Posted by: Dirk | April 29, 2015

Goodhart on pegged exchange rates

I am reading Charles Goodhart’s book Money, Information and Uncertainty in the second edition from 1989 to see what I could use in a course on global macroeconomics. Apart from the fact that it is out of date it contains a good mixture between empirical puzzles and theoretical explanations, often based on balance sheets and accounting. Here is a very interesting paragraph from page 435 which reminds one of the euro:

If the exchange rate is pegged it is not going to be doing this job [of achieving external balance]. If the authorities are not driven to abandon their internal objectives – and the whole idea was to prevent this happening – then an external imbalance will develop, and often grow over time, as the ‘equilibrium’ rate diverges from the pegged rate (e. g., under the influence of differing trend rates of inflation among the various countries). For a time such imbalances may, perhaps, be financed by acceptable fluctuations in reserve holdings or by relatively small variations in interest rates vis-à-vis other countries. There are, however, fairly narrow bounds to the extent that this is possible, particularly in support of a rate that appears to be overvalued. Reserves are limited and there can be difficulties in arranging large-scale international borrowing on acceptable terms. The main problem, however, is that such financing of itself does nothing to correct the imbalance caused by a divergence between the pegged and the ‘equilibrium’ exchange rate. At some point in time there will, therefore, be pressures on the authorities to correct the external imbalance by adjusting the exchange rate. It will generally be obvious under such conditions which way the exchange rate must move, if it moves at all: there is only a ‘one-way option’. This ‘one-way option encourages speculation against the pegged currency, and such speculation will cause large-scale flows of capital out of the country which is seen as a devaluation candidate into the country which is seen as a revaluation candidate. The volume of such flows was much increased, but not caused, by the development of an efficient, large-scale, international money market in the shape of the euro-dollar market.


One wishes that the creators of the euro would have read this text-book before the creation of the euro. The TARGET2 system has worked properly, but as mentioned by Goodhart “such financing of itself does nothing to correct the imbalance caused by a divergence between the pegged and the ‘equilibrium’ exchange rate”. The imbalance bothers not because it has to be financed – TARGET2 takes care of that – but because employment is low in those areas where the ‘equilibrium’ exchange rate is not correct.

We have two problems in the euro zone today:

  1. general lack of aggregate demand
  2. uneven geographic distribution of aggregate demand

Recent policy measures have not explicitly addressed #1 or #2 and often made things worse (fiscal brake, austerity, etc.), except for the QE which lowered the euro’s exchange rate and thus might increase foreign demand. Without a conversation centering on aggregate demand we will not be able to work out effective solutions, I’m afraid. More muddling through to come…


  1. Yes; there re TWO problems, and only one instrument: monetary policy.

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