Exercises 3 Exchange rate regimes

Transcription

1 Exercises 3 Exchange rate regimes Haakon O.Aa. Solheim April 16, 2002 Exercise 1. Question What do we mean with the n-1 problem in a multilateral exchange rate system? Solution The n-1 problem relates to the fact that when two currencies have a fixed exchange rate, the ratio of the money supplies in the two countries is fixed. Two currencies and one exchange rate implies one monetary policy. If the money supply of one country changes, the money supply of the other country must change as well. In a multilateral exchange rate agreements all countries must agree on changes in the money supply. If two countries disagree about the optimal money supply, the system can not survive unless one of the parties is willing to compromise. 2. Question Assume that the UIP holds. Use the n-1 problem to illustrate the strains put on the EMS-system by the German unification. Solution See De Grauwe, ch The German contraction of the money supply lead to a reduced demand for e.g. the French franc. The market rate of appreciated, and the market rate of the FRF depreciated. To assure that the system was held within the established target zone either Germany had to increase its money supply or France had to reduce its money supply. In the early 1990 s the Bundesbank s policy clearly did not fit several of the other countries in the EMS. The system got a credibility problem. The countries with a weak commitment to fix their rates within the EMS left the system in However, France never devalued its exchange rate. It was forced to widen the target zone of exchange rate fluctuations in 1993, however. Norwegian School of Management (BI). haakon.o.solheim@bi.no. 1

2 /ECU Figure 1: Money supply shock in Germany... D S o S 1 The Bundesbank contracted the German money supply to contain inflationary pressure. M 2

3 FRF/ECU Figure 2: And the consequences for France D 1 FRF D 0 FRF S FRF A money supply shock in Germany decreased demand for FRF. To hold the exchange rate within the target zone France needed to contract their money supply as well. M FRF 3

4 Figure 3: A change in the target zone /ECU D New zone S o S 1 M A change in the target zone would have allowed the Bundesbank to contract the German money supply without putting strains on the fixed exchange rate. 3. Question In a meeting in 1991 Germany suggested to revalue the inside the EMS system (increase the value of relative to the other currencies in the system). Could this have alleviated the strains on the system? Solution A German appreciation would have shifted the target zone up in the case of France, and down in the case of Germany. This would have allowed Germany to decrease its money supply without affecting the money supply of France. 4. Question France vetoed the German suggestion. Why would the French do this? Solution Some possible arguments: France believed that the fixed exchange rate was an important symbol for European integration. Changing the rate could endanger the credibility of the system. France probably wanted to put pressure on Germany to compromise. After all the EMS was a multilateral agreement, and it was 4

5 problematic that the Bundesbank acted without regard to common European goals. It was not clear that the FRF was overvalued. In fact the FRF remained relatively stable against the over the period from 1990 to A de facto devaluation of the FRF could have lead to increased inflation in France. 5