Unit 7 Macroeconomic policy in the global economy
7.9 Implications of global capital mobility for interest rates in different monetary/exchange rate regimes
The behaviour of investors in global capital markets to equalize returns on investing in assets in different countries (summarized in the UIP condition) has a very important effect on what policymakers can do in their own economies. In this section, we explain how this works in different exchange rate regimes.
The key features we point to in this section are as follows:
In economic models, ‘in the long term or long run’ and ‘in equilibrium’ often mean the same thing. The use of the terms in this paragraph is a good example.
- In flexible exchange rate regimes, the policymaker controls the nominal policy interest rate, while global financial markets determine the level of the exchange rate. The UIP condition implies that the level of the exchange rate be consistent with market expectations of depreciation or appreciation, as captured by the gap between the home and foreign interest rates. So if, for example, the policymaker at home sets the policy rate, \(i\), five percentage points higher than the foreign rate \(i^*\), the current level of home’s exchange rate must be consistent with an expected depreciation of its nominal exchange rate of 5%. Otherwise the expected return on investing in home and foreign bonds will not be the same. We also show that this in turn implies that in the long run, real interest rates are determined by global financial markets.
- In fixed or target exchange rate regimes, UIP works in reverse. If the exchange rate is fixed, expected depreciation is zero and global markets (not the policymaker) determine interest rates.
- And if the exchange rate is truly fixed, this implies that home and foreign policy rates must be equal. But if markets do not fully believe in the fixed rate, the interest rate required to maintain home’s exchange rate may be higher, to protect global investors from the possibility that the fixed rate may be abandoned.
FlexIT regimes: Inflation, nominal interest rates, and exchange rate depreciation in the long run
In this unit, we have considered exchange rate depreciation, \(𝛿\), from two different perspectives.
From the model in Section 7.3, we know that in equilibrium (unchanging output and employment), the real exchange rate is stable, which means that exchange rate depreciation and inflation differentials must offset each other. Hence over the long term (which in the model, is when the economy is in equilibrium):
\[\delta \approx \pi - \pi^*\]In the previous section, we argued that for equilibrium in global financial markets, the expected returns on domestic and foreign assets should be the same, taking into account expected depreciation; that is, we expect the UIP condition will hold:
\[\delta^E \approx i \text{ } – \text{ } i^*\]Extension 7.8 provides evidence that UIP does appear to hold on average.
To understand the implications of both conditions holding, at least over the long term, consider again the case of South Africa.
South Africa has relatively recently adopted a FlexIT regime, with an inflation target of \(\pi^T = 4.5\%\). If the central bank does its job well, then actual inflation will at least on average converge to this target—so over the long run, we would expect \(\pi = \pi^T\).
Now consider the exchange rate of the rand against the US dollar. The US also has a FlexIT regime, but with a lower inflation target of \(\pi^T = 2\%\). If both central banks on average achieve their target, then we would expect that on average if the real exchange rate is stable:
\[\delta = \pi^T - \pi^{T*} = 2.5\%\]While market expectations are by no means always correct, the evidence in Extension 7.8 suggested that they do not do too bad a job. It seems reasonable to assume that the depreciation rate expected by investors in financial markets will be roughly in line with actual depreciation (at least over the long term):
\[\delta^E \approx 2.5\%\]If that is the case, and if UIP also holds, we would expect to find:
\[i \text{ } – \text{ } i^* \approx \delta^E \approx \pi^T - \pi^{T*} \approx 2.5\%\]Then over the long term, if the dollar policy rate is \(i^* = 4\%\), the South African policy rate, \(i\), must be 6.5%—to be consistent with inflation targets being achieved, and market expectations of rand depreciation.
How can this be consistent with the South African central bank being able, at any point, to choose its policy rate? The answer is that it can do so, but the choice is tightly constrained. If it wishes over the long term to achieve both a stable real exchange rate and stable inflation target, its nominal interest rate is pinned down.
This is the real interest rate that means the AD curve intersects the 45-degree line at the level of output consistent with supply-side equilibrium (as discussed in Figure 5.13).
This is consistent with the analysis in Unit 5, where we argue that although a central bank can choose its nominal interest rate, it is the real interest rate that determines outcomes in the real economy, and we saw that over the long term, the central bank doesn’t get to choose the real interest rate: they have to set nominal rates to achieve a real interest rate consistent with supply-side equilibrium. The real interest rate must deliver the equilibrium level of aggregate demand and output. Otherwise, inflation will not be constant.
