HOMEWORK 4.

THE MACROECONOMICS OF SOFT PEGS AND IMPERFECT CAPITAL MOBILITY + CURRENCY CRISES

1.
Under fixed Exchange rates and imperfect capital mobility why would the central bank choose
to sterilize the effects of BOP surpluses and deficits on the money supply? Explain (also using
graphs) in the context of a concrete example.
The central bank may choose to sterilize to keep the economy on a stable MM curve. This
may be desirable, for example, if the bank wants to stabilize GDP around its current value
(for example to keep it close to potential) and the economy is subject to goods market shocks
(that shift GM) or international financial shocks (that shift BB).

2.
Consider two small open economies, A and B, with fixed exchange rates and imperfect capital
mobility. The two countries are identical except that capital flows are more sensitive to
interest rate differentials in country A than in B. How would you expect the effectiveness of
fiscal policies in the two countries to be influenced by this difference between them?
The BB curve is flatter in economy A. A flatter BB means that changes in fiscal policy have
smaller impacts on the domestic interest rate in this case: there is less crowding out and
therefore fiscal policy is more powerful.

3.
Would you expect the international transmission of business cycles (think of a change in θ) to
have been more extensive under the Gold Standard or under Bretton Woods? Why?
Transmission would have been more extensive under the gold standard, because the bond
market equilibrium condition is the horizontal UIP curve, rather than the upward-sloping
BB curve. Since a change in θ shifts the GM curve, the impact of this shock on domestic
output is larger in the former case, when there is no crowding out caused by changes in the
domestic interest rate, than in the latter, where there is.

4.
Consider a country operating with a fixed exchange rate under imperfect capital mobility.
What would be the effects of an increase in world interest rates on real GDP, the domestic
interest rate, the CC and the NFA of the balance of payments and the central bank’s stock of F
C *? Describe two policy responses that could be implemented to restore the original level or
real GDP, and show how they would work.
The increase in the foreign interest rate would have caused the BB curve to shift upwards,
leaving GM and MM unaffected on impact. Since the new BB would intersect GM above
the MM curve, capital would flow out, and central bank reserves would drop; in the
absence of sterilization, M would decrease by as much as the decrease of forex reserves,
and MM would shift leftwards, so as to cross GM at the point of intersection with the new
BB. The domestic interest rate would increase (though by less than the foreign rate),
which would have contractionary effects on real output. With lower output and a higher
domestic interest rate, private absorption would be lower, imports would be lower and net
exports would increase, which would improve the CA. If, for example, at the initial point
CA=NFA=0, at the new equilibrium CA>0, NFA>0 and CA=NFA (there would be a CA
surplus, matched by private capital outflows.
Possible policy responses to restore the original level of GDP:
- Expansionary fiscal policy could shift the GM curve rightwards, to intersect the new BB
above the old Y.
- Sterilization would have prevented BB from shifting at all.
- Exchange rate devaluation would have shifted both GM and BB to the right.
- Perfectly effective capital controls would have produced financial autarky, completely
insulating the economy from the foreign interest rate shock.

5.
Consider a small open economy that operates a fixed exchange rate under conditions of
perfect capital mobility. What tradeoffs does the country face in choosing between a “soft”
and an “hard” peg for its currency?
A hard peg enhances credibility and monetary stability, and makes a country less
vulnerable to speculative attaks and to both first and second generation currency crises.
However this benefits come at the cost of foregoing the exchange rate as a policy tool. Since
both monetary policy and exchange rate policy are not viable in this case, the only available
policy instrument is fiscal policy. A single policy tool is not enough to reach both internal
and external balance in the short run.

6.
How would you define a currency crises? Why do first-generation type currency crises arise?
Identify the factors that determine how long the currency peg can be sustained in a first-
generation currency crisis model.
A currency crises is caractherized by a big devaluation of the exchange rate, which is
preceded by huge increases in the domestic interest rates in the attempt to stop the loss of
foreign exchange reserves. First generation-type currency crises arise because the central
bank wants to finance an ongoing fiscal deficit, and this goal is in conflict with the
objective of maintaining a fixed exchange rate, as a continuous increase of Bc determines a
continuous loss of forex reserves.
The key factors that determine how long the peg can be sustained are the size of the initial
stock of foreign exchange reserves and the rate at which the central bank increases BC each
period. The larger the first and the smaller the second, the longer the peg can be sustained.
Obviously the degree of capital mobility is also relevant: the higher capital mobility the
quicker and the larger the loss of forex reserves.

7.
Explain why the degree of capital mobility might affect the sustainability of “soft” currency
pegs. Explain why hard pegs might be more sustainable than soft pegs.
When capital mobility is perfect, an expected future depreciation shifts the UIP curve
proportionately, leaving the GM curve unchanged. Since monetary policy is ineffective in
influencing real GDP in this case, the only way that the central bank could respond to the
contraction in GDP induced by the higher domestic interest rate would be to devalue the
currency. This makes the economy highly vulnerable to a speculative attack. When capital
mobility is imperfect, on the other hand, the BB curve has a positive slope and shifts up less
than in proportion to a depreciation in the expected future exchange rate. These two
characteristics combine to make the ensuing recession milder than under perfect capital
mobility. Moreover, the central bank retains control over the money supply, so it can
respond to the recession by adopting a more expansionary monetary policy. The milder
effects on the economy and availability of monetary policy as an instrument make
speculative attacks less likely to be successful when capital mobility is imperfect.
“Hard” pegs are more likely to be sustainable because the exchange rate is harder to
change. This makes speculative attacks less likely to happen, and less likely to be
successful when they do happen.

8.
Consider a small open economy that operates a fixed exchange rate under conditions of
perfect capital mobility. What tradeoffs does the country face in choosing between a “soft”
and an “hard” peg for its currency?
Under a soft peg, the economy could achieve target values of real GDP and net exports
simultaneously in the short run by using a combination of fiscal policy and exchange rate
policy, but would be vulnerable to both first- and second-generation currency crises. A
hard peg provides more protection against crises of both types, but in this case exchange
rate policy cannot be used. Since fiscal policy cannot achieve desired values of both the
level of output and net exports at the same time, the economy would have to choose between
the two objectives, at least in the short run. In the medium run the two goals can be
achieved (both under soft and hard pegs) through price deflation and real exchange rate
devaluation, but this would be a long and painful process, with output below potential and
high unemployment for a long time.

9.
What is the impossible trinity (or the trilemma) of international macroeconomics? Of the three
goals implied in the trinity, which ones were sacrificed by the Gold Standard system? And by
the Bretton Woods system?
A fixed exchange rate, perfect capital mobility and monetary discretion cannot exist
simultaneously. During the Gold Standard system countries opted for hard pegs and perfect
capital mobility, and sacrificed monetary discretion and therefore the possibility to use
monetary policy as a stabilization tool. Under Bretton Woods capital mobility was
sacrificed: countries imposed capital controls in order to be able to use monetary policy to
reach internal goals under fixed exchange rates.