Exchange Rates and International

Trade

João Pedro Kulicz Roling Gonçalves

International Financial Markets

 Paul Robin Krugman

● Paul Krugman is a highly influential American economist known for his work in
international economics, trade theory, and economic geography
● He was born on February 28, 1953 in New York. Krugman completed his
undergraduate studies at Yale University in 1974 and went on to earn a Ph.D. in
economics from the Massachusetts Institute of Technology (MIT) in 1977.
● Has made significant contributions to the field of economics, particularly to the areas
of international trade and currency control.
 Government Policies toward the Foreign
Exchange Market (Floating, Fixed and
Managed Exchange Rate)
According to Krugman’s theory, government policies toward the foreign exchange (forex) market can vary
widely depending on the economic goals of a country. Governments implement a range of policies to manage their
currencies, influence exchange rates, and stabilize their economies. Some key policies are in the field Exchange
Rates:

1. Fixed Exchange Rates: The government pegs its currency to another major currency, such as USD or EUR, at
a fixed rate. Central banks must maintain reserves of the foreign currency to defend the peg, as seen in
countries like Hong Kong.
2. Floating Exchange Rates: The currency's value is determined by market forces without direct government
intervention. Most developed nations, like the U.S. and the Eurozone, use this system.
3. Managed Exchange Rates: Governments allow the currency to float but intervene occasionally to stabilize
it, usually through the central bank buying or selling currency. China uses a form of managed float.
How Central Banks should fix the exchange
rate in Fixed Exch ange Rates System

- The foreign exchange market is in equilibrium when the interest parity

condition holds.
- That is, when the domestic interest rate, R, equals the foreign interest rate,
R*, plus the expected rate of depreciation ((E - E*)/E).
- However, when the exchange rate is fixed at certain rate and the markets
participants expect it to remain fixed, the expected rate of domestic
depreciation ((E-E*)/E) is zero.
- Given this logic, we have the equilibrium (R*=R) at the fixed exchange rate.
Monetary Policy with Fixed
Exchange Rates
- To hold the domestic interest rate at equilibrium, the central bank’s foreign
exchange intervention must adjust the money supply so that equates
aggregate real domestic money demand and the real money supply.
- When the central bank intervenes to hold the exchange rate fixed, it must
automatically adjust the domestic money supply so that money market
equilibrium is maintained with both rates at same level.
- That is, the central bank must always intervene on money supply to keep the
interest rate at the same level
- To do this the government must hold a reserve of the peg currency.
Example

- Suppose that central bank has been fixing its interest rate at the same level
of foreign rate and that asset markets are in equilibrium.
- Suddenly output rises.
- A rise in output increases the demand for domestic money, and this push the
domestic interest rate upward.
- To prevent the appreciation of the domestic currency, the central bank has to
buy foreign assets to balance the supply and demand.
- To buy foreign assets, the central bank issues domestic money.
- Thus, the central bank must have a reserve of foreign currency and always
control it regarding the supply and demand of domestic money.
 Example

- Now suppose that the Central Bank want to increase the output by
buying domestic assets, what makes the money supply increase.
- The new equilibrium shows that there’s a higher exchange rate with
the higher output.
- To move back the interest rate to the original equilibrium, the Central
Bank has to sell foreign assets for domestic currency.
- The money the bank receives goes out of circulation, and the asset
market equilibrium curve shifts back toward its initial position as the
domestic money supply falls.
- “Under a fixed exchange rate, central bank monetary policy tools are
powerless to affect the economy’s money supply or its output.”
Krugman’s concerns about the
adoption of Fixed Interest Rates
- Krugman has emphasized that maintaining a fixed rate can lead to
significant economic distortions, especially when a country’s fundamentals
diverge from the currency it is pegged to.
- When speculators, or even the market, anticipate that a government might
abandon its currency peg, the cost of defending the currency’s value
increases.
- He argues that while fixed rates offer short-term stability, they often require
significant reserves and can limit a country's ability to respond to domestic
economic conditions
Argentina’s Economic Shock

- During the late 1990s and early 2000s, Argentina had pegged its currency, the
peso, to the U.S Dollar in a 1:1 ratio, a move that was successful in stabilizing
the inflation and restoring confidence in the economy.
- As the country faced fiscal deficits and external shocks, including a strong U.S.
dollar and lower commodity prices, Argentina struggled to maintain this peg.
- The fixed exchange rate regime became increasingly costly as the central bank
depleted its foreign exchange reserves to defend the peso. As investor
confidence declined and capital outflows intensified, the central bank was
forced to continue selling foreign reserves, leading to a full-blown balance of
payments crisis.
 Milton Friedman

- One of the most influential economists of 20th century.

- He was generally known for advocating floating exchange rates in developed
economies, where he believed that allowing currencies to fluctuate freely would
eliminate the need for exchange controls and promote economic freedom.
- He argued that developing countries, with weaker institutions and higher inflation
risks, could benefit from the stability provided by fixed exchange rates, as it
would prevent irresponsible monetary policies and inflationary taxation
Floating Exchange Rates

- A system where the value of a currency is determined by market forces,

without direct government or central bank intervention.
- Lower needing of currency reserves.
- More flexibility for monetary policy,
- Allow different economies to adjust to economic shocks more effectively by letting
the exchange rate act as an automatic stabilizer.

