Chapter Twenty: Notes -- Exchange Rate Regimes and Crises

Given the increasing globalization of economies, students of macroeconomics must understand how economies are connected.
Exchange rates in many nations, especially smaller, less developed countries, are vital to economic performance. Daily newspapers commonly post the exchange rate to the U.S. dollar on the front page. Significant exchange rate movements are known by most people almost immediately. In contrast, exchange rate movements in the United States are barely noticed by most U.S. citizens.

The major reason for other nations' attention to the U.S. exchange rate is that their economies are highly dependent on trade flows with the United States. Inflation and unemployment are often affected severely by exchange rate fluctuations. In Mexico, for example, the peso was suddenly devalued in December of 1994. The result in 1995 was a surge in inflation, a wave of bankruptcies, a subsequent severe monetary contraction and a deep recession. In Argentina in December of 2001, just the talk of devaluation led to riots on the streets of Buenos Aires. U.S. citizens by comparison have the luxury of living in an economy that is not so affected by foreign exchange rate movements because the United States is not so reliant on a single country for its trading activities.

Given the increasing globalization of economies, students of macroeconomics must understand how economies are connected. The relationship can be complicated, but a study of exchange rates and international stabilization policy helps to put together the pieces of the puzzle.

A nation essentially has three options for exchange rate regimes. It can adopt a floating, fixed, or crawling peg exchange rate regime.

A flexible exchange rate regime lets the forces of supply and demand determine currency values.

A fixed exchange rate regime pegs the value of the domestic currency to another currency.

A government can prevent or delay a devaluation by drawing down its stock of foreign reserves or raising domestic interest rates to attract capital inflows.

A crawling peg is a hybrid between a fixed and flexible exchange rate regime.

Exchange Rate Regimes

Many transition economies (see
Chapter 21) initially pegged their currencies to a major currency like the U.S. dollar and then subsequently moved to "crawling pegs." Other countries let their exchange rates float on the market. A nation essentially has three options for exchange rate regimes. It can adopt a floating, fixed, or crawling peg exchange rate regime. Each has its advantages and disadvantages. What factors enter into the decision to adopt a specific exchange rate regime?

Flexible Exchange Rates

Equilibrium Exchange Rate Flexible exchange rate regimes let the forces of supply and demand for foreign exchange determine currency values. Most large industrial countries have flexible (floating) exchange rates. As the figure titled "Equilibrium Exchange Rate" illustrates, the demand and supply of foreign exchange intersect at point E so that the equilibrium quantity of foreign exchange is FEE and the equilibrium exchange rate is eE.

In Chapter 7 we discussed the factors that determine the slopes of the demand and supply curves and the factors that could shift the supply and demand curves. Capital inflows, for example, shift the supply curve of foreign exchange to the right as foreigners purchase domestic assets, which leads to a lower exchange rate and a stronger domestic currency. Capital outflows, in contrast, shift the demand curve for foreign exchange to the right as domestic citizens convert local currency to foreign currency in order to purchase foreign assets. The domestic exchange rate rises and the currency depreciates.

Two significant advantages arise from flexible exchange rate regimes. First, trade imbalances are corrected automatically with no need for government intervention. Suppose that U.S. exports decline because Japan's economy enters a recession. The supply curve for foreign exchange shifts to the left, increasing the U.S. exchange rate, thereby weakening the U.S. dollar. The weaker domestic currency allows Japanese and other foreign consumers to purchase more now-cheaper U.S. exports; meanwhile, U.S. imports slow down as import prices become more expensive. The negative effects from the Japanese recession on the U.S. economy are automatically dampened.

Increase in Capital Outflows

As another example, suppose that Japanese interest rates rise due to a reduction in the Japanese money supply, but U.S. interest rates are unchanged. As the figure titled "Increase in Capital Outflows" illustrates, U.S. savers attempt to capture the relatively high Japanese interest rate returns by purchasing Japanese assets (and Japanese yen in the process), which shifts the demand curve for foreign exchange to the right, increasing the equilibrium exchange rate. Recall that in a flexible exchange rate regime, the balance of payments must sum to zero. Because U.S. capital outflows increase, narrowing the capital account surplus, the current account deficit must fall. The increased U.S. exchange rate makes U.S. exports cheaper and imports more expensive, narrowing the trade deficit (and the current account deficit) automatically.

