exchange rate regimes overview and policy issues
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EXCHANGE RATE REGIMES
Overview and policy issues
Outline
Types of ER regimes Advantages and disadvantages of
fixing/floating Choice of ER regime Empirical Evidence on Exchange Regimes
HARD PEGS
•Currency union
•Dollarization
•Currency board
FLOATING
•Managed float
•Free float
Classifying ER regimes
INTERMEDIATE
•Basket peg
•Crawling peg
•Band
Hard pegs
Dollarization Use another country’s currency as sole legal tender E.g. Ecuador, El Salvador, Panama
Currency union Share same currency with other union members E.g. Euro area, ECCU, CFA franc zone
Currency board Legally commit to exchange domestic currency for
specified foreign currency at fixed rate E.g. Hong Kong(1983), Estonia(1992), Lithuania (1994),
Bulgaria(1997), Bosnia and Herzegovina, Argentina (until 2001)
Intermediate regimes
Conventional (soft) peg Single currency peg (e.g. Malaysia, Nepal, Namibia) Currency basket peg (e.g. Malta, Fiji, Latvia)
Band Pegged exchange rate within horizontal bands (>±1%) E.g. Denmark (2.25%), Tonga (5%), Hungary (15%)
Crawling peg Backward or forward looking E.g. Bolivia
Crawling band Symmetric or asymmetric E.g. Belarus (5%), Israel (22%)
Floating
Managed floating No preannounced path for the exchange rate Management by sterilized intervention or interest rate
(monetary) policy E.g. Thailand, Indonesia, Mongolia, Singapore, Brazil
Independently floating E.g. U.S., Japan, EMU
ER arrangements of IMF members (as of July 2005)
No separate legal tender 41 Currency board 7 Peg (including de facto pegs) 40 Horizontal band 5 Crawling peg 5 Crawling band 1 Managed floating 54 Independently floating 34
...Not as simple as it sounds...de jure vs. de facto exchange rate
Distinction between what countries declare as their official de jure regime, and their actual de facto exchange rate practices. (Reinhart and Rogoff 2004) de jure: what the countries say they do de facto: what they actually do
Countries listed in the official IMF classification as managed floating, 53 percent turned out to have de facto pegs, crawls or narrow bands.
How to distinguish ‘Hard Peg’ and “Floating” from ‘Intermediate’?
Is the fixed ER policy an institutional commitment rather than merely a declared policy? YES Hard Peg NO Intermediate
Is there an explicit target around which the CB intervenes? YES Intermediate NO Floating
The Impossibility Trinity
A country must give up one of three goals:
1. Exchange rate stability (by Hard Peg)2. Monetary Independence3. Financial Market Integration (absence of
capital control)
Advantages of fixed ER
1. Provide a nominal anchor for monetary policy
2. Reduce transactions costs and exchange rate risk int’l trade & investment
Disadvantages of fixed ER
Loss of monetary policy autonomy Loss of exchange rate as a shock absorber
=>Consequences for output and employment Loss of lender of last resort (?) Danger of speculative attacks and crashes Loss of seigniorage revenue (in the case of
dollarization)
No Monetary Policy Autonomy Under Fixed ER with Perfect Capital Mobility
Monetary policy cannot stimulate output (on the other hand, fiscal policy is very effective in stimulating output)
Interestrate, i
0
1
Y1Y0
i1
i0 BP
LM
IS
Perfect capital mobility
Output, Y
• •
Real Shocks Not Absorbed (but magnified) Under Fixed ER
Adverse real shock would tend to lower activity and interest rates, leading to pressure to depreciate; CB must sell reserves and contract money supply, worsening the fall in output
•
•1
02
Y0Y2 Y1
i1
i0 BP
LM
IS
Perfect capital mobility
Interestrate, i
Output, Y
•
(20.0)
(10.0)
-
10.0
20.0
30.0
40.0
50.0
60.0
1993Q1 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1
-
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000
Growth Interest rates Debt
The Debacle of Argentina’s Peg
Advantages of flexible ER
1. Monetary Policy independence (discretionary policy)
2. Automatic adjustment to trade shocks
Monetary Policy Under Floating ER with Perfect Capital Mobility
Under flexible ER, monetary policy is very effective in stimulating output (on the other hand, fiscal stimulus leads to appreciation and loss of competitiveness)
Think Short x Long run though (and the role of expectations)
Interestrate, i
0
1
Y1Y0
i1
i0 BP
LM
IS
Perfect capital mobility
Output, Y
• • •
2
Y2
Real Shocks Absorbed (and offset) Under Floating ER
Real adverse shock (like a fall in external demand) would lower output and interest rates, leading to a depreciation and output recovery due to higher exports and lower imports
•
•1
0
Y0Y1
i1
i0 BP
LM
IS
Perfect capital mobility
Interestrate, i
Output, Y
Disadvantages of flexible ER
Exchange rate uncertainty Need to find a less obvious anchor
=> Consequences for inflation Danger of speculative (irrational?) bubbles
Irrational Bubble?Brazil: Daily Exchange Rate in 2001
1.5
1.7
1.9
2.1
2.3
2.5
2.7
2.9
Macroeconomic Stability: Exchange Rate Arrangements or Policy Discipline?
