Lecture 21:
Exchange Rate Regimes
ITF220 Prof.J.Frankel
What exchange rate regimes do countries choose?
1. Classification of exchange rate regimes
What regimes should countries choose?
2. Advantages of fixed rates
3. Advantages of floating rates
4. How should the choice be made?
1.
2.
3.
4.
5.
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. De facto classification of countries’ regimes
II. The corners hypothesis
ITF220 Prof.J.Frankel
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
ITF220 Prof.J.Frankel
Trends in distribution of EM exchange rate regimes
•
•
•
•
1973-1985 – Many abandoned fixed exchange rates
1986-94 – Exchange rate-based stabilization programs
1990s -- Corners Hypothesis: countries move to either hard peg or free float
Since 2001 -- The rise of the “managed float” category.
Distribution of
Exchange Rate
Regimes in Emerging
Markets, 1980-2011
}
(percent of total)
Ghosh, Ostry & Qureshi, 2014,
“Exchange Rate Management and Crisis
Susceptibility: A Reassessment,” IMF.
2. Advantages of fixed rates
1) 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 (1995-98); Engel-Rogers (1996).
- Currency unions:
Rose (2000).
ITF220 Prof.J.Frankel
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.
ITF220 Prof.J.Frankel
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.
ITF220 Prof.J.Frankel
4. Which dominate: advantages of fixing or
advantages of floating?
Performance by category is inconclusive.
• To over-simplify 3 important studies (see Addendum I):
– Ghosh, Gulde & Wolf: “hard pegs work best”
– Sturzenegger & Levy-Yeyati: “floats are best”
– Reinhart-Rogoff: “limited flexibility performs best.”
• Why the different answers?
– The de facto schemes do not correspond to each other.
– A country’s circumstances determine the appropriate regime.
ITF220 Prof.J.Frankel
Which dominate: advantages of
fixing or advantages of floating?
Answer depends on circumstances:
No one exchange rate regime is right
for all countries or all times.
• Traditional criteria for choosing - Optimum Currency Area.
Focus is on trade and stabilization of business cycle.
• 1990s criteria for choosing –
Focus is on financial markets and stabilization of speculation.
ITF220 Prof.J.Frankel
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 pegging its currency to a neighbor,
nor so large that it would be better off splitting
into sub-regions with different currencies.
ITF220 Prof.J.Frankel
Professor Jeffrey Frankel
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.
ITF220 Prof.J.Frankel
Professor Jeffrey Frankel
New popularity in 1990s of
institutionally-fixed corner
• currency boards
(e.g., Hong Kong, 1983- ; Lithuania, 1994- ;
Argentina, 1991-2001; Bulgaria, 1997- ;
Estonia 1992- ; Bosnia, 1998- ; …)
• dollarization
(e.g., Panama, El Salvador, Ecuador;
or euro-ization: Montenegro)
• monetary union
(e.g., the eurozone, 1999-).
ITF220 Prof.J.Frankel
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.
ITF220 Prof.J.Frankel
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.
ITF220 Prof.J.Frankel
Two additional considerations,
particularly relevant to developing countries
• (i) Level of financial development
• (ii) Prevalence of real shocks
ITF220 Prof.J.Frankel
Professor Jeffrey Frankel
(i) Level of financial development
Aghion, Bacchetta, Ranciere & Rogoff (2005)
– 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.
ITF220 Prof.J.Frankel
(ii) Real Shocks
• An old 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
ITF220 Prof.J.Frankel
Professor Jeffrey Frankel
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
(oil producers, Africa, Latin America, etc.);
• => Unfavorable terms of trade shock for others
(oil importers like Japan, Korea, India, Turkey).
• Commodity prices fell in 2014-15.
• Textbook theory says a country where trade shocks
dominate should accommodate by floating.
ITF220 Prof.J.Frankel
Appendix I:
Fashions in international currency policy
• 1980-82: Monetarism (=> target the money supply)
• 1984-1997: Fixed exchange rates
(incl. currency boards)
• 1993-2001: The corners hypothesis
(either firm fix of float)
• 1998-2007: 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.
ITF220 Prof.J.Frankel
Appendix II:
The corners hypothesis
• The claim:
“Countries can either rigidly peg or freely float,
but should abandon intermediate regimes like target zones.”
• Origins:
• 1992-93 ERM crises --
Eichengreen
(1994)
• Late-1990’s crises in emerging markets
ITF220 Prof.J.Frankel
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)
ITF220 Prof.J.Frankel
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.
ITF220 Prof.J.Frankel
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).
ITF220 Prof.J.Frankel
Adjusted de jure classification schemes
1. Ghosh, Gulde, Ostry & Wolf (1995)
identify “peggers” who in fact devalue often.
2. Reinhart & Rogoff (2003, 04)
add category of “free falling”.
De facto classification schemes
1. Shambaugh (2004): variability of exchange rate.
2. Levy-Yeyati & Sturzenegger (2005):
cluster analysis based on variability of Δ exchange
rates vs. variability of Δ reserves
ITF220 Prof.J.Frankel
The de facto schemes do not agree
•
That de facto schemes to classify exchange
rate regimes differ from the IMF’s previous
de jure classification is by now well-known.
•
It is less well-known that the de facto
schemes also do not
agree with each other !
ITF220 Prof.J.Frankel
Correlations Among Regime Classification
Schemes
IMF
IMF
GGW
LY-S
R-R
GGW
LY-S
R-R
1.00
(100.0)
0.60
1.00
(55.1)
(100.0)
0.28
0.13
1.00
(41.0)
(35.3)
(100.0)
0.33
(55.1)
0.34
0.41
1.00
(35.2)
(45.3)
(100.0)
(Frequency of outright coincidence, in %, given in parenthesis.)
Sample: 47 countries.
From Frankel, “Experience of and Lessons from Exchange Rate Regimes in
Emerging Economies,” ADB, 2004. Table 3, prepared by Marina Halac & Sergio Schmukler.
ITF220 Prof.J.Frankel
Three studies
of how well
exchange rate
regimes perform
give different
answers.
ITF220 Prof.J.Frankel