Polisci110G Week 7 notes
Polisci110G Week 7 notes Polisci110G
Popular in Governing the Global Economy
Popular in Political Science
This 3 page Class Notes was uploaded by Erica Evans on Monday February 22, 2016. The Class Notes belongs to Polisci110G at Stanford University taught by Kenneth Scheve in Fall 2016. Since its upload, it has received 11 views. For similar materials see Governing the Global Economy in Political Science at Stanford University.
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Date Created: 02/22/16
Polisci110G 2/18/2016 Exchange Rates: • Countries decide how exchange rate will be set • Doesn't the market decide though? No! • Fixed exchange rate: Countries will choose how it’s set – by fixing it to another country. So it fluctuates not at all, or over a narrow range for an extended time period. • Floating exchange rate: the government doesn’t try to set it, but lets the supply and demand or assets determine what the exchange rate is • Fixed-‐but-‐adjustable: Bretton-‐Woods System à fixed currencies to the dollar but were allowed to reset them. • Managed flow: governments intervene but there are no rules and rates vary significantly. History: • Before WWI, countries had lots of different systems, but at some point Britain adopted a Gold Standard (the currency is worth x amounts of gold. Anyone can redeem cash for gold, or gold for cash). Britain was the most important economy in the world, so lots of countries moved to a gold standard (others are floating or on a silver or bimetallic standard). • In WWI, all countries suspended the gold standard • Would the Int. financial system return to the gold standard? • Late 1920’s they got there and most countries were back to the Gold Standard… but it didn’t last (Great Depression hmmm) • After WWII, a bunch of countries are pegged to the dollar, the pound etc. Lots of fixed exchange rates, but not a Gold Standard. Floating becomes more popular. th • In the later half of the 20 century: 1974: 74% countries have fixed. Moves to 58% in 1990, and then 26% in 2000 à more countries adopting floating exchange rates. Albion peg to the Wotan exercise: • 1% economic downturn in home country • “Our policies will not change unless economic conditions deteriorate further” • Let’s learn more… maybe we will change our minds! What are the political considerations – who are the winners and losers? • 2 main ideas: • Exchange rate volatility discourages trade and capital flows. You will have more certainty about prices and you will trade more with that country • One argument à the greater the economic integration b/w home country and base country, the more the home country will benefit from a fixed rate. • (even more pronounced in a currency union like the EU) • Costs of a fixed exchange rate: a country choosing to fix its exchange rate is sacrificing its independent monetary policy. • It depends on how symmetric or asymmetric the shocks to the economy are. Suppose the countries are the Netherlands and Germany à very similar and close. They will have fewer asymmetric shocks, so low cost for a dependent monetary policy. But if it is Germany and Greece à very different. There will be very asymmetric shocks. Germany will not adjust if Greece is struggling because Germany is not affected. • Symmetry of shocks vs. Market integration à allows you to set the fix line (when the benefits of a fixed exchange rate out-‐weigh the costs). • What determines where the fix line is? Why does Denmark fix its exchange rate while the UK floats the pound? • How much does Denmark trade with Germany vs. the U.K? A lot more with Germany! Denmark would be more symmetric with Germany because the U.K.’s economy is a lot more global (they trade with the U.S. and Asia etc… so they would experience shocks that have nothing to do with the Euro area) The “Trilemma” in Theory: • THIS IS REALLY IMPORTANT! A lot of political leaders don’t understand this! • It is reasonable for leaders to want three things 1) fixed exchange rate to increase trade 2) (financial integration) capital mobility to allow capital to move to places where it can be best invested. This is especially important if you are a capital-‐poor country 3) monetary policy economy à having an independent monetary policy that allows you to adjust. • The problem is you cannot have all three of these things! • Fiscal policy = tax and spending, raising taxes so the gov. can do stuff. • Monetary policy = central bank setting interest rates. When interest rates go down, it’s cheaper to borrow, which spurs growth, but may cause inflation. When you raise the interest rate it’s more expensive to borrow, so more unemployment, but prices will come down. • Why can’t we have it all? • Investor’s behavior when capital markets are open: • If you are a U.S. investor, you want the expected dollar return of your investment to be the same all over the world – otherwise you will move your money to where it is more profitable. • If the ER is fixed, the expected exchange rate depreciation is 0. You know if you take your dollars and buy some Euros, then take the Euros and buy the dollars back, it will be the same. • The only way there will be an expected return that is the same is if the interest rate is exactly the same. So the home country can’t set it’s interest rates independently of the base country. • Compare fixed exchange rates and intermediate exchange rates à poor country that fixes their exchange rate will have very volatile experience… b/c they don't have an independent monetary policy. How the Trilemma has influenced historical relations: • In the late 19 century, many countries were under the gold standard. • Countries that had a gold standard also had a fixed exchange rate. • The ratio of gold prices in each country – arbitrage kept the exchange rate stable • The gold standard is an example of a fixed exchange rate system with high capital mobility. • With the exception of the U.S., countries wanted to trade more. • The gold standard was adopted because there was increasing trade integration. • The cost of lost monetary autonomy was bearable because the symmetry was high, or governments were not worried about the cost. • Benefits of the gold standard: exchange rate and price stability. Allowed for adjustment in trade imbalances à a natural equilibrium through the flow of gold. • The price levels were arbitrarily set by supply and demand for gold. So when there was a discovery of gold in California, this would increase the monetary supply. If they didn’t discover anything, then there was no money supply. • This lack of independent monetary supply generated political conflict. • There were various depressions and deflationary periods. • Like recently in Japan à Japan over the past 2 decades has had a problem with deflation. There is not enough accommodation in the monetary supply – prices are falling, people are waiting to buy things. • This kind of deflation happened until the 1890’s. \ • Prior to 1896 – massive political conflict over the gold standard. • William Jennings Bryan “Crucify us on a Cross of Gold” • WWI disrupted the Gold standard. There was lower trade, so fixed exchange rates are less attractive. • By the late 1920’s most countries have returned to the Gold Standard. • The depression was different than the previous deflations though • When countries leave the gold standard, they can choose either of the 2 sides of the triangle.
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