WEBVTT 00:00:00.000 --> 00:00:01.996 align:middle line:90% [SQUEAKING] 00:00:01.996 --> 00:00:03.992 align:middle line:90% [RUSTLING] 00:00:03.992 --> 00:00:04.990 align:middle line:90% [CLICKING] 00:00:04.990 --> 00:00:16.185 align:middle line:90% 00:00:16.185 --> 00:00:17.810 align:middle line:84% RICARDO J. CABALLERO: So today, my plan 00:00:17.810 --> 00:00:20.760 align:middle line:84% is to finish the open economy part of the course. 00:00:20.760 --> 00:00:23.940 align:middle line:84% And we will talk about exchange rate regimes. 00:00:23.940 --> 00:00:29.180 align:middle line:84% But before I do that, I need to finish a few things that we 00:00:29.180 --> 00:00:31.410 align:middle line:90% didn't in the previous lecture. 00:00:31.410 --> 00:00:32.990 align:middle line:84% And that will help as an introduction 00:00:32.990 --> 00:00:35.480 align:middle line:84% for the kind of things I want to talk about today. 00:00:35.480 --> 00:00:41.990 align:middle line:84% And let me start just reviewing that last slide 00:00:41.990 --> 00:00:45.238 align:middle line:84% that we discussed, which is the Mundell-Fleming model. 00:00:45.238 --> 00:00:47.030 align:middle line:84% And the Mundell-Fleming model, essentially, 00:00:47.030 --> 00:00:51.440 align:middle line:84% is our old IS-LM model, in which the IS a little different 00:00:51.440 --> 00:00:55.100 align:middle line:84% because now we have a net export term, which 00:00:55.100 --> 00:00:59.990 align:middle line:84% is a function of new things like foreign output, foreign income, 00:00:59.990 --> 00:01:04.010 align:middle line:84% and most importantly, the real exchange rate. 00:01:04.010 --> 00:01:07.640 align:middle line:84% And the real exchange rate itself, because of the UIP, 00:01:07.640 --> 00:01:09.230 align:middle line:84% uncovered interest parity condition, 00:01:09.230 --> 00:01:11.660 align:middle line:84% is a function of expected exchange rate, 00:01:11.660 --> 00:01:16.940 align:middle line:90% the foreign interest rate. 00:01:16.940 --> 00:01:19.310 align:middle line:84% And it also gives yet another reason 00:01:19.310 --> 00:01:22.880 align:middle line:84% for why the interest rate affects 00:01:22.880 --> 00:01:25.160 align:middle line:90% domestic aggregate demand. 00:01:25.160 --> 00:01:28.490 align:middle line:84% There's the traditional investment effect 00:01:28.490 --> 00:01:30.350 align:middle line:84% of an increase in interest rate, but we also 00:01:30.350 --> 00:01:34.670 align:middle line:84% get the appreciation effect of an increase in the interest 00:01:34.670 --> 00:01:37.410 align:middle line:84% rate, which is contractionary from the point of view 00:01:37.410 --> 00:01:38.650 align:middle line:90% of aggregate demand. 00:01:38.650 --> 00:01:42.690 align:middle line:84% But this is like that without this extra net export term. 00:01:42.690 --> 00:01:47.700 align:middle line:84% And in this diagram, we have the same interest rate here. 00:01:47.700 --> 00:01:53.280 align:middle line:84% From this diagram, which portrays the uncovered interest 00:01:53.280 --> 00:01:56.310 align:middle line:84% by the condition, we can get, for any given 00:01:56.310 --> 00:01:59.070 align:middle line:84% international interest rate and expected exchange 00:01:59.070 --> 00:02:03.220 align:middle line:84% rate for the next period, we can get the current exchange rate, 00:02:03.220 --> 00:02:03.720 align:middle line:90% OK? 00:02:03.720 --> 00:02:06.510 align:middle line:90% So that was our model. 00:02:06.510 --> 00:02:08.680 align:middle line:84% And we did a few experiments here. 00:02:08.680 --> 00:02:11.850 align:middle line:84% The first one was, well, what happens if the expected exchange 00:02:11.850 --> 00:02:12.930 align:middle line:90% rate goes up? 00:02:12.930 --> 00:02:15.150 align:middle line:84% The first thing is which curves move? 00:02:15.150 --> 00:02:17.680 align:middle line:84% Well, if the expected exchange rate goes up, 00:02:17.680 --> 00:02:21.930 align:middle line:84% then I know that, for any given interest rate, 00:02:21.930 --> 00:02:25.500 align:middle line:84% the current exchange rate will go up, OK? 00:02:25.500 --> 00:02:28.910 align:middle line:84% I know that this curve, in other words, will shift to the right. 00:02:28.910 --> 00:02:30.100 align:middle line:90% Why do I know that? 00:02:30.100 --> 00:02:31.850 align:middle line:84% Well, because if the current exchange rate 00:02:31.850 --> 00:02:34.620 align:middle line:84% doesn't move by the same amount of respect to the exchange rate, 00:02:34.620 --> 00:02:36.170 align:middle line:90% now I'm going to expect-- 00:02:36.170 --> 00:02:38.960 align:middle line:84% I'm going to have expected capital gain or loss, which 00:02:38.960 --> 00:02:42.950 align:middle line:84% will be inconsistent with the previous parity of interest 00:02:42.950 --> 00:02:43.620 align:middle line:90% rate. 00:02:43.620 --> 00:02:48.020 align:middle line:84% So we have agreed that we had certain expected appreciation. 00:02:48.020 --> 00:02:49.425 align:middle line:90% So let's make it very simple. 00:02:49.425 --> 00:02:51.050 align:middle line:84% Suppose that this interest rate happens 00:02:51.050 --> 00:02:53.060 align:middle line:84% to be equal to the international interest rate. 00:02:53.060 --> 00:02:55.430 align:middle line:84% Then we know that this exchange rate has to be equal 00:02:55.430 --> 00:02:57.320 align:middle line:84% to the expected exchange rate because you cannot expect 00:02:57.320 --> 00:02:59.360 align:middle line:84% an appreciation or depreciation of the currency if the interest 00:02:59.360 --> 00:03:00.510 align:middle line:90% rates are the same. 00:03:00.510 --> 00:03:03.810 align:middle line:84% But if now the expected exchange in next period goes up, 00:03:03.810 --> 00:03:05.840 align:middle line:84% and if the exchange rate today doesn't move, 00:03:05.840 --> 00:03:09.380 align:middle line:84% that would mean that you expect also an appreciation 00:03:09.380 --> 00:03:12.448 align:middle line:84% of the currency, and which means that investing in domestic bonds 00:03:12.448 --> 00:03:14.990 align:middle line:84% would give you a higher return because the same interest rate 00:03:14.990 --> 00:03:16.320 align:middle line:90% plus expected appreciation. 00:03:16.320 --> 00:03:18.860 align:middle line:84% So we know that the uncovered interest parity condition 00:03:18.860 --> 00:03:22.070 align:middle line:84% will move to the right as a result of the increase 00:03:22.070 --> 00:03:23.390 align:middle line:90% in expected exchange rate. 00:03:23.390 --> 00:03:25.670 align:middle line:84% But that also means that, at any given interest rate, 00:03:25.670 --> 00:03:27.720 align:middle line:90% you get a higher-- 00:03:27.720 --> 00:03:30.387 align:middle line:84% an appreciated exchange relative to the previous one 00:03:30.387 --> 00:03:32.220 align:middle line:84% before the increase in the expected exchange 00:03:32.220 --> 00:03:36.570 align:middle line:84% rate, which means that the IS will shift to the left. 00:03:36.570 --> 00:03:38.835 align:middle line:84% So if the expected exchange rate goes up, 00:03:38.835 --> 00:03:40.460 align:middle line:84% that leads to an appreciation, and that 00:03:40.460 --> 00:03:44.060 align:middle line:84% leads to contraction in aggregate demand. 00:03:44.060 --> 00:03:46.370 align:middle line:90% OK, good. 00:03:46.370 --> 00:03:48.320 align:middle line:84% Next experiment was, well, what happens 00:03:48.320 --> 00:03:50.100 align:middle line:90% if foreign output comes down? 00:03:50.100 --> 00:03:51.560 align:middle line:84% Well if foreign output comes down, 00:03:51.560 --> 00:03:54.710 align:middle line:84% then this has nothing to do with the interest parity condition. 00:03:54.710 --> 00:03:57.560 align:middle line:84% It's not-- it doesn't show up in this expression. 00:03:57.560 --> 00:03:59.600 align:middle line:84% But it does shift this because it 00:03:59.600 --> 00:04:02.570 align:middle line:84% reduces our exports for any given level of interest rate 00:04:02.570 --> 00:04:03.540 align:middle line:90% and output. 00:04:03.540 --> 00:04:05.283 align:middle line:84% And so the IS shifts to the left. 00:04:05.283 --> 00:04:06.200 align:middle line:90% So that's contraction. 00:04:06.200 --> 00:04:07.850 align:middle line:84% That's the way you import the recession 00:04:07.850 --> 00:04:10.160 align:middle line:90% from the rest of the world, OK? 00:04:10.160 --> 00:04:15.450 align:middle line:84% As I said before, people around Asia and Latin America are very, 00:04:15.450 --> 00:04:17.120 align:middle line:84% very worried about the-- actually, 00:04:17.120 --> 00:04:19.940 align:middle line:84% the Europeans as well because Germany [CHUCKLES] exports a lot 00:04:19.940 --> 00:04:20.750 align:middle line:90% to China-- 00:04:20.750 --> 00:04:22.833 align:middle line:84% are very worried about contractions in China 00:04:22.833 --> 00:04:24.500 align:middle line:84% and so on because, through that channel, 00:04:24.500 --> 00:04:26.430 align:middle line:90% it's contractionary as well. 00:04:26.430 --> 00:04:29.840 align:middle line:84% Now we're in the other part of the cycle 00:04:29.840 --> 00:04:32.120 align:middle line:90% because China is reopening. 00:04:32.120 --> 00:04:35.850 align:middle line:84% And that sort of gives lots of hope to Europe and so on. 00:04:35.850 --> 00:04:38.990 align:middle line:84% And that's one of the reasons why the euro has appreciated vis 00:04:38.990 --> 00:04:40.840 align:middle line:90% a vis the dollar recently. 00:04:40.840 --> 00:04:43.450 align:middle line:90% 00:04:43.450 --> 00:04:46.453 align:middle line:84% And then the last experiment that I don't remember 00:04:46.453 --> 00:04:47.620 align:middle line:90% whether we finished or not-- 00:04:47.620 --> 00:04:49.610 align:middle line:84% I think I said it very quickly-- is, well, 00:04:49.610 --> 00:04:51.360 align:middle line:84% what happens if the international interest 00:04:51.360 --> 00:04:53.400 align:middle line:90% rate goes up? 00:04:53.400 --> 00:04:54.050 align:middle line:90% What moves? 00:04:54.050 --> 00:04:55.925 align:middle line:84% Well, the first thing that will move is this. 00:04:55.925 --> 00:04:57.230 align:middle line:90% This was a parameter, OK? 00:04:57.230 --> 00:04:59.390 align:middle line:90% So what do I know? 00:04:59.390 --> 00:05:01.580 align:middle line:84% That if I keep the interest rate constant, 00:05:01.580 --> 00:05:03.890 align:middle line:84% and the international interest rate went up, 00:05:03.890 --> 00:05:05.450 align:middle line:84% what has to happen to the exchange-- 00:05:05.450 --> 00:05:07.560 align:middle line:84% and expected exchange rate hasn't changed, 00:05:07.560 --> 00:05:09.200 align:middle line:84% what has to happen to the exchange rate 00:05:09.200 --> 00:05:14.880 align:middle line:84% today to be indifferent between the two things, the two bonds? 00:05:14.880 --> 00:05:16.020 align:middle line:90% So this is an experiment. 00:05:16.020 --> 00:05:18.110 align:middle line:84% Suppose you were at any domestic interest rate. 00:05:18.110 --> 00:05:19.310 align:middle line:90% We don't touch that. 00:05:19.310 --> 00:05:22.730 align:middle line:84% Now I increase international interest rate, 00:05:22.730 --> 00:05:26.600 align:middle line:84% and I say expected exchange rate is the same as it used to be. 00:05:26.600 --> 00:05:29.120 align:middle line:84% What has to happen to the current exchange rate 00:05:29.120 --> 00:05:31.790 align:middle line:84% in order to be indifferent between investing in the US 00:05:31.790 --> 00:05:34.868 align:middle line:90% bond or the foreign bond? 00:05:34.868 --> 00:05:36.360 align:middle line:90% AUDIENCE: It has to go down. 00:05:36.360 --> 00:05:36.840 align:middle line:90% RICARDO J. CABALLERO: Exactly. 00:05:36.840 --> 00:05:37.715 align:middle line:90% It has to depreciate. 00:05:37.715 --> 00:05:39.190 align:middle line:90% Why? 00:05:39.190 --> 00:05:42.190 align:middle line:84% AUDIENCE: So that the uncovered interest parity [INAUDIBLE] 00:05:42.190 --> 00:05:43.732 align:middle line:84% RICARDO J. CABALLERO: That's correct, 00:05:43.732 --> 00:05:47.380 align:middle line:84% but why is it that you need the exchange falls today 00:05:47.380 --> 00:05:49.900 align:middle line:90% in order to restore-- 00:05:49.900 --> 00:05:55.270 align:middle line:84% to have the interest parity condition holding? 00:05:55.270 --> 00:05:59.210 align:middle line:84% OK, so remember what happened is that you had the same interest 00:05:59.210 --> 00:05:59.710 align:middle line:90% rate. 00:05:59.710 --> 00:06:02.210 align:middle line:84% And now the international interest rate went up. 00:06:02.210 --> 00:06:04.000 align:middle line:90% That means it's nothing moves. 00:06:04.000 --> 00:06:06.220 align:middle line:84% Now you prefer-- you were indifferent before. 