INTERNATIONAL MACROECONOMICSSEMINAR I

“The Choice of an Appropriate Exchange Rate Regime”

March 2004

Outline

• The exchange rate adjustment mechanism

• Advantages and disadvantages of exchange rate regimes

• Classification of exchange rate regimes

• Corner solutions

• Intermediate regimes

• Optimal choice of an exchange rate regime and further discussions

The Exchange Rate Adjustment Mechanism

(Stefanie and Bengu)

Exchange Rate Adjustment to External Shocks

• External Demand Shock(same for Fiscal Expansion)

– Recession in another country

– Introduction of new technology

• Price Shock in World Markets– Commodity Price Changes

– Oil-price crises

• World Interest Rate Shock Balance of Payment Problems

Fixed Exchange Rates

Flexible Exchange Rates

Effects

Negative Demand Shock in Flexible Exchange Rate Regime

i

Y

BP = 0

Y*

A’

A

IS1

IS2

LM

PROBLEM: STICKY PRICES / WAGES

- Prices/Wages do not react instantaneously to shocks in the goods market, where adjustment takes time.

- This causes exchange rate to be volatile and to over-shoot (Dornbusch`s 1976 paper), that is, to exceed its equilibrium value first and then, as time passes, get equal to it.

Exchange Rate Overshooting

• Exchange Rates and Prices do not move at the same rate

• Monetary expansion pushes interest rates down, exchange rate adjusts immediately, prices adjust only gradually, hence in the SR abrupt change in relative prices and competitiveness

• Flexible Exchange Rates produce large exchange rate fluctuations

Exchange rate

Prices

External Negative Demand Shock in Fixed Exchange Regime

Y

i i

IS1

LM2

12Y2 Y1

LM1

Y3

IS2

Price Adjustment versus Devaluation

P/E

Y

NX=0

NX’=0

AA’

A’’

Y*Y <

Three Options

A: Intervention

AA’A’’ : AAM

AA’’: Devaluation

Automatic Adjustment Process with a Balance of Payment DeficitP

YY*

NX=0

AS1

AD1E’

Y <

EAS2

AD2

Effects of Negative Demand Shocks

Fixed Rates Flexible Rates

•Negative Effect on output and employment and losses of foreign reserves or international credit expansion

•Contraction in output has no long run effects on equilibrium output.

•Possibility of sticky prices and overshooting of exchange rates

Automatic Adjustment Mechanism Fixed But Adjustable

•Automatic adjustment through a sequence of price and money adjustment based on trade balance.

•Long and painful.

•Implicit assumption of price-stickiness

•Immediate devaluation

•Works only if increasing price level does not off-set devaluation gain

•Possibility of J-Curve Effect

Advantages and Disadvantages of Exchange Rate Regimes

(Neng, Katarina and Zhu Yiang)

• Frankel, J. “No Single Currency Regime is Right for All Countries at All Times” 1996

• Obstfeld, M. and K. Rogoff, “The Mirage of Fixed Exchange Rates” 1995

• Stockman, A. “Choosing an Exchange Rate System” 1999

Full Capital Controls

Pure Float

Monetary union

Monetary independence Exchange rate stability

Full financial integration

The Impossible Trinity

FixedFlexible

♦ Currency Union

♦ Currency Board

♦ Truly fixed exchange rate

♦ Free float

♦ Managed float

(dirty float)

♦ Fixed but adjustable peg

♦ Crawling peg

♦ Basket peg

♦ Target zone or band[Intermediate Regimes]

Frankel (1999)“No Single Currency Regime is Right for all …”

Flexible exchange rate regimes:

♦ Free float - The central bank does not intervene in the foreign exchange market, but rather allows private supply and demand to clear on their own.

e.g. United States

♦ Managed float - also known as dirty float, it is defined as a readiness to intervene in the foreign exchange market, without defending any particular parity.

Intermediate regimes:

♦ Fixed but adjustable peg - countries that declare themselves fixed, in fact periodically undergo realignments.

e.g. Bretton Woods regime

♦ Crawling peg - in high-inflation countries, the peg can be regularly reset in a series of devaluations, as often as weekly.

♦ Basket peg - the exchange rate is fixed in terms of a weighted basket of currencies instead of any one major currency.

♦ Target zone or band - the authorities intervene when the exchange rate hits pre-announced margins on either side of a central parity.

e.g. ERM (the Exchange Rate Mechanism)

Fixed exchange rate regimes:

♦ Currency Union - the currency that circulates domestically is the same as is circulating in one or more major neighbors or partners.

e.g. EMU

♦ Currency board - a monetary institution that only issues currency that is fully backed by foreign assets.

e.g. Argentina, Hong Kong

♦ “Truly fixed” exchange rate - fixing to one of main world currencies – dollar, euro, etc.

Advantages: The major advantage is that it allows the country to

pursue independent monetary policy. When the economy is hit by a shock, the central bank is able to respond very fast.

Flexible exchange rate regimes

Disadvantages: Exchange-rate uncertainty reduces international trade, discourages investment and increases costs of hedging the exchange rate risk A tendency toward volatility that does not always derive from macroeconomic fundamentals, including occasional speculative bubbles and crashes

Fixed exchange rate regimes

Advantages: To reduce transaction costs and exchange rate

risk, which can discourage trade and investment To provide a credible nominal anchor for monetary

policy (credibility/expectation)

Disadvantages: A tendency toward borrowers’ effectively-unhedged exposure in foreign currency, ending badly in speculative attacks and multiple equilibrium Monetary policy is less powerful (or completely powerless)

Issue 1 Why It Is Difficult to Peg?♦ Technically Possible♦ Real Problem: Competing Government

Objectives

Issue 2 Is the cost of Fixed exchange regime very high? (OCA)

♦ Experience similar shocks♦ Or, have high factor mobility

In summary...