• The accession countries maintain a wide diversity of exchange rate regimes, from a currency board arrangement (Estonia) to floating regimes (Poland and the Czech Republic). Hungary's system, a preannounced crawling peg, had a band of 2.25 percent on either side until May 2004.
• Estonia has come close to achieving the EU inflation level with its currency board, as has the Czech Republic with its floating regime. Poland has followed approximately the same path of disinflation with a wide-band crawling peg, and Hungary with a narrow-band crawling peg
Macroeconomic Stability: Exchange Rate Arrangements or Policy Discipline?
What have countries done in the 1990s?
0
10
20
30
40
50
60
70
Hard Peg Intermediate Floating
No
. o
f co
un
trie
s a
s %
of
tota
l
1991 1999
16%(25)
42%(77)
23%(36)
34%(63)
62%(98)
24%(45)
Source: Fischer (2001)
The bipolar view
The intermediate ER regimes are no longer feasible (Summers 1999, Eichengree 1999, Fisher 2001)
The # of independent currencies in the world is declining.
Lack of theoretical foundation
Lessons from soft pegs
Long-lived (adjustable) pegs are the exception, not the rule.
Exits are often involuntary, the result of a speculative attack.
Greater international capital mobility has increased the likelihood of speculative attacks.
Pegs can only be maintained if the authorities are prepared to subordinate all other economic policy goals to the exchange rate commitment, otherwise exit is inevitable.
Source: Bubula and Otker-Robe (2004)
Choice of ER regime
Criteria (old and new): Structural characteristics of economy Nature of shocks to which economy is
exposed Objective function of national authorities Other considerations
(1) Structural characteristics
What makes a country more suited for fixed rather than flexible ER? (OCA criteria)
Size and openness Labor mobility Wage and price flexibility Fiscal redistribution mechanisms Diversity in production Financial development
(2) Nature of shocks
Nominal or real? Domestic or external? Temporary or permanent? Symmetric or asymmetric?
With or without capital mobility?
(3) Objective function
Real output stability BOP, competitiveness Price stability, inflation Political objectives e.g. desire for
integration
(4) Other considerations
Credibility of monetary policy Need of inflation tax Adequacy of reserves Strength and regulation of financial
system Rule of law
Who might be suited to a hard peg?
Small open economies whose trade is dominated by a single low-inflation partner Symmetric real shocks
Flexible labor market and/or migration Access to fiscal policy as a counter-cyclical
tool Countries with low credibility of domestic
monetary policy and a high degree of currency substitution
Important to have a healthy financial sector and/or access to external credit lines
Who might be suited to floating?
Economies that are affected by mostly idiosyncratic macroeconomic shocks and have relatively inflexible labor markets
Countries with an independent central bank that is credible and able to implement counter-cyclical monetary policy
Countries with well-developed capital markets
Who might be suited to an intermediate regime?
