1 chapter 7 exchange-rate regimes: evidence and credibility aspects © pierre-richard agénor and...

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Chapter 7Exchange-Rate Regimes: Evidence and Credibility

Aspects

© Pierre-Richard Agénor and Peter J. Montiel

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Evidence on Exchange-Rate Regimes. Credibility and Exchange Rate Management. Exchange Rate Bands.

Evidence on Exchange Rate Regimes

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Industrial countries: managed floating (exchange rates were determined largely by market forces).

Developing countries: official parity (exchange rate has remained as a policy instrument).

Official parity: fixed peg; permitting exchange rate to crawl over time.

Fixed peg: Use of pegs to a single currency and to alternative

baskets of currencies. These pegs are fixed for long periods of time or

periodically adjusted.

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When exchange rate has been allowed to depreciate: Crawl has been against either a single currency or a

basket. Rate of crawl has either followed a well-defined

feedback rule or been discretionary. When a rule was in place, it has sometimes been made

known to the public and sometimes not. When discretion has been used, the future path of the

exchange rate has at times been preannounced and at times not.

Official parity has been maintained with the assistance of a large array of exchange controls.

Implication: official parity coexists with a parallel market.

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Forms of exchange-rate arrangements in developing countries have evolved systematically over time.

Figure 7.1: After the collapse of the Bretton Woods system, most

developing nations continued to peg against a single currency.

In 1976 more than 60% of all developing IMF member countries did so.

Major shift was away from pegging to the U.S. dollar to “flexible arrangements”.

These are various forms of crawl and limited instances of flexible rates.

In 1997, 57% of the countries were classified as operating a “managed floating” or “independently floating” regime.

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Figure 7.1Developing Countries: Exchange Rate Arrangements

(number of countries)

Source: International Monetary Fund.

0 10 20 30 40 50 60

1982 1989 1997

Pegged to a single currency

Pegged to a basket of currencies

Crawling peg

Adjusted to a set of indicators

Managed floating

Independently floating

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But many countries classified in this group intervene heavily to manage their exchange rates.

Systematic patterns of exchange-rate arrangements are observable across regions in the developing world.

Figure 7.2: geographical distribution of exchange rate regimes.

Fixed exchange rates have been dominant in Africa. Twelve Asian countries pegged to a single currency or a

basket of currency in 1997. Sixteen Asian have followed a managed floating or

independently floating regime. Among Western Hemisphere countries, in 1997, the

number of countries with exchange rate pegged to a single currency:11;

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Figure 7.2aExchange Rate Arrangements for Developing Countries


1982 1989 1997

0 2 4 6 8 10 12

Asia

0 5 10 15 20 25 30

Africa

Pegged to asingle currency


Crawling peg


Managed floating




Crawling peg


Managed floating



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Figure 7.2bExchange Rate Arrangements for Developing Countries


1982 1989 1997

0 5 10 15 20

Europe and Middle East

0 5 10 15 20 25

Latin America and Caribbean



Crawling peg


Managed floating




Crawling peg


Managed floating



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operating a managed float or an independently floating regime: 21.

Reason for near absence of free floating in developing countries: limited financial development achieved; large role of the public sector as a supplier of foreign

exchange. Switch to basket pegs from single currency peg to

dampen the impact of external sources of real exchange instability.

Switch from pegging to crawling to avoid a domestic source of instability.

Regional variations in currency pegs reflect geographical differences in trading patterns.

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Reliance on discretionary crawls in Asia reflect export promotion policy associated with outward-oriented development strategies.

Credibility and Exchange Rate Management

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Dilemma in using exchange rate as a policy instrument.

Nominal depreciation: It improves the trade balance and the balance of

payments. But it cause a rise in the price level, which may turn into

inflation and erode external competitiveness.

Fixed exchange rate: It stabilizes prices in the presence of a large current

account deficit. But it is not viable if there is a shortage of foreign

exchange reserves or an external borrowing constraint.

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Arguments in favor of adopting a fixed exchange-rate regime: role of the exchange rate as an anchor for the

domestic price level; “credibility effect'' that a fixed rate may attach to a

disinflation program.

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Time Inconsistency and Exchange-Rate Policy. Credibility of a Fixed Exchange Rate. Reputation, Signaling, and Exchange-Rate

Commitment. Credibility Effects of Monetary Unions.

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Time Inconsistency and Exchange-Rate Policy

Small open economy producing traded and nontraded goods.

Exchange rate is determined by a policymaker whose preferences relate to external competitiveness; price stability.

Foreign-currency price of traded goods is determined on world markets.

