Distinguished Lecture on Economics in Government Exchange rate Regimes: is the Bipolar View Correct? Stanley Fischer Ahmad Bash P13-18

Fear of Floating 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

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