User talk:Pinillaj

--Pinillaj 11:46, 10 July 2006 (UTC)

The Fundamentals of Money: National and International
1. Introduction

2. Characteristics of Money

3. The concentration of the money supply process

4. Money and state monopolies

5. Money and inflaiton

6. International money: how different from national money?

7. Commitment versus coercion in the international monetary systems

8. The international gold standard

--Pinillaj 11:46, 10 July 2006 (UTC)

Modeling the collapse of Fixed Echange Rate Systems
Why did the fixed exchange rate systems collapsed? Why in 1970 most countries stopped convertibiility of their currencies at a fixed exchange to the US Dollar? These questions will try to be answered with the use of formal models to analyze why fixed exchange rate systems tend to disappear. Consequently, it will question about the models including credibility and its influencing factors but also the analysis of the “timing” of the collapse.

Three models will help to analyze these issues: Barro-Gordon model, Krugman and Obstfeld models.

1. Credibility of fixed exchange rates: a formal analysis The issue of credibility in a country with fixed exchange rate systems is analyzed utilizing the Barro-Gordon model. This model identifies the factors that influence the credibility of fixed-exchange rate systems.

1.A. We start with the Phillips curve:

(4.1)   U = UN  + a(pe – p)

i.e. only unexpected inflation rate can affect unemployment rate

The model assumes rational expectations. This suggests that people will use all available information to estimate the level of unemployment and that they will not be systematically wrong in making these estimations. Thus on average:

pe = p so that U = UN

Graphically the Phillips curve becomes:

1.B. Next step is to introduce the preferences of the authorities

Assumption: authorities care about both inflation and unemployment.

The indifference curves of authorities are in general as follow:

Equilibrium of the model Assumptions: Government will maintain the inflation rate equal to zero Economic agents believe this announcement Expectations of inflation equal to zero Equilibrium is in point A

The government can do better than point A. In fact along U1 we meet other indifference curves closer to the origin, so with a lower loss of welfare.

Government will not succumb to this temptation to engineer surprise inflation because the economic agents will increase their expectations of inflation and the Phillips curve will shift upwards until U2 for example. So, government should evaluate the short-term gain from cheating against the future losses that result from the shift upwards of Phillips curve before cheating.

Another Example Assumption: Now we have a short-sighted politician who gives low weight to future losses and decides to cheat. Given the new expectations, Phillips curve will shift upwards until point E.

Characteristics of E: It is on the vertical Phillips curve and means that agents expectations are realized. The authorities don’t have any incentive to surprise economic agents with this inflation.

Interpretation of E: Equilibrium achieved in a rational expectations world when authorities follow a discretionary policy. E is not attractive but still the only equilibrium that can be sustained given the authorities are short-sighted and that the private sector knows this.

This model is static and one way to rationalize static assumptions is to consider that political institutions favor short-duration objectives for politicians who are also as rational as private agents.

Depending on the preference of the monetary authorities, (either ‘wet’ or ‘hard-nosed’) the equilibrium level of inflation will change. A zero inflation rate is probably only in A where government don’t care about unemployment.

The Barro-Gordon model makes clear 2 issues: 1. The preferences of the authorities matter a great deal in determining the location of the discretionary equilibrium, and therefore the equilibrium level of inflation.

2. The only way a zero rate of inflation rule can be credible is when authorities show no concern whatsoever for unemployment.

Extension of the model to an open economy: Assumptions Two countries Germany (a ‘hard-nosed’ government) and Italy (a ‘wet’ government).

PPP(Purchasing Power Parity) holds, and its equilibrium condition is stated as

(4.2) S = kPI/PG, where

S is the equilibrium price of the German mark in units of lira PI is the price level in Italy PG is the price level in Germany k is a factor of proportionality which we assume to be a constant here (could be considered as the real exchange rate, R, thus we would have the same equation as in chapter 3)

An increase in Italian prices relative to German one leads to a loss of competition.

(4.3) S = PI  - PG   if  PI(inflation)=10 and PG=5 therefore the lira must be devaluated by 5% against mark.

Inflation outcomes on graph

Italy has a higher equilibrium rate of inflation, so its currency has to depreciate continuously.

