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Outline
Types of ER regimes Advantages and disadvantages of fixing/floating Choice of ER regime Empirical Evidence on Exchange Regimes
Classifying ER regimes
INTERMEDIATE
FLOATING
Managed float Free float
Basket peg
Crawling peg Band
Hard pegs
Dollarization
Use another countrys currency as sole legal tender E.g. Ecuador, El Salvador, Panama Share same currency with other union members E.g. Euro area, ECCU, CFA franc zone 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)
Currency union
Currency board
Intermediate regimes
Band
Single currency peg (e.g. Malaysia, Nepal, Namibia) Currency basket peg (e.g. Malta, Fiji, Latvia) Pegged exchange rate within horizontal bands (>1%) E.g. Denmark (2.25%), Tonga (5%), Hungary (15%)
Crawling peg
Crawling band
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
Currency board Peg (including de facto pegs) Horizontal band Crawling peg Crawling band
Managed floating Independently floating
7 40 5 5 1
54 34
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.
Is the fixed ER policy an institutional commitment rather than merely a declared policy?
A country must give up one of three goals: Exchange rate stability (by Hard Peg) Monetary Independence Financial Market Integration (absence of capital control)
Advantages of fixed ER
1. 2.
Provide a nominal anchor for monetary policy Reduce transactions costs and exchange rate risk intl trade & investment
Disadvantages of fixed ER
Loss of lender of last resort (?) Danger of speculative attacks and crashes Loss of seigniorage revenue (in the case of dollarization)
Monetary policy cannot stimulate output (on the other hand, fiscal policy is very effective in stimulating output)
i0 i1
BP
IS Y0 Y1
Output, Y
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
Interest rate, i LM 2 0
i0 i1
BP
IS
Y2 Y1 Y0
Output, Y
Interest rates
Advantages of flexible ER
1.
2.
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)
Interest rate, i LM
i0 i1
2 1
BP
IS Y0 Y1 Y2 Output, Y
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
Interest rate, i LM 0
i0 i1
BP
IS Y1 Y0
Output, Y
Disadvantages of flexible ER
2.7
2.5
2.3
2.1
1.9
1.7
1.5
ay
ar
O ct
Fe b
ov
Ap
Ju
Au
Ja
Ju
Se
ec
The intermediate ER regimes are no longer feasible (Summers 1999, Eichengree 1999, Fisher 2001) The # of independent currencies in the world is declining.
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.
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
Size and openness Labor mobility Wage and price flexibility Fiscal redistribution mechanisms Diversity in production Financial development
Nominal or real? Domestic or external? Temporary or permanent? Symmetric or asymmetric? With or without capital mobility?
Real output stability BOP, competitiveness Price stability, inflation Political objectives e.g. desire for integration
Credibility of monetary policy Need of inflation tax Adequacy of reserves Strength and regulation of financial system Rule of law
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
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
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
1981
1991
2001
60 50 40 30 20 10 0
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)
Impacts on Growth
Using a de jure classification, Levy-Yeyati and Sturzenegger (2003) find: Developing countriesless flexible exchange rate regimes are associated with slower growth and greater output volatility; Developed countriesregimes do not appear to have any significant impact on growth
2.0% 1.2%
1.7%
1.0%
2.2% 1.9%
1.9% 1.5%
1.4%
Intermediate 1.0%
Own classification
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
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