Week 9

Question 1

What are the 3 different XR regimes ?

Answer 1

1. free floating
2. managed floating
3. currency peg

Question 2

What is a free floating XR ?

Answer 2

The value of the currency is determined by the supply and the demand in the market.

Question 3

What is the difficulty with the free floating XR ?

Answer 3

Often used only temporary solution as it can lead to excessive fluctuations.

Question 4

Which XR regime reduce the fluctuation and how ?

Answer 4

The managed floating XR is similar to the free floating but the government intervenes by buying or selling its own currency to minimize the fluctuations.

Question 5

What is a currency peg XR ?

Answer 5

The currency’s value is pegged to a basket of currencies or to another country’s currency. This is often done between countries that trade a lot.

Question 6

How can we know the XR regime of a country ?

Answer 6

The XR regime of every country is based on self-declaration.

Question 7

What is the risk with the self-declaration of the XR regime ?

Answer 7

Countries can lie in order to under- or over- evaluate its currency.

Question 8

Which authors developped a theory to fight against th risk posed by self-declaration of XR regime ?

Answer 8

Reinhart & Rogoff created a de facto measurement of XR to bypass the problem. This approach is based on the XR behavior and separates the XR regime in several categories.

Question 9

What is the XR dilemma ?

Answer 9

The unholy trinity theory developped by Mundell and Flemming.

Question 10

Explain the unholy trinity theory

Answer 10

Mundell’s model describes 3 goals that governments have: 1) stability; 2) flexibility; 3) mobility. However the dilemma does not allow the governments to reach all 3 goals. Consequently there is a trade-off situation in which only two or the three goals can be reached. The national choice depends upon priorities and circumstances.

Question 11

Why a country would want a fixed XR ?

Answer 11

It provides stability and encourages economic transactions due to less risks.

Question 12

Why a country would want flexibility ?

Answer 12

It keeps unemployment low.

Question 13

Why a country would want capital mobility ?

Answer 13

Developing countries who are scarce in capital will support a capital mobility approach to receive capital.

Question 14

What explain the Philipp curve ?

Answer 14

There is a trade-off, an inverse relationship between unemployment and inflation. When the general prices of goods increase (inflation), then the unemployment decreases. Whereas when the unemployment increase, the general prices of goods decrease (deflation).

Question 15

What says the partisan model about the class interests ?

Answer 15

The partisan model distingushes between 2 groups and 2 different types of income:

1. workers = income from employment
2. capital owners = income from capital returns

Question 16

What are the preferences of the socialist party ?

Answer 16

Employment > income redistribution > growth > price stability > BoP equilibrium

Question 17

What are the preferences of the center party ?

Answer 17

Price stability > growth > employment > redistribution > BoP equilibrium

Question 18

What are the preferences of the conservative party ?

Answer 18

Price stability > BoP equilibrium > growth > employment > redistribution

Question 19

According to Frienden's theory of the sectoral interest what prefer the 4 following categories:
1. exporters
2. international investors
3. non-tradable producers
4- imports-competitors

Answer 19

1. exporters = high XR stability and low level
2. international investors = high XR stability and high level
3. non-tradable producers = low XR stability and high level
   4- imports-competitors = low XR stability and low level

Question 20

How can the sector model explain the creation of the EMS in 1979 ?

Answer 20

In 1979, the BW broke down, there was no more stable exchange rate. As a consequence trade was inhibited between the European countries. A small BW system was then created in Europe which set a fixed XR. One of the main motivation was trade and this was put forward by a roundtable of European industrialists. This results in hard pegs to the Deutsch mark.

Question 21

How can the class model explain the French behavior in 1980s ?

Answer 21

There was a partisan shift in 1981 with the election of the president Mitterant (socialist). The party platform of Mitterrand was clearly class based, as a consequence he prioritized flexibility and employment over stability.

Question 22

What supports Bearce about the ideology and the XR stability ?

Answer 22

Bearce sees parties as agents directly influencing the monetary exchange rate regime:

• left parties = pro-flexibility
• right parties = pro-stability

Question 23

Explain the theory of the elections and the XR stability by Stein and Streb

Answer 23

The question observed by Stein and Streb is : How do elections affect XR stability ?
If a governement announces a fixed XR, and then devalues its currency, it is seen as incompetence, as the promise has not been kept. The devaluation looks like a tax for the ppulation. Consequently the governement should introduce devaluations only after elections.

Question 24

After WW2, what was the choosen approach for the economy ?

Answer 24

After WW2, there is a consensus which goals are:
- high price stability
- full employment
To reach these goals we would need:
- monetary and fiscal policy
- fixed XR
- capital control
- exploite the trade-off between inflation and unemployment
This consensus sets rational expectations.

Question 25

Explain the time consistency problem

Answer 25

In a time consistency model, there are 2 actors: the government and the labour unions. When the government decides to increase the prices of goods (= inflation), then the labour unions will enter in discussion with the employers in order to increase the wages. Here the governement has an incentive to cheat increasing inflation in order to decrease unemployment (Phillips curve). This game goes on and on… Thus the Phillips curve requeres adaptive expectations

Question 26

What brings the time consistency problem ?

Answer 26

We observe that under rational expectations (postWW2 consensus) the Phillips curve only works in the short run.

Question 27

What are the solutions for the problem caused by the relationship inflation-employment (time consistency problem) ?

Answer 27

1. the central-bank independence

2. fixed XR

Question 28

Why and how does the central-bank independence represent a solution for the problem of relationship inflation-employment (time consistency problem) ?

Answer 28

The solution of a central independent bank relies on the idea of a conservative banker: it would mean an insulation of monetary policy, an increase in the time horizon and allow for reputation building.
A CBI causes low-inflation and no effect on employment.

Question 29

Why and how does the fixed XR represent a solution for the problem of relationship inflation-employment (time consistency problem) ?

Answer 29

In this model, government search reputation building: investors look for certainty in governments, as their aim is safety of investments. The governement look for growth, employment and investment has the incentive to introduce a fixed XR, as it serves as an instrument to signal commitment.

Question 30

Which solution between the fixed XR and the CBI has less cost ?

Answer 30

the Central bank independence

Question 31

According to Bodea why did the former communist countries decide to get a fixed XR ?

Answer 31

The parties choose a fixed XR to overcome the credibility problem.

Question 32

How does the political regime affect the XR ? explain with a theory

Answer 32

In democracies, there will be more societal demand for flexibility. Whereas in autocracies, there is a lack of credibility in the safety of investments, and governements therefore have to appl a fixed XR.