Contradictory government objectives

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From the course by IE Business School

Trade, Immigration and Exchange Rates in a Globalized World

37 ratings

IE Business School

Trade, Immigration and Exchange Rates in a Globalized World

37 ratings

Course 2 of 3 in the Specialization Globalization, Economic Growth and Stability

This is the second of the three courses part of the Globalization, Economic Growth and Stability Specialization. This course will focus on facets of globalization that affect a country´s economic perspectives and decisions. Globalization has recently been the predominant subject in many political debates, and this course will go into the determinants of globalization. It will be separated into four modules; the first module will explain exchange rates. It will cover what determines exchange rate and how different exchange rates affect the economy and the reality of currencies. The second module will explore trade, the reality of free trade, and what occurs to a country´s economy with protectionism. The third module will go into the balance of payments, it will help you understand how economic transactions between a country and the rest of the world work. The fourth module will focus on Immigration, which is probably one of the most controversial subjects today. It will explain how migration affects host countries and it will cover current migration trends.

From the lesson

Exchange Rates

How do exchange rates affect the economy?6:28

How can governments intervene to influence the value of the currency?6:48

Contradictory government objectives4:34

Different exchange-rate regimes and the world´s key currencies by turnover4:56

Meet the Instructors

Gayle Allard
Professor
Economics

[MUSIC]

We just talked about how governments can intervene to influence the value of

a currency.

And we've discussed earlier different indicators that will influence the value

of a currency.

And you may have in your mind an emerging picture of

some of the contradictions that this leads us into.

And here I just would like to describe to you something that is often called in

economic literature, the impossible trinity.

The idea is that we have a little triangle, and you can see it

here on this slide, where we put at the top we've got free capital mobility.

Now this is part of globalization, we're not discussing it in this course.

But you know one of the things we've tried to achieve with our

globalized world is that capital can flow fairly freely around the world.

Which is an advantage to the countries that don't have much capital, right?

And it's advantage to the countries that do have capital.

So free capital mobility is an objective for many countries.

Then we've got, down here on the right hand side of this triangle,

we've got monetary policy autonomy.

Now you know from understanding economic policy making or

any macro course you might have taken.

That countries like to be able to use their interest rates

to influence their economy.

If they raise an interest rate, they're going to slow down an economy.

If they reduce the interest rate, they're going to stimulate the economy.

So they like to have the independence to do that.

We've got that down here.

And then on this part of the triangle, we've got exchange rate management.

What this refers to is that sometimes countries like to have

a certain currency value, as we've mentioned.

Sometimes they're happy with a weak currency or a strong currency for

whatever reason.

Because of the size of their foreign debt,

because of their need to export in order to grow.

So the triangle has these three components.

Free capital mobility, monetary autonomy, an exchange rate management.

The idea here is that you can't have all three at once, hence impossible trinity.

You can't get all three of those objectives at the same time.

You can pick two.

You pick two sides, two angles of the triangle, but you can't have all three.

So, just to give you an example.

Imagine that I'm a country that likes to maintain a certain exchange right, okay?

I like the Yen to be at a certain value, so I can export a lot if I'm in Japan.

Well, if the Yen goes up and I want to bring it down

I will either have to reduce interest rates, which would then mean my interest

rates are not being used for my economy, they're being used for my currency.

Or I would have to stop money from leaving the country or

coming into the country and influencing the value of the currency.

So I'd have to give up one of those two angles, okay?

The way countries often resolve this contradiction is, in the case of China for

instance, the flow of capital is regulated by the government,

so that they can keep the other two angles of the triangle.

In the case of, say, the United States, Australia, Canada, the UK,

the Euro zone, which have floating currencies.

They don't manage their exchange rate.

They have to give that up, so they can maintain free capital flows and

they can continue to have monitory autonomy.

So there are contradictions as governments try to manage their economies.

Very specifically, down here at the bottom sometimes you may be forced to use

your interest rate in order to keep the currency at a certain place.

And that movement may not be the best one for your country.

We have some beautiful examples in the past.

Not beautiful, but very telling examples in the past.

I'm thinking of the UK in the early 90s,

when we had the crisis in the European monetary system.

And the UK was in recession, okay?

When you're in recession you know from understanding economic policy making, that

you should reduce interest rates in order to stimulate the economy and get it going.

But if you reduce interest rates, the pound would fall.

And they obliged to hold the pound at a certain level.

So you see they could not have both of these objectives at once and

still maintain free capital flows.

This is one of the realities of currency markets and monetary policy making.

[MUSIC]

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