00:06:06.220 --> 00:06:09.280 align:middle line:84% Now you would prefer to invest in the international bond. 00:06:09.280 --> 00:06:12.040 align:middle line:84% If I don't change the US rate, then I 00:06:12.040 --> 00:06:15.160 align:middle line:84% have to compensate you by some other means. 00:06:15.160 --> 00:06:16.772 align:middle line:84% The only way I can compensate you 00:06:16.772 --> 00:06:18.730 align:middle line:84% in this model, the only thing that's endogenous 00:06:18.730 --> 00:06:22.138 align:middle line:84% is by an expected appreciation of the exchange rate 00:06:22.138 --> 00:06:23.680 align:middle line:84% because that would give you a capital 00:06:23.680 --> 00:06:27.970 align:middle line:84% gain from holding the bond, the US bond, a currency capital 00:06:27.970 --> 00:06:28.490 align:middle line:90% gain. 00:06:28.490 --> 00:06:31.450 align:middle line:84% Now, since the expected exchange rate is given, 00:06:31.450 --> 00:06:33.520 align:middle line:84% the only way I can give you that is depreciating 00:06:33.520 --> 00:06:34.450 align:middle line:90% the currency today. 00:06:34.450 --> 00:06:36.640 align:middle line:84% So then you can expect an appreciation tomorrow, 00:06:36.640 --> 00:06:37.880 align:middle line:90% from today to tomorrow. 00:06:37.880 --> 00:06:39.700 align:middle line:90% OK, that's the mechanism. 00:06:39.700 --> 00:06:43.300 align:middle line:84% OK, so that means that this curve here 00:06:43.300 --> 00:06:45.610 align:middle line:90% will shift to the right. 00:06:45.610 --> 00:06:48.340 align:middle line:84% For any given interest rate, you need a-- sorry, to the left. 00:06:48.340 --> 00:06:50.500 align:middle line:84% For any given-- I made that mistake in the previous lecture 00:06:50.500 --> 00:06:51.000 align:middle line:90% as well. 00:06:51.000 --> 00:06:53.950 align:middle line:84% So for any given interest rate, this curve 00:06:53.950 --> 00:06:56.305 align:middle line:84% will have to move to the left, OK? 00:06:56.305 --> 00:06:57.930 align:middle line:84% So if the interest rate doesn't change, 00:06:57.930 --> 00:06:59.513 align:middle line:84% and international interest rate is up, 00:06:59.513 --> 00:07:01.110 align:middle line:84% you need an exchange rate today that 00:07:01.110 --> 00:07:02.530 align:middle line:90% is lower than it used to be. 00:07:02.530 --> 00:07:04.620 align:middle line:84% So you can expect an appreciation from now 00:07:04.620 --> 00:07:07.290 align:middle line:90% to the next period, OK? 00:07:07.290 --> 00:07:08.790 align:middle line:84% So that's when it moves to the left. 00:07:08.790 --> 00:07:09.650 align:middle line:90% Now, what happens? 00:07:09.650 --> 00:07:11.090 align:middle line:90% What else moves in that case? 00:07:11.090 --> 00:07:15.480 align:middle line:90% 00:07:15.480 --> 00:07:20.190 align:middle line:84% I remember when I'm asking the question, what else moves, 00:07:20.190 --> 00:07:22.650 align:middle line:84% I mean, when a curve moves, what you need to do 00:07:22.650 --> 00:07:24.420 align:middle line:84% is just take something as given and then 00:07:24.420 --> 00:07:27.820 align:middle line:84% see whether we get the same equilibrium output or not. 00:07:27.820 --> 00:07:29.610 align:middle line:84% So I'll take an interest rate as given-- 00:07:29.610 --> 00:07:32.310 align:middle line:84% that's the easiest-- and then ask the question, well, 00:07:32.310 --> 00:07:34.548 align:middle line:84% will I get the same equilibrium output or not? 00:07:34.548 --> 00:07:36.090 align:middle line:84% If I get the same equilibrium output, 00:07:36.090 --> 00:07:37.977 align:middle line:90% that means the IS doesn't move. 00:07:37.977 --> 00:07:39.810 align:middle line:84% But if I get a different equilibrium output, 00:07:39.810 --> 00:07:41.880 align:middle line:84% it means the IS has moved because, for the same interest 00:07:41.880 --> 00:07:43.930 align:middle line:84% rate, I'm getting a different equilibrium output. 00:07:43.930 --> 00:07:45.360 align:middle line:90% So what happens in this case? 00:07:45.360 --> 00:07:48.340 align:middle line:90% 00:07:48.340 --> 00:07:51.250 align:middle line:90% Does IS move or not? 00:07:51.250 --> 00:07:52.675 align:middle line:90% When IS star goes up? 00:07:52.675 --> 00:08:05.040 align:middle line:90% 00:08:05.040 --> 00:08:07.515 align:middle line:84% Going to simplify the question-- yes, it does. 00:08:07.515 --> 00:08:08.505 align:middle line:90% [CHUCKLES] Which way? 00:08:08.505 --> 00:08:15.790 align:middle line:90% 00:08:15.790 --> 00:08:19.390 align:middle line:84% Will I get more or less output when the international interest 00:08:19.390 --> 00:08:20.860 align:middle line:90% rate goes up? 00:08:20.860 --> 00:08:23.500 align:middle line:84% And I'm taking-- look the kinds of things I'm taking as given. 00:08:23.500 --> 00:08:26.270 align:middle line:84% I'm also taking as given international output. 00:08:26.270 --> 00:08:29.080 align:middle line:90% So I'm not moving Y star. 00:08:29.080 --> 00:08:33.159 align:middle line:84% I'm not moving expected exchange rate. 00:08:33.159 --> 00:08:37.510 align:middle line:84% And I'm asking the question, if the domestic central bank-- 00:08:37.510 --> 00:08:39.520 align:middle line:84% the Fed, in the case of the US-- does not 00:08:39.520 --> 00:08:42.062 align:middle line:84% change the interest rate, what happens to equilibrium output? 00:08:42.062 --> 00:08:45.240 align:middle line:90% Does it go down or up? 00:08:45.240 --> 00:08:48.000 align:middle line:84% If the international interest rate goes up, 00:08:48.000 --> 00:08:50.160 align:middle line:90% the domestic interest does not. 00:08:50.160 --> 00:08:52.050 align:middle line:84% What has to happen to the exchange rate? 00:08:52.050 --> 00:08:55.390 align:middle line:90% 00:08:55.390 --> 00:08:56.387 align:middle line:90% You answered it before. 00:08:56.387 --> 00:08:57.220 align:middle line:90% AUDIENCE: Goes down. 00:08:57.220 --> 00:08:57.970 align:middle line:84% RICARDO J. CABALLERO: It has to go down. 00:08:57.970 --> 00:08:59.320 align:middle line:90% That means it has to depreciate. 00:08:59.320 --> 00:09:01.300 align:middle line:84% What happened to net exports when 00:09:01.300 --> 00:09:02.710 align:middle line:90% the exchange rate depreciates? 00:09:02.710 --> 00:09:06.520 align:middle line:90% 00:09:06.520 --> 00:09:08.520 align:middle line:84% What does it mean that exchange rate depreciate, 00:09:08.520 --> 00:09:10.270 align:middle line:84% especially if you have the-- in this case, 00:09:10.270 --> 00:09:12.133 align:middle line:84% we have the price is completely fixed. 00:09:12.133 --> 00:09:14.175 align:middle line:84% So now, if the nominal exchange rate depreciates, 00:09:14.175 --> 00:09:16.660 align:middle line:84% it means that the real exchange rate depreciates. 00:09:16.660 --> 00:09:17.790 align:middle line:90% What does that mean? 00:09:17.790 --> 00:09:21.857 align:middle line:90% 00:09:21.857 --> 00:09:22.565 align:middle line:90% What got cheaper? 00:09:22.565 --> 00:09:26.680 align:middle line:90% 00:09:26.680 --> 00:09:28.840 align:middle line:84% OK, you need in order to study for the quiz. 00:09:28.840 --> 00:09:30.400 align:middle line:90% [CHUCKLES] 00:09:30.400 --> 00:09:32.200 align:middle line:90% Domestic goods are cheaper. 00:09:32.200 --> 00:09:34.300 align:middle line:90% So that means that-- 00:09:34.300 --> 00:09:38.050 align:middle line:84% and equivalently, foreign goods got more expensive. 00:09:38.050 --> 00:09:41.020 align:middle line:84% That means, for any given level of domestic interest rate, 00:09:41.020 --> 00:09:43.750 align:middle line:84% now there will be less imports and more exports. 00:09:43.750 --> 00:09:45.680 align:middle line:84% That means net export will be more, 00:09:45.680 --> 00:09:49.015 align:middle line:84% which means the IS will shift to the right, OK? 00:09:49.015 --> 00:09:55.950 align:middle line:90% 00:09:55.950 --> 00:09:56.450 align:middle line:90% Good. 00:09:56.450 --> 00:09:59.407 align:middle line:84% So these things you need to control. 00:09:59.407 --> 00:10:01.490 align:middle line:84% I understand that it's a little confusing to think 00:10:01.490 --> 00:10:02.790 align:middle line:90% about exchange rates and so on. 00:10:02.790 --> 00:10:08.110 align:middle line:90% 00:10:08.110 --> 00:10:10.570 align:middle line:84% So anything that happens here with the exchange rate 00:10:10.570 --> 00:10:12.310 align:middle line:90% is just a relative price. 00:10:12.310 --> 00:10:15.370 align:middle line:84% The more expensive are your goods, 00:10:15.370 --> 00:10:17.860 align:middle line:84% the harder it will be to sell them [CHUCKLES] 00:10:17.860 --> 00:10:21.510 align:middle line:84% and the more tempted you will be to buy foreign goods. 00:10:21.510 --> 00:10:23.080 align:middle line:90% That's what it does. 00:10:23.080 --> 00:10:25.450 align:middle line:84% So that's contraction, appreciation or contraction 00:10:25.450 --> 00:10:26.110 align:middle line:90% here or not. 00:10:26.110 --> 00:10:27.980 align:middle line:84% Here, the story's a little different. 00:10:27.980 --> 00:10:31.280 align:middle line:84% It's all about equalizing expected returns. 00:10:31.280 --> 00:10:34.030 align:middle line:84% So you need to have a movement in the exchange rate today 00:10:34.030 --> 00:10:36.250 align:middle line:84% so that you are always indifferent between investing 00:10:36.250 --> 00:10:37.477 align:middle line:90% in one side or the other. 00:10:37.477 --> 00:10:38.935 align:middle line:84% It's about the return, the expected 00:10:38.935 --> 00:10:41.310 align:middle line:90% exchange in the exchange rate. 00:10:41.310 --> 00:10:42.740 align:middle line:90% So OK, good. 00:10:42.740 --> 00:10:46.370 align:middle line:90% 00:10:46.370 --> 00:10:49.505 align:middle line:84% OK, I got this a little unclear, but [CHUCKLES] 00:10:49.505 --> 00:10:50.255 align:middle line:90% we'll keep trying. 00:10:50.255 --> 00:10:54.130 align:middle line:90% 00:10:54.130 --> 00:10:56.800 align:middle line:84% Is there anything particularly unclear? 00:10:56.800 --> 00:10:58.060 align:middle line:90% Or it's all a blur? 00:10:58.060 --> 00:11:01.470 align:middle line:90% [CHUCKLES] OK, got it. 00:11:01.470 --> 00:11:06.170 align:middle line:90% 00:11:06.170 --> 00:11:09.920 align:middle line:84% Well, let me-- so all of this I describe here 00:11:09.920 --> 00:11:14.680 align:middle line:84% is allowing the exchange rate to move. 00:11:14.680 --> 00:11:19.450 align:middle line:84% We're saying, look, if we move something or the foreigners move 00:11:19.450 --> 00:11:21.350 align:middle line:84% something, then we ask the question, well, 00:11:21.350 --> 00:11:24.820 align:middle line:84% what does the exchange rate has to do today here? 00:11:24.820 --> 00:11:29.530 align:middle line:84% And typically, when that's done, we 00:11:29.530 --> 00:11:32.260 align:middle line:84% call those regimes floating exchange rate 00:11:32.260 --> 00:11:35.560 align:middle line:84% systems, meaning the exchange rate can float, can move around. 00:11:35.560 --> 00:11:38.560 align:middle line:84% As interest rates in different parts of the world change, 00:11:38.560 --> 00:11:41.590 align:middle line:84% then the exchange rate moves around. 00:11:41.590 --> 00:11:43.720 align:middle line:84% We typically call that flexible exchange rate. 00:11:43.720 --> 00:11:46.990 align:middle line:84% I think the distinction is a lot harder to make in practice, 00:11:46.990 --> 00:11:49.810 align:middle line:84% but-- for reasons I'll explain later. 00:11:49.810 --> 00:11:52.930 align:middle line:84% But that's what is meant as a floating exchange rate 00:11:52.930 --> 00:11:56.110 align:middle line:84% system, one in which really you're doing-- 00:11:56.110 --> 00:11:58.780 align:middle line:84% each country is doing its own policies and so on, and exchange 00:11:58.780 --> 00:12:05.040 align:middle line:84% it does what it needs to do so the financial markets clear. 00:12:05.040 --> 00:12:07.080 align:middle line:84% Many countries, however, do something 00:12:07.080 --> 00:12:10.500 align:middle line:84% which is the polar opposite of that, which is called a fixed 00:12:10.500 --> 00:12:12.690 align:middle line:90% exchange rate regime. 00:12:12.690 --> 00:12:16.290 align:middle line:84% So some countries really peg their currencies 00:12:16.290 --> 00:12:18.730 align:middle line:90% to a major currency. 00:12:18.730 --> 00:12:22.450 align:middle line:84% An extreme case is the eurozone, where they gave up 00:12:22.450 --> 00:12:26.270 align:middle line:84% their individual currencies and they have a common currency. 