Macro

MACRO ECONOMICS AND FLOATING EXCHANGE RATE POLICY
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CHP 1 : MACRO ECONOMIC POLICY
1.1 ) Meaning
Macroeconomic stability is a necessary condition for development and for growth. However,
the record of the past two decades shows that recently fashionable ideas, and policy
recommendations, of what makes for good macroeconomic management and for such
stability have been overly narrow. Indeed, in many countries they have wrought the opposite
of what was intended.
Developments over the past decade have changed perceptions across the world about the
nature of desirable macroeconomic policies. The Asian financial crisis of the late1990s and
the meltdown in Argentina at the turn of the decade showed the possibility of apparently
prudent fiscal strategies still being associated with unsustainable macroeconomic processes
that created the possibilities of crises. The emphasis placed explicitly by the UN and the
international community on achieving the Millennium
Development Goals and the need to ensure finance for development have indicated the need
for changing the emphasis of economic strategies. All these and related factors have
produced a broad understanding that macroeconomic management in open developing
economies should be guided by the following framework:
Macroeconomic policy needs to be developed within a coordinated framework, so that
fiscal, monetary, exchange rate and capital management policies are consistent.
The time horizon should be medium term, set within a systematic framework that
provides the contours within which macroeconomic and public expenditure strategies are
organized.

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Economic growth, livelihood stability and employment generation must be given
significance, and should not be crowded out by an overly narrow focus on
macroeconomic stability and inflation control.
It is not just the aggregate rate of economic growth, but also the pattern of that growth,
which is crucial. Indeed, a moderate but sustainable rate of growth, which involves
employment generation and poverty reduction, is preferable to a higher rate of growth
that is based on greater income inequalities and has more potential for volatility and
crisis.
For most countries, the primary goal should be productive employment generation
providing decent work. This requires more than macroeconomic policy alone; in
particular, industrial policies providing carefully considered incentives to promote
desired investment and financial policies including directed credit will play a role.
The significance of public expenditure in sustaining and expanding the productive human
resource base of the country through social spending must be recognized.
Macroeconomic policies must ensure that public expenditure in the social sectors is
maintained at adequate levels.
Developing country governments need to be more confident of the positive effects of
appropriate expansionary fiscal policy and, in particular, of the critical role of public
investment.
There needs to be more emphasis on raising public resources in ways that do not
adversely affect the poor, for example through effective implementation of progressive
direct taxation, (flexible) trade taxes and taxes on capital movements.

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Monetary policy should accommodate fiscal policy, not the other way around, and both
should be targeted to real economic goals such as employment generation, livelihood
protection and expansion and poverty reduction. This has implications for the kind of
independence to be given to central banks. It also means that inflation targeting, in itself,
cannot be the central goal of monetary policy.
Exchange rates should be flexibly managed, even to the point of creating a band within
which market forces are allowed to work. This requires some control over capital account
movements, preferably through a range of flexible instruments.
Last, but not least, all macroeconomic policies must take full account of equity
considerations and impacts.
In short, pragmatism, within a growth-enhancing framework, and flexibility, guided by the
specific requirements of each countrys context, should be the guiding principles, rather than
a dogmatic one size fits all approach.
The following material expands on the above points. We do not propose any specific policies
as it would be impossible to do so given the differences between developing countries.
Instead, we raise some major issues for consideration and suggest the policy space that is
available to address them. We begin with placing macroeconomic policy in context in the
following section, and then consider fiscal policy, monetary policy, managing economic
cycles, and exchange rate policy in the next four sections.
Macroeconomic policy addresses the overall aggregates of the economy: prices, output,
employment, investment and savings, government balances, and balances on the external
account.

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The goals of macroeconomic policy can and do vary. They include creating conditions for
sustained growth; price stabilization or inflation control; reducing unemployment; smoothing
economic cycles and volatility in output and employment; correcting aggregate and sectorial
imbalances; reducing poverty, and providing greater equity for all, especially the
marginalized.

1.2 ) There are three major policy instruments to manage these macroeconomic aggregates,
namely,
(a) Fiscal policy;
(b) Monetary policy, and
(c) Exchange rate policy.
Fiscal policy covers matters such as taxation and other methods of resource mobilization, and
levels and patterns of expenditure, that is, the aggregate fiscal stance. Monetary policy
centrally addresses the base interest rate and levels of credit in the economy. Exchange rate
policy, in contemporary open economies, is largely related to monetary policy.
Macroeconomic policy involves trade-offs between its conventionally accepted goals. Thus,
a quest for macroeconomic stability focusing on inflation control may imply sacrificing
employment, and counter-cyclical measures may worsen sectorial imbalances. These short
run goals in turn have a bearing on development policies. The quest for macroeconomic
stability may lead to insufficient emphasis, or worse, on strategies for sustainable and more
inclusive development, or improving human development and meeting broader social

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objectives. In particular, the goals of price stability and employment generation can be in
conflict. Unfortunately, the pursuit of price stability or the correction of external imbalances
has too often become so dominant as to lead to the neglect of pervasive and persistent
unemployment and underemployment. However, a shift in focus making productive
employment generation the most important goal need not generate imbalances or instability.