Countries that perceive official ER announcements to have large benefits and low costs BUT
are vulnerable to asymmetric shocks that are best addressed by monetary policy
Evidence on Exchange Rate Regimes
ER regimes and inflation
Sample of developing countries (Annual percentage change, median of group)
Source: WEO (Oct. 1997)
Do hard pegs lower inflation?
Source: Ghosh et al (1997).
Do hard pegs induce greater fiscal discipline?
0.1
1
10
100
1000
10000
1971 1981 1991 2001
-1
0
1
2
3
4
5
1991 1993 1995 1997 1999 2001
0102030405060
1991 1993 1995 1997 1999 2001
Inflation (% per year, log scale)
Fiscal deficit (% of GDP)
Public debt (% of GDP)
Source: IMF, WEO
Argentina
Does ER variability discourage trade?
Study Coverage Results
Coes (1981) Brazil, 1965-74 Yes
Brada & Mendez (1988) 30 developed & emerging economies,
1973-77
Mixed
Caballero & Corbo (1989) 6 emerging economies Yes
Paredes (1989) Chile & Peru Yes
Medhora (1990) W. African Monetary Union No
Savides (1992) 62 developed & emerging economies,
1973-86
Yes (unexpected variability only)
Grobar (1993) 10 emerging markets, 1963-85 Yes, mostly
Frankel & Wei (1993) 63 countries, 1980, 1985, 1990 Mixed
Arize, Osang & Slottje (2000)
Paiva (2003)
13 emerging economies, 1973-96
Brazil, 1990-2002
Yes
Yes
Do currency unions encourage trade?
Source: Rose (2004)
Partial effect of CU on trade, all else constant
Most estimates are positive, ... economically large, and statistically significant
Histogram of γ estimates, -2<γ<2 Histogram of γ estimates, 0<γ<1.2
Tijt = β1Dij + β2(YiYj)t + ΣkβkZijt + γCUijt + uijt
Does floating afford greater monetary policy autonomy?
Source: Calvo & Reinhart (2002)
“Fear of floating”
Fear of Floating
The fear of floating stems from the costs of exchange rate volatility
Calvo and Reinhart (2002): many countries that claim to have floating exchange rates do not in practice allow the rate to float freely, but use interest rate and intervention policies as the means of smoothing exchange rate fluctuations.
The greater the dependence on foreign currency borrowing, the greater fear of floating (Hausmann and others, 2000)
ER regimes and growth
Sample of developing countries (Annual percentage change, median of group)
Source: WEO (Oct. 1997)
ER regimes and growth
Impacts on Growth Using a de jure classification, Levy-Yeyati and
Sturzenegger (2003) find:
Developing countries—less flexible exchange rate regimes are associated with slower growth and greater output volatility;
Developed countries—regimes do not appear to have any significant impact on growth
Which ER regime is best for growth?
1.7%
3.1%
1.4%
1.9%
2.2%Limited flexibility
Peg
Managed float
Free float 0.5%
Regular peg 0.9%
Float
Currency board
1.0%
1.2%
2.0%Intermediate
Fix
Float
1.5%
1.9%Float
Intermediate 1.0%
Fix
Ghosh, Gulde & Wolfe (2000)
Reinhart & Rogoff (2002)
Levy-Yeyati & Sturzenegger (2002)
Levy-Yeyati & Sturzenegger (2002)
IMF classification
Own classification
Average per capita growth rates
Summary of empirical evidence
There is some evidence that hard pegs lower inflation
There is mixed evidence on hard pegs and fiscal discipline
There is some evidence that a common currency increases trade and integration and exchange rate volatility discourages trade and investment
There is strong evidence that the extent of monetary policy autonomy under floating ER is limited in practice
There is mixed evidence on exchange rate regimes and growth
Conclusion
Whatever the ER regime is, it must be consistent with macroeconomic policy objectives Role of fiscal and monetary discipline Role of capital controls
The choice of ER regime is likely to be of second-order importance to the development of good fiscal, financial, and monetary institutions in producing macroeconomic success