Lecture Exchange Rate Pol

8/14/2019 Lecture Exchange Rate Pol

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KINGSTON UNIVERSITY, LONDONSCHOOL OF ECONOMICS

Monetary Economicsin Developing Countries (FE3178), 2009-2010

Exchange rate policy

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Exchange rate policy

A countrys choice of exchange rate regime is an

important subject of debate at the theoretical, empirical,

and policy levels.

The main options available to countries choosing a

flexible exchange rate policy are dealt with in

Chapter 8.

Here we explain fixed exchange rate regimes and other

selected exchange rate policy issues.

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Does the exchange rate matter?

That is a basic but relevant question.

Explaining the link between a countrys choice of

exchange rate regime and its economic performance is

difficult.

In this regard, Razin and Rubinstein (2006) note that

there are two puzzles in international macroeconomics.

One directly relevant to this Chapters focus is that there

is no systematic difference in macroeconomic

performance across countries operating different

exchange rate regimes.

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The theory underpinning the choice of exchange rate

regimes is fairly standard, and basic textbooks introduce

the topic, usually employing the well-known Mundell-

Fleming apparatus (e.g. Krugman and Obstfeld, 2006).

The standard theory prescribes that for the case of an

economy mainly facing real shocks, e.g. arising from

adverse terms of trade developments, a flexible

exc hange rate regime is preferablebecause flexible

exchange rates can accommodate these shocks and limit

their potential impact on real variables like employment

and output.

By contrast, ifnominal shocks prevail in a given

economy then, in principle, a fixed exchange rate may

be more suitable, because the fixed exchange rate

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regime accommodates money demand or supply shocks

while minimising output volatility.

In practice, throughout the world, countries have

experimented with fixed and floating exchange rate

arrangements, and with several varieties that fall between

these extremes.

How important is exchange rate policy for monetary

policy, one of this books main themes?

It is very important, and exchange rate policy is naturally

linked to monetary policy.

On the one hand, by adopting a fixed exchange rate

regime a country actually surrenders its ability to

determine money supply. That is, monetary policy

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becomes secondary to maintaining the desired exchange

rate; a country strictly following this policy loses its

monetary independence.

On the other hand, a flexible exchange rate regime

allows an economy to pursue an independent monetary

policy strategy, such as inflation targeting and others

analysed in Chapter 8.

Even when operating a monetary policy strategy like

inflation targeting in open economies the exchange rate

remains a crucial variable.

Svensson (2000) advances three key reasons as to why

this is the case.

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First, the exchange rate explicitly allows for an

additional channel via which monetary policy can be

transmitted.

Second, the exchange rate is a forward-looking variable,

and therefore can provide valuable information in

designing and implementing monetary policy.

Third, foreign shocks mainly propagate thorough the

exchange rate.

However, on this last issue Frankel (2005) shows that the

pass-through coefficient from the exchange rate to

import prices significantly fell in the 1990s for a large

sample of developing countries.

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Returning to the potential benefits from operating a

flexible exchange rate regime, note that by designing and

implementing its own monetary policy a country can

react to idiosyncratic economic circumstances, i.e. it can

apply a countercyclical monetary policy.

That is, it can, in principle, ease monetary conditions

during downturns, and tighten the policy stance during

booms.

But that is an ideal situation, and in fact Kaminsky,

Reinhart, and Vghs (2004) empirical evidence reveals

that, in developing countries, monetary policy tends to be

procyclical.

A further reason why countries desire to achieve stable

exchange rates is because they are important for

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international trade: exchange rate instability leads to

trade instability, and an appreciated exchange rate (that

is, a relatively expensive domestic currency) adversely

affects the competitiveness of a countrys exports.

However, managing an economy using a flexible

exchange rate regime demands solid financial, fiscal,

and monetary policy institutions.

And in developing countries these institutions are

generally weak.

That is largely the reason why fixing the exchange rate in

one way or another features prominently in the history of

developing economies policymaking.

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On this issue, Obstfeld and Rogoff (1995, page 73) warn

that Many recent efforts to peg exchange rates within

narrow ranges have ended in spectacular debacles

These events are not unprecedented, but their ferocity

and scope have called into question the viability of fixed

rates among sovereign nations in todays world of highly

developed capital markets.

Moreover, Huang and Weis (2006) analytical model

shows that, in the presence of weak public institutions,

standard policies such as pegging the exchange rate and

dollarizing the economy are not adequate.

Instead, they argue that following Rogoffs (1985)

suggestion of appointing a conservative central banker

may be a better option.

