1. INTERNATIONAL MACROECONOMICS SEMINAR I “The Choice of an Appropriate Exchange Rate Regime” March 2004

2. Outline The exchange rate adjustment mechanism Advantages and disadvantages of exchange rate regimes Classification of exchange rate regimes Corner solutions Intermediate regimes Optimal choice of an exchange rate regime and further discussions

3. The Exchange Rate Adjustment Mechanism (Stefanie and Bengu)

4. Exchange Rate Adjustment to External Shocks External Demand Shock (same for Fiscal Expansion) –Recession in another country –Introduction of new technology Price Shock in World Markets –Commodity Price Changes –Oil-price crises World Interest Rate Shock  Balance of Payment Problems Fixed Exchange Rates Flexible Exchange Rates Effects

5. Negative Demand Shock in Flexible Exchange Rate Regime i Y BP = 0 Y* A’ A IS 1 IS 2 LM

6. PROBLEM: STICKY PRICES / WAGES -Prices/Wages do not react instantaneously to shocks in the goods market, where adjustment takes time. -This causes exchange rate to be volatile and to over-shoot (Dornbusch`s 1976 paper), that is, to exceed its equilibrium value first and then, as time passes, get equal to it.

7. Exchange Rate Overshooting Exchange Rates and Prices do not move at the same rate Monetary expansion pushes interest rates down, exchange rate adjusts immediately, prices adjust only gradually, hence in the SR abrupt change in relative prices and competitiveness Flexible Exchange Rates produce large exchange rate fluctuations Exchange rate Prices

8. External Negative Demand Shock in Fixed Exchange Regime Y i i IS 1 LM 2 Y2Y2 Y1Y1 LM 1 Y3Y3 IS 2

9. Price Adjustment versus Devaluation P/E Y NX=0 NX’=0 A A’ A’’ Y*Y < Three Options A: Intervention AA’A’’ : AAM AA’’: Devaluation

10. Automatic Adjustment Process with a Balance of Payment Deficit P Y Y* NX=0 AS 1 AD 1 E’ Y < E AS 2 AD 2

11. Effects of Negative Demand Shocks Fixed RatesFlexible Rates Negative Effect on output and employment and losses of foreign reserves or international credit expansion Contraction in output has no long run effects on equilibrium output. Possibility of sticky prices and overshooting of exchange rates Automatic Adjustment MechanismFixed But Adjustable Automatic adjustment through a sequence of price and money adjustment based on trade balance. Long and painful. Implicit assumption of price-stickiness Immediate devaluation Works only if increasing price level does not off-set devaluation gain Possibility of J-Curve Effect

12. Advantages and Disadvantages of Exchange Rate Regimes (Neng, Katarina and Zhu Yiang) Frankel, J. “No Single Currency Regime is Right for All Countries at All Times” 1996 Obstfeld, M. and K. Rogoff, “The Mirage of Fixed Exchange Rates” 1995 Stockman, A. “Choosing an Exchange Rate System” 1999

13. Full Capital Controls Pure Float Monetary union Monetary independence Exchange rate stability Full financial integration The Impossible Trinity

14. FixedFlexible ♦ Currency Union ♦ Currency Board ♦ Truly fixed exchange rate ♦ Free float ♦ Managed float (dirty float) ♦ Fixed but adjustable peg ♦ Crawling peg ♦ Basket peg ♦ Target zone or band [Intermediate Regimes] Frankel (1999) “No Single Currency Regime is Right for all …”

15. Flexible exchange rate regimes: ♦ Free float - The central bank does not intervene in the foreign exchange market, but rather allows private supply and demand to clear on their own. e.g. United States ♦ Managed float - also known as dirty float, it is defined as a readiness to intervene in the foreign exchange market, without defending any particular parity.

16. Intermediate regimes: ♦ Fixed but adjustable peg - countries that declare themselves fixed, in fact periodically undergo realignments. e.g. Bretton Woods regime ♦ Crawling peg - in high-inflation countries, the peg can be regularly reset in a series of devaluations, as often as weekly. ♦ Basket peg - the exchange rate is fixed in terms of a weighted basket of currencies instead of any one major currency. ♦ Target zone or band - the authorities intervene when the exchange rate hits pre-announced margins on either side of a central parity. e.g. ERM (the Exchange Rate Mechanism)

17. Fixed exchange rate regimes: ♦ Currency Union - the currency that circulates domestically is the same as is circulating in one or more major neighbors or partners. e.g. EMU ♦ Currency board - a monetary institution that only issues currency that is fully backed by foreign assets. e.g. Argentina, Hong Kong ♦ “Truly fixed” exchange rate - fixing to one of main world currencies – dollar, euro, etc.

18.  Advantages:  The major advantage is that it allows the country to pursue independent monetary policy. When the economy is hit by a shock, the central bank is able to respond very fast. Flexible exchange rate regimes  Disadvantages:  Exchange-rate uncertainty reduces international trade, discourages investment and increases costs of hedging the exchange rate risk  A tendency toward volatility that does not always derive from macroeconomic fundamentals, including occasional speculative bubbles and crashes

19. Fixed exchange rate regimes  Advantages:  To reduce transaction costs and exchange rate risk, which can discourage trade and investment  To provide a credible nominal anchor for monetary policy (credibility/expectation)  Disadvantages:  A tendency toward borrowers’ effectively-unhedged exposure in foreign currency, ending badly in speculative attacks and multiple equilibrium  Monetary policy is less powerful (or completely powerless)

20. Issue 1 Why It Is Difficult to Peg? ♦ Technically Possible ♦ Real Problem: Competing Government Objectives Issue 2 Is the cost of Fixed exchange regime very high? (OCA) ♦ Experience similar shocks ♦ Or, have high factor mobility

21. In summary... Whether the advantages of fixed exchange rates or the advantages of floating exchange rate are likely to dominate is depend on characteristics of the country and the period in question.

