The Case for Floating Exchange rates Symmetry Floating exchange rates remove two main asymmetries of the Bretton Woods system and allow Central banks abroad to be able to determine their own domestic money supplies The U.S. to have the same opportunity as other countries to influence its exchange rate against foreign currencies Copyright C 2003 Pearson Education, Inc Slide 19-6
Copyright © 2003 Pearson Education, Inc. Slide 19-6 ▪ Symmetry • Floating exchange rates remove two main asymmetries of the Bretton Woods system and allow: – Central banks abroad to be able to determine their own domestic money supplies – The U.S. to have the same opportunity as other countries to influence its exchange rate against foreign currencies The Case for Floating Exchange Rates
The Case for Floating Exchange rates Exchange Rates as automatic Stabilizers Floating exchange rates quickly eliminate the fundamental disequilibriums" that had led to parity changes and speculative attacks under fixed rates Figure 19-1 shows that a temporary fall in a country's export demand reduces that country's output more under a fixed rate than a floating rate Copyright C 2003 Pearson Education, Inc Slide 19-7
Copyright © 2003 Pearson Education, Inc. Slide 19-7 ▪ Exchange Rates as Automatic Stabilizers • Floating exchange rates quickly eliminate the “fundamental disequilibriums” that had led to parity changes and speculative attacks under fixed rates. – Figure 19-1 shows that a temporary fall in a country’s export demand reduces that country’s output more under a fixed rate than a floating rate. The Case for Floating Exchange Rates
The Case for Floating Exchange rates Figure 19-1: Effects of a Fall in Export Demand Exchange rate, E DD2 DD (a Floating exchange rate AA1 Output,Y Exchange rate, E DD DD1 (b )Fixed exchange rate AA AA2 Copyright C 2003 Pearson Education, Inc Output, y Slide 19-8
Copyright © 2003 Pearson Education, Inc. Slide 19-8 AA1 DD1 Figure 19-1: Effects of a Fall in Export Demand AA2 DD2 AA1 DD2 DD1 E2 2 Y2 Y2 Output, Y Exchange rate, E (a) Floating exchange rate Output, Y Exchange rate, E (b) Fixed exchange rate Y1 E1 1 Y1 E1 1 Y3 3 The Case for Floating Exchange Rates
The Case against Floating Exchange rates There are five arguments against floating rates Discipline Destabilizing speculation and money market disturbances Injury to international trade and investment Uncoordinated economic policies The illusion of greater autonomy Copyright C 2003 Pearson Education, Inc Slide 19-9
Copyright © 2003 Pearson Education, Inc. Slide 19-9 The Case Against Floating Exchange Rates ▪ There are five arguments against floating rates: • Discipline • Destabilizing speculation and money market disturbances • Injury to international trade and investment • Uncoordinated economic policies • The illusion of greater autonomy
The Case against Floating Exchange rates Discipl ne Floating exchange rates do not provide discipline for central banks Central banks might embark on inflationary policies(e.g the German hyperinflation of the 1920s) The pro-floaters' response was that a floating exchange rate would bottle up inflationary disturbances within the country whose government was misbehaving Copyright C 2003 Pearson Education, Inc Slide 19-10
Copyright © 2003 Pearson Education, Inc. Slide 19-10 ▪ Discipline • Floating exchange rates do not provide discipline for central banks. – Central banks might embark on inflationary policies (e.g., the German hyperinflation of the 1920s). • The pro-floaters’ response was that a floating exchange rate would bottle up inflationary disturbances within the country whose government was misbehaving. The Case Against Floating Exchange Rates