Transcript Distinguished Lecture on Economics in Government Exchange rate

Distinguished Lecture on Economics in
Government
Exchange rate Regimes: is the Bipolar
View Correct?
Stanley Fischer
Ahmad Bash
P13-18
Fear of Floating
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Many countries that claim to have floating exchange rates don’t allow the
exchange rate to float freely, but rather deploy interest rate and intervention
policy to affect its behavior.
As long as such interventions are not undertaken to defend a particular
exchange rate, or narrow range of exchange rates (this is described as
managed floating)
Emerging countries are not wiling to allow their exchange rates to float
Most policy makers are concerned with the behavior of the nominal and the
real exchange rates
Changes in the nominal exchange rate affects inflation rate
Changes in the real exchange rate affects the wealth of domestic citizens,
allocation of resources, (economic and political effect)
In most countries that adopt floating exchange rate regimes, monetary policy
is likely to respond to some extent to movements of the exchange rate
The USA is one of the few countries that largely ignores its exchange rate in
the conduct of monetary policy
Canada, France, Germany, Italy, Japan, UK do pay attention to the exchange
rate when they conduct monetary policy
• Recent converts to floating exchange rates have opted for inflation
targeting ( movements in the exchange rate will be taken into account
indirectly in setting monetary policy because exchange rate affects prices)
• Q:. Why should monetary policy not target both nominal exchange rate
and the inflation rate? Central banks face this question in a situation with
an appreciated exchange rate, and current account in large deficit
• A: monetary policy fundamentally affects the nominal exchange rate and
not the real exchange rate, and if the government wants to take care of
current account balance by reducing an imbalance between domestic
savings and investment, it is fiscal policy.
• Q: should in a floating rate system, should monetary policy be used in the
short run to affect the real exchange rate?
• A: if the nominal exchange rate moves faster than the real exchange rate,
then monetary policy can influence the real exchange rate in the short run
• There is almost certainly a short run trade-off between the real exchange
rate and inflation (similar to PC)
• The intervention in could be used either by interest rate or directly from
time to time in the foreign exchange markets to stabilize the exchange rate
• The Banco of Mexico has developed a method of more or less automatic
intervention designed to reduce day to day movements in the exchange
rates
• Since there are difficulties for an emerging country to defend a narrow
range of exchange rate, John Williamson (2000) proposes alternative
regimes ( the Basket, Band, Crawl arrangements)
• He also recommends that if necessary, country can allow the exchange
rate to move temporarily outside the band, so that speculators cannot
predict when the central bank is going to intervene
Viable Hard Pegs
• At the end of 1999, over quarter of the IMF’s 183 members have very hard
pegs such as no independent legal tender, or currency board, or
dollarization, or currency union
• Advantages of the currency boards:
1- Modern currency boards have often been instituted to gain credibility
following a period of high inflation.
2- Countries with currency boards experienced lower inflation and higher
GDP growth compared to both floating regimes and simple pegs
3- Removal of the nominal exchange rate as a means of adjustment ( also
weakness)
• In the case of shocks, economy can adjust via a change either in exchange
rates or domestic prices and wages. The nominal exchange rate
adjustment is typically much quicker
• Argentina in 2000, currency board arrangements prevented the nominal
exchange rate from moving
• For a country with a history of extreme monetary disorder, a currency
board appears to be a means of obtaining credibility for a low inflation
monetary policy more rapidly and at lower cost than appears possible any
other way
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Disadvantages of currency board:
1- central bank cannot create money, it may not act as lender of last resort
during financial crisis
• However, this issue can be compensated in various ways:
1-creating banking sector stabilization fund
2- setting up a deposit insurance scheme
3- strengthening financial sector supervision and prudential controls by
allowing foreign banks to operate in the economy
• With respect to assets markets, a country obtains essentially no benefit from
exchange rate flexibility. For example, emerging countries cannot borrow from
abroad in their own currencies and so the exchange rate creates a source of
additional risk. For this reason, some researchers argue for going beyond
currency boards to dollarization and perhaps in the longer run to wider
currency union.
• Dollarization or currency board? Appraise the gains and losses
1- reduction of spreads between domestic and foreign interest rates
2- Strengthening of financial system
3- Loss of forgoing seigniorage and giving up national currency
• Hard peg exchange rate systems have become more attractive nowadays
• For a small economy, heavily dependent in its trade and capital account
transactions on a particular large economy, it may make sense to adopt
the currency of that country
• While the requirements for the effective operation of such a system are
demanding, in terms of the strength of the financial system and fiscal
soundness, meeting those requirements is good for the economy in any
case