22. Corner Solutions-Bipolar View (Wei Wei Zheng and Susilawani)

24. A. HARD PEG Characteristics of countries that should fix firmly Small size Preponderance of economic fluctuations that originate domestically rather than abroad Openness to trade High labor mobility Availability of a fiscal mechanism to cushion downturns A high correlation of the local business cycle with the country to which a currency peg is contemplated

25. Additional characteristics for most rigid institutional arrangement: currency board, full dollarization or monetary union A strong need to import monetary and financial stability due to a history of hyperinflation An absence of credible public institutions Unusually large exposure to nervous investors Access to an adequate reserve Law: essential for Currency board Willingness of the foreign country whose currency is used to allow input into monetary policy ( A case of full monetary union such as EMU) The same monetary policy with the foreign country that the currency is pegged to

26. Currency Board A monetary institution that only issues currency that is fully backed by foreign assets Principal attributes:  An exchange rate that is fixed by policy and law  A reserve requirement demanding that for each dollar’s worth of domestic currency is backed by a dollar’s worth of foreign reserves  A self correcting balance of payment mechanism Example: A payment deficit contracts the MS contracts the spending automatically  Countries with currency board- Hong Kong, Argentina, Estonia, Lithuania, Bulgaria, Bosnia  Strength - Create policy environment by removing from the monetary authorities the option of printing money to finance government deficits

27. Dollarization/ Monetary union A total surrender of monetary independence. In other words, to give up totally the domestic currency for foreign currency Still retain a small degree of monetary independence although not zero. In the case of Argentina, its convertibility law ensures the switch from one currency to another.

28. B. Free Floating Large economy  Higher integration within the border than across the border  High mobility of labor, trade and fiscal transfer  Higher correlation of the business cycle within the border than across the border Confidence of international investors Strong and well functioning central banks Exchange rate fluctuation is not a major concern Example: United States

29. Intermediate Regimes (Peng Dai, Tolga and Meng Huang)

30. What is the optimal choice of an exchange rate regime? It is the solution to the minimization of a loss function If monetary shocks dominate  fixed If real shocks dominate  flexible If neither dominates  managed float If consider AS function and wage indexation  depends on the degree of indexation

31. What is the optimal choice of an exchange rate regime? Optimization seldom gives corner solutions Shocks can be partially absorbed by exchange rates and partially by CB accommodation So, why the popularity of the bipolar view?

32. Bipolar View Why the popularity of the bipolar view? Although There is no “satisfactory” theoretical argument (e.g. impossible trinity, unhedged foreign liabilities, reluctance to exit the peg) in support of bipolar view, The problem of verifiability in complicated and nontransparent intermediate regimes might be an explanation.

33. Bipolar View Why the popularity of the bipolar view? Many arguments on grounds of susceptibility to currency crises Previous unsuccessful episodes and lack of mature and well-established institutions undermine the credibility of new intermediate regimes Reluctance of CB to realign in time before a crisis outbreaks

34. Beyond Bipolar View Can corner solutions remedy these deficiencies on their own? Unlikely. Should consider all aspects of a monetary framework together rather than in isolation. Free float  No costly devaluation CB autonomy  Exchange rate stability and lower inflation Announced Monetary Targets  Lower inflation and inflation persistence, more flexibility through transparency

35. The Optimal Choice of an Exchange Rate Regime (Yin-Che and Deren)

36. Theory of optimal exchange rate regimes-Choice criteria size of an economy openness of an economy labor market flexibility capital mobility fiscal redistribution exposure to shocks quality of policies diversified production/export performance

37. Weaknesses in the standard theory of optimal exchange rate regime choices (Calvo and Mishkin, 2003) Theory fails in some respects. Examples: –Fiscal transfers do not change relative prices –Labor mobility is a poor substitute for exchange rate flexibility –The standard theory implicitly assumes an ability to set up institutions that will assure a fixed exchange rate –Presumes that a time-consistent choice is made on the exchange rate regime, whereas in many countries, the exchange rates the exchange rate regime may frequently shift –The financial sector is ignored –Pays no attention to transaction costs and liquidity considerations Thus, the theory does not apply well to especially emerging markets

38. How to compare exchange rate regimes? Analytical arguments often lead to opposing conclusions. Current discussion is based on the empirical evidence.

39. The Problem of Classification (Reinhart and Rogoff, 2004) In practice, exchange rate regimes often differed from what they were officially announced to be. Freely falling exchange rates should be taken into account seperately. Solution: Natural Classification (5 main categories) –Fixed –Limited Flexibility –Managed Floating –Freely Floating –Freely Falling

40. Empirical Evidence-Conclusions Empirical evidence depends entirely on classification. Taking into account “Natural Classification” Rogoff et al (2003) concludes Corners Hypothesis-Bipolar view finds less support Intermediate regimes are more durable As economies mature, the degree of exchange rate flexibility rises –Developing Countries Superior performance of pegged regimes with commitment through public announcement –Emerging Markets Need to consider adopting more flexible exchange rate regimes as they develop economically and institutionally (Goldstein, 2002 suggests managed floating plus) –Advanced Countries Free floats registed better performance

42. “No single currency regime is right for all countries or at all times” Frankel, 1999