Exchange Rate Regimes

ExchangExchange Rate e Rate RegimesRegimes

Thorvaldur GylfasonJoint Vienna Institute/IMF Institute

August 24–September 4, 2009

1. Real vs. nominal exchange rates

2. Exchange rate policy and welfare

3. Exchange rate regimes To float or not to float

11

*P

ePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Increase in Q means real appreciation

ee refers to

foreign currency

content of

domestic currency

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Devaluation or

depreciation of e

makes Q also

depreciate

unless P rises so

as to leave Q

unchanged

*P

ePQ

*P

ePQ

1.1. Suppose ee falls fallsThen more rubles per dollar, so XX rises rises, ZZ falls falls

2.2. Suppose PP falls fallsThen XX rises rises, ZZ falls falls

3.3. Suppose P*P* rises risesThen XX rises rises, ZZ falls falls

Capture all three by supposing QQ fallsfalls

Then XX rises rises, ZZ falls falls

Foreign exchangeForeign exchange

Real exch

an

ge r

ate

Real exch

an

ge r

ate

ImportsImports

ExportsExports

22

Earnings from

exports of goods,

services, and capital

Payments for

imports of goods,

services, and capital

Equilibrium

Equilibrium between demand and supply in foreign exchange market establishes• Equilibrium real exchange rate• Equilibrium in balance of

paymentsBOP = X + FBOP = X + Fxx – Z – F – Z – Fz z

= X – Z + F= X – Z + F = current account + capital

account = 0 X – Z = current account

F = capital and financial account

Foreign exchangeForeign exchange

Real exch

an

ge r

ate

Real exch

an

ge r

ate

ImportsImports

ExportsExports

Overvaluation

Deficit

RR R moves when e is fixed

Foreign exchangeForeign exchange

Pri

ce o

f fo

reig

n e

xch

ang

ePri

ce o

f fo

reig

n e

xch

ang

e

Supply (exports)Supply (exports)

Demand (imports)Demand (imports)

Overvaluation

Deficit

Overvaluation works like a price ceiling

SupplySupply

DemandDemand

EE

ProducerProducersurplussurplus

ConsumeConsumerrsurplussurplus

Quantity

Price

AA

BB

CC

Total welfare gainwelfare gain associatedwith market equilibrium equalsproducer surplus (= ABE) plusconsumer surplus (= BCE)

R = 0, so R is

fixed when e floats

SupplySupply

DemandDemand

Price ceilingPrice ceiling

EE

FF

GG

Quantity

PriceWelfareWelfarelossloss

Price ceiling imposes awelfare losswelfare loss equivalent to the triangle EFG

AA

BB

CC

Consumer surplus = Consumer surplus = AFGHAFGHConsumer surplus = Consumer surplus = AFGHAFGH

HH

JJ

Producer surplus = CGHProducer surplus = CGHProducer surplus = CGHProducer surplus = CGH

Total surplus = AFGCTotal surplus = AFGC Total surplus = AFGCTotal surplus = AFGC

SupplySupply

DemandDemand

Price ceilingPrice ceiling

EE

FF

GG

Quantity

PriceWelfareWelfarelossloss

Price ceiling imposes awelfare loss welfare loss that results from shortage (e.g., deficit)

AA

BB

CC

HH

JJ

Shortage

Remember:

Devaluation needs to be accompanied by fiscal and fiscal and monetary restraint monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation

To work, nominal devaluation must result in realreal devaluation

*P

ePQ

The real exchange rate always always floatsfloatsThrough nominal exchange rate

adjustment or price change

Even so, it matters how countries set their nominal exchange rates because floating takes time

There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

33

There is a range of optionsMonetary union or dollarization

Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC)

