INTERNATIONAL MACROECONOMICS SEMINAR I

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INTERNATIONAL MACROECONOMICSSEMINAR IThe
Choice of an Appropriate Exchange Rate Regime
March 2004
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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

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The Exchange Rate Adjustment Mechanism(Stefanie
and Bengu)
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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
Effects
Flexible Exchange Rates
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Negative Demand Shock in Flexible Exchange Rate
Regime
i
LM
A
BP 0
A
IS1
IS2
Y
Y
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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 (Dornbuschs 1976 paper), that is, to
  exceed its equilibrium value first and then, as
  time passes, get equal to it.

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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
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External Negative Demand Shock in Fixed Exchange
Regime
i
i
LM2
LM1
IS1
IS2
Y
Y2
Y1
Y3
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Price Adjustment versus Devaluation
P/E
Three Options A Intervention AAA AAM AA
Devaluation
A
A
A
NX0
NX0
Y
Y
Y lt
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Automatic Adjustment Process with a Balance of
Payment Deficit
P
AS1
AS2
E
E
AD1
AD2
NX0
Y
Y
Y lt
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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
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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

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Full Capital Controls
The Impossible Trinity
Exchange rate stability
Monetary independence
Pure Float
Monetary union
Full financial integration
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Fixed
Flexible
? 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
Frankel (1999) No Single Currency Regime is
Right for all
Intermediate Regimes
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• 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.

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• 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)

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• 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.

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Flexible exchange rate regimes

• 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.

• 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

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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-unhedge
  d
• exposure in foreign currency, ending badly in
  speculative
• attacks and multiple equilibrium
• Monetary policy is less powerful (or completely
  
• powerless)

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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
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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.
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Corner Solutions-Bipolar View(Wei Wei Zheng and
Susilawani)
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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

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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

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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
  dollars worth of domestic currency is backed by
  a dollars 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
•  

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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.

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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

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Intermediate Regimes(Peng Dai, Tolga and Meng
Huang)
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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

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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?

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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.

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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

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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

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The Optimal Choice of an Exchange Rate
Regime(Yin-Che and Deren)
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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

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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

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How to compare exchange rate regimes?

• Analytical arguments often lead to opposing
  conclusions.
• Current discussion is based on the empirical
  evidence.

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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

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Empirical Evidence-Conclusions

• Empirical 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 Countries
• Free floats registed better performance

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No single currency regime is right for all
countries or at all timesFrankel, 1999