EXCHANGE RATE REGIMES

Overview and policy issues

Outline

Types of ER regimes Advantages and disadvantages of

fixing/floating Choice of ER regime Empirical Evidence on Exchange Regimes

HARD PEGS

•Currency union

•Dollarization

•Currency board

FLOATING

•Managed float

•Free float

Classifying ER regimes

INTERMEDIATE

•Basket peg

•Crawling peg

•Band

Hard pegs

Dollarization Use another country’s currency as sole legal tender E.g. Ecuador, El Salvador, Panama

Currency union Share same currency with other union members E.g. Euro area, ECCU, CFA franc zone

Currency board 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)

Intermediate regimes

Conventional (soft) peg Single currency peg (e.g. Malaysia, Nepal, Namibia) Currency basket peg (e.g. Malta, Fiji, Latvia)

Band Pegged exchange rate within horizontal bands (>±1%) E.g. Denmark (2.25%), Tonga (5%), Hungary (15%)

Crawling peg Backward or forward looking E.g. Bolivia

Crawling band Symmetric or asymmetric E.g. Belarus (5%), Israel (22%)

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 E.g. U.S., Japan, EMU

ER arrangements of IMF members (as of July 2005)

No separate legal tender 41 Currency board 7 Peg (including de facto pegs) 40 Horizontal band 5 Crawling peg 5 Crawling band 1 Managed floating 54 Independently floating 34

...Not as simple as it sounds...de jure vs. de facto exchange rate

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.

How to distinguish ‘Hard Peg’ and “Floating” from ‘Intermediate’?

Is the fixed ER policy an institutional commitment rather than merely a declared policy? YES Hard Peg NO Intermediate

Is there an explicit target around which the CB intervenes? YES Intermediate NO Floating

The Impossibility Trinity

A country must give up one of three goals:

1. Exchange rate stability (by Hard Peg)2. Monetary Independence3. Financial Market Integration (absence of

capital control)

Advantages of fixed ER

1. Provide a nominal anchor for monetary policy

2. Reduce transactions costs and exchange rate risk int’l trade & investment

Disadvantages of fixed ER

Loss of monetary policy autonomy Loss of exchange rate as a shock absorber

=>Consequences for output and employment Loss of lender of last resort (?) Danger of speculative attacks and crashes Loss of seigniorage revenue (in the case of

dollarization)

No Monetary Policy Autonomy Under Fixed ER with Perfect Capital Mobility

Monetary policy cannot stimulate output (on the other hand, fiscal policy is very effective in stimulating output)

Interestrate, i

0

1

Y1Y0

i1

i0 BP

LM

IS

Perfect capital mobility

Output, Y

• •

Real Shocks Not Absorbed (but magnified) Under Fixed ER

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

•

•1

02

Y0Y2 Y1

i1

i0 BP

LM

IS

Perfect capital mobility

Interestrate, i

Output, Y

•

(20.0)

(10.0)

-

10.0

20.0

30.0

40.0

50.0

60.0

1993Q1 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

Growth Interest rates Debt

The Debacle of Argentina’s Peg

Advantages of flexible ER

1. Monetary Policy independence (discretionary policy)

2. Automatic adjustment to trade shocks

Monetary Policy Under Floating ER with Perfect Capital Mobility

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)

Interestrate, i

0

1

Y1Y0

i1

i0 BP

LM

IS

Perfect capital mobility

Output, Y

• • •

2

Y2

Real Shocks Absorbed (and offset) Under Floating ER

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

•

•1

0

Y0Y1

i1

i0 BP

LM

IS

Perfect capital mobility

Interestrate, i

Output, Y

Disadvantages of flexible ER

Exchange rate uncertainty Need to find a less obvious anchor

=> Consequences for inflation Danger of speculative (irrational?) bubbles

Irrational Bubble?Brazil: Daily Exchange Rate in 2001

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

Macroeconomic Stability: Exchange Rate Arrangements or Policy Discipline?

• The accession countries maintain a wide diversity of exchange rate regimes, from a currency board arrangement (Estonia) to floating regimes (Poland and the Czech Republic). Hungary's system, a preannounced crawling peg, had a band of 2.25 percent on either side until May 2004.

• Estonia has come close to achieving the EU inflation level with its currency board, as has the Czech Republic with its floating regime. Poland has followed approximately the same path of disinflation with a wide-band crawling peg, and Hungary with a narrow-band crawling peg

Macroeconomic Stability: Exchange Rate Arrangements or Policy Discipline?

