Exporting US Inflation: - PowerPoint Presentation

Slide1

Exporting US Inflation: 1966–1972

Effect on Internal and External Balance of a Rise in the Foreign (US) Price Level, P*

The “simple” solution for the £, M,

¥, FF, …

Revalue against the

$

Let the

$

depreciate

The Case

for Floating Exchange Rates

Monetary policy autonomy…w/o capital controls

Each country can choose “appropriate” long-run inflation rate

Symmetry

$

can “devalue” as necessary…not constrained as leader

Exchange rates as automatic stabilizers

Floating cushions output against real shocks

Something’s

gotta

adjust…if not

E

, then

Y

Temporary reduction in demand for country’s exports

 depreciation attenuates output reduction

AA

1

DD

1

Effects of a Temporary Fall in Export Demand

AA

2

DD

2

AA

1

DD

2

DD

1

E

2

2

Y

2

Y

2

Output,

Y

Exchange rate,

E

(a) Floating

exchange rate

Output,

Y

Exchange rate,

E

(b) Fixed

exchange rate

Y

1

E

1

1

Y

1

E

1

1

Y

3

3

Depreciation

leads to higher

demand for and

output of

domestic products

Fixed exchange

rates mean output

falls as much as

the initial fall in

aggregate demand

The Case

for Floating Exchange Rates

Monetary policy autonomy…w/o capital controls

Each country can choose “appropriate” long-run inflation rate

Symmetry

$

can “devalue” as necessary…not constrained as leader

Exchange rates as automatic stabilizers

Floating cushions output against real shocks

Something’s

gotta

adjust…if not

E

, then

Y

Temporary reduction in demand for country’s exports

 depreciation attenuates output reduction

Permanent reduction in demand for country’s exports

 depreciation restores equilibrium automatically

The Case

Against Floating Exchange Rates

Lack of discipline

Destabilizing speculation

Hot money

…but “fundamental disequilibrium”

 one-way bet under fixed rates

A “vicious circle” of depreciation and inflation.

E

deprec



P

im

up

CoL

up W up P up  E

deprec

Floating exchange rates make a country more vulnerable to money market disturbances…that’s the tradeoff:

L

up



R

up 

E

-

apprec

.



CA

&

Y

down

AA

1

DD

Output,

Y

Exchange

rate,

E

E

1

Y

1

1

A Rise in Money Demand Under a Floating Exchange Rate

AA

2

E

2

Y

2

2

The Case

Against Floating Exchange Rates

Lack of discipline

Destabilizing speculation

Hot money

…but “fundamental disequilibrium”

 one-way bet under fixed rates

A “vicious circle” of depreciation and inflation.

E

deprec



P

im

up

CoL

up W up P up  E

deprec

Floating exchange rates make a country more vulnerable to money market disturbances…that’s the tradeoff:

L

up



R

up 

E

-

apprec

.



CA

&

Y

down

Recall: fixed rates cushion output against monetary shocks

L up

 M up

 nothing shifts under fixed rates

Injury to International Trade and Investment

Exchange rate riskBut forward markets can protect traders against foreign exchange risk.International investments face greater uncertainty about payoffs denominated in home country currency.Uncoordinated Economic PoliciesCountries can engage in competitive currency depreciations.A large country’s fiscal and monetary policies affect other economies …aggregate demand, output, and prices become more volatile across countries if policies diverge.

The Case

Against

Floating Exchange Rates

Macroeconomic Interdependence Under Floating Rate

The Large Country Case

Effect of a permanent monetary expansion by US

$

depreciates, US output rises

Small country’s output may rise or fall.

Its currency appreciates

 Its CA and

output decrease

US economy expands



It sells more to US

 Its output rises

Effect of a permanent fiscal expansion by US

US output rises, US currency appreciates

Small country’s output rises

Its currency depreciates

 Its CA and output rise

US economy expands  It sells more to US  Its output rises

Large Country => Locomotive

Injury to International Trade and Investment

Exchange rate riskBut forward markets can protect traders against foreign exchange risk.International investments face greater uncertainty about payoffs denominated in home country currency.Uncoordinated Economic PoliciesCountries can engage in competitive currency depreciations.A large country’s fiscal and monetary policies affect other economies …aggregate demand, output, and prices become more volatile across countries if policies diverge.Free Float Really Managed FloatFear of depreciation – inflation spiral  intervention

The Case Against Floating Exchange Rates

More Case Against Floating Exchange Rates

Speculation and volatility in the foreign exchange market

Expectation of depreciation in

short-run



Rush

to sell currency

 Depreciation in short-run

… and recovery to fundamental value in long-run

High nominal and real exchange rate volatility under floating

Violation of Purchasing Power Parity

Disruption

of trade

???

Nominal and Real Effective Dollar Exchange Rate Indexes, 1975–2010Purchasing Power Parity???

Source: International Monetary Fund, International Financial Studies.

Milestones ‘a Floating

Vietnam ExpansionInflationCommodity price boom F L O A T I N GYom Kippur War O i l S h o c kStop – Go InflationRecycling petrodollarsAmerica Held Hostage 2nd O i l S h o c kVolcker DisinflationTwin DeficitsRust BeltLost Decade

Plaza AccordLouvre AccordBlack MondayJapan BubbleS & L DebacleBerlin Wall DownMaastrichtERM CrisisTequila CrisisEmerging Mkt BoomEast Asia CrisisContagionLTCMDot.com bubbleUS Capital InflowUS CA DeficitGreenspan Put

Global Savings Glut

China rising

Developed country aging

Reserve buildup

Tech slowdown

G

l

o

b

a

l

H

o

u

s

i

n

g

B

u

b

b

l

e

Leveraging

US Saving

down

C R I S I S

Deleveraging

The Great Recession

Rush to safety