1.3 ) Short-term and long-term linkages
Economic policy makers have often assumed that macroeconomic policies are short run
measures to address current problems, most importantly stabilisation and correcting
aggregate imbalances, and that they can be treated separately from measures to promote
economic growth and development. However, short-term measures can determine the
contours of future growth and affect possible future economic strategies. For example, a non-
judicious reduction in public expenditure to correct a fiscal deficit, resulting in a reduction in
important infrastructure investment, directly affects future growth prospects. Conversely,
policies such as development plans or economic adjustment exercises designed for the
medium or longer term directly impact upon current conditions and affect short run
movements. Policies of trade liberalization designed to reduce external deficits by bringing
domestic relative prices closer in line with world trade prices may create incentives to reduce
investment and increase consumption, thereby creating imbalances within the economy; or
they may reduce trade tax revenue, creating pressure on the public deficit.
Short run macroeconomic policy and longer term growth strategies are inextricably linked,
not separate and independent. In particular, public investment affects growth directly, by

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improving the supply conditions of infrastructure, etc., thereby expanding the capital base of
the economy and the potential for further accumulation, and indirectly, through its positive
linkage effects with private investment. For developing countries, the paramount concern is
to access a more growth-oriented, employment generating macroeconomic stance, and public
investment is a critical factor in achieving this. However, it should also be recognized that
macroeconomic policies are not the only factor determining the rate and pattern of growth,
and that the investment climate in general (including for both public and private investment)
has a significant role to play. Microeconomic interventions and other policies can influence
the incentives to invest and the distribution of investment in important ways. In addition to
growth associated with productive employment generation, a major concern of
macroeconomic policy is the reduction of economic volatility. Economic instability is
undesirable for many reasons. There are direct costs of income variability in the presence of
imperfect capital and insurance markets, so that income smoothing over the economic cycle
is imperfect and downswings are associated with consumption falls especially among the
poor. In general, in all countries, the poor bear the brunt of economic fluctuations: they suffer
most in slumps, through higher unemployment and lower real wages; and they tend to gain
relatively less from booms which, especially in recent times, have been more associated with
higher returns to capital and not necessarily with higher employment generation.


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CHP 2 : EXCHANGE RATE POLICIES IN OPEN DEVELOPING ECONOMIES
Managing exchange rates to ensure growth and stability has become one of the most
significant requirements of macroeconomic policy. This is especially so after trade
liberalization reduced the ability of governments to manage the balance of payments by other
means and to ensure that higher levels of the exchange rate are not associated with lower
levels of activity and employment. With trade liberalization, even prior to the liberalization
of capital flows, a significantly overvalued domestic currency is likely to generate
unemployment, and an undervalued one, to generate inflation.
The problem is how to achieve a desirable value of the exchange rate, to encourage
investment in traceable yet provide price stability, and to avoid sharp destabilizing changes.
Developing countries have been through a gamut of strategies, from strongly fixed exchange
rate systems to completely flexible floating regimes. Both extremes have shown their
disadvantages. Fixed exchange rate regimes are too rigid and delay eventually necessary
movements of the exchange rate, which then become subject to very sharp shifts with
associated crises. Completely flexible rates are usually too volatile and can depress longer-
term investment because of the considerable uncertainty thereby generated.
In general, exchange rates are managed directly or indirectly by governments, and not left
solely to the determination of market forces. For developing countries, intermediate regimes,
such as managed floats or crawling pegs, work best. They allow governments to adjust the
level of the exchange rate to external conditions as well as to the current policy priorities for
the domestic economy. These managed floats are best maintained through a combination of
capital account and banking policy measures, along with the more usual open market

