...policy independence from adopting floating exchange rates.

The (Limited) Power of Exchange rates

                                                                                   Biagio Bossone  

In an old post, Antonio Fatas challenged the 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, arguing that where countries run large persistent current account deficits sudden stops of capital could be contractionary even under floating rates. Economists’ views on this topic range between extremes, from Andrew Rose concluding from empirical observations that the ‘insulation’ power from shocks is not dissimilar across exchange rate regimes, to Paul Krugman countering that the adjustment works though import compression (and thus is contractionary) under fixed rates while it works through depreciation and export growth (and is therefore expansionary) under floating rates. Somewhere in the middle lies Brad DeLong’s claim that in a sudden stop central banks may commit to keeping the short-term safe nominal interest rate at zero (swapping out cash and pulling in bonds ad libitum) unless and until the perceived quality of the country’s liabilities deteriorates to a point where people move out of bothgovernment bonds and cash and into foreign securities. DeLong reckons, however, that this scenario materializes only under extremely dysfunctional circumstances. More recent research has overall produced inconclusive evidence.

Who’s right and who’s wrong?

In my recent contribution to the topic, I have approached the issue differently, asking for whomexchange rates should matter and the extent to which they would then matter. Broadly speaking, my conclusion is that the effectiveness of the exchange rate as an adjustment mechanism in any given country depends on the country’s degree of financial integration into the global markets and the credibility of its policymakers. In particular:

  • with floating rates and full financial integration, the policymaking space is determined by the size of public debt and the degree of policy credibility
  • a large debt and weak policy credibility inhibit the power of floating rates to insulate the economy from shocks and to grant independence to its policymakers

· when the country’s financial stocks are significantly large, market expectations become fundamental determinants of equilibrium exchange rates and purchasing power parities.

To see why this is the case, take a country that is fully financially integrated and suffers from weak policy credibility, and assume that its policymakers commit to expanding public liabilities (debt and/or money) so as to stabilize output and employment in a deep recession or a secular stagnation environment. Under persistent expansion of the public liabilities, the country authorities would soon be faced with a dilemma:

  • they may either be forced to set the interest rates on debt liabilities high enough to prevent the exchange rate from falling at levels that would make liabilities unsustainable, or
  • they may decide to monetize debt as much as needed to keep rates low and to guarantee debt service – this would expose the country’s exchange rate to a risk of free fall and a drop in the real value of the liabilities.

Under the former option, the country would have to abandon its policy objective of stabilizing output and employment. Under the latter option, the country would fail to achieve the objective anyway. In ex-ante (equilibrium) terms, the two options would be equivalent from the standpoint of liabilities holders, for the expected losses from the risk of debt default (as compensated ex ante by higher interest rate premia) equals the expected losses from a depreciating currency.[1] All else equal, both options would carry the same probability of ending up in a sudden stop or capital flights – the exchange rate would be a ‘veil’, with no influence on the economy’s real variables.

A crucial assumption underpinning this conclusion is the country’s full integration in the global financial markets, which by removing frictions between domestic and foreign market eliminates any systematic differences between the intertemporal behavior of resident and nonresident agents, respectively, and between their valuations of the country’s liabilities. Under this assumption, faced with the prospects of the country issuing excess liabilities, residents and nonresidents alike would substitute bothdomestic debt and money holdings with foreign assets deemed to be safer stores of value.

As a consequence, the policy space available to a country that is fully financially integrated into the global markets and operates under a floating exchange rate regime grows narrower with the economy’s stock of liabilities and is limited by the country’s market reputation as issuer of liabilities. The conclusion holds irrespective of the currency of denomination of the liabilities, and irrespective of whether the liabilities are held domestically or abroad.

‘Modigliani-Miller’ applied to macroeconomies

These equivalences resemble the neutrality proposition of the Modigliani-Miller theorem for corporate finance, whereby, under condition of perfect competition, the value of a firm’s capital is unaffected by the type of security used to finance capital acquisition. Equivalently, if traded in an open competitive market, a public liability must carry identical value independently of the form and exchange rate regime under which it is issued and traded.

Obviously, we do not live in world of perfectly competitive markets, and any departure from a lean and clean ‘Modigliani-Miller’ type of paradigm (or any relaxation of its underpinning assumptions), softens the equivalences above. Yet, with all imperfections, not all people in the markets can be fooled all the times and – once again, assuming full financial integration – a country could not ground its policy framework on the expectation that domestic savers are any more willing than foreigners to accept losses on their public debt holdings, or that investors value the public debt differently if this is expressed in domestic or foreign currency.

