Module Summary -- International Economics

Chapter Twenty: Module Summary -- Exchange Rate Regimes and Crises

A nation essentially has three options for exchange rate regimes. It can adopt a floating, fixed, or crawling peg exchange rate regime.
Flexible exchange rate regimes let the forces of supply and demand for foreign exchange determine currency values.
Two significant advantages arise from flexible exchange rate regimes. First, trade imbalances are corrected automatically with no need for government intervention. Second, stabilization policy can be conducted without concern for the impact on exchange rates.
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 increasing exchange rate risk. Second, some countries forego inflation-fighting credibility.
Two alternatives are available to a government to overvalue its currency. First, it can draw down its foreign reserves--the stock of foreign currency and foreign liquid assets that it owns. Second, it can adjust domestic interest rates by changing the quantity of money in the economy.
Two significant advantages arise from fixed exchange rates. First, exchange rate risk is eliminated. Second, the domestic government gains a measure of external credibility in fighting inflation.
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 dollar, and the U.S. 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.
A fixed exchange rate regime requires that the domestic country relinquishes control of its domestic monetary policy. In addition, the domestic government traps itself into an inflexible policy in which one devaluation can ruin the government's credibility.
The crawling peg regime is 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.
Stable countries without a history of high inflation tend to adopt flexible exchange rates. Countries that need additional inflation-fighting credibility adopt fixed exchange rates. Transition economies have tended to adopt crawling pegs while they grow into more stable economies with lower inflation rates.
The Mexican Peso Crisis occurred primarily because Mexico ran inflation rates higher than those in the U.S., which led to a real appreciation of its currency. Eventually the country ran out of foreign reserves, and the peso devalued.
The overvalued Asian currencies led to the Asian Crisis. The currencies became overvalued as a result of a surge in capital inflows 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 and a currency devaluation.
To quell hyperinflation, Argentina adopted in 1991 a currency board, a monetary authority that issues money convertible into a foreign anchor currency. The Argentine peso was pegged one-to-one to the U.S. dollar. The Argentine Peso Crisis of 2001-02 primarily resulted from an appreciation of the U.S. dollar, which made Argentina's exports less competitive and pushed the economy into recession. Argentina defaulted on its debt in December 2001 and devalued the peso in January 2002.
A sharp and sudden devaluation typically leads to a burst of inflation, a wave of bankruptcies and a severe recession.
Expansionary monetary policy in an open economy has a larger effect on output than in a closed economy because lower domestic interest rates weaken the domestic currency, which increases net exports.
Expansionary fiscal policy in an open economy has a smaller effect on output than in a closed economy because higher domestic interest rates from the crowding out effect strengthens the domestic currency, which decreases net exports.
On January 1, 2002 the twelve European countries that form the European Monetary Union (EMU) began the process of destroying their local currencies and jointly floated a new paper currency called the euro. The union creates an economic area comparable in size to that of the U.S.
Members in the EMU are more vulnerable to recession because they have transferred control over monetary policy to the European Central Bank. It remains to be seen how the EMU will fare over time.