00:12:26.270 --> 00:12:33.370 align:middle line:84% So Germany and Italy have an ultra peg exchange rate 00:12:33.370 --> 00:12:35.320 align:middle line:84% because they have the same currency, OK? 00:12:35.320 --> 00:12:38.410 align:middle line:84% Now, most of the times, fixed exchange rates 00:12:38.410 --> 00:12:41.110 align:middle line:90% are a little weaker than that. 00:12:41.110 --> 00:12:42.730 align:middle line:84% For example, the Hong Kong dollar 00:12:42.730 --> 00:12:44.830 align:middle line:84% has been pegged to the dollar for a long time, 00:12:44.830 --> 00:12:46.990 align:middle line:84% for the US dollar for a long time. 00:12:46.990 --> 00:12:48.580 align:middle line:90% And I'll show you a few others. 00:12:48.580 --> 00:12:50.650 align:middle line:84% Many countries go through some phase 00:12:50.650 --> 00:12:52.660 align:middle line:84% where they tried to peg the currency, 00:12:52.660 --> 00:12:54.820 align:middle line:84% and it typically fails at some point. 00:12:54.820 --> 00:12:58.570 align:middle line:84% But they have periods in which the currency is pegged. 00:12:58.570 --> 00:13:01.720 align:middle line:84% So let me-- suppose that you have a pegged exchange rate. 00:13:01.720 --> 00:13:04.390 align:middle line:84% Let me show you some features of it. 00:13:04.390 --> 00:13:09.010 align:middle line:84% Suppose you are in a peg or a fixed exchange rate regime 00:13:09.010 --> 00:13:10.610 align:middle line:90% pegged to another currency. 00:13:10.610 --> 00:13:12.157 align:middle line:90% And suppose this is credible. 00:13:12.157 --> 00:13:13.990 align:middle line:84% That's a big issue with fixed exchange rate, 00:13:13.990 --> 00:13:14.950 align:middle line:90% but suppose it's credible. 00:13:14.950 --> 00:13:17.367 align:middle line:84% There are some countries that have credible fixed exchange 00:13:17.367 --> 00:13:18.320 align:middle line:90% rates. 00:13:18.320 --> 00:13:21.440 align:middle line:84% Well, if you have a fixed exchange rate with respect 00:13:21.440 --> 00:13:24.690 align:middle line:84% to some other currency, and it's credible, 00:13:24.690 --> 00:13:26.298 align:middle line:84% then you know the expected exchange 00:13:26.298 --> 00:13:28.590 align:middle line:84% rate is equal to exchange rate and equal to a constant. 00:13:28.590 --> 00:13:31.110 align:middle line:84% That's what it means to have a fixed exchange rate, OK? 00:13:31.110 --> 00:13:33.250 align:middle line:90% It's constant. 00:13:33.250 --> 00:13:35.460 align:middle line:84% But if this is constant, means you never 00:13:35.460 --> 00:13:38.660 align:middle line:84% can expect an appreciation or depreciation 00:13:38.660 --> 00:13:39.950 align:middle line:90% because it's constant. 00:13:39.950 --> 00:13:41.420 align:middle line:90% It's fixed. 00:13:41.420 --> 00:13:44.180 align:middle line:84% And if you can't expect an appreciation or depreciation, 00:13:44.180 --> 00:13:48.550 align:middle line:84% then uncovered interest parity condition tells you that-- 00:13:48.550 --> 00:13:50.450 align:middle line:90% what does it tell you? 00:13:50.450 --> 00:13:52.200 align:middle line:84% That your interest rate has to be the same 00:13:52.200 --> 00:13:53.430 align:middle line:90% as the foreign interest rate. 00:13:53.430 --> 00:13:56.220 align:middle line:90% 00:13:56.220 --> 00:13:58.250 align:middle line:90% Why? 00:13:58.250 --> 00:14:02.103 align:middle line:84% What would happen in a credible peg, 00:14:02.103 --> 00:14:04.520 align:middle line:84% in a credible fixed exchange rate if the domestic interest 00:14:04.520 --> 00:14:06.410 align:middle line:84% rate is higher than international-- 00:14:06.410 --> 00:14:10.040 align:middle line:84% than the currency, the interest rate of the country you 00:14:10.040 --> 00:14:12.170 align:middle line:90% are pegging to? 00:14:12.170 --> 00:14:13.080 align:middle line:90% What would happen? 00:14:13.080 --> 00:14:15.300 align:middle line:84% Suppose that-- I mean, a fixed exchange rate, 00:14:15.300 --> 00:14:16.790 align:middle line:84% and we have the same interest rate, 00:14:16.790 --> 00:14:21.290 align:middle line:84% and now, you unilaterally decide to raise interest rates. 00:14:21.290 --> 00:14:24.322 align:middle line:84% What do you think would happen with capital flows? 00:14:24.322 --> 00:14:28.320 align:middle line:84% What would you do to your portfolio? 00:14:28.320 --> 00:14:32.640 align:middle line:84% If the exchange rate is pegged and is credible, 00:14:32.640 --> 00:14:35.610 align:middle line:84% it is as if they were issuing the same currency 00:14:35.610 --> 00:14:36.640 align:middle line:90% because it's the same-- 00:14:36.640 --> 00:14:38.390 align:middle line:84% it's a different currency, different name, 00:14:38.390 --> 00:14:41.040 align:middle line:84% but it has a constant in front of it, OK? 00:14:41.040 --> 00:14:43.620 align:middle line:84% So it's as if it was issued in the same currency. 00:14:43.620 --> 00:14:46.790 align:middle line:84% Two bonds that are identical and issued in the same currency 00:14:46.790 --> 00:14:48.540 align:middle line:84% cannot be paying different interest rates, 00:14:48.540 --> 00:14:53.280 align:middle line:84% because you would all invest all your money in the bond that is 00:14:53.280 --> 00:14:55.550 align:middle line:90% paying a high interest rate. 00:14:55.550 --> 00:14:56.990 align:middle line:90% And that's what happens here. 00:14:56.990 --> 00:14:59.812 align:middle line:84% So it's-- mechanically, what would happen is, 00:14:59.812 --> 00:15:02.270 align:middle line:84% for some crazy reason, a country has a fixed exchange rate, 00:15:02.270 --> 00:15:04.930 align:middle line:84% credible fixed exchange rate decides to have an interest rate 00:15:04.930 --> 00:15:08.830 align:middle line:84% higher than the currency, the interest rate in the currency 00:15:08.830 --> 00:15:12.890 align:middle line:84% it's being pegged to, then you will see massive capital flows 00:15:12.890 --> 00:15:13.650 align:middle line:90% to that country. 00:15:13.650 --> 00:15:16.112 align:middle line:84% So there will be an enormous pressure for an appreciation 00:15:16.112 --> 00:15:16.820 align:middle line:90% of that currency. 00:15:16.820 --> 00:15:19.820 align:middle line:90% 00:15:19.820 --> 00:15:21.830 align:middle line:84% But what the central bank would have to do 00:15:21.830 --> 00:15:24.920 align:middle line:84% is start buying massive amounts of-- 00:15:24.920 --> 00:15:27.110 align:middle line:84% supplying massive amounts of currency 00:15:27.110 --> 00:15:30.320 align:middle line:84% for those that want to buy it because there 00:15:30.320 --> 00:15:33.650 align:middle line:84% would be an infinite demand for that, OK? 00:15:33.650 --> 00:15:36.260 align:middle line:84% So in practice, what that means-- 00:15:36.260 --> 00:15:40.670 align:middle line:84% and sometimes you can do that for a little while, 00:15:40.670 --> 00:15:43.830 align:middle line:90% but not in a sustained manner. 00:15:43.830 --> 00:15:46.790 align:middle line:84% So what happens in practice is that, if you really 00:15:46.790 --> 00:15:51.230 align:middle line:84% have a pegged exchange rate, and you have free capital mobility, 00:15:51.230 --> 00:15:54.950 align:middle line:84% which is people can move in and out of your bonds-- 00:15:54.950 --> 00:15:56.520 align:middle line:90% China doesn't, for example. 00:15:56.520 --> 00:15:58.700 align:middle line:84% So it can allow itself to both control 00:15:58.700 --> 00:16:00.450 align:middle line:90% a little bit the currency and-- 00:16:00.450 --> 00:16:02.960 align:middle line:90% 00:16:02.960 --> 00:16:05.430 align:middle line:90% eh, eh be semi-pegged. 00:16:05.430 --> 00:16:07.430 align:middle line:84% And it still can move its domestic interest rate 00:16:07.430 --> 00:16:09.045 align:middle line:84% because they have capital controls. 00:16:09.045 --> 00:16:10.670 align:middle line:84% But if you don't have capital controls, 00:16:10.670 --> 00:16:12.623 align:middle line:84% and people can move money in and out, 00:16:12.623 --> 00:16:14.540 align:middle line:84% it can do portfolio investment, as it happened 00:16:14.540 --> 00:16:17.130 align:middle line:84% with most of the advanced economies, then, 00:16:17.130 --> 00:16:22.880 align:middle line:84% effectively, you give up domestic monetary policy 00:16:22.880 --> 00:16:25.070 align:middle line:84% because whatever the other country does, 00:16:25.070 --> 00:16:29.960 align:middle line:84% the country you're pegging to does, you have to follow. 00:16:29.960 --> 00:16:30.960 align:middle line:90% So that's what it means. 00:16:30.960 --> 00:16:34.840 align:middle line:84% You peg-- you give up your domestic monetary policy 00:16:34.840 --> 00:16:37.925 align:middle line:84% if you choose to peg to another country. 00:16:37.925 --> 00:16:40.050 align:middle line:84% A little later, I'm going to tell you why countries 00:16:40.050 --> 00:16:41.320 align:middle line:90% may choose to do that. 00:16:41.320 --> 00:16:43.530 align:middle line:90% But that's what you do. 00:16:43.530 --> 00:16:45.450 align:middle line:84% And the uncovered interest parity 00:16:45.450 --> 00:16:47.350 align:middle line:90% tells you that's what you do. 00:16:47.350 --> 00:16:50.010 align:middle line:84% You're not going to be able to deviate very significantly 00:16:50.010 --> 00:16:53.100 align:middle line:84% from the interest rate that the other country's setting 00:16:53.100 --> 00:16:56.410 align:middle line:84% if you want to maintain your fixed exchange rate. 00:16:56.410 --> 00:16:59.760 align:middle line:84% Now, in practice, there are many hybrid regimes. 00:16:59.760 --> 00:17:04.109 align:middle line:84% There are very, very few pure float regimes-- 00:17:04.109 --> 00:17:04.890 align:middle line:90% a few. 00:17:04.890 --> 00:17:08.339 align:middle line:84% I mean, maybe five or something like that. 00:17:08.339 --> 00:17:13.319 align:middle line:84% So there are all sorts of degrees of exchange rate regimes 00:17:13.319 --> 00:17:17.490 align:middle line:84% which are hybrids between fixed exchange rates and fully 00:17:17.490 --> 00:17:19.020 align:middle line:90% flexible exchange rates. 00:17:19.020 --> 00:17:23.109 align:middle line:84% Let me show you just a few randomly-- more or less 00:17:23.109 --> 00:17:25.369 align:middle line:90% randomly selected in Bloomberg. 00:17:25.369 --> 00:17:31.430 align:middle line:84% So there you have in white is the US-euro. 00:17:31.430 --> 00:17:32.440 align:middle line:90% That's a float. 00:17:32.440 --> 00:17:34.450 align:middle line:84% That's a cleanest float you can imagine. 00:17:34.450 --> 00:17:36.760 align:middle line:90% I mean, there is no-- 00:17:36.760 --> 00:17:39.210 align:middle line:84% then another which is a very clean float 00:17:39.210 --> 00:17:43.730 align:middle line:90% is the dollar-yen, Japanese yen. 00:17:43.730 --> 00:17:47.700 align:middle line:84% Now, that's a currency that has that freely float. 00:17:47.700 --> 00:17:49.760 align:middle line:84% But if there is a major dislocation, 00:17:49.760 --> 00:17:52.460 align:middle line:84% central banks do intervene to [INAUDIBLE].. 00:17:52.460 --> 00:17:55.922 align:middle line:84% It means, in normal circumstances, they float. 00:17:55.922 --> 00:17:57.380 align:middle line:84% And the same is true with the euro. 00:17:57.380 --> 00:17:59.840 align:middle line:84% But if there's a big dislocation, some major bank 00:17:59.840 --> 00:18:01.520 align:middle line:84% collapses or something like that, 00:18:01.520 --> 00:18:04.100 align:middle line:84% then there are major dislocations 00:18:04.100 --> 00:18:05.045 align:middle line:90% in financial markets. 00:18:05.045 --> 00:18:06.170 align:middle line:90% They become very segmented. 00:18:06.170 --> 00:18:08.040 align:middle line:84% Arbitrage is not that easy and so on. 00:18:08.040 --> 00:18:10.460 align:middle line:90% Then central banks intervene. 00:18:10.460 --> 00:18:14.520 align:middle line:84% But for the normal business cycle and so on, they do not. 00:18:14.520 --> 00:18:16.620 align:middle line:84% They don't intervene in the currency market. 00:18:16.620 --> 00:18:18.040 align:middle line:90% The intervene in different ways. 00:18:18.040 --> 00:18:18.998 align:middle line:90% And that's the reason-- 00:18:18.998 --> 00:18:20.820 align:middle line:90% I'll get there. 00:18:20.820 --> 00:18:22.780 align:middle line:90% And the other one is the pound. 00:18:22.780 --> 00:18:25.710 align:middle line:84% Now the US dollar versus the British pound, 00:18:25.710 --> 00:18:30.490 align:middle line:90% then it's also as a pure float. 00:18:30.490 --> 00:18:31.750 align:middle line:90% These are also pure float. 00:18:31.750 --> 00:18:37.090 align:middle line:84% This is the US versus the Aussie dollar 00:18:37.090 --> 00:18:44.170 align:middle line:84% and against the Canadian dollar and against the Swedish krona. 00:18:44.170 --> 00:18:47.727 align:middle line:84% Those are pretty floating regimes. 