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operations of the central bank purchasing or selling currency in the foreign exchange market.
The argument for keeping the exchange rate low is usually presented in terms of promoting
the export sectors. This is not only for purely trade reasons, but also because it is felt that the
traded goods sectors thereby encouraged are more dynamic compared to non-traded sectors,
and that the higher rates of technical progress will spill over to other sectors. Thus, it is
argued that the expansion of traded goods sectors is more likely to enhance growth than, say,
the expansion of the construction sector. A second argument focuses on poverty. A high level
of the exchange rate could lead to lower domestic prices for sectors such as agriculture,
which in turn would adversely affect peasant cultivators. In countries where peasant
cultivators form an important segment of the population and economy, this would directly
affect rural poverty. In such cases, the government may prefer to maintain a low exchange
rate and combine it with some export taxes: external balance can then be achieved along with
protecting agriculturalists and generating revenues for development expenditures.
However, all these possibilities are available mainly when there is some possibility of
containing very volatile flows of mobile capital. When capital flows are liberalized, exchange
rates become exceedingly difficult to manage. This can lead to unintended and undesirable
processes and outcomes.
For example, the evidence on capital inflows and subsequent crises suggests that once an
emerging market is chosen by financial markets as an attractive destination, processes are
set in motion which are likely to eventually culminate in crisis. This works through the
effects of a surge of capital inflows on exchange rates in the following way. An appreciating
real exchange rate encourages investment in nontrade able sectors, the most obvious being
real estate, and in domestic asset markets generally. At the same time, this upward movement

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of the currency discourages investment in traceable and therefore contributes to a process of
relative decline in real economic sectors, and even deindustrialization in developing
countries. Given the interest rate differentials between domestic and international markets
and the lack of prudence on the part of international lenders and investors, local agents
borrow heavily abroad to directly or indirectly invest in the property and stock markets. It is
important to remember that high real rates of interest tend to be associated with appreciating
exchange rates, which in turn has the negative consequences already described. The two
conditions high interest rate and high exchange rate therefore go together, with adverse
effects on investment and the level of economic activity.
One important conclusion is that, as far as possible, exchange rates in open developing
countries still need to be managed, preferably within a band, along the lines of a crawling
peg which can adjust to changing internal and external economic circumstances. A related
conclusion is that capital flows need to be managed, in terms of both inflows and outflows,
to prevent excessive volatility and possible crisis.


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CHP 3 : Floating Exchange Rate
3.1 ) Definition
A country's exchange rate regime where its currency is set by the foreign-exchange market
through supply and demand for that particular currency relative to other currencies. Thus,
floating exchange rates change freely and are determined by trading in the forex market. This
is in contrast to a "fixed exchange rate" regime.
3.2 ) Meaning
In some instances, if a currency value moves in any one direction at a rapid and sustained
rate, central banks intervene by buying and selling its own currency reserves (i.e. Federal
Reserve in the U.S.) in the foreign-exchange market in order to stabilize the local currency.
However, central banks are reluctant to intervene, unless absolutely necessary, in a floating
regime. A floating exchange rate occurs when governments allow the exchange rate to be
determined by market forces and there is no attempt to influence the exchange rate. In recent
years, several countries have pursued inflation targets as the primary goal of monetary
policy. Therefore, by targeting inflation, they have given less importance to the exchange rate
and more countries have allowed their exchange rate to float freely.
3.3 ) Dirty Floating
Sometimes, countries are not in an official exchange rate mechanism, but they still do pay
attention to the value of the exchange rate. Though they have no published target for the
exchange rate, they may intervene under certain circumstances. For example, if the exchange
rate deteriorated rapidly, they may increase interest rates to keep the value stronger.

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CHP 4 : EVOLUTION OF FLOATING EXCHANGE RATES
From the Gold Standard to Floating Exchange Rates
4.1 ) The Forex Market's Ancient Roots
As commerce between different countries increased in early human civilized history, a
standardized medium of exchange was needed to facilitate commercial transactions. The first
generally-accepted medium of exchange consisted of the precious metals gold and silver.
This practice gave rise to the minting of coins during the Roman era, which in turn evolved
into the issuing of paper currency in the Middle Ages.
Paper money was originally introduced as a way to represent the value of gold for security
purposes. Gold would first be deposited into a trusted bank, and a receipt would then be
issued for the amount of gold on deposit that could be used as a medium of exchange in place
of gold.
These receipts eventually evolved into becoming the principal instruments of exchange, and
so governments began to issue currency backed by the country's gold reserves. This was later
to become the first international monetary standard, known as the Gold Standard.
The modern history of the forex market begins to take shape in the late 1800s as described in
the following sections.
4.2 ) The Gold Standard
The origins of the Gold Standard in international commerce begin in 19th century Britain
after the English Monarchy adopted the Gold Standard in 1816 with the passage of the
Coinage Act.