What have countries done in the 1990s?

0

10

20

30

40

50

60

70

Hard Peg Intermediate Floating

No

. o

f co

un

trie

s a

s %

of

tota

l

1991 1999

16%(25)

42%(77)

23%(36)

34%(63)

62%(98)

24%(45)

Source: Fischer (2001)

The bipolar view

The intermediate ER regimes are no longer feasible (Summers 1999, Eichengree 1999, Fisher 2001)

The # of independent currencies in the world is declining.

Lack of theoretical foundation

Lessons from soft pegs

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.

Source: Bubula and Otker-Robe (2004)

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

(1) Structural characteristics

What makes a country more suited for fixed rather than flexible ER? (OCA criteria)

Size and openness Labor mobility Wage and price flexibility Fiscal redistribution mechanisms Diversity in production Financial development

(2) Nature of shocks

Nominal or real? Domestic or external? Temporary or permanent? Symmetric or asymmetric?

With or without capital mobility?

(3) Objective function

Real output stability BOP, competitiveness Price stability, inflation Political objectives e.g. desire for

integration

(4) Other considerations

Credibility of monetary policy Need of inflation tax Adequacy of reserves Strength and regulation of financial

system Rule of law

Who might be suited to a hard peg?

Small open economies whose trade is dominated by a single low-inflation partner Symmetric real shocks

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

Who might be suited to floating?

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

Who might be suited to an intermediate regime?

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

Evidence on Exchange Rate Regimes

ER regimes and inflation

Sample of developing countries (Annual percentage change, median of group)

Source: WEO (Oct. 1997)

Do hard pegs lower inflation?

Source: Ghosh et al (1997).

Do hard pegs induce greater fiscal discipline?

0.1

1

10

100

1000

10000

1971 1981 1991 2001

-1

0

1

2

3

4

5

1991 1993 1995 1997 1999 2001

0102030405060

1991 1993 1995 1997 1999 2001

Inflation (% per year, log scale)

Fiscal deficit (% of GDP)

Public debt (% of GDP)

Source: IMF, WEO

Argentina

Does ER variability discourage trade?

Study Coverage Results

Coes (1981) Brazil, 1965-74 Yes

Brada & Mendez (1988) 30 developed & emerging economies,

1973-77

Mixed

Caballero & Corbo (1989) 6 emerging economies Yes

Paredes (1989) Chile & Peru Yes

Medhora (1990) W. African Monetary Union No

Savides (1992) 62 developed & emerging economies,

1973-86

Yes (unexpected variability only)

Grobar (1993) 10 emerging markets, 1963-85 Yes, mostly

Frankel & Wei (1993) 63 countries, 1980, 1985, 1990 Mixed

Arize, Osang & Slottje (2000)

Paiva (2003)

13 emerging economies, 1973-96

Brazil, 1990-2002

Yes

Yes

Do currency unions encourage trade?

Source: Rose (2004)

Partial effect of CU on trade, all else constant

Most estimates are positive, ... economically large, and statistically significant

Histogram of γ estimates, -2<γ<2 Histogram of γ estimates, 0<γ<1.2

Tijt = β1Dij + β2(YiYj)t + ΣkβkZijt + γCUijt + uijt

Does floating afford greater monetary policy autonomy?

Source: Calvo & Reinhart (2002)

“Fear of floating”

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)

ER regimes and growth

Sample of developing countries (Annual percentage change, median of group)

Source: WEO (Oct. 1997)

ER regimes and growth

Impacts on Growth Using a de jure classification, Levy-Yeyati and

Sturzenegger (2003) find:

Developing countries—less flexible exchange rate regimes are associated with slower growth and greater output volatility;

Developed countries—regimes do not appear to have any significant impact on growth

Which ER regime is best for growth?

1.7%

3.1%

1.4%

1.9%

2.2%Limited flexibility

Peg

Managed float

Free float 0.5%

Regular peg 0.9%

Float

Currency board

1.0%

1.2%

2.0%Intermediate

Fix

Float

1.5%

1.9%Float

Intermediate 1.0%

Fix

Ghosh, Gulde & Wolfe (2000)

Reinhart & Rogoff (2002)

Levy-Yeyati & Sturzenegger (2002)

Levy-Yeyati & Sturzenegger (2002)

IMF classification

Own classification

Average per capita growth rates

Summary of empirical evidence

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 Role of fiscal and monetary discipline Role of capital controls

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