14 Exchange rate regimes, fixed rates and the policy trilemma (W10 L19)

What is an exchange rate regime?

A macroeconomic policy choice about whether the nominal exchange rate floats or is fixed.

What is a floating exchange rate?

A market-determined price of the currency set by supply and demand. Floats can be clean (no intervention) or dirty/managed.

What is a fixed exchange rate?

Policy-makers set the price of the currency, either in terms of a foreign currency (currency standard) or a commodity such as gold (commodity standard). A currency union is a strong form of currency standard.

How is a fixed exchange rate maintained?

Policy-makers must take the other side of the market by buying or selling foreign currency or gold. The regime collapses if reserves are exhausted, and crisis occurs when the regime is not credible.

When is a pegged exchange rate undervalued or overvalued?

Undervalued if E_peg < E_fun and overvalued if E_peg > E_fun, where E_fun is the fundamental value at which supply equals demand.

What are international reserves?

The central bank’s holdings of other major currencies, gold and so on, used to buy and sell currency to defend a peg.

What happens to reserves when a peg is undervalued?

There is excess demand for the currency, so the central bank sells its currency and builds up reserves.

What happens to reserves when a peg is overvalued?

There is excess supply of the currency, so the central bank buys it back and depletes reserves. The ability to defend it is limited by the stock of reserves.

Why are overvalued pegs unsustainable?

Central banks have limited reserves, so a long-held overvalued rate drains them and forces a devaluation. Expectations of devaluation can cause a crisis now, so unsustainable pegs invite speculative attacks.

What is a speculative attack?

A massive selling of domestic currency assets by investors who expect devaluation. It forces the central bank to deplete reserves, which makes devaluation more likely, so it can be a self-fulfilling prophecy.

Why does defending a peg constrain monetary policy?

The alternative to devaluing is raising r to boost demand for domestic assets, but if r must be used for the exchange rate it can no longer stabilise unemployment and inflation.

What is the policy trilemma?

A central bank can only pursue two of three goals at once, which are independent monetary policy, a fixed exchange rate, and free international capital flows.

What are the three possible combinations in the trilemma?

Independent monetary policy plus free capital flows (not fixed), fixed exchange rate plus independent monetary policy (needs capital controls), and fixed exchange rate plus free capital flows (no independent monetary policy).

Which sides of the trilemma did Australia choose?

According to your notes, side C (free capital flows and fixed exchange rate) before 1983 and side A (independent monetary policy and free capital flows) since 1983.