Agents in the nontraded goods sector set their prices to protect their position relative to the traded goods

sector;

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respond to domestic demand shocks. Prices in the nontraded goods sector are set before the

policymaker sets the exchange rate. Domestic rate of inflation:

= N + (1-)(+T*), 0 < <1,

: rate of devaluation of the nominal exchange rate;

N: rate of increase in the price of nontradables;

T*:rate of increase in the price of tradables;

(1-): degree of openness.

(1)

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Government's loss function:

Lg = -[(+T*-N) - ] + 2/2, , 0.

: target rate of depreciation. Lg depends on deviations of the rate of depreciation of

the real exchange rate from and inflation rate. Government's objective is to minimize its loss function. Agents in the nontraded goods sector change prices in

reaction to fluctuations in the domestic price of tradable goods; exogenous demand disturbance to their sector dN.

(2)

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Their loss function:

Lp = [N - (a+T) - dN]2/2, 0,

a: expected rate of depreciation of the exchange rate. When the authorities decide whether or not to devalue

the exchange rate, they know prices set in the nontraded goods sector.

Substituting (1) in (2) and setting T* = 0, optimal rate of

adjustment of the nominal exchange rate:

(3)

= 1-

(1-)

- N (4)

*

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From (3), optimal rate of inflation in the nontradable goods sector from the perspective of agents in that sector:

N = dN + a.

In a discretionary regime, equilibrium values of the nontradable inflation rate and the rate of devaluation (N, ) are found by imposing rational expectations (a = ) on the part of

agents in the nontraded goods sector; solving (4) and (5) simultaneously.

~ ~

(5)

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This yields:

N = (+dN)/ 0,

= (-dN)/ 0,

where = /(1-); = / 1; = /(1-) > 0. In the absence of demand shocks, the optimal

discretionary policy requires a positive rate of devaluation; results in a positive rate of inflation in the nontradable

sector.

~

~

(6)

(7)

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When dN 0, whether the sign of depends on: relative importance of the real-exchange-rate target; inflation objective in the government's loss function.

When the latter predominates, optimal policy is appreciation of the nominal exchange rate.

Substituting (6) and (7) in (1)-(3) yields the solutions for the inflation rate and the policymaker’s loss function under discretion:

= /,

Lg = (dN+) + (/)2/2.

(8):economy's inflation rate is independent of the demand shock and increasing with /.

(8)

(9)

~

~

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Inflation is positive because, if it were zero, the policymaker would always have an incentive to devalue.

Thus policymaker incurs a net loss unless dN takes on a large negative value, which simultaneously improves competitiveness; reduces the rate of increase in nontradable prices.

Consider now the case in which the government is able to commit to a predetermined exchange rate.

Government substitutes (5) into (3) and minimizes with respect to .

In this case the government will announce and maintain a fixed exchange rate.

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If the private sector believes the announcement and acts on that basis, (5) yields N = dN which in turn implies = dN and

Lg = (dN+) + 2 /2,

if dN 0,

Lg = .

Lg Lg.

_

_

__

(10)

(11)_ ~

_

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Policymaker cannot achieve the gain in competitiveness sought in the discretionary regime.

Reason: price setters increase nontradable prices accordingly.

Binding commitment entails lower inflation rate gain with no loss in competitiveness.

Consider that government announces at the beginning of the period its intension to maintain the exchange rate fixed ( = 0).

But it implements a discretionary change once price decisions have been made.

If price setters believe the zero-devaluation announcement, they will choose N = dN.

..

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Substituting this in (4), optimal rate of devaluation chosen by the policymaker becomes

= - dN.

Minimized value of the policymaker's loss function under this “cheating” regime

Lg = -[ - dN/(1-) - ] + 2/2,

where = (1 - ). For dN 0, Lg < Lg < Lg. Loss is lower when the government succeeds in

“fooling” the private sector. For dN 0, = > = / > = 0.

..

.. ..

..

.. _ ~

.. ~ _

(13)

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Although is higher under cheating than under discretion, = .

Reason: for dN 0, N = 0 and N = / > 0. in the nontradable sector is lower when price setters

are fooled than in the discretionary regime. Under discretion, - N = 0. Authorities are incapable of altering the real exchange

rate by a nominal devaluation. If the private sector can be successfully misled by the

fixed exchange rate announcement, - N = . This entails reputational costs.

..~

~..

~~

.. ..

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Figure 7.3: three different solutions. PP: reaction function of the private sector [equation (4)]

and has a positive slope. GG: policymaker's reaction function under discretion

[equation (5)] and has a negative slope. Noncooperative equilibrium at point A: intersection of

curves GG and PP. Precommitment solution: B. “Cheating” solution: C.

