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Domestic financial market structures differ from those that existed forty years ago. Then forced savings could be channeled through regulation into capital formation in the traded goods sector. Japan did so, as did European countries also. Thus then the distortions of undervalued exchange rates, repressed consumption and forced savings in the periphery offset other distortions that would have resulted in too little investment in the highly productive traded goods sector.
Since then, in the s, with persisting undervalued exchange rates, in a more deregulated financial environment, low interest rates and ample credit were available for the non-traded goods sector and the property market. Some Asian countries experienced property market booms that weakened their financial institutions.
Currently, the same policies have led to real estate booms in coastal China.
Asian authorities are aware that the export benefits of their exchange rate policy are offset by heightened financial risks. Eichengreen predicts that Asian authorities will let their exchange rates rise, and will emphasize expansion of domestic demand, not of exports, that they recognize that traded goods are not the sole center of productivity and growth externalities.
They will therefore promote balanced investment in both non-traded and traded goods. This will cause the dollar to decline and may force the Fed to raise interest rates, curbing domestic absorption. The euro may rise against the dollar, harming European exports. Eichengreen asks whether more monetary and fiscal restraint by the U.
Had the U. Lower U. In , Germany might not have revalued the mark and delayed the end of the dollar standard. Eichengreen believes that by raising the price of gold, expectations would have arisen that the step would be repeated, increasing the likelihood of a run on the U. A better course would have been floating the price of gold, but the authorities resisted severing the dollar-gold link until there was no other alternative.
Also, had the U. In the present situation, Asian central banks foil the U.
In short, Eichengreen doubts that changed U. Countries would have needed additional reserves as the world economy grew, and gold and liquid claims on the U.
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As changed U. World economic growth would have slowed and also demand for international reserves. But this would not have solved the Triffin dilemma that for other countries to acquire dollars, the U. This representative firm should analyze the decision of investing in a new project under the different exchange regimes. In the fixed exchange rate regime there is not stochastic components in the model.
However, the monopolist firm has an exchange rate that triggers the investment independently from the fixed exchange rate. Proposition 1 : Consider that the monopolist firm obtains in each period t a profit given by 6 , so the monopolist's dynamic problem is. Then, the solution for this non stochastic optimization problem is given by.
These conditions mean that there are profits in the foreign market and that the profit share obtained in the domestic market is not enough to cover the investment's present value in each period t. Otherwise, the project would be executed independently of the nominal exchange rate level. So, the main result of this model is, that under a fixed exchange regime, the monopolist firm will invest if. It means that under this regime the monopolist firm will invest, if the present value of the project's future return is greater than its cost, just as predicted by the net present value rule Jorgenson, An adjacent conclusion is that under a fixed exchange regime many investment projects are abandoned because they are not viable under the established exchange rate In other words, the exchange rate fixation only implies that investments are compatible with the established rate.
In the first place, it is only effective to eliminate uncertainty if the policymaker has the capacity to maintain it during a long period. Otherwise, the expectation of a possible future depreciation will generate, as much as or more uncertainty, than in a free float regime. This credibility problem had already been presented by Kydland and Prescott's original work and then, the analysis was extended to the best exchange rate regime in the context of an open economy.
It evaluates the cost-benefit of abandoning this exchange rate instrument.
Economic agents realize that there may be future situations in which a change in the exchange rate would be optimal for policymakers and, therefore, the incentive arises for them to renege on their commitment. The credibility problem can only be solved if the authorities, in playing their game against the other economic agents, are really able to convince agents that their only objective is the maintenance of fixed exchange rates, regardless of the costs induced by this choice of strategy.
Nonetheless, exiting a fixed exchange rate regime, may also be costly since, in general, it is followed by strong depreciations 7. In general, the main conclusion of the literature is that an exchange rate policy should be as consistent as possible 8 to solve uncertainty problems. Consider now that the profit given by 6 is composed by deterministic and stochastic components. It is assumed that the nominal exchange rate floats freely and that it is a stochastic process that follows a geometric Brownian movement.
The other parameters in the model are assumed to be deterministic. Therefore, the nominal exchange rate is the only fact responsible for the uncertainty regarding the future profits. Under these conditions, the monopolist's dynamic problem will be:. This last condition means that the profit share obtained in the domestic market is not enough to cover the investment's present value in each period t.