Analysis of credibility problem of fixed exchange rates Assumptions Germany and Italy decide to fix their exchange rates. This means that the inflation rates are equal in both countries ( =0).

Problem Which inflation rate to select? That of Germany will be selected, the lowest is better for italy to peg its currency to a low inflation currency.

Is this arrangement Credible? No. Italian private agents know that the authorities have an incentive to go out to C and not staying in B to have the same level of inflation as in Germany. This arrangement can stand if only the governments of the 2 countries have the same preferences regarding inflation and unemployment.

Assumption Lets assume that both countries have the same preferences and economic agents are aware of this.

Graphic representation

G

If an asymmetric shock occurs in Italy and the curve shifts to the right, a conflict will happen because Italy would like to accommodate the shock by staying in point F. But the German leaders who want to stay in E will force Italy to be in G and absorb all the shock through unemployment. This conflict leads to a loss of confidence in the commitment of the exchange rate.

If Italy is the leader, it would want to be in F and force German authorities to be in H. This means a loss of welfare in Germany which will have an incentive to allow its exchange rate to appreciate. A crisis is then evident.

If the shock is permanent, it will affect also the unemployment rate.

Generalization of the result When shocks in the short-term Phillips curve are not perfectly correlated, those shocks will lead to a conflict about the appropriate policy response.

To form a credible fixed exchange rate arrangement, it is necessary that shocks should be highly correlated in addition to the requirement that contries should have the same preferences.

If there is no correlation of the shocks, it must be imposed to one of the countries a stronger set of conditions on the preferences.

In our example, if there is a shock in Italy, the fixed exchange rate arrangement can be credible if Italy stops pursuing independent inflation and unemployment objectives (so, its indifference curves should dissapear). Then it has to convince the private agents that its only objective is fixing the exchange rate to make this arrangement credible.

Few countries like Netherlands have experienced this arrangement.

2. Disinflation by pegging to low inflation currency Assumptions A high inflation country (Italy) decides to fix its exchange rate to a low inflation currency.

Possible If		Italy and Germany have the same preferences Italy decides to change its preferences

Problem Italian economic agents are not sure about the seriousness of this conversion. They need proof. But, how to get proof?

The proof

Italian agents will get proof if the authorities allow unemployment to increase to K so they observe that the authorities have changed their indifference curves. Then, the private agents will be willing to reduce their expectations of inflation so that the Phillips curve can shift downward. So the process of desinflation will be painful but necessary to establish credibility.

Why the process of disinflation may not be successful? Previously private agents intercept increase in the unemployment rate as evidence that the authorities have changed their preferences. However, if it is a result of an asymmetric shock and then the authorities have changed their preferences, an increase of unemployment can be interpreted:

As an evidence that authorities are committed to reducing inflation. In that case inflationary expectations will decrease;

As a result of a shock which will increase the incentive to follow more expansive policies and private agents may think that devaluation will happen.

This uncertainty about the source of the increase in the unemployment rate will make it difficult to establish low inflation.

•	Problem of the dynamics of disinflation process in an open economy (former figure) o	Suppose that the increase of unemployment rate is a result of a change in the preferences o	Italy pegs its exchange rate to the currency of Germany

So this leads to a problem of competitiveness in Italy which will face the problem of an overvaluation of its currency. A speculative crisis is in motion, leading to a devaluation. So adjustment to low inflation equilibrium fails. This was the example of the Latin American Countries during the 1970’s and 1980’s (Argentina, Brazil, Chile) and also EMS countries like Italy and Spain.

3. The Krugman Model Main issue to be analyzed Can theory be used to predict the timing of the collapse?

Assumption One country facing the rest of the world Purchasing power parity condition and quantity theory of money

Model building: 1. Purchasing parity condition

(4.4)

Where: P is the index of domestic prices P* is the index of foreign prices k is the factor of proportionality which we assume to be constant here

2. Quantity theory of money (4.5) P = mM

Where: M is the domestic money stock m is the factor of proportionality

Assuming the same relation holds for foreign country:

(4.6) P* = m*M*

Substituting (4.6) and (4.5) into (4.4) we have:

(4.7)

i.e. The equilibrium exchange rate S changes in proportion to the domestic money stock and changes in inverse proportion to the foreign money stock. To keep the exchange rate fixed, the domestic money stock must increase at the same rate as the foreign money stock.