Discretionary solution: Characterized by a “devaluation bias.” Private agents know that once they set prices of

nontradables, the policymaker has the incentive to devalue.

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Figure 7.3Credibility and Commitment: Alternative Equilibria

B

A

P

PG

G

C

d

_ ..

a

Source: Agénor (1994a, p. 7).

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So they set prices at a higher level. This level is where authorities are unwilling to trade off a

higher for a more depreciated real exchange rate. Precommitment solution provides a better outcome. Argument in favor of a fixed exchange rate, assuming

the commitment can be made binding and perceived by price setters.

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Credibility of a Fixed Exchange Rate

Precommitment to a preannounced zero-devaluation rule can be successful only if the authorities incur some penalty if they deviate from the rule.

One form of this penalty: if the government departs from the preannounced rule, public will not believe its announcements in the

following periods; economy would revert to the discretionary

equilibrium.

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Zero-devaluation rule is credible if the temptation to deviate from the rule is less than the discounted value of the “punishment”.

Barro and Gordon (1983) and Horn and Persson (1988):

C: degree of credibility of a fixed exchange rate. It is difference between the present value of the

punishment (Lg - Lg) and the temptation (Lg - Lg):

C = (Lg-Lg) – [/(1-)](Lg-Lg),

: discount rate.

..~_ _

.. _ ~_(14)

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Substituting (9), (10), and (13) in (14) and setting dN 0, necessary condition for the degree of credibility of a fixed exchange rate to be positive is

2(1-)/(1-) > = 0.

Fixed exchange rate can be credible only if that would obtain in a discretionary regime is high enough to “discourage” any attempt to devalue.

Using (8), (15) requires 0.5. Fixed exchange rate is the optimal strategy under

perfect information about the policymaker's preferences. Required condition: future costs of higher are not

sufficiently discounted so as to fall short of the current gain from a depreciation of the real exchange rate.

~ _(15)

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Credibility requires that the short-term benefits from be forgone in order to secure the gain from low over the long term.

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Reputation, Signaling, and Exchange-Rate Commitment

How reputational factors and signaling considerations may help mitigate the time inconsistency problem faced by the policymaker in choosing an exchange-rate policy.

Rogoff (1989): Continuum of types of policymakers that differ with

respect to the cost incurred from reneging on a fixed exchange-rate commitment.

As time proceeds, private beliefs are updated on the basis of observed exchange-rate policy.

The longer the policymaker sticks to a fixed exchange rate, the lower is the expected rate of devaluation.

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If the policymaker deviates from the fixed exchange-rate target, private agents will raise devaluation expectations.

Sequential process of this type leads agents to revise continually upward the threshold level of cost below which government has an incentive to renege.

As a result, devaluation expectations tend to fall over time.

This behavior of expectations creates an incentive to commit to a fixed exchange-rate rule.

“Reputation”: mechanism leading to a progressively lower expected rate of depreciation.

Government with low cost of reneging may be tempted to devalue early in its term in office.

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But if the policymaker's horizon is long enough, the temptation to devalue is lowered.

Reason: costs resulting from high devaluation expectations.

Implication of the analysis: even policymakers who are concerned with a balance-of-payments target may tend, at the start of their term in office to lower expectations.

But they may devalue near the end of their term in an attempt to improve competitiveness and raise output.

Nominal devaluation will “work”, as long as the policymaker has a reputation of being a “pegger”.

Critical element: public's lack of information about the policymaker.

Complete credibility is impossible to achieve.

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But reputational factors can help mitigate the time inconsistency problem.

Consider there are only two types of policymakers. They differ in the relative weights they attach to

“internal” target (inflation) and “external” target (the real exchange rate).

D: policymakers (“devaluers”) attach a value both to low inflation and to a more depreciated real exchange rate.

P: policymakers (“peggers”) attach a lower weight to the real exchange rate in its loss function.

Price setters do not know the type of government, but they have a prior probability that it is type P.

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As time proceeds, private agents observe the exchange rate policy and revise their assessment of the policymaker's type.

Policymaker who cares more about inflation can signal this preference to the private sector by inducing a temporary recession.

Vickers (1986): Policymakers with greater concern about output and

employment are unwilling to bear this cost. Thus the signal successfully conveys the policymaker's

preference for low inflation. Even P-type policymaker may have an incentive to

devalue by less than it would otherwise find optimal, in order to signal its preferences to the public.

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One way for the P-type government to reveal its identity: selection of an exchange-rate policy that the D-type policymaker would not find optimal to replicate.

It is costly for P-type policymaker, but could be a credible signaling device.

Assume that the policy horizon is limited to two periods.

