Exchange Rate Determination and Policy

Colin F. Bullock

Learning Objectives
PPP and long run exchange rate determination. The market for domestic assets and exchange rate determination in the short run. The Mundell-Fleming Model and monetary, fiscal and trade policy under fixed and floating exchange rates. Fixed vs floating exchange rates in small open economies.

Introduction
Exchange rates are the rate at which one countrys currency trades for another countrys currency. The exchange rate may either be expressed as units of foreign currency per unit of local currency (US$/J$) or units of local currency per unit of foreign currency. An increase in US$/J$ is an appreciation of the Jamaica dollar and an increase in J$/US$ is a depreciation of the Jamaica dollar. The spot market is for settlement in two days while the forward market may be for settlement for longer periods, usually over thirty days. Depreciation makes exports cheaper abroad and imports more expensive at home. Appreciation does the opposite.

Exchange Rates in the Long Run

The Law of one price: for two countries producing an identical commodity with no trade restrictions and transport costs, the exchange rate ensures that price is the same in both countries. Purchasing Power Parity (PPP): An application of the law of one price to the general price level (the cost of an identical basket of goods) in two countries.

Limitations of PPP
Product differentiation; goods not identical. Transport costs are not likely to be minimal Countries use tariffs and quotas to restrict trade. The general price level includes many nontraded goods that do not influence the exchange rate.

Exchange Determinants in the Long Run

A factor that increases the demand for domestic goods relative to foreign goods will appreciate the exchange rate (and vice versa). A rise in the countrys price level relative to other countries depreciates the currency. Increased restrictions on trade cause an appreciation of the currency. Increased preference for a countrys products appreciates the currency. Increased productivity appreciates the countrys currency.

Summary of Long Range Influences on the Exchange Rate

Short Run Influence of the Market for Domestic assets

Impact of Increased Domestic Interest Rate

Impact of Increased Foreign Interest Rate

Impact of Expected Increase in Exchange Rate

Mishkin Summary of Influences I

Mishkin Summary II

Domestic vs Real Interest rates

Recall the Fisher equation: in = ir + e If the increase in the nominal interest rate is due to an increase in the real interest rate, it appreciates the domestic currency. If it is due to an increase in the expected rate of inflation, it depreciates the domestic currency.

Money Supply and Expected Inflation

The Mundell-Fleming Model of the Small Open Economy

r = r* (Domestic interest rate = world interest rate) IS Curve: Y = C(Y-T) + I(r*) + G + NX(e) LM Curve: M/P = L (r*,Y)

Derivation of the IS Curve

Derivation of the LM Curve

Mundell-Fleming Equilibrium

Fiscal Policy Under Floating Exchange Rates

Monetary Policy Under Floating Exchange Rates

Trade Policy Under Floating Exchange Rates

Fixed Exchange Rate Governs the Money Supply

Fiscal Expansion Under Fixed Exchange Rates

Monetary Expansion Under Fixed Exchange Rates

Trade Restrictions Under Fixed Exchange rates

Mundell-Fleming Policy Effects Summary

Fixed Exchange Rates for Developing Countries?

FOR Facilitates price stability Against Prices stability depends on the true market exchange rate and not merely the official exchange rate. There is a loss of independent exchange rate policy. There is a loss of independent monetary policy. Policy is entirely dependent on fiscal policy which may be driven into deficits by shocks.

Stability reduces uncertainty and encourages investment. Avoids independent monetary policy that a small country may not be able to manage. Discourages irresponsible fiscal and monetary policy that is inconsistent with exchange rate stability.

A disincentive for political irresponsibility.

Encourages hard work and productivity in the absence of inflationary gains.

Structural inflationary impulses may cause a loss of competitiveness.

May require costly exchange control to defend exchange rate

Floating Exchange Rates for Developing Countries?

For Allows independent exchange rate policy Allows independent monetary policy. Against Facilitates exchange rate instability and price uncertainty. Independent monetary policy is likely to be irresponsible and inflationary.

Policy is more flexible in the face of shocks.

Policy can more easily retain price competitiveness. There is greater capacity to avoid the development of parallel fx markets. The budget may be balanced over time rather than constantly.

Flexibility allows for postponement of difficult decisions in the face of shocks.

Exchange rate policy cannot sustain enhanced competitiveness in face of high import price dependence. On-going exchange rate depreciation may encourage dollarization and loss of monetary policy. The facilitation of fiscal deficits may become endemic through the build-up of external debt.

From Peg to Float in Jamaica

Jamaica entered independence with an exchange rate fixed to the British pound (1:1). In the late 1960s, the peg was switched to the United States Dollar at (J$0.7 = $US$1). Foreign exchange pressures in the 1970s and 1980s elicited a variety of foreign exchange systems with devaluation to J$6 = US$1. With very negative NIR, minimal gross reserves and an active // market, Jamaica liberalized its fx. system between Sept 1990 and Sept 1991.

Performance Under Managed Float

Liberalization in less than ideal circumstances re tightness of macroeconomic policy and financial sector regulation. This facilitated exchange rate slippage, triple digit inflation and loose financial institution management culminating in crisis. Beneficial results in NIR moving from negative to positive and the elimination of the parallel market in foreign exchange.

Should Jamaica Return to a Peg?

Concern about slippage in exchange rate over time and impact on inflation and uncertainty. Negative comparisons with Barbados and other fixed exchange rate economies. Perspectives on the ineffectiveness of depreciation in fostering competitiveness. In reality, Jamaica lost capacity to fix due to inappropriate fiscal policy and low productivity which is what drives depreciation. These factors will create problems in peg or float. Barbados retained peg because of more effective fiscal policy and even now has competitiveness issues. Floating has benefitted NIR and fx. market and success of fix or float depends on effective fiscal policy.

Readings
Mishkin Ch. 17 Mankiw (7th ed.), Macroeconomics Ch. 12 Ghatak and Sanchez-Fung Ch. 10 Articles by Hon. Edward Seaga and Colin Bullock in Mona School of Business Review Vol. I, #1.