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Why exchange rates matter in a crisis latvia vs czech republic
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Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.co m/ Why Exchange Rates Matter in a Crisis: Latvia vs. Czech Republic Posting prepared May 24, 2010 Terms of Use: These slides are intended as a resource for economics teachers. You are free to use these slides in your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, BVT Publishers http://www.bvtpublishing.com/disciplines.php?Economics . Check
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A resource for teaching economics in the form of a set of PowerPoint slidesdiscussing exchange rate policy in Latvia and the Czech Republic during the current economic crisis
Transcript of Why exchange rates matter in a crisis latvia vs czech republic
Free Slides fromEd Dolan’s Econ Blog
http://dolanecon.blogspot.com/
Why Exchange Rates Matter in a Crisis: Latvia
vs. Czech RepublicPosting prepared May 24, 2010
Terms of Use: These slides are intended as a resource for economics teachers. You are free to use these slides in your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, BVT Publishers http://www.bvtpublishing.com/disciplines.php?Economics . Check dolanecon.blogspot.com regularly for more slides like this
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Economic Crisis in Europe
The 27 countries of the European Union, like the United States, have been hit hard by the global economic crisis
But average figures for the EU tell only part of the story
We need also to ask what has caused the impact of the crisis to vary from country to country within the EU
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Fixed and Flexible Exchange Rates
Exchange rate policy is one factor that has made a big difference
16 EU countries are members of the euro area, and several others have currencies that are firmly pegged to the euro
Other EU countries have exchange rates that vary from day to day depending on supply and demand
Source: Europa.eu
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
A Comparison: Latvia and the Czech Republic
The Czech Republic has a flexible exchange rate, while the Latvian exchange rate is firmly fixed to the euro
In the first years after joining the EU (2004-2007), both countries enjoyed a boom
The crisis caused a sharp recession in both countries, but the recession in Latvia was more severe
Why the difference?
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Exchange Rates in Latvia and the Czech Republic
After 2004, rapid growth and a strong inflow of capital caused appreciation of the Czech koruna.
In 2004, it took 33 koruna to buy one euro; by 2008, the koruna had strengthened to 23 per euro.
After 2008, the koruna depreciated sharply, back to almost 30 per euro at one point
During the whole period, the Latvian currency, the lats, remained firmly fixed at an exchange rate of .71 lats per euro
Stro
nger
Kor
una
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Rapid Inflation in Latvia
In Latvia, the boom years after 2004 brought rapid inflation, the fastest in the EU
The fixed exchange rate kept interest rates low and helped fuel a housing bubble
Central bank actions to hold the exchange rate steady led to rapid growth of the money supply, further fueling inflation
Wages rose and the country lost competitiveness
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Low Inflation in the Czech Republic
In contrast, inflation in the Czech Republic remained low in the boom years, barely higher than the EU average
A stengthening exchange rate kept import prices low, holding average price increases down
Not needing to hold the exchange rate fixed, the Czech central bank was able to use monetary policy to avoid overheating of the economy
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
In Czech Republic, Exchange Rate Helps Absorb Impact of Crisis
When the global financial crisis hit, the Czech koruna depreciated sharply, from 23 per euro to almost 30 per euro
The depreciation absorbed much of the impact of the crisis by quickly improving the country’s competitiveness relative to its EU trading partners
Inflation slowed moderately, but there was no threat of deflation
Weaker Koruna
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Crisis in Latvia Forces Adjustment through “Internal Devaluation”
The crisis hit Latvia much harder With no change in the exchange
rate, Latvia could restore competitiveness only through deflation
Restoring competitiveness through a fall in prices and wages is sometimes called a strategy of “internal devaluation”
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Consequences for Unemployment
“Internal devaluation” through deflation has been very painful to Latvia, and has brought soaring unemployment
The extra flexibility of a floating exchange rate has helped the Czech Republic adjust more smoothly to the crisis
Unemployment in Latvia is the highest in the EU, but in the Czech Republic, it has stayed below the EU average
Posting P100524 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Bottom Line
During good times, a fixed exchange rate is beneficial in promoting trade and economic integration
However, during a boom, a fixed exchange rate can contribute to overheating
When there is a sharp downturn, a flexible exchange rate can speed adjustment compared with the painful process of “internal devaluation” that a fixed-rate country must undergo
