This document discusses three issues related to exchange rates and macroeconomic policy: devaluation and revaluation of fixed exchange rates, monetary policy under floating exchange rates, and international business cycles. It explains that devaluation increases exports and revaluation decreases exports under a fixed exchange rate regime. For floating rates, it describes how monetary policy affects exchange rates and aggregate demand. It also notes how recessions can spread between countries through trade links and the impact of exchange rate regimes.
2. EXCHANGE RATES AND
MACROECONOMIC POLICY
There are three policy issues raise by
open-economy macroeconomics
3. DEVALUATION AND REVALUATION OF
FIXED EXCHANGE RATES
A reduction in the value of a currency
that is set under a fixed exchange rate
regime is called devaluation
Remember that depreciation is a
downward move in the value of a
currency.
So devaluation is a depreciation that is
due to a revision in a fixed exchange rate
target.
4. DEVALUATION AND REVALUATION OF
FIXED EXCHANGE RATES
A devaluation makes domestic goods
cheaper in terms of a foreign currency,
which will lead to higher exports.
At the same time, it makes foreign goods
more expensive in terms of domestic
currency, and reduces imports.
The effect of devaluation is to increase
the balance of payments on the current
account.
5. DEVALUATION AND REVALUATION OF
FIXED EXCHANGE RATES
An increase in the value of a currency that
is set under a fixed exchange rate regime is
called a revaluation.
A revaluation makes domestic goods more
expensive in terms of foreign currency,
which reduces exports, and makes foreign
goods cheaper in domestic currency, which
increases imports.
So revaluation reduces the balance of
payments on the current account.
6. DEVALUATION AND REVALUATION OF
FIXED EXCHANGE RATES
Devaluations and revaluations serve two
purposes, under a fixed exchange rate
regime.
1. First, they can be used to eliminate
shortages or surpluses in the foreign
exchange market.
2. Second, devaluation and revaluation
can be used as tools of macroeconomic
policy.
7. DEVALUATION AND REVALUATION OF
FIXED EXCHANGE RATES
A devaluation, by increasing exports and
reducing imports, increases aggregate
demand; so a devaluation can be used
to reduce or eliminate a recessionary
gap.
A revaluation, by decreasing exports and
increasing imports, decreases aggregate
demand; so a revaluation can be used to
reduce or eliminate an inflationary gap.
8. MONETARY POLICY UNDER A
FLOATING EXCHANGE RATE REGIME
With a floating exchange rate regime, a
country’s central bank retains its ability to
pursue independent monetary policy, and
can increase aggregate demand by
cutting the interest rate, or decrease
aggregate demand by raising the interest
rate.
However, the exchange rate adds
another dimension to the effects of
monetary policy.
9. MONETARY POLICY UNDER A
FLOATING EXCHANGE RATE REGIME
A lower interest rate leads to higher investment
and consumer spending.
However, with a lower interest rate, foreigners
has less incentive to move funds into the
country, as they will receive a lower rate of return
on their loans.
The demand for the currency falls.
At the same time, residents have more incentive
to move funds abroad because the rate of return
in foreign countries is relatively higher than at
home.
Thus, the supply of the currency increases.
10. MONETARY POLICY UNDER A
FLOATING EXCHANGE RATE REGIME
The decrease in demand and increase in
supply for the currency causes the
exchange rate to fall, and the currency
depreciates.
This depreciation in the currency
increases aggregate demand, increasing
the amount of exports and reducing
imports.
11. MONETARY POLICY UNDER A
FLOATING EXCHANGE RATE REGIME
In a closed economy, a reduction in the
interest rate increases investment and
consumer spending.
In an open economy with a floating
exchange rate, a reduction in the interest
rate leads not only to increased
investment and consumer spending, but
to an increase in net exports, which
further increases AD.
12. INTERNATIONAL BUSINESS CYCLES
Not all demand changes or shocks
originate from the domestic economy.
Economies sometimes face shocks
coming from abroad.
The key point is that changes in AD
affect the demand of goods and services
produced abroad as well as at home.
13. INTERNATIONAL BUSINESS CYCLES
Other things equal, a recession leads to a
fall in imports and an expansion leads to a
rise in imports.
Since one country’s imports are another
country’s exports, so there is a link between
aggregate demand in different national
economies.
This is one reason business cycles in
different countries sometimes seem to be
sinchronized.
14. INTERNATIONAL BUSINESS CYCLES
The extent of this link depends on the
exchange rate regime.
If a recession abroad reduces the
demand for a country’s exports, this is
also a reduction in the demand for the
country’s currency in the foreign
exchange market.
If the country has a fixed exchange rate,
it responds with exchange market
intervention.
15. INTERNATIONAL BUSINESS CYCLES
However, if the country has a floating
exchange rate, the currency depreciates.
Because now the county’s goods and
services are relatively cheaper to
foreigners when the demand for exports
falls, the quantity of goods and services
exported doesn’t fall by as much as it
would under a fixed rate.
16. INTERNATIONAL BUSINESS CYCLES
At the same time, the fall in the currency
makes imports more expensive to the
citizens of the country, leading to a fall in
imports.
Both effects limit the decline in the
country’s aggregate demand compared
to what it would have been under a fixed
exchange rate regime.
17. INTERNATIONAL BUSINESS CYCLES
One of the advantages of a floating
exchange rates is that it helps insulate
countries from the recessions originating
abroad.
18. SOME COUNTRIES WITH FIXED EXCHANGE
RATES
Antarctican dollar Central African CFA Macanese pataca
Aruban florin franc Maldivian rufiyaa
Bahamian dollar Comorian franc Moroccan dirham
Cook Islands dollar Namibian dollar
Bahraini dinar
Cuban convertible peso Nepalese rupee
Barbadian dollar
Danish krone Netherlands Antillean
Belarusian ruble guilder
Djiboutian franc
Belize dollar New Caledonian franc
East Caribbean dollar
Bermudian dollar Falkland Islands pound Omani rial
Bhutanese ngultrum French Polynesian franc Panamanian balboa
Bosnia and Gibraltar pound Qatari riyal
Herzegovina Guernsey pound Saudi riyal
convertible mark Swazi lilangeni
Hong Kong dollar
Bulgarian lev Jordanian dinar Trinidad and Tobago
Caribbean guilder Lebanese pound dollar
Cayman Islands dollar Lithuanian litas United Arab Emirates
dirham
Venezuelan bolívar