Fixed exchange rate system & Inflation

Hi,

In the CT7 Chapter 20 notes, there's something about under a fixed exchagne rate system, if your currency is fixed against a low inflation currency, you can control your own inflation easily. Does anyone know how this works?

Many thanks!

ActStudent

 

This is based on the idea of purchasing power parity (PPP) as described on p10 of Chapter 20.

PPP suggests that if the UK inflation is x% pa greater than the US inflation rate say, then ulitmately the £ will depreciate by x% pa against the US $. This is because UK exports become more expensive/less competitive and so demand for the £ to buy UK exports falls. At the same time, US imports become relatively cheaper in £ terms, and so the UK sells more £ to obtain US $ to buy those imports. The excess supply of £ means that the value of the £ falls.

The point with regard to fixed exchange rates is that PPP implies that we can only maintain a fixed exchange against another currency, if our economy has the same inflation rate as the other country. (As if it wasn't, then the value of the currency must change).

So, if we fix our exchange rate against that of a low-inflation currency, everyone knows that (because of PPP) we can only keep our exchange rate fixed if our inflation rate is at the same low rate as that in the other currency. If everyone believes that will actually be the case (because it is a credible policy, which the government will stick to), then they will come to expect lower inflation, they will act accordingly (and demand low wage increases) and so actual inflation will turn out to be low.

 

Thanks very much for your reply. I really appreciate that.

I guess the bit I'm specifically unclear about is:

What happens when the UK inflation rate is higher or lower than US inflation rate, but the exchange rate is fixed agains USD? What will the UK government have to do?

Why (or why not) is this situation not sustainable in the long term?

 

If the exchange rate was floating then it would tend to depreciate. This is because UK exports would become less competitive and so would tend to fall in value, whereas imports from the US would become relatively cheaper and so would tend to increase in value. The UK would therefore sell more £ to buy $, in order to buy imports from the US, and the US would sell fewer $ to buy £, in order to buy UK exports. There would therefore be an excess supply of £, leading to a fall in the value of the £.

If the exchange rate is fixed, then this process cannot happen "naturally". However, investors will realise that the £ ought to depreciate and they will come to see it as over-valued. They will therefore start to speculatively sell the £ and buy $ (which they know to ought to appreciate and will see as under-valued). So there will again be an excess supply of £. The only way the Bank of England can then maintain the fixed value of the £, is by selling its foreign currency reserves in order to buy up the excess £. However, it cannot do this for very long because it has only limited reserves of foreign currency and the investors/speculators are able to sell a lot more £ than the Bank of England is therefore able to buy up. So, eventually the UK will have to "give in" and devalue the £ - ie lower the fixed exchange rate against the $.

This actually happened in both 1967 and 1992.

 

I agree.

However, under a fixed system when £ ought to appreciate, the UK government has an infinite amount of £ to sell, and they can in theory keep on building up their $ reserve. Is this true? (by the way, does this increase the money supply in the UK, and lower the interest rate?)

Also under a fixed system where there's control of capital flow (such as in China), why do you still need to have a foreign currency reserve?

Going back to the original quesiton, is it true that under the above two scenarios, the fixed exchange rate system will have NO EFFECT on keeping inflation rates low?

Thanks!

 

In theory, it is true that under a fixed system when the £ ought to appreciate, the UK government could print an infinite amount of £ to sell, which they could then use to keep on building up their $ reserve. However, this would lead to a corresponding increase in the money supply and lower the interest rate. Ultimately, this is likely to lead to inflation, which would in turn then remove the excess demand for £s and hence the upward pressure on the £.

In principle, if you have complete control over capital flows into and out of your country/currency then you do not need to have a foreign currency reserve. However, you may hold such reserves in anticipation of the time when you relax capital controls, as will probably start to happen with China in the near future, as it becomes more integrated into the international financial system. Equally, there may be other strategic and political reasons for holding foreign currency reserves.

I think the answer to your final question is true. Typically, a fixed exchange rate can help to keep your inflation rate low if you fix your exchange rate to that of a low-inflation economy. This is because if your inflation exceeds that in the low-inflation economy, then the pressure is on your currency to depreciate and so you will need high interest rates to protect your currency, which in turn will tend to reduce inflation (down to the rate in the low-inflation country).

Conversely, if your inflation is less than that in the other economy, then the pressure is on your currency to appreciate. So you will need lower interest rates to prevent your currency appreciating, which in turn will tend to increase inflation (up to the rate in the other country).