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This arrangement may be superior as the central bankers

degree of conservatism could optimally be proportional

to an economys institutional quality.

In light of the above it seems worth asking: can

developing countries actually choose an exchange rate

regime and pursue an independent monetary policy?

Frankel, Schmukler, and Servn (2004) tackle this issue.

They do so by examining time series and cross section

data for a large sample of developed and developing

economies ranging from 1970 to 1999.

What the authors seek to establish is if countries running

flexible exchange rate regimes are in a better position to

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isolate foreign shocks and their likely impact on the

domestic economy.

Frankel, Schmukler, and Servn look into economies

operating an array of exchange rate regimes, including

fixed, flexible and options between these two.

Their findings show that throughout the sample period

under scrutiny local interest rates have shown a close

association with international interest rate developments.

Importantly, this is true regardless of what type of

exchange rate regime a country is operating.

If tenable, these results imply that in reality developing

countries have little monetary independence. However,

floating regimes do appear to provide some degree of

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monetary independence: Frankel, Schmukler, and

Servns empirical evidence shows that interest rates

adjustments vis--vis international developments are

slower in economies running a flexible exchange rate

policy.

Shambaugh (2004) further examines whether or not a

countrys choice of exchange rate policy actually

determines its degree of monetary independence.

Particularly, he tackles the classical open economy

policy trilemma of choosing at most two objectives from

(1) fixing the exchange rate, (2) keeping domestic

monetary autonomy, and (3) allowing capital mobility.

The study focuses on short-term interest rates

movements as monetary policys indicator, and employs

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data comprising over 100 countries during the period

1973-2000.

Shambaughs main finding is that there is a significant

difference in terms of monetary independence between

countries that peg their exchange rates and countries that

operate a floating regime.

Particularly, pegging the exchange rate does seem to

imply less monetary independence, and vice versa.

The investigation also shows that, in line with the

predictions from the trilemma, fixing the exchange rate

and allowing capital mobility lead to less domestic

monetary policy independence.

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Thus the basic message arising from this research is that,

as predicted by theory, countries cannot run a fixed

exchange rate regime while also keeping their monetary

independence and allowing capital mobility.

Fixed exchange rates

Operating a fixed exchange rate regime basically implies

that the monetary authorities set the value of the

domestic currency with reference to another currency or

a basket of currencies.

Thus a fixed exchange rate regime is expected to bring

more credibility to the exchange rate stance, which in

turn positively affects inflationary expectations. And

because announcing a fixed exchange rate regime

implies that the central bank will buy or sell the domestic

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currency at a given rate, the viability of such a regime

crucially depends on the level of international reserves

held by the authorities.

That level is usually gauged in relation to the amount of

money circulating in the economy, that is, in relation to

the central banks liabilities with the rest of the economy.

There are several benefits from running a fixed

exchange rate regime, including lower currency volatility

and thus a more stable environment for international

trade.

Investment also benefits from the absence of a currency

risk premium.

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However, a significant drawback from extreme forms of

fixed exchange rate regimes would be loosing the central

banks last resort lending power.

But last resort lending activities are expected to be

effective only with the backing of a credible institutional

setting. Therefore, even if adopting a regime that allows

the central bank to print money, a non-credible banking

rescue operation will likely trigger inflationary

expectations and increase the probability of observing a

devaluing currency.

Currency areas

Mundell (1961) is the seminal contribution to the theory

of optimum currency areas (OCAs) (see also McKinnon,

1963). The main argument in Mundells framework

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endorsing currency unions is the potential reduction of

transactions costs. These lower costs will be observed in

the financial transactions and trade between members of

a currency union.

On the other hand, as with other extreme fixed exchange

rate regimes, the main drawback from adopting this

policy is the loss of monetary independence. Whether or

not forming currency areas is beneficial critically

depends on factor mobility and price flexibility.

When thinking about forming or joining a currency area,

countries need to carefully evaluate if the criteria

underlying the OCAs literature are likely to be met.

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These criteria are:

The synchronisation of business cycles; that is, how

conjoined economic activity is in the countries

aspiring to form part of a currency union;

The extent of factor mobility, capital and labour,

within the proposed union;

Overall macroeconomic convergence, say in terms

of exchange rates and fiscal policy;

The presence of links in terms of trade and financial

transactions amongst the countries forming the

union.

In contrast to options like dollarisation, joining a

currency union does not necessarily imply a complete

loss of monetary policy independence. For instance, in

Europes case, members of the European Monetary

Union (EMU) form part of the European Central Banks

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(ECB) board, and thus have a say in Euro area-wide

monetary policymaking.

