Unit 7 Macroeconomic policy in the global economy
7.3 A flexible exchange rate regime with no stable inflation target (FlexNIT)
In two of the three policy regimes set out in the previous section, the government deliberately ‘ties its hands’: in a FlexIT economy by giving independence to an inflation-targeting central bank; in a Fix economy by giving up domestic monetary policy entirely.
To understand why governments choose to tie their hands, we first consider the case of a FlexNIT economy—in which the government does not tie its hands: a country with a flexible exchange rate, but without the discipline of an inflation target. As a result, it conducts its own monetary policy—but is susceptible to problems controlling inflation. We also show in this section that exchange rate flexibility may then exacerbate inflationary pressures.
The real exchange rate with a flexible nominal exchange rate
Consider the definition of the real exchange rate (competitiveness) between two countries:
\[c = \frac{e \times P^*}{P}\]Taking the foreign price level, \(P^*\), as given, the formula tells us that there are two ways in which the real exchange rate can change in a flexible exchange rate regime: either through domestic inflation, or through changes in the nominal exchange rate.
Starting with a FlexIT regime in both the domestic and foreign countries, if they had similar inflation targets and get close to those targets, then \(P\) would change at approximately the same rate as \(P^*\), so the price ratio, \(P^*/P\), would be reasonably stable.
As a result, in a FlexIT economy, a change in the nominal exchange rate, \(e\), typically translates into a similar proportional change in the real exchange rate, \(c\). As illustrated in Figure 7.5, this is the mechanism in a FlexIT regime through which exchange rate adjustment reinforces the central bank’s interest rate decision.
However, in the FlexNIT regime, the central bank does not have an inflation target. So things work differently. We begin by rearranging the expression for the real exchange rate. Dividing both top and bottom of the fraction by the foreign price level, \(P^*\), we can write the real exchange rate as:
\[c = \frac{e \times P^*}{P} = \frac{e}{P/P^*}\]In words:
\[\text{Real exchange rate} = c = \frac{\text{Nominal exchange rate}}{\text{Price ratio}}\]This tells us that, other things being equal, a rise in \(e\) (a depreciation) will translate to a rise in \(c\) (a real depreciation or improvement in home competitiveness), but that will be offset by any increase in the price ratio, \(P/P^*\) (home prices relative to those elsewhere). The price ratio will increase if domestic inflation is higher than foreign inflation.
If one country has systematically higher inflation than another, it would lose competitiveness continuously unless its nominal exchange rate depreciated continuously to offset this. But if both the nominal exchange rate, \(e\), and the price ratio, \(P/P^*\), rose in proportion (for example, if both doubled) then the real exchange rate and home’s competitiveness would not change at all.
To understand the implications of this relationship, we again analyse the impact of a positive aggregate demand shock, as in Figure 7.5, but this time without the discipline of a stable inflation target.
FlexNIT regime: The impact of a positive domestic demand shock
To clarify the contrast with the FlexIT case, we start from the same initial position as in Figure 7.5. A country is hit by a demand shock that is specific to the domestic economy. Follow the steps in Figure 7.7 to analyse what happens next.
Figure 7.7 The impact of a positive demand shock on a country with a flexible exchange rate regime and no inflation target, FlexNIT. (Contains Question 7.6.)
The initial effects of a positive demand shock
Inflation rises
Question 7.6 Choose the correct answer(s)
Read the following statements about potential consequences and choose the correct option(s). Assume the demand shock is one-off and lasts a few periods.
- The Phillips curve will shift upwards because inflation expectations change from 2% to 4%. (There is no inflation target to anchor expectations.)
- The demand shock is one-off (the AD curve shifts upwards once) so output will eventually return to its initial level.
- Inflation will not return to 2%; it will keep rising because inflation expectations are not anchored.
- When output eventually returns to \(Y_0\), inflation will be stable but higher than 2% since there is no inflation target to anchor expectations at 2%.
Inflation expectations change
Inflation becomes permanently higher
Figure 7.7 shows that without the discipline imposed by an inflation target, there is nothing to stop inflation drifting upwards, as inflationary expectations adjust at each round of wage and price setting. As a result, by the time the demand shock unwinds, higher inflation will have become embedded in the system.
In the example in Figure 7.7, inflation in the domestic economy ends up stabilizing at 10% while it is 2% elsewhere. What does this imply for the nominal exchange rate?