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The Coinage Act was the first instance of defining the value of the British Pound Sterling in
relation to gold. The value of one pound of 22-Karat gold at the time was set to be equivalent
to 46 14 s 6 d or 46 Pounds, 14 Shillings and 6 Pence.
Silver was also used as a standard means of exchange. Nevertheless, the price of silver was
pegged in relation to gold, and at the time of the Coinage Act, it was set to a ratio of 15
units of silver to one unit of gold.
Before the advent of the Gold Standard in, most countries would use physical gold or silver
for the payment of goods and debts. Nevertheless, by linking their currencies to the value of
gold as a standard, nations found they could use printed paper currency backed by gold in
reserve for the payment of debts.
Since the printed currency of different nations related to the price of gold, the currencies also
related to each other. Furthermore, as different amounts of each currency were needed for the
purchase of one ounce of gold, this created a rate of exchange among the currencies.
By the beginning of the 20th century, all of the major industrial powers had converted to the
gold standard with a set amount of gold backing a specified amount of currency.
The gold standard gave stability to the world economy, enabled the industrial revolution and
began a new era of international trade among nations.
4.3 ) Disruptions in the Gold Standard
The breakout of the First World War brought an end, at least temporarily, to the gold
standard. The enormous amount of capital needed to fund military defense projects against

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the German aggressors was far beyond the amount of gold available to back all of the
currency.
As nations began ignoring the gold standard and no longer defined the values of their
currencies in terms of gold, mass speculation in the currency markets soon followed.
By the end of the 1930s, Germany had revived its arms industry and was ready to embroil the
world in a Second World War. The British Pound Sterling also lost considerable value when
the Germans hatched a counterfeiting campaign which adversely affected the once powerful
U.K. currency.
4.4 ) How the U.S. Dollar Became so Prominent
The only nation involved in World War II that did not suffer significant physical damage
with respect to its infrastructure and mainland was the United States.
All other involved nations had to rebuild and this left their economies in considerable
disarray. Some countries also paid for the assistance of the United States in the conflict.
4.5 ) The Bretton Woods Accord
Before the end of World War II, the United Nations' Monetary and Financial Conference was
held in Bretton Woods, New Hampshire in 1944. The meeting brought together delegates
from all of the Allied nations who then worked out and signed the Bretton Woods Accord.
Due to pressure from the United States, the U.S. Dollar eventually became the currency
selected. The Accord effectively pegged the price of gold to $35 U.S. Dollars per ounce and
all other currencies to the U.S. Dollar with a maximum deviation of 1%.

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The Bretton Woods Accord also established the International Monetary Fund and the Bank
for Reconstruction and Development that are currently part of the World Bank.
4.6 ) Nixon Takes the U.S. Dollar of the Gold Standard
As the United States accumulated massive budget and trade deficits during the 1950s and
1960s, the U.S. Dollar began losing its status as the world's only reserve currency. Also,
Richard Nixon, then the U.S. President, decided to end the Dollar's convertibility into gold in
August of 1971, essentially taking the U.S. Dollar off of the Gold Standard.
An agreement known as the Smithsonian Agreement, was signed by the members of the G10
Nations in December of 1971 which provided international currencies with temporary
stability. In addition, another agreement was signed among European Nations in Basle,
Switzerland in 1972 which established a "snake in the tunnel" system for minimizing
exchange rate movements.
As currency pressures came to a head, most major nations decided to allow their currencies
to float freely by March of 1973. This was the beginning of the modern-day fluctuating
exchange rate system.
4.7 ) European Currency Union and the Modern Era
Nevertheless, controlled exchange-rate systems continued to be attempted periodically even
after 1973. The European Exchange Rate Mechanism of the 1990's was one such attempt.
This mechanism, combined with the increasing political integration of Europe, eventually led
to the consolidation of the major European currencies that created the Euro.

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The consolidation process began with the signing of the Maastricht Treaty in 1991 by the
European nations which created the European Union. The European nations then attempted
to fix exchange rates among the 12 member nations which in turn led to the creation of the
Euro from the 12 currencies of the European Union.
The European Monetary Union had a major setback in late 1992 when the Pound Sterling
was forced to leave the system and devalue. Nevertheless, the national currencies of the other
twelve European nations were replaced by the Euro in 2002.
Today exchange rates float freely for most major currencies depending on supply and
demand pressures, and no major paper currencies have their values fixed to the price of gold
or other hard assets.
In the process, the shift to floating exchange rates spawned today's massive foreign exchange
market that now provides ample trading opportunities for forex speculators with its active
exchange rate fluctuations and notable trends seen in many currency pairs. The recent
availability of online forex brokers taking accounts in amounts of under $100 has made the
forex market truly available to just about anyone to participate in.


