SEU Module 13 Fiscal and Monetary Policies Under the Fixed Exchange Rate Critical Thinking: Fiscal and Monetary Policies under the Fixed Exchange Rate in S

SEU Module 13 Fiscal and Monetary Policies Under the Fixed Exchange Rate Critical Thinking: Fiscal and Monetary Policies under the Fixed Exchange Rate in Saudi Arabia (130 Points)

How do fiscal and monetary policies under the fixed exchange rate in Saudi Arabia help the country to increase the living standard? What are the goals of the monetary and fiscal policies, and how are they achieved? What are the challenges that the country may encounter on the journey to achieve the goals? What are the instruments they may use to overcome these challenges?

Your essay is required to be eight to ten pages in length, which does not include the title page and reference pages, which are never a part of the content minimum requirements.
Support your submission with course material concepts, principles, and theories from the textbook and at least three scholarly, peer-reviewed journal articles.
Use academic writing standards and follow APA style guidelines.

Thank you Module 13: Exchange Rate Systems and Currency Crises
1. Exchange Rate Systems
Chapter 14 of your textbook discusses the different exchange rate systems. There are
two main types: fixed rate systems and floating rate systems. In the first case,
exchange rates are fixed to some external standard of value. In the latter case,
exchange rates are determined by markets forces (demand and supply). Pay attention
that exchange rates are not fully determined by one model or the other. For example,
a country may fix its currency to the value of another currency that may float. The
United States has a flexible exchange rate. By contrast, Hong Kong has a fixed
exchange rate—it is fixed to the U.S. dollar.
Carbaugh’s (2019) discussion of floating exchange rate systems is anchored in
the impossible trinity—the principle that a country can have any two, but not all three,
of the following policies.
Due to free capital, a country cannot have both independent monetary policy and a
fixed exchange rate. This is because changes in money supply lead to changes in
supply and demand for currency and the exchange rate.
In the 1970s the world’s largest nations abandoned the Bretton Woods system of fixed
exchange rates. The U.S. President Richard Nixon stated that the gold supply was not
adequate to cover the dollars in circulation which prevented the dollar’s convertibility
into gold. Consequently, the Bretton Woods System collapsed, and the countries were
free to float their currency or fix it to another currency. The largest nations adopted a
managed float system within which central banks can interfere in the exchange market
in accordance with the guidelines established by the International Monetary Fund
(IMF).
Today, smaller countries often fix their currency to the currency of a larger trading
partner.
Watch this video as it provides an interesting discussion of the choice of the exchange
rate system.

The differences between fixed and floating exchange rates are explored. There is also a
discussion about the managed floating exchange rates.
2. Historic Currency Crisis
A currency crisis is also called a speculative attack because it is often related to the
activities of currency speculators.
The currency crises that struck Mexico in 1994, and East Asia in 1997, demonstrate a
major problem with the current system of floating exchange rates: market instability
can lead to dramatic changes—and in particular falls—in the exchange rate(s) of a
country or group of countries. A currency crisis might also lead to general economic
instability and deep economic recession.
The Asian crisis in 1997
July 1997:
•
•
•
Thailand abandoned its fixed exchange rate, devalued its currency and
requested technical assistance from the IMF. The reason for devaluing of the
currency was that investors were withdrawing capital, and this put downward
pressure on the exchange rate.
The Philippine peso was devalued.
The Singapore dollar started a gradual decline.
August 1997:
•
•
Thailand agreed to the proposed austerity measures by the IMF. Indonesia
allowed its currency to freely float.
Indonesia asked the IMF and the World Bank for help after a significant fall of
their currency.
October 1997: South Korean currency began to weaken and requested help from the
IMF.
The Asian crisis in 1998
June 1998: Japan announced that the country was in recession for the first time in
23 years.
October 1998:
•
•
Japan announced an aid package to help Southeast Asia recover from the
recession.
The Federal Reserve cut the interest rate to prevent the U.S. from falling into a
recession.
March 1999: The economies started to slowly recover from the recession.
The Mexican crisis in 1994
December 1994:
•
•
•
•
The Mexican Government devalued the peso against the U.S. dollar. The
devaluation was caused by the monetary and fiscal policies which were more
expansionary than they should have been.
To avoid capital flight the Central Bank increased the interest rate which hurt
the economic growth. Consequently, Mexico faced a default.
The Central Bank allowed the currency to float freely and it continued to
depreciate. There was a hyperinflation of 52%.
The Mexican economy was in a severe recession with high unemployment.
1995: The U.S. Government, the IMF, and G7 provided aid and helped the Mexico to
recover from the economic crisis.
Note that small and open economies are especially vulnerable to currency crisis. They
usually have large inflows of foreign investment suggesting that large portions of the
currency may be held by foreign investors.
