International_Economic_Policy.ipynb

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    "# 15. International Economic Policy\n",
    "\n",
    "**QUESTIONS**\n",
    "\n",
    "1. How has the world organized its international monetary system?\n",
    "2. hat is a fixed exchange rate system? A floating exchange rate system?\n",
    "3. What are the costs and benefits of fixed exchange rates vis-a-vis floating exchange rates?\n",
    "4. Why do most countries today have floating exchange rates?\n",
    "5. Why does western Europe now have a common currency, the euro, and thus fixed exchange rates within western Europe?\n",
    "6. What caused the major currency crises of the 1990s?\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "**Glossary Entries**:\n",
    "\n",
    "**floating exchange rates**: A system of international monetary arrangements by which central banks let exchange rates be decided by supply and demand, so that they \"float\" against one another as supplies and demands vary.\n",
    "\n",
    "**fixed exchange rates**: A system of international monetary arrangements by which central banks buy and sell in foreign exchange markets so as to keep their relative exchange rates fixed.\n",
    "\n",
    "**gold standard**: A system by which central banks preserve fixed exchange rates by always being willing to buy or sell their currencies at fixed rates in terms of the precious metal gold.\n",
    "\n",
    "**currency arbitrage**: A situation, operating under the gold standard, whereby people buying or selling one currency at any price other than the ratio of the two gold parities would find themselves facing an unlimited demand, and would soon find themselves losing a nearly unlimited amount of money.\n",
    "\n",
    "**foreign exchange reserves**: Foreign currency-denominated assets held by a country's central bank or treasury to use in foreign exchange interventions.\n",
    "\n",
    "**internal balance**: When unemployment is equal to its natural rate, inflation is unchanging, and GDP is equal to potential output.\n",
    "\n",
    "**external balance**: When the trade surplus (or deficit) of a country is equal to the value of investors' new long-term investments abroad (or foreigners' new long-term investments here).\n",
    "\n",
    "**currency crisis**: A situation where a country's currency is in serious trouble relative to the exchange rates of other countries.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "Up to this point we have assumed that the economy’s exchange rate is a float­ ing exchange rate, one that rises and falls freely as supply balances demand in the market for foreign exchange. This chapter changes the focus and considers alternative international monetary arrangements. How do such alternative arrangements — chiefly fixed exchange rate systems — work? What are the relative costs and benefits of fixed versus floating exchange rates? How did we arrive at our current system of largely floating exchange rates? And what difference does having this system make?\n",
    "\n",
    "Our current system is unusual: For most of the past century the dominant regime for international exchange rates has been one of fixed, not floating, exchange rates. This chapter begins by sketching the economic history of the international monetary system in order to understand how we got here from there. It then analyzes how the economy works when the government fixes the exchange rate. The chapter concludes by analyzing some of the major international shocks to the world economy in the 1990s. Three separate major international financial crises (and a host of lesser crises) struck during that decade: the European crisis of 1992, the Mexican crisis of 1995, the East Asian crisis of 1997-1998. The years since 1998 have been more quiescent. There have been crises in Brazil, Turkey, Argentina, and elsewhere, and there is the threat of a future crisis involving the United States, but nothing of the magnitude of the decade before. \n",
    "\n",
    "Yet.\n",
    "\n",
    "&nbsp;"
   ]
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    "## 15.1 The History of Exchange Rate Régimes\n",
    "\n",
    "### 15.1.1 The Classical Gold Standard\n",
    "\n",
    "#### 15.1.1.1 What the Classical Gold Standard Was\n",
    "\n",
    "In the generation before World War I nearly all of the world economy was on a particular fixed exchange rate system: the gold standard. A government would define a unit of its currency as worth such-and-such an amount of gold. It would stand ready to buy or sell its currency for gold at that price at any time, in any amount. Such a currency was convertible, for it could be converted into gold freely (and gold could be converted into it freely). The currency’s price in terms of gold was its parity.\n",
    "\n",
    "When two countries were on the gold standard, their nominal exchange rate was fixed at the ratio of their gold parities. People wishing to turn British currency — pounds sterling — into U.S. currency — American dollars — could begin by taking British currency to the Bank of England and exchanging it for gold at the pound’s parity. They would then ship the gold across the Atlantic to New York, take it to the U.S. Treasury office in New York, and exchange it for dollars.\n",
    "\n",
    "At the post-World War II parities of the Bretton Woods “gold exchange’' standard, the U.S. dollar was defined as equal to 1/35 troy ounce of gold, and the British pound sterling was set equal to 1/14.58333 ounce of gold. Thus the exchange rate of the dollar for the pound was £1.00 = \\$2.40. At the parities that had prevailed from 1879 to 1931 (with an interruption for World War I), the dollar-pound exchange rate was £1.00 = \\$4.86.\n",
    "\n",
    " Suppose that supply and demand in the market for foreign exchange in 1910 had balanced not at £1.00 = $4.86 but at some other value — say £1.00 = $5.00. Someone with an idle pound sterling note could then get $5 for it by selling it on the foreign exchange market. But that $5 could then buy enough gold at the U.S. Treasury to recover the original £1, with 14 cents left over. So if the market exchange rate ever drifted up from £1.00 = \\$4.86 to £1.00 = \\$5.00, a huge mass of people selling pounds would enter the market and drive the exchange rate back to £1.00 = \\$4.86 as they attempted to carry out this currency arbitrage. Thus under the gold standard, nominal exchange rates were fixed at the ratio of countries’ gold parities.\n",
    " \n",
    "The gold standard was thus a fixed exchange-rate system.\n",
    "\n",
    "This gold-standard system grew up gradually. It originated when Sir Isaac Newton, in his government job as master of the mint in Britain, fixed the gold par­ ity of the British pound sterling. Because the industrial revolution began in Britain, Britain became the largest trading nation in the world in the nineteenth century. Other countries’ governments sought easy access to the British market for the products made by their citizens. A fixed gold parity meant the prices their countries’ producers charged would appear stable to British customers. It also meant that British investors would not fear that depreciation and devaluation would erode the value of the principal that they had lent. Throughout the late nineteenth century, country after country joined the gold standard. By the eve of World War I the overwhelming fraction of world commerce and investment flowed between countries on the gold standard.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "##### 15.1.1.1.1 Currency Arbitrage Under the Gold Standard: An Example\n",
    "\n",
    "As long as central banks or treasuries stood ready to keep their currencies con­ vertible at their gold parities, the ratio of two gold parities determined the nomi­ nal exchange rate. Why? Because of currency arbitrage. People buying or selling one currency at any price other than the ratio of the two gold parities would find themselves facing an unlimited demand, and would soon find themselves losing a nearly unlimited amount of money.\n",
    "\n",
    "Suppose — as originally envisioned under the Bretton Woods system — that the U.S. Treasury stood ready to buy or sell gold from qualified parties at the price of $35 an ounce, that the British Treasury stood ready to buy or sell gold from qualified parties at the price of £14.58333 an ounce, but that the pound sterling was trading in the foreign exchange market not for the $2.40 that was the ratio of the gold parities, but instead for 10 percent more — \\$2.64.\n",
    "\n",
    "Then someone with an ounce of gold could\n",
    "* Trade it to the British Treasury for £14.58333.\n",
    "* Then trade those pounds sterling for dollars in the foreign exchange market and wind up with \\38.50.\n",
    "* Trade that \\$38.50 to the U.S. Treasury for 1.1 ounces of gold.\n",
    "* Repeat the process as rapidly as possible, making a 10 percent profit each time the circle was completed.\n",
    "\n",
    "Note that those who sell dollars for pounds at the rate of \\$2.64 = £1.00 are losing 10 percent of their value each time the circle is completed. The only things hindering this round-trip “arbitrage” process — as long as currencies remain convertible and parities remain fixed — are the costs of transporting and insuring the gold. Thus there can be very small fluctuations of exchange rates within the “gold points,” but gold is cheap to transport and straightforward to insure: These fluctuations are minor indeed.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    ">**How to Profit in the Foreign Exchange Market**\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Growth of the Gold Standard**: Between 1870 and 1910 the industrialized portions of the world almost universally joined the gold standard. The gold standard, however, remained weak in the mostly agricultural, relatively poor periphery of the world economy. Source: Christopher M. Meissner, \"A New World Order: Explaining the Diffusion of the Classical Gold Standard, 1870-1913\" Journal of International Economics, 2005; and Niall Ferguson and Moritz Schularick, \"The Empire Effect: The Determinants of Country Risk in the First Age of Globalization, 1880-1913,\" mimeo, New York University, 2004.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 15.1.1.2 A Gold Standard Tends to Produce Contractionary Policies\n",