The graphical representation

and

Analysis How a system of fixed exchange rates functions?

Assumption The authorities fix the exchange rate at. If they choose, there is no problem with the fixed exchange rate system.

Now suppose that we start at the level M1. The equilibrium exchange rate S1 is below the agreed exchange rate. This means that the domestic currency is cheaper than the foreign. Consequently, there would be an increase in the country’s exports and a decrease in imports. This current account surplus, (if no capital movement), will make a positive balance of payments. Therefore, the central bank accumulates international reserves.

Generalization Whenever the real exchange rate is below the fixed exchange rate there is an accumulation of international reserves.

The system will be stable if the authorities follow the rules of the game (allow the money stock to vary).

But, What happens if the rules of the game are not followed?

Example If the authorities decide (from M1) to increase the money stock at a constant rate without regards for the balance of payments position (i.e. to finance governement budget deficits). We start moving from point F to point E, the international reserves will increase but at a declining rate and stop increasing when they reach point E.

When will the fixed exchange rate collapse? Crucial Assumption Economic Agents have perfect knowledge about the full structure of the model.

Suppose that it will start when the system reaches point G. At that point, all the countries reserves would be depleted. But, at point G the exchange rate will have to jump from point G to point H. The agents will buy foreign currency some seconds before the collapse creating huge profit for all speculators

Result By applying the same logic expressed before we reach the conclusion that the system will collapse when we reach point E. Once the international reserves and the money stock reach point E monetary authorities can switch directly to H (as flexible exchange rate) thus avoiding speculative gains. So the collapse of the fixed exchange system will reach before the authorities run out of international reserves.

This is an interesting result because the timing of the attack is independent of the stock of international reserves the authorities start with. The economic agent’s concern is in the fundamental variables. If these are out of line with the fixed exchange rate commitment they will start the attack precipitating the collapse. If economic agents perccieve that the monetary authorities are not consistent with their commitment to keep the exchange rate fixed.

4. The Obstfeld model Main issue to be analyzed Can the collapse occur even if the monetary authorities are consistent with their commitment to keep the exchange rate fixed?

Assumptions Exchange rate is pegged at the level S2

Money stock is fixed at M2 Monetary policies are in perfect line with the exchange rate commitment

Result It seems that there is no problem if the monetary authorities decide to fix S at S2 and maintain M at M2.

Problem There are infinite combinations of S and M to maintain the fixed exchange rate commitment (S1 and M1, S3 and M3).

Another Problem Assumptions Multiple equilibrium worlds Perfect foresight Each equilibrium is feasible Exchange rate is at S2 Money stock is at M2 Speculators know that they could have made S3 and M3 a feasible choice

They buy foreign exchange at the price S2 expecting that the equilibrium will switch to S3-M3 so that they can obtain a higher profit.

Result The authorities have an incentive to concede to the speculators and to devaluate. They move to S3-M3

Differences between the Krugman model and the Obstfeld model Krugman: An inconsistent monetary policy triggers speculation and this leads to the breakdown of the fixed exchange rate system.

Obstfeld: Self-fullfilling nature of speculation: the speculators force authorities to a new equilibrium with higher S and M. The speculation provokes a change in monetary policy and a breakdown of the fixed exchange rate system.

Capital mobility has enhanced the fragility of fixed exchange rate arrangements.

The currency to attack will be the one which speculators expect that the monetary authorities will not be willing to defend their currency. They will not attack a strong-willed authority.

Relation between Krugman and Obstfeld models, the n-1 and adjustment problems. The n-1 problem arise when conflicts about the nature of monetary policies for a system emerge. (Obstfeld analysis is relevant here). Speculators become suspicious about the future commitment of particular countries.

Adjustment problems are often associated with changes in fundamental variables (i.e. inflation, unemployment) and this raises doubts about the sustainability of the fixed exchange rate. (Krugman analysis is relevant here).

5. Target Zone models Fixed exchange rate systems are never completely fixed. This means that there is a band of free fluctuation around the official rate.

Main issue to be analyzed How the exchange rate behaves within the band? Can economic theory be used to answer this question?