- Useful instrument for macroeconomic adjustments

Monetary Policy with Floating
Exchange Rates

- Under a floating exchange rate system, monetary policy autonomy is

preserved
- Meaning central banks can adjust interest rates or money supply to manage
domestic economic conditions without worrying about maintaining a specific
exchange rate.
- For example, when unemployment rises, central banks can expand the
money supply to stimulate growth without triggering a potencial currency
crisis
Bretton Woods

- Purpose: Established to create a stable international monetary system post-

World War II.
- Key Features:
- Fixed Exchange Rates: Currencies were pegged to the U.S. dollar, which
was convertible into gold at $35 per ounce.
- U.S. Dollar as Anchor: The U.S. dollar became the world’s reserve
currency, as it was tied to gold.
- Creation of International Institutions:
○ International Monetary Fund (IMF): Provided financial assistance
to countries facing balance of payments crises.
○ World Bank: Focused on post-war reconstruction and development
projects.
- Goal: To promote international economic stability, rebuild war-torn
economies, and prevent the competitive devaluations that contributed to the
Great Depression.
Reasons for its collapse

- U.S. Fiscal Deficits and Inflation: In the 1960s, U.S. spending on the Vietnam
War and social programs (like the Great Society) caused fiscal deficits and
inflation, which weakened confidence in the dollar.
- Gold Reserves Strain: Other countries began demanding U.S. gold in exchange
for their dollar reserves, decreasing U.S. gold reserves.
- Nixon Shocks (1971):
- End of Gold Convertibility: In August 1971, President Richard Nixon
announced the suspension of the dollar’s convertibility into gold, effectively
ending the Bretton Woods system.
- Temporary Measures: This move was meant to be temporary, but it marked
the beginning of the end for fixed exchange rates.
Post-Bretton Woods System

- Shift to Floating Exchange Rates: By 1973, most major currencies

adopted floating exchange rates, where currency values are determined by
market forces rather than being fixed to the dollar.
- Impacts:
- Greater flexibility for countries to manage monetary policy.
- Increased volatility in exchange rates.
- The U.S. dollar remained the world’s dominant reserve currency, but no
longer backed by gold.
Krugman’s critical perspective

- U.S. Monetary Dominance: The U.S. was able to conduct its domestic
monetary policies largely independently while other countries had to peg
their currencies to the dollar, limiting their monetary policy flexibility.
- Imported Inflation: Countries that maintained fixed exchange rates with
the dollar were forced to import inflation from the U.S. when the Federal
Reserve expanded the money supply to finance the Vietnam War and social
programs like Medicare.
- The Trilemma: Krugman explains that the Bretton Woods system was
ultimately a victim of the "trilemma"—the impossibility of simultaneously
having fixed exchange rates, free capital movement, and independent
monetary policy. By the early 1970s, countries had to choose between these
goals, and most chose to prioritize domestic monetary autonomy, leading to
the adoption of floating exchange rates .
Floating Exchange Rate Crisis

- Switzerland had a managed float system with the Swiss franc (CHF) being
pegged to the euro since 2011.
- However, in January 2015, the Swiss National Bank (SNB) suddenly removed
the peg, allowing the franc to float freely.
- This decision was driven by increasing pressure from the European Central
Bank's (ECB) policies and a large influx of foreign capital into Switzerland.
- The removal of the peg caused the Swiss franc to appreciate sharply by nearly
30% against the euro within a single day. This sudden appreciation severely
hurt the Swiss economy, particularly export-driven companies and tourism, as
Swiss goods and services became much more expensive relative to other
countries.
Swiss Franc Value Over time
(www.xe.com/currencycharts)
Morocco's case

- The country pegs its currency, the dirham, to a basket of currencies

dominated by the euro and the U.S. dollar.
- This system has helped Morocco maintain low inflation and economic
stability, which is especially beneficial for an emerging economy with a
strong focus on trade.
- Morocco’s fixed exchange rate has supported its credibility in monetary
policy by providing stability in a region where fluctuating exchange rates
could cause instability.
Morocco’s time line
Inflation in Morocco

https://take-profit.org/en/statistics/inflation-rate/morocco/
References

Fixed Exchange Rates: https://www.econlib.org/library/Enc1/ExchangeRates.html;

https://www.bankofcanada.ca/wp-content/uploads/2010/06/r984b.pdf;
https://princeton.edu/~pkrugman/CRISES.pdf;
https://www.nber.org/system/files/chapters/c9803/c9803.pdf; Chapter 18 and 19
International Economics

Floating: https://www.xe.com/currencycharts/?from=CHF&to=EUR&view=10Y;
https://tradingeconomics.com/argentina/inflation-cpi;
https://pt.tradingeconomics.com/united-states/inflation-cpi