is lowered because of high interest. Another example is when a country has balance of payments problems. If it has adopted a fixed exchange rate policy, it can only cure this problem by deflating its economy. This causes unemployment. The depreciation of the currency in the floating exchange rates would "cure" this problem automatically in the short run. But depreciation has several problems from the moral point of view. Most countries want to (in non-economic terms) keep its currency "strong", or more economically, to boost it's exports. But allowing for depreciation would be just the opposite.

Absence of crisis is also an advantage of floating rates. With fixed rates there are often speculative pressures for the government to lower the rate. Government can defend the currency by fbuying it up, but when it runs out of reserves it will have to abandon the fixed rate, and it will also loose much of money. This happened in England with the ERM in 1992. Floating exchange rates have helped governments to be more flexible in overcoming the oil price increase shocks in 1970's as western countries are importing and producing different amounts of oil. With fixed exchange rate there is also a concern of importing inflation, whereas with floating exchange rates when the inflation in the UK is lower than in other OECD countries, its currency can just appreciate and the inflation rates in the UK is not affected by rising import prices.

Floating rates also require lower government reserves to maintain. High reserves are needed with fixed exchange rates to support the rate. Governments usually buy up the excess supply or sell to the excess demand, because of the relative inelastic supply and demand, not as much must be bought and sold as might be predicted:

In this example the fixed rate is taken to be 100 (price floor) and equilibrium is E. When demand decreases to DD1. The government buys up the excess E1A to maintain the rate. The reverse applies when the demand falls to DD2 then the government has to sell E2B to maintain the rate.

It was argued in the past that the floating exchange rate decreases business confidence and thus decreases investment. The discipline was said to be lost. However, nowadays buying currencies forward is possible and thus floating rates are commonly adopted.

However governments might still wish to keep the exchange rates fairly stable, so that there would be no large speculative movements. They can do this by using the dirty float. This is buying and selling their own currency to affect its demand and thus the exchange rate. This is done by the Exchange Equalisation Account. Dirty float's main advantage is that it can smooth the cyclical changes while not committing the government to keep an unrealistic exchange rate. The Exchange Equalisation Account was set up in 1932 and is controlled by the Bank. Nearly all governments operate a similar "dirty float" system. The Equalisation Account is not always succesful and it lost large sums of money in 1970s and in 1992 by defending an unrealistically high exchange rate.

When the exchange rate is not allowed to move freely based on the demand and supply, that is called fixed exchange rates. A government can base the exchange rate on the gold standard (largely abandoned nowadays) or it can peg its currency (fix the exchange rate to another currency, e.g. 1DEM=8 Estonian crowns). The peg is called an adjustable peg, if the rate is fixed, but if it can vary a bit, for example it can depreciate 2% a year.  Adjustable peg is used when the country that pegs the rate thinks that it is going to have a higher inflation or lower growth than the other country.

Another method of stabilising the rate is by exchange controls. This means putting restrictions on changing currencies into effect (used by USSR for many years in the past). However this means the economy will lose the main advantage gained from the fixed rate - its certainty, because one can never be sure how much they can exchange. Black market can also develop, which is bad for the countrys reputation and decreases its tax revenues.

At present Fixed exchange rate is gaining popularity inside Europe in order to establish common ground for the future common currency. Main advantage of the common currency is the elimination of transaction costs, so that the raw material producers do not have to go through expensive process of currency exchange when they want to sell their product to English producers. However this will mean that the countries must have fairly similar economies. Main concernes and frictions arise on the grounds of unemployment, wage bargaining and the benefit level. Capital movements must also be free to obtain the maximum benefit, and the relative inflation/unemployment preference (the position on the Philips curve) of the contries must be similar (if we believe in the Pihips curve). More on these issues on the final part concerning the European Union.

There are some alternative equilibrium theories invented. Most famous is the purchasing power parity (PPP) theory with it's law of one price. It basically says that the exchange rate will be the ratio between the German consumer price index and the UK consumer price index. These indexes are measured by how much the same basket of goods costs in different countries. But the basket determining domestic price has nothing to do with international trade pluss there are non-tradable goods in existance. So the PPP theory does not hold very well in the short term. However in the long term there is quite a lot of evidence for the PPP theory between fairly similar countries.

The portfolio balance theory assumes that large investors will know in which country they can gain most profits and switch their investment accordingly determining the exchange rate. This theory ignores future expectations. The interest rate parity theory deals with forwards and is a bit advanced to discuss at this level.

This was a brief overview of the actual theory laying behind the exchange rates. I would now like to discuss the different set of policies under the two confronting system, starting with the floating rate. Even in the floating exchange rate system, it is advisable for the governments to intervene in order to rectify the so called internal and external balance. This is called the stabilisation policy(SB). Internal balance (IB) is achieved at the point of full employment and stable inflation. We are assuming a trade off between unemployment and inflation at this point (standard Philips curve). External balance (EB) is the balance on the Balance of Payments.

Tinbergen's rule says you need as many policy instruments as there are problems needed to be solved at the same time. Mundell's Principle of Effective Market Classification says that these instruments should the targeted to the problems they have most effect on. Today's governments have two main policy instruments - the fiscal policy (government spending and the public spending borrowing requirement) and the monetary policy (through the availability and the price of money - interest rate).