In effect, global markets impose the same outcome. Over the long term, the nominal interest differential must match the inflation differential:
\[i-i^* \approx \pi - \pi^*\]Rearranging this equation:
\[i-\pi = i^* - \pi^*\]Equivalently:
\[r = r^*\]Over the long term, the real interest rate must be the same in the home and foreign economies.
Fixed exchange rate regimes and global capital mobility
We now turn to fixed exchange rate regimes. We will show that global capital mobility explains why such countries cannot control their policy interest rate in the short run or the long run.
While the share of the global population in common currency, dollarized, or euro-ized economies is relatively small, we know from Section 7.5 that a much larger share lives in countries where, in recent years, the exchange rate has changed very little. Many such countries fix their exchange rate against the dollar.
Consider the case of a home country with its own currency, but with an exchange rate that is successfully held completely constant, as for example in the case of Denmark, which has held its exchange rate against the euro almost unchanged since the inception of the euro.
Denmark does have a central bank, with the power to set interest rates. But it is straightforward to show that, if UIP holds, fixing the exchange rate means that in practice the central bank entirely gives up any power to set the interest rate.
To understand why, consider the general case of a country that successfully fixed its bilateral exchange rate against some other currency. Assume that markets have complete confidence that it will continue to be fixed. In such countries, UIP implies:
\[\begin{align*} i &= \underbrace{\delta^E}_\text{=0} + i^* \\ \Rightarrow i &= i^* \end{align*}\]So we have a striking result. The country has its own currency, and a central bank with the power—in principle—to set its own policy rate. But once we take into account the commitment to the fixed exchange rate, in practice there is no such power. With a truly fixed exchange rate, it faces the same constraint as a country in a common currency area: its monetary policy is entirely dependent on the policy of the foreign central bank. For Denmark, this means that its policy rate is pinned down by the ECB policy interest rate. In Figure 7.20, we show that this is extremely close to holding in the data.
The results for a Fix economy (whether the country retains its own currency, joins a common currency area, or adopts another currency) are as follows:
- Home’s long-run inflation rate (at equilibrium unemployment) is equal to the inflation target in the foreign country to which its exchange rate is fixed. Unless this is the case, home’s competitiveness will be changing—and so will output and unemployment.
- Home cannot vary its interest rate to stabilize shocks. Global capital mobility and trading behaviour in financial markets (summarized in the UIP condition) means that home has no choice about the policy interest rate. So it can’t be used to stabilize shocks.
Hence when choosing a Fix regime, a government chooses to be bound by the monetary policy decisions of another country (in the eurozone, a group of countries).
This is not just a theoretical relationship; the example later in this section illustrates for Denmark that it is extremely close to holding in the data.
What happens when the fixed/target exchange rate is not fully credible?
Example 2 in Section 7.6 described how Argentina had a fixed exchange rate against the dollar between 1991 and 2001. In the months leading up to the eventual abandonment of the fixed exchange rate, there was widespread speculation in financial markets that the peso would depreciate. The eventual abandonment of the fixed exchange rate was followed by a dramatic depreciation (and a huge financial and economic crisis). Economists describe such a change in beliefs in the financial markets as a loss of credibility in the fixed exchange rate.
When the fixed exchange rate is not fully credible, then speculation in the markets will produce a gap between \(i\) and \(i^*\). Crucially, UIP tells us that any such gap is driven entirely by how credible the exchange rate commitment is and for as long as the exchange rate target is maintained, these expectations are outside the control of the central bank.
So, in practice, it is the behaviour of traders in integrated global capital markets, encapsulated in the model by the UIP condition that imposes the feature which we simply asserted earlier in this unit—namely, that any attempt by the home economy to control the nominal exchange rate (by choosing a Fix regime) means that the central bank entirely gives up control over its nominal interest rate, and therefore of its monetary policy.
The extension to this section works through the details of this process in a numerical example.
To put it another way: if the expectation in the foreign exchange market is that the peso will depreciate by 10% over the year ahead, and the Argentine government wants to stick with a fixed exchange rate, then it must accept that its policy interest rate will be 10 percentage points higher than the US Federal Reserve’s policy interest rate set in dollars.