00:18:47.727 --> 00:18:49.810 align:middle line:84% They are a little different from the previous ones 00:18:49.810 --> 00:18:52.540 align:middle line:84% I showed you because these are currencies 00:18:52.540 --> 00:18:56.050 align:middle line:84% that are much more prone to sell off 00:18:56.050 --> 00:18:58.610 align:middle line:90% during risk-off environments. 00:18:58.610 --> 00:19:01.780 align:middle line:84% And that's the reason you see these spikes here, OK? 00:19:01.780 --> 00:19:04.270 align:middle line:90% This was COVID-- biggest spike. 00:19:04.270 --> 00:19:06.952 align:middle line:84% You didn't see it in the dollar-euro 00:19:06.952 --> 00:19:07.910 align:middle line:90% and so on and so forth. 00:19:07.910 --> 00:19:09.868 align:middle line:84% So these are currencies that are free floaters, 00:19:09.868 --> 00:19:13.090 align:middle line:84% but they're very exposed to risk, the risk 00:19:13.090 --> 00:19:14.410 align:middle line:90% environment in the market. 00:19:14.410 --> 00:19:15.952 align:middle line:84% But it's still they're free floaters. 00:19:15.952 --> 00:19:18.920 align:middle line:90% 00:19:18.920 --> 00:19:21.642 align:middle line:84% The Swedes are a little bit more independent-minded. 00:19:21.642 --> 00:19:23.600 align:middle line:84% But they do control a bit more of the currency. 00:19:23.600 --> 00:19:29.890 align:middle line:84% But still, I consider those free floaters. 00:19:29.890 --> 00:19:32.090 align:middle line:84% These are currencies that are a little different. 00:19:32.090 --> 00:19:35.350 align:middle line:90% This is the Brazilian real. 00:19:35.350 --> 00:19:38.410 align:middle line:84% The ZAR is the South African Rand. 00:19:38.410 --> 00:19:42.040 align:middle line:90% And this is the Colombian peso. 00:19:42.040 --> 00:19:43.630 align:middle line:90% And you see several things here. 00:19:43.630 --> 00:19:47.200 align:middle line:84% They do move, so they have a big component of flexible exchange 00:19:47.200 --> 00:19:49.710 align:middle line:90% rates. 00:19:49.710 --> 00:19:52.690 align:middle line:84% They do intervene a lot more, though, 00:19:52.690 --> 00:19:56.530 align:middle line:84% because they are exposed to much more risk-off type environments 00:19:56.530 --> 00:19:58.980 align:middle line:84% and so on and they need to intervene fairly frequently 00:19:58.980 --> 00:20:01.510 align:middle line:84% to control movements in the exchange rate. 00:20:01.510 --> 00:20:05.580 align:middle line:84% But you also see a trend in these things. 00:20:05.580 --> 00:20:09.720 align:middle line:84% So their currencies are becoming chronically weaker relative 00:20:09.720 --> 00:20:12.010 align:middle line:90% to the dollar. 00:20:12.010 --> 00:20:15.520 align:middle line:84% And the reason for that is because there are countries 00:20:15.520 --> 00:20:17.082 align:middle line:90% that have higher inflation. 00:20:17.082 --> 00:20:19.540 align:middle line:84% So if you want to maintain the real exchange rate constant, 00:20:19.540 --> 00:20:21.790 align:middle line:84% and you have higher inflation than the other country, 00:20:21.790 --> 00:20:25.740 align:middle line:84% then your nominal exchange rate has to be depreciated, 00:20:25.740 --> 00:20:27.490 align:middle line:84% because your prices are rising at a faster 00:20:27.490 --> 00:20:28.840 align:middle line:90% pace than the other one. 00:20:28.840 --> 00:20:33.137 align:middle line:84% Well, if the exchange rate was not appreciating on-- 00:20:33.137 --> 00:20:34.720 align:middle line:84% depreciating on average, then it would 00:20:34.720 --> 00:20:37.270 align:middle line:84% mean that you were becoming more and more expensive, OK? 00:20:37.270 --> 00:20:39.910 align:middle line:84% So that's the reason countries that have higher inflation, 00:20:39.910 --> 00:20:43.360 align:middle line:84% they tend to have these trends as well, OK? 00:20:43.360 --> 00:20:45.490 align:middle line:90% But it's still fairly floating. 00:20:45.490 --> 00:20:54.310 align:middle line:84% Here, these are all currencies that are, to a different degree, 00:20:54.310 --> 00:20:56.080 align:middle line:84% targeted, in the sense that they're 00:20:56.080 --> 00:21:00.820 align:middle line:84% contained in terms of they're not free to float at will. 00:21:00.820 --> 00:21:02.920 align:middle line:90% The scale here will mislead you. 00:21:02.920 --> 00:21:04.630 align:middle line:84% If I had put it in the same scale 00:21:04.630 --> 00:21:07.420 align:middle line:84% as the euro-dollar or the euro-yen 00:21:07.420 --> 00:21:10.540 align:middle line:84% and the dollar-yen or the euro-yen as well, 00:21:10.540 --> 00:21:14.210 align:middle line:84% then these things would have been-- looked very small, OK? 00:21:14.210 --> 00:21:16.150 align:middle line:84% So I should have put a real floater there 00:21:16.150 --> 00:21:17.900 align:middle line:84% so you would have seen that these guys are 00:21:17.900 --> 00:21:18.668 align:middle line:90% moving a lot less. 00:21:18.668 --> 00:21:20.460 align:middle line:84% And these are different kinds of countries. 00:21:20.460 --> 00:21:24.870 align:middle line:84% This is the Hong Kong dollar that, for all practical purpose, 00:21:24.870 --> 00:21:26.100 align:middle line:90% is pegged. 00:21:26.100 --> 00:21:28.680 align:middle line:84% This little wiggles is just technical things that happen 00:21:28.680 --> 00:21:30.270 align:middle line:90% overnight and stuff like that. 00:21:30.270 --> 00:21:33.000 align:middle line:84% But they're pegged to the dollar, OK? 00:21:33.000 --> 00:21:35.810 align:middle line:84% So the Hong Kong dollar is pegged to the dollar. 00:21:35.810 --> 00:21:40.030 align:middle line:84% And that means they really don't have independent monetary policy 00:21:40.030 --> 00:21:43.920 align:middle line:84% relative to the US, vis a vis the US. 00:21:43.920 --> 00:21:44.950 align:middle line:90% This is the CNH. 00:21:44.950 --> 00:21:50.710 align:middle line:90% This is the Chinese renmimbi. 00:21:50.710 --> 00:21:52.570 align:middle line:90% And it's a currency. 00:21:52.570 --> 00:21:55.630 align:middle line:84% Again, I should have put it with a real floater there. 00:21:55.630 --> 00:21:57.790 align:middle line:90% It's a lot more controlled. 00:21:57.790 --> 00:22:02.550 align:middle line:84% So it moves around, but in a much tighter range. 00:22:02.550 --> 00:22:04.390 align:middle line:84% And they are thinking about exchange rate. 00:22:04.390 --> 00:22:06.820 align:middle line:84% When part of their policy programs and so on, 00:22:06.820 --> 00:22:11.090 align:middle line:84% the exchange rate is something they are thinking about. 00:22:11.090 --> 00:22:13.895 align:middle line:84% This one here, the blue one, is an interesting one. 00:22:13.895 --> 00:22:17.970 align:middle line:90% 00:22:17.970 --> 00:22:22.170 align:middle line:90% That's the Singaporean dollar. 00:22:22.170 --> 00:22:25.770 align:middle line:84% And the Singaporean dollar, they have a very interesting regime. 00:22:25.770 --> 00:22:31.830 align:middle line:84% They have a target zone, meaning they let the exchange rate 00:22:31.830 --> 00:22:34.440 align:middle line:90% move within a range only. 00:22:34.440 --> 00:22:37.650 align:middle line:84% But it's not pegged against a single currency. 00:22:37.650 --> 00:22:41.760 align:middle line:84% It's pegged against a basket of currencies. 00:22:41.760 --> 00:22:44.190 align:middle line:90% And the recipe is secret. 00:22:44.190 --> 00:22:47.845 align:middle line:84% So everyone is always guessing what they're doing and so on. 00:22:47.845 --> 00:22:49.470 align:middle line:84% They do change the weights a little bit 00:22:49.470 --> 00:22:50.910 align:middle line:90% to keep the markets confused. 00:22:50.910 --> 00:22:53.550 align:middle line:90% But the currency is very stable. 00:22:53.550 --> 00:22:56.430 align:middle line:84% We all understand it's a weighted average of the euro, 00:22:56.430 --> 00:22:58.380 align:middle line:90% the renminbi, and the dollar. 00:22:58.380 --> 00:23:00.930 align:middle line:84% But they don't disclose exactly the thing. 00:23:00.930 --> 00:23:03.840 align:middle line:84% But you can filter out what they're doing. 00:23:03.840 --> 00:23:07.530 align:middle line:84% And they keep things in a range, and they occasionally 00:23:07.530 --> 00:23:09.480 align:middle line:90% change the slope of that range. 00:23:09.480 --> 00:23:12.370 align:middle line:84% But it's very regulated in that constraint. 00:23:12.370 --> 00:23:14.850 align:middle line:84% And in fact, they state their monetary policy 00:23:14.850 --> 00:23:16.350 align:middle line:90% in terms of the effects. 00:23:16.350 --> 00:23:18.300 align:middle line:90% They said, that's our policy. 00:23:18.300 --> 00:23:20.770 align:middle line:84% Interest rate is whatever it needs to be, 00:23:20.770 --> 00:23:22.620 align:middle line:84% so the exchange rate remains in that range. 00:23:22.620 --> 00:23:24.930 align:middle line:84% That's the way they state the monetary policy. 00:23:24.930 --> 00:23:26.668 align:middle line:90% They don't even think about-- 00:23:26.668 --> 00:23:28.710 align:middle line:84% so I let the markets determine the interest rate. 00:23:28.710 --> 00:23:31.445 align:middle line:84% We determine the exchange rate here in that range, 00:23:31.445 --> 00:23:32.445 align:middle line:90% and it's a narrow range. 00:23:32.445 --> 00:23:35.270 align:middle line:90% 00:23:35.270 --> 00:23:40.940 align:middle line:84% Again, I should have put a real floater 00:23:40.940 --> 00:23:42.240 align:middle line:90% that you would have seen that. 00:23:42.240 --> 00:23:46.400 align:middle line:84% OK, so the point is that everything goes. 00:23:46.400 --> 00:23:48.290 align:middle line:84% There are all sorts of arrangements 00:23:48.290 --> 00:23:50.600 align:middle line:90% happening around the world. 00:23:50.600 --> 00:23:53.560 align:middle line:84% These are different kind of currencies, no? 00:23:53.560 --> 00:24:03.875 align:middle line:84% This is the Turkish lira and the Argentinian peso. 00:24:03.875 --> 00:24:06.250 align:middle line:84% I think, through this sample, this has been called pesos. 00:24:06.250 --> 00:24:07.960 align:middle line:84% Since they have this very high inflation, 00:24:07.960 --> 00:24:10.043 align:middle line:84% they keep changing the name of the currency and so 00:24:10.043 --> 00:24:13.398 align:middle line:84% on because you have to remove zeros from things. 00:24:13.398 --> 00:24:14.940 align:middle line:84% But I think, through all that period, 00:24:14.940 --> 00:24:17.920 align:middle line:84% this is still the Argentinian peso. 00:24:17.920 --> 00:24:20.350 align:middle line:84% So I mean, look at the scale, though. 00:24:20.350 --> 00:24:25.430 align:middle line:84% [LAUGHS] So you cannot see it, but all-- 00:24:25.430 --> 00:24:27.890 align:middle line:84% these two countries are all the time 00:24:27.890 --> 00:24:29.640 align:middle line:84% fighting against the exchange rate. 00:24:29.640 --> 00:24:32.180 align:middle line:84% In fact, Argentina today has, like, five different exchange 00:24:32.180 --> 00:24:32.900 align:middle line:90% rates. 00:24:32.900 --> 00:24:34.760 align:middle line:84% There is the official exchange rate. 00:24:34.760 --> 00:24:36.193 align:middle line:90% There is the blue exchange rate. 00:24:36.193 --> 00:24:37.610 align:middle line:84% There is the purple exchange rate. 00:24:37.610 --> 00:24:38.900 align:middle line:90% There are all sorts of things. 00:24:38.900 --> 00:24:40.820 align:middle line:84% You should never pay with a credit card 00:24:40.820 --> 00:24:42.680 align:middle line:84% if you go to Argentina if you do tourism, 00:24:42.680 --> 00:24:45.080 align:middle line:84% because you don't want to pay the official exchange rate. 00:24:45.080 --> 00:24:48.680 align:middle line:84% You can get three times that in the blue market. 00:24:48.680 --> 00:24:50.180 align:middle line:84% They don't call it the black market. 00:24:50.180 --> 00:24:53.510 align:middle line:84% Since everyone does it, they think blue is fine. 00:24:53.510 --> 00:24:56.840 align:middle line:84% So there are all sorts of exchanges. 00:24:56.840 --> 00:24:58.760 align:middle line:84% But still this is the official one. 00:24:58.760 --> 00:25:00.320 align:middle line:84% And even the official one you see 00:25:00.320 --> 00:25:03.100 align:middle line:90% sort of as completely exploded. 00:25:03.100 --> 00:25:05.080 align:middle line:84% The Turkish lira looks pretty good 00:25:05.080 --> 00:25:07.840 align:middle line:84% here just because I put it next to the Argentinian peso. 00:25:07.840 --> 00:25:10.600 align:middle line:84% Otherwise, it also would look pretty bad. 00:25:10.600 --> 00:25:12.730 align:middle line:84% But most of these countries are all the time 00:25:12.730 --> 00:25:14.440 align:middle line:84% paying the exchange rate because they use 00:25:14.440 --> 00:25:16.360 align:middle line:90% that to stabilize inflation. 