Session 11. Fixed Exchange Rates and Currency Crisis
v The IS/LM Model for a Fixed Exchange Rate Regime
v The Impossible Trinity and capital controls.
v The 1994-95 Mexican Peso Crisis
Macroeconomics in the Global Economy Antonio Fatás
Review: The IS/LM Model for a Small Open Economy (with a flexible exchange rate)
The key assumption is that if the domestic interest rate (i.e. the point where the IS and LM curves cross) is different from the world interest rate, then this difference will trigger immediate capital outflows or inflows, which in turn will depreciate or appreciate the currency. This leads to a change in NX and a shift in the IS curve.
r Appreciation Interest rate LM
Foreign r* Depreciation interest rate
IS
Y Output
Macroeconomics in the Global Economy Antonio Fatás
1 Floating Exchange Rates
v Under floating exchange rates, the nominal exchange rate is endogenous. Assuming perfect capital mobility, we have two equations and two unknowns (Y and e)
Y = C (Y, Ye T, r, wealth) + I (r, future productivity) + G + NX (ε, Y, Yf)
M = L(r,Y) P
Remember that prices are constant and that capital mobility implies: r = r*
Macroeconomics in the Global Economy Antonio Fatás
Fiscal Policy and Flexible Exchange Rates
In a small open economy fiscal policy has no effect on output unless monetary policy accommodates fiscal policy. An increase in government spending or a tax cut shifts the IS curve to the right and pushes up interest rates leading to an appreciation of the currency. The appreciation of the currency leads to falling exports. Unless the money supply increase, the decrease in exports will perfectly offset the increase in output caused by government spending. LM r Interest rate
Foreign r* interest rate
IS
Macroeconomics in the Global Economy Y Output Antonio Fatás
2 IS/LM under Fixed Exchange Rates
Under fixed exchange rates, the nominal exchange rate becomes exogenous (fixed). Assuming perfect capital mobility, we have two equations but only one unknown (Y)
f Y = C (Y, Ye T, r, wealth) + I (r, Profitability) + G + NX (ε, Y, Y )
M = L(r*,Y) P
The system is over-determined. We need to find an endogenous variable: Monetary policy. The money supply cannot be exogenous if the exchange rate is to remain fixed. Money supply needs to ensure that monetary conditions (interest rate, money supply) are consistent with the announced fixed exchange rate.
Macroeconomics in the Global Economy Antonio Fatás
Attempt to Boost the Economy with Standard Monetary Tools
Monetary policy cannot influence the economy by simply increasing money supply (or lowering interest rate). Here is the same example:
1. The attempt to expand the economy by an increase in money LM supply leads to Interest rate r lower interest rates 1 at home… 3. To avoid devaluation, 3 the central bank must reduce money supply to its original level. Foreign r* interest rate 2. … which causes a capital outflow and 2 a pressure on the IS currency to devalue. Y Output Macroeconomics in the Global Economy Antonio Fatás
3 The Impossible Trinity
Key lesson: In a world with high capital mobility a country cannot fix the exchange rate of its currency and run at the same time independent monetary policy.
Independent monetary policy
Fixed exchange rate Capital mobility
A country can select only two of these options.
Macroeconomics in the Global Economy Antonio Fatás
Non-standard Expansionary Monetary Policy: Devaluation
Monetary policy can influence the economy only if it lets the currency devalue. Doing so is equivalent to an increase in the money supply. In this case, exports and output increase.
LM Interest rate r 1
Foreign r* interest rate 2
IS
Y Output Macroeconomics in the Global Economy Antonio Fatás
4 Fiscal Policy and Fixed Exchange Rates
1. Expansionary fiscal policy (increase in govt. spending, cut in taxes) shifts the IS to the right. If the money supply was held constant, interest rates would increase (because of increasing money demand). This increase will trigger a capital inflow and pressure to appreciate the currency.