Currency boardLegal commitment to exchange

domestic for foreign currency at a fixed rate

Fixed exchange rate (peg)Crawling pegManaged floatingPure floating

Currency union or dollarization Currency board

Peg FixedFixed Horizontal bandsHorizontal bands

Crawling peg Without bandsWithout bands With bandsWith bands

Floating ManagedManaged

IndependentIndependent

FIXEDFIXED

FLEXIBLFLEXIBLEE

DollarizationUse another country’s currency as sole legal tender

Currency unionShare same currency with other union members

Currency boardLegally commit to exchange domestic

currency for specified foreign currency at fixed rate

Conventional (fixed) pegSingle currency pegCurrency basket peg

Flexible pegFixed but readily adjusted

Crawling pegComplete

Compensate for past inflation

Allow for future inflation

PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment

Fixed but adjustable

Managed floatingManagement by sterilized

interventionManagement by interest rate

policy, i.e., monetary policy

Pure floating

Governments may try to keep the national currency overvalued• To keep foreign exchange cheap• To have power to ration scarce

foreign exchange• To make GNP look larger than it

is

Other examples of price ceilings• Negative real interest rates• Rent controls in cities

Inflation can result in an overvaluation of the national currency• Remember: Q = eP/P*Q = eP/P*

Suppose e adjusts to P with a lag

Then Q is directly proportional to inflation

Numerical example

Time

Real exchange rate

100

110

105 Average

Suppose inflation is 10 percent per year

Time

100

120

Real exchange rate

110 Average

Hence, increased

inflation lifts the

realreal exchange rate

as long as the

nominal exchange

rate adjusts with a

lag

Suppose inflation rises to 20 percent per year

Under floatingfloatingDepreciation is automatic: e

movesBut depreciation may take time

Under a fixed exchange rate fixed exchange rate regimeregimeDevaluation will lower e and

thereby also Q – provided inflation is kept under control

Does devaluation improve the current account?The Marshall-Lerner condition

B = eeX – Z = eX(e) – Z(e)Not clear that a lower ee helps BB

because decrease in ee lowerslowers eXeX if XX stays put

Let’s do the arithmeticBottom line is:Devaluation strengthens current

account as long as1ba

Suppose prices are

fixed, so that e = Q

a = elasticity of exportsb = elasticity of imports

ValuatioValuation effect n effect arises arises from the from the ability ability to affect to affect foreign foreign pricesprices

ZeXB )()( eZeeXB

de

dZ

de

dXeX

de

dB

e

Z

Z

e

de

dZ

e

X

X

e

de

dXeX

de

dB

1 1

-a b

- +

Export elasticityExport elasticityImportImport

elasticityelasticity

e

Z

Z

e

de

dZ

e

X

X

e

de

dXeX

de

dB

XbabXaXXde

dB 1

0de

dB 1baif

XX

Assume X = Z/e initially

Appreciation weakens current

account

Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied

Industrial countries: a = 1, b = 1

Developing countries: a = 1, b = 1.5

Hence, 1ba Devaluation

strengthens the

current account

Elasticity ofElasticity of Elasticity ofElasticity ofexportsexports importsimports

Argentina 0.6 0.9Brazil 0.4 1.7India 0.5 2.2Kenya 1.0 0.8Korea 2.5 0.8Morocco 0.7 1.0Pakistan 1.8 0.8Philippines 0.9 2.7Turkey 1.4 2.7Average 1.1 1.5

Small countries are price takers price takers abroad• Devaluation has no effect on the

foreign currency price of exports and imports

So, the valuation effect does notnot arise

Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged

Hence, if a > 0 or b > 0, devaluation strengthens the current account

In view of the success of the EU and the euro, economic and monetary unions appeal to many other countries with increasing force

Consider four categoriesExisting monetary unionsDe facto monetary unionsPlanned monetary unions Previous – failed! – monetary unions

CFA franc14 African countries

CFP franc3 Pacific island states

East Caribbean dollar8 Caribbean island states

Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note

Euro, more recent16 EU countries plus 6 or 7 others

Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

Australian dollar Australia plus 3 Pacific island states

Indian rupee India plus Bhutan (plus Nepal)

New Zealand dollar New Zealand plus 4 Pacific island states

South African rand South Africa plus Lesotho, Namibia, Swaziland –

and now Zimbabwe Swiss franc

Switzerland plus Liechtenstein US dollar

US plus Ecuador, El Salvador, Panama, and 6 others

East African shilling (2009) Burundi, Kenya, Rwanda, Tanzania, and

Uganda Eco (2009)

Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia)