A second advantage of flexible exchange rates is that stabilization policy can be conducted without concern for the impact on exchange rates. An increase in the money supply, for example, lowers domestic interest rates. The lower rates lead to net capital outflows because investing in U.S. assets is relatively less attractive. The exchange rate rises in response to restore equilibrium in the foreign exchange market. As we explain below, governments with fixed exchange rates do not have this option. Stabilization policy may be impossible to conduct if it has an effect on the exchange rate.

Despite these advantages, two disadvantages arise from flexible exchange rate regimes. As supply and demand curves shift, exchange rates can fluctuate wildly in short time intervals. Such fluctuations increase exchange rate risk. Exchange rate risk is the risk of incurring negative returns from unexpected changes in exchange rates. Suppose that one U.S. dollar purchases 8 Mexican pesos (e = 1/8), and a U.S. firm agrees today to pay in one month 800 pesos for imported goods. At the current exchange rate, the U.S. firm must pay $100 (800 pesos x 1/8) to purchase the goods. One month later the exchange rate rises to 1/4, such that one U.S. dollar purchases just 4 pesos. At the higher exchange rate, the U.S. firm must pay $200 (800 pesos x 1/4) to buy 800 pesos. The devalued dollar increases U.S. import prices and reduces the profits of the U.S. importer.

Given the potential for significant exchange rate risk, countries that have limited shocks to their demand and supply curves for foreign exchange are more likely to adopt flexible exchange rate regimes. Such countries typically have wealthy, stable economies. Foreign investors are less likely to panic, for example, given bad news from a stable economy. Even after the September 11, 2001 terrorist attacks on the U.S., for example, the demand for the U.S. dollar across the world remained strong.

A second potential disadvantage from flexible exchange rates is that some countries forego inflation-fighting credibility. In particular, economies with present or historically high inflation rates may need externally generated credibility to lower domestic inflation. By pegging the currency to a stable foreign currency, the government is committing itself to long-term inflation rates similar to inflation rates in the nation to which the currency is pegged. Flexible exchange rates require the government to make no such commitment. The result may be that some governments continue to print money and run high inflation rates, accepting the constant nominal devaluations. In sum, large stable economies with limited histories of high inflation are more likely to adopt a flexible exchange rate regime.

Fixed Exchange Rates

A second regime that countries may adopt is a fixed exchange rate. The government and the central bank essentially commit themselves to pegging (fixing) the value of the domestic currency to a foreign currency. For example, Poland might peg its currency, the zloty, to the U.S. dollar such that 4 zloty equal one dollar. From Poland's perspective, the pegged exchange rate is 4. Three possibilities arise. The pegged exchange rate may be equal to, higher than, or lower than the market exchange rate, eM. Fixed Exchange Rate Regime

Let us first consider the (unlikely) case in which both the pegged exchange rate and the equilibrium market exchange rate of the zloty to the U.S. dollar is 4. In this case, neither the government nor the central bank must intervene in currency markets to alter the value of the exchange rate. The market determines the exchange rate that the Polish government desires. Of course, the government would have to intervene if the supply or demand curves shifted for any reason.

A more likely scenario is that the pegged exchange rate is set below the market equilibrium exchange rate. As the figure titled "Fixed Exchange Rate Regime" illustrates, the true market exchange rate is at eM but the Polish government wishes to peg the currency at the lower exchange rate eP. For example, the market exchange rate may be 5 (5 zlotys to the U.S. dollar) but the Polish government pegs the exchange rate at 4 (4 zlotys to the U.S. dollar). At eP the quantity supplied of foreign exchange is at FES (point B) while the quantity demanded of foreign exchange is higher at FED (point C). How does the Polish government defend this exchange rate and keep the zloty from devaluing to point A?

Fixed Exchange Rate Supported by Foreign Reserves

Two alternatives are available to the Polish government. First, it can draw down its foreign reserves--the stock of foreign currency and foreign liquid assets (such as U.S. government bonds) that it owns. Poland's central bank will likely conduct the international transactions in which it purchases the Polish currency as it sells the foreign currency. For example, the Polish central bank might sell U.S. government bonds and purchase Polish government bonds. In essence, the central bank is simulating an increase in capital inflows when it purchases its domestic currency using the foreign currency. As illustrated in the figure titled "Fixed Exchange Rate Supported by Foreign Reserves" the supply curve for foreign exchange--including the draining of foreign reserves (R)--shifts to the right to S+R to maintain the domestic exchange rate at eP. Maintaining the value of the currency by drawing down international reserves is not a long-run solution. If the difference is large between the true market equilibrium exchange rate and the pegged exchange rate, international reserves can disappear quickly, and the central bank will no longer be able to support the overvalued currency.