00:25:16.360 --> 00:25:17.650 align:middle line:90% The whole thing breaks up. 00:25:17.650 --> 00:25:19.957 align:middle line:84% And then, boom, they go through big spikes. 00:25:19.957 --> 00:25:21.040 align:middle line:90% You see this, for example. 00:25:21.040 --> 00:25:22.665 align:middle line:84% They're trying to stabilize-- there you 00:25:22.665 --> 00:25:25.020 align:middle line:84% see that they're trying to stabilize the currency. 00:25:25.020 --> 00:25:28.560 align:middle line:84% They're not floating there, that range. 00:25:28.560 --> 00:25:31.520 align:middle line:84% They were a little successful and [WHISTLES] 00:25:31.520 --> 00:25:36.000 align:middle line:84% And that happens all the time today. 00:25:36.000 --> 00:25:38.070 align:middle line:90% And now, obviously-- 00:25:38.070 --> 00:25:40.720 align:middle line:84% I mean, look at the size of this. 00:25:40.720 --> 00:25:42.530 align:middle line:84% This is an appreciation of the dollar, 00:25:42.530 --> 00:25:44.715 align:middle line:84% so it's a depreciation of the Argentinian peso. 00:25:44.715 --> 00:25:46.215 align:middle line:84% What do you think is happening here? 00:25:46.215 --> 00:25:49.400 align:middle line:90% 00:25:49.400 --> 00:25:51.265 align:middle line:84% It looks very smooth, by the way. 00:25:51.265 --> 00:25:52.640 align:middle line:84% It's not that it's moving around. 00:25:52.640 --> 00:25:56.740 align:middle line:84% It's just [WHISTLES] What do you think is happening. 00:25:56.740 --> 00:26:01.560 align:middle line:90% 00:26:01.560 --> 00:26:04.650 align:middle line:84% Very high inflation, in the thousands. 00:26:04.650 --> 00:26:06.750 align:middle line:84% And that's what is happening here. 00:26:06.750 --> 00:26:08.700 align:middle line:84% But again, this is a hybrid system. 00:26:08.700 --> 00:26:11.760 align:middle line:84% They try to stabilize frequently the exchange rate. 00:26:11.760 --> 00:26:14.643 align:middle line:84% The thing goes, and then they stabilize it again and so 00:26:14.643 --> 00:26:15.310 align:middle line:90% on and so forth. 00:26:15.310 --> 00:26:18.165 align:middle line:84% But you can't fight just having much higher inflation 00:26:18.165 --> 00:26:19.290 align:middle line:90% than the rest of the world. 00:26:19.290 --> 00:26:20.917 align:middle line:84% You have higher inflation, then there's 00:26:20.917 --> 00:26:23.250 align:middle line:84% no way around that your currency is going to depreciate. 00:26:23.250 --> 00:26:27.200 align:middle line:90% They try to, but they can't. 00:26:27.200 --> 00:26:33.050 align:middle line:84% Anyways, so let me go back to this model 00:26:33.050 --> 00:26:36.080 align:middle line:84% and think a little bit more about the decision 00:26:36.080 --> 00:26:39.650 align:middle line:84% to have one kind of exchange or the other one 00:26:39.650 --> 00:26:42.400 align:middle line:84% and therefore everything that goes in between. 00:26:42.400 --> 00:26:45.195 align:middle line:84% So remember, just to remind you, that that's the model we have. 00:26:45.195 --> 00:26:47.920 align:middle line:90% 00:26:47.920 --> 00:26:49.840 align:middle line:84% So let me think about policy first, 00:26:49.840 --> 00:26:53.110 align:middle line:84% and then let's think how do you deal 00:26:53.110 --> 00:26:55.360 align:middle line:84% with policy in the different exchange rate regimes. 00:26:55.360 --> 00:26:57.250 align:middle line:84% And then we'll see why would countries 00:26:57.250 --> 00:26:59.400 align:middle line:84% would want one thing or the other. 00:26:59.400 --> 00:27:01.070 align:middle line:84% So suppose a country is in a recession. 00:27:01.070 --> 00:27:02.790 align:middle line:90% We're in this model. 00:27:02.790 --> 00:27:07.930 align:middle line:84% And suppose that we are in the flexible exchange rate regime. 00:27:07.930 --> 00:27:10.950 align:middle line:84% So what should the fiscal policy do? 00:27:10.950 --> 00:27:13.130 align:middle line:90% Suppose you are in a recession. 00:27:13.130 --> 00:27:15.590 align:middle line:90% What should fiscal policy do? 00:27:15.590 --> 00:27:18.880 align:middle line:90% 00:27:18.880 --> 00:27:21.730 align:middle line:84% There's nothing unique of closed economy here-- 00:27:21.730 --> 00:27:23.402 align:middle line:90% in open economy. 00:27:23.402 --> 00:27:25.860 align:middle line:84% In closed economy, you would have given me the same answer. 00:27:25.860 --> 00:27:29.760 align:middle line:84% If you are in a recession, what will you do with fiscal policy? 00:27:29.760 --> 00:27:32.310 align:middle line:84% Have expansionary fiscal policy, increase [INAUDIBLE].. 00:27:32.310 --> 00:27:35.130 align:middle line:84% So that means you move the IS to the right. 00:27:35.130 --> 00:27:36.900 align:middle line:84% Nothing changes in the open economy. 00:27:36.900 --> 00:27:38.583 align:middle line:90% You keep doing that. 00:27:38.583 --> 00:27:41.000 align:middle line:84% The only thing that you get is a little smaller multiplier 00:27:41.000 --> 00:27:43.760 align:middle line:84% because part of that will go to imports. 00:27:43.760 --> 00:27:47.000 align:middle line:84% But still, it moves you in the right direction, OK? 00:27:47.000 --> 00:27:50.540 align:middle line:84% And yes, and countries rely on other countries doing also 00:27:50.540 --> 00:27:52.250 align:middle line:84% their own expansionary fiscal policy. 00:27:52.250 --> 00:27:54.250 align:middle line:84% But suppose we're talking about a recession that 00:27:54.250 --> 00:27:55.440 align:middle line:90% is unique to this country. 00:27:55.440 --> 00:27:58.980 align:middle line:84% Then you're going to do an expansionary fiscal policy. 00:27:58.980 --> 00:28:02.860 align:middle line:90% What would the central bank do? 00:28:02.860 --> 00:28:04.640 align:middle line:90% In closed economy? 00:28:04.640 --> 00:28:05.300 align:middle line:90% What-- 00:28:05.300 --> 00:28:06.300 align:middle line:90% AUDIENCE: Drop interest rates. 00:28:06.300 --> 00:28:08.008 align:middle line:84% RICARDO J. CABALLERO: Drop interest rate. 00:28:08.008 --> 00:28:10.330 align:middle line:84% Well, in open economy, it does the same. 00:28:10.330 --> 00:28:11.940 align:middle line:90% You just drop the interest rate. 00:28:11.940 --> 00:28:13.770 align:middle line:84% It turns out that will depreciate 00:28:13.770 --> 00:28:18.280 align:middle line:84% your currency, which will help you, [CHUCKLES] as well. 00:28:18.280 --> 00:28:20.340 align:middle line:84% So it's very expansionary because of that, 00:28:20.340 --> 00:28:22.590 align:middle line:84% because your currency depreciates, so net export 00:28:22.590 --> 00:28:24.190 align:middle line:90% goes up as a result of that. 00:28:24.190 --> 00:28:26.070 align:middle line:90% So you get the investment kick. 00:28:26.070 --> 00:28:28.740 align:middle line:84% You lose a little bit because part of it goes to imports. 00:28:28.740 --> 00:28:31.770 align:middle line:84% But then you also get the effect of net exports 00:28:31.770 --> 00:28:33.510 align:middle line:84% that comes from the exchange rate, OK? 00:28:33.510 --> 00:28:37.080 align:middle line:84% So monetary policy is a great policy in open economy 00:28:37.080 --> 00:28:40.210 align:middle line:84% because it gets reinforced by the exchange rate. 00:28:40.210 --> 00:28:41.590 align:middle line:90% It's even better than fiscal-- 00:28:41.590 --> 00:28:44.116 align:middle line:84% other things equal, when you compare the two. 00:28:44.116 --> 00:28:47.650 align:middle line:84% The two policies lose power relative to the closed economy 00:28:47.650 --> 00:28:49.640 align:middle line:84% because the multiplier is smaller. 00:28:49.640 --> 00:28:52.275 align:middle line:84% But the difference is that the interest rate policy 00:28:52.275 --> 00:28:54.400 align:middle line:84% gets an extra kick that comes from the depreciation 00:28:54.400 --> 00:28:55.910 align:middle line:90% of the currency. 00:28:55.910 --> 00:28:57.145 align:middle line:90% So it's a very powerful tool. 00:28:57.145 --> 00:29:02.180 align:middle line:90% 00:29:02.180 --> 00:29:07.190 align:middle line:84% So that's what you do if you have a flexible exchange rate. 00:29:07.190 --> 00:29:09.630 align:middle line:84% And that's what countries do in practice 00:29:09.630 --> 00:29:11.800 align:middle line:90% when they are free-floaters. 00:29:11.800 --> 00:29:13.810 align:middle line:84% Suppose you have a fixed exchange rate regime. 00:29:13.810 --> 00:29:16.740 align:middle line:90% 00:29:16.740 --> 00:29:19.280 align:middle line:84% And it's a credible fixed exchange rate regime. 00:29:19.280 --> 00:29:23.110 align:middle line:84% Then I asked you, again, the question, 00:29:23.110 --> 00:29:25.645 align:middle line:84% what kind of fiscal policy would you run in that country? 00:29:25.645 --> 00:29:29.310 align:middle line:90% 00:29:29.310 --> 00:29:31.020 align:middle line:90% The same, expansionary. 00:29:31.020 --> 00:29:32.100 align:middle line:90% That's what you would do. 00:29:32.100 --> 00:29:35.310 align:middle line:84% And it's effective, as it was in closed economy, 00:29:35.310 --> 00:29:37.560 align:middle line:84% a little less because the multiplier is a little less. 00:29:37.560 --> 00:29:38.430 align:middle line:90% That's it. 00:29:38.430 --> 00:29:40.840 align:middle line:84% But no difference in the analysis. 00:29:40.840 --> 00:29:44.370 align:middle line:84% In fact, fiscal policy has exactly the same effect 00:29:44.370 --> 00:29:47.045 align:middle line:84% as fiscal policy in the flexible exchanges in this case 00:29:47.045 --> 00:29:49.170 align:middle line:84% because I haven't moved the exchanges in any event, 00:29:49.170 --> 00:29:52.300 align:middle line:90% in either of the two cases. 00:29:52.300 --> 00:29:54.130 align:middle line:90% What should the central bank do? 00:29:54.130 --> 00:29:58.180 align:middle line:90% 00:29:58.180 --> 00:30:00.949 align:middle line:90% That's a trickier question. 00:30:00.949 --> 00:30:02.574 align:middle line:84% AUDIENCE: If there's a [INAUDIBLE] does 00:30:02.574 --> 00:30:05.273 align:middle line:84% central bank know naturally what the foreign country's doing? 00:30:05.273 --> 00:30:07.190 align:middle line:84% RICARDO J. CABALLERO: Yes, central bank knows. 00:30:07.190 --> 00:30:08.420 align:middle line:90% So it will have too much. 00:30:08.420 --> 00:30:09.810 align:middle line:90% Yeah, exactly. 00:30:09.810 --> 00:30:11.557 align:middle line:84% So the central bank cannot do anything. 00:30:11.557 --> 00:30:13.640 align:middle line:84% I'm saying suppose it is an [INAUDIBLE] recession. 00:30:13.640 --> 00:30:15.640 align:middle line:90% This country's in recession. 00:30:15.640 --> 00:30:19.600 align:middle line:84% Now it wants to use his policy tools to deal with that. 00:30:19.600 --> 00:30:23.020 align:middle line:84% It has fiscal, but it doesn't have monetary policy. 00:30:23.020 --> 00:30:26.345 align:middle line:84% Unless the cycle of the other country coincides with 00:30:26.345 --> 00:30:28.720 align:middle line:84% your cycle-- so it's a global recession or something like 00:30:28.720 --> 00:30:29.910 align:middle line:90% that-- 00:30:29.910 --> 00:30:31.660 align:middle line:84% then you're doomed because other country's 00:30:31.660 --> 00:30:34.118 align:middle line:84% doing the monetary policy for what they're doing, what they 00:30:34.118 --> 00:30:35.530 align:middle line:90% need, not for what you need. 00:30:35.530 --> 00:30:37.670 align:middle line:84% And therefore, you don't have monetary policy. 00:30:37.670 --> 00:30:40.240 align:middle line:84% So that's a costly thing of a fixed exchange rate. 00:30:40.240 --> 00:30:43.030 align:middle line:84% We already said, but now we're making it very concrete, 00:30:43.030 --> 00:30:46.090 align:middle line:84% because we are in a recession, and you realize now 00:30:46.090 --> 00:30:48.850 align:middle line:84% that you don't have a tool that you had before. 00:30:48.850 --> 00:30:54.280 align:middle line:84% So that's a cost of a fixed exchange rate. 00:30:54.280 --> 00:30:55.570 align:middle line:90% Here is an example. 00:30:55.570 --> 00:31:01.000 align:middle line:84% Here, what I'm plotting is the policy rate in the US. 00:31:01.000 --> 00:31:02.680 align:middle line:90% That's the blue one. 00:31:02.680 --> 00:31:04.780 align:middle line:84% And that's the policy rate in Hong Kong. 00:31:04.780 --> 00:31:06.730 align:middle line:84% Very small difference, but you can see that-- 00:31:06.730 --> 00:31:08.170 align:middle line:90% these are technical things. 00:31:08.170 --> 00:31:09.820 align:middle line:84% But you can see that Hong Kong has 00:31:09.820 --> 00:31:11.770 align:middle line:90% to follow the US, essentially. 00:31:11.770 --> 00:31:14.430 align:middle line:90% It's exactly the same shape. 