LM Interest rate r 2 1 2. To avoid appreciation, the central bank is forced to increase in the money supply. Foreign r* interest rate
IS
Y Output Macroeconomics in the Global Economy Antonio Fatás
Summary of Policy Effects in the Open Economy Model
Exchange rate regime Flexible Fixed IMPACT ON: Policy Y e NX Y e NX Fiscal expansion 0 ↑ ↓ ↑ 0 0 Monetary expansion ↑ ↓ ↑ 0 0 0
This table shows the direction of impact of various economic policies on income (Y), the exchange rate (e), and the trade balance (NX).
Macroeconomics in the Global Economy Antonio Fatás
5 The Mexican Peso Crisis in 1994: Background
An economy that had suffered recurrent exchange rate crises and debt default (in the early 80’s). Going back to capital markets, hoping to increase trade, attract large inflows of foreign investment, grow faster. Mexico sees stability of the exchange rate a requirement to provide reassurance to foreign investors.
Macroeconomics in the Global Economy Antonio Fatás
The Mexican Crisis: A Perspective
After the debt crisis of the early 1980s Mexico was isolated from the world capital markets until the end of the decade. Then, in the years 1990-93 Mexico received $91 billion of net capital flows (about 20% of the total capital flows to developing countries). $61 billion took the form of portfolio investment. Interest rates declined to reach a low of about 9% in early 1994. The country ran an increasingly large current account deficit. The economy boomed during these years r Investment Saving
Real interest rate in autarky
World real interest rate CA deficit
Saving, Investment Macroeconomics in the Global Economy Antonio Fatás
6 The Mexican Crisis: The Nominal Exchange Rate
From November 1991 Peso was “fixed” within a band that was slowly depreciating (less than 5% per year). In October 1992 the band allowed for a slightly faster depreciation. In January 1993 a new Peso was introduced and remained stable (around 3.1 Pesos per USD) for most of 1993.
7
6
5
4
3 USD/Peso USD/Peso
2
1
0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
Macroeconomics in the Global Economy Antonio Fatás
The Mexican Crisis: Inflation and the Interest Rate
Despite the efforts from the Central Bank to bring inflation down to levels similar to the US, inflation remained higher than US levels even during the period of stability of the nominal exchange rate
120
100
80
60
40
20
0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Interest Rate Inflation
Macroeconomics in the Global Economy Antonio Fatás
7 The Mexican Crisis: The Real Exchange Rate
A stable nominal exchange rate combined with high inflation meant an appreciating currency in real terms during the 1990-94 period.
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0 1990 1991 1992 1993 1994 1995 1996 1997 1998
Nominal Real
Macroeconomics in the Global Economy Antonio Fatás
The Mexican Crisis: A Perspective As growth picked up (partly fueled by the capital inflows), the current account imbalance was getting bigger every year requiring additional capital inflows. Strong growth kept inflation high and therefore the real exchange rate kept appreciating leading to a loss of “competitiveness” and hurting the current account. 6
4
2
0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 -2
-4
-6
-8
Real Growth Current Account (% of GDP)
Macroeconomics in the Global Economy Antonio Fatás
8 The Mexican Crisis: Imbalances
Despite a booming economy and record levels of capital inflows, imbalances were growing during the period 1991-1994. 1. Higher inflation and a constant nominal exchange rate leads to an overvalued real exchange rate. 2. The current account deficit increases and becomes unsustainable.
These imbalances in the case of an emerging market are risky because changes in the confidence of foreign investors can produce a fast reversal of capital flows and a crisis.
Macroeconomics in the Global Economy Antonio Fatás
The Mexican Crisis In addition to imbalances getting bigger we have in 1994: 1. Internal political turmoil as there is a peasant uprising in Chiapas as well as the assassination of leading presidential candidate (risk premium increases) 2. A change in international conditions as the Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. Foreign interest rate in 1994 + r LM risk premium on the peso
r*1994+ θ
r*1993 Foreign interest rate in 1993 IS
Output Y
Macroeconomics in the Global Economy Antonio Fatás
9 The Mexican Crisis: Monetary Policy
When the risk premium increases, the central bank must raise interest rates (and cut money supply) to maintain the exchange rate parity. Otherwise there will be continuous capital outflows.
