Economics of International Finance
Econ. 315
Chapter 7
Flexible Versus Fixed Exchange
Rates, The European Monetary
System, and Macroeconomic
Policy Coordination
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Introduction:
Advocates of flexible exchange rate system argue that:
1. It is more efficient than fixed exchange rate system to correct for
BOP disequilibria.
2. By allowing to achieve external balance, it facilitates the
achievement of internal balance and other economic objectives of
the nation.


Advocates of the fixed exchange rate system argue that flexible
exchange rates:
1. Increases uncertainty and Reduces international trade and
investment
2. More likely to lead to destabilizing speculation
3. Inflationary
Careful examination of the theoretical arguments raised by each side
does not lead to any clear-cut conclusion that one system is superior to
another and most of this is based on painful weaknesses systems
adopted.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

In this chapter we examine the case of fixed and flexible
exchange rates, the debate on an optimum currency area,
currency board arrangements, and dollarization.
The case for flexible Exchange Rates:

We saw that under flexible exchange rates, a deficit or
surplus is automatically corrected by a depreciation or
appreciation, without any government intervention and loss
or accumulation of international reserves. Fixing exchange
rates may result in excess demand or supply of foreign
exchange (due to overvaluation or undervaluation of the
currency) that can be corrected by a change in economic
variables other than the exchange rate, which may lead to
policy mistakes and use of policies which do not achieve
purely internal economic objectives.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
A. Market Efficiency:

It is more efficient or less costly to change the exchange rate because:
1.
A flexible exchange rate corrects BOP equilibria smoothly and
continuously as they occur.
2.
A flexible exchange rate stabilizes speculation which dampen
fluctuations in exchange rates. Fixed exchange rates is likely to give
rise to destabilizing speculations and forces the country to make a
large discrete change in exchange rate.
3.
Flexible exchange rates clearly identify the degree of comparative
advantage and disadvantage of the nation in various commodities,
while fixed exchange rates distorts the pattern of trade and prevent the
most efficient allocation of resources throughout the world, e.g., leads
the country to export a commodity in which it does not have a
comparative disadvantage (because it is cheaper due to undervalued
domestic currency).
B. Policy Advantages
1.
The nation does not have to concern itself with its external balance and
can use all policies to achieve its domestic goals. The possibility of policy
mistakes and delays would also be minimized under flexible exchange rate
system.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
2.
Flexible exchange rate policy enhances the effectiveness of monetary
policy, e.g., an anti-inflationary policy that improves BOP will result in an
appreciation, which further reduces domestic inflationary pressures as by
encouraging imports and discouraging exports.
3.
Different nations can pursue domestic policies aimed at reaching their own
inflation-unemployment trade-off. Under fixed exchange rates, different
inflation rates in different nations results in BOP pressures (deficit in
more inflationary nations and surplus in less inflationary nations) that
restrain each nation from achieving its optimum inflation-unemployment
trade-off.
4.
Flexible exchange rates prevent the government from setting exchange
rates at a level other than equilibrium or to benefit one sector at the
expense of another, e.g., LDCs usually keep exchange rate undervalued
(overvaluation of their domestic currency) to encourage imports of capital
goods, but this discourage their agricultural exports.
5.
Flexible exchange rates does not impose the cost of government
intervention in the foreign exchange market to maintain exchange rates
fixed.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
The Case for Fixed Exchange Rates
A.
Less Uncertainty

Fixed exchange rates avoids the wild day-to-day fluctuations
that occur under flexible exchange rate, and that discourages
specialization and the flow of international trade and
investment.
Look at figure 1, shifts from D€ to D’€ or to D*€ cause the
exchange rate to fluctuate from R’ to R*. If the supply curve
is Less elastic (S’€), exchange rate fluctuates from R” to R**.
Figure 2 also shows that exchange rates fluctuates widely on
a daily basis.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
FIGURE 1 Shifts in the Nation’s Demand Curve for Foreign Exchange and Uncertainty.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

Excessive short run fluctuations in exchange rates under a
flexible exchange rate system may be costly in terms of higher
frictional unemployment if they lead to over-frequent
attempts at allocating domestic resources among the various
sectors of the economy. We noted also that short run
tendency of exchange rates overshoots its long term level.