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CHP 5 : KEY FACTORS AFFECTING EXCHANGE RATE
All forex trading involves the exchange of one currency with another. At any one time, the
actual exchange rate is determined by the supply and demand of the corresponding
currencies. Keep in mind that the demand of a certain currency is directly linked to the
supply of another. Likewise, when you supply a certain currency, it would mean that you
have the demand for another currency. The following factors affect the supply and demand of
currencies and would therefore influence their exchange rates.
5.1 ) Monetary Policy
When a central bank believes that intervention in the forex market is effective and the results
would be consistent with the governments monetary policy, it will participate in forex
trading and influence the exchange rates. A central bank generally participates by buying or
selling the domestic currency so as to stabilize it at a level that it deems realistic and ideal.
Judgment on the possible impact of governments monetary policy and prediction on future
policy by other market players will affect the exchange rates as well.
5.2 ) Political Situation
Growing global tension will result in instability in the forex market. Irregular inflow or
outflow of currencies may result in significant fluctuations in exchange rates.
The stability of a foreign currency is closely related to the political situation of that place. In
general, the more stable the country is, the more stable its currency will be.
We will illustrate how political factors influence exchange rates with some actual examples.
At the end of 1987, the US Dollar was suffering from continuous depreciation. In order to

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stabilize the US Dollar, the G7 Finance Ministers and central bank governors released a joint
statement on 23 December 1987 announcing plans for a large-scale intervention in the forex
market. On 4 January 1988, the group started to dump Japanese Yen and Deutsche Mark in
huge volumes while buying US Dollars. This resulted in a rebound of the US Dollar and
maintained its exchange rate at a stable level.
For our second example, if you have been observing the Euro, you would have noticed that
for three consecutive months during the Kosovo War, the Euro fell by about 10% against the
US Dollar. One of the reasons was the downward pressure on the Euro caused by the Kosovo
War.
5.3 ) Balance of Payments
Balance of payments of a country will cause the exchange rate of its domestic currency to
fluctuate. The balance of payments is a summary of all economic and financial transactions
between the country and the rest of the world. It reflects the countrys international economic
standing and influences its macroeconomic and microeconomic operations.
The balance of payments can affect the supply and demand for foreign currencies as well as
their exchange rates.
An economic transaction, such as export, or capital transaction, such as inflow of foreign
investment, will result in foreign revenue. Since foreign currencies are normally not allowed
to circulate in the domestic market, there is a need to exchange these currencies into the
domestic currency before circulation. This in turn creates a supply of foreign currencies in
the forex market. On the other hand, an economic transaction, such as import, or capital
transaction, such as outflow of investment to a foreign country, will result in foreign

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payments. In order to meet a countrys economic needs, it is necessary to convert the
domestic currency into foreign currencies. This creates a demand for foreign currencies in the
forex market. When all these transactions are consolidated into a table of international
balance of payments, this would become the countrys foreign exchange balance of
payments. If the foreign revenue is larger than payment, there will be a larger supply of
foreign currencies. If the foreign payment is larger than revenue, then the demand for foreign
currencies will be higher. When the supply of a foreign currency increases but its demand
remains constant, it will directly drive the price of that foreign currency down and increase
the value of the domestic currency. On the other hand, when the demand for a foreign
currency increases but its supply remains constant, it will drive the price of the foreign
currency up and decrease the value of the domestic currency.
5.4 ) Interest Rates
When a countrys key interest rate rises higher or falls lower than that of another country, the
currency of the nation with lower interest rate will be sold and the other currency will be
bought so as to achieve higher returns. Given this increase in demand for the currency with
higher interest rate, the value of that currency will rise against other currencies.
Let us use an example to illustrate how interest rates affect exchange rates. Assume there are
two countries, A and B. Both countries do not exercise foreign exchange control and capital
funds can flow freely between them. As part of its monetary policy, Country A raises its
interest rate by 1% while the interest rate of Country B remains unchanged. There is a huge
volume of liquid capital in the market that flows freely between these two countries, seeking
out the best possible interest rate. With all other conditions remaining unchanged, as Country

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As key interest rate rises, a large portion of the liquid capital will flow into Country A.
When the liquid capital flows out from Country B to Country A, a large amount of Country
Bs currency will be sold in exchange for Country As currency. In this way, the demand for
Country As currency will increase, strengthening it against Country Bs currency.
In fact, in todays globalized market, this scenario applies to the whole world. Over the years,
the market trend has been shifting towards free capital mobility and elimination of foreign
exchange restrictions.
This enables liquid capitals (also known as hot money) to flow freely in the international
market. A point to note though is that such capital will only be moved to a region or country
with higher interest rate if their investors believe that the change in exchange rate will not
nullify the returns gained with higher interest rate.
5.5 ) Market Judgment
The forex market does not always follow a logical pattern of change. Exchange rates are also
influenced by intangible factors such as emotions, judgments as well as analysis and
comprehension of political and economic events. Market operators must be able to interpret
reports and data such as balance of payments, inflation indicators and economic growth rates
accurately.
In reality, before these reports and data become available to the public, the market would
have already made its own predictions and judgments, and these will be reflected in the
prices. In the event that the actual reports and data deviate too much from the predictions and
judgments of the market, huge fluctuations in exchange rates will occur.

