Assignment #4: Flexible Exchange Rate Systems, Fixed vs. Flexible Exchange Rates and Optimal Currency Areas

1. Consider a world consisting of two countries, home and foreign. Write down equations describing real goods, aggregate commodity market or flow equilibrium in the two economies. Then write down equations describing equality of the demand and supply of money in the two countries, assuming that each country's money supply is held exclusively by its own residents.

• Assume that there is zero capital mobility between the two economies and write down an equation describing balance of payments equilibrium. Demonstrate that flexible exchange rates insulate each economy from all shocks arising in the other economy. Then explain the process by which the domestic money shock is transmitted to the rest of the world.

• Now explain what one might mean by "perfect capital mobility" and make the changes in the zero capital mobility model above necessary to incorporate it.

• Explain how world asset equilibrium is achieved when capital is perfectly mobile internationally and show how it differs from the achievement of world asset equilibrium under zero capital mobility.

• Assuming perfect international capital mobility, show how one would derive a single world asset equation expressing the world interest rate as a function of the relevant domestic and foreign money, income, and price level variables when the exchange rate is flexible.

• Does a flexible exchange rate insulate each economy from real and monetary shocks in the other economy when there is international capital mobility?

2. What is meant by exchange rate overshooting? Explain why overshooting might occur and outline the mechanism by which equilibrium is maintained in an overshooting environment. Does overshooting depend on the existence of perfect capital mobility. Is undershooting also possible? Explain the circumstances under which it can occur? Are overshooting effects frequently observed in the data? Why or why not? Can the substantial variability of exchange rates in many countries during the period of managed floating be attributed to overshooting?

3. True or False: Explain your answer.

• If the Canadian authorities follow a policy of increasing the domestic money supply at a constant rate year after year they will effectively insulate Canada from the business cycle abroad.

• In a small open economy with perfect capital mobility, fiscal policy is impotent when the exchange rate is flexible.

• The Bank of Canada can moderate a decline in the Canadian dollar on the international currency market by borrowing U.S. dollars from a consortium of U.S. banks and selling them in return for Canadian currency.

4. Over the past 45 years the value of the Canadian dollar in terms of a weighted average of the currencies of the major industrial countries has undergone substantial adjustments from time to time. It rose about 15% in the early 1950s, fell by roughly the same amount in the early 1960s, was relatively stable during the remainder of the 1960s, fluctuated within a range of plus or minus 10% during the first half of the 1970s, fell by more than 30% between 1977 and 1980, rose about 20% between 1980 and 1984, fell back nearly to its 1980 level by 1987, appreciated by more than 15% to the early 1990s and then depreciated substantially to the present.

Write an essay on the economic forces that determine the external value of a country's currency, paying special attention to the Canadian dollar. In your essay, deal with the following issues:

• the relationship between the real exchange rate, the nominal exchange rate and the ratio of the domestic to the foreign price level.

• the factors determining the nominal exchange rate in the long run under the working assumption of continuous full employment, and the implications of these factors with respect to the behavior of the real relative to the nominal exchange rates.

• the factors determining the nominal exchange rate on a day-to-day and month-to-month basis when there is not necessarily full employment. Here, outline the role of monetary changes and foreign exchange market speculation and deal with the concept of overshooting.

• how one might distinguish whether a particular parallel movement of the real and nominal exchange rates was due to long-run real factors or monetary factors.

• the different kinds of monetary and exchange rate policies the Canadian authorities could follow in the face of exogenous real and monetary shocks originating in the rest of the world and, in particular, the issue of whether Canada can, should, and does follow an independent monetary policy.

• the relationship between domestic interest rates and the external value of the domestic currency.

5. Consider the observed movements in the real and nominal exchange rates and the ratios of domestic to foreign price levels for the major industrial countries.

• What generalizations can be made about the extent to which real exchange rate movements are reflected in nominal exchange rates as opposed to changes in inflationary trends.

• How would you characterize the major movements in real exchange rates during the past 30 years? Can you discern any major international real exchange rate adjustments between Europe and North America or the U.S. and the rest of the G10?