    "\n",
    "Even in its turn-of-the-century heyday around 1900 the gold standard had already manifested certain serious weaknesses as an international monetary system. The most important of these weaknesses was that the gold standard tended to be contractionary. In some circumstances it pushed countries to raise their interest rates to reduce production and raise unemployment. And it never provided a countervailing push to other countries to lower their interest rates to raise production and to lower unemployment. \n",
    "\n",
    "To see why, we need to digress for a moment into the role played under a gold standard by a country’s gold and other foreign exchange reserves. If the exchange rate is floating in the home country H, foreigners’ earnings in currency H must be used to buy H’s exports or be invested in country H: Nothing else can be done with them. Under a floating-rate system a country’s net exports NX plus foreign savings $ S^f $ must add up to zero:\n",
    "\n",
    ">$ NX + S^f = 0 $\n",
    "\n",
    "The exchange rate moves up or down in response to the supply and demand for foreign exchange in order to make this so.\n",
    "\n",
    "Under a gold standard things are different. \n",
    "\n",
    "There is an extra participant in the market: the country’s treasury or central bank. One can do something else with foreign-currency earnings besides using them to buy imports or make investments abroad: Take them to the foreign country’s treasury, turn them into gold, ship the gold back home, take the gold to the treasury there, and turn the gold into real spendable cash. Under a gold standard it is net exports plus net investment from abroad minus the flow of gold into your country — FG — that together add up to zero:\n",
    "\n",
    ">$ NX + S^f - FG = 0 $\n",
    "\n",
    "What happens if a country finds that net exports plus net investment from abroad are less than zero? Its treasury will find itself losing gold, as a long line of foreigners come into its office, demand gold in exchange for currency, and then ship the gold out of the country With each such transaction the country’s gold reserves shrink. Eventually the government’s gold reserves are gone.\n",
    "\n",
    "At this point the country has a choice. One option is to abandon the fixed exchange rate system. It “closes the gold window,” announces that the country will no longer buy back its currency at the established gold parity, aban­ dons its fixed exchange rate, and lets the exchange rate float. The only other option is to solve its gold-outflow problem by attracting more foreigners to invest. The way to increase net investment from abroad is to raise domestic interest rates. If net investment from abroad rises enough, gold will no longer flow out.\n",
    "\n",
    "Thus under a gold standard, countries that run persistent balance-of-payments deficits — losing gold — must eventually raise interest rates to stay on the gold standard. However, surplus countries — those gaining gold — face no symmetrical crisis in which they must lower interest to stay on the gold standard. Their central banks can lower interest rates if they wish. But if they do not so wish, they can keep interest rates constant and watch their gold reserves grow.\n",
    "\n",
    "This asymmetry means that a fixed exchange rate system like the gold standard puts periodic contractionary pressure on the world economy. Such pressure turned the interwar period into a disaster; the gold standard’s contractionary pressure on countries to raise interest rates played a major role in generating the worldwide Great Depression of the 1930s.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.1.2 The Collapse of the Gold Standard\n",
    "\n",
    "The international gold standard was suspended when World War I began in 1914. Every country used inflation to help finance its massive war expenditures. Inflation was inconsistent with the gold standard. Under the gold standard attempted inflation simply leads everyone to immediately trade their currency for solid gold.\n",
    "After World War I was over, politicians and central bankers sought to restore the gold standard. They believed that the pre-World War I system of a fixed exchange rate based on the gold standard had been a success. They saw restoring it as an important step to restoring general economic prosperity. The gold standard had, after all, delivered 40 years of more rapid economic and industrial growth than the world had ever seen before.\n",
    "\n",
    "More than half a decade was needed to fully restore the gold standard. But the revived gold standard did not produce prosperity. Instead, in less than half a decade the Great Depression began, and the restored gold standard broke apart. \n",
    "\n",
    "The consensus of economic historians today is that the Great Depression had its principal origin in the United States, where for reasons not fully understood some combination of small shocks set off a downward spiral of destabilizing deflation. But a combination of mistaken policies and flaws in the functioning of the post-World War I gold standard then quickly amplified the Great Depression and propagated it around the world.\n",
    "\n",
    "Economists Barry Eichengreen and Ben Bernanke argue that four factors made the post-World War I gold standard a much less secure monetary system than the pre-World War I gold standard:\n",
    "\n",
    "1. Everyone knew that governments could abandon their gold parities in an emergency. After all, they had done so during World War I. Thus everyone was eager to turn currency holdings into gold at the first sign of trouble. This meant countries had to maintain much larger gold reserves in order to keep the gold standard functioning.\n",
    "\n",
    "2. Everyone knew that governments had taken on the additional responsibility of trying to keep interest rates low enough to produce full employment.\n",
    "\n",
    "3. After World War 1 countries held their reserves not in gold but in foreign currencies. This was fine in normal times, but it meant that at the first sign of trouble not only would citizens show up trying to turn their currency into gold, but foreign central banks would do so too, greatly multiplying the mag­ nitude of the gold outflow.\n",
    "\n",
    "4. The post-World War I surplus economies, the United States and France, did not lower their interest rates as gold flowed in.\n",
    "\n",
    "These factors meant that as soon as a recession set in and gold drains began from countries with weak currencies, their governments found themselves under immediate and massive pressure to raise interest rates and lower output further if they were to stay on the gold standard. If they stayed on the gold standard, they guaranteed themselves high real interest rates and deep depression. If they abandoned the gold standard, they went against all the advice of bankers and gold standard advocates.\n",
    "\n",
    "There was a clear divergence in the 1930s between those countries that abandoned the gold standard early in the Depression and those that stubbornly clung to gold. Those that clung to their gold parities found themselves forced to raise interest rates and contract their money supplies in order to avoid large gold losses that would rapidly exhaust their reserves. Those that abandoned the gold bloc and floated their exchange rates could avoid deflation, and avoid the worst of the Great Depression. By the middle of the 1930s the Great Depression was in full swing, and the gold standard was over.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Economic Performance and Degree of Exchange Rate Depreciation during the Great Depression**: The further countries moved away from their gold-standard exchange rates, the faster they recovered from the Great Depression. Source: Barry Eichengreen and Jeffrey Sachs, \"Exchange Rates and Economic Recovery in the 1930s,\" Journal of Economic History (December 1985), pp. 925-946.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.1.3 The Bretton Woods System\n",
    "\n",
    "After World War II, economists took careful note of what they thought had gone wrong after World War I. Led by Harry Dexter White for the United States and John Maynard Keynes for Great Britain, governments tried to set up an interna­ tional monetary system that would have all the advantages and none of the draw­ backs of the gold standard. The system they set up came to be called the “Bretton Woods system,” after a New Hampshire mountain resort town that was the loca­ tion in late 1944 of a key international monetary conference.\n",
    "Three principles guided this first post-World War II international monetary system:\n",
    "\n",
    "* In ordinary times, exchange rates should be fixed: Fixed exchange rates encourage international trade by making the prices of goods made in a foreign country predictable, and so have powerful advantages.\n",
    "\n",
    "* In extraordinary times — whenever a country found itself in recession with a significantly overvalued currency that discouraged its exports, or found itself suffering from inflation because an undervalued currency raised the prices of imports and stimulated export demand — exchange rates should be changed. Such “fundamental disequilibrium” could and should be corrected by revaluing or devaluing the currency.\n",
    "\n",
    "* An institution was needed — the International Monetary Fund — to watch over the international financial system. The IMF would make bridge loans to countries that were adjusting their economic policies. It would ensure that countries did not abuse their privilege of changing exchange rates. Exchange rate devaluation and revaluation would remain an exceptional measure for times of “fundamental disequilibrium,” rather than becoming a standard tool of economic policy.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.1.4 Our Current Floating-Rate System\n",
    "\n",
    "The Bretton Woods system in its turn broke down in the early 1970s. The United States saw inflation accelerate in the 1960s. It found itself with an overvalued exchange rate and a significant trade deficit at the end of the 1960s. The United States sought to devalue its currency: to reduce the value of the dollar in terms of other currencies, so that exports would rise and imports would fall.\n",