Agénor (1994a): P-government will depart from the optimal, perfect-

information response in the first period in order to successfully reveal its type.

By devaluing by less than it would find otherwise optimal, an anti-inflation government is able to signal its commitment to price stability to private agents.

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So it can secure the gain from lower inflation expectations in the second period.

Result: Fixing the exchange rate may prove successful in

signaling the anti-inflationary commitment of the policymaker.

Thus it will enhance the credibility of a stabilization program.

It may be beneficial for a government to revalue its currency to convey unambiguous information about its policy preferences.

Example: Chile revalued its currency twice in 1977, in an attempt to demonstrate the government's resolve to fight inflation.

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There are situations in which signaling considerations either are not important for or incapable of mitigating the time inconsistency

problem faced by policymakers operating under a fixed exchange-rate regime.

If both types of policymakers have a high rate of time preference, optimal solutions obtained under perfect information and uncertain preferences may not be very different from each other.

Reason: D-type policymakers have a reduced incentive to

masquerade as P-type. b

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If price setters understand that the future is heavily discounted, P-policymakers need not send an overly “strong” signal to distinguish themselves from D.

Another situation: when implementing a disinflation program, a country is faced with a large current account deficit and a financing constraint.

If the deficit is unsustainable and perceived by private agents, a “high” rate of depreciation will appear inevitable and will undermine any signaling attempt.

Other ways for P-type to send signals for public to identify its preferences: removal of capital controls, drastic cut in the budget deficit, appointment of a “conservative” central banker.

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Credibility Effects of Monetary Unions

Alternative way to attach credibility to a fixed exchange-rate regime: surrender the power to alter the exchange rate.

Example: forming a monetary union under which a group of countries adopt a common currency and fix their parity against a major currency.

By “tying their hands” when joining a fixed exchange-rate arrangement, “weak” policymakers can combat inflationary expectations more effectively.

For such monetary arrangements to be credible, it must be based on institutional features that make it costly to alter the exchange rate.

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There are costs associated with using of the exchange rate as a policy instrument, particularly in the presence of large external shocks.

Previous model is extended to capture the institutional and macroeconomic constraints imposed by an international monetary arrangement.

Country must decide whether or not to keep its exchange rate fixed within the framework of a monetary union with its major trading partner.

Assumptions: Inflation in the partner country is positive (T* > 0). Both the policymaker and private agents learn about

changes in foreign prices immediately after their occurrence, and make their decisions afterward.

For simplicity, let dN 0.

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Discretionary solution:

N = / 0,

= / - T* 0,

which yields an overall inflation rate equal to

= N = /,

and constant real exchange rate

+ T* - N = 0.

Loss for the policymaker:

Lg = (/)2/2.

~

~

~ ~

~

~

(16)

(17)

(18)

(19)

(20)

~ ~

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If the authorities keep the nominal exchange rate fixed, and if their commitment to such a policy is assumed by price setters ( = 0, N = = T*), loss function is:

Lg = (T*)2/2.

Comparison of (19) and (20): loss under a commitment is higher than under discretion when T* > /.

When the foreign price shock is small, its direct inflationary impact is limited.

So the rate of appreciation of the nominal exchange rate required to offset its impact in the discretionary regime is small.

_

__ _

(21)

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If the commitment to the fixed exchange rate is credibly enforced, the rate of appreciation of the real exchange rate is the same under both regimes.

Overall effect on inflation under precommitment is T* while under discretion it is /.

For a policymaker concerned with both inflation and competitiveness, the desirability of “tying one's hands” depends on what one's hands are tied to.

When union members have stable, low inflation rates, precommitment to a fixed exchange rate may help maintaining financial discipline.

But when the economy is subject to large nominal shocks, the credibility gain may be outweighed by the cost of lost autonomy.

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Exchange-rate arrangements involving a peg incorporate an “escape clause.”

This allows members to deviate from the declared parity under exceptional circumstances.

Assumptions: T* is a random variable that follows a uniform

distribution over the interval (0, c) and is realized after private agents make their price decisions.

Domestic country maintains a fixed parity when foreign price shocks are “small.”

But it is allowed to alter the fixed exchange rate discretionarily if the foreign price shock is “large.”

Probability that the contingency mechanism will be invoked is q = Pr(T* ) where 0 q 1, and is a given threshold.

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Probability:

q = Pr(T* ) = (1/c)dT* = (c-)/c.

Price setters form expectations prior to the realization of the foreign price shock.

If they are aware of the policy rule followed by the authorities, the expected rate of depreciation of the exchange rate:

a = qE( | T* ) + (1–q).0,

or

a = [q/(1+q)] (-T*),

T* = E(T* | T* ) = (c+)/2.