Fixed Exchange Rate Supported by Contractionary Monetary Policy

The second alternative that the Polish government has to defend the overvalued zloty is to adjust domestic interest rates by changing the quantity of money in the economy. Instead of drawing down its reserves, the Polish central bank could increase interest rates, which entices some foreign investors to place their funds in Poland. This time, private capital flows increase, strengthening the value of the zloty. This scenario is depicted in the figure titled "Fixed Exchange Rate Supported by Contractionary Monetary Policy". Of course, the increased domestic interest rates slow domestic investment and may even lead to a recession.

Why might a government intentionally overvalue its currency, especially given that an overvalued currency dampens exports? At least two reasons exist. First, the government may wish to purchase imported intermediate inputs at a bargain price. Suppose that U.S. computer equipment is absolutely critical to operate a Polish electricity plant. By overvaluing the currency, the government is reducing the price of the computer goods. A second reason is that inflation may back the government into a situation of defending an overvalued currency. The government may not have intended to overvalue the currency, but a few years of high inflation relative to the anchor currency led to a real appreciation of the currency. If Poland runs an annual inflation rate of 10 percent while inflation in the U.S. is just 2 percent, the cost of Polish goods and services in U.S. dollars gradually increases such that the real value of the zloty rises. Given the high inflation, Poland has to maintain the overvalued currency or abandon the pegged exchange rate and devalue the currency.

Undervalued Fixed Exchange Rate

The third possibility under a fixed exchange rate regime is that the market exchange rate eM is below the pegged exchange rate, eP. In this case, Poland is intentionally depreciating its currency relative to the U.S. dollar. For example, the market exchange rate might be five, but the zloty is pegged at a value of six. Such a scenario is depicted in the figure titled "Undervalued Fixed Exchange Rate." The government may opt for such an exchange rate target because it wishes to promote exports. Indeed, Japan operated for decades with an undervalued exchange rate and its exports increased rapidly.

To defend the undervalued currency, the Polish government and/or central bank could either accumulate foreign reserves by selling domestic currency or lower domestic interest rates by expanding the money supply. Either of these policies shifts the demand curve for foreign exchange to the right, increasing the exchange rate until it crosses the supply curve at point C with exchange rate eP.

Two significant advantages arise from fixed exchange rates. First, exchange rate risk is eliminated. Indeed, after World War II the major industrial countries formed the Bretton Woods system of international exchange rates. This was a fixed exchange rate system built around the U.S. dollar. Participating countries pegged their currencies to the U.S. dollar, and the United States set a value for its currency in terms of gold. Thus, other currencies were indirectly tied to the gold standard. The International Monetary Fund (IMF) was set up to administer this system.

For a variety of reasons the Bretton Woods system collapsed between 1971 and 1973. At certain times, a country would find its fixed exchange rate in serious disequilibrium and an exchange rate revaluation would be necessary. Currency devaluations in particular proved difficult due to political resistance and speculative runs on the currency. If rumors circulated that the IMF may be preparing for a currency devaluation in Great Britain, for example, holders of the British pound would sell pounds and purchase other currencies until devaluation did indeed occur, at which time the investors would buy back pounds at a cheaper price. This speculation on currencies made devaluation all the more likely--a self-fulfilling prophecy.

The most serious difficulty with the Bretton Woods system was that it provided no stable devaluation opportunities for the U.S dollar. The U.S. had run significant balance of payments deficits with the rest of the world because of its overvalued currency and foreign central banks were soaking up U.S. dollars to hold as reserves. The glut of dollars on the foreign markets made it impossible for the U.S. to credibly commit to exchange the dollars for other countries' domestic currencies. In 1972 the U.S. dollar was devalued and participants lost confidence in it as the anchor currency. The system of fixed exchange rates has never been replaced, and exchange rate risk has increased significantly.

A second advantage from fixed exchange rate regimes is that the domestic government gains a measure of external credibility in fighting inflation. By pegging the domestic currency to a stable foreign currency, the government is committing itself to long-term inflation rates similar to inflation rates in the nation for which the currency is pegged. Otherwise, the exchange rate will become overvalued and the government will ultimately have to devalue.