    "\n",
    "Policy makers in other countries thought that the United States should instead raise interest rates. Higher U.S. interest rates would make foreigners more willing to invest in the United States. The foreign currency committed to those investments could then be used to finance the excess of imports over exports that was the U.S. trade deficit. In the end the deadlock was broken by unilateral American action, and the Bretton Woods system fell apart.\n",
    "\n",
    "Since the early 1970s the exchange rates at which the currencies of the major industrial powers trade against each other have been “floating” rates. The exchange rate is announced by the government but fluctuates according to the balance of demand and supply on that day in the foreign exchange market. There seem to be few if any prospects for a restoration of a global system of fixed exchange rates over the next generation. Thus this book has assumed as its standard case that exchange rates are free to float and are set by market forces.\n",
    "\n",
    "Nevertheless, the older system is worth studying for three reasons. First, understanding the functioning of a fixed-rate system sheds light on how a floating-rate system works. Second, economic policy makers still debate the costs and benefits of a fixed-rate system relative to our current floating-rate system. Third, perhaps the pendulum will swing back in a generation and we will find ourselves once more in a fixed exchange rate system.\n",
    "\n",
    "Indeed, the countries of Europe now largely are in such a system.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.1.5 The Eurozone\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.1.6 RECAP: The History of Exchange Rate Régimes\n",
    "\n",
    "In the generation before World War I nearly all of the world economy was on a fixed exchange rate system called the gold standard, under which nominal exchange rates were equal to the ratio of currencies- gold parities. The interna­ tional gold standard was suspended when World War I began in 1914. After World War I attempts to rebuild the gold standard created a system vulnerable to shocks that played a key role in causing the Great Depression. Therefore, after World.War II economists built a fixed exchange rate system — the Bretton Woods system — that they hoped would combine the advantages of fixed- and floating-rate systems. But this system collapsed in the early 1970s, and was replaced by our current floating exchange rate system.\n",
    "\n",
    "&nbsp;"
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    "## 15.2 How a Fixed Exchange-Rate System Works\n",
    "\n",
    "We begin by distinguishing between two different economic environments in which a fixed exchange rate system works. The first is an environment of very high capital mobility, like the situation the advanced industrial countries face today. Foreign exchange speculators buy and sell bonds denominated in different currencies with a few presses on a keyboard. Hot money — funds that speculators can shift from country to country as fast as they can press the “enter” key — flows around the world nearly instantaneously in response to differences in expected rates of return. Governments find themselves in large part dancing to the tune called by international currency speculators.\n",
    "\n",
    "The second is an environment of lower capital mobility. The ability of individuals in one country to invest their money in a second is low and limited. Flows of capital out of one country into another are limited. And governments that are willing to do so can shift the exchange rate for a time by using their foreign exchange reserves to intervene in the foreign exchange market.\n",
    "\n",
    "A fixed exchange rate is a commitment by a country to buy and sell its currency at fixed, unchanging prices in terms of other currencies. To carry out this commitment, the country’s central bank and treasury must maintain foreign exchange reserves. If people come to your central bank or treasury under a fixed exchange rate system wanting to exchange your currency for pounds sterling or gold bars, the central bank or treasury must have the pounds sterling or the gold bars to trade to them.\n",
    "\n",
    "But the foreign exchange reserves of a country are limited. With today’s high degree of capital mobility the world has a great many potential foreign exchange speculators. All of them are seeking to make sure that their wealth is invested in the place that offers the highest expected return. Their decisions about where to invest their money are the result of a delicate balance between greed and fear, and all the foreign exchange reserves a government has cannot materially alter the balance of foreign exchange supply and demand for more than a day or two.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.2.1 High Capital Mobility\n",
    "\n",
    "Under high capital mobility, countries’ foreign exchange reserves are all but irrelevant. The real exchange rate is set by the same exchange rate equation we have seen before, as greed balances fear in the mind of the typical foreign exchange speculator:\n",
    "\n",
    ">$ \\epsilon = {\\epsilon}_o - {\\epsilon}_r(r - r^f) $\n",
    "\n",
    "Remember, in this equation $ {\\epsilon}_o $ is foreign exchange speculators’ belief about the long-run fundamental value of the real exchange rate; $ r - r^f $ is the difference between home and foreign real interest rates; and $ {\\epsilon}_r $ is a parameter that tells at what point fear balances greed: It tells how much speculators would be willing to bid up the value of dollar-denominated assets if those assets had an extra 1 unit (100 percentage points) per year interest rate differential. The higher the interest rate differential in favor of the home country, the lower the real exchange rate (which, remember, is defined as the value of foreign currency).\n",
    "\n",
    "Why must this equation for the exchange rate hold? Suppose that the government sets a fixed parity such that the fixed value of foreign currency $ \\epsilon^* $ is lower than given by the equation above. Foreign exchange speculators see foreign currency as a bargain. The extra interest return and potential capital gain from appreciation they get from investing their money in foreign currency- denominated assets more than offsets any risks. So foreign exchange speculators come to the government to sell it the (overvalued) home currency and buy from it the (undervalued) foreign currency at the fixed exchange rate parity. The government spends down its reserves, buying its own currency in exchange for its stocks of other countries’ currencies and of gold: It is a fixed exchange rate system after all.\n",
    "\n",
    "The next day — or hour, or minute — the foreign exchange speculators do it again. And again. And again. The government rapidly runs out of reserves. When its reserves are gone, it can no longer buy and sell foreign currency for domestic currency at the fixed exchange rate parity because it no longer has any foreign currency — or gold — to sell. How long does this process take? Under high capital mobility, hours or days. There are lots of potential foreign exchange speculators. They are all eager to profit by betting against a central bank, especially a central bank that is carrying out its exchange transactions not for economic but for political reasons.\n",
    "\n",
    "Thus if the government wants to keep the exchange rate at $ \\epsilon^* $, its central bank must set interest rates so that the equilibrium value of the exchange rate produced by the equation: \n",
    "\n",
    ">$ \\epsilon = {\\epsilon}_o - {\\epsilon}_r(r - r^f) $\n",
    "\n",
    "corresponds to the desired fixed exchange rate value $ \\epsilon^* $.\n",
    "\n",
    "For this equation to hold, the central bank must set the domestic real interest rate r at a value $ r^p $ (superscript \"p\" for \"pegged):\n",
    "\n",
    ">$ r^p = r^f + \\frac{\\epsilon_o - \\epsilon^*}{\\epsilon_r} $\n",
    "\n",
    "Monetary policy no longer can play a role in domestic stabilization: You cannot ask the central bank to lower interest rates to fight unemployment or raise interest rates to fight inflation because the interest rate is already devoted to maintaining the fixed exchange rate system. There is no monetary policy reaction function — no MPRF Under a fixed exchange rate system with high capital mobility, not macroeconomic policy makers but international currency speculators determine the interest rate.\n",
    "\n",
    "This means that international financial shocks coming from abroad are immediately transmitted to the domestic economy:\n",
    "\n",
    "* An increase in foreign interest rates rf requires an immediate, point-for-point increase in domestic interest rates — and a move up and to the left along the IS curve.\n",
    "\n",
    "• An increase in foreign exchange speculators’ view of the long-run fundamental value of the exchange rate by $ {\\Delta}{\\epsilon}_o $ requires an immediate increase in domestic\n",
    "interest rates of $ ({\\Delta}{\\epsilon}_o)/\\epsilon_r $.\n",
    "\n",
    "Countries on fixed exchange rate systems find their interest rates tightly linked. This led John Maynard Keynes to warn in the 1920s against an attempt by Britain to return to the fixed exchange rate gold standard. It would, Keynes warned, force Britain to receive the full force of interest rate shocks delivered by the unstable U.S. economy. Earlier, when Britain was the leading industrial power before World War I, people expressed it differently: “When [the] London [money market] catches cold,” they said, “Buenos Aires [or New York or Sydney] catches pneumonia.”\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**The Real Exchange Rate, Long-Run Expectations, and Interest Rate Differentials**: When there is no differential between home and foreign real interest rates, the value of the real exchange rate is $ \\epsilon_o $: what foreign exchange speculators believe and expect the long-run equilibrium value of the ex change rate to be. When home interest rates are higher than foreign interest rates, the value of the exchange rate is lower. When home interest rates are lower than foreign interest rates, the value of the exchange rate is higher.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Domestic Interest Rates Are Set by Foreign Exchange Speculators and the Exchange Rate Target**: Under high capital mobility, maintaining a fixed exchange rate requires that the central bank ignore domestic conditions and focus on the exchange rate alone in setting interest rates.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Effect of Foreign Shocks under Fixed Exchange Rates**: If the exchange rate is fixed and if capital mobility is high, external shifts in foreign exchange speculators' opinions or for­ eign interest rates have direct and immediate effects on domestic interest rates and on domestic output.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.2.2 Low Capital Mobility\n",