_

_

(22)

c

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As long as contingency mechanism will be invoked, the expected rate of depreciation is lower than under pure discretion since q < 1.

Discretionary exchange-rate policy when the escape clause is activated:

_

This is lower than the value that would prevail under pure discretion, obtained by setting q = 1, because devaluation expectations are lower.

Implication: the higher q is, the more effective the contingency mechanism will be in mitigating the devaluation bias of the discretionary regime.

= + qT*

1 + q- T*

~ (23)

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High value of q generates real costs in circumstances in which foreign price shocks turn out to be “small.”

In a purely discretionary regime, actual change in the real exchange rate is given by, using (22) and (23) with q = 1 and noting that N = a + T*,

+ T* - N = -(T*-T*).

This reflects unanticipated changes in the foreign inflation rate. When possibility to invoke an escape mechanism exists, the

actual rate of depreciation of the real exchange rate is determined by the size of the foreign price shock.

~

~~ _

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If the realized value of T* is sufficiently large to trigger the contingency mechanism, (22) and (23) imply

This indicates that real rate of depreciation is lower than under pure discretion.

However, if T* turns out to be “small,” the authorities will maintain the nominal exchange rate fixed.

Change in real exchange rate in this case: T* - N = a. Thus (22) indicates that high probability of using the

contingency mechanism may have a negative effect on competitiveness.

~

_

+ T* - N =(1–q) + 2qT*

1 + q- T*.~ ~

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Thus (22) indicates that high probability of using the contingency mechanism may have a negative effect on competitiveness.

Reason: nontradable prices are set at a level that may be higher than they would be if instead a = 0.

Thus if escape mechanisms are to be considered as part of an exchange-rate arrangement, q should not be “too high”.

Exchange Rate Bands

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Rationale for Exchange Rate Bands. Bands and Monetary Policy Credibility. Experience with Exchange Rate Bands.

Central Parity. Band Width. Intramarginal Intervention.

Lessons from Experience.

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Rationale for Exchange Rate Bands

Changes in the nominal exchange rate influence both economy's price level and its real exchange rate.

Policy conflicts: change in the nominal exchange rate causes one of these variables to move in the direction desired by policymakers, and the other in the opposite direction.

Example: nominal devaluation to facilitate real exchange rate depreciation causes an increase in domestic price level.

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Even when domestic prices are fully flexible, nominal and real roles of the nominal exchange rate will not be independent.

Reason: value of the domestic price level may indirectly influence equilibrium relative price of traded goods through wealth effects.

Conflict is more acute when domestic nontraded goods prices are sticky.

In this case, achieving adjustments in the real exchange rate while retaining the nominal anchor role of the nominal rate may require undesirable changes in the domestic price level or temporary slowdown in economic activity.

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Under fixed exchage rates: Nominal exchange rate is used to provide a nominal

anchor. Relative price adjustments rely on the domestic wage-

price mechanism.

Under flexible exchange rates: Nominal exchange rate provides the adjustment in

relative prices. Economy's nominal anchor is provided by the money

supply. In the pure forms of these arrangements, exchange rate

is not actively managed, and thus ceases to function as a policy instrument.

Thus the potential policy conflict is choice of regime.

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Countries preserve some degree of exchange rate flexibility to promote relative price adjustment.

One way is announced exchange rate bands. This involves the announcement of a central parity with

a range of fluctuation around that parity. Relative to fixed exchange rates, exchange rate bands

allow exchange rate to facilitate temporary relative price adjustments;

preserve some degree of monetary autonomy depending on width of the band.

Relative to completely flexible rates, exchange rate bands can provide: nominal anchor for the domestic price level,

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limit the range of fluctuation of nominal exchange rates.

Achieving these objectives depends on how bands are managed.

Whether the band succeeds in stabilizing the exchange rate depends on its credibility.

Krugman's target zone model: Analyses stabilizing effect of a credible exchange rate

band on exchange rate fluctuations. Perfectly credible band tends to exhibit a honeymoon

effect. That is presence of announced band is stabilizing.

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Reason: near the limits of the band, likelihood of intervention to prevent movement outside the band causes agents to expect the exchange rate to revert toward the central parity.

Such an expectation will itself restrict fluctuations in the exchange rate.

Sensitivity of the exchange rate to the fundamentals diminishes as the exchange rate approaches the limits of the band (smooth pasting).

Announcement of a band makes linear relationship between the exchange rate and the fundamentals S-shaped.

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Exchange rate lies below flexible-rate value when changes in the

fundamentals drive it above the central parity, above flexible-rate value when changes in the

fundamentals drive it below the central parity.