For a detailed explanation on the European debt crisis, watch this video.
https://www.youtube.com/watch?v=j4_tyEl84IQ&feature=emb_logo
At the heart of the European debt crisis is the euro, the currency that ties together 18 countries
in an intimate manner. So, when one country teeters on the brink of financial collapse, the
entire continent is at risk. How did such a flawed system come to be?
Carbaugh (2019) argued that “currency crises are not simply caused by big currency
speculators who arise out of nowhere. There must be an underlying reason for a
currency crisis to come about” (p. 483).
Carbaugh (2019) lists several causes of currency crises, shown here:
1- Budget deficits
Budget deficits and inflation.
2- Weak Economy
Frail financial structures.
3- Deregulation
Deregulations of financial structures and meddling by the government in financial
markets.
4- Politics
Political factors like instability and a lack of good governance.
5- External Influences
External economic factors like Increase of the interest rates of the big economies.
6- Exchange Rates
An exchange rate that is fixed to currency that overvalues it.
In other words, the speculative activity that causes currency crisis is economically
rational, or at least embodies a rational component.
However, some economists have theorized that currency crises may embody irrational
components that make crises self-fulfilling prophecies (Obstfeld, 1986; Radelet &
Sachs, 1998).
As the East Asian crisis of 1997 illustrates, an initially solvent economy can succumb
to currency crisis, which can, in turn, spread to other economies.
INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 14:
ExchangeRate Systems
and Currency
Crises
© 2019 Cengage. All rights reserved.
2
Chapter Outline
(1 of 2)
Exchange-Rate Practices
Choosing an Exchange-Rate System:
Constraints Imposed by Free-Capital Flows
Fixed Exchange-Rate System
Floating Exchange Rates
Managed Floating Rates
© 2019 Cengage. All rights reserved.
3
Chapter Outline
(2 of 2)
The Crawling Peg
Currency Manipulation and Currency Wars
Capital Controls
Increasing the Credibility of Fixed Exchange
Rates
© 2019 Cengage. All rights reserved.
4
Exchange-Rate Practices (1 of 5)
In choosing an exchange-rate system, a
nation must decide whether to allow its
currency to be determined by market forces
(floating rate) or be fixed (pegged) against
some standard of value
© 2019 Cengage. All rights reserved.
5
Exchange-Rate Practices (2 of 5)
• Floating exchange-rate system
• Nation must decide whether currency should
float independently, float in unison with other
currencies, or crawl according to
predetermined formula
• Pegged exchange-rate system
• Fixed against some standard of value; nation
must decide whether to
• Anchor to single currency, basket of currencies, or
gold
© 2019 Cengage. All rights reserved.
6
Exchange-Rate Practices (3 of 5)
• Members of the IMF
• Exchange rates should not be manipulated
• To prevent effective balance-of-payments
adjustments
• To gain unfair competitive advantage over other
members
• Members should act to counter short-term
disorderly conditions in exchange markets
• When members intervene in exchange markets,
must take into account interests of other
members
© 2019 Cengage. All rights reserved.
7
Exchange-Rate Practices (4 of 5)
TABLE 14.1 Exchange-Rate Arrangements of IMF Members,* 2015
Exchange Arrangement
Percentage of IMF Members
Hard pegs
No separate legal tender
Currency board
6.8
5.8
Soft pegs
Conventional pegged (fixed) exchange rates
Stabilized arrangement
Crawling peg
Crawling-like arrangement
Pegged exchange rate within horizontal bands
23.0
11.5
1.6
10.5
0.5
Floating
Managed floating
Free floating
Other
19.4
15.7
5.2
100.0
*Includes 188 member countries.
Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, 2015. See
also International Monetary Fund, Classification of Exchange Rate Arrangements and Monetary Policy Frameworks,
available at http://www.imf.org/.
© 2019 Cengage. All rights reserved.
8
Exchange-Rate Practices (5 of 5)
TABLE 14.2 Choosing an Exchange-Rate System
Characteristics of Economy
Implication for the Desired Degree of Exchange-Rate Flexibility
Size and openness of the
economy
If trade is a large share of national output, then the costs of currency
fluctuations can be high. This suggests that small, open economies may best be
served by fixed exchange rates.
Inflation rate
If a country has much higher inflation than its trading partners, its exchange
rate needs to be flexible to prevent its goods from becoming uncompetitive in
world markets. If inflation differentials are more modest, a fixed rate is less
troublesome.
Labor-market flexibility
The more rigid wages are, the greater the need for a flexible exchange rate to
help the economy respond to an external shock.
Degree of financial
development
In developing countries with immature financial markets, a freely floating
exchange rate may not be sensible because a small number of foreign exchange
trades can cause big swings in currencies.
