1. EXCHANGE RATE REGIMES Overview and policy issues

2. Outline  Types of ER regimes  Advantages and disadvantages of fixing/floating  Choice of ER regime  Empirical Evidence on Exchange Regimes

3. HARD PEGS Currency union Dollarization Currency board FLOATING Managed float Free float Classifying ER regimes INTERMEDIATE Basket peg Crawling peg Band

4. Hard pegs  Dollarization Use another country’s currency as sole legal tender E.g. Ecuador, El Salvador, Panama  Currency union Share same currency with other union members E.g. Euro area, ECCU, CFA franc zone  Currency board Legally commit to exchange domestic currency for specified foreign currency at fixed rate E.g. Hong Kong(1983), Estonia(1992), Lithuania (1994), Bulgaria(1997), Bosnia and Herzegovina, Argentina (until 2001)

5. Intermediate regimes  Conventional (soft) peg Single currency peg (e.g. Malaysia, Nepal, Namibia) Currency basket peg (e.g. Malta, Fiji, Latvia)  Band Pegged exchange rate within horizontal bands (>±1%) E.g. Denmark (  2.25%), Tonga (  5%), Hungary (  15%)  Crawling peg Backward or forward looking E.g. Bolivia  Crawling band Symmetric or asymmetric E.g. Belarus (  5%), Israel (  22%)

6. Floating  Managed floating No preannounced path for the exchange rate Management by sterilized intervention or interest rate (monetary) policy E.g. Thailand, Indonesia, Mongolia, Singapore, Brazil  Independently floating E.g. U.S., Japan, EMU

7. ER arrangements of IMF members (as of July 2005)  No separate legal tender41  Currency board7  Peg (including de facto pegs)40  Horizontal band5  Crawling peg5  Crawling band1  Managed floating54  Independently floating34

8. ...Not as simple as it sounds... de jure vs. de facto exchange rate  Distinction between what countries declare as their official de jure regime, and their actual de facto exchange rate practices. (Reinhart and Rogoff 2004) de jure: what the countries say they do de facto: what they actually do  Countries listed in the official IMF classification as managed floating, 53 percent turned out to have de facto pegs, crawls or narrow bands.

9. How to distinguish ‘Hard Peg’ and “Floating” from ‘Intermediate’?  Is the fixed ER policy an institutional commitment rather than merely a declared policy? YES  Hard Peg NO  Intermediate  Is there an explicit target around which the CB intervenes? YES  Intermediate NO  Floating

10. The Impossibility Trinity  A country must give up one of three goals: 1. Exchange rate stability (by Hard Peg) 2. Monetary Independence 3. Financial Market Integration (absence of capital control)

11. Advantages of fixed ER 1. Provide a nominal anchor for monetary policy 2. Reduce transactions costs and exchange rate risk  int’l trade & investment

12. Disadvantages of fixed ER  Loss of monetary policy autonomy  Loss of exchange rate as a shock absorber =>Consequences for output and employment  Loss of lender of last resort (?)  Danger of speculative attacks and crashes  Loss of seigniorage revenue (in the case of dollarization)

13. No Monetary Policy Autonomy Under Fixed ER with Perfect Capital Mobility  Monetary policy cannot stimulate output (on the other hand, fiscal policy is very effective in stimulating output) Interest rate, i 0 1 Y1Y1 Y0Y0 i1i1 i0i0 BP LM IS Perfect capital mobility Output, Y

14. Real Shocks Not Absorbed (but magnified) Under Fixed ER  Adverse real shock would tend to lower activity and interest rates, leading to pressure to depreciate; CB must sell reserves and contract money supply, worsening the fall in output 1 0 2 Y0Y0 Y2Y2 Y1Y1 i1i1 i0i0 BP LM IS Perfect capital mobility Interest rate, i Output, Y

15. The Debacle of Argentina’s Peg

16. Advantages of flexible ER 1. Monetary Policy independence (discretionary policy) 2. Automatic adjustment to trade shocks

17. Monetary Policy Under Floating ER with Perfect Capital Mobility  Under flexible ER, monetary policy is very effective in stimulating output (on the other hand, fiscal stimulus leads to appreciation and loss of competitiveness)  Think Short x Long run though (and the role of expectations) Interest rate, i 0 1 Y1Y1 Y0Y0 i1i1 i0i0 BP LM IS Perfect capital mobility Output, Y 2 Y2Y2

18. Real Shocks Absorbed (and offset) Under Floating ER  Real adverse shock (like a fall in external demand) would lower output and interest rates, leading to a depreciation and output recovery due to higher exports and lower imports 1 0 Y0Y0 Y1Y1 i1i1 i0i0 BP LM IS Perfect capital mobility Interest rate, i Output, Y

19. Disadvantages of flexible ER  Exchange rate uncertainty  Need to find a less obvious anchor => Consequences for inflation  Danger of speculative (irrational?) bubbles

20. Irrational Bubble? Brazil: Daily Exchange Rate in 2001

21. Macroeconomic Stability: Exchange Rate Arrangements or Policy Discipline? The accession countries maintain a wide diversity of exchange rate regimes, from a currency board arrangement (Estonia) to floating regimes (Poland and the Czech Republic). Hungary's system, a preannounced crawling peg, had a band of 2.25 percent on either side until May 2004. Estonia has come close to achieving the EU inflation level with its currency board, as has the Czech Republic with its floating regime. Poland has followed approximately the same path of disinflation with a wide-band crawling peg, and Hungary with a narrow-band crawling peg

22. Macroeconomic Stability: Exchange Rate Arrangements or Policy Discipline?

23. What have countries done in the 1990s? 16% (25) 42% (77) 23% (36) 34% (63) 62% (98) 24% (45) Source: Fischer (2001)

24. The bipolar view  The intermediate ER regimes are no longer feasible (Summers 1999, Eichengree 1999, Fisher 2001)  The # of independent currencies in the world is declining. Lack of theoretical foundation

25. Lessons from soft pegs  Long-lived (adjustable) pegs are the exception, not the rule.  Exits are often involuntary, the result of a speculative attack.  Greater international capital mobility has increased the likelihood of speculative attacks.  Pegs can only be maintained if the authorities are prepared to subordinate all other economic policy goals to the exchange rate commitment, otherwise exit is inevitable.