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Bands and Monetary Policy Credibility

If “tying one's hands” by pegging to a low-inflation currency makes an anti-inflationary policy stance credible, is this outcome lost when a fixed exchange rate is replaced by a band?

Coles and Philippopoulos (1997): Generalize Barro-Gordon analysis to the case of bands. Optimal monetary policy strategies depend on the

position of the exchange rate within the band.

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Two cases: deterministic case in which the partner country's

inflation rate is nonstochastic; case where “center” country's inflation rate is subject

to random shocks.

Deterministic case: Barro-Gordon result emerges when the exchange rate

lies initially inside the target zone. Domestic inflation matches foreign inflation, as under

fixed exchange rates. From the perspective of resolving time-inconsistency

issues, a target zone would be inferior to a fixed exchange rate with very narrow bands.

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When partner country experiences stochastic inflation shocks, this result does not hold.

Reason: If the center country experiences a negative inflation

shock, this constrains domestic inflation by moving the exchange rate to the top of the band.

But, if it experiences a positive inflation shock, domestic economy does not have to follow it.

Thus, in the face of unstable partner-country inflation, band stabilizes the domestic inflation rate.

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Experience with Exchange Rate Bands

In theory, credible bands stabilize exchange rate fluctuations relative to flexible

exchange rates; domestic inflation relative to fixed exchange rates.

How have exchange rates bands performed in practice? Examples: Chile (1985), Israel (1989), Mexico (1989),

Colombia (1991), Indonesia (1994), Brazil (1995), Ecuador (1994).

These bands have been implemented in the aftermath of exchange-rate-based stabilization programs.

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Thus, they represent the “flexibilization” stage of such programs.

Although many of these bands share this common background, the choices have been rather different.

Choices that countries have made in managing their bands:

Definition of the central parity must be stated in terms of some currency or basket of currencies.

If domestic rate of inflation exceeds the rate of inflation of trading partners and is expected to continue to do, then unalterably fixed central parity is not an option; so choice must be made between frequent discrete realignments of central parity and, adoption of a crawling central parity.

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It is required to determine relevant set of “fundamental” determinants of the

equilibrium real exchange rate that are affected by mode of accommodation of the central parity to permanent shocks;

expected duration of changes in these variables; extent of adjustment in the real exchange rate; adjustment path for the central parity.

Width of the band has to be determined. Rules governing foreign exchange intervention inside

the bands need to be established.

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Central Parity

Experiences of Chile, Colombia, Indonesia, and Mexico. All of them have adopted a crawling central parity. Rules governing the behavior of the central parity have

differed across countries.

Chile: 1982 financial crisis had been partly caused by

overvalued real exchange rate. Crawling peg was intended to safeguard

competitiveness. Central parity was set in terms of the U.S. dollar. Then it was defined in terms of a basket of currencies.

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This switch reflected attempt to stabilize the real effective exchange rate in the face of

fluctuations in the value of the dollar; add uncertainty to the nominal exchange rate to

discourage speculative capital inflows. Central parity has been adjusted continuously. Daily depreciations for the coming month determined as

a function of the difference between actual domestic rate of inflation during the previous

month and; forecast of foreign inflation over the coming month.

Since the band was specified in “real” terms, the Chilean band was not used to supply the economy with a nominal anchor.

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Nominal anchor was provided by monetary policy. Periodic discrete devaluations and revaluations of the

central parity have been implemented. Discrete revaluation of 5% was implemented in January

1992, and one of 10% in November 1994. Figure 7.4: after the Mexican crisis in late 1994, Chilean

exchange rate reverted to its prerevaluation behavior. As the value of the U.S. dollar began to increase in mid-

1995, the Chilean central parity began to depreciate. By early 1997, this had triggered another revaluation. New type of accommodation for changes in

“fundamentals” (December 1995): rate of crawl set at 2% below the inflation differential.

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Figure 7.4Chile: Nominal Exchange Rate and Intervention Bands,

January 1995-July 1997(Pesos per U.S. dollar)


1995

D3

1995

D27

1995

D51

1995

D75

1995

D99

1995

D12

3

1995

D14

7

1995

D17

1

1995

D19

5

1995

D21

9

1995

D24

3

1996

D7

1996

D31

1996

D55

1996

D79

1996

D10

3

1996

D12

7

1996

D15

1

1996

D17

5

1996

D19

9

1996

D22

3

1996

D24

7

1997

D9

1997

D33

1997

D57

1997

D81

1997

D10

5

1997

D12

9

1997

D15

3

1997

D17

7

300

350

400

450

500

550

Upper intervention band

Lower intervention band

Center intervention band

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Reasons: offset a favorable productivity differential for Chile, keep the real exchange rate aligned with its

equilibrium value.