    "\n",
    "Now turn to the case of lower, as opposed to higher, capital mobility. Suppose that existing barriers to international financial flows are sufficient to make it difficult and costly to move money across national borders. Thus the government’s foreign exchange reserves are sizable relative to flows of capital. Capital mobility today is limited for many developing countries with “thin” financial markets. Capital mobility was limited for all countries only a few decades in the past. It may be limited in the future as well, either as future governments impose explicit controls on types of transactions or as small taxes on international transactions levied by future governments put sand in the wheels of international finance.\n",
    "\n",
    "If capital mobility is low, the rate at which the government buys or sells its currency for foreign exchange has an impact on foreign exchange supply and demand and thus on the current exchange rate. The exchange rate is determined by foreign currency speculators’ expectations, interest rate differentials, and also the speed at which the government is accumulating or spending its foreign exchange reserves R:\n",
    "\n",
    ">$ \\epsilon = \\epsilon_o - \\epsilon_r(r-r^f) + \\epsilon_R({\\Delta}R $\n",
    "\n",
    "A change $ {\\Delta}R $ in foreign exchange reserves raises the value of the exchange rate by an amount equal to a parameter $ \\epsilon_R $ times the change in reserves. When the government is accumulating reserves, the value of foreign currency is higher than it would otherwise be: The government is in there buying foreign currency, raising the demand. When the government is spending reserves, the value of foreign currency is lower than it would otherwise be.\n",
    "\n",
    "Under such barriers to capital mobility, the central bank regains some freedom of action to use monetary policy for domestic uses. It does not have to directly and immediately transmit adverse shocks due to foreign exchange speculator confidence or foreign interest rates to the domestic economy in the form of higher interest rates and a recession. As long as it has reserves, it can choose to let them run down for a while rather than raising domestic interest rates. The domestic interest rate r is now:\n",
    "\n",
    ">$ r = r^f + \\frac{\\epsilon_o - \\epsilon^*}{\\epsilon_r} + \\frac{\\epsilon_R}{\\epsilon_r}({\\Delta}R) $\n",
    "\n",
    "and is different from the $ r^p $ required to maintain the peg under conditions of high capital mobility by:\n",
    "\n",
    "$ r = r^p + \\frac{\\epsilon_R}{\\epsilon_r}({\\Delta}R) $\n",
    "\n",
    "But the amount of freedom of action for monetary policy is limited by (1) the sen­ sitivity of exchange rates to the magnitude of foreign exchange market interven­ tions performed by the central bank and (2) the amount of reserves. The level of foreign exchange reserves must be positive. Policies that spend reserves cannot be continued forever, because once the government’s foreign exchange reserves have fallen to zero it can no longer finance interventions in the foreign exchange market. (Note, however, that reserves can be replenished if they drop dangerously close to zero. That is what loans from the IMF, or from other major economy central banks, are for.)\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**With Limited Capital Mobility a Central Bank Can Shift the Exchange Rate by Spending Reserves**\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.2.3 RECAP: How a Fixed Exchange Rate System Works\n",
    "\n",
    "In an environment of very high capital mobility monetary policy no longer can play a role in domestic stabilization if you have a fixed exchange rate: International currency speculators rather than macroeconomic policy makers determine the value of your domestic interest rate. In an environment of low capital mobility central banks have some freedom of action to set domestic interest rates to help the domestic economy but their freedom of action is limited and is constrained by foreign exchange speculators and by limited foreign exchange reserves.\n",
    "\n",
    "&nbsp;"
   ]
  },
  {
   "cell_type": "markdown",
   "metadata": {},
   "source": [
    "## 15.3 The Choice of Exchange Rate Systems\n",
    "\n",
    "Economists either applaud or deplore the breakdown of the Bretton Woods system and the resort to floating exchange rates, depending on their underlying philosophy For some, like Nobel Prize-winner Milton Friedman, the exchange rate is a price. Economic freedom and efficiency require that prices be set by market supply and demand. They should not be set by the decrees of governments. Thus the replacement of the fixed exchange rate, administered-price Bretton Woods system by the floating exchange rate, market-price system of today is a very positive change.\n",
    "\n",
    "For others, like Nobel Prize-winner Robert Mundell, the exchange rate is the value that the government promises that the currency it issues will have. A stable exchange rate means that the government is keeping the contract it has made with investors in foreign countries. To let the exchange rate float is to break this  contract — and everyone knows that markets work only if people do not break their contracts. Thus the replacement of the fixed exchange rate, administered- price Bretton Woods system by the floating exchange rate, market-price system of today is a very negative change.\n",
    "\n",
    "What’s the right answer? \n",
    "\n",
    "“It depends.”\n",
    "\n",
    "Philosophy is all very well, but what should really matter are the details of how the choice of an exchange rate regime affects the economy.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.3.1 Benefits of Fixed Exchange Rates\n",
    "\n",
    "Under a floating exchange rate system, exporters and firms whose products compete with imported goods never know what their competitors’ costs are going to be. Exchange rate-driven fluctuations in the costs to their foreign competitors are an extra source of risk, and businesses do not like unnecessary risks. The fact that exchange rates fluctuate discourages international trade and makes the international division of labor less sophisticated than it would otherwise be. \n",
    "\n",
    "Fixed exchange rate systems avoid these costs and encourage international trade by reducing exchange rate fluctuations as a source of risk. They avoid the churning of industrial structure — the pointless and inefficient shift of resources into and out of tradable goods sectors — as the exchange rate fluctuates around its fundamental value. That is an important advantage. That advantage was behind the decision of nearly all western European countries at the start of 1999 to form a monetary union: to fix their exchange rates against each other irrevocably, so that even their national currencies will eventually disappear.\n",
    "\n",
    "Fixed exchange rate systems avoid some political vulnerabilities as well. Large exchange rate swings are a powerful source of political turmoil. This political turmoil is avoided by fixed exchange rate systems.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.3.2 Costs of Fixed Exchange Rates\n",
    "\n",
    "Under fixed exchange rates, monetary policy is tightly constrained by the require­ ment of maintaining the exchange rate at its fixed parity. Interest rates that are too low for too long exhaust foreign exchange reserves, and are followed either by a sharp tightening of monetary policy or by an abandonment of the fixed exchange rate. A floating exchange rate allows monetary policy to concentrate on maintaining full employment and low inflation at home — on attaining what economists call internal balance. By contrast, under a fixed exchange rate system the level of interest rates must be devoted to maintaining external balance — the fixed exchange rate. And fixed exchange rates have the disadvantage of rapidly trans­ mitting monetary or confidence shocks: Interest rates move in tandem all across the world in response to shocks. The central bank must respond to any shift in international investors’ expectations of future profitability or future monetary policy by shifting short-term interest rates.\n",
    "\n",
    "This is the cost-benefit calculation facing those who have to choose between fixed and floating exchange rates. Is it more important to preserve the ability to use monetary policy to stabilize the domestic economy, rather than dedicating monetary policy to maintaining a constant exchange rate? Or is it more important to preserve the constancy of international prices, and thus expand the volume of trade and the scope of the international division of labor?\n",
    "\n",
    "Canadian economist Robert Mundell set out the terms under which fixed exchange rates would work better than floating ones with his concept of an “optimal currency area.” Mundell said the major reason not to have fixed exchange rates is that floating exchange rates allow adjustment to shocks that affect two countries differently. This benefit would be worth little if two coun­ tries suffer the same shocks, and react to them in the same way. It would also be worth little if factors of production possessed high mobility: Then the effects of shocks would be transient because labor and capital would rapidly adjust, and the benefits from different policy reactions to economic shocks would be small.\n",
    "\n",