Credibility of policy makers
The weaker the reputation of the central bank, the stronger the case for
pegging the exchange rate to build confidence that inflation will be controlled.
Capital mobility
The more open an economy to international capital, the harder it is to sustain a
fixed rate.
© 2019 Cengage. All rights reserved.
9
Choosing an Exchange-Rate System:
Constraints Imposed by Free Capital Flows
(1 of 2)
Allowing free capital flows
• Constrains a country’s
• Choice of exchange-rate system
• Ability to operate independent monetary policy
Impossible trinity
• A country can maintain only two of the
following three policies:
• Free capital flows
• Fixed exchange rate
• Independent monetary policy
© 2019 Cengage. All rights reserved.
10
Choosing an Exchange-Rate System:
Constraints Imposed by Free Capital Flows
(2 of 2)
© 2019 Cengage. All rights reserved.
11
Fixed Exchange-Rate System
(1 of 9)
Use of fixed exchange rates
• Used primarily by small, developing nations
with currencies anchored to key currency
Key currencies
• Widely traded on world money markets
• Have demonstrated relatively stable values
over time
• Widely accepted as means of international
settlement
© 2019 Cengage. All rights reserved.
12
Fixed Exchange-Rate System
(2 of 9)
TABLE 14.3 Key Currencies: Currency Composition of Official Foreign Exchange
Reserves of the Member Countries of the International Monetary Fund, 2016
Key Currency
Composition of Official Foreign Exchange Reserves
U.S. dollar
63.9%
Euro
19.7
British pound
4.4
Japanese yen
4.2
Canadian dollar
2.0
Australian dollar
1.8
Chinese yuan
1.1
Other
2.9
100.0
Source: From Currency Composition of Official Foreign Exchange Reserves (COFER), International Monetary Fund, 2017,
available at www.imf.org.
© 2019 Cengage. All rights reserved.
13
Fixed Exchange-Rate System
(3 of 9)
• Anchoring to single currency
• Generally done by developing nations whose
trade and financial relations are mainly with a
single industrial-country partner
• Some nations anchor to special drawing
right (SDR)
• Basket of four currencies established by IMF
© 2019 Cengage. All rights reserved.
14
Fixed Exchange-Rate System
(4 of 9)
• Par value and official exchange rate
• In terms of gold or other key currencies
• Official exchange rate
• Can be determined by comparing par values of two
currencies
© 2019 Cengage. All rights reserved.
15
Fixed Exchange-Rate System
(5 of 9)
• Exchange-rate stabilization
• Exchange stabilization fund
• Used to defend official rate through purchases and
sales of foreign currencies
• Fundamental disequilibrium
• Long-term, official exchange rate and the market
exchange rate may diverge, reflecting changes in
fundamental economic conditions like income
levels, tastes, preferences, and technological
factors
© 2019 Cengage. All rights reserved.
16
Fixed Exchange-Rate System
(6 of 9)
• Devaluation and revaluation
• Devaluation-counteracting payments deficit
• Revaluation-counteracting payments surplus
• Depreciation and appreciation
• Actual impact on market exchange rate
caused by
• A redefinition of par value
• Changes in exchange rate
• Changes in the supply or demand of foreign exchange
© 2019 Cengage. All rights reserved.
17
Fixed Exchange-Rate System
(7 of 9)
• Bretton Woods System of Fixed
Exchange Rates
•
•
•
•
Semi-fixed exchange-rate system
Adjustable pegged exchange rates
Currencies tied to each other
Nation could repeg its exchange rate via
devaluation or revaluation policies
• Use fiscal and monetary policies first to
correct payment imbalances
© 2019 Cengage. All rights reserved.
18
Fixed Exchange-Rate System
(8 of 9)
• Bretton Woods System (cont.)
• Agree to defend existing par values
• Correct fundamental disequilibrium by
repegging currencies
• Up to 10% without permission from IMF
• By greater than 10% with the fund’s permission
• Par value set in terms of gold or gold content
of U.S. dollar in 1944
• Market exchange rates were almost but not
completely fixed
© 2019 Cengage. All rights reserved.
19
Fixed Exchange-Rate System
(9 of 9)
• Bretton Woods System (cont.)
• Operational problems (cont.)
• Currency devaluation indicated failure of domestic
policies
• Currency revaluations unacceptable to exporters
• Repegging exchange rates only as a last resort
• Difficult because of adjustable pegged rates
• Speculators had incentive to move out of
weakening currency
© 2019 Cengage. All rights reserved.
