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Exchange Rate Arrangements: Various Options Choice before an authority – Fixed Exchange Rate System – Floating Exchange Rate System Exchange Rate Arrangements: Various Options THE CASE FOR FLOATING EXCHANGE RATES • 1. Monetary policy autonomy. • If central banks were no longer obliged to intervene in currency markets to fix exchange rates, authorities would be able to use monetary policy to reach internal and external balance. • Further, no country would be forced to import inflation (or deflation) from abroad. Exchange Rate Arrangements: Various Options • 2. Symmetry. • Under a system of floating rates the inherent asymmetries of Bretton Woods would disappear and the United States would no longer be able to set world monetary condition all by itself. • At the same time, the United States would have the same opportunity as other countries to influence its exchange rate against foreign currencies. Exchange Rate Arrangements: Various Options • 3. Exchange rates as automatic stabilizers. • Even in the absence of an active monetary policy, the swift adjustment of marketdetermined exchange rates would help countries maintain internal and external balance in the face of changes in aggregate demand. • The long and agonizing period of speculation preceding exchange rate realignments under the Bretton Woods rules would not occur under floating. Exchange Rate Arrangements: Various Options • THE CASE AGAINST FLOATING • EXCHANGE RATES 1. Discipline. • Central banks freed from the obligation to fix their exchange rates might embark on inflationary policies. • In other words, the "discipline" imposed on individual countries by a fixed rate would be lost. Exchange Rate Arrangements: Various Options • 2. Destabilizing speculation and money market disturbances. • Speculation on changes in exchange rates could lead to instability in foreign exchange markets, and this instability, in turn, might have negative effects on countries' internal and external balances. • Further, disturbances to the home money market could be more disruptive under floating than under a fixed rate. Exchange Rate Arrangements: Various Options • 3. Injury to international trade and investment. • Floating rates would make relative international prices more unpredictable and thus injure international trade and investment. Exchange Rate Arrangements: Various Options • 4. Uncoordinated economic policies. • If the Bretton Woods rules on exchange rate adjustment were abandoned, the door would be opened to competitive currency practices harmful to the world economy. • As happened during the interwar years, countries might adopt policies without considering their possible beggar-thy-neighbor aspects. • All countries would suffer as a result. Exchange Rate Arrangements: Various Options • 5. The illusion of greater autonomy. • Floating exchange rates would not really give countries more policy autonomy. • Changes in exchange rates would have such pervasive macroeconomic effects that central banks would feel compelled to intervene heavily in foreign exchange markets even without a formal commitment to peg. • Thus, floating would increase the uncertainty in the economy without really giving macroeconomic policy greater freedom. Exchange Rate Arrangements: Various Options Various Alternatives Available Under Floating Exchange Rate System 1. 2. 3. 4. 5. 6. 7. 8. 9. Free Float Dirty Float Floating Within A Band Sliding Band Crawling Band Crawling Peg Fixed but Adjustable Currency Board Dollarization Exchange Rate Arrangements: Various Options Free Float • • Value of foreign exchange freely determined in the market. Actual and expected changes in demand/ supply of assets and goods reflected in exchange rate changes Exchange Rate Arrangements: Various Options Dirty Float • • • • Sporadic central bank interventions in foreign exchange markets. Modes and frequency of intervention vary as do the objectives guiding the interventions. Active interventions results in changes in international reserves. Indirect interventions (through changes in interest rates, liquidity and other financial instruments) does not result in changes in reserves Exchange Rate Arrangements: Various Options Floating Within A Band • • • • • The exchange rate is allowed to fluctuate within a band. The center of the band is a fixed rate, either in terms of one currency or of a basket of currencies. The width of the band varies. Some band systems are the result of cooperative arrangements, other are unilateral Example: (The Vietnam government announced a raft of plans, including widening the currency trading band, to help counter the nation’s fastest inflation in more than 12 years. It plans to widen the currency’s trading band against the dollar to 2%, up from the current 0.75%. (7 March 2008)) Exchange Rate Arrangements: Various Options Sliding Band • • • There is no commitment by the authorities to maintain the central parity "indefinitely" . Instead it is clear at the outset that the central parity will be adjusted periodically (e.g. due to competitiveness considerations) The system is an adaptation of the band regime to the case of high inflation economies. Exchange Rate Arrangements: Various Options Crawling Band • • • • A band system whereby the central parity crawls overtime. Different rules can be used to determine the rate of crawl. The two most common are backward looking crawl (e.g. based on past inflation differential ) and forward looking crawl (e.g. based on the expected or target, rate of inflation) Exchange Rate Arrangements: Various Options Crawling Peg • • The normal exchange rate is adjusted periodically according to a set of indicator (usually lagged inflation differentials) and is not allowed the alternate beyond a narrow range (say two percent) One variant of the system consists of adjusting the nominal rate by a pre-announced rate set deliberately below ongoing inflation. Exchange Rate Arrangements: Various Options Fixed but Adjustable • • • • The regime epitomized by the Bretton Woods System. The exchange rate is fixed but the central bank is not obliged to maintain the parity indefinitely. No tight constraints are imposed on the monetary and fiscal authorities regarding policies that are inconsistent with preserving the parity. Adjustments of the parity (devaluation) are a powerful policy instrument Exchange Rate Arrangements: Various Options Currency Board • • Fixed exchange rate system with institutional (legal and even constitutional) constraints on monetary policy and no scope for altering the parity. The monetary authority can issue domestic money only when it is fully backed by inflows of foreign exchange Exchange Rate Arrangements: Various Options Dollarization • Generic name given to and extreme form of a currency board system where the country gives up completely its monetary autonomy by adopting another countries currency