    " As far as the United States, western Europe, and Japan are concerned, the issue of fixed versus floating exchange rates appears to have been decided: None of these three powers is willing to sacrifice its freedom of action in monetary policy. Within western Europe the answer also appears clear: Monetary union means that there is now one pan-European monetary policy, and Italy, for example, no longer retains the ability to use monetary policy to lower interest rates in Milan when unemployment is relatively high. Elsewhere in the world, the question is still under debate.\n",
    "\n",
    "Moreover, fixed exchange rate systems have one more major disadvantage: They seem to make large-scale currency crises more likely. The decade of the 1990s saw three major large-scale currency crises, all of which threatened prosperity in the immediately affected countries, and all of which raised fears (initially at least) of their much wider spread to the world economy as a whole.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "#### 15.3.2.1 Are Western Europe and the United States Optimal Currency Areas?: Some Details\n",
    "\n",
    "Today the two largest economic regions within which exchange rates are fixed are the United States and western Europe’s “euro zone.” \n",
    "\n",
    "California, for example, does not have a separate exchange rate vis-a-vis the rest of the United States. Almost all of the countries of western Europe are now committed to their common currency, the euro. Does this make economic sense? Or should there be a separate “California dollar” to allow California to have a different monetary policy than the rest of America?\n",
    "\n",
    "Few economists today would maintain that western Europe’s euro zone meets Robert Mundell’s criteria for an optimal currency area. Shocks to the economy of Portugal are very different from shocks to the economy of western Germany. South­ ern Italy has few similarities in economic structure with Denmark. Vulnerability to different shocks would be relatively unimportant if factors of production were mobile. But the fact that different European countries have different languages means there is little chance that a boom in Denmark and a bust in Portugal will see large-scale migration to compensate.\n",
    "\n",
    "Why then has western Europe embarked on monetary union? One reason is that some economists and policy makers hope that the benefits from economic integration are very large indeed — large enough to offset even substantial costs from adopting a common currency. But the main reason is that European monetary uni­ fication is not so much an economic as a political project: an attempt to knit Europe together as a single entity whether or not monetary union makes narrow economic sense.\n",
    "\n",
    "Practically all economists today believe, by contrast, that the United States is an optimal currency area, although the U.S. economy’s regions are no more subject to common shocks than western Europe’s countries are. The mid-1980s saw the high dollar decimate midwestern manufacturing while leaving most of the rest of the country much less affected. The health of the economies of Texas and Oklahoma still depend substantially on the price of oil. Southern California’s defense-industry boom and bust of the 1980s and early 1990s and northern California’s high-tech boom and bust of the 1990s make it clear that California is so big a state that its component parts experience very different economic shocks. \n",
    "\n",
    "But even though the United States’ component parts experience different shocks, factor mobility across the United States is remarkably high. Capital and workers move to where returns and wages are high with remarkable speed — fast enough that it is hard to believe that different parts of the United States could gain substantially from following the different monetary policies that separate currencies and floating exchange rates would allow.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.3.3 RECAP: The Choice of Exchange Rates\n",
    "\n",
    "Fixed exchange rate systems encourage international trade and the international divison of labor by reducing exchange rate fluctuations, which are a significant source of risk to those planning either on exporting or on relying on imports. But fixed exchange rate systems also tightly constrain domestic monetary policy. Is it more important to promote a more productive international division of labor? Is it more imoprtnat to stabilize the domestic economy? There are the questions that central bankers and finance ministers get paid the big bucks to guess the answers to.\n",
    "\n",
    "&nbsp;"
   ]
  },
  {
   "cell_type": "markdown",
   "metadata": {},
   "source": [
    "## 15.4 Currency Crises\n",
    "\n",
    "### 15.4.1 The European Crisis of 1992\n",
    "\n",
    "The first of the three major financial crises that hit the world economy in the 1990s came in the fall of 1992. In 1990 West German Chancellor Helmut Kohl reunified Germany, a country that had been divided since the end of World War II first into zones of occupation — French, British, American, and Russian — and then into two separate countries — East Germany and West Germany.\n",
    "\n",
    "The two parts of Germany had very similar levels of economic development and economic structures before World War II. But since World War II they had diverged. West Germany had become one of the richest and most developed economies on Earth, while East Germany had turned into a standard communist economy with dirty industry, inefficient factories, and inadequate infrastructure. Chancellor Kohl undertook a program of massive public investment to try to bring East Germany up to the West German standard as quickly as possible.\n",
    "\n",
    "The expansion of German government purchases shifted the German IS curve to the right in the years after 1990. The German central bank, the Bundesbank, responded by raising real interest rates in order to keep real GDP in the range thought to be consistent with the Bundesbank’s inflation targets.\n",
    "\n",
    "The rise in the real interest rate generated a rise in the German exchange rate vis-a-vis the dollar and the yen, and a sharp fall in German net exports as financial capital flowed into Germany. The other countries of western Europe had then fixed their exchange rates relative to the German mark as part of the European Exchange Rate Mechanism (ERM). Britain, France, Italy, and other countries found themselves trapped: The rise in interest rates in Germany required that they too increase interest rates because had risen in the equation:\n",
    "\n",
    ">$ r^p = r^f + \\frac{\\epsilon_o - \\epsilon^*}{\\epsilon_r} $\n",
    "\n",
    "and $ r^p $ had to rise in response if the ERM was to be maintained. Without the surge of spending found in Germany and without the ability or desire to rapidly shift policy to run large deficits, such increases in interest rates threatened to send the other European economies into recession.\n",
    "\n",
    "Politicians in other European countries — Britain, Sweden, Italy, France, and elsewhere — promised that their commitment to their fixed exchange rate parity was absolute. They promised that high interest rates and the risk of a domestic recession were prices worth paying for the benefits of a fixed exchange rate system within western Europe itself. But foreign exchange speculators did not believe they would keep their promise to maintain the fixed exchange rate parity when unemployment began to rise.\n",
    "\n",
    "Thus foreign exchange speculators’ expectations of the long-run fundamental value of the real exchange rate, $ \\epsilon_o $ rose as well. This expectation that other European currencies would lose value vis-a-vis the German mark in the long run put their values under pressure in the short run as well.\n",
    "\n",
    "The domestic real interest rate required to maintain the exchange rate parity, given by \n",
    "\n",
    ">$ r^p = r^f + \\frac{\\epsilon_o - \\epsilon^*}{\\epsilon_r} $\n",
    "\n",
    "was rising not just because of higher real interest rates in Germany but also because of foreign exchange speculators’ more pessimistic expectations. The governments of much of western Europe found themselves in a trap. Different governments undertook different strategies:\n",
    "\n",
    "* Some tried to avoid the consequences of the shift in expectations. They spent reserves like water in the hope that a demonstrated commitment to maintain the parity would reverse the shift in speculator expectations. All this did was give international currency traders like George Soros the opportunity to make profits measured in the billions by betting on the abandonment of the fixed exchange rate. Economists Maurice Obstfeld and Ken Rogoff report that the British government may have lost \\$7 billion in a few hours during the September 1992 speculative attack on the pound.\n",
    "* Some tried to demonstrate that they would defend the parity no matter how high the interest rate required to keep the exchange rate fixed. The Swedish government raised its overnight interest rate to 500 percent per year for a brief time. But all this did was reinforce speculators’ opinion that the political and economic cost of keeping the exchange rate parity was too high for gov­ ernments that sought to win reelection.\n",
    "* Finally, some abandoned their parity against the German mark and let their currencies float as for a while they turned monetary policy to setting interest rates consistent with internal balance.\n",
    "\n",
    "In less than two months what had seemed a durable framework of fixed exchange rates in western Europe had collapsed into a floating-rate system.\n",
    "\n",
    "But governments interested in long-run exchange stability within Europe regrouped. They proposed to try again to fix their exchange rates, with the European Monetary Union that began in January 1999. This time, however, they decided not to peg their exchange rates while keeping their national currencies (thus retaining at least the possibility of someday changing parities), but to eliminate their separate national currencies entirely: not fixed exchange rates, but monetary union. The hope was to eliminate once and for all any fear or expectation that exchange rates might ever change again.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**German Fiscal Policy and Monetary Response in the Early 1990s**: The reunification of Germany led to a large outward shift in the IS curve and a large increase in real interest rates as Germany's central bank, the Bundesbank, fought to keep real GDP from rising too far above its planned targets.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">>**Effect of German Policy on Other European Countries**: At the start of the 1990s governments in other western European countries were raising interest rates and contracting their economies, risking a recession, in order to maintain the parities of ERM exchange rates.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.4.2 The Mexican Crisis of 1994-1995\n",
