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CHAPTER 20 GOVERNMENT POLICIES TOWARD THE FOREIGN EXCHANGE MARKET Objectives of the Chapter This chapter lays out the foreign exchange regimes available to a country and explores some lessons of history about each of those regimes. Particular attention is paid to the options open to a country that is trying to defend a fixed exchange rate. These range from intervention in the foreign exchange market to the imposition of exchange controls. There is a simple but real trade-off involved in choosing an exchange rate regime (other than the choice of certainty versus uncertainty in the value of one’s currency internationally). With a fixed exchange rate, a country loses independent monetary policy. This is good insofar as monetary authorities have an inflationary bias; it is bad insofar as the country might need stabilization tools. The reverse is true under a flexible exchange rate regime: monetary authorities retain their power to affect price levels -- for both good and evil! After studying Chapter 20 you should know 1. the variety of exchange rate policies countries have used. 2. how a country can respond to pressure on the value of its currency. 3. the implications of temporary versus permanent imbalances in exchange rates. 4. the benefits and costs of foreign exchange controls. 5. how fixed rates have performed in the past. 6. how flexible rates have performed in the past. Important Concepts Adjustable peg: A system in which a country tries to keep its exchange rate fixed for long periods of time and only changes the pegged rate when there is a substantial payments disequilibrium at that rate. Beggar-thy-neighbor policies: Policies such as devaluations or tariffs intended to benefit one country’s economy at the expense of another. Such policies were widespread during the Great Depression of the 1930s. Bretton Woods system: Under this post-World War II agreement organizing international financial affairs between 1944 and 1971, countries were allowed devaluations and revaluations of an adjustable peg exchange rate when faced with fundamental disequilibria that would otherwise require drastic domestic adjustment to keep the exchange rate fixed. Keynes was one of the architects of the Bretton Woods system. Capital controls: Government limits placed on the use of the foreign exchange market to make payments related to international financial activity (as opposed to payments for goods and services). Clean float: Exchange rates determined by a freely-functioning foreign exchange market. 110
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Crawling peg: An exchange rate system in which the pegged rate is changed frequently according to a set of indicators or in response to monetary authority direction. Deficits without tears: A situation in which a country’s currency is considered an international reserve so that the country can finance its official settlements deficit by issuing its own currency. The U.S. had extraordinary leeway to finance its payments deficits by issuing dollars in the 1950s and 1960s. Dirty float:
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