• What factors, in general, can explain the sorts of real exchange rate movements that have occurred during the past 30 years? Consider the possible role of short-term monetary and cyclical factors as well as longer-term ones. Does the raw data tell you anything about the likelihood that significant overshooting adjustments have been present.

6. Suppose that the Canadian authorities embark on a monetary expansion with the degree of money growth and growth of the demand for money abroad remaining at their initial levels. Trace out the effects on the exchange rate, output, employment, prices and domestic interest rates in the following three situations:

• The monetary expansion is unannounced--indeed, denied--by the Canadian authorities. All the usual statistics remain available to private agents.

• The monetary expansion is announced when it begins and the authorities do what they say they are going to do.

• The monetary expansion is announced one year before it is to begin and the authorities implement the policy as promised.

7. Monetarists frequently argue that the Canadian government should maintain a constant rate of domestic monetary expansion.

• If such a policy were adopted, which monetary aggregate should be stabilized and why?

• In comparison to current policy, would stabilization of domestic monetary expansion make the growth rate of domestic GNP more stable over the business cycle in the face of the usual variations in the rate of monetary growth in the rest of the world? Does your answer to this question depend on whether expectations are rational?

• Suppose, alternatively, that the Canadian authorities adopt a policy of pegging the Canadian dollar to the U.S. dollar at some appropriate rate of exchange. Given the type of changes we have observed in Canadian relative to world prices and in the real exchange rate in the post-war period, would you expect this policy to increase the stability of output and prices in Canada?

8. The MacDonald Commission recommended that the Canadian Government expand the money supply and drastically lower interest rates in order to bring down the current high level of unemployment. At the same time it recommended that fiscal policy be tightened in order to bring the Federal deficit under control.

(a) Outline the factors determining the level of interest rates in Canada and the various avenues by which these interest rates can be influenced by domestic policy. Pay particular attention to the relationships between

• the money supply and interest rates.

• capital flows and interest rates.

• interest rates and the exchange rate.

(b) Outline the effect of a reduction of the federal deficit on output, employment and prices in the Canadian economy. Assume that the standard Keynesian propositions about the effects of tax cuts and increases in government expenditures are qualitatively correct. Pay particular attention to

• the mechanism by which changes in the deficit affect aggregate demand.

• the relationship between changes in the deficit and the exchange rate.

• the relationship between the output and employment effects of the deficit and the stance adopted with respect to monetary policy.

9. The U.S. dollar appreciated very substantially between 1980 and 1984 and then depreciated back to near its 1980 level by 1985. Why did this happen? Was this bad for the U.S. economy? Would the same underlying real exchange rate change have occurred had nominal exchange rates been fixed? Can one explain the movements in U.S. real interest rates and the U.S. trade balance by these movements in the real exchange rate?

10. The Federal Funds Rate is the interest rate at which banks in the United States borrow reserves from each other overnight. It is often asserted in the literature that the U.S. Federal Reserve System `determines' this interest rate and, as a result, other short-term interest rates in the United States as well. One often hears in the popular press, for example, that the Fed. has been reducing or is about to lower U.S. interest rates. Is this true?

11. A controversial move is afoot to integrate the monetary systems of a number of members of the European Economic Community. A timetable by which monetary union is to be achieved was set out in an agreement at Maastricht in 1991 and, as of the year 2000 eleven countries have adopted a common currency (the Euro) in which all national currencies are defined (although national currencies still remain in circulation). The question is whether monetary union is a good thing for the Community to pursue. One can think of five possible levels of integration:

• freely floating exchange rates with totally independent monetary policies--i.e., no integration.

• managed floating according to which nations adjust their monetary policies, with or without intervening directly in foreign exchange markets, to maintain `orderly conditions'.

• defined limits to exchange rate flexibility such that countries are not permitted to let their exchange rates move outside some band or target zone.

• rigidly fixed exchange rates (perhaps with very small margins of flexibility) with provisions for adjustment when necessary.

• a common currency.

• seignorage and inflationary finance.

• real exchange rate variability.

• countercyclical monetary policy.

• exchange rate policy viz. the rest of the world.

• labour mobility.

• fiscal policy coordination.

• fiscal federalism.

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