26. Source: Bubula and Otker-Robe (2004)

27. Choice of ER regime Criteria (old and new):  Structural characteristics of economy  Nature of shocks to which economy is exposed  Objective function of national authorities  Other considerations

28. (1) Structural characteristics What makes a country more suited for fixed rather than flexible ER? (OCA criteria)  Size and openness  Labor mobility  Wage and price flexibility  Fiscal redistribution mechanisms  Diversity in production  Financial development

29. (2) Nature of shocks  Nominal or real?  Domestic or external?  Temporary or permanent?  Symmetric or asymmetric?  With or without capital mobility?

30. (3) Objective function  Real output stability  BOP, competitiveness  Price stability, inflation  Political objectives e.g. desire for integration

31. (4) Other considerations  Credibility of monetary policy  Need of inflation tax  Adequacy of reserves  Strength and regulation of financial system  Rule of law

32. Who might be suited to a hard peg?  Small open economies whose trade is dominated by a single low-inflation partner Symmetric real shocks  Flexible labor market and/or migration  Access to fiscal policy as a counter-cyclical tool  Countries with low credibility of domestic monetary policy and a high degree of currency substitution  Important to have a healthy financial sector and/or access to external credit lines

33. Who might be suited to floating?  Economies that are affected by mostly idiosyncratic macroeconomic shocks and have relatively inflexible labor markets  Countries with an independent central bank that is credible and able to implement counter-cyclical monetary policy  Countries with well-developed capital markets

34. Who might be suited to an intermediate regime?  Countries that perceive official ER announcements to have large benefits and low costs BUT  are vulnerable to asymmetric shocks that are best addressed by monetary policy

35. Evidence on Exchange Rate Regimes

36. ER regimes and inflation Sample of developing countries (Annual percentage change, median of group) Source: WEO (Oct. 1997)

37. Do hard pegs lower inflation? Source: Ghosh et al (1997).

38. Do hard pegs induce greater fiscal discipline? Inflation (% per year, log scale) Fiscal deficit (% of GDP) Public debt (% of GDP) Source: IMF, WEO Argentina

39. Does ER variability discourage trade? StudyCoverageResults Coes (1981)Brazil, 1965-74Yes Brada & Mendez (1988)30 developed & emerging economies, 1973-77 Mixed Caballero & Corbo (1989)6 emerging economiesYes Paredes (1989)Chile & PeruYes Medhora (1990)W. African Monetary UnionNo Savides (1992)62 developed & emerging economies, 1973-86 Yes (unexpected variability only) Grobar (1993)10 emerging markets, 1963-85Yes, mostly Frankel & Wei (1993)63 countries, 1980, 1985, 1990Mixed Arize, Osang & Slottje (2000) Paiva (2003) 13 emerging economies, 1973-96 Brazil, 1990-2002 Yes

40. Do currency unions encourage trade? Source: Rose (2004) Partial effect of CU on trade, all else constant Most estimates are positive,... economically large, and statistically significant Histogram of γ estimates, -2<γ<2 Histogram of γ estimates, 0<γ<1.2 T ijt = β 1 D ij + β 2 (Y i Y j ) t + Σ k β k Z ijt + γCU ijt + u ijt

41. Does floating afford greater monetary policy autonomy? Source: Calvo & Reinhart (2002) “Fear of floating”

42. Fear of Floating  The fear of floating stems from the costs of exchange rate volatility  Calvo and Reinhart (2002): many countries that claim to have floating exchange rates do not in practice allow the rate to float freely, but use interest rate and intervention policies as the means of smoothing exchange rate fluctuations.  The greater the dependence on foreign currency borrowing, the greater fear of floating (Hausmann and others, 2000)

43. ER regimes and growth Sample of developing countries (Annual percentage change, median of group) Source: WEO (Oct. 1997)

44. ER regimes and growth  Impacts on Growth Using a de jure classification, Levy-Yeyati and Sturzenegger (2003) find: Developing countries—less flexible exchange rate regimes are associated with slower growth and greater output volatility; Developed countries—regimes do not appear to have any significant impact on growth

45. Which ER regime is best for growth? Limited flexibility Peg Managed float Free float 0.5% Regular peg 0.9% Float Currency boardIntermediate Fix Float Intermediate 1.0% Fix Ghosh, Gulde & Wolfe (2000) Reinhart & Rogoff (2002) Levy-Yeyati & Sturzenegger (2002) IMF classification Own classification Average per capita growth rates

46. Summary of empirical evidence  There is some evidence that hard pegs lower inflation  There is mixed evidence on hard pegs and fiscal discipline  There is some evidence that a common currency increases trade and integration and exchange rate volatility discourages trade and investment  There is strong evidence that the extent of monetary policy autonomy under floating ER is limited in practice  There is mixed evidence on exchange rate regimes and growth

47. Conclusion  Whatever the ER regime is, it must be consistent with macroeconomic policy objectives Role of fiscal and monetary discipline Role of capital controls  The choice of ER regime is likely to be of second-order importance to the development of good fiscal, financial, and monetary institutions in producing macroeconomic success