20
Floating Exchange Rates (1 of 4)
• Floating exchange rates (flexible)
• Currency prices established daily in foreignexchange market
• Without restrictions imposed by government policy
• Equilibrium exchange rate
• Demand for and supply of home currency
• Changes in exchange rate
• Correct a payments imbalance
• Shifts in imports and exports of goods, services, and
short-term capital movements
© 2019 Cengage. All rights reserved.
21
Floating Exchange Rates (2 of 4)
• Trade restrictions, jobs, and floating exchange
rates
• During economic downturns, labor unions lobby for
import restrictions to save jobs of domestic workers
• Implementation of import restrictions
•
•
•
•
Helps one industry
Shifts jobs from other industries to protected industry
Has no significant impact on aggregate employment
Leads to short-term employment gains in protected
industry being offset by long-term employment losses in
other industries
© 2019 Cengage. All rights reserved.
22
Floating Exchange Rates (3 of 4)
• Arguments for floating rates
• Respond quickly to changing supply and demand conditions
• Clear the market of shortages or surpluses of a given
currency
• Simplified institutional arrangements that are relatively easy
to enact
• Continuous adjustment in the balance of payments
• Partially insulate home economy from external forces
• Nations have greater freedom to pursue policies that
promote domestic balance
© 2019 Cengage. All rights reserved.
23
Floating Exchange Rates (4 of 4)
• Arguments against floating rates
• Unregulated market may lead to wide fluctuations in
currency values and discourage foreign trade and
investment
• Inflationary bias; monetary authorities may lack financial
discipline
• Greater freedom for domestic financial management
© 2019 Cengage. All rights reserved.
24
Managed Floating Rates
(1 of 6)
Managed floating system
• Informal guidelines established by IMF for
coordination of exchange-rate policies
• Nations might intervene in exchange markets to
avoid exchange-rate alterations that would weaken
their competitive position
• Concern that floats over time might lead to
disorderly markets with erratic fluctuations in
exchange rates
• Nation can alter degree to which it intervenes
in foreign-exchange market
© 2019 Cengage. All rights reserved.
25
Managed Floating Rates
(2 of 6)
• When U.S. suspended gold convertibility & allowed
overvalued dollar to float, hoped free market
adjustment would result in depreciation of dollar
against undervalued currencies
• Clean float
• Market solution; but foreign central banks refused
to permit and intervened in exchange market
• Dirty float
• Interference in market; forces of supply & demand
not allowed to play equilibrating role
© 2019 Cengage. All rights reserved.
26
Managed Floating Rates
(3 of 6)
• Leaning against the wind
• Intervene to reduce short-term fluctuations in
exchange rates without attempting to adhere
to any particular rate over long term
• Target exchange rates
• To reflect long-term economic forces that
underlie exchange-rate movements
© 2019 Cengage. All rights reserved.
27
Managed Floating Rates
(4 of 6)
• Managed floating rates in the short run and long run
• Market intervention stabilizes exchange rates in short term; allows
market forces to determine exchange rates in long term
© 2019 Cengage. All rights reserved.
28
Managed Floating Rates
(5 of 6)
• Exchange-rate stabilization & monetary policy
• To stabilize a currency’s exchange value; expansionary/contractionary
monetary policy
© 2019 Cengage. All rights reserved.
29
Managed Floating Rates
(6 of 6)
• Is exchange-rate stabilization effective?
• May be useful when exchange rate is under
speculative attack
• May be helpful in coordinating private-sector
expectations
• Research provides some support for shortterm effectiveness
• Does not support long-term intervention
© 2019 Cengage. All rights reserved.
30
The Crawling Peg
Crawling peg system
• Small, frequent changes in par value of currency
to correct balance-of-payments disequilibrium
• Process of exchange-rate adjustment is
continuous for all practical purposes
• Used by nations with high inflation rates
• Combines flexibility of floating rates with stability
usually associated with fixed rates
© 2019 Cengage. All rights reserved.
31
Currency Manipulation and
Currency Wars (1 of 3)
Currency manipulation
• Purchase or sale of currency by fiscal or
monetary authority to influence its value
• In 2000s, U.S. accused Japan, China, South
Korea, Singapore, and other countries of
keeping the exchange values of their
currencies artificially low in order to boost
international competitiveness and trade
surpluses.
• U.S. has been doing the same thing
© 2019 Cengage. All rights reserved.
32
Currency Manipulation and
Currency Wars (2 of 3)
• Is China a currency manipulator?
• U.S.: China manipulates the yuan
• Yuan significantly undervalued relative to dollar
• U.S. exports to China more expensive
• Harms U.S. production and employment
• Chinese goods cheaper for American consumers
• More imports
• Huge trade surplus with United States
• Large accumulation of dollar reserves
© 2019 Cengage. All rights reserved.
33
Currency Manipulation and
Currency Wars (3 of 3)
• Is China a currency manipulator?
• Others say there…
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