Different long-run inflation rates and nominal depreciation with a flexible exchange rate
At supply-side equilibrium, the real exchange rate (competitiveness) must be constant—otherwise, net exports and therefore output and employment will change and it will not be an equilibrium.
The formula for the real exchange rate shows that it changes if the nominal exchange rate changes, or if the home and foreign inflation rates are different. But with a flexible exchange rate, it is possible in principle for the exchange rate to adjust to keep competitiveness constant when inflation rates differ. If home’s inflation is higher than abroad’s, then home’s competitiveness can stay unchanged as long as its nominal exchange rate depreciates enough.
To formulate this more precisely, we introduce a new Greek letter, \(\delta\) (lower case ‘delta’, the Greek letter ‘d’), to represent the rate of depreciation of the nominal exchange rate. If \(e\) changes from \(e_0\) to \(e_1\) over one year, the depreciation rate is:
\[\delta = \frac{e_1 - e_0}{e_0}\]and \(\delta > 0\) implies that the nominal exchange rate is depreciating: that is, an increase in the price of foreign currency in home currency.
When we carefully examine the expression for competitiveness:
\[c = \frac{e \times P^*}{P}\]we can work out how c changes in response to inflation and depreciation:
- Depreciation, \(\delta\), increases \(e\), raising \(c\).
- Foreign inflation, \(π^*\), increases \(P^*\), raising \(c\).
- Domestic inflation, \(π\), increases \(P\), reducing \(c\).
The overall effect can be summarized by:
\[\text{Rate of change of competitiveness} \approx \delta + \pi^* - \pi\]Remember: a real depreciation implies that the relative price of foreign goods increases, so home competitiveness improves. In Extension 7.3, we show how to derive the approximation mathematically.
In words, this says that the rate at which the real exchange rate depreciates is approximately equal to the rate at which its nominal exchange rate depreciates plus the extent to which foreign inflation abroad exceeds home inflation.
We argued at the start of this section that supply-side equilibrium requires that competitiveness (the real exchange rate) must be constant—otherwise, output and employment will be changing. The expression above for the rate of change of competitiveness implies that competitiveness will remain constant (its rate of change will be zero) only if the right-hand side of the expression is precisely zero. Rearranging this expression, we have:
\[\text{Constant competitiveness} \Rightarrow \delta = \pi - \pi^*\]That is, for the real exchange rate to be stable, the rate of depreciation of the nominal exchange rate must exactly offset the difference between inflation at home and abroad. If home has higher inflation, the nominal exchange rate must depreciate to maintain competitiveness.
For example, assume that inflation abroad is 2%, and domestic inflation has stabilized at 10%. Then constant competitiveness implies that the nominal exchange rate must be depreciating at a rate of 8%. Note that we have not said that the nominal exchange rate will end up depreciating by this amount—just that, unless it does, the real exchange rate will be appreciating or depreciating. This would have an impact on the real economy (output and employment), taking the economy away from its supply-side equilibrium.
Question 7.7 Choose the correct answer(s)
Read the following statements and choose the correct option(s).
- \(c = eP^*/P = e / (P/P^*)\), or in other words, the nominal exchange rate divided by the price ratio. \(P\) refers to prices in the home economy and \(P^*\) refers to prices abroad.
- If there was an appreciation in the nominal exchange rate (a decrease in \(e\)) and domestic inflation was higher than inflation abroad, then \(c\) would definitely decrease (a real appreciation and a decline in competitiveness).
- The rate of change of competitiveness would be approximately equal to \(3\% + 2\% \text{ } – \text{} 8\% = \text{ } –3\%\). In this case, the real exchange rate would be appreciating at a rate of approximately 3%.
- There may be a decline in employment in exporting sectors, as well as a decline in employment in sectors where domestic production competes with imports.
Without a stable inflation target, changes in the real exchange rate may reinforce shocks, rather than stabilizing them
Figure 7.5 shows that in our benchmark FlexIT economy, changes in the real exchange rate play an important role in stabilization. When a positive demand shock hits the economy, the central bank tightens monetary policy, and the resulting appreciation of the nominal and real exchange rate depresses aggregate demand, thereby reinforcing the impact of the monetary contraction.
What would we expect to happen in a FlexNIT economy with its own monetary policy, but without a stable inflation target? Without a clear objective of stabilizing inflation, there is a real possibility that exchange rate movements may actually amplify shocks. This will be the case where the government attempts to maintain aggregate demand higher than the level consistent with equilibrium unemployment. This has indeed been quite a common feature of such economies.
