CH20: Exchange Rate Regimes

What is the Real Effective Exchange Rate (REER)?

A measure of a country’s exchange rate relative to a basket of other currencies, adjusted for price differences

How can REER adjust in the short run?

Only through changes in the nominal exchange rate (E)

How can REER adjust in the medium run?

Through changes in the nominal exchange rate, domestic price level (P), or foreign price level (P*)

What improves REER competitiveness?

Lower relative unit labor costs or slower domestic wage growth compared to productivity

What happens to REER in countries with synchronized business cycles and similar inflation targets?

REER remains relatively constant over the medium run

What triggers an exchange rate crisis under fixed exchange rates?

Expectations of devaluation can lead to speculative attacks and rising interest rates

What are a government’s options during a speculative attack?

Either devalue the currency or defend the exchange rate, possibly causing a recession due to high interest rates.

Why are fixed exchange rates vulnerable to crises?

Maintaining parity requires using foreign reserves and raising interest rates, both of which are costly

Example of fixed exchange rate crisis in Europe?

The EMS crisis of 1992, where financial markets bet against fixed parities, leading to major realignments

How does the current exchange rate behave under flexible regimes?

It moves one-for-one with changes in expected future exchange rates and interest rates

What is a key characteristic of flexible exchange rates?

They are volatile, often driven by changing market expectations

What does volatility imply for countries under flexible regimes?

They must be prepared for frequent and possibly large fluctuations in the exchange rate.

What is an optimal currency area according to Robert Mundell?

A region where:

1. Countries have similar shocks, or

2. Prices and wages are flexible, or

3. There is high factor mobility (e.g., labor)

What are the benefits of a fixed exchange rate?

Stability in trade, lower interest rates, and discipline on inflation

What are the costs of a fixed exchange rate?

Loss of independent monetary policy, especially problematic if countries don’t meet optimal currency area criteria.

What is a hard peg?

A commitment like dollarization or a currency board that makes changing the exchange rate very difficult

What was Spain’s experience with the Euro pre- and post-2008?

Benefited from low interest rates before 2008; suffered during the recession due to inability to adjust the exchange rate

What is the real interest rate parity condition?

The real exchange rate depends on current and expected future domestic and foreign real interest rates

What happens if real interest rates differ between countries?

It leads to changes in the real exchange rate over time