Although fixed exchange rate may impose uncertainty and
instability surrounding the periodical large discrete changes
in par values, truly fixed exchange rate systems such as the
gold standard keep exchange rates fixed and uncertainty
would be absent.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
B. Stabilizing Speculation

Under flexible exchange rates, with destabilizing speculations,
speculators purchase a foreign currency when the exchange rate is
rising, in the expectation that the exchange rate will rise even
more, and sell when the rate is falling in the expectation that the
rate will fall even more. Fluctuations in exchange rates resulting
from business cycles will be amplified. The opposite is under
stabilizing fluctuations.
Look at figure 3 which shows the larger fluctuations under
destabilizing expectations, which is more likely to occur under
flexible exchange rates system.
But Advocates of flexible exchange rate system argue that
destabilizing speculations can also occur under fixed exchange rate
system (Bretton woods system).
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
FIGURE 3 Fluctuations in Exchange Rate in the Absence of Speculation and with Stabilizing and Destabilizing
Speculation.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
C. Price Discipline:

Fixed exchange rates impose a price discipline on the nation not present
under flexible exchange rates. A nation with a higher inflation rate is
likely to face persistent deficit in its BOP and a loss of reserves under a
fixed exchange rate system. Since deficits and reserve loss can’t continue
forever, the nation needs to restrain its excessive rate of inflation and thus
facing some price discipline. Flexible exchange rates can be more
inflationary than fixed exchange rates.
Advocates of flexible exchange rates argue that flexible exchange rates
can insulate the economy from external shocks much more better than
under fixed exchange rates. But fixed exchange rates provide more
stability to an open economy subject to large internal shocks.

In general, fixed exchange rate system is preferable for a small open
economy that trades mostly with one or a few larger nations and in which
disturbances are primarily of a monetary nature.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Optimum Currency Areas (OCA)

Developed by Mundell and Mckinnon during 1960s. An OCA or block
refers to a group of nations whose national currencies are linked through
permanently fixed exchange rates and the conditions that make such an
area optimum.
Advantages:

The formation of an OCA eliminates the uncertainty that arises when
exchange rates are not permanently fixed, thus stimulating specialization
in production and the flow of trade and investment among member
regions or nations.

The formation of an OCA also encourages producers to view the entire
area as a single market and to benefit from greater economies of scale in
production.

With permanently fixed exchange rats, OCA is likely to experience
greater price stability than if exchange rates could change between the
various member nations. This encourages the use of money as a store of
value and as medium of exchange and discourages barter deals arising
under more inflationary circumstances.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

An OCA also saves the cost of official intervention into the foreign
exchange market involving the currencies of the member countries, the
cost of hedging, the cost of exchanging one currency for another to pay for
goods and services.
Disadvantages:

Each nation can not pursue their own independent stabilization and
growth policy, e.g., a depressed nation with high unemployment may
need to expansionary fiscal and monetary policies, while a more
prosperous nation may need contractionary policies. But intra-flows of
trade and labor from excess supply to excess demand areas reduce the
costs of an OCA.
Conditions for an OCA:
An OCA is likely to be beneficial under the following conditions:
1.
The greater is the mobility of resources among various member
nations
2.
The greater are their structural similarities
3.
The more willing they are to closely coordinate their fiscal, monetary
and other policies.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Optimum currency area
The case of GCC Countries
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Common (single) Currency. The GCC project



