The Open Economy: Exchange Rates (cont.) & The BOP

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Fixed Exchange Rates • Last week: monetary policy more effective in an open economy with a flexible exchange rate. • When exchange rates are fixed, monetary policy less effective as a stabili... sation tool. • Fixed exchange rates determined by government, not the market. – Fixed to what? Gold, another currency … – Devaluation vs revaluationGold Standard I • CB holds enough gold to convert money into gold at an agreed exchange rate. • Bretton Woods – CBs fixed exchange rates to $US; $US-gold exchange rate $35/ounce. • System collapsed: – France reduced holdings of $US – Vietnam War  persistent US balance of payments deficits 3Gold Standard II • Advantages: – Low inflation  MS can only grow at rate of growth in gold supply – Fixed international exchange rates  less uncertainty in international trade – Importers sell gold, exporters buy gold, MS ↓ in importing countries  more competitive – Makes “financial repression” (r < π) more difficult – can‟t inflate away debt 4Gold Standard III • Disadvantages: – Countries with large natural gold reserves have a natural advantage – Could limit economic growth  MS can only grow at rate of growth in gold supply – LR price stability but SR instability – Unstable  speculative attacks • Fiat money – Money that has value only because a government says so! Role of the IMF • When the IMF bails out a country that is under attack, it usually poses as a condition that the government cut its budget deficit and interest rates to be kept high Monetary Policy and Fixed Exchange Rates Fixed vs Flexible Exchange Rates Balance of Payments • The BOP records transactions between residents and non-residents. • BOP = current account + capital account • If have a flexible exchange rate, the current account balance and the capital account balance should be equal, but because of data gathering errors they are not. For this reason, the account shows a statistical discrepancy. [Show More]

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