From which critical structure can we explain the behavior of exchange rate within the band? Using Krugman’s model we have the graphical representation:

Main Features There is a band of fluctuation (Su and SL) Once the limits are reached, the authorities are committed to keeping the exchange rate within the band.

The authorities announce to fix the stock of money in  so that they can keep S safely within the band even if there are random disturbances in the money supply.

Suppose that because of a shock the stock of money became M1, so they sell currency knowing that exchange will decrease instead of increasing and this precipitates the decrease.

Result The exchange rate will be located at a point below the AA line (when the stock is positive) and above AA line when the stock is negative.

Example What will happen when the stock brings the exchange rate outside the band (M2 for example). The exchange rate must be SU, but the speculators are aware the authorities will bring back the equilibrium exchange rate to. Then they will sell their currency decreasing the exchange rate, which will be below SU in the S-shaped curve.

Conclusion The exchange rate will lie on a point in the S-shaped curve. Speculators will be stabilizers. In this model the authorities do not have to intervene because the speculators, by selling foreign currency, will adjust the exchange rate back to its equlibrium point.

Empirical tests of the Target Zone model Implications of the model Exchange rates and domestic interest must be inversely related

(interest parity condition 3.1) r = r* + μ Where: r is the domestic interest rate. r* is the foreign interest rate. μ is the expected future rate of price increase of the foreign currency (expected depreciation of the domestic currency).

Empirical evidence In the simple target zone model the movements of the domestic interest rate will be negatively correlated with the movements of the exchange rate in the band.

Conclusion The simple target zone model has been soundly rejected by the empirical evidence. This is because very few exchange rate regimes are fully credible.

Target Zone model with less than full credibility Assumptions Shocks in the money stock drives S upwards Speculators are uncertain about how to interpret this

Result 1 If the shock is a result of a random disturbance that the authorities will correct, then there is no problem.

Result 2 If the shock is a result of a change in policy, whereby authorities have decided to increase M, doubts will rise about the commitment of the authorities toward the fixed exchange rate.

In this case of uncertainty, speculators will interpret this as a signal for fundamental changes or more trouble to come.

They will buy foreign currency instead of selling it and the exchange rate will lie on an inverted S-cruve:

The speculators are destabilizing here and this seems to be the rule, as empirical works seem to suggest.

Policies to avoid the destabilizing effect of speculators: authorities have to intervene in the foreign exchange market before the limit of the band is reached and this also limits the movements of exchange rates within the band.

Conclusion Existence of bands does not give additional credibility to policy-makers. But this can increase the speculative attacks, which are very difficult to contain.

6. Capital controls and fixed exchange rates Conclusion of Obstfeld: “The liberalization of capital movements since 1980’s have contributed to the problem of self-fulfilling speculative crisis.”

Proposition of some economists: Control of capital to reduce the fragility of fixed exchange rate regimes (tax of 1% in all capital movements, proposed by Tobin (1995) for example).

Two questions about the capital controls: 1. Can capital control solve the credibility issues to which fixed exchange rate systems lead? NO. When capital controls are established, speculators will still have more doubts about the commitment of the authorities of keeping the exchange rate fixed. And the same process happens as in the absence of control but here speculation will be more difficult.

2. Can these controls be effective: can they help to avoid the collapse? NO. Capital controls cannot be effective enough to avoid a collapse in a world of high trade interaction. Speculators have many ways to avoid controls.

Capital controls can only be effective if trade is heavily controlled. This conclusion comes from the Bretton-Woods system collapse. Despite the fact that Germany and USA introduced capital controls, when credibility undermines controls become increasingly infeffective in sustaining the fixed exchange rate system Of course those capital controls can postpone a little bit the timing of the collapse but they did not avert the collapse itself.

7. Conclusion This chapter has used formulation to show that fragility will lead to the collapse fo every fixed exchange rate system.

Facts also show that fixed exchange rate arrangements cannot stand, since the Bretton-Woods agreement collapsed, the number of countries using flexible arrangements have risen from 30 in 1980’s to 90 in 1993 and those using fixed exchange rates have decreased from 60 to 45.

However, floating exchange arrangements are also not without problems.