[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

tary policy from a country’s control—in this case, giving it to the Fed. The potential
drawback is that the Fed bases its policy decisions on U.S. economic conditions
and would be unlikely to alter monetary policy in response to a domestic economic
or financial crisis in a country that had switched to dollars.
At the time it dollarized, Ecuador faced the threat of hyperinflation. By adopting
the dollar as its currency, Ecuador has enjoyed low inflation instead. Thanks to
high oil prices, real output has grown.
Can Governments Stabilize Exchange Rates? Some economists are
skeptical about the ability of government to stabilize the exchange rate even in the
short run. If the current exchange rate between the peso and the dollar is 10 pesos
to the dollar, and if the market knows that the exchange rate must change in the
near future to 12 pesos to the dollar, it will be futile for the Mexican government to
try to maintain the current exchange rate in the short run. Mexican investors,
believing that there will be a devaluation of the peso, know that the gains from holding
assets in dollars will be enormous. By converting their pesos to dollars
and holding them for the short period until the peso is devalued, they obtain a
large return.
The result will be what is referred to as a run on the peso, as those holding assets
denominated in pesos seek to sell them now. This run will be too large for the Mexican
government to stop by buying pesos and selling dollars, as more private individuals
are willing to sell pesos and buy dollars than the Mexican government has resources
to cope with. The government may be successful in postponing the fall of the peso
for a few days, but in doing so it may pay a huge price. It would have obtained the capital
gain on the dollars it held if it had not sold dollars for pesos. Instead, the capital
gain is earned by private individuals. If the government spends $1 billion trying to
support the peso and the peso goes down 20 percent (as in our example), the cost of
the short-run support is more than $200 million.
Critics of government stabilization programs make several points. First, they
stress the difficulties in determining the equilibrium exchange rate that is supposed
to be stabilized. Is there any reason, they ask, to believe that government bureaucrats
are in a better position to make judgments about the equilibrium exchange rate than
the thousands of investors who buy and sell foreign exchange every day? If the
government makes mistakes, as it is almost bound to do, it can actually contribute
to destabilizing the exchange rate rather than to stabilizing it.
Exchange rates often need to change. For example, if one economy grows faster
than another or has higher inflation than another, the exchange rate will have to
adjust to compensate. How will a scheme for stabilizing exchange rates let them
adjust naturally while controlling them at the same time?
Second, critics of government stabilization programs question whether international
economic cooperation is achievable. Running domestic economic policy is
difficult enough. For example, will a country take steps to raise its exchange rate
and thus hurt its exporters to keep a political agreement with foreign countries?
Thus, there are serious questions about whether stabilizing the currency is
possible either economically or politically.
774 ∂ CHAPTER 34 THE INTERNATIONAL FINANCIAL SYSTEM