§16 Exchange Rate Regimes

Fixed Exchange Rates

• Some countries peg their currency to a major currency (typically the US dollar).

• If credible, then $E^e = E = \overline{E}$ , which implies (from interest parity condition):

  $$1 = \frac{1 + i}{1 + i^*} \implies i = i^*$$

• Under a fixed exchange rate and perfect capital mobility, the domestic interest rate is equal to the foreign interest rate.

• This means the central bank gives up monetary policy as a policy instrument.

Mundell-Fleming Model

• Equilibrium in goods markets with fixed prices

  $$\begin{aligned} Y &= C(Y - T) + I(Y, i) + G + NX(Y, Y^*, E) \\ &= C(Y - T) + I(Y, i) + G + NX \left( Y, Y^*, \frac{1 + i}{1 + i^*} \overline{E}^e \right) \end{aligned}$$

  where we used the interest parity condition:

  $$E = \frac{1 + i}{1 + i^*} \overline{E}^e$$

Fixed Exchange Rate Regime

• What if the country is in a fixed exchange rate regime, with a credible $E = E^e = \overline{E}$ ?

• Fiscal policy still works.

• But the country has no independent monetary policy to fight its domestic recession!

  $$\overline{E} = \frac{1 + i}{1 + i^*} \overline{E} \Rightarrow i = i^*$$

Speculative Attacks

• What if the country is in a fixed exchange rate regime, but speculators think the peg will not last: $E^e \ll \overline{E}$ ?

  $$\overline{E} = \frac{1 + i}{1 + i^*} E^e \Rightarrow i \gg i^*$$

• The country has to hike interest rates and cause a deeper recession to defend its peg!… Or devalue (e.g. the UK and the EMS)

Flexible Exchange Rates Can Be Volatile

• Up to now it sounds as if it makes no sense to have a fixed exchange rate: no independent monetary policy, speculative attacks…

• But flexible exchange rates can be very volatile, which is costly for a variety of reasons: planning is more complex, inflation is less anchored in very open economies, NX less predictable, etc.

• Recall the uncovered interest parity condition:

  $$E_t = \frac{1 + i_t}{1 + i^*_t} E^e_{t+1}; \quad E^e_{t+1} = \frac{1 + i^e_{t+1}}{1 + i^{*e}_{t+1}} E^e_{t+2}; \quad \ldots$$

$$E_t = \frac{1 + i_t}{1 + i^*_t} \frac{1 + i^e_{t+1}}{1 + i^{*e}_{t+1}} \frac{1 + i^e_{t+2}}{1 + i^{*e}_{t+2}} \ldots \frac{1 + i^e_{t+n}}{1 + i^{*e}_{t+n}} E^e_{t+n+1}$$

• The future matters a bit too much for some economies and events.

Choosing Between Exchange Rate Regimes

• Loosing independent monetary policy is less costly if:
  • Macroeconomics shocks are very similar across the pegged economies (e.g. Euro area);
  • Plenty of fiscal capacity (e.g. HK);
  • Or very flexible labor/goods markets (e.g. HK).
    • Why? because fixed nominal exchange rate does not mean fixed real exchange rate.
• Gaining nominal exchange rate stability is particularly important if:
  • There is a lot of trade across regions;
  • Cross financial exposure;
  • Unanchored inflation (depreciation) expectations.

— Apr 24, 2025

§16 Exchange Rate Regimes by Lu Meng is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. Permissions beyond the scope of this license may be available at About.