Is there any measurable gain from joining a

currency union? Frankel and Rose (2002) throw light on

this matter. Particularly, they seek to ascertain a currency

unions impact on trade and on income using a two-stage

strategy. First they calculate the effect of currency unions

on trade by estimating gravity equations (which seek to

explain international trade by means of countries sizes

and their physical distance to trading partners) for a large

sample of economies.

Frankel and Rose augment the benchmark gravity

equations using dummy variables to capture the effect of

currency unions and currency boards on trade. For

example, in this classification, the United States and

Panama would be part of a common currency area, while

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the United States and Hong Kong are linked via the

currency board dummy.

The study concludes that a currency union significantly

increases a countrys trading with its partners.

Furthermore, it also boosts trade with other economies.

Frankel and Rose subsequently run regressions to

ascertain the extent to which trade affects income, and in

so doing they employ information obtained in the first

stage of their empirical modelling.

To this end they estimate growth equations in the spirit

of Mankiw, Romer, and Weils (1992) contribution to

growth empirics. The analysis finds that every one

percent increase in total trade relative to GDP leads to an

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increase in income per capita of at least one-third of a

percent in the course of a 20-year period.

Overall, Frankel and Roses findings would seem to

endorse the potential benefits that an economy could gain

from being part of a currency union, even if it implies

surrendering its ability to implement an independent

monetary policy. However, as with all empirical

evidence, these findings should be interpreted with

caution and are likely to be scrutinised in future studies.

Notwithstanding the empirical evidence on the topic,

Alesina and Barro (2002) argue that the type of economy

likely to benefit from losing its monetary independence

by giving up its own currency is (1) a small open

economy, (2) one that trades mainly with a large

economy and whose business cycle is correlated with

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that economys, and (3) one in which keeping inflation in

check has been problematical.

Currency unions in developing countries: Africas

case

Africa provides an interesting case study of monetary

unions. There are two such unions operating in the

continent, broadly known as the Franc Zone.

One is the Central African Economic and Monetary

Community (CEMAC for its French initials) and is

comprised of Cameroon, the Central African Republic,

Chad, Republic of Congo, Equatorial Guinea, and

Gabon. The central bank for the CEMAC is the Banque

des tats de lAfrique centrale (BEAC).

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There is also the West African Economic and Monetary

Union (UEMOA for its French initials) including Benin,

Burkina Faso, Cote dIvoire, Guinea-Bissau, Mali, Niger,

Senegal, and Togo.

For the latter currency area the monetary issuing

institution is the Banque Centrale des tats de lAfrique

de louest (BCEAO). Further, as noted by Masson and

Patillo (2004), there is an informal arrangement between

South Africa and a group of small neighbouring

economies. In this case South Africa is the country

setting monetary policy, while Lesotho, Namibia, and

Swaziland form part of the monetary area in question.

Fieldings (2005a, b) research project is an important

effort to gain a better understanding of macroeconomic

policy in the Fran Zone. The programme reaches several

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conclusions. One is that countries forming CEMAC and

UEMOA seem to face similar external shocks, thus

complying with a key requirement for an optimal

currency area to be feasible.

Additionally, Fielding seeks to ascertain if the central

banks conducting policy in the Franc Zone (BEAC and

BCEAO) actually behave as modern central banks.

Particularly, the inquiry is interested on the relevance of

Taylor-type rules, discussed in Chapter 8, for explaining

monetary policy behaviour in the region.

The key finding in this respect is that monetary policy is

not as systematically conducted as in more advanced

economies, which is not surprising.

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Currency boards

A currency board is similar to a traditional fixed

exchange rate regime but rather stricter. In a currency

board regime some proportion of the amount of money

circulating in the economy is fully backed by reserve

currency.

That policy implies that the monetary authority will be

able to honour its standing liabilities at any point in time.

There is a basic and persuasive argument against

currency boards: adjusting to shocks becomes a problem.

By contrast, under a flexible exchange rate regime

relative prices adjust swiftly. Other arguments against a

currency board are:

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The negative implications for sovereignty;

Loss of seigniorage;

Loss of monetary policy independence;

Loss of lender of last resort;

Weaknesses in fiscal policy may prevent the typical

developing country from benefiting from adopting a

currency board arrangement.

For instance, Argentinas notable failure in operating a

currency board is partly attributed to fiscal policy

mismanagement (e.g. Calvo, Izquierdo, and Talvi, 2003).