GCC countries decided in 2000 that they will unify their currencies by the
year 2010
As a preliminary step towards a unified currency they adopted a common
peg to the US dollar policy. By 2003 all GCC pegged to the US$
In 2005 the criteria of convergence (to join the common currency) was
agreed upon
Why the GCC want to establish a common currency?
Advantages of the common currency
1. Common currency: trade and investment

the reduction in transaction costs: currency conversion costs, exchange
rate prediction costs and in-house costs of maintaining separate foreign
currency expertise

removing volatility in exchange rates

removing the pressures on hedging exchange rate risk

companies will charge a single price rather than price discrimination

lower pressures on price arbitrage
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
2. Common currency and growth
 restructuring industrial facilities to be placed in the
most efficient location instead of having facilities in
different location.
 Improved allocation of market capital.
 Intensify cross-border competitive pressures.
3. Common currency and capital markets
 break down barriers between national capital
markets.
 companies will be able to raise capital in different
capital markets.
 pressure on firm managements to perform better
will increase.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Convergence criteria
In 2005 GCC agreed upon the convergence criteria for
member states to join the common currency. These are:
1.
2.
3.
4.
5.
Short-term interest rates for each member will be no higher
than 2 percentage points over the average of the three lowest
countries.
Inflation will be no higher than 2 percentage points above the
maximum weighted average for the six countries.
The fiscal deficit will be no higher than 3 percent of GDP;
and no more than 5 percent of GDP when oil prices are weak
Government debt will not exceed 60 percent of GDP.
Foreign exchange reserves/import coverage will be at least 4
months.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
The 2010 Deadline: Can the GCC meet the 2010 deadline?
-
Oman’s decision
Kuwait abandons the common peg
The common market stage 2007
The common currency could be a threat to cooperation and
integration among GCC countries.
More urgent issues:
1.
2.
3.
4.
5.
6.
Diversification and broader production base
Enhance intra trade
Fight Inflation. Inflation is a very critical issue for countries
like Kuwait
Better coordination of policies and more political
responsibility towards the council
Enhancing the institutional structure of the GCC
Enhance and upgrade the statistical data base
"GULFSTAT"
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Currency Boards Arrangements (CBAs):


Are the most extreme form of exchange rate peg (fixed
exchange rate system). Under CBA’s the nation rigidly fixes
(often by law), its currency to a foreign currency. The central
bank gives up:
1. control over money supply.
2. Its function of conducting an independent monetary
policy. Money supply increases only in response to BOP
surplus (increase in MS) and deficit (decrease in MS).
3. Control over Inflation and interest rate, as these are
determined by the country against whose currency is
pegged or fixed (e.g., inflation of US).
Countries usually adopt this system in times of a deeper
crisis in order to control inflation.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

Conditions of successful CBA.
1.
2.

Sound banking system: the central bank can’t be a lender
of the last resort (No control over MS)
Prudent fiscal policy: the central bank can’t lend the
government (by increasing the M. base).
Main disadvantage: the country can’t conduct its own
monetary policy.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

Dollarization.

Adopting another nation’s currency (US $ or another
currency) as its own legal tender (currency).

Benefits of Dollarization.
1.
2.
3.
Avoiding the cost of exchanging the domestic currency for
dollars and the need to hedge foreign exchange risks
Facing a rate of inflation similar to that of the US (or that
of the currency used instead of the domestic currency),
(also similar interest rates and commodity arbitrage).
Avoiding foreign exchange crises, the need for foreign
exchange and trade controls, fostering budgetary
discipline and encouraging more rapid and full
international financial integration.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Costs of Dollarization
1.
2.
3.

Cost of replacing the domestic currency to the dollar
(about 4-5% of GDP, paid once).
The loss of independent monetary and exchange rate
policies.
Loss of the CB as a lender of the last resort when financial
institutions face a crisis.
Good candidates for dollarization are small open economies
for which the US (or Europe) is the dominant economic
partner and which have a history of poor monetary
performance.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

List of Officially Dollarized Economies.