Colombia: Crawling peg system from 1967 to 1991 to stabilize the

real exchange rate. In the early 1990s, the country received large capital

inflows. It sterilized to sustain competitiveness. To reduce the cost of sterilization, sellers of foreign

exchange received foreign exchange certificates (certificados de cambio) instead of domestic currency.

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Central bank redemption options introduced a de facto band for the exchange rate.

Formal band introduced in January of 1994. Band was set relative to the U.S. dollar, and

implemented with a crawling central parity. Central parity was set equal to the exchange rate

prevailing on the date the band was implemented. Due to continuing pressures from inflows, the central

parity was revalued in December of 1994. Figure 7.5: behavior of the exchange rate within the

band is U-shaped distribution predicted by the Krugman target-zone model.

Political uncertainties in mid-1995 pushed the exchange rate to the top of the band.

77

Figure 7.5Colombia: Nominal Exchange Rate and Intervention Bands,

October 1994-October 1996(Pesos per U.S. dollar)

Oct

94

Nov

94

Dec

94

Jan

95

Feb

95

Mar

95

Apr

95

May

95

Jun

95

Jul 9

5

Aug

95

Sep

95

Oct

95

Nov

95

Dec

95

Jan

96

Feb

96

Mar

96

Apr

96

May

96

Jun

96Ju

l 96

Aug

96

Sep

96

Oct

96

Nov

96

Dec

96

Jan

96

Feb

96

Mar

96

Apr

96

May

96

Jun

96

Jul 9

6

Aug

96

Sep

96

Oct

96

700

800

900

1,000

1,100

1,200

1,300

1,400




78

Pressures from capital inflows moved the rate to the bottom of the band.

Thus, margins have been binding in Colombia.

Indonesia: Substantial real effective depreciation of the rupiah in

the mid-1980s due to international debt crisis. Since then, exchange rate management has been used

to maintain external competitiveness. Consistent with this objective, the exchange rate has

been managed through the use of a crawling peg. Result: stable real effective exchange rate from 1988

until Asian currency crisis in July 1997. In January 1994, band was introduced to enhance

exchange rate flexibility.

79

Central parity was set with regard to an unannounced currency basket.

It is depreciated with inflation differentials. In August 1997, intervention margins were removed. Figure 7.6.

Israel: Management of the central parities was targeted at price

level stabilization. Band grew out in “heterodox” stabilization program of

1985. It represented “flexibilization” stage of the program. Inflation was brought down. But, convergence to international levels was slow.

80

Figure 7.6Indonesia: Nominal Exchange Rate and Intervention Bands,

October 17 1997-November 7 1997(Rupiah per U.S. dollar)

10/3

/94

11/4

/94

12/8

/94

1/11

/95

2/14

/95

3/20

/95

4/21

/95

5/25

/95

6/28

/95

8/1/

95

9/4/

95

10/6

/95

11/9

/95

12/1

3/95

1/16

/96

2/19

/96

3/22

/96

4/25

/96

5/29

/96

7/2/

96

8/5/

96

9/6/

96

10/1

0/96

11/1

3/96

12/1

7/96

1/20

/97

2/21

/97

3/27

/97

4/30

/97

6/3/

97

7/7/

97

8/8/

97

9/11

/97

10/1

5/97

2,000

2,500

3,000

3,500

4,000




81

Appreciation of the real exchange rate resulted in discrete devaluations in both 1987 and 1988.

Formal band was introduced with 3% fluctuation margins in January of 1989.

Figure 7.7: behavior of exchange rate within the band. Devaluations took place in June 1989, in both March

and September 1990, and in March 1991. In December 1991, the “horizontal” band was

abandoned, and the central parity was allowed to crawl. Rate of crawl: difference between the government's

targeted rate of inflation over the coming year and a forecast of foreign inflation.

As inflation fell in Israel, the rate of crawl was reduced.

82

Figure 7.7Israel: Nominal Exchange Rate and Intervention Bands 1/

January 1989-June 2001

Source: Bank of Israel.1/ End of week daily rates. Updated to June 27, 2001.

6/16

/89

12/1

/89

5/18

/90

11/2

/90

4/19

/91

10/4

/91

3/20

/92

9/4/

92

2/19

/93

8/6/

93

1/21

/94

7/8/

94

12/2

3/94

6/9/

95

11/2

4/95

5/10

/96

10/2

5/96

4/11

/97

9/26

/97

3/11

/98

8/28

/98

2/12

/99

7/30

/99

1/14

/00

6/30

/00

12/1

5/00

6/1/

01

1

2

3

4

5

6

7



Midpoint intervention band

Currency basket

83

Band was adjusted with changes in the underlying equilibrium real exchange rate to be associated with trade liberalization.