Still, other authors find evidence supporting currency

boards beneficial impact on economic performance (e.g.

Ghosh, Gulde, and Wolf, 2000).

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Dollarisation

Dollarisation is a generic term for identifying a countrys

use of another countrys currency, and that may or may

not be the US dollar the term arises from the US

dollars importance in the world economy (e.g. Levy-

Yeyati and Sturzenegger, 2003b).

The concept of dollarisation is somewhat related to

considerations in the currency substitution literature (e.g.

Calvo and Vegh, 1996). However, the latter emphasises

the use of a foreign currency as a medium of exchange in

undertaking domestic transactions

Full dollarisation (also known as official or de jure

dollarisaton) is an extreme form of monetary

arrangement, as an economy actually surrenders its

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ability to issue currency (e.g. Panama and Ecuador).

Such a policy completely eliminates currency risk, which

is not the case when operating a currency board.

But partial or de facto dollarisation is also a common

phenomenon, and may emerge from high inflation and

exchange rate depreciation, with dollar demand arising

for transacting, speculating or hedging against currency

risk.

By adopting the currency of a credible economy a

country is effectively tackling the inflation bias problem

studied by Barro and Gordon (1983); introduced in

Chapter 7.

Recall that this time-consistency problem basically arises

from policymakers desire to push the economy above its

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potential, and/or from the central banks financing of

budget deficits. But if a country is able to commit to a

policy providing a solid nominal anchor, such as the

inflation targeting explained in Chapter 8, overcoming

Barro and Gordons predicament is feasible.

Unfortunately, many developing countries lack the

institutions and human capital to successfully operate

such a policy, and it is in that context that options like

dollarising the economy become appealing.

However, the cost of losing the ability to implement an

independent monetary policy will be higher if the

business cycle of the pegging country is dissimilar from

that of the anchor country. A further cost when

dollarising is the loss of seigniorage revenues.

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As noted above, some economies face informal or de

facto dollarisation, which can generate adverse dynamics

in key macroeconomic relationships such as money

demand (e.g. Agnor and Khan, 1996).

For instance, Kamin and Ericsson (2003) draw attention

to the irreversibility in dollarization in Argentina,

Bolivia and Peru. Specifically, for Argentina they use a

novel measure of foreign currency holdings in analyzing

money demand.

Kamin and Ericsson show that in Argentina reductions in

peso money demand are similar in magnitude to the

amount of dollar assets held by Argentine residents.

Along similar lines, Oomes and Ohnsorge (2006)

investigate money demand in Russia incorporating a

measure of foreign currency holdings. They find that

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statistical support for the stability of money demand is

effectively reestablished using this more comprehensive

monetary aggregate.

Financial dollarisation -that is the use of a foreing

currency in financial, mainly banking, transactions- is a

further development arising from institutional features

characterising developing countries. Levy-Yeyati (2006)

thoroughly discusses financial dollarisation and explains

why the phenomenon takes place.

One basic reason put forward is developing countries

weak fiscal and monetary policy institutions. This results

in investors having little faith in the economys currency

stability; in turn the monetary authorities will display a

fear of floating.

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Thus, foreigners are not willing to buy a countrys debt if

it is denominated in its own currency -that is the original

sin problem tackled by Eichengreen and Hausmann

(1999) and also closely related to the material in Chapter

11. (That topic somehow relates to the Peso problem

literature on economic fundamentals basically

maintaining that there may be uncertainty about an

economys future prospects, which leads to negative

expectations undermining the currency and is in turn

reflected through a premium on that currencys value.)

In financing their investment projects, many countries

have therefore resorted to issuing debt in foreign

currency, with the implication that firms balance sheets

become vulnerable to exchange rate fluctuations. That

weakness in firms balance sheets can subsequently

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become a fundamental element in causing crises, as

Chapter 11 explains.

Levy-Yeyatis empirical analysis on financial

dollarisation, using data on more than 100 countries for

the period 1975-2002, reaches several conclusions. One

is that inflation rates tend to be higher in financially

dollarised economies. The study also finds that

financially dollarised economies are more vulnerable to

banking crises, i.e. they suffer from financial fragility

(see also De Nicol, Honohan, and Ize, 2005).

A further adverse effect arising from financial

dollarisation is more output volatility. Worse, all the

above negative effects do not seem to lead to greater

financial depth. Thus it is not surprising that Levy-Yeyati

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suggests that countries facing financial dollarisation

should start a de-dollarisation process.

How can that be achieved?

