EXCHANGE RATE REGIMES
Overview and policy issues
Outline




Types of ER regimes
Advantages and disadvantages of fixing/floating
Choice of ER regime
Empirical Evidence on Exchange Regimes
Classifying ER regimes
HARD PEGS
INTERMEDIATE
FLOATING
• Currency union
• Basket peg
• Managed float
• Dollarization
• Crawling peg
• Free float
• Currency board
• Band
Hard pegs

Dollarization



Currency union



Use another country’s currency as sole legal tender
E.g. Ecuador, El Salvador, Panama
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)
Intermediate regimes

Conventional (soft) peg



Band



Pegged exchange rate within horizontal bands (>±1%)
E.g. Denmark (2.25%), Tonga (5%), Hungary (15%)
Crawling peg



Single currency peg (e.g. Malaysia, Nepal, Namibia)
Currency basket peg (e.g. Malta, Fiji, Latvia)
Backward or forward looking
E.g. Bolivia
Crawling band


Symmetric or asymmetric
E.g. Belarus (5%), Israel (22%)
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
ER arrangements of IMF
members
(as of July 2005)
No separate legal tender
Currency board
41
7

Peg (including de facto pegs)
Horizontal band
Crawling peg
40
5
5

Crawling band






Managed floating
Independently floating
1
54
34
...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.
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
The Impossibility Trinity

1.
2.
3.
A country must give up one of three goals:
Exchange rate stability (by Hard Peg)
Monetary Independence
Financial Market Integration (absence of
capital control)
Advantages of fixed ER
1.
2.
Provide a nominal anchor for monetary policy
Reduce transactions costs and exchange rate
risk  int’l trade & investment
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)
No Monetary Policy Autonomy Under
Fixed ER with Perfect Capital Mobility
Interest
rate, i
LM

Monetary policy cannot
stimulate output (on the
other hand, fiscal policy is
very effective in stimulating
output)
i0
i1
0
•
BP
1
•
IS
Y0 Y1
Output, Y
Perfect capital mobility
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
Interest
rate, i
LM
i0
i1
0
2
•
•
BP
1
•
IS
Y2 Y1 Y0
Output, Y
Perfect capital mobility
The Debacle of Argentina’s Peg
60.0
160,000
50.0
140,000
40.0
120,000
30.0
100,000
20.0
80,000
10.0
60,000
-
40,000
(10.0)
20,000
(20.0)
1993Q1
1994Q1
1995Q1
1996Q1
Growth
1997Q1
1998Q1
Interest rates
1999Q1
Debt
2000Q1
2001Q1
Advantages of flexible ER
1.
2.
Monetary Policy independence (discretionary
policy)
Automatic adjustment to trade shocks
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
LM
i0
i1
2
0
•
1
•
BP
•
IS
Y0 Y1 Y2 Output, Y
Perfect capital mobility
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
Interest
rate, i
LM
i0
i1
0
•
1
BP
•
IS
Y1 Y0
Output, Y
Perfect capital mobility
Disadvantages of flexible ER


Exchange rate uncertainty
Need to find a less obvious anchor
=> Consequences for inflation

Danger of speculative (irrational?) bubbles
Irrational Bubble?
Brazil: Daily Exchange Rate in 2001
2.9
2.7
2.5
2.3
2.1
1.9
1.7
ec
D
ov
N
O
ct
Se
p
g
Au
l
Ju
n
Ju
ay
M
Ap
r
ar
M
Fe
b
Ja
n
1.5
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
Macroeconomic Stability: Exchange Rate
Arrangements or Policy Discipline?
What have countries done in the
1990s?
62%
(98)
No. of countries as % of total
70
60
50
40
30
20
16%
(25)
34%
(63)
24%
(45)
42%
(77)
23%
(36)
10
0
Hard Peg
Intermediate
1991
Source: Fischer (2001)
1999
Floating
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
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.
Source: Bubula and Otker-Robe (2004)
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
(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
(2) Nature of shocks

Nominal or real?
Domestic or external?
Temporary or permanent?
Symmetric or asymmetric?

With or without capital mobility?



(3) Objective function




Real output stability
BOP, competitiveness
Price stability, inflation
Political objectives e.g. desire for integration
(4) Other considerations





Credibility of monetary policy
Need of inflation tax
Adequacy of reserves
Strength and regulation of financial system
Rule of law
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
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
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
Evidence on
Exchange Rate Regimes
ER regimes and inflation
Sample of developing countries
(Annual percentage change, median of group)
Source: WEO (Oct. 1997)
Do hard pegs lower inflation?
Source: Ghosh et al (1997).
Do hard pegs induce greater
fiscal discipline?
Inflation (% per year, log scale)
Argentina
10000
1000
100
10
1
0.1
1971
5 Fiscal deficit (% of GDP)
4
3
2
1
0
-1 1991 1993 1995 1997 1999 2001
Source: IMF, WEO
1981
60
50
40
30
20
10
0
1991
2001
Public debt (% of GDP)
1991 1993 1995 1997 1999 2001
Does ER variability discourage
trade?
Study
Coverage
Results
Coes (1981)
Brazil, 1965-74
Yes
Brada & Mendez (1988)
30 developed & emerging economies,
1973-77
Mixed
Caballero & Corbo (1989)
6 emerging economies
Yes
Paredes (1989)
Chile & Peru
Yes
Medhora (1990)
W. African Monetary Union
No
Savides (1992)
62 developed & emerging economies,
1973-86
Yes (unexpected
variability only)
Grobar (1993)
10 emerging markets, 1963-85
Yes, mostly
Frankel & Wei (1993)
63 countries, 1980, 1985, 1990
Mixed
Arize, Osang & Slottje (2000)
Paiva (2003)
13 emerging economies, 1973-96
Brazil, 1990-2002
Yes
Yes
Do currency unions encourage
trade?
Partial effect of CU on trade, all else constant
Tijt = β1Dij + β2(YiYj)t + ΣkβkZijt + γCUijt + uijt
Most estimates are positive,
Histogram of γ estimates, -2<γ<2
Source: Rose (2004)
... economically large, and
statistically significant
Histogram of γ estimates, 0<γ<1.2
Does floating afford greater
monetary policy autonomy?
“Fear of floating”
Source: Calvo & Reinhart (2002)
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)
ER regimes and growth
Sample of developing countries
(Annual percentage change, median of group)
Source: WEO (Oct. 1997)
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
Which ER regime is best for growth?
Average per capita growth rates
Ghosh, Gulde & Wolfe (2000)
3.1%
Currency board
1.7%
Float
Levy-Yeyati & Sturzenegger (2002)
Fix
Regular peg 0.9%
2.0%
Intermediate
Float
1.2%
1.0%
IMF classification
Reinhart & Rogoff (2002)
Limited flexibility
1.9%
Managed float
Peg
Free float 0.5%
2.2%
Levy-Yeyati & Sturzenegger (2002)
1.9%
Float
Fix
1.5%
1.4%
Intermediate 1.0%
Own classification
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
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