1. Lecture 20: Exchange Rate Regimes
Prof.J.Frankel

2. What exchange rate regimes do countries choose?
Classification of exchange rate regimes
What regimes should countries choose?
2. Advantages of fixed rates
Advantages of floating rates
How should the choice be made?
Performance by category
Traditional criteria for choosing: OCA framework
Further criteria to suit a country for institutionally fixed rate
Financial development
Commodity price volatility and other trade/supply shocks.
Appendices: I. Fashions in international currency policy
II. The corners hypothesis
III. De facto classification of countries’ regimes
Prof.J.Frankel

3. 1. Classification of exchange rate regime Continuum from flexible to rigid
FLEXIBLE CORNER
1) Free float 2) Managed float
INTERMEDIATE REGIMES
3) Target zone/band 4) Basket peg
5) Crawling peg 6) Adjustable peg
FIXED CORNER
7) Currency board 8) Dollarization
9) Monetary union
Prof.J.Frankel

4. Trends in distribution of EM exchange rate regimes
– Many abandoned fixed exchange rates
– Exchange rate-based stabilization programs
1990s -- Corners Hypothesis: countries move to either hard peg or free float
Since The rise of the “managed float” category.
Distribution of Exchange Rate Regimes in Emerging Markets,
(percent of total) }
Ghosh, Ostry & Qureshi, 2014, “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” IMF.
Prof.J.Frankel

5. 2. Advantages of fixed rates
Encourage trade <= lower exchange risk.
In theory, can hedge risk. But costs of hedging:
transactions costs, missing markets, and risk premia.
Empirical: Exchange rate volatility ↑ => trade ↓ ?
Shows up in:
- Cross-section evidence,
especially small & less developed countries.
- Borders, e.g., Canada-US: McCallum-Helliwell ( ); Engel-Rogers (1996).
- Currency unions: Rose (2000).
Prof.J.Frankel

6. Advantages of fixed rates, cont.
2) Encourage investment
3) Provide nominal anchor for monetary policy
By anchoring inflation expectations, achieve lower inflation for same Y.
But which anchor? Exchange rate target vs. alternatives.
4) Avoid competitive depreciation
“Currency Wars”.
5) Avoid speculative bubbles that can afflict floating.
Prof.J.Frankel

7. 3. Advantages of floating rates
1) Monetary independence.
2) Automatic adjustment to trade shocks.
3) Central bank retains seignorage.
4) Central bank retains Lender of Last Resort capability, for rescuing banks.
5) Avoiding crashes that hit pegged rates.
Prof.J.Frankel

8. 4. Which dominate: advantages of fixing or advantages of floating?
Empirical studies of performance by category are inconclusive.
See Appendix III, last slide.
Why?
No one exchange rate regime is right for all countries.
The answer depends on a country’s circumstances.
Traditional criteria for choosing: Optimum Currency Area.
Prof.J.Frankel

9. Optimum Currency Area (OCA)
Broad definition: An optimum currency area is a region (not necessarily coinciding with one country’s borders) that should have its own currency & own monetary policy.
This definition can be given more content:
An OCA can be defined as a region that is neither so small and open that it would be better off linking to the currency of a neighbor, nor so large that it would be better off splitting into sub-regions with different currencies.
Professor Jeffrey Frankel
Prof.J.Frankel 9

10. Optimum Currency Area criteria for fixing exchange rate:
Small size and openness
because then advantages of fixing are large.
Symmetry of shocks
because then giving up monetary independence is a small loss.
Labor mobility
because then it is possible to adjust to shocks even without ability to expand money, cut interest rates or devalue.
Fiscal transfers in a federal system
because then consumption is cushioned in a downturn.
Professor Jeffrey Frankel
Prof.J.Frankel 10

11. New popularity in 1990s of institutionally-fixed corner
currency boards
(e.g., Hong Kong ; Lithuania ;
Argentina ; Bulgaria ;
Estonia ; Bosnia ; Timor, 2000-…)
dollarization
(e.g., Panama, El Salvador, Ecuador;
or euro-ization: Montenegro)
monetary union
(e.g., the eurozone, ).
Prof.J.Frankel

12. Currency boards
Definition: A currency board is a monetary institution that only issues currency fully backed by foreign assets Its principal attributes include the following:
An exchange rate that is fixed not just by policy, but by law.
A reserve requirement stipulating that each dollar’s work of domestic currency is backed by a dollar’s worth of foreign reserves.
A self-correcting balance of payments mechanism, in which a payments deficit automatically contracts the money supply, resulting in a contraction of spending.
Prof.J.Frankel