The paper suggests that countries should avoid policies

that favour the use of foreign currency, e.g. US dollars,

and the monetary authorities should actively develop and

promote financial instruments denominated in domestic

currency. Last but not least, the traditional recipe of

fostering sound fiscal and monetary policies, and the

economys institutions more generally, is crucial in

undertaking a successful de-dollarisation strategy.

There is an on-going research effort on financial

dollarisation. For instance, Ize and Levy-Yeyati (2003)

explain the problem using a portfolio approach. This

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view basically rationalizes dollarisation as the product of

economic agents choice of currency according to the

related returns.

The authors show that the degree of pass-through from

exchange rate changes to domestic prices can be crucial

in determining dollarisation.

In terms of policy, that conclusion implies that

combining an inflation targeting monetary policy regime

with a floating exchange rate is likely to reduce

incentives to dollarise.

Additionally, Broda and Levy-Yeyati (2006) put forward

the idea that a positive correlation between currency risk

and default risk, alongside a blind bank liquidation

policy (i.e. one that does not discriminate on the basis of

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the currency, e.g. dollars or pesos, in which the banking

operations in question take place), can be fundamental in

determining financial dollarization. But telling other

stories on the overall issue of dollarisation is feasible,

e.g. Duffy et als 2006 dollarisation traps: in that

setting dollarization persists even after inflation

stabilization.

Fear of floating

Monetary authorities are well aware of the potential

adverse impact that exchange rate fluctuations may have

on the economy, and design and implement monetary

policy accordingly. Calvo and Reinhart (2002) label this

policy approach fear of floating.

They note (page 394) that central bankers in

emerging market economies appear to be extremely

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mindful of external factors in general and the foreign

exchange value of their currency, in particular.

Calvo and Reinhart highlight the exchange rates

significant role in monetary policy making, which gives

rise to what they label fear of floating, even under an

inflation targeting regime. Factors driving fear of floating

are:

Liability dollarisation;

Output costs associated with exchange rate

fluctuations;

Inelastic supply of funds during crises; and

Lack of credibility and fear of loss of access to the

international capital markets.

The fear of floating argument is present in Calvo and

Reinharts empirical analysis. They use a sample

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comprising 39 countries and consisting of monthly

observations over the period 1970-1999.

The results from their fact-finding exercises show that

variations in the exchange rate are relative low compared

to variations in international reserves and interest rates.

Such results can be interpreted as evidence that the

monetary authorities are consistently using their key

policy instruments to diminish exchange rate fluctuations

and their adverse impact on the economy. That is, they

have a fear of floating.

A simple analytical model helps in rationalising these

results. Calvo and Reinhart develop a framework

consisting of basic relationships, including uncovered

interest parity (UIP), a purchasing parity power (PPP)

equation making explicit the pass-through mechanism

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from the exchange rate to domestic prices, a money

demand relationship, and a central bank welfare function.

The latter is positively related to seigniorage revenues

and negatively related to inflations deviation from

target.

A key element in the model is that by reacting to shocks

to the exchange rate, the central bank can prevent

exchange rate fluctuations and variations in domestic

inflation. The latter is a desirable outcome for a central

bank operating an inflation targeting regime.

In translating their analytical model to the real world,

Calvo and Reinhart employ a variance ratio capturing

exchange rate variability in comparison with monetary

policy instruments.

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The variance ratio in question is

( )222

Fi

+

=

In the equation22

,i

, and2

F

are the variance of the

exchange rate, interest rate, and foreign reserves,

respectively.

Foreign reserves, a component in the monetary bases

assets side, are included as the model intends to capture

the empirical behaviour of countries that are known to

practice foreign exchange market interventions. In the

equation lambdas values can range from zero to one.

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So, for instance, observing a value of zero implies that

the authorities are strictly committed to pegging the

exchange rate.

Using Australia as benchmark, Calvo and Reinharts

exercise reveals that 83 percent of the countries for

which they compute the equation display lambdas that

are below that of Australia. That number rises to 95 and

90 percent when using Japan and the United States as

benchmarks, respectively.

Further, when they split their original sample and look

into emerging markets, the numbers reveal that countries

with higher variability either had annual inflation rates

above 30 percent, or were those for which the period in

question followed a currency crisis.

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Calvo and Reinhart interpret these findings as endorsing

their analytical model, because if the weight placed on

the inflation target is lower than that for seigniorage, then

the exchange rate will be more variable in relation to

monetary policys instruments.

The latter result reflects the fact that dampening shocks

to the exchange rate is less successful the lower the

commitment to an inflation target.

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Lecture Exchange Rate Pol