Despite these advantages, two significant drawbacks exist to fixed exchange rate regimes. First, the domestic country relinquishes control of its domestic monetary policy. Interest rates must be adjusted primarily to control international capital flows. If the Polish zloty is pegged to the U.S. dollar and the U.S. raises its interest rates, Poland must raise its interest rates in order to avoid capital outflows and a weaker currency. If Poland's economy is in a recession, the last thing that it needs is higher interest rates.

The second disadvantage to a fixed exchange rate regime is that the domestic government traps itself into an inflexible policy in which one devaluation can ruin the government's credibility. Fixed exchange rates offer few escape clauses should devaluation become necessary. As with the Bretton Woods system, if private investors sense that a devaluation is inevitable, they send their assets abroad until devaluation occurs. Pegged exchange rates, therefore, may not be sustainable over the longer term.

The countries most likely to adopt fixed exchange rates are the ones that benefit the most from such a regime, which are usually the ones that need external validation to contain inflation. Many Latin American nations with histories of hyperinflation resort to fixed exchange rates when they need to signal to markets that they are serious about controlling inflation. In contrast, nations with a history of stable currencies typically avoid fixed exchange rate regimes.

Crawling Pegs

A third exchange rate regime is the crawling peg--a hybrid between fixed and flexible exchange rates. Under this system, a government typically announces a range of exchange rates in which it will allow the currency to trade. If the exchange rate moves outside one of the predefined bounds, the government intervenes to move the currency back into the acceptable range. For example, Poland may decide that it will allow the zloty to trade between four and five zloty to the U.S. dollar. If the zloty weakens to the point at which the exchange rate moves above six, the government will sell its dollar reserves and purchase zloty. Over time the exchange rate ranges are adjusted to reflect market movements.

A crawling peg has some of the advantages and disadvantages of both fixed and flexible exchange rate regimes. Exchange rate risk is reduced but not eliminated. The government gains some credibility in fighting inflation, but less credibility than under a fixed exchange rate regime. A crawling peg gives the government an "out" in that one devaluation does not ruin the government's credibility. Indeed the devaluations are typically preannounced and anticipated by the market. Finally, the country retains some control over domestic monetary policy. The money supply can be changed as long as the exchange rates remain in the desired range.

Several countries making the transition from socialism to capitalism had adopted crawling peg regimes. Poland and Russia, for example, adopted this approach. These governments needed some credibility in fighting inflation but they also knew that devaluation may be inevitable down the road. A crawling peg also gave domestic firms some insulation against exchange rate risk. A crawling peg is most likely perceived as a temporary regime by governments. As transition economies become more stable and inflation better controlled, they may opt to float their currencies.

Exchange rate crises occur when an overvalued currency is suddenly devalued. Devaluations can lead to inflation and recession simultaneously.

Mexico's fixed exchange rate regime failed because Mexico ran inflation rates higher than those in the U.S., and the foreign reserves used to support the peso were depleted.

Devaluations from the Asian Crisis were the result of massive capital outflows as investors realized that assets were overpriced.

Argentina adopted a currency board to control its money supply, and it pegged the peso to the U.S. dollar at an exchange rate of 1.

Argentina's peso appreciated with the U.S. dollar, which led to a severe recession. Eventually the peso was devalued.

Exchange Rate Crises

Countries around the world periodically experience exchange rate crises where the value of the domestic currency plummets rapidly. Some recent examples include the Mexican peso crisis of 1994 and the Asian Crisis of 1997. At the time of this writing, Argentina just announced a devaluation of the peso. This crisis forced two Presidents to resign, bank accounts were frozen, and riots erupted on the streets of Buenos Aires. What causes these crises? Why do citizens react with such emotion when their currencies devaluate so quickly? What are the economic effects of these crises? We answer these questions by examining the Mexican, Asian, and Argentine experiences.

The Mexican Peso Crisis

The 1980s in Mexico is termed the "lost decade." After borrowing heavily in international markets during the 1970s when oil prices were high, Mexico entered a state of crisis when oil prices plummeted in the early 1980s. The Mexican government defaulted on its debt in 1982 and the economy experienced both recession and high inflation simultaneously. President Salinas assumed power in 1988 and implemented a series of economic reforms, one of which included pegging the exchange rate at about 3 pesos to the U.S. dollar. The fixed exchange rate gave the Mexican government more credibility in its efforts to reduce inflation, and it allowed Mexican businesses to operate with less concern for exchange rate risk.