This underlines the fact that the choice of exchange rate regime is the choice of monetary policy regime: these two cannot be separated when countries operate in a world of global financial markets and the government does not impose controls on flows of capital (that is, on transactions in financial markets).
Figure 7.19 summarizes the exchange rate regime / monetary policy regime pairs.
| Exchange rate regime | Monetary policy |
|---|---|
| Flexible (FlexIT): level of nominal exchange rate set by global financial markets; stable inflation target | The nominal interest rate is the key tool of monetary policy. With a stable target rate of inflation, a rise in nominal interest rates normally translates into a rise in real interest rates, and a real appreciation, which helps to stabilize the economy. But in the long run, real interest rates are determined in global financial markets. |
| Flexible (FlexNIT): level of nominal exchange rate set by global financial markets; no inflation target | The nominal interest rate is the key tool of monetary policy. But without a stable inflation target, rises in nominal interest rates often reflect upward shifts in inflation and expected depreciation rather than a change in real interest rates. But in the long run, real interest rates are determined in global financial markets. |
| Fixed (credible): held constant against the dollar, or another currency | No control. $$i = i^*$$ Inflation will be stable when it is equal to the other country’s inflation rate. |
| Fixed (not completely credible): markets expect that the exchange rate may deviate from the level it is fixed at | No control. Domestic policy rate depends on foreign policy rate and market expectations about the depreciation of the currency. |
Figure 7.19 An exchange rate regime is a monetary policy regime.
Example: Nominal interest rates and exchange rate expectations in Spain and Denmark
Figure 7.20 revisits the examples of both Spain and Denmark and compares the predictions of UIP with the pattern of interest rates.
For the Spanish case, we focus on the period before Spain joined the euro and examine its interest differential and exchange rate versus Germany. When examining the data, we need to bear in mind that during this period, monetary policymaking was less formalized than has been the case under inflation targeting. There was no clearly identifiable policy interest rate. Instead, we use data on the interest rates paid by the Spanish and German governments when borrowing by issuing bonds. Up until the point where both countries adopted the euro in 1999, borrowing by each government was in terms of their own currencies (the peseta and the Deutsche Mark). So, as discussed above, these rates would have been essentially free of any default risk in their respective currencies, so we can treat them as being fairly good proxies for the policy interest rate.
Figure 7.20 Exchange rates and interest rates in Spain, Germany, and Denmark (1960–2023).
Spain’s exchange rate against Germany’s (1960–2024)
Spain’s exchange rate against Germany’s (1960–2024)
Spain’s exchange rate against Germany’s (1960–2024)
Interest rates in Spain (1960–1998)
Spain’s interest rate and exchange rate in the 1970s to 1990s
Spain’s interest rate and exchange rate in the 1990s
Spain’s interest rate and exchange rate in the 1960s and early 1970s
Danish and ECB interest rates (1999–2023)
The patterns of interest rate and exchange rate movements are broadly in line with what the UIP model would predict, as long as we bear in mind some of the key assumptions of the model.
- During most of the period when Spain had a floating exchange rate, and capital controls were not in place, the interest differential was close to average rates of depreciation in the past, suggesting that markets were extrapolating past behaviour.
- But as Spain got closer to adopting the euro, markets appear to have been more forward-looking, with the interest differential falling as markets factored in future stability of the exchange rate.
- In the earliest years in the chart, when Spain had an (almost) fixed exchange rate, UIP does not appear to have held. But this reflects significant capital controls in that period—Spanish investors would have preferred to invest in German bonds, but they were not allowed to buy them.
- In contrast, the assumption of free capital mobility has been close to holding in Denmark in recent years. Denmark has successfully maintained a fixed exchange rate against the euro, and—just as UIP would predict—its risk-free interest rate has closely tracked the interest rate set by the ECB.
Question 7.16 Choose the correct answer(s)
Suppose Country A (the home country) has a FlexIT regime with an inflation target of 2.5%, and Country B (the foreign country) has a FlexIT regime with an inflation target of 5%. Based on this information, read the following statements and choose the correct option(s).
- On average, we would expect depreciation to be 2.5 – 5 = –2.5% (an appreciation).
- If UIP holds, then the home policy rate = foreign policy rate + depreciation = 4 – 2.5 = 1.5%.
- In the long term, the nominal interest differential should be equal to the inflation differential.
- The real interest rate (not the nominal interest rate) in the home and foreign economies will be the same in the long term.