    "\n",
    "In the winter of 1994-1995 the second of the major currency crises of the 1990s hit the world economy. The Mexican peso crisis came as a shock to economists and to economic policy makers. Previous speculative attacks on and collapses in the value of currencies had occurred for one of two reasons. In situations of limited capital mobility, governments with overvalued exchange rates and large inflation- financed budget deficits had suffered speculative attacks. And in cases like western Europe in 1992, currencies had suffered speculative attacks when speculators judged that the policies needed to maintain fixed exchange rates had become inconsistent with the government’s political survival.\n",
    "\n",
    "Mexico, however, fit neither of these two cases. The government’s budget was balanced, so an outbreak of renewed inflation was not generally expected. The government’s willingness to raise interest rates was not in question: In the end the government of Mexico raised real interest rates to 40 percent per year during the crisis. The Mexican peso was not clearly overvalued: In the winter of 1993-1994 the Mexican government had conducted large exchange rate interventions and had eased monetary policy to try to keep the value of the peso from rising. Yet the Mexican peso lost half of its value in four months starting in December 1994. The peso fell from about 3.5 to about 7 to the U.S. dollar before recovering somewhat in the summer of 1995.\n",
    "\n",
    "The sudden reversal of investor expectations about the long-run fundamental value of the Mexican peso was startling. At the start of 1994 Mexico had just joined the world’s club of industrialized countries, the Organization for Economic Cooperation and Development (OECD). It had just entered into the North American Free Trade Agreement (NAFTA), which granted Mexico tariff-free markets for its prod­ ucts in North America. Expectations were that the Mexican peso would strengthen in real terms in the future, and that the profits from investing in Mexico were high.\n",
    "\n",
    "Optimism eroded in 1994. At the start of the year a guerrilla uprising in the poor southern Mexican province of Chiapas cast doubt on political stability. Further doubt was cast by a wave of assassinations killing, among others, Luis Donaldo Colosio, the presidential candidate of the ruling Party of the Revolution (Institutionalized) (PRI). During the presidential election year of 1994 itself, the central bank raised the money supply, causing some international investors to worry that macroeconomic policy was more political and less “technocratic” than they had thought. All of these events plus a wave of pessimism reduced foreign exchange speculators’ estimates of the long-run value of the Mexican peso and raised their assessment of the long-run fundamental value of the exchange rate, $\\epsilon_o $.\n",
    "\n",
    "During 1994 the Mexican government spent $50 billion in foreign exchange reserves supporting the peso, believing at each moment that the adverse shift in expectations had to turn around. It did not. By the end of 1994 the Mexican government was out of foreign exchange reserves. And so it devalued the peso and let it float against the dollar.\n",
    "\n",
    "The devaluation of the peso had destructive consequences, however. First, a great many — naive — investors in New York and elsewhere had believed the Mexican government when it said that it would do whatever was necessary to defend the value of the peso. The increase in the value of the Mexican exchange rate s led to a further fall in the perceived fundamental value of the peso which added pressure for further depreciation and a further rise in the value of the dollar relative to the peso. \n",
    "\n",
    "A more serious problem soon became clear: Much of the Mexican government’s debt was indexed to the dollar in the form of securities called tesebonos. Each depreciation of the peso raised the peso value of the Mexican government’s debt, increasing the temptation for the Mexican government to default on its debt, and the resulting financial distress led to further rises in foreign exchange speculators’ opinions of $ \\epsilon_o $.\n",
    "\n",
    "The Mexican government seemed faced with a horrible choice. The first option was to raise interest rates to defend the peso, but adverse movements in foreign exchange speculator expectations meant that the level of interest rates that would be required by the formula:\n",
    "\n",
    ">$ r^p = r^f + \\frac{\\epsilon_o - \\epsilon^*}{\\epsilon_r} $\n",
    "\n",
    "was a level that would produce a Great Depression in Mexico. This first option would produce catastrophe.\n",
    "\n",
    "The second option was to keep interest rates low and let the value of foreign currency rise much further. This would mean that Mexican companies — and the Mexican government — would be unable to pay their dollar-denominated and dollar-interest debts. Companies would declare bankruptcy. The government would default on its debt. Mexican exports would fall because foreign creditors would try to seize Mexican goods as soon as they left the country. Mexican imports would fall because foreign creditors would try to seize goods purchased by Mexico before they entered the country.\n",
    "\n",
    "The result would be to delink Mexico from the world economy. Mexico’s foreign trade would fall drastically. Meanwhile, international committees of lenders and creditors would thrash out a settlement of the bankruptcies with Mexican companies and the default with the Mexican government. This second option would produce catastrophe too. The Mexican government of Presidents Carlos Salinas and Ernesto Zedillo had bet Mexico’s economic future on increased integration with the world economy and the use of foreign capital to finance domestic industrialization.\n",
    "\n",
    "The U.S. government and the IMF tried to give the Mexican government more options. The Clinton administration proposed loan guarantees to Mexico. But these guarantees fell through because neither then-Speaker of the House Newt Gingrich nor then-Majority Leader of the Senate Robert Dole nor other congressional lead­ ers were willing to spend political capital on the issues. The administration then made direct loans to Mexico out of the U.S. Treasury’s Exchange Stabilization Fund. These built Mexico’s foreign exchange reserves back to a level where they could support the peso to some degree without pushing domestic interest rates to Great Depression-causing levels.\n",
    "\n",
    "These loans allowed the Mexican government to refinance its debt and helped restore confidence that the Mexican government would not be forced into hyperinflation or resort to default. As time passed, Wall Street investors calmed down too. They recognized that Mexico was still the same country with relatively bright economic growth prospects, with promises of financial support if necessary from the U.S. Treasury and the IMF, and with NAFTA-guaranteed tariff-free access to North America, the largest market in the world. Thus the Mexican economic meltdown of 1994-1995 was a short, sharp recession that reduced Mexican real GDP by about 6 percent, but that was then followed by resumed economic growth.\n",
    "\n",
    "The central lessons were two. First, the views of foreign exchange speculators could change radically with extraordinary speed. Second, developing countries that had not carefully prepared beforehand were extremely vulnerable to the shocks that such changes in international expectations could deliver.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**Mexico's Nominal Exchange Rate: The Value of the U.S. Dollar in Mexican Pesos**: The magnitude and rapidity of the collapse\n",
    "of the Mexican peso at the end of 1994 came as\n",
    "a surprise.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.4.3 The East Asian Crisis of 1997-98\n",
    "\n",
    "Two and a half years after the beginning of the Mexican crisis, the third interna­ tional financial crisis of the 1990s hit the world economy. For 20 years before 1997 the economies of the Asian Pacific rim had been the fastest-growing economies the world had ever seen. But in mid-1997 foreign investors began to worry about the long-run sustainability of the East Asian miracle and the growing overhang of non­ performing loans in East Asian economies. They began to change their opinions of the fundamental long-term value s0 of East Asia’s exchange rates.\n",
    "\n",
    "In Thailand, Malaysia, South Korea, and Indonesia the values of domestic currency fell, and once again falling currency values caused a further swing in foreign exchange speculators’ expectations of e0. Indonesia was hit worst: Real GDP fell by one-sixth in 1998; the Indonesian currency, the rupiah, lost three-quarters of its nominal value against the dollar; and short-term real interest rates rose to 30 per­ cent and nominal interest rates to 60 percent. Figure 15.11 shows the shock to two other currencies’ exchange rates.\n",
    "\n",
    "Once foreign exchange speculators began lowering their estimates of the long- run value of investments in East Asia, other, deeper problems in the Asian economies became apparent and were magnified. As East Asian exchange rates fell, it became clear that many of East Asia’s banks and companies had borrowed heavily abroad in amounts denominated in dollars or yen. They had used those borrowings to make loans to the politically well connected, or to make investments that turned out not to be profitable in the long run.\n",
    "\n",