Mexican Exchange Rates
MonthExchange Rate
Aug 19943.38
Jan 19955.64
Source: Federal Reserve Bank of St. Louis

The fixed exchange rate held throughout the remaining term of Salinas, which ended in August of 1994. In the years leading up to the devaluation, however, signs of trouble emerged that hinted that the peso was overvalued. The trade deficit widened sharply in the early 1990s because imports rose more quickly than exports. Mexican inflation rates were consistently higher than those in the United States, which made U.S. imports relatively cheap in Mexico. In 1994, goods exports totaled US $60.8 billion while imports were US $79.3 billion. In December of 1994, just four months after Salinas' successor (Zedillo) took office, the peso was suddenly and sharply devalued from 3.4 pesos to nearly 6 pesos to the dollar. The devaluation occurred because the Mexican central bank could no longer defend the peso and the growing trade deficit by selling its now depleted stock of foreign reserves.

The devaluation led to a depression-like year in 1995. Mexico's GDP contracted by 6.2 percent and inflation rose from 7.1 percent in 1994 to 52 percent in 1995. Output declined for three reasons. First, the devaluation of the exchange rate increased import prices sharply, simultaneously increasing inflation and reducing the purchasing power of the Mexican consumer. The price hike reduced consumption demand. Second, many business debts were denominated in foreign currency, and the devaluation essentially doubled their debts. Many companies went bankrupt and closed. Finally, Mexico increased interest rates to reduce the capital outflow and to attract capital inflows into the nation. The high interest rates reduced investment and increased variable-rate debts of Mexican businesses.

In essence, the fixed exchange rate regime failed because Mexico ran inflation rates higher than those in the United States. Mexicans were outraged at the perceived mishandling of the exchange rate and the subsequent hardships that they endured. Indeed, President Salinas went into exile in Ireland amid accusations of corruption and scandal.

The Asian Crisis

East Asia has for decades been heralded as the region of economic miracles. Growth was so rapid that the nations and economic areas of Taiwan, South Korea, Hong Kong, Indonesia and Singapore grew from poor economies to some of the wealthiest nations of the world. Much of this growth occurred under flexible exchange rate regimes.

In March of 1998, Indonesia's currency traded at 8,300 rupiahs to the dollar, about one-fourth its value on July 1, 1997 when it took just 2,430 rupiahs to purchase a dollar. Likewise, the South Korean won has declined to about half its July 1997 level. Growth in Indonesia, South Korea, Thailand, and a few other Asian nations slowed considerably in 1998. Banks were saddled with large debts, and many giant corporations went bankrupt. The International Monetary Fund (IMF) conditionally lent billions of dollars to Indonesia and South Korea to help bail them out. What went wrong?

Paul Krugman, an economist at MIT, explains the Asian crisis with a comparison to a play that has two acts. [Fortune, March 2, 1998.] The first act was a story of a bubble in real-estate and asset prices. Over time, prices of real estate and other assets soared, driven in part by large amounts of foreign investment. Foreigners viewed East Asia as a safe-haven for funds with high returns.

The second part of the act was the bursting of the bubble. A slump in the semiconductor market and a strengthening of the U.S. dollar probably triggered the crisis. Foreign and domestic investors pulled their funds out of Asia, which caused asset prices to plunge. The flow of funds out of the country put downward pressure on Asian currencies, which made the crisis worse by increasing the real debt-load of Asian firms holding foreign debt. In Indonesia, for example, four times as many rupiahs were now required to pay US $1 in debt than before the crisis began. With heavy debt loads and low asset values, many firms declared bankruptcy or defaulted on their payments. Banks were left with bad loans and high foreign debts, and many of them began to fail. In order to avert a larger financial collapse, some Asian governments with assistance from the I.M.F. stepped in to bail out the financial sector. The result, however, was slow growth and higher unemployment.

The devaluations in the Asian crisis were fundamentally different from the devaluation in the Mexican crisis. The overvalued Asian currencies resulted in part from a surge in capital inflows (which shifts the supply curve for foreign exchange to the right) as investors tried to capture the high returns from Asian financial markets. As the perceived high returns failed to materialize, partly because of corruption and misallocation of credit, investors reversed course, which led to large capital outflows.

