Macroeconomic Interdependence: adjustment problems under fixed exchange rates

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• Case study: Bretton Woods fixed exchange rate system 1945 – 1973
• Currency had to remain within upper and lower bands – ‘snake in a tunnel’
• A shock could push a currency outside the permitted level that would require selling reserves of an overvalued currency to reduce its value
• Bretton Woods was targeting rates rather than fixed rates, so there was an option to devalue
• 1965 onwards USA had expansionary fiscal policy (Vietnam War & social spending) caused inflation
• in 1967 the pound was devalued, showed a large currency could devalue, increased speculative activity in money markets
• 1971 US Dollar was devalued, 1973 devalued again
• system was abolished 1973

Options to combat a depreciating currency

• example: shock increases demand for $ so that S (exchange rate $/euro) increases

1. Adjustment

• This method involves selling $ for euro in the market: demand falls, prices fall, unemployment rises, competitiveness increases

2. Devaluation

• Exchange rate changed artificially by ECB and backed up by reserves so that the euro can be bought at a lower exchange rate
• Devaluation was another option that avoids the problems of reduced output and employment resulting from supporting the currency, exports are reduced as is demand for the US dollars
• Reduces the credibility of the currency: it is tempting to devalue because of its advantages, but it threatens the credibility of the fixed exchange rate system.

Credibility

• Investors who anticipate the devaluation will sell their holdings of the currency falling in value, thereby accelerating the devaluation

Liquidity preference

• when currencies are linked in fixed or quasi-fixed exchange rate systems, expectations are changed so that interest rate equate between the members
• problem is that the anchor country may set interest rates for their own domestic needs rather than the needs of the whole group of countries
• country A  (supply of money)
• country B  (supply of money)
• liquidity preference is positively related to price (money in pocket to make purchases) output (increased demand requires money) but negatively on interest rates (opportunity cost of holding money)
• assuming perfect K mobility & convertibility currencies are linked so that:
• mu = expected rate of devaluation of currency A
• 

Without fixed exchange rates: the (n-1) problem

• n countries
• n-1 exchange rates
• one country does not need to look after exchange rates so it can set money supply freely to control inflation etc.
• a source of conflict within the fixed exchange rate system