    "The fact that East Asia’s financial system was based on close links between gov­ ernments, banks, and businesses — and that it was very difficult to obtain finan­ cial accounts from any East Asian organization — increased fear that more East Asian banks and companies were bankrupt than had been thought. This caused a further increase in foreign exchange speculators’ views of the long-run fundamen­ tal value of the exchange rate.\n",
    "\n",
    "The vicious circle continued. Each loss of value in the exchange rate increased the burden of foreign-denominated debt and increased the likelihood of general bankruptcy. Each increase in the perceived burden of foreign-denominated debt caused a further loss of value in the exchange rate. Poor bank regulation had cre­ ated a situation in which a small initial shock to exchange rate confidence could produce a major crisis. The shorter term the debt held by a country and its citi­ zens, the more easily capital can flee — and the larger is the impact of the crisis.\n",
    "\n",
    "As the Asian crisis developed, the IMF stepped in with substantial loans to boost foreign exchange reserves, made in return for promises to improve bank regula­ tion and reform the financial system. The hope was that short-term loans would allow East Asian economies to avoid catastrophe until the pendulum of Wall Street expectations began to swing back. The hope proved sound. Since mid-1998, investors in New York and elsewhere have remembered that East Asia’s economies had been the fastest-growing in the world in the previous generation, and were in all likeli­ hood good places to invest.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.4.4 The Euro Crisis of 2010-12\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.4.5 The Crisis That Didn't: The Dollar in the 2000s\n",
    "\n",
    "Where is the next currency crisis going to occur? One possibility is that it will occur in the United States. Since 1998 U.S. exports have stagnated and imports have grown so that at the start of 2005 the U.S. imports half again as much as it exports — a trade deficit of more than \\$600 billion a year, as Figure 15.12 shows. Will foreigners be willing on net to invest some \\$600 billion of their wealth in the United States each year, every year, without ever drawing down their wealth? Almost surely not. What will happen if foreigners’ desired annual net investments in the United States fall to, say, \\$200 billion a year? The dollar will fall in value, and on the rule of thumb that a 1 percent fall in the value of the dollar raises annual net exports in the long run by about \\$10 billion, the fall in the dollar would have to be on the order of 40 percent.\n",
    "\n",
    "Logically, currency speculators should want to be compensated for this risk — so interest rates in the United States would be above interest rates elsewhere — but they are not. This means one of two things: First, perhaps international econ­ omists’ expectation of a decline in the U.S. trade deficit and a large fall in the dollar are wrong — something else is going to happen. Second, perhaps investors and speculators do not have rational expectations.\n",
    "If the second possibility is the correct one, then a dollar crisis in the second half of the decade of the 2000s is a serious possibility. At some point speculators’ expectations will begin to factor in the possibility of a large decline in the dollar, and that factoring-in will produce a steep fall in the dollar and a rise in U.S. interest rates. However, a dollar crisis — should it happen — would not be as serious an event as all these other financial crises we have seen over the past decade and more. In other countries — because so much of their foreign debt was denominated in dollars — a fall in the value of the currency raised the burden of international debt and wors­ ened the crisis. In the United States — because so much of its foreign debt is denominated in dollars — a fall in the value of the dollar will lower the burden of international debt and ease the crisis.\n",
    "\n",
    "French President Charles de Gaulle complained more than 40 years ago about the “exorbitant privilege” the United States had because of the key role played by the dollar as the currency in which contracts were written and which everybody wanted to hold as their reserves. This exorbitant privilege is still operating, mak­ ing the United States less vulnerable to international monetary disturbances than other countries are.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "\n",
    "\n",
    ">**The U.S. Current- Account Deficit**: The U.S. trade deficit began to grow in the late 1990s as foreigners took some of their earnings from U.S. imports and spent them investing in the dot-com bubble. The deficit continued to grow to extraordinary size in the 2000s, in large part as we would expect from the model of Chapter 7: a cut in taxes produces a fall in net exports.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.4.6 The Next Crisis?\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.4.7 RECAP: Currency Crises\n",
    "\n",
    "Three major (and many more minor) financial crises hit the world economy in the 1990s. The western European crisis of 1992 came about because foreign exchange ; speculators (correctly) doubted the commitment of other European countries to maintain their fixed parity with Germany as German interest rates rose. The Mexican crisis of 1994-1995 came about because foreign exchange speculators (incorrecdy) doubted the commitment of the Mexican government to low inflation and economic reform, and because the fact that Mexico’s government had borrowed heavily in dollars meant that a reduction in the value of the peso destabilized Mexico’s finances. The East Asian crisis of 1997-1998 came about because foreign exchange speculators (correctly) feared that much recent investment in East Asia had been unproductive and (incorrectly) feared that the age of fast growth in East Asia was over, and because heavy dollar borrowings by East Asian companies meant that a reduction in the value of their currencies threatened to send much of East Asia’s manufacturing and financial corporations into bankruptcy.\n",
    "\n",
    "&nbsp;"
   ]
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    "## 15.5 Managing Crises\n",
    "\n",
    "We can see the real exchange rate equation:\n",
    "\n",
    ">$ \\epsilon = \\epsilon_o — \\epsilon_r(r- r^f) + \\epsilon_R{\\Delta}R $\n",
    "\n",
    "as offering a country a menu of choices for the value of foreign currency $ \\epsilon $, the value of the domestic real interest rate, r, and spending-down its foreign exchange reserves R. The higher the domestic real interest rate r and the more negative is the current change in reserves $ {\\Delta}R $, the more appreciated is the exchange rate and the lower is the value of $ \\epsilon $.\n",
    "\n",
    "If for any of a number of reasons speculators lose confidence in the future of the economy, their assessment of the fundamental price of foreign goods and currrency suddenly and massively shifts. The menu of choices that a country has for its combination of the interest rate and the exchange rate suddenly deteriorates. If the interest rate r is to remain unchanged, the value of foreign exchange must rise a good deal. If the exchange rate is to remain unchanged, then the domestic real interest rate r must rise a good deal. \n",
    "\n",
    "Raising interest rates appears unattractive because it will create a recession. No domestic purpose would be served by such a recession; it is just the result of foreign investors’ change of opinion. Thus, letting the exchange rate depreciate would seem to be the natural, inevitable policy choice. A sudden panic by foreign exchange speculators is a sudden fall in demand for your country’s products: International investors are no longer willing to hold your country’s bonds at prices and interest rates that they were happy with last month. What does a business do when all of a sudden demand for the products it makes falls? The firm cuts its price. Perhaps a country faced with a sudden fall in demand for the products it makes should do the same — cut its price. And the easiest way for a country to “cut its price” is to let the home-currency value of foreign currency and goods rise.\n",
    "\n",
    "Yet throughout the 1990s, whenever international investors suddenly turned pessimistic about investing in a country, observers reacted with shock and horror when the value of foreign currency rose. This was the story in the collapse of the European Monetary System in 1992, the collapse of the Mexican peso in 1994-1995, and the East Asian financial crisis of 1997-1998. In all these cases the trigger of the crisis was a sudden change of heart on the part of investors in the world economy’s industrial core — in New York, Frankfurt, London, and Tokyo.\n",
    "\n",
    "Economists will long argue whether it was the relative optimism of investors before the crisis or the relative pessimism of international investors after the crisis that was the irrational speculative wave. The right answer is probably “yes”; financial markets were excessively enthusiastic before the crisis and were excessively pessimistic afterwards. But why did such changes in international investor sentiment cause a crisis rather than an embarrassment? Why not let the exchange rate depreciate — the value of foreign currency rise — and keep domestic monetary and fiscal policy aimed at maintaining internal balance?\n",
    "\n",
    "The answer appears to be that letting the value of foreign currency rise is dangerous if banks, businesses, and governments have borrowed massively abroad in foreign currencies. Then a depreciation of the exchange rate bankrupts the economy: The foreign-currency value of all the foreign-currency and business assets is brought down by the depreciation, while the home-currency value of their liabilities is unchanged. Such an interlinked chain of general bankruptcies destroys the economy’s ability to transform household saving into investment and shifts the IS curve far and fast back to the left. Such chains of bankruptcies are the stuff of which Great Depressions are made.\n",
    "\n",
