lecture14.1 - Chapter 19: Macroeconomic policy and...

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Unformatted text preview: Chapter 19: Macroeconomic policy and coordination under floating exchange rate regime. Part2. The collapse of fixed rates We have seen how in late 1960s and early 1970s the strains on the Bretton Woods regime took their toll. In 1973, the core countries elected to float their exchange rates. This was, for them, a step they took with regret and they viewed it as a temporary emergency measure. But since then there has been no attempt to rebuild a global fixed rate regime (n.b. euro). Even then many economists were advising a switch to a floating rate system as a better choice. Obvious now. Radical then. The case for floating rates What is the case for floating? Floating allows some degree of monetary policy autonomy when capital markets are integrated. No asymmetry of U.S. and rest of world with float (unlike reserve currency regime). Exchange rates automatic stabilizers : Flexible exchange rates can absorb shocks. No threat of speculative attacks (no peg to adjust) saving governments from having to defend peg in reval./deval. crises. Floating E as an automatic stabilizer A key argument for flexible E was that they would offer swift, fairly painless adjustment to certain shocks. Consider, for example, a demand shock in the goods market (e.g. a fall in export demand) as might affect an open economy. Under a flexible E, the contraction would be smaller (and could even be offset). Under a fixed E, the shift inward of DD would be met by a shift inward of AA, and the contractionary effect would be amplified. In the longer run it could mean a peg change (speculation) or prolonged unemployment (Problems of internal/external balance). The case against floating rates Flexible E. It all sounds so good, doesnt it? Is there a downside ? Arguments against floating (then & now) are: Discipline (allows central banks to inflate) Destabilizing speculation (floating E could attract speculators as in any volatile asset market, destabilizing money demand) Injury to trade and investment (real welfare enhancing activity could be discouraged by E risk) Lack of policy coordination (as in 1930s, countries could pursue own interests, with collectively damaging policies) Illusion of greater autonomy (central banks would retain some E target anyway, so extra volatility would not buy more room for maneuver) Our modeling of an open economy focused on the case of a small country case that cannot affect foreign prices, output and interest rate through its monetary policy. Question: If the world is made up by two large countries: home and foreign? How do Home macro policies affect Foreign? What is transmission of policies in a floating exchange rate regime?...
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lecture14.1 - Chapter 19: Macroeconomic policy and...

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