Macroeconomic policy and exchange rate regimes under globalfinancial integration
I want to come back to the post I wrote recently on Angry Bear, regarding the power of exchange rates to insulate economies from shocks and to grant independence to economic policy action, with the purpose to derive some clear (and testable) propositions.
For the benefit of readers, let me explain that my previous post originated from Antonio Fatas’ challenge to conventional wisdom whereby sudden stops – or the abrupt reductions in net capital inflows caused by crisis confidence – are relevant only for countries with fixed exchange rates, whereas they are not much of a concern for countries that have their own currencies. An interesting yet non-conclusive controversy followed, with positions ranging from that expressed by Paul Krugman, who holds that the adjustment mechanism to a confidence crisis varies with the underlying exchange rate regime (i.e., it is contractionary under fixed rates and expansionary under floating) to Andrew Rose’s observation that the economic performance of ‘fixers’ versus ‘floaters’ has not been dissimilar since 2007, going through Brad DeLong’s claim that under extraordinary dysfunction (not just a change in market views of the long-term fundamental value of the currency), exchange-rate depreciation no longer yields expansionary effects.
In my post, I argued that the dysfunction need not be as extreme as DeLong claims, and that the effectiveness of floating rates depends ultimately on how financial markets evaluate the sustainability of an economy’s public liabilities (both money and debt) against its macro policy framework. As my arguments go, even with floating, a largely indebted and financially integrated country suffering from poor credibility in the eyes of the markets would find its policy space severely constrained by the need to protect its liabilities from the risk of future (internal and external) value losses, as determined by the market response to its policy stance. If the country was in recession or secular stagnation and intended to recover output and employment gaps through active demand management, markets might undermine the country’s good intentions and bring it back on its policy decisions, under the threat of sudden stops and capital flights. The exchange rate is, therefore, a ‘veil’: markets see the economy’s risks through it, and are indifferent to the underlying exchange rate regime.
The key variables determining the latitude of the policy space available to an economy wanting to exploit the ‘insulating’ and ‘independence’ power of floating exchange rates are: i) the economy’s stock of (debt and money) liabilities, ii) its level of credibility in the markets’ judgment (whether the judgment is right or wrong is another matter), and iii) its degree of integration in the global financial markets. Thus,
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