Small discrete devaluations were implemented in November 1992, July 1993, and May 1995.

Mexico: Band was adopted as a response to overvaluation of the

currency caused by the use of the exchange rate as a nominal anchor in stabilization program in 1987.

Since convergence to trading-partner inflation rates was slow, and real exchange rate appreciated.

Mexican government did not respond with step devaluations.

Instead, in November 1991 it implemented a band with a depreciating upper margin and stable lower margin.

84

No central parity was announced. Lower end of the band was fixed relative to the U.S.

dollar at the value that prevailed on the date that the band was adopted.

Predetermined rate of daily depreciation relative to the dollar was announced for the upper end.

This implied a gradually increasing band width. During Mexican crisis in December 1994, the width of

the band had increased to 14%. Figure 7.8: behavior of exchange rate. During most of the year leading up to the crisis,

exchange rate depreciated to the top of the band.

85

Figure 7.8Mexico: Nominal Exchange Rate and Intervention Bands, 1994

(Pesos per U.S. dollar)

Source: Bank of Mexico and Bloomberg, Inc.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2.5

3

3.5

4

4.5

5

5.5

6



86

Band Width

Factors that influence the desired band width: degree of uncertainty regarding the equilibrium real

exchange rate; desired scope for monetary autonomy; variance of shocks that policymakers desire to

accommodate with a relative price response. Band widths increase over time in each of the cases.

Width of the Chilean band: Started out with a fluctuation range of 0.5% around

the central parity in August 1984. Widened to 2% by June 1985 and had increased to

10% by 1992.

87

Width of the Colombian band: 12.5% under the certificados de cambio system. Widened to 7% when a crawling peg was formally

adopted at the beginning of 1994.

Width of Indonesian band: Initially 1% on either side of the central parity in 1994. Increased to 2% in June 1995, 3% in January 1996, 5%

in June, and 8% in September 1996 due to capital flow pressures.

During this time, rupiah was at the lower end of the band.

88

Width of Israeli band: Increased from 3% around the central parity when the

band was initially announced in June 1989 to 5% in March 1990.

Remained at 5% after crawling band was adopted at the end of 1991.

Widen to 7% due to large capital inflows during 1995 in order to preserve some degree of monetary autonomy; create uncertainty about the nominal exchange rate to

discourage speculative short-term inflows.

89

Width of Mexican band: Widened automatically over time, because its upper

bound was depreciated continuously while its lower bound was fixed.

All of these countries received very large capital inflows during the time that the bands were in operation.

Increase in band widths used to stabilize the domestic economy in the face of such inflows.

Widening of the exchange rate band was used to absorb some of the capital inflow pressure instead of monetary expansion or sterilized intervention.

90

Intramarginal Intervention Chile and Colombia have made use of the full band

width, with the exchange rate regularly approaching the upper and lower bounds.

In Colombia, volatility of the nominal exchange rate increased after the adoption of the band.

Thus the band was intended to reduce the scale of intervention in the foreign exchange market.

Israel was active in restricting fluctuations to a narrower zone inside the band.

Mexico intervened to restrict fluctuations of the exchange rate inside the band until after March 1994.

91

Lessons from Experience Adoption of a band is a commitment to limited nominal

exchange rate flexibility, not to a specific choice of nominal anchor. Thus bands are compatible with a variety of different

weights that may be attached by the authorities tocompetitiveness and, price stability objectives.

Differences in these weights is reflected in differences in the management of the central parity.

Mexico and Colombia: since inflation stabilization was important, the band associated with continuous real appreciation.

92

Chile: since external competitiveness was crucial, real exchange rate depreciated.

Israel: real exchange rate was stable since the adoption of the band.

Moving to band from a fixed rate, or band with a crawling central parity from one with a fixed parity, has not been associated with an acceleration of inflation. Additional exchange rate flexibility has not been

associated with a loss of price stability. This is consistent with the view that flexibility can

enhance credibility.

93

Adoption of a band does not represent a solution to credibility problems.

Active management of the central parity to keep it in line with the equilibrium real exchange rate is indispensable to preserve the bands when capital mobility is high.

94

Appendix: Krugman’s Target Zone Model

Figure 7.9.

95

Figure 7.9Krugman's Basic Target Zone Model

F

45º

F

sH

sL

m+

s

Z

Z

Source: Adapted from Svensson (1992, p. 123).

A

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