U.S. dollar.
British Virgin Islands
East Timor
Ecuador (uses its own coins)
El Salvador
Marshall Islands
Micronesia
Palau
Panama (uses its own coins)
Pitcairn Islands (also uses the New Zealand dollar)
Turks and Caicos Islands
Euro.
1. Kosovo
2. Monaco (formerly French franc; issues own coins)
3. Andorra (formerly French franc and Spanish peseta)
4. San Marino (formerly Italian lira; issues own coins)
5. Vatican City (formerly Italian lira; issues its own coins)
6. Montenegro
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
New Zealand dollar.
1.
2.
3.
Niue
Tokelau
Pitcairn Island (also uses U.S. dollar)
Others.
1.
2.
3.
Cyprus, Northern (Turkish lira)
Liechtenstein (Swiss franc)
Tuvalu (Australian dollar, prints its own notes)
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University



Exchange Rate Bands.
Allowing fixed exchange rate to fluctuate within narrowly defined limits,
i.e.,:
1.
The nation decide the par value of its currency.
2.
Allow a band of fluctuations above and below the par value.
3.
Actual exchange rate “within bands” is then determined by market
forces, but it is prevented from moving outside the band by official
intervention in foreign exchange markets.
The advantage of the small band of fluctuation is that
monetary authorities will not have to intervene constantly to
maintain the par value, but to prevent the rate from moving
outside the allowed limit of fluctuations.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

The nation could increase the width of the band to eliminate
official intervention in the foreign exchange market. This
would represent a flexible exchange rate system.

A preference of fixed exchange rate would allow only a very
narrow band, while a preference for flexible exchange rates
would make the band very wide.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Upper limit
Lower limit
FIGURE 4 Exchange Rate Band
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Kuwaiti Dinar fixed band
5/1/2003:

Par rate was 299.63 fils per dollar

Band is ±3.5%, i.e.,


310.11 fils/$ maximum rate
289.14 fils/$ minimum rate
11/5/2006:

289.14 fils/dollar (minimum limit was exhausted due to the
weak dollar).
20/5/2007:

De-linking the KD to the $ and the return to currency basket
peg, the rate revalued on that day to 288.06 fils/dollar
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Kuwaiti Dinar peg
KWD/$
.31011
Upper band
+ 3.5%
C.Rate.29963
- 3.5%
.28914
Lower band
Time
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Adjustable Peg Systems

Adjustable peg system requires defining the par vale and the
allowed band of fluctuation, with the stipulation that the par value
will be changed periodically and the currency devalued to correct a
BOP deficit or revalued to correct a surplus.

A truly adjustable peg system would be the one under which the
nations with BOP disequilibria would take the advantage of the
flexibility provided by the system to change the par value without
waiting for the exchange market pressure which would be
unbearable if faced with a deficit or a surplus (see figure 5).

To work as intended, an objective rule would have to be agreed
upon and enforced to determine the timing of the par value
adjustment, e.g., when the international reserves falls by a certain
percentage. A potential problem would be that speculators may
know the rule and engage in destabilizing speculations to make
profits.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
FIGURE 5 Adjustable Pegs
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Crawling Pegs

Crawling pegs “sliding practices”, is advised to avoid
relatively large changes in par values and possible
destabilizing speculations. The par values are changed by
small pre-announced amounts at specified intervals until
equilibrium exchange rate is reached.

Look at figure 6. instead of a single devaluation of 6%, there
are 3 mini devaluations of 2% each. Note that if the upper
band before the mini devaluation coincide with (or perhaps
can be greater than) the lower band of the next mini
devaluation, there will be no change in the actual spot rate.

The country can neutralize scheduled speculation profits by
equal rises in short term interest rates (net speculation profit
= zero).
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Three mini devaluations
Instead of a 6%
Single devaluation
FIGURE 6 Crawling Pegs.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

Advantages
1. Eliminates the political risks attached to a large
devaluation
2. Prevents destabilizing speculations.
3. If combined with wider bands, it can create greater
flexibility

Crawling peg seems best suited for a developing country that
faces real shocks and differential inflation rates

Managed Floating

Under managed floating, the monetary authorities are
responsible for intervention in the foreign exchange market
to smooth out short term fluctuations without affecting long
term trend in exchange rates.

If successful, the country enjoys most of the benefits of fixed
