Transcript Seminar Question 1 Slides

INTERNATIONAL MACROECONOMICS
SEMINAR I
“The Choice of an Appropriate
Exchange Rate Regime”
March 2004
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
The Exchange Rate Adjustment Mechanism
(Stefanie and Bengu)
Exchange Rate Adjustment to
External Shocks
• External Demand Shock
(same for Fiscal Expansion)
Fixed Exchange Rates
– Recession in another country
– Introduction of new technology
• Price Shock in World Markets
Effects
– Commodity Price Changes
– Oil-price crises
• World Interest Rate Shock
 Balance of Payment Problems
Flexible Exchange Rates
Negative Demand Shock in
Flexible Exchange Rate Regime
i
LM
A
BP = 0
A’
IS1
IS2
Y*
Y
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 (Dornbusch`s 1976 paper), that is,
to exceed its equilibrium value first and then,
as time passes, get equal to it.
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
External Negative Demand Shock in
Fixed Exchange Regime
i
i
LM2
LM1
IS1
IS2
Y3
Y2 Y1
Y
 2 1

Price Adjustment versus
Devaluation
P/E
Three Options
A: Intervention
A’
A
A’’
AA’A’’ : AAM
AA’’: Devaluation
NX=0
NX’=0
Y<
Y*
Y
Automatic Adjustment Process with
a Balance of Payment Deficit
AS1
P
AS2
E
E’
AD1
AD2
NX=0
Y
Y < Y*
Effects of Negative Demand Shocks
Fixed Rates
Flexible Rates
•Negative Effect on output and
•Contraction in output has no long run
employment and losses of foreign reserves effects on equilibrium output.
or international credit expansion
•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
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
Full Capital
Controls
The Impossible Trinity
Monetary independence
Exchange rate stability
Pure
Float
Monetary
union
Full financial integration
Flexible
Fixed
♦ Free float
♦ Currency Union
♦ Managed float
♦ Currency Board
♦ Truly fixed exchange
rate
(dirty float)
♦ Fixed but adjustable peg
♦ Crawling peg
♦ Basket peg
♦ Target zone or band
[Intermediate Regimes]
Frankel (1999)
“No Single Currency
Regime is Right for
all …”
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.
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)
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.
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
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-unhedged
exposure in foreign currency, ending badly in speculative
attacks and multiple equilibrium
 Monetary policy is less powerful (or completely
powerless)
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
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.
Corner Solutions-Bipolar View
(Wei Wei Zheng and Susilawani)
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
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
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 dollar’s worth of domestic
currency is backed by a dollar’s 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
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.
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
Intermediate Regimes
(Peng Dai, Tolga and Meng Huang)
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
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?
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.
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
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
The Optimal Choice of an Exchange
Rate Regime
(Yin-Che and Deren)
Theory of optimal exchange rate
regimes-Choice criteria
• size of an economy
• fiscal redistribution
• openness of an economy
• exposure to shocks
• labor market flexibility
• quality of policies
• capital mobility
• diversified production/export
performance
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
How to compare exchange rate regimes?
• Analytical arguments often lead to opposing
conclusions.
• Current discussion is based on the empirical
evidence.
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
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
“No single currency regime is right for
all countries or at all times”
Frankel, 1999