00:31:14.430 --> 00:31:19.310 align:middle line:84% So Hong Kong doesn't have independent monetary policy, OK? 00:31:19.310 --> 00:31:22.520 align:middle line:84% Again, those are technical gaps and not really-- 00:31:22.520 --> 00:31:23.640 align:middle line:90% just look at the shape. 00:31:23.640 --> 00:31:25.760 align:middle line:84% It's exactly the same, not moving around. 00:31:25.760 --> 00:31:30.170 align:middle line:84% So Hong Kong doesn't have monetary policy, period. 00:31:30.170 --> 00:31:31.280 align:middle line:90% Not something they have. 00:31:31.280 --> 00:31:33.770 align:middle line:84% If they get a recession that has to do with their own cycle 00:31:33.770 --> 00:31:35.720 align:middle line:84% and that is not a result of something that 00:31:35.720 --> 00:31:38.690 align:middle line:84% is happening in the US, they don't have the tool 00:31:38.690 --> 00:31:41.710 align:middle line:90% to deal with that. 00:31:41.710 --> 00:31:44.740 align:middle line:84% Of course, during COVID, and during the global financial 00:31:44.740 --> 00:31:46.300 align:middle line:90% crisis, they were aligned. 00:31:46.300 --> 00:31:49.080 align:middle line:84% So they [CHUCKLES] would have moved in the same direction. 00:31:49.080 --> 00:31:50.150 align:middle line:90% That worked. 00:31:50.150 --> 00:31:53.050 align:middle line:84% But if there is a shock that is Chinese-centric 00:31:53.050 --> 00:31:56.230 align:middle line:84% that is affecting Hong Kong, the US monetary policy 00:31:56.230 --> 00:31:58.270 align:middle line:90% is not going to react to that. 00:31:58.270 --> 00:32:02.030 align:middle line:84% And that that's a problem for Hong Kong. 00:32:02.030 --> 00:32:03.490 align:middle line:90% Still, they choose to do it. 00:32:03.490 --> 00:32:06.170 align:middle line:90% A good question is, why? 00:32:06.170 --> 00:32:07.548 align:middle line:90% Always there is politics. 00:32:07.548 --> 00:32:09.090 align:middle line:84% There is more than the kind of thing. 00:32:09.090 --> 00:32:10.632 align:middle line:84% But there are also economic arguments 00:32:10.632 --> 00:32:13.930 align:middle line:84% for why you may want to do these things. 00:32:13.930 --> 00:32:16.500 align:middle line:84% Another situation that I mentioned 00:32:16.500 --> 00:32:19.240 align:middle line:84% happens all the time, every other day in Argentina, 00:32:19.240 --> 00:32:22.010 align:middle line:84% for example, is speculative attacks on the currency. 00:32:22.010 --> 00:32:23.760 align:middle line:84% So you want to have a fixed exchange rate, 00:32:23.760 --> 00:32:25.260 align:middle line:84% but the markets don't believe you, 00:32:25.260 --> 00:32:29.280 align:middle line:84% that you're going to be able to keep it there. 00:32:29.280 --> 00:32:30.700 align:middle line:90% And so what happens? 00:32:30.700 --> 00:32:31.950 align:middle line:90% So look at this equation here. 00:32:31.950 --> 00:32:35.730 align:middle line:84% Suppose that you have a fixed exchange rate, 00:32:35.730 --> 00:32:37.230 align:middle line:84% but now the market thinks you're not 00:32:37.230 --> 00:32:40.090 align:middle line:90% going to be able to sustain it. 00:32:40.090 --> 00:32:43.870 align:middle line:84% So that means suppose that this guy starts going down. 00:32:43.870 --> 00:32:47.320 align:middle line:84% This happens, again, in Argentina, every other day-- 00:32:47.320 --> 00:32:49.113 align:middle line:84% probably today, every single day. 00:32:49.113 --> 00:32:51.530 align:middle line:84% They want to say that they want [INAUDIBLE] exchange rate, 00:32:51.530 --> 00:32:52.947 align:middle line:84% but the markets don't believe you. 00:32:52.947 --> 00:32:54.940 align:middle line:84% And they expect your currency to lose value 00:32:54.940 --> 00:32:58.430 align:middle line:84% in the next few hours, in the case of Argentina. 00:32:58.430 --> 00:33:00.561 align:middle line:90% So this guy is going down. 00:33:00.561 --> 00:33:02.870 align:middle line:90% [WHISTLES] 00:33:02.870 --> 00:33:05.670 align:middle line:84% What happens to the current exchange rate? 00:33:05.670 --> 00:33:09.120 align:middle line:90% So expected exchange goes down. 00:33:09.120 --> 00:33:10.745 align:middle line:84% Everyone expects your currency to drop. 00:33:10.745 --> 00:33:13.490 align:middle line:90% 00:33:13.490 --> 00:33:17.630 align:middle line:84% What will tend to happen to the currency 00:33:17.630 --> 00:33:19.745 align:middle line:84% today, to the Argentinian peso today? 00:33:19.745 --> 00:33:22.560 align:middle line:90% 00:33:22.560 --> 00:33:23.560 align:middle line:90% AUDIENCE: It also drops. 00:33:23.560 --> 00:33:24.852 align:middle line:90% RICARDO J. CABALLERO: It drops. 00:33:24.852 --> 00:33:28.770 align:middle line:84% But if you have a fixed exchange rate, you can't let it drop. 00:33:28.770 --> 00:33:31.170 align:middle line:84% And so if you're going to maintain an exchange-- a fixed 00:33:31.170 --> 00:33:33.210 align:middle line:84% exchange rate, and now you have a speculative attack, 00:33:33.210 --> 00:33:35.070 align:middle line:84% people think your currency is going to drop. 00:33:35.070 --> 00:33:36.900 align:middle line:84% And you want to maintain your peg. 00:33:36.900 --> 00:33:39.000 align:middle line:90% That's called defending the peg. 00:33:39.000 --> 00:33:41.533 align:middle line:84% If you want to defend the peg, then the only option 00:33:41.533 --> 00:33:43.950 align:middle line:84% you have as this guy is dropping to keep the exchange rate 00:33:43.950 --> 00:33:46.252 align:middle line:84% is to raise interest rates a lot. 00:33:46.252 --> 00:33:48.460 align:middle line:84% That's the way you fight-- the main way you fight it. 00:33:48.460 --> 00:33:51.200 align:middle line:84% I mean, you fight it by closing capital accounts and so on, 00:33:51.200 --> 00:33:53.410 align:middle line:90% but that's the last resort. 00:33:53.410 --> 00:33:55.820 align:middle line:84% You first try to fight it with monetary policy. 00:33:55.820 --> 00:33:57.970 align:middle line:84% So if this thing is dropping, you 00:33:57.970 --> 00:34:00.730 align:middle line:84% fight it by increasing interest rate a lot. 00:34:00.730 --> 00:34:02.843 align:middle line:84% And that's the way you stabilize the currency. 00:34:02.843 --> 00:34:05.010 align:middle line:84% But what happens when you raise interest rates a lot 00:34:05.010 --> 00:34:08.560 align:middle line:90% to defend the parity, the peg? 00:34:08.560 --> 00:34:09.760 align:middle line:90% What is the problem of that? 00:34:09.760 --> 00:34:16.695 align:middle line:90% 00:34:16.695 --> 00:34:17.820 align:middle line:90% AUDIENCE: Increases output. 00:34:17.820 --> 00:34:20.362 align:middle line:84% RICARDO J. CABALLERO: Yeah, you generate a domestic recession 00:34:20.362 --> 00:34:23.250 align:middle line:84% because just to defend your currency, your peg, 00:34:23.250 --> 00:34:26.330 align:middle line:84% you had to raise interest rates a lot. 00:34:26.330 --> 00:34:31.489 align:middle line:84% So it means you're going to have a recession at home, OK? 00:34:31.489 --> 00:34:33.350 align:middle line:84% So that's another problem of fixed exchange. 00:34:33.350 --> 00:34:35.517 align:middle line:84% It's a problem-- that's not a problem for Hong Kong. 00:34:35.517 --> 00:34:37.010 align:middle line:90% It was in 1997. 00:34:37.010 --> 00:34:39.230 align:middle line:84% They did have a speculative attack despite the fact 00:34:39.230 --> 00:34:42.080 align:middle line:84% that they had twice the number of reserves 00:34:42.080 --> 00:34:43.755 align:middle line:90% relative to their money base. 00:34:43.755 --> 00:34:45.380 align:middle line:84% But still, they had speculative attack. 00:34:45.380 --> 00:34:47.239 align:middle line:84% But it rarely happens in Hong Kong. 00:34:47.239 --> 00:34:51.199 align:middle line:84% In Argentina, again, every other day, but in-- 00:34:51.199 --> 00:34:52.639 align:middle line:90% same in Turkey. 00:34:52.639 --> 00:34:54.290 align:middle line:90% In Turkey, it's every 15 days. 00:34:54.290 --> 00:34:59.850 align:middle line:90% But it's happening all the time. 00:34:59.850 --> 00:35:01.970 align:middle line:84% So that's a problem, as well, because if you 00:35:01.970 --> 00:35:05.075 align:middle line:84% have to spend a lot of energy defending your peg, then 00:35:05.075 --> 00:35:06.950 align:middle line:84% you're going to be causing lots of recessions 00:35:06.950 --> 00:35:13.260 align:middle line:84% at home just to stabilize the currency, OK? 00:35:13.260 --> 00:35:15.540 align:middle line:84% Thus, bigger economies say, well, OK, 00:35:15.540 --> 00:35:20.790 align:middle line:84% well, Argentina, Turkey, and so on, but these are bigger boys. 00:35:20.790 --> 00:35:24.520 align:middle line:84% Here we have-- this is the ERM crisis. 00:35:24.520 --> 00:35:27.810 align:middle line:84% So before the euro, more or less, 00:35:27.810 --> 00:35:34.110 align:middle line:84% the eurozone plus the UK had a system called the ERM-- 00:35:34.110 --> 00:35:35.085 align:middle line:90% EMS, ERM. 00:35:35.085 --> 00:35:36.300 align:middle line:90% ERM is the model. 00:35:36.300 --> 00:35:39.690 align:middle line:84% Anyway, EMS is European Monetary System. 00:35:39.690 --> 00:35:43.390 align:middle line:84% ERM is Exchange Rate Mechanism, or something like that. 00:35:43.390 --> 00:35:44.400 align:middle line:90% And they're both linked. 00:35:44.400 --> 00:35:48.360 align:middle line:84% But let's call it the European Monetary System. 00:35:48.360 --> 00:35:52.160 align:middle line:84% And the basic idea of the European Monetary System 00:35:52.160 --> 00:35:56.930 align:middle line:84% was that they behave very much like Singapore with respect 00:35:56.930 --> 00:36:01.460 align:middle line:84% to each other, meaning they allow themselves to move around, 00:36:01.460 --> 00:36:03.770 align:middle line:90% but only in narrow bands. 00:36:03.770 --> 00:36:08.900 align:middle line:84% The countries that have the more stable 00:36:08.900 --> 00:36:13.280 align:middle line:84% domestic monetary position, like France, [INAUDIBLE] Germany, 00:36:13.280 --> 00:36:16.700 align:middle line:84% the Deutschmark, and the French franc, where they have 00:36:16.700 --> 00:36:19.550 align:middle line:90% is bands of 2.5% up and down. 00:36:19.550 --> 00:36:21.620 align:middle line:84% And they move within those ranges. 00:36:21.620 --> 00:36:24.290 align:middle line:84% They didn't have a full peg, but they allowed themselves 00:36:24.290 --> 00:36:25.310 align:middle line:90% to move a little bit. 00:36:25.310 --> 00:36:28.430 align:middle line:84% Portugal, which was a little-- had a little less discipline, 00:36:28.430 --> 00:36:30.840 align:middle line:84% they had 5% for each side and stuff like that. 00:36:30.840 --> 00:36:34.490 align:middle line:84% But the point is they would have narrow bands, OK? 00:36:34.490 --> 00:36:36.620 align:middle line:84% And they moved around in those narrow bands, 00:36:36.620 --> 00:36:39.110 align:middle line:90% and they kept their-- 00:36:39.110 --> 00:36:43.580 align:middle line:84% kept it for quite a while before the euro. 00:36:43.580 --> 00:36:47.330 align:middle line:84% Now, here the whole system came under a speculative attack. 00:36:47.330 --> 00:36:50.110 align:middle line:90% 00:36:50.110 --> 00:36:52.380 align:middle line:90% What happened around there? 00:36:52.380 --> 00:36:54.410 align:middle line:90% You probably have no idea. 00:36:54.410 --> 00:36:56.250 align:middle line:90% [LAUGHS] 00:36:56.250 --> 00:36:58.250 align:middle line:84% AUDIENCE: Maybe the end of the Cold War? 00:36:58.250 --> 00:37:02.080 align:middle line:84% RICARDO J. CABALLERO: Well, it's really linked to that, yes. 00:37:02.080 --> 00:37:04.780 align:middle line:84% Yeah, it's the German reunification. 00:37:04.780 --> 00:37:10.480 align:middle line:84% So what happens is, when East Germany and West Germany unify, 00:37:10.480 --> 00:37:12.490 align:middle line:84% they had to have a massive fiscal policy, 00:37:12.490 --> 00:37:14.830 align:middle line:84% massive expansionary fiscal policy. 00:37:14.830 --> 00:37:18.430 align:middle line:84% And that big expansion put lots of upward pressure 00:37:18.430 --> 00:37:22.480 align:middle line:90% on German interest rates. 00:37:22.480 --> 00:37:25.720 align:middle line:84% And that led to big appreciations 00:37:25.720 --> 00:37:27.340 align:middle line:90% of the Deutschmark. 00:37:27.340 --> 00:37:29.290 align:middle line:84% And the other countries tried to fight it 00:37:29.290 --> 00:37:31.990 align:middle line:84% because it had to be in this very narrow band. 00:37:31.990 --> 00:37:35.020 align:middle line:84% But they were experiencing these big speculative attacks. 00:37:35.020 --> 00:37:38.765 align:middle line:84% And so they had to raise the interest rate enormously. 