Figure 7.8 describes the interaction between changes in the exchange rate and inflation in a FlexNIT economy during the period when inflation is increasing. This illustrates the possibility that, in order to maintain a given level of output, the policymaker may seek to maintain a competitive real exchange rate when inflation picks up, by allowing the nominal exchange rate to depreciate to offset the impact of inflation on competitiveness.
The depreciation will initially accentuate the impact of the demand shock by increasing net exports; but the depreciation will in turn boost inflation through its impact on import prices. Wage inflation will respond to the higher cost of living. As inflation picks up, nominal depreciations will need to become progressively larger to offset the impact of inflation on the real exchange rate. For as long as the policymaker attempts to keep a competitive real exchange rate, the outcome is likely to be a mutually reinforcing spiral of depreciation followed by higher inflation followed by ever-larger depreciations.
Figure 7.8 Positive demand shock in a FlexNIT economy: an inflation–depreciation spiral.
Effect on inflation
Figure 7.8a
Effect on the price ratio
Figure 7.8b
Impact of inflation on the real exchange rate if the nominal exchange rate stayed unchanged
Figure 7.8c
Monetary policy relaxes
The real exchange rate depreciation is only temporary
Figure 7.8e
Inflation rises
Figure 7.8f
Effect on the price ratio and competitiveness
Figure 7.8g
The impact of further nominal depreciation
Figure 7.8h
The spiral continues
For how long this process goes on will depend on the extent to which the general public is prepared to tolerate ever-rising inflation, and whether the policymaker takes this into account. Below, we will discuss evidence of this process in Spain, before it adopted the euro. But first we consider the objectives of the policymaker.
Why might a policymaker allow an inflation–depreciation spiral to take hold?
We know that both high unemployment and high and rising inflation are unpopular because they cause real suffering for households (as discussed in Unit 4). But unless the government is willing and able to make improvements on the supply side of the economy to reduce equilibrium unemployment, it faces an unpleasant trade-off between unemployment and inflation.
The attempt to keep unemployment below equilibrium implies a positive bargaining gap. Combining this with the updating of inflation expectations produces ever-increasing inflation, as shown in Section 4.6. In the model in Unit 4, the economy had no interactions with the rest of the world. We now extend that analysis to an economy integrated in global markets.
In a flexible exchange rate economy without an inflation target (FlexNIT), if the policymaker tries to keep unemployment below equilibrium, it will result in inflation at home rising above inflation abroad. To prevent competitiveness from worsening, with the associated decline in exports and rise in unemployment, the government must keep monetary policy loose and allow the exchange rate to depreciate. But this will raise inflation further. The only way to keep unemployment below equilibrium is to have a process of rising inflation and an ever more rapidly depreciating nominal exchange rate.
Figure 7.9 The effects of loose monetary policy in a FlexNIT economy.
An example: Spain before the euro—Floating exchange rates and inflation
For almost 30 years before Spain joined the eurozone in 1999, it had a FlexNIT regime, with its own currency, the peseta. Figure 7.10 shows what happened to inflation and the exchange rate during this period, and helps to provide background on why Spain chose to join the eurozone.
Figure 7.10 Spanish vs German inflation during the period of flexible exchange rates.
Inflation rates in 1970
Figure 7.10a
Spain and Germany’s response to the 1970s oil shocks
Inflation rises in Spain
The nominal and real exchange rate
An inflation–depreciation spiral?
The nominal and real exchange rate in 1977
Figure 7.10f
High inflation and Spain’s policy response
Figure 7.10g
The real appreciation dampened aggregate demand
Figure 7.10h
The nominal exchange rate and inflation in Spain and Germany in the 1990s
Question 7.8 Choose the correct answer(s)
Read the following statements about Figure 7.10 and choose the correct option(s).
- Spain’s central bank was controlled by the government, and let inflation rise. Germany’s central bank was independent from the government and was committed to an inflation target, so it took measures to keep inflation low.
- The nominal exchange rate depreciated by a similar amount to the rise in the price ratio. These offsetting effects meant that the real exchange rate changed by a smaller amount than the nominal exchange rate did.
- The average rate of depreciation, \(\delta\) was 5.5%, and the average gap between inflation rates over this period was 6.2%.
- Spanish inflation converged towards German inflation only in the 1990s, as Spain was preparing to adopt a fixed exchange rate regime.