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Accurate interpretation of reports and data alone is not adequate, a good forex trader must
also be able to determine market reactions before the information becomes publicly
available.
5.6 ) Speculation
Speculation by major market operators is another crucial factor that influences exchange
rates. In the forex market, the proportion of transactions that are directly related to
international trade activities is relatively low. Most of the transactions are actually
speculative tradings which cause currency movement and influence exchange rates. When
the market predicts that a certain currency will rise in value, it may spark a buying frenzy that
pushes the currency up and fulfill the prediction. Conversely, if the market expects a drop in
value of a certain currency, people will start selling it away and the currency will depreciate.
For example, after World War II, the United States enjoyed a period of political stability,
well-managed economy, low inflation rate and an average annual economic growth of about
5% in the early 1960s. At that time, all the other countries in the world were willing to use
US Dollar as the mode of payment to safeguard their wealth. This causes acontinuous rise in
value of the US Dollar. However, from the end of 1960s to early 1970s, the Vietnam War,
Watergate scandal, serious inflation, increased tax burden, trade deficit and declining
economic growth caused the US Dollar to plunge in value.


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CHP 6 : MUNDELL AND FLEMING MODEL
Mundell and Fleming have given jointly their model in terms of IS, LM and
BP schedules. They have extended the IS, LM model to incorporate External
Balance by way of incorporating B. P. Schedule.
IS schedule represents Investment and savings schedule
LM schedule represents Demand for and Supply of money schedule BP
schedule represents Balance of payments schedule
Y

The intersection between IS and LM schedules determine internal balance
which is shown by the Point E at which rate of interest is of the order of OR0
and national income is Oyo since point E lies above and to the left of BP
schedule it shows that the economy is running a balance of payments surplus.

Y 0
R
0
E

BP

National Income

X
IS

Rate of

LM


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Under these circumstances if the economy would like to achieve both internal
and external balance then it has three options

Diagram (a) shows appreciation in the foreign exchange rate such that BP curve shifts
upward and passes through equilibrium point E and intersects IS and LM curves. As such the
internal balance and the external balance are achieved.
Diagram (b) shows the central bank pursuing the expansionary monetary policy by lowering
down the rate of interest such that LM schedule shifts to the right and passes through IS and

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BP schedules thus at the point of intersection i.e. E1 once again internal balance and external
balance are achieved.
Diagram (c) shows the Government switches over to the expansionary fiscal policy such that
the IS curve shifts to the right upward and passes through the intersecting point E1 as such
once again internal and external balance are attained.
Diagram (d) shows the role of monetary and fiscal policy when there is a perfect capital
mobility i.e. BP curve is a horizontal straight line going parallel to X axis. Initial equilibrium
is at E at which IS and LM schedules intersect each other with BP schedule given. When the
central bank follows expansionary monetary policy which shifts the LM schedule to the right
leading to LM schedule. When the Government follows expansionary fiscal policy the IS
schedule. With the BP schedule given IS1 and LM1 schedules intersect at the point E1 leading
to establishing internal and external balance at a higher level with the national income
increasing from OY to OY1.


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CHP 7 : ADVANTAGES AND DISADVANTAGES OF FLOATING EXCHANGE RATES
Fiat currency doesnt imply a fixed exchange rate. In fact, fiat currencies are compatible with
a floating exchange rate regime, in which the value of a currency is determined in foreign
exchange markets.
Floating exchange rates have these main advantages:
No need for international management of exchange rates: Unlike fixed exchange rates
based on a metallic standard, floating exchange rates dont require an international
manager such as the International Monetary Fund to look over current account
imbalances. Under the floating system, if a country has large current account deficits, its
currency depreciates.

No need for frequent central bank intervention: Central banks frequently must intervene
in foreign exchange markets under the fixed exchange rate regime to protect the gold
parity, but such is not the case under the floating regime. Here theres no parity to
uphold.

No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a
fixed exchange rate regime while portfolio flows are moving in and out of the country. In
a floating exchange rate regime, the macroeconomic fundamentals of countries affect the
exchange rate in international markets, which, in turn, affect portfolio flows between
countries. Therefore, floating exchange rate regimes enhance market efficiency.


