9.3 Exchange rates and macroeconomic policies

Exchange Rates and Macroeconomic Policies

Exchange rates connect domestic economies to the global financial system, transmitting the effects of policy decisions across borders. How a country's currency moves shapes its trade competitiveness, capital flows, and inflation. This section covers what drives exchange rates in the short and long run, how monetary and fiscal policy affect them, and why different exchange rate regimes involve real tradeoffs.

Determinants of Exchange Rates

Exchange rates respond to different forces depending on the time horizon. In the short run, capital flows and relative returns dominate. In the long run, price levels and productivity matter more.

Short-run determinants:

• Interest rate differentials — Higher domestic interest rates attract foreign capital, increasing demand for the currency and causing appreciation. For example, when U.S. Treasury yields rise relative to European bonds, investors shift funds into dollars, pushing the dollar up.
• Inflation rate differentials — Higher inflation erodes a currency's purchasing power, leading to depreciation. Venezuela's hyperinflation caused the bolívar to collapse because holders rapidly dumped the currency for more stable alternatives.
• Current account balance — A trade surplus means foreigners need to buy your currency to pay for your exports, pushing it up. China's persistent surpluses put upward pressure on the yuan. Conversely, the U.S. trade deficit creates selling pressure on the dollar.
• Political and economic stability — Stable countries attract capital inflows, appreciating their currencies. Switzerland's franc has long served as a "safe haven" currency for exactly this reason.

Long-run determinants:

• Purchasing Power Parity (PPP) — Over time, exchange rates tend to adjust so that identical goods cost roughly the same across countries when converted to a common currency. The formula is:

$S = \frac{P}{P^*}$

where $S$ is the exchange rate, $P$ is the domestic price level, and $P^*$ is the foreign price level. The Big Mac Index is a simplified, real-world test of PPP: if a Big Mac costs more in one country than another (after converting currencies), PPP suggests that country's currency is overvalued.

• Productivity differentials — When a country's tradable sector (manufacturing, tech) grows more productive, its goods become more competitive and its currency tends to appreciate. Japan in the 1980s experienced rapid productivity gains in manufacturing, which contributed to a strengthening yen.

Impact of Policies on Exchange Rates

Monetary policy works primarily through the interest rate channel:

• Expansionary monetary policy (lowering interest rates or quantitative easing) reduces the return on domestic assets. Capital flows out, demand for the currency falls, and it depreciates. This makes exports cheaper and imports more expensive, which tends to improve the current account. The Federal Reserve's quantitative easing programs after 2008 weakened the dollar through exactly this mechanism.
• Contractionary monetary policy (raising interest rates) does the opposite. Higher returns attract capital inflows, the currency appreciates, exports become less competitive, and imports become cheaper. The Fed's rate hikes in 2022–2023 strengthened the dollar significantly against most currencies.

Fiscal policy affects exchange rates more indirectly, and the direction depends on how it interacts with interest rates:

• Expansionary fiscal policy (tax cuts or increased spending) raises aggregate demand. If the economy is near capacity, this pushes interest rates up as the government borrows more and competes for funds. Higher rates attract capital, appreciating the currency. The 2017 U.S. tax cuts contributed to dollar strength through this channel. However, the stronger currency and higher demand also pull in imports, potentially worsening the current account.
• Contractionary fiscal policy (spending cuts or tax increases) reduces aggregate demand and puts downward pressure on interest rates, leading to depreciation. Greece's austerity measures in the 2010s would have caused depreciation if Greece had its own currency; being in the eurozone, the adjustment instead came through painful internal deflation.

Expectations in Exchange Rate Dynamics

Currency markets are forward-looking. Traders don't just react to current conditions; they trade on what they expect to happen.

• Expectations — Market participants use all available information to form views about future exchange rates. If traders expect a central bank to raise rates next month, the currency often appreciates now, before the actual policy change. The Brexit referendum in 2016 illustrates this vividly: the pound dropped roughly 8% overnight as the unexpected "Leave" result forced a sudden revision of expectations about the UK economy.
• Overshooting (Dornbusch model) — This is one of the most important concepts in exchange rate theory. It explains why currencies often move more than fundamentals would justify in the short run. The mechanism works in three steps:

1. An expansionary monetary policy shock lowers domestic interest rates.
2. Because goods prices are "sticky" (slow to adjust), the exchange rate bears the full burden of adjustment. Capital flows out immediately, and the currency depreciates past its new long-run equilibrium.
3. Over time, as domestic prices gradually rise, the currency appreciates back toward its long-run level.

The key insight: financial markets adjust instantly, but goods markets adjust slowly. That mismatch causes the overshoot. The Plaza Accord of 1985, where major economies coordinated to weaken the dollar, triggered exchange rate movements that initially overshot the intended targets.

Effectiveness of Exchange Rate Regimes

Countries face a fundamental choice in how they manage their currency, and each regime involves tradeoffs.

Fixed exchange rate regimes:

Floating exchange rate regimes:

Managed float (intermediate regimes):

These regimes try to capture benefits of both systems. The central bank allows the exchange rate to move with market forces but intervenes when movements become excessive or disorderly.

• Singapore uses a managed float where the Monetary Authority targets a trade-weighted exchange rate band, adjusting it based on economic conditions. This gives Singapore some flexibility while keeping volatility in check.
• Chile used a crawling peg for years, gradually adjusting the target rate to reflect inflation differentials, before eventually moving to a full float.

The tradeoff with managed floats is that they require skill and credibility from policymakers. If the market doubts the central bank's commitment or ability to intervene effectively, speculation can overwhelm the regime.