Applied International Macroeconomics

APPLIED INTERNATIONAL MACROECONOMICS

Spring 2019: Practice Problems #12

Due Wednesday March 27 @ 9:30 am

1. Please attach some item from the media related to central banks and inflation targets.

2.   This question introduces you to a few more exchange-rate regimes and helps you identify why they often didn’t work so well. With a “crawling peg” the goal is for the exchange rate to move by roughly the same amount as the inflation differential between the home and anchor countries. With an “exchange-rate band” the exchange rate is supposed to stay close to a specific target level but is allowed to move within a fixed band around that target. A “crawling band” is a combination of these two.

As you can imagine, crawling pegs and crawling bands were most often used by high-inflation countries. The goal was to have a predictable exchange rate without losing competitiveness, as they would with a fixed rate. However, the governments typically under-estimated their future inflation rates and eventually this approach proved just as difficult to maintain as a fixed rate.

Consider Zunaria, a small European country with 30% inflation that is just entering a program to achieve lower inflation (“dis-inflate”). Columns 1 and 2 of the table below show the Zunarian central bank’s forecasts for Zunarian and European inflation over the next few years.

Zunaria decides to adopt a crawling band to the euro and decided that the franc should depreciate according to the expected inflation differential (column 3). In addition they set the edges of the band at the target exchange rate plus & minus 5%.

Unfortunately, Zunaria’s forecasts for its own inflation prove overly optimistic, as shown in column 4, though Europe’s inflation fulfills the forecast of roughly 2% every year.