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Greater insulation from other countries economic problems: Under a fixed exchange rate
regime, countries export their macroeconomic problems to other countries. Suppose that
the inflation rate in the U.S. is rising relative to that of the Euro-zone.
Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for
European goods, which then increases the Euro-zones price level. Under a floating exchange
rate system, however, countries are more insulated from other countries macroeconomic
problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for
European goods.
Floating exchange rates also have disadvantages:
Higher volatility: Floating exchange rates are highly volatile. Additionally,
macroeconomic fundamentals cant explain especially short-run volatility in floating
exchange rates.

Use of scarce resources to predict exchange rates: Higher volatility in exchange rates
increases the exchange rate risk that financial market participants face. Therefore, they
allocate substantial resources to predict the changes in the exchange rate, in an effort to
manage their exposure to exchange rate risk.

Tendency to worsen existing problems: Floating exchange rates may aggravate existing
problems in the economy. If the country is already experiencing economic problems such
as higher inflation or unemployment, floating exchange rates may make the situation
worse.

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CHP 8 : DIFFERENCE BETWEEN A FIXED AND A FLOATING EXCHANGE RATE
A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary
authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a
floating exchange rate is determined in foreign exchange markets depending on demand and
supply, and it generally fluctuates constantly.
A fixed exchange rate regime reduces the transaction costs implied by exchange rate
uncertainty, which might discourage international trade and investment, and provides a
credible anchor for low-inflationary monetary policy. On the other hand, autonomous
monetary policy is lost in this regime, since the central bank must keep intervening in the
foreign exchange market to maintain the exchange rate at the officially set level.
Autonomous monetary policy is thus a big advantage of a floating exchange rate. If the
domestic economy slips into recession, it is autonomous monetary policy that enables the
central bank to boost demand, thus 'smoothing" the business cycle, i.e. reducing the impact of
economic shocks on domestic output and employment. Both types of exchange rate regime
have their pros and cons, and the choice of the right regime may differ for different countries
depending on their particular conditions. In practice there is a range of exchange rate regimes
lying between these two extreme variants, thus providing a certain compromise between
stability and flexibility. The exchange rate in the Czech Republic was pegged to a basket of
currencies until early 1996, then the peg was effectively eliminated through a substantial
widening of the fluctuation band, and now the Czech economy operates in the so-called
managed floating regime, i.e. the exchange rate is floating, but the central bank may turn to
interventions should there be any extreme fluctuations.

27
CHP 9 : ARGUMENTS FOR AND AGAINST FLOATING EXCHANGE RATES
Arguments for Floating Exchange Rates
The Bretton Woods system collapsed in 1973 because central banks were unwilling to
continue to buy over-valued dollar denominated assets and to sell undervalued foreign
currency denominated assets. In 1973, central banks thought they would temporarily stop
trading in the foreign exchange market, and would let exchange rates adjust to supply and
demand, and then would re-impose fixed exchange rates soon.
But no new global system of fixed rates was started again.
1. Monetary policy autonomy
Without a need to trade currency in foreign exchange markets, central banks are freer to
influence the domestic money supply, interest rates, and inflation.
Central banks can more freely react to changes in aggregate demand, output, and prices in
order to achieve internal balance.
2. Automatic stabilization
Flexible exchange rates change the prices of a countrys products and help reduce
fundamental disequilibria.
One fundamental disequilibrium is caused by an excessive increase in money supply and
government purchases, leading to inflation, as we saw in the US during 19651972.
Inflation causes the currencys purchasing power to fall, both domestically and
internationally, and flexible exchange rates can automatically adjust to account for this
fall in value, as purchasing power parity predicts

28
Another fundamental disequilibrium could be caused by a change in aggregate demand of
a countrys products.
Flexible exchange rates would automatically adjust to stabilize high or low aggregate
demand and output, thereby keeping output closer to its normal level and also stabilizing
price changes in the long run.
In the long run, a real depreciation of domestic products occurs as prices fall (due to low
aggregate demand, output and employment) under fixed exchange rates.
In the short run and long run, a real depreciation of domestic products occurs through a
nominal depreciation under flexible exchange rates.
Fixed exchange rates cannot survive for long in a world with divergent macroeconomic
policies and other changes which affect national aggregate demand and national income
differently.
3. Flexible exchange rates may also prevent speculation in some cases.
Fixed exchange rates are unsustainable if markets believe that the central bank does not
have enough official international reserves
4. Symmetry (not possible under Bretton Woods)
The U.S. is now allowed to adjust its exchange rate, like other countries.
Other countries are allowed to adjust their money supplies for macroeconomic goals, like
the U.S. could.


