1. Exchange Rate Regimes Thorvaldur Gylfason Joint Vienna Institute/IMF Institute August 24–September 4, 2009

2. 1.Real vs. nominal exchange rates 2.Exchange rate policy and welfare 3.Exchange rate regimes To float or not to float

3. 1 Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Increase in Q means real appreciation e e refers to foreign currency content of domestic currency

4. Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

5. 1.e falls 1. Suppose e falls Then more rubles per dollar, X risesZ falls so X rises, Z falls 2.P falls 2. Suppose P falls X risesZ falls Then X rises, Z falls 3.P* rises 3. Suppose P* rises X risesZ falls Then X rises, Z falls Q falls Capture all three by supposing Q falls X risesZ falls Then X rises, Z falls

6. Foreign exchange Real exchange rate Imports Exports 2 Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium

7. Equilibrium between demand and supply in foreign exchange market establishes Equilibrium real exchange rate Equilibrium in balance of payments BOP = X + F x – Z – F z = X – Z + F = X – Z + F = current account + capital account = 0 X – Z = current account F = capital and financial account X – Z = current account F = capital and financial account

8. Foreign exchange Real exchange rate Imports Exports Overvaluation Deficit R R moves when e is fixed

9. Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Overvaluation Deficit Overvaluation works like a price ceiling

10. Supply Demand E Producersurplus Consumersurplus Quantity Price A B C welfare gain Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) welfare gain Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE)  R = 0, so R is fixed when e floats

11. Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss welfare loss equivalent to the triangle EFG Price ceiling imposes a welfare loss welfare loss equivalent to the triangle EFG A B C Consumer surplus = AFGH H J Producer surplus = CGH Total surplus = AFGC

12. Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss welfare loss that results from shortage (e.g., deficit) Price ceiling imposes a welfare loss welfare loss that results from shortage (e.g., deficit) A B C H J Shortage

13. Remember: fiscal and monetary restraint Devaluation needs to be accompanied by fiscal and monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation real To work, nominal devaluation must result in real devaluation

14. always floats The real exchange rate always floats Through nominal exchange rate adjustment or price change Even so, it matters how countries set their nominal exchange rates because floating takes time There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates 3

15. There is a range of options Monetary union or dollarization Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate Fixed exchange rate (peg) Crawling peg Managed floating Pure floating

16.  Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Managed Independent FIXED FLEXIBLE

17. Dollarization  Use another country’s currency as sole legal tender Currency union  Share same currency with other union members Currency board  Legally commit to exchange domestic currency for specified foreign currency at fixed rate Conventional (fixed) peg  Single currency peg  Currency basket peg

18. Flexible peg  Fixed but readily adjusted Crawling peg  Complete  Compensate for past inflation  Allow for future inflation  Partial  Aimed at reducing inflation, but real appreciation results because of the lagged adjustment Fixed but adjustable

19. Managed floating  Management by sterilized intervention  Management by interest rate policy, i.e., monetary policy Pure floating

20. Governments may try to keep the national currency overvalued To keep foreign exchange cheap To have power to ration scarce foreign exchange To make GNP look larger than it is Other examples of price ceilings Negative real interest rates Rent controls in cities

21. Inflation can result in an overvaluation of the national currency Q = eP/P* Remember: Q = eP/P* Suppose e adjusts to P with a lag Then Q is directly proportional to inflation Numerical example

22. Time Real exchange rate 100 110 105 Average Suppose inflation is 10 percent per year

23. Time 100 120 Real exchange rate 110Average real Hence, increased inflation lifts the real exchange rate as long as the nominal exchange rate adjusts with a lag Suppose inflation rises to 20 percent per year

24. floating Under floating Depreciation is automatic: e moves But depreciation may take time fixed exchange rate regime Under a fixed exchange rate regime Devaluation will lower e and thereby also Q – provided inflation is kept under control Does devaluation improve the current account? The Marshall-Lerner condition

25. e B = eX – Z = eX(e) – Z(e) eB elowerseXX Not clear that a lower e helps B because decrease in e lowers eX if X stays put Let’s do the arithmetic Bottom line is: Devaluation strengthens current account as long as Suppose prices are fixed, so that e = Q a = elasticity of exports b = elasticity of imports a = elasticity of exports b = elasticity of imports Valuation effect arises from the ability to affect foreign prices