In order to keep the external balance stable, when the fiscal deficit is increased then interest rates must be increased as well. This is because when there is a fiscal deficit, there will be a current account deficit (as income will rise and that will raise imports) and thus interest rate must increase to attract overseas funds in order to keep the balance in zero. IB is similar. When there is an increase in the interest rate that depresses the economic activity then the fiscal deficit should be increased to stimulate the economy.

It is argued that the elasticity of IB with respect to interest is less elastic than the elasticity of EB, because the investment decisions are not that marginal and hard to alter, whereas the capital flows affecting EB are very volatile. So diagrammatically:

Areas marked in this graph as deficit and unemployment mean that there is a deficit in the external balance (balance of payments) and unemployment internally when economy chooses a mix of policies which would lie inside that area. Equilibrium position for the economy would be in A. In this situation, using Mundell's Principle, monetary policy should be directed to achieve external balance, because EB is more sensitive to interest rate changes. Similarly, fiscal policy should be used to rectify IB problems. So if the economy is in B then the government should not use the fiscal policy to stimulate exports, but instead should attract foreign funds by raising the interest rate.

However this model has some flaws. The trade off between inflation and unemployment, the Philips curve, is questionable. Empirically it has been found to hold only in a few consecutive years lately. Then hysterisis and unemployment spirals will occur as the peoples expectations about unemployment and thus NAIRU (natural rate of unemployment) will change. However, this is well beyond this essay. Relative slopes of EB and IB are also questionable. Depending of how one defines them, the policy implications will change. If IB is more inelastic than EB then the correct policy would be to use fiscal policy for EB and vice-versa.

One can look this policy from a IS-LM-BP perspective. This is drawing capital market (investment saving - IS) equilibrium, together with money market (LM) and external balance of payments equilibrium (BP) to the same diagram. The axes are similar - interest rate and income. Graphically:

LM slopes up because when income (Y) increases people need more money, their liquidity preference increases (cash balance effect). As money supply is kept constant by government interest has to be higher in order to persuade people to give up money in favour of bonds. Similarly BP slopes up, because when Y increases, then imports will increase and thus higher interest rates are needed to attract foreign money in order to balance EB. EB is more vertical than LM, because empirically interest has less effect on capital movements and import quantities than it has in the money market. IS slopes down because when interest is increased the investment decreases. As people save a fixed proportion of their income, and we need less savings for investment, then income must be lower. Government monetary policy shifts LM and fiscal policy shifts IS. Note that fiscal policy leads to an outcome further from the Yf - the full employment income.

When governments have a fixed exchange rate, the policy mix is much more restricted. Basically one must keep the external balance by using monetary policy. So monetary policy becomes passive - it just follows the world pattern of trade cycles and speculation. Fiscal policy only is left for determining the IB. Thus countries often have to swallow a bitter pill of high unemployment in fixed exchange rate systems in order to keep the inflation under control, because as seen before from the ISLM curve, the IS curve is less suited for inflation adjustments, as it will lead to a lower employment outcome.

However, if several countries adopt fixed exchange between themselves, then they can co-ordinate their monetary policy with rest of the world and also taking into account their own common internal problems, thus taking the best of both world. Individual countries still have fiscal policies to adjust their minor differences, but the fiscal deficit has to be used to a lot lesser extent, and as shown before, fiscal deficit is generally undesirable because at the end it generates equilibrium further away from full employment output.

As seen, the floating exchange with government intervention is the most flexible system. But it more expensive in terms of lost employment and management than a common fixed exchange rate. However this common exchange rate must be administered very carefully for not to initiate speculative action, and it could only work between similar countries. As long these two propositions are not fulfilled England should remain in floating exchange rate, however when a regime with enough control and discipline is set up, it might be well worth to delegate the monetary policy to a common authority in the European Union.

With that introduction let me now explore the policy implications of the EU a bit further. I shall concentrate on the labour market and wage rigidities, but similar arguments can be used in favour of greater pre-unification co-ordination in other key areas like the long-term interest rates; the amount of government debt as a percentage of GDP and its repayment (the PSBR); inflation rates; free capital movement and also on standard work security and other laws and regulations as the capital movement assumption means the capital moves immediately to the least regulated area.

Wage rigidities, according to de Grauwe, are an important thing to consider in the Union. As the exchange rate is fixed, then unions find it much easier to claim similar wages and benefits. This will require further laws on international bargaining. But also when some countries have decentralised wage bargaining, the small unions will not take account the inflationary effects of their wage claims. So they will require higher pay than possible without introducing inflation. This must all be regulated so that countries joining the Union would not loose out to other countries with more deregulated labour markets.

Final issue I shall discuss is the cross subsidation of different countries that will occur when a common central bank is set up in order to achieve the full benefits of the Union and elliminate the speculation. This means that prospering countries will contribute more in taxes, but will receive less in benefits, like food subsidies and unemployment benefits. This subsidation is not in fact undesirable. Germany's experience has shown that open and effective cross subsidation can lead to much more equality between the areas, and thus arguably increase the welfare of the nation. However from the policy perspective, this subsidation should be monitored, and it should not be excessive, with some countries contributing huge sums and other free riding.