Possibility of changing exchange rate system

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Possibility of changing exchange rate system

• Eiji Ogawa
• Hitotsubashi University

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Introducing possibility of collapsing exchange
rate system

• We introduce possibility of collapsing exchange
  rate system as well as the possibility of
  realignments to analyze what effects the
  possibilities have on exchange rate fluctuations.
• We suppose that the monetary authorities may
  change their exchange rate system to a flexible
  exchange rate system after the exchange rate band
  system collapses because of speculative attacks.

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Assumptions in the models

• Symmetric two countries. The two economies have
  the same size and the same parameters
• Equilibrium in product markets under flexible
  prices.
• The economies are under full employments. Their
  GDP are given at full employment levels.
• No capital control. Capital movements are perfect
  between the two economies.
• Risk-neutral investors. Home currency denominated
  and foreign currency denominated financial assets
  are perfect substitutes.
• Economic agents have rational expectations by
  using an information set as of a current time t.

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A system of the model

• Domestic money market equilibrium
• Foreign money market equilibrium
• Exogenous real exchange rate
• Uncovered interest rate parity

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Exchange rate and fundamentals

• From equation (1.1) through (1.4), nominal
  exchange rate is derived
• Fundamentals f

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Probability process of the fundamentals

• Assume that without intervention in forex markets
  the fundamental level follows a Brownian motion
  process

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Options of exchange rate policy

• The monetary authorities have options
• Keeping the current band and pushing the exchange
  rate into the current central rate by their forex
  intervention.
• Changing the central parity into a new level
  under the current exchange rate band system.
• Abandoning the exchange rate band system and
  shifting to a flexible exchange rate system after
  they intervene in forex markets (with r of
  selling foreign currency gt decrease in money
  supply).

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Probabilities of the monetary authorities options

• They may abandon the current exchange rate band
  system and shift to the flexible exchange rate
  system with probability of .
• They may keep the current exchange rate band
  system with probability of .
• They may change into a new central parity with
  unchanged width and bring the exchange rate to
  the new central parity with probability under
  the current band system.
• They may keep the current central parity and
  bring the exchange rate back to the parity with
  probability under the current band
  system.

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Exchange rate under the flexible exchange rate
system

• The exchange rate after the exchange rate system
  is changed to the flexible system with forex
  intervention of r
• The exchange rate immediately after the collapse
  of the band system

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Continuity principle of rational speculation

• The exchange rate should not be expected to
  change at times when intervention is known to be
  imminent because rational market participants
  always take a chance of speculation and exploit
  expected capital gains.

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Fundamental level and central parity

• Immediately before the intervention
• Immediately after the intervention

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Assumption of an upward trend

• Assume that the fundamental level has an upward
  trend. The floor is not effective ( ).
  From eq. (3.2),

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Exchange rate fluctuations

• Exchange rate
• If , the exchange rate fluctuations are
  the same as flexible exchange rate system.
• If , the exchange rate fluctuations are
  smaller than flexible exchange rate system.
• If , the exchange rate fluctuations are
  larger than flexible exchange rate system.

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Signs of

• From eq. (3.5),
• Stabilizing effect of the band system depends
  whether expected return of speculation
  is smaller than expected loss of
  speculation

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Effects of the probability of collapse of the
band system

• If
  , increase in the probability reduces
  exchange rate fluctuations.
• If
  , especially if the expected return of
  speculation is smaller than
  forex intervention amount r, increase in the
  probability expands exchange rate fluctuations.

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Relation between and (1)

• Relation between and
• (1) in the case of

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Relation between and (2)

• Relation between and
• (2) in the case of

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Relation between and for

• Relation between and for
  is drawn in a field of ( , )

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In the case of
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In the case of
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In the case of
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Stabilizing effect of forex intervention

• Lager size of forex intervention extends an area
  where the forex intervention stabilizes exchange
  rate fluctuations. The forex intervention of
  selling foreign currency decreases money supply
  and, in turn, appreciate fundamentals of the home
  currency. Speculators know about it and hesitate
  their speculative attacks.
• With no forex intervention, the possibility of
  collapse always destabilizes exchange rate
  fluctuations.

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In the case of
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Realignments may stabilize exchange rate
fluctuations

• If rate of realignments is smaller than
  the band , or if the monetary authorities make
  realignments within the band, the realignments
  should always stabilize exchange rate
  fluctuations.
• In contrast, if the monetary authorities make
  realignments out of the band, the realignments
  may destabilize exchange rate fluctuations.

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Conclusion

• Possibility of collapsing the exchange rate band
  may improve the stabilizing effects of the band
  system in the case of loss in the stabilizing
  effects because the forex intervention appreciate
  the fundamentals.
• The monetary authorities suggest any changes in
  regimes such as collapse of the band and increase
  of the band to suppress speculative attacks
  because speculators expect to obtain gains from
  the speculative attacks. However, the suggestion
  will lose credibility of the regime in the long
  run.