The equivalences above do not imply that all countries are subject to the same intertemporal resource constraint. This is, indeed, where country specificities – most notably, their policy credibility and reputation as issuers of liabilities – come into play. Country specificities would be factored into by the markets and determine the ‘elasticity’ of each country’s intertemporal resource constraint and, hence, the latitude of the policy space available to the country under floating rates. This elasticity would ultimately be a function of the markets’ (right or wrong) judgment of the sustainability of the country’s liabilities and their (right or wrong) judgment’s reflection on the market value of the liabilities. The resulting impact on the interest rates carried by the liabilities defines the space available to policymakers for active demand management.

Exchange rate equilibrium: fundamentals vs. speculation

Based on the foregoing arguments, the fundamental equilibrium exchange rate (FEER) of a country under floating becomes endogenous to the market reaction to the country’s policy stance, since its determinants now incorporate the valuation that markets attribute to the country’s domestic and foreign liabilities.

Thus, where a country’s stocks of liabilities are of significant size relative to its real economy, market expectations on the country’s capacity to financially sustain the liabilities do not only determine the deviations of the country’s actual exchange rate from its purchasing power parity (PPP), where such deviations are understood as transitory divergences from the long-term equilibrium of the exchange rate due to speculative phenomena. Market expectations determine the PPP itself.

Take again the same fully financially-integrated and poorly-credible country running a large stock of public debt. Under the equivalences above, all else equal, the country’s equilibrium general price level must be lower than with under a smaller stock of debt. Public debt and policy credibility affect the country’s PPP by a factor that increases with the former and the inverse of the latter. Also, dynamically, if the interest rate on domestic public liabilities bears a credibility premium vis-à-vis the interest rate on foreign assets (say, a risk-free reserve asset), the uncovered interest parity condition would require that domestic expected inflation be proportionately lower than expected foreign inflation. Market expectations determine the evolution of PPP over time.

Importantly, the relevant stocks of liabilities include not only those that are denominated in foreign currency and/or are held by foreign residents; they also include the liabilities that are denominated in the country’s currency and are held by country residents. Even in the hypothetical case that a country’s public debt were entirely held by residents and expressed in the domestic currency, the market valuation of the debt would still be a determinant of the FEER, since the latter would need to reach the level where the economy generates (also through the external sector) the resources needed to finance the fiscal budget and sustain the public debt.


The implications of the above discussion can be summarized as follows:

  • If affected by lack of credibility, there is not much an economy can attain in terms of insulation from shocks and policy independence from adopting floating exchange rates.
  • All countries face an intertemporal budget constraint, irrespective of whether they operate under floating or fixed exchange rates. Generally, a floating rate regime grants policymakers greater flexibility than a fixed rate regime; however, such flexibility varies inversely with the country’s credibility in the perception of financial markets.
  • More specifically, the larger a country’s public liability position (both in domestic and foreign currency), the higher its vulnerability to changes in market expectations and the more binding the intertemporal budget constraint imposed by the markets on its policy choices.
  • Finally, in the case of financially integrated economies suffering from credibility gaps, their vulnerability to changes in market expectations would be high irrespective of whether the liabilities are denominated in a foreign or domestic currency. Faced with a shock, the country would in both cases be exposed to the same risk of sudden stops and capital flights.
  • For these economies, the exchange rate is a ‘veil’ in that markets detect the underlying risks regardless of the existing exchange rate regime and the currency of denomination of the country’s public liabilities. As a consequence, floating rates would not insulate such economies from shocks, nor would they grant greater independence to their policy makers than fixed rates.

[1] In terms of expected losses, a rational investor should be indifferent to the currency in which debt liabilities are held. If the liabilities consist of public debt denominated in a foreign currency, the investors face the risk of the country defaulting on its debt obligations at some point in the future and protect their investments by asking a proportionate risk premium on the debt interest rate. If, on the other hand, the public debt is denominated in the domestic currency, the investors are protected against the risk of default (since the issuer can always monetize the debt); yet they are exposed to the risk of currency depreciation that is associated with the prospects of unbounded monetization. In (ex-ante) equilibrium, the two options must be equivalent from the investors’ standpoint: the expected loss from the risk of debt default (as compensated ex ante by higher interest rate premia) equals the expected loss from debt repayments in a depreciating currency (a form of default of its own).