The Argentine Peso Crisis of 2001-02

Argentina is in the midst of an exchange rate crisis that has yet to play out fully. This economic crisis is similar in some ways to the Mexican crisis, though additional constraints imposed on the Argentine government made devaluation more difficult. As with Mexico, the Argentine crisis has its roots in the economic troubles of the 1980s.

Because of high debt levels and irresponsible fiscal policy in the 1970s and 1980s, the Argentine government printed money to pay off debts, which resulted in hyperinflation. Inflation reached absurd levels, exceeding 3,000 percent in 1989. In 1991, to quell that inflation, Argentina adopted a currency board, a monetary authority that issues money convertible into a foreign anchor currency. A currency board is an even stronger commitment to a fixed exchange rate system because the currency board is forbidden by law to print money. The Argentine currency board was to hold roughly one U.S. dollar in reserve for every peso in circulation. With this institutional arrangement, the potential for a run on the peso was diminished (but not impossible) because the currency board had the dollars to back up the currency. The Argentine peso was pegged one-to-one to the U.S. dollar.

Argentine Inflation Rates (%)
MonthExchange Rate
Source: Latin Business Chronicle

The currency board eradicated inflation in Argentina throughout the 1990s. Indeed, as Table 2 shows, Argentina experienced deflation (falling prices) since 1999 into 2002. The economy has also been in recession since that time; unemployment exceeded 18 percent as of December 2001. Because of the recession, Argentina is once again in the middle of an exchange rate crisis.

The primary problem for the exchange rate crisis is that Argentina's exports have gradually become less competitive in the world economy as the U.S. dollar has appreciated. Businesses in countries like Brazil (with floating exchange rates) produce products at lower cost than Argentina's businesses. The subsequent weak economy and falling tax revenues forced Argentina to default on its debt in December of 2001.

For months, most Argentine citizens and foreign investors believed that the only way out of the steep recession was to devalue the peso to make the economy's products more competitive internationally. The belief that devaluation was inevitable led to capital flight. Argentine citizens had the option in the 1990s to hold their deposits in U.S. dollars, believing that their funds were safe from devaluation. The government, however, froze bank accounts in late 2001 to prevent these dollars from leaving the country. It allowed depositors to remove a fraction of their savings from banks each month. Riots broke out in Buenos Aires, and the President resigned in late 2001. In fact, the interim President was also forced to resign after just a few days in office.

Recently, the new President announced a devaluation of the peso from an exchange rate of 1 to 1.4. It now takes 1.4 pesos to purchase one U.S. dollar. Devaluation in Argentina will make exports more competitive and ultimately aid economic growth. Devaluation, however, will also cause hardships similar to those experienced in Mexico in 1995. Inflation will rise as import prices increase, and debts denominated in dollars will increase, resulting in a wave of bankruptcies and bank failures. In addition, inflation may return with a vengeance to Argentina if the government resorts to printing money to pay off its debts. It is no wonder that Argentine citizens are so upset at their government as they face yet another economic crisis.

Exchange rate crises occur for different reasons around the world. Mexico's currency became overvalued by having inflation rates significantly higher than those in the United States. Argentine products gradually became overvalued because the peso was tied to the rising dollar. In Asia, many nations were flooded with foreign investment, which overvalued their currencies. When the wave of optimism ended, foreign investment fled, leading to sharply devalued currencies. In each case, economic imbalances persisted and built over time. The pressure for devaluation is analogous to water building behind a weak dam. Eventually, the dam breaks and the water floods the area downstream. Equivalently, the pressure for devaluation builds until the currency loses its value, and the economic damage spreads throughout the economy.

Expansionary monetary policy has a larger effect on output in an open economy than in a closed economy.

Open-economy fiscal policy are smaller than the closed-economy results.

Stabilization Policy with Flexible Exchange Rates

Thus far, we have analyzed fiscal and monetary policy in a closed economy, ignoring their international effects. Chapter 12 looked at fiscal policy while Chapter 15 examined monetary policy. Economies, however, are more closely linked than ever before. Domestic stabilization policy affects the exchange rates of nations that let their currencies float in the market, which in turn effects international trade flows.

Monetary Policy

Open-Economy Monetary Policy As the figure titled "Open-Economy Monetary Policy" illustrates, expansionary monetary policy has a larger effect on output in an open economy than in a closed economy. The Aggregate Demand curve shifts to ADO rather than ADC, the closed economy result. Why is this so?