00:37:38.765 --> 00:37:41.140 align:middle line:84% The UK tried to do it for a while and, essentially, said, 00:37:41.140 --> 00:37:42.040 align:middle line:90% ah, we give up. 00:37:42.040 --> 00:37:45.250 align:middle line:84% And then they abandoned the system. 00:37:45.250 --> 00:37:48.572 align:middle line:84% The French tried to stay in there for quite a bit, OK? 00:37:48.572 --> 00:37:49.780 align:middle line:90% You can see the French franc. 00:37:49.780 --> 00:37:50.488 align:middle line:90% They didn't move. 00:37:50.488 --> 00:37:51.310 align:middle line:90% They didn't move. 00:37:51.310 --> 00:37:53.350 align:middle line:84% But it was extremely costly for them 00:37:53.350 --> 00:37:55.340 align:middle line:84% because the interest rate has to go up a lot. 00:37:55.340 --> 00:37:57.880 align:middle line:84% And so they got into a big recession and so on. 00:37:57.880 --> 00:38:00.340 align:middle line:84% Eventually, the whole system broke up, broke down. 00:38:00.340 --> 00:38:02.120 align:middle line:90% I mean, everyone left. 00:38:02.120 --> 00:38:05.030 align:middle line:84% And eventually, they rejoined, but now in the euro. 00:38:05.030 --> 00:38:07.610 align:middle line:84% And the euro is a little different because, in the euro, 00:38:07.610 --> 00:38:08.630 align:middle line:90% you gave up-- 00:38:08.630 --> 00:38:10.910 align:middle line:84% there's no space for speculative attacks, 00:38:10.910 --> 00:38:14.200 align:middle line:84% because it's a single currency, OK? 00:38:14.200 --> 00:38:17.140 align:middle line:90% So that's the most extreme form. 00:38:17.140 --> 00:38:18.970 align:middle line:84% Speculative attacks nowadays in Europe 00:38:18.970 --> 00:38:20.710 align:middle line:90% happen through different means. 00:38:20.710 --> 00:38:26.140 align:middle line:84% It's the-- well, anyways let me not get into that. 00:38:26.140 --> 00:38:29.120 align:middle line:84% But here you have-- so I'm saying having a fixed exchange 00:38:29.120 --> 00:38:31.030 align:middle line:84% rate is not easy, even for countries 00:38:31.030 --> 00:38:32.860 align:middle line:84% that have sort of very well developed 00:38:32.860 --> 00:38:37.640 align:middle line:84% financial markets and so on and so forth. 00:38:37.640 --> 00:38:42.085 align:middle line:84% Now, it would seem, given all that I said, that-- 00:38:42.085 --> 00:38:44.460 align:middle line:84% I mean, there is no reason to have a fixed exchange rate. 00:38:44.460 --> 00:38:47.230 align:middle line:84% It is something-- you give up an instrument. 00:38:47.230 --> 00:38:50.770 align:middle line:84% And on top of that, you're subject to speculative attacks 00:38:50.770 --> 00:38:52.330 align:middle line:90% all the time-- 00:38:52.330 --> 00:38:53.110 align:middle line:90% not all the time. 00:38:53.110 --> 00:38:55.180 align:middle line:84% Well, it depends on how bad you are. 00:38:55.180 --> 00:38:57.850 align:middle line:84% But you have to be very well behaved, 00:38:57.850 --> 00:39:00.670 align:middle line:84% because otherwise, you're subject to speculative attacks 00:39:00.670 --> 00:39:03.220 align:middle line:90% all the time. 00:39:03.220 --> 00:39:05.380 align:middle line:90% So why not do flexible exchange? 00:39:05.380 --> 00:39:08.110 align:middle line:84% Why-- what is wrong with flexible exchange rate? 00:39:08.110 --> 00:39:11.680 align:middle line:84% Well, I think the main problem of flexible exchange rate 00:39:11.680 --> 00:39:13.660 align:middle line:90% is that it tends to move a lot. 00:39:13.660 --> 00:39:16.180 align:middle line:84% I mean, we know that it moves a lot more than fundamentals, 00:39:16.180 --> 00:39:20.168 align:middle line:84% meaning productivity is a little higher in one country than 00:39:20.168 --> 00:39:20.710 align:middle line:90% in the other. 00:39:20.710 --> 00:39:22.720 align:middle line:84% Demand is a little higher than a country. 00:39:22.720 --> 00:39:24.370 align:middle line:84% But the exchange rate moves a lot more 00:39:24.370 --> 00:39:27.970 align:middle line:84% than those little differences justify. 00:39:27.970 --> 00:39:30.070 align:middle line:84% And the reason-- one way of understanding this 00:39:30.070 --> 00:39:31.430 align:middle line:90% is the following. 00:39:31.430 --> 00:39:33.340 align:middle line:84% And this will serve as an introduction 00:39:33.340 --> 00:39:36.160 align:middle line:84% to the next topic of the course, which will be asset pricing 00:39:36.160 --> 00:39:37.690 align:middle line:90% and things like that. 00:39:37.690 --> 00:39:40.230 align:middle line:84% So let's look at-- revisit our interest parity condition, 00:39:40.230 --> 00:39:45.690 align:middle line:84% but now let's not assume that the next-- 00:39:45.690 --> 00:39:48.188 align:middle line:84% the expected exchange rate is fixed. 00:39:48.188 --> 00:39:50.730 align:middle line:84% I mean, that was an assumption just to make our life simpler, 00:39:50.730 --> 00:39:52.710 align:middle line:90% but it needs not be. 00:39:52.710 --> 00:39:56.330 align:middle line:84% So that's the uncovered interest parity condition is this. 00:39:56.330 --> 00:39:59.440 align:middle line:84% Well, you see, I can replace this guy here 00:39:59.440 --> 00:40:00.940 align:middle line:84% for what will happen next period. 00:40:00.940 --> 00:40:03.580 align:middle line:84% It's the same thing shifted by a period with an expectation 00:40:03.580 --> 00:40:04.130 align:middle line:90% there. 00:40:04.130 --> 00:40:07.390 align:middle line:84% So E t plus 1 expected-- this guy here 00:40:07.390 --> 00:40:12.040 align:middle line:84% is equal to 1 plus expected domestic interest rate one 00:40:12.040 --> 00:40:15.640 align:middle line:84% period from now divided by 1 plus international interest 00:40:15.640 --> 00:40:17.260 align:middle line:84% rate expected one period from now 00:40:17.260 --> 00:40:21.280 align:middle line:84% times the expected exchange rate for t plus 2, two years 00:40:21.280 --> 00:40:22.160 align:middle line:90% from now. 00:40:22.160 --> 00:40:23.420 align:middle line:90% And I can keep doing this. 00:40:23.420 --> 00:40:25.240 align:middle line:84% I can replace this by something equivalent 00:40:25.240 --> 00:40:28.250 align:middle line:84% to that with all the subindex shifted by one year, blah, blah, 00:40:28.250 --> 00:40:29.480 align:middle line:90% blah, blah, blah, blah. 00:40:29.480 --> 00:40:32.320 align:middle line:84% And so I can end up writing this exchange rate 00:40:32.320 --> 00:40:35.410 align:middle line:84% as this product of lots of things 00:40:35.410 --> 00:40:38.590 align:middle line:84% that can happen in the future, the monetary policy path 00:40:38.590 --> 00:40:40.880 align:middle line:84% at home, the monetary policy path-- 00:40:40.880 --> 00:40:44.170 align:middle line:84% not the next period, the path for years to come, 00:40:44.170 --> 00:40:47.710 align:middle line:84% of a monetary policy in the other country. 00:40:47.710 --> 00:40:50.470 align:middle line:84% And there is always an expected exchange rate at the end 00:40:50.470 --> 00:40:55.260 align:middle line:84% there that is free, that can move around. 00:40:55.260 --> 00:40:57.750 align:middle line:84% So the problem of this exchange is that the future 00:40:57.750 --> 00:41:01.170 align:middle line:90% matters too much, in a sense. 00:41:01.170 --> 00:41:03.060 align:middle line:84% And people have lots of imagination, 00:41:03.060 --> 00:41:05.430 align:middle line:84% so all sorts of weird things they imagine. 00:41:05.430 --> 00:41:07.740 align:middle line:84% And when people have lots of imagination, 00:41:07.740 --> 00:41:09.940 align:middle line:84% then these things are moving a lot. 00:41:09.940 --> 00:41:12.240 align:middle line:84% And that's the reason you see enormous fluctuations 00:41:12.240 --> 00:41:13.750 align:middle line:90% in nominal exchange rate. 00:41:13.750 --> 00:41:18.070 align:middle line:90% Now-- and that's a problem. 00:41:18.070 --> 00:41:20.100 align:middle line:84% It's a problem to have a very volatile exchange 00:41:20.100 --> 00:41:23.550 align:middle line:84% rate because it makes transactions more difficult. 00:41:23.550 --> 00:41:26.280 align:middle line:84% I mean, if the price of things are-- relative price of things 00:41:26.280 --> 00:41:28.738 align:middle line:84% are changing all the time, it's a little bit more difficult 00:41:28.738 --> 00:41:29.970 align:middle line:90% to plan. 00:41:29.970 --> 00:41:31.745 align:middle line:84% Financial investments become more-- 00:41:31.745 --> 00:41:33.120 align:middle line:84% because you get all this exchange 00:41:33.120 --> 00:41:34.750 align:middle line:90% rate volatility in between. 00:41:34.750 --> 00:41:37.800 align:middle line:84% So that's one of the main reasons 00:41:37.800 --> 00:41:43.210 align:middle line:84% you would prefer, if you could, to have a more managed exchange 00:41:43.210 --> 00:41:43.710 align:middle line:90% rate. 00:41:43.710 --> 00:41:46.770 align:middle line:84% It's because you don't want this all this artificial volatility 00:41:46.770 --> 00:41:50.130 align:middle line:84% that comes from behavioral traits and things of that kind, 00:41:50.130 --> 00:41:50.730 align:middle line:90% OK? 00:41:50.730 --> 00:41:51.870 align:middle line:90% That's the main reason. 00:41:51.870 --> 00:41:54.920 align:middle line:90% 00:41:54.920 --> 00:41:57.067 align:middle line:84% Look at this example, for example-- 00:41:57.067 --> 00:41:58.650 align:middle line:84% example for example, sorry about that. 00:41:58.650 --> 00:42:03.480 align:middle line:84% But this is Russia during the war. 00:42:03.480 --> 00:42:09.710 align:middle line:84% This was the ruble, the Russian currency. 00:42:09.710 --> 00:42:13.540 align:middle line:84% And when they invaded, of course, this thing collapsed. 00:42:13.540 --> 00:42:16.030 align:middle line:90% The currency collapsed, OK? 00:42:16.030 --> 00:42:19.150 align:middle line:84% And this period is a little longer than you think. 00:42:19.150 --> 00:42:21.580 align:middle line:84% But it collapsed for quite a while. 00:42:21.580 --> 00:42:25.070 align:middle line:84% And then it recovered a lot-- actually overshot and came down. 00:42:25.070 --> 00:42:28.300 align:middle line:84% So this is not because the central bank said, 00:42:28.300 --> 00:42:33.130 align:middle line:84% we're going to devalue the currency or anything. 00:42:33.130 --> 00:42:35.020 align:middle line:84% It's just people said, well, this 00:42:35.020 --> 00:42:36.400 align:middle line:90% is a country going into war. 00:42:36.400 --> 00:42:38.800 align:middle line:84% It's going to be a mess, [MUTTERS] So all 00:42:38.800 --> 00:42:44.020 align:middle line:84% that future I talk about, essentially, 00:42:44.020 --> 00:42:46.660 align:middle line:90% destroy the currency, OK? 00:42:46.660 --> 00:42:48.960 align:middle line:84% Now, a lot of that recovery happened there 00:42:48.960 --> 00:42:52.200 align:middle line:84% not because people now began to see the future as a better 00:42:52.200 --> 00:42:53.460 align:middle line:90% future or anything like that. 00:42:53.460 --> 00:42:56.730 align:middle line:84% It's because they have to hike interest rates massively. 00:42:56.730 --> 00:42:58.440 align:middle line:84% They were around 4% or 5%, and they 00:42:58.440 --> 00:43:01.685 align:middle line:84% had to go to 20% interest rates to defend the exchange rate. 00:43:01.685 --> 00:43:03.810 align:middle line:84% Remember I told you, you have a speculative attack, 00:43:03.810 --> 00:43:05.810 align:middle line:84% and you have enormous pressure on your currency. 00:43:05.810 --> 00:43:07.650 align:middle line:84% Well, the main tool you have to offset that 00:43:07.650 --> 00:43:09.810 align:middle line:90% is to raise interest rates. 00:43:09.810 --> 00:43:11.610 align:middle line:84% So they hiked interest rates massively. 00:43:11.610 --> 00:43:13.420 align:middle line:84% They did a lot of other things as well. 00:43:13.420 --> 00:43:16.080 align:middle line:84% They put capital controls on lots of things. 00:43:16.080 --> 00:43:18.100 align:middle line:84% But this was the main thing they did. 00:43:18.100 --> 00:43:19.600 align:middle line:84% And so they dragged the recession-- 00:43:19.600 --> 00:43:22.140 align:middle line:84% the economy into recession for war-related reasons 00:43:22.140 --> 00:43:24.630 align:middle line:84% and because of the monetary policy response 00:43:24.630 --> 00:43:26.370 align:middle line:90% they had to do with that, OK? 00:43:26.370 --> 00:43:28.560 align:middle line:84% So that's an extreme case of a war. 00:43:28.560 --> 00:43:35.040 align:middle line:84% But that's the kind of things that can happen in a floating 00:43:35.040 --> 00:43:36.420 align:middle line:90% exchange rate. 00:43:36.420 --> 00:43:42.800 align:middle line:84% Even when-- I mean, the main constraint 00:43:42.800 --> 00:43:44.940 align:middle line:84% in Argentina and Turkey and so on is reserves. 