Khaleeji (2010) Bahrain, Kuwait, Qatar, Saudi-Arabia, and

United Arab Emirates Other, more distant plans

Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa, Africa

Danish krone 1886-1939 Denmark and Iceland 1886-1939: 1 IKR = 1 DKR 2009: 2,500 IKR = 1 DKR (due to inflation in

Iceland) Scandinavian monetary union 1873-1914

Denmark, Norway, and Sweden East African shilling 1921-69

Kenya, Tanzania, Uganda, and 3 others Mauritius rupee

Mauritius and Seychelles 1870-1914 Southern African rand

South Africa and Botswana 1966-76 Many others

No significant

divergence of

prices or currency

rates following

separation

CentripetalCentripetal tendency to joinjoin monetary unions, thus reducing number of currencies To benefit from stable exchange rates stable exchange rates at the

expense of monetary independence CentrifugalCentrifugal tendency to leaveleave monetary

unions, thus increasing number of currencies To benefit from monetary independence monetary independence

often, but not always, at the expense of exchange rate stability

With globalization, centripetal tendencies appear stronger than centrifugal ones

FREE CAPITAL MOVEMENTS

FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCE

MonetaryMonetaryUnion (EU)Union (EU)

Free to choose

only two of three

options; must

sacrifice one

FREE CAPITAL MOVEMENTS

FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCECapital controls Capital controls

(China)(China)

Free to choose

only two of three

options; must

sacrifice one

FREE CAPITAL MOVEMENTS

FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCE

Flexible Flexible exchange exchange rate (US, UK, Japan)rate (US, UK, Japan)

Free to choose

only two of three

options; must

sacrifice one

FREE CAPITAL MOVEMENTS

FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCE

MonetaryMonetaryUnion (EU)Union (EU)

Flexible Flexible exchange exchange rate (US, UK, Japan)rate (US, UK, Japan)

Capital controls Capital controls (China)(China)

Free to choose

only two of three

options; must

sacrifice one

If capital controls are ruled out in view of the proven benefits of free trade free trade in goods, services, labor, and also capital (four freedomsfour freedoms), …

… then long-run choice boils down to one between monetary independencemonetary independence (i.e., flexible exchange rates) vs. fixed ratesflexible exchange rates) vs. fixed rates Cannot have both!Cannot have both!

Either type of regime has advantages as well as disadvantages

Let’s quickly review main benefits and costs

BenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Floating Floating exchange exchange ratesrates

BenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Stability of Stability of trade and trade and investmentinvestment

Low inflationLow inflation

Floating Floating exchange exchange ratesrates

BenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Stability of Stability of trade and trade and investmentinvestment

Low inflationLow inflation

InefficiencyInefficiency

BOP deficitsBOP deficits

Sacrifice of Sacrifice of monetary monetary independenceindependence

Floating Floating exchange exchange ratesrates

BenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Stability of Stability of trade and trade and investmentinvestment

Low inflationLow inflation

InefficiencyInefficiency

BOP deficitsBOP deficits

Sacrifice of Sacrifice of monetary monetary independenceindependence

Floating Floating exchange exchange ratesrates

EfficiencyEfficiency

BOP BOP equilibriumequilibrium

BenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Stability of Stability of trade and trade and investmentinvestment

Low inflationLow inflation

InefficiencyInefficiency

BOP deficitsBOP deficits

Sacrifice of Sacrifice of monetary monetary independenceindependence

Floating Floating exchange exchange ratesrates

EfficiencyEfficiency

BOP BOP equilibriumequilibrium

Instability of Instability of trade and trade and investmentinvestment

InflationInflation

In view of benefits and costs, no single exchange rate regime is right for all countries at all times

The regime of choice depends on time and circumstance If inefficiencyinefficiency and slow growth due to

currency overvaluation are the main problem, floating rates can help

If high inflationinflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation

Ones both problems are under control, time may be ripe for monetary union

What do countries do?

No national currency 17%Other types of fixed rates 23Dollarization 5Currency board 4Crawling pegs 3Bilateral fixed rates 3Managed floating 26Pure floating 19 100

51%

49%

Gradual tendency towards floatingtendency towards floating, from 10% of LDCs in 1975 to over 50% today, followed by increased interest in fixed ratesincreased interest in fixed rates through economic and monetary unions

The EndThe End