13. 1990’s criteria for the firm-fix corner
suiting candidates for currency board or union (e.g., Calvo)
Regarding credibility:
a desperate need to import monetary stability, due to:
history of hyperinflation,
absence of credible public institutions,
location in a dangerous neighborhood, or
large exposure to nervous international investors;
a desire for integration with a particular neighbor/ trading partner.
Regarding other “initial conditions”:
an already-high level of private dollarization
high pass-through to import prices
access to an adequate level of reserves.
Prof.J.Frankel

14. (i) Level of financial development
Two additional considerations, particularly relevant to developing countries
(i) Level of financial development
(ii) Prevalence of real shocks
Professor Jeffrey Frankel
Prof.J.Frankel

15. (i) Level of financial development
Fixed rates are better for countries at low levels of financial development: because markets are thin.
When financial markets develop, exchange flexibility becomes more attractive.
Prof.J.Frankel

16. (ii) Real Shocks Textbook wisdom regarding the source of shocks:
Fixed rates work best if shocks are mostly internal demand shocks (especially monetary);
floating rates work best if shocks tend to be real shocks (especially external trade shocks).
One case of supply shocks: natural disasters
Most common case of real shocks: trade
Prof.J.Frankel 16

17. Terms-of-trade variability
Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008, and again in 2011.
=> Favorable terms of trade shocks for some (Africa, Latin America, & other oil exporters);
=> Unfavorable terms of trade shock for others (oil importers like Japan, Korea, India, Turkey).
Commodity prices fell in
A country where trade shocks dominate should accommodate by floating.
Prof.J.Frankel

18. End of Lecture 21: Exchange Rate Regimes
Prof.J.Frankel

19. Appendix I: Fashions in international currency policy
: Monetarism (=> target the money supply)
: Fixed exchange rates
(incl. currency boards)
: The corners hypothesis (either firm fix or float)
: Inflation Targeting became the new conventional wisdom.
2008-: IT lost some of its attractiveness in the Global Financial Crisis, due to its neglect of asset prices. IT
Prof.J.Frankel 19

20. Appendix II: The corners hypothesis
The claim:
“Countries can either rigidly peg or freely float, but should abandon intermediate regimes like target zones.”
Origins:
ERM crises -- Eichengreen (1994)
Late-1990’s crises in emerging markets
Prof.J.Frankel

21. Intermediate regimes target zone (band)
Krugman-ERM type (with nominal anchor)
Bergsten-Williamson type (FEER adjusted automatically)
basket peg (weights can be either transparent or secret)
crawling peg
pre-announced (e.g., tablita)
indexed (to fix real exchange rate)
adjustable peg
(escape clause, e.g., contingent
on terms of trade or reserve loss)
Prof.J.Frankel

22. The rise & fall of the Corners Hypothesis
It became fashionable in the late 1990s.
But:
Since Argentina’s 2001 crisis forced it to abandon its “convertibility plan,” currency boards and the corners hypothesis have lost popularity.
The intermediate regimes are alive and well.
The dominant long-term trend is, rather, toward flexibility.
Prof.J.Frankel

23. Appendix III: De facto classification of regimes
De jure regime  de facto
Many countries that say they float, in fact intervene heavily in the foreign exchange market. [1]
Many countries that say they fix, in fact devalue when trouble arises. [2]
Many countries that say they target a basket of major currencies in fact fiddle with the weights. [3]
[1] “Fear of floating” -- Calvo & Reinhart (2001, 2002); Reinhart (2000).
[2] “The mirage of fixed exchange rates” -- Obstfeld & Rogoff (1995).
[3] Parameters kept secret -- Frankel, Schmukler & Servén (2000).
Prof.J.Frankel

24. A number of studies have classified countries by de facto exchange rate regimes. But their designations are not highly correlated with each other.
Andrew Rose, 2011, "Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky,” J. Ec. Literature, Vol. 49, No. 3, Sept., pp
Prof.J.Frankel

25. Which exchange rate regimes show higher growth on average
Which exchange rate regimes show higher growth on average? Different classification schemes give different results.
Growth Effects of Deviations from Fixed Exchange Rate Regimes
IMF classification => crawls do best
R&R classification => floats do best
LY&S classification => fixed rates do best.
Andrew Rose, 2011, "Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky,” Journal of Economic Literature, Vol. 49, No. 3, Sept., pp Table 2.
Prof.J.Frankel