26. 11 -ab -+ Export elasticity ImportelasticityImportelasticity

27. if X Assume X = Z/e initially Appreciation weakens current account

28. Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation strengthens the current account

29. Elasticity ofElasticity of exportsimports Argentina0.60.9 Brazil0.41.7 India0.52.2 Kenya1.00.8 Korea2.50.8 Morocco0.71.0 Pakistan1.80.8 Philippines0.92.7 Turkey1.42.7 Average1.11.5

30. price takers Small countries are price takers abroad Devaluation has no effect on the foreign currency price of exports and imports not So, the valuation effect does not arise Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged Hence, if a > 0 or b > 0, devaluation strengthens the current account

31.  In view of the success of the EU and the euro, economic and monetary unions appeal to many other countries with increasing force  Consider four categories  Existing monetary unions  De facto monetary unions  Planned monetary unions  Previous – failed! – monetary unions

32.  CFA franc  14 African countries  CFP franc  3 Pacific island states  East Caribbean dollar  8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note  Euro, more recent  16 EU countries plus 6 or 7 others Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

33.  Australian dollar  Australia plus 3 Pacific island states  Indian rupee  India plus Bhutan (plus Nepal)  New Zealand dollar  New Zealand plus 4 Pacific island states  South African rand  South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe  Swiss franc  Switzerland plus Liechtenstein  US dollar  US plus Ecuador, El Salvador, Panama, and 6 others

34.  East African shilling (2009)  Burundi, Kenya, Rwanda, Tanzania, and Uganda  Eco (2009)  Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia)  Khaleeji (2010)  Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates  Other, more distant plans  Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa, Africa

35.  Danish krone 1886-1939  Denmark and Iceland 1886-1939: 1 IKR = 1 DKR  2009: 2,500 IKR = 1 DKR (due to inflation in Iceland)  Scandinavian monetary union 1873-1914  Denmark, Norway, and Sweden  East African shilling 1921-69  Kenya, Tanzania, Uganda, and 3 others  Mauritius rupee  Mauritius and Seychelles 1870-1914  Southern African rand  South Africa and Botswana 1966-76  Many others No significant divergence of prices or currency rates following separation

36.  Centripetaljoin  Centripetal tendency to join monetary unions, thus reducing number of currencies stable exchange rates  To benefit from stable exchange rates at the expense of monetary independence  Centrifugalleave  Centrifugal tendency to leave monetary unions, thus increasing number of currencies monetary independence  To benefit from monetary independence often, but not always, at the expense of exchange rate stability  With globalization, centripetal tendencies appear stronger than centrifugal ones

37. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Free to choose only two of three options; must sacrifice one

38. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Capital controls (China) Free to choose only two of three options; must sacrifice one

39. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Flexibleexchange rate (US, UK, Japan) Flexibleexchange Free to choose only two of three options; must sacrifice one

40. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Flexibleexchange rate (US, UK, Japan) Flexibleexchange Capital controls (China) Free to choose only two of three options; must sacrifice one

41. free trade four freedoms  If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … monetary independence flexible exchange rates) vs. fixed rates  … then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates  Cannot have both!  Either type of regime has advantages as well as disadvantages  Let’s quickly review main benefits and costs

42. BenefitsCosts Fixed exchange rates Floating exchange rates

43. BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

44. BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates

45. BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium

46. BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation

47.  In view of benefits and costs, no single exchange rate regime is right for all countries at all times  The regime of choice depends on time and circumstance inefficiency  If inefficiency and slow growth due to currency overvaluation are the main problem, floating rates can help inflation  If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation  Ones both problems are under control, time may be ripe for monetary union What do countries do?

48. No national currency 17% Other types of fixed rates 23 Dollarization 5 Currency board 4 Crawling pegs 3 Bilateral fixed rates 3 Managed floating 26 Pure floating 19 100 51% 49% tendency towards floating increased interest in fixed rates Gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today, followed by increased interest in fixed rates through economic and monetary unions The End