An increase in the money supply reduces domestic interest rates, which makes domestic assets less attractive to foreigners seeking high returns in international capital markets. All else equal, an increase in the money supply reduces capital inflows, shifting the supply of foreign exchange to the left. The equilibrium exchange rate rises, leading to a weaker domestic currency. Recall that a weak currency results in cheaper export prices abroad and more expensive import prices at home, increasing net exports. Monetary policy still boosts domestic investment because interest rates fall, but it has an extra positive effect on net exports by weakening the domestic currency.

Contractionary monetary policy has exactly the opposite effect. Higher interest rates resulting from a Federal Reserve open market sale, for example, makes U.S. assets more attractive, which leads to additional capital inflows and a stronger U.S. dollar. Net exports fall, amplifying the output reduction from monetary policy.

Fiscal Policy

Open-Economy Fiscal Policy Unlike monetary policy, the impacts of open-economy fiscal policy are smaller than the closed-economy results. As the figure titled "Open-Economy Fiscal Policy" illustrates, Aggregate Demand shifts to ADC in a closed-economy fiscal policy expansion, but Aggregate Demand shifts only to ADO in the open-economy case. In this case, international trade flows dampen the effect on output.

Recall from the discussion of budget deficits in Chapter 13 that expansionary fiscal policy simultaneously increases the demand for loanable funds. When the government borrow more funds, it drives up interest rates, crowding out--or displacing--private investment. Higher interest rates attract foreign investment, shifting the supply curve of foreign exchange to the right. The exchange rate falls, strengthening the domestic currency. The strong currency, then, reduces net exports because exports become more expensive abroad while imports are cheaper at home. The reduction in net exports partially dampens the output effect from expansionary fiscal policy.

On January 1, 2002 the twelve European countries of the European Monetary Union began the process of destroying their local currencies and jointly floated a new paper currency called the euro.

The European Monetary Union

On January 1, 2002 twelve European countries began the process of destroying their local currencies and jointly floated a new paper currency called the euro. By July 1, 2002 the euro will be the only currency in circulation. The nations that comprise the European Monetary Union (EMU) include Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Each of these nations abandoned their domestic monetary policy, leaving it under the control of the European Central Bank (ECB). Why did these nations abandon their currencies and why do members of the EMU have to give up their domestic monetary policy?

Until the euro was introduced, businesses had to purchase the foreign currency of each respective nation to conduct transactions across European nations. The idea is similar to a person from Georgia having to purchase currency from Florida before doing business in that state. Besides the inconveniences and fees involved in exchanging currencies, firms had to worry about exchange rate risk. The EMU removes these inconveniences and risks by using a single currency, just as each state in the United States uses the dollar. By joining currencies, the fifteen-member union creates an economy comparable in size to that of the U.S.

The nations in the EMU had to make a huge sacrifice in order to reap the benefits. Each government transferred control of the supply of euro to the ECB; therefore, each nation gave up its domestic monetary policy. An open market operation is impossible by any of the fifteen nations because EMU governments have no authority to purchase or sell bonds by creating euros. These nations have to rely solely on fiscal policy to counteract the business cycle.

Relinquishing control over monetary policy leaves countries more vulnerable to recessions. When Italy, for example, enters into a recession, it will desire that the ECB lower interest rates to increase economic activity. The other members of the union, however, may have strong growth and inflationary pressures such that the ECB actually raises interest rates. The recession in Italy may worsen as a consequence.

Again, this scenario is not much different from California experiencing a recession while the rest of the states in the union enjoy strong growth. The Federal Reserve may not cut interest rates just to ease the pain in California. But the U.S. has two advantages that the EMU does not have. First, U.S. states have fairly uniform labor policies. Second, the U.S. has an open and mobile labor market with wages set in a national market. Californians that are unemployed can "vote with their feet" and move to a part of the nation that is doing well. In contrast, Italians will have more difficulty moving to other nations to find employment because of the language, legal and cultural barriers.

In sum, Italy may linger in recession longer than it would if it could print money to stimulate production. The vulnerability of these nations to recessions may undo the European Monetary Union. Under severe political pressure, some countries may opt out of the agreement and go back to their former currencies. No matter the outcome, the EMU experiment is one that economists and European citizens will undoubtedly follow with great interest.

Additional reading on the EMU is available at the St. Louis Federal Reserve Bank and from the European Commission.

Copyright © 1996-2006 - All Rights Reserved