But what do capital outflows do to reserves? Those investors who want to leave Mexico will take their peso holdings, go to the central bank and exchange them for dollars. The reserves of the central bank will go down and eventually could be exhausted.
Why are central banks reluctant to increase interest rates? If the growth in the economy is low, then higher interest rates will further reduce consumption and investment and generate a recession.
Macroeconomics in the Global Economy Antonio Fatás
Understanding the Crisis
These events put downward pressure on the peso. Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to maintain the peso exchange rate. Is this enough? What happened to international reserves and to the money supply?
Monetary Base in 1994
20
15
10
5
0 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec -5
-10
Monetary Base Change in foreign Reserves Change in Domestic Credit
Macroeconomics in the Global Economy Antonio Fatás
10 Mexico: The Crisis
The decline in reserves due to the foreign exchange interventions increases the perception that this is not a sustainable situation. As foreign reserves get close to zero, the crisis is unavoidable. 30000 1
0.9 25000 0.8
0.7 20000 0.6
15000 0.5 USD/Peso USD Millions 0.4 10000 0.3
0.2 5000 0.1
0 0
Foreign Reserves Exchange Rate
Macroeconomics in the Global Economy Antonio Fatás
The Crisis
v Dec. 20: Mexico devalues the peso by 13% (fixes the exchange rate at 25 cents instead of 29 cents)
v This is a surprise to many investors. It is also revealed that the central bank is running out of reserves…
v Investors dump their Mexican assets and pull their capital out of Mexico.
v Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets the currency float.
v In a week, the peso depreciates by another 30%.
Macroeconomics in the Global Economy Antonio Fatás
11 Mexico: Real GDP Growth
The crisis led to a deep recession but with the help of the US and the the IMF (who provided funds to avoid a bigger crisis), Mexico returned to growth in the years that followed.
8
6
4
2
0 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 -2
-4
-6
-8
-10
Macroeconomics in the Global Economy Antonio Fatás
Lessons from the Peso crisis
1. In a regime with fixed exchange rates monetary policy must be consistent with the regime.
2. One indicator of ‘inconsistency’ is the real exchange rate appreciation: % change in RER = % change in NER + π – π* 3. Business cycle synchronization: when the US starts raising interest rates, then Mexico must also raise interest rates.
4. The nature of capital inflows (hot money vs. FDI) may also make a difference because certain flows are easy to reverse and to put too much strain on the exchange rate regime.
5. The current account deficit (S – I) is key to understand whether it can be potentially dangerous for the stability of the economy.
Macroeconomics in the Global Economy Antonio Fatás
12 Lessons from the Mexican Peso crisis
“Credibility is not a gift -it has to be earned. It is built up one step at a time and supported by facts, and by consistency. Even more, credibility is never owned; it is rented, because it can be taken away at any time”
Pedro Aspe, Economic Transformation the Mexican Way (1993)
Macroeconomics in the Global Economy Antonio Fatás
Session 11. Summary
v The IS/LM model for an open economy introduces two modifications: v Demand (Y) includes also Net Exports, which depend on the real exchange rate v Perfect capital mobility is assumed (r = r*).
v In an open economy with a fixed exchange rate regime, macroeconomic policies have the following effects: v Fiscal policy is very powerful. Fiscal expansions cause pressure on the currency to appreciate and to eliminate this pressure the central bank increases money supply. v Monetary policy is endogenous. In order to preserve the exchange rate, the central bank must supply money according to money demand. No independent monetary policy is possible.
v Fixed exchange rate regimes are sustainable only as long as fundamentals (monetary and real) are consistent with the exchange rate.
Macroeconomics in the Global Economy Antonio Fatás
13 Appendix: Change in the World Interest Rate
r LM Interest rate
New world rate r* 1. The world interest rate goes up. World interest rate r* 2. With the domestic rate at the old level, 3. To avoid devaluation the there are pressures home country raises on the currency to be interest rates to the world IS devalued. level. This shifts the LM curve to the left. Y Output
Macroeconomics in the Global Economy Antonio Fatás
14