Otherwise the project would be executed independently of the nominal exchange rate level. Fixing the exchange rate, this expectation disappears. Besides, the firm should have an increase on their profits to compensate the uncertainty due the nominal exchange rate. Corollary 1: , the firm profit present value should be greater than the invested value. The results can be seen in figure 1. This means that a depreciation of This impact is larger when the depreciation trend is increased.
Therefore, under a free float regime, the uncertainty regarding the exchange rate is capable of reducing the investment. Thus, policies that seek to reduce the negative impact of uncertainty on investment can have a different effect from that expected, since the impact of uncertainty also changes when the exchange rate trend is altered.
According to the author, in a high uncertainty environment, with volatile exchange rates, the firms have incentives to adopt a "wait and see" behavior, regarding investments and negotiations with foreign markets. Huizinga and Bell and Campa give empirical support to this result.
The Exchange Rate System Lessons Of The Past And Options For The Future.
The authors found a negative relationship between the exchange rate volatility and the investment of European and American firms, respectively. There are, therefore, advantages and disadvantages regarding investment in both regimes. In practice, policymakers have been seen to adopt intermediate regimes, such as managed float and crawling peg.
In this regime, there is not an explicit goal for the nominal exchange rate, but the monetary authority intervenes, whenever it crosses a certain value limit. Interventions occur only at boundaries. Limits can be inferior or superior. Supposing that firms are capable of identifying these limits and that these can only exist, initially, in one direction.
The active firm's value now does not more include the restriction on overvaluations to rule out speculative bubbles, since the function has a superior limit. The explanation for this result is that, in this case, the reduction in the active firm value is equal to the reduction in the inactive firm value. In other words, when the future profits are reduced, the superior limit also is reduced, in the same magnitude as the opportunity cost of the investing option.
As a result, in a managed float regime, with an exchange rate superior limit, there are no distortions in the agents' decision. Another interesting point is that the critical value does not depend of the limit value established, even though it affects the firm's value directly. In this model, the firm's value is lower and, consequently, the firm loses money when a superior limit for the exchange rate is established.
The remaining model interpretations are similar to the free float regime model; however, it changes when there is an inferior limit for the exchange rate. Proposition 4: If a monopolistic firm faces a lower limit E l , then the critical value is. Under an exchange rate lower limit, the increase in the firm's value is superior to the increase in the opportunity costs.
It means to say that, under an exchange regime, with managed float, the establishment of an inferior limit for the exchange rate reduces the possibility of losses, with the foreign market making the exports and, consequently, the investment is viable, even if the nominal exchange rate is at a low level. It is possible to show that, the expression that multiplies the difference between the project value and the present value of future profits in the domestic market is always lower when there is an inferior limit.
It will be seen more clearly further ahead in a numerical example. In the previous subsection we have seen what happens when superior and inferior limits, for the nominal exchange rate, are adopted. In the case of a superior limit, the active firm's value is reduced while, in the case of an inferior limit, it is increased. But, what happens when both are adopted simultaneously in an explicit form?
This is the case of a crawling peg regime. It should be pointed out that, in this regime, if the bands are too narrow it has few differences regarding a fixed exchange rate regime. However, it is assumed that these bands are wide enough so that there is some space for fluctuation.
Again, the interventions occur only at boundaries and else the possibility of intra marginal interventions within the band is excluded. Under these assumptions no analytical solution to , the critical value for the nominal exchange under a crawling peg regime, may be obtained. Since there are two non linear equations with two unknown values that remain to determine two unknowns.
As it can be seen in the appendix 5. It shows that the critical value for the nominal exchange under a crawling peg regime which calls the investment option is optimal decreases when the bandwidth increases.
The Exchange Rate System Lessons Of The Past And Options For The Future! Free
This result is explained by the fact that a wider bandwidth implies larger profit expectations due to possible exchange rate depreciations. Another model result is that, the crawling peg critical value will always be between the critical value for an inferior limit and a superior limit same value as the free float regime. It is possible to observe this in a simulation using the same parameter values.