29
Effects of a fall in Export Demand

A Rise in Money Demand under a Floating Exchange Rate

Depreciation leads to
higher demand for and
output of domestic
products
Reduction in aggregate
demand
Fixed exchange rates mean
output falls as much as the initial
fall in aggregate demand

30
Arguments against Floating Exchange Rates
1. Uncoordinated macroeconomic policies
Flexible exchange rates lose the coordination of monetary policies through fixed
exchange rates.
Lack of coordination may cause expenditure switching policies: each country may
want to maintain a low-valued currency, so that aggregate demand is switched to
domestic products at the expense of other economies
In contrast, expenditure changing fiscal policies are thought to change the level of
aggregate demand in the short run for both domestic and foreign products.
Lack of coordination may cause volatility in national economies: because a large
countrys fiscal and monetary policies affect other economies; aggregate demand, output,
and prices become more volatile across countries if policies diverge.
Volatile aggregate demand and output, especially in export sectors and import-competing
sectors, lead to volatile employment. Volatility, not stabilization, may occur.

2. Speculation and volatility in the foreign exchange market may become worse, not better.
If traders expect a currency to depreciate in the short run, they may quickly sell the
currency to make a profit, even if it is not expected to depreciate in the long run.
Expectations of depreciation lead to actual depreciation in the short run.
Earlier we assumed that expectations do not change when temporary economic changes
occur, but this assumption is not valid if expectations change quickly in anticipation of
even temporary economic changes.

31
Such speculation tends to increase the fluctuations of exchange rates around their long
run values, as currency traders quickly react to changing (interpretations of) economic
news.
In fact, volatility of exchange rates since 1973 has become larger.

3. Reduction of trade and international investment caused by uncertainty about exchange
rates.
But precisely because of a desire to reduce this uncertainty, forward exchange rates and
derivative assets were created to insure against exchange rate volatility.
And international investment and trade have expanded since the Bretton Woods system
was abandoned.
And controls on flows of financial asset flows are often necessary under fixed exchange
rate systems, in order to prevent capital flight and speculation.

4. Discipline: if central banks are tempted to enact inflationary monetary policies, adherence
to a fixed exchange rates may force them not to print so much money.
But the temptation may not go away: devaluation due to inflationary monetary policy
may still occur.
And inflation is contained in the country that creates it under flexible exchange rates: the
U.S. could no longer export inflation after 1973.
And inflation targets may be better discipline than exchange rate targets.


32
5. Illusion of greater monetary policy autonomy
Central banks still need to intervene in the foreign exchange market because the
exchange rate, like inflation, affects the economy a great deal.
But for the U.S., exchange rate stability is usually considered less important by the
Federal Reserve than price stability and low unemployment.
Arguments for flexible exchange rates are that they allow monetary policy autonomy, can
stabilize the economy as aggregate demand and output change, and can limit some forms of
speculation.
Arguments against flexible exchange rates are that they allow expenditure switching policies,
can make aggregate demand and output more volatile because of uncoordinated policies
across countries, and make exchange rates more volatile.


33
CONCLUSIONS
In study of the macroeconomics under floating exchange rate system the more importance is
given to Mundell and Fleming Fixed price Model. This is largely because the range of policy
problems is much more intensive than under the floating price monetary model.
Nevertheless, it is possible to amend the Mundell and Fleming model to allow for price
flexibility, so broadening its relevance and to modify the flexible price assumption of the
monetary model, say by using Dornbusch sticky price variation. We chose not to pursue
these possibility, which fall more within the province of texts on macroeconomics policy and
international finance.
Our concern is more with the environment within which policy-making takes place, and in
particular the influence of the exchange-rate system and the degree of capital mobility. This
then raise the question of whether one exchange-rate system is better than the other, and if so,
under what circumstances. The country should adopt which exchange-rate system the fixed
one or the floating exchange-rate system.


34
APPENDIX/BIBLIOGRAPHY

Articles
http://www.thehindubusinessline.com/features/investment-world/macro-view/exchange-
rate-fixed-or-floating/article3588893.ece
http://www.economist.com/topics/floating-exchange-rates

Books
International Economics Third Edition By Bo Sodersten and Geoffery Reed
International Economics 2
nd
Revised Edition By H G Mannur
International Economics By D. M. Mithani
International Macroeconomics By Peter J. Montiel

Webilography
www.investopedia.com/terms/m/macroeconomics.asp
http://economics.about.com/cs/studentresources/f/macroeconomics.html
http://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2000/5/cj20n1-13.pdf
http://www.dummies.com/how-to/content/advantages-and-disadvantages-of-floating-
exchange-.html

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