00:43:44.940 --> 00:43:46.273 align:middle line:90% They don't have enough reserves. 00:43:46.273 --> 00:43:48.680 align:middle line:84% So if you have to defend your currency by intervening 00:43:48.680 --> 00:43:52.918 align:middle line:84% in the FX market, if you don't have enough, 00:43:52.918 --> 00:43:53.960 align:middle line:90% then you're not credible. 00:43:53.960 --> 00:43:56.810 align:middle line:84% I mean, if you have massive capital outflows, 00:43:56.810 --> 00:43:59.450 align:middle line:84% and you have a few billion dollars there, 00:43:59.450 --> 00:44:00.960 align:middle line:90% it's not going to work. 00:44:00.960 --> 00:44:02.240 align:middle line:90% That's not the case of Russia. 00:44:02.240 --> 00:44:03.740 align:middle line:84% They had massive amount of reserves. 00:44:03.740 --> 00:44:05.210 align:middle line:90% So that was not the issue. 00:44:05.210 --> 00:44:06.980 align:middle line:84% It was all about expectations of things 00:44:06.980 --> 00:44:08.063 align:middle line:90% that happen in the future. 00:44:08.063 --> 00:44:11.405 align:middle line:84% It was all about these kind of terms, OK? 00:44:11.405 --> 00:44:13.990 align:middle line:90% 00:44:13.990 --> 00:44:17.320 align:middle line:84% Anyway, so that added to the cost they had. 00:44:17.320 --> 00:44:19.990 align:middle line:90% 00:44:19.990 --> 00:44:23.330 align:middle line:84% So how do we choose these things, then, in practice? 00:44:23.330 --> 00:44:24.680 align:middle line:90% Again, there are lots of things. 00:44:24.680 --> 00:44:27.900 align:middle line:84% And politics play a role and so on. 00:44:27.900 --> 00:44:30.050 align:middle line:90% But there is a case-- 00:44:30.050 --> 00:44:34.220 align:middle line:84% so again, I would put it even the other way around. 00:44:34.220 --> 00:44:36.170 align:middle line:84% I think that, if you could, you would like 00:44:36.170 --> 00:44:38.910 align:middle line:90% to have a fixed exchange rate. 00:44:38.910 --> 00:44:41.520 align:middle line:84% If you could, you would like to have a fixed exchange 00:44:41.520 --> 00:44:43.980 align:middle line:84% because then you remove all this spurious noise that 00:44:43.980 --> 00:44:46.740 align:middle line:84% happens every single day because of exchange rate volatility 00:44:46.740 --> 00:44:47.910 align:middle line:90% that complicates your life. 00:44:47.910 --> 00:44:51.250 align:middle line:90% 00:44:51.250 --> 00:44:53.210 align:middle line:90% So when can you do that? 00:44:53.210 --> 00:44:54.910 align:middle line:84% Well, first, you can do it with respect 00:44:54.910 --> 00:44:59.400 align:middle line:84% to some other country where the shocks are very similar 00:44:59.400 --> 00:45:03.150 align:middle line:90% because if you know that-- 00:45:03.150 --> 00:45:05.430 align:middle line:90% say your Mexico, but-- 00:45:05.430 --> 00:45:07.320 align:middle line:84% or the north of Mexico, something like that, 00:45:07.320 --> 00:45:09.153 align:middle line:84% and you know that all your shocks are really 00:45:09.153 --> 00:45:10.200 align:middle line:90% shocks to the US. 00:45:10.200 --> 00:45:13.230 align:middle line:84% Then the US can do the monetary policy for you 00:45:13.230 --> 00:45:14.640 align:middle line:84% because you have the same shocks. 00:45:14.640 --> 00:45:16.710 align:middle line:90% [CHUCKLES] I'm exaggerating. 00:45:16.710 --> 00:45:19.732 align:middle line:84% So if you are very similar, then it 00:45:19.732 --> 00:45:21.440 align:middle line:84% makes sense to have a fixed exchange rate 00:45:21.440 --> 00:45:23.120 align:middle line:84% because why pay for all that volatility 00:45:23.120 --> 00:45:25.130 align:middle line:84% when you're going to be doing the same policies 00:45:25.130 --> 00:45:27.755 align:middle line:84% in both countries, more or less at the same time because you're 00:45:27.755 --> 00:45:28.910 align:middle line:90% exposed to the same shocks? 00:45:28.910 --> 00:45:30.050 align:middle line:90% So that's one thing. 00:45:30.050 --> 00:45:33.320 align:middle line:84% That's one reason why the eurozone is the eurozone, 00:45:33.320 --> 00:45:35.180 align:middle line:84% because there are European countries that 00:45:35.180 --> 00:45:37.220 align:middle line:84% have very similar business cycles and so on. 00:45:37.220 --> 00:45:38.490 align:middle line:90% Germany is a little different. 00:45:38.490 --> 00:45:40.230 align:middle line:84% That's the reason they always have some problems. 00:45:40.230 --> 00:45:42.800 align:middle line:84% I mean, the north and the south, they're a little different. 00:45:42.800 --> 00:45:47.780 align:middle line:84% But they're much more similar than other countries. 00:45:47.780 --> 00:45:50.690 align:middle line:90% 00:45:50.690 --> 00:45:55.490 align:middle line:84% And so that's what they have one. 00:45:55.490 --> 00:46:01.765 align:middle line:84% Another option is when you have lots of fiscal capacity 00:46:01.765 --> 00:46:03.640 align:middle line:84% because, if you have lots of fiscal capacity, 00:46:03.640 --> 00:46:04.980 align:middle line:84% then the cost of not having monetary policy 00:46:04.980 --> 00:46:07.230 align:middle line:84% is not that large, because you can fight your business 00:46:07.230 --> 00:46:09.030 align:middle line:90% cycle with fiscal policy. 00:46:09.030 --> 00:46:10.780 align:middle line:84% That's the case of Hong Kong, for example. 00:46:10.780 --> 00:46:12.820 align:middle line:84% Hong Kong-- Hong Kong, first of all, 00:46:12.820 --> 00:46:14.320 align:middle line:84% is not subject to speculated attacks 00:46:14.320 --> 00:46:16.220 align:middle line:84% because they have massive amount of reserves. 00:46:16.220 --> 00:46:18.092 align:middle line:84% So anyone that dares attacking them 00:46:18.092 --> 00:46:19.300 align:middle line:90% is going to lose their shirt. 00:46:19.300 --> 00:46:20.590 align:middle line:90% So they're safe. 00:46:20.590 --> 00:46:23.230 align:middle line:90% 00:46:23.230 --> 00:46:25.180 align:middle line:84% Soros tried many years back, and he 00:46:25.180 --> 00:46:27.700 align:middle line:84% didn't do as well as he did attacking the British pound. 00:46:27.700 --> 00:46:30.910 align:middle line:90% 00:46:30.910 --> 00:46:32.830 align:middle line:84% But they also have lots of fiscal resources, 00:46:32.830 --> 00:46:35.560 align:middle line:84% so they can fight their domestic recessions and so 00:46:35.560 --> 00:46:37.490 align:middle line:90% on with fiscal policy. 00:46:37.490 --> 00:46:40.880 align:middle line:84% The other factor, which also applies to Hong Kong, 00:46:40.880 --> 00:46:43.950 align:middle line:84% if you have very flexible factor markets. 00:46:43.950 --> 00:46:46.550 align:middle line:84% So if wages move very easily, prices move very easily 00:46:46.550 --> 00:46:49.010 align:middle line:84% domestically, then you don't care 00:46:49.010 --> 00:46:51.528 align:middle line:84% about having a fixed nominal exchange 00:46:51.528 --> 00:46:53.570 align:middle line:84% rate because a fixed nominal exchange rate is not 00:46:53.570 --> 00:46:55.778 align:middle line:84% the same as a fixed real exchange rate, which is what 00:46:55.778 --> 00:46:57.410 align:middle line:90% you really need to move around. 00:46:57.410 --> 00:46:59.035 align:middle line:84% If your prices are flexible, it doesn't 00:46:59.035 --> 00:47:00.952 align:middle line:84% matter that the nominal exchange doesn't move, 00:47:00.952 --> 00:47:02.610 align:middle line:84% because the prices are moving around. 00:47:02.610 --> 00:47:04.610 align:middle line:84% And so you still have lots of flexibility 00:47:04.610 --> 00:47:05.990 align:middle line:90% in the real exchange. 00:47:05.990 --> 00:47:07.670 align:middle line:84% And that's the reason I would say-- 00:47:07.670 --> 00:47:08.930 align:middle line:90% it's one of the reasons-- 00:47:08.930 --> 00:47:10.100 align:middle line:90% political reasons, as well-- 00:47:10.100 --> 00:47:11.480 align:middle line:90% but why they can afford it. 00:47:11.480 --> 00:47:13.580 align:middle line:84% I think, in the case of Hong Kong, it's the other way around. 00:47:13.580 --> 00:47:14.997 align:middle line:84% There were some political reasons. 00:47:14.997 --> 00:47:17.420 align:middle line:90% 00:47:17.420 --> 00:47:21.830 align:middle line:84% And then they built a system so that it's a coherent system 00:47:21.830 --> 00:47:24.260 align:middle line:84% because they have lots of fiscal capacity, 00:47:24.260 --> 00:47:26.330 align:middle line:84% they can defend the currency well, 00:47:26.330 --> 00:47:27.800 align:middle line:84% and they have very flexible market. 00:47:27.800 --> 00:47:33.402 align:middle line:90% 00:47:33.402 --> 00:47:36.692 align:middle line:84% This is-- well, again, this is what I said before. 00:47:36.692 --> 00:47:39.985 align:middle line:84% If you-- this is what I said before. 00:47:39.985 --> 00:47:42.372 align:middle line:84% If you don't like that noise, if you-- especially 00:47:42.372 --> 00:47:44.330 align:middle line:84% if you're going to be trading a lot with people 00:47:44.330 --> 00:47:47.770 align:middle line:84% and so on, in Europe, many people 00:47:47.770 --> 00:47:49.480 align:middle line:84% cross the border many times a day, 00:47:49.480 --> 00:47:52.180 align:middle line:84% and you want to go shopping one way or the other. 00:47:52.180 --> 00:47:55.330 align:middle line:84% It's a pain if the exchange rate is moving all the time. 00:47:55.330 --> 00:47:57.182 align:middle line:84% It's much easier if things are stable. 00:47:57.182 --> 00:47:59.140 align:middle line:84% And the same applies to financial transactions. 00:47:59.140 --> 00:48:00.880 align:middle line:84% People have deposits in different banks 00:48:00.880 --> 00:48:02.690 align:middle line:90% and stuff like that. 00:48:02.690 --> 00:48:05.565 align:middle line:84% It's better if you don't have all that fluctuation. 00:48:05.565 --> 00:48:06.940 align:middle line:84% And in the case of the euro area, 00:48:06.940 --> 00:48:11.710 align:middle line:84% they decided that the advantages of having a very fixed 00:48:11.710 --> 00:48:16.090 align:middle line:84% exchange rate were more than the cost 00:48:16.090 --> 00:48:17.680 align:middle line:84% for individual countries of not having 00:48:17.680 --> 00:48:20.390 align:middle line:90% independent monetary policy. 00:48:20.390 --> 00:48:21.640 align:middle line:90% It's still a work in progress. 00:48:21.640 --> 00:48:22.557 align:middle line:90% They're building that. 00:48:22.557 --> 00:48:26.440 align:middle line:84% It's not finished, but they're working at it. 00:48:26.440 --> 00:48:30.510 align:middle line:84% The other reason why countries fix exchange rate-- 00:48:30.510 --> 00:48:32.230 align:middle line:84% and that's the Argentinian reason 00:48:32.230 --> 00:48:37.090 align:middle line:84% and so on-- is when they have no control on inflation, 00:48:37.090 --> 00:48:38.770 align:middle line:90% they have no credibility. 00:48:38.770 --> 00:48:41.740 align:middle line:84% And so if you peg to another currency that has credibility, 00:48:41.740 --> 00:48:43.800 align:middle line:84% then the idea, the hope at least, 00:48:43.800 --> 00:48:46.260 align:middle line:84% is that you will inherit the credibility 00:48:46.260 --> 00:48:47.490 align:middle line:90% of the other currency. 00:48:47.490 --> 00:48:50.280 align:middle line:84% And that's what they tried to do. 00:48:50.280 --> 00:48:53.430 align:middle line:84% Argentina had a currency board like Hong Kong for a while. 00:48:53.430 --> 00:48:55.830 align:middle line:84% The whole idea was to control inflation. 00:48:55.830 --> 00:48:57.990 align:middle line:90% Well, let's peg to someone. 00:48:57.990 --> 00:49:01.620 align:middle line:84% And if the markets believe you, then 00:49:01.620 --> 00:49:03.300 align:middle line:84% it would work because then you inherit 00:49:03.300 --> 00:49:05.790 align:middle line:84% the credibility of the-- you're saying, when you take 00:49:05.790 --> 00:49:07.290 align:middle line:84% a fixed exchange rate, I'm not going 00:49:07.290 --> 00:49:09.910 align:middle line:84% to run monetary policy, which is the main source of inflation. 00:49:09.910 --> 00:49:11.880 align:middle line:84% So I'm going to let the credible country run 00:49:11.880 --> 00:49:13.200 align:middle line:90% the monetary policy for me. 00:49:13.200 --> 00:49:15.030 align:middle line:84% And that's what gives you credibility. 00:49:15.030 --> 00:49:18.360 align:middle line:84% As long as somebody believes it, you're not going to [LAUGHS] 00:49:18.360 --> 00:49:19.710 align:middle line:90% quit the thing. 00:49:19.710 --> 00:49:22.350 align:middle line:84% But that's the reason countries do it, often 00:49:22.350 --> 00:49:25.610 align:middle line:90% to stabilize inflation, as well. 00:49:25.610 --> 00:49:38.000 align:middle line:90%