    "Some specific steps should have been taken to reduce vulnerability to a crisis. Strongly discourage — that is, tax — borrowers from borrowing in foreign currencies. If you are going to accept free international capital flows (in an attempt to use foreign financing for your industrial revolution), then be sure that your exchange rate can float without causing trouble for the domestic economy. If your exchange rate  must stay fixed (to fight inflation or for other reasons), then recognize that an important part of keeping it fixed is controls over capital movements.\n",
    "\n",
    "But once the crisis has hit, good options are rare. Is there a possible path to safety? Can you raise interest rates enough to keep the depreciation from triggering bankruptcy and hyperinflation while still avoiding a high-interest-rate-generated recession? Can you depreciate the exchange rate far enough to restore demand for home-produced goods without depreciating it so far as to bankrupt local businesses and banks?\n",
    "\n",
    "Maybe.\n",
    "\n",
    "The dilemmas are real. It is economic policy malpractice to claim that it is obvi­ ous that in a financial crisis interest rates should not be raised and the exchange rate should be allowed to find its own panicked-market level even if banks and firms have large foreign-currency debts. It is also economic policy malpractice to claim that in a financial crisis interest rates should be raised high enough to keep the exchange rate from falling at all. It’s not that simple. So if sudden changes of opinion by international investors cause so much trouble, shouldn’t we keep such sudden changes of opinion from having destructive effects? Shouldn’t we use capital controls and other devices to keep international flows of investment small, manageable, and firmly corralled?\n",
    "\n",
    "Once again, maybe.\n",
    "\n",
    "The first generation of post-World War II economists— John Maynard Keynes, Harry Dexter White, and their students — would have said, “Yes.” Sudden changes of opinion on the part of international investors can cause enormous damage to countries that allow free movement of capital. Such sudden changes of opinion are a frequent fact of life. Therefore, make it illegal, or at least very difficult, to borrow from and lend to, invest in, or withdraw investments from foreign countries. \n",
    "\n",
    "The second and third generations of post-World War II economists had a different view. They regretted that capital controls kept people with money to lend in the industrial core away from people who could make good use of the money to expand economic growth. The balance of opinion shifted to the view that too much was sacrificed in economic growth at the periphery for whatever reduction in instability capital controls produced. Moreover, a regime of capital controls encouraged corruption. Often it was the cousin of the wife of the vice minister of finance who received permission to borrow abroad. Thus, capital controls paved the way to kleptocracy: rule by the thieves.\n",
    "\n",
    "So today we have the benefits of free international flows of capital. The ability to borrow from abroad does promise to give successful emerging market economies the power to cut a decade or two off the time needed for them to industrialize. It promises to give investors in the world economy’s industrial core the opportunity to earn higher rates of return. But this free flow of financial capital also is giving us a major international financial crisis every three years or so.\n",
    "\n",
    "What is to be done will be one of the major economic policy debates of the next decade. Should we try to move toward a system in which capital is even more mobile than it is today, but in which international financial crises may become an even more common occurrence? Or should we try to move toward a system in which capital is less mobile — more controlled — and in which some of the benefits of international investment are traded for less vulnerability to financial crises? We don’t have to have a global economy as vulnerable to currency crises as the economy of the 1990s was.\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.5.1 The Argentinian Crisis of 2001: Yet Another Example\n",
    "\n",
    "During the 1990s, some economists argued that the reason that economies such as Mexico, Korea, Thailand, Malaysia, Indonesia, and Brazil were subject to such sharp financial crises was that their exchange rates were not fixed enough. When a crisis developed, the fact that the government could change the exchange rate meant that financiers feared that the government would change the exchange rate. The result was large-scale capital flight, which triggered the devaluation financiers had feared, and the devaluation of the home currency set off the chain of threatened bankruptcies that turned an adjustment of international prices into a full-blown crisis. If, some economists argued, the government lacked the power to change the exchange rate, no one would fear devaluation, capital flight would be avoided, and the crisis would never occur.\n",
    "\n",
    "Thus, in the aftermath of all these other crises, the Argentinean government of the 1990s believed that it had arrived at an institutional setup that would guarantee the credibility of its currency and eliminate any possibility of a crisis. It set up an independent currency hoard to manage its exchange rate, fixed its currency to the dollar, and obligated the currency board by law to make sure that the supply of cash money in the economy was no greater than the currency board’s foreign exchange reserves. With one Argentinean peso equal to one dollar, and with the currency board having more dollars in its asset holdings than there were cash pesos in the Argentinean economy, the theory was that confidence in the fixed exchange rate would be complete. If people did begin to doubt the peg, they would trade their cash pesos for dollars at the currency board. The cash money supply would thus fall because the currency board would not spend but would retire the cash pesos it was offered. A falling money stock would raise the value of the peso. And as pesos became scarce and more valuable, confidence would return.\n",
    "That was the theory.\n",
    "\n",
    "The collapse of the Argentinean economy at the end of 2001 provides a test case for this theory And the answer appears to be, “No.” \n",
    "\n",
    "Even if— as the Argentinean government did — the government delegates control over the exchange rate to an : external authority a “currency board,” and assigns the currency board the mission of keeping the exchange rate fixed, a large-scale financial crisis is still possible. And Argentina has had one: The peso collapsed at the end of 2001, and Argentinean GDP declined by 15 percent in 2002.\n",
    "\n",
    "What happened? In practice, things worked differently than in theory Argentina’s federal and state governments did not balance their budgets. As long as the Argen­ tinean economy was growing, the fiscal deficits were of little concern. But internal inflation made Argentina’s exports noncompetitive. The fear that the currency board might someday end made Argentina’s interest rates higher than those elsewhere. High interest rates tended to discourage investment. The resulting decline in real aggregate demand meant recession. Recession meant larger fiscal deficits.\n",
    "\n",
    "In the end, a government deficit must lead to one of three things: Taxes must be raised, inflation must take hold and expropriate the debt holders, or the government must formally default. The failure of Argentina’s government to effectively collect the taxes due it under law meant that as 2000 and 2001 proceeded, confidence that taxes would be raised diminished.\n",
    "\n",
    "The currency board was a creature of the government. Would the government continue to let the currency board exist if the consequences were (1) a recession and (2) a sharp cutback in government spending as the government’s sources of\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "### 15.5.2 RECAP: Managing Crises\n",
    "\n",
    "&nbsp;"
   ]
  },
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   "source": [
    "## 15.6 Globalization and the China Shock\n",
    "\n",
    "&nbsp;"
   ]
  },
  {
   "cell_type": "markdown",
   "metadata": {},
   "source": [
    "**Chapter Summary**\n",
    "\n",
    "1. For most of the past century, the world has operated with fixed exchange rates — not, as today, with floating exchange rates.\n",
    "2. Under fixed exchange rates, monetary policy has only very limited freedom to respond to domestic conditions. Instead, the main goal of monetary policy is to adjust interest rates to maintain the fixed exchange rate.\n",
    "3. Why would a country adopt fixed exchange rates? To make it easier to trade by making foreign prices more predictable and less volatile. Fixed exchange rate systems increase the volume of trade and encourage the international division of labor.\n",
    "4. Nevertheless, in the past generation countries usually concluded that freedom to set their own monetary policies to satisfy domestic concerns is more important than the international integration benefits of fixed exchange rates.\n",
    "5. An exception is western Europe, which has permanently and irrevocably fixed its exchange rates via a monetary union.\n",
    "6. Wide swings in foreign exchange speculators’ views of countries’ future prospects caused three major currency crises in the 1990s.\n",
    "7. Such currency crises, although triggered by speculative changes in opinion, were greatly worsened by poor bank regulation and other policies that threatened to send economies subject to capital flight into a vicious spiral ending in depression and hyperinflation.\n",
    "\n",
    "&nbsp;"
   ]
  },
  {
   "cell_type": "markdown",
   "metadata": {},
   "source": [
    "## <font color=\"880000\">Catch Our Breath</font>\n",
    "\n",
    "<img src=\"https://tinyurl.com/20181029a-delong\" width=\"300\" style=\"float:right\" />\n",
    "\n",
    "* Ask me two questions…\n",
    "* Make two comments…\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "* Further reading…\n",
    "\n",
    "<br clear=\"all\" />\n",
    "\n",
    "----\n",
    "\n",
    "Lecture Support: <>    \n",
    "Keynote: <>\n",
    "\n",
    "&nbsp;\n",
    "\n",
    "----"
   ]
  }
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