Whether the advantages of fixed exchange rates or the advantages of floating exchange rate are likely to dominate is depend on characteristics of the country and the period in question.

Corner Solutions-Bipolar View

(Wei Wei Zheng and Susilawani)

A. HARD PEG

Characteristics of countries that should fix firmly

• Small size• Preponderance of economic fluctuations that originate domestically

rather than abroad• Openness to trade• High labor mobility• Availability of a fiscal mechanism to cushion downturns• A high correlation of the local business cycle with the country to

which a currency peg is contemplated

Additional characteristics for most rigid institutional arrangement: currency board, full dollarization or monetary union

• A strong need to import monetary and financial stability due to a history of hyperinflation

• An absence of credible public institutions

• Unusually large exposure to nervous investors

• Access to an adequate reserve

• Law: essential for Currency board

• Willingness of the foreign country whose currency is used to allow input into monetary policy ( A case of full monetary union such as EMU)

• The same monetary policy with the foreign country that the currency is pegged to

Currency Board

• A monetary institution that only issues currency that is fully backed by foreign assets

• Principal attributes: An exchange rate that is fixed by policy and law A reserve requirement demanding that for each dollar’s worth of domestic

currency is backed by a dollar’s worth of foreign reserves A self correcting balance of payment mechanism

Example: A payment deficit contracts the MS contracts the spending automatically

Countries with currency board- Hong Kong, Argentina, Estonia, Lithuania, Bulgaria, Bosnia

Strength - Create policy environment by removing from the monetary authorities the option of printing money to finance government deficits

 

Dollarization/ Monetary union

• A total surrender of monetary independence. In other words, to give up totally the domestic currency for foreign currency

• Still retain a small degree of monetary independence although not zero. In the case of Argentina, its convertibility law ensures the switch from one currency to another.

B. Free Floating

• Large economy Higher integration within the border than across the border High mobility of labor, trade and fiscal transfer Higher correlation of the business cycle within the border than across

the border

• Confidence of international investors

• Strong and well functioning central banks

• Exchange rate fluctuation is not a major concern

• Example: United States

Intermediate Regimes

(Peng Dai, Tolga and Meng Huang)

What is the optimal choice of an exchange rate regime?

• It is the solution to the minimization of a loss function

• If monetary shocks dominate fixed• If real shocks dominate flexible• If neither dominates managed float• If consider AS function and wage

indexation depends on the degree of indexation

What is the optimal choice of an exchange rate regime?

Optimization seldom gives corner solutions

• Shocks can be partially absorbed by exchange rates and partially by CB accommodation

So, why the popularity of the bipolar view?

Bipolar View

Why the popularity of the bipolar view?Although• There is no “satisfactory” theoretical

argument (e.g. impossible trinity, unhedged foreign liabilities, reluctance to exit the peg) in support of bipolar view,

• The problem of verifiability in complicated and nontransparent intermediate regimes

might be an explanation.

Bipolar View

Why the popularity of the bipolar view?• Many arguments on grounds of

susceptibility to currency crises• Previous unsuccessful episodes and lack of

mature and well-established institutions undermine the credibility of new intermediate regimes

• Reluctance of CB to realign in time before a crisis outbreaks

Beyond Bipolar View

Can corner solutions remedy these deficiencies on their own?

• Unlikely. Should consider all aspects of a monetary framework together rather than in isolation.

• Free float No costly devaluation• CB autonomy Exchange rate stability and

lower inflation• Announced Monetary Targets Lower inflation

and inflation persistence, more flexibility through transparency

The Optimal Choice of an Exchange Rate Regime

(Yin-Che and Deren)

Theory of optimal exchange rate regimes-Choice criteria

• size of an economy

• openness of an economy

• labor market flexibility

• capital mobility

• fiscal redistribution

• exposure to shocks

• quality of policies

• diversified production/export

performance

Weaknesses in the standard theory of optimal exchange rate regime choices

(Calvo and Mishkin, 2003)

• Theory fails in some respects. Examples: – Fiscal transfers do not change relative prices

– Labor mobility is a poor substitute for exchange rate flexibility

– The standard theory implicitly assumes an ability to set up institutions that will assure a fixed exchange rate

– Presumes that a time-consistent choice is made on the exchange rate regime, whereas in many countries, the exchange rates the exchange rate regime may frequently shift

– The financial sector is ignored

– Pays no attention to transaction costs and liquidity considerations

• Thus, the theory does not apply well to especially emerging markets

How to compare exchange rate regimes?

• Analytical arguments often lead to opposing conclusions.

• Current discussion is based on the empirical evidence.

The Problem of Classification (Reinhart and Rogoff, 2004)

• In practice, exchange rate regimes often differed from what they were officially announced to be.

• Freely falling exchange rates should be taken into account seperately.

• Solution: Natural Classification (5 main categories)– Fixed– Limited Flexibility– Managed Floating– Freely Floating– Freely Falling

Empirical Evidence-ConclusionsEmpirical evidence depends entirely on classification. Taking

into account “Natural Classification” Rogoff et al (2003) concludes

• Corners Hypothesis-Bipolar view finds less support• Intermediate regimes are more durable• As economies mature, the degree of exchange rate flexibility

rises– Developing Countries

Superior performance of pegged regimes with commitment through public announcement

– Emerging Markets Need to consider adopting more flexible exchange rate regimes as they develop economically and institutionally (Goldstein, 2002 suggests managed floating plus)

– Advanced CountriesFree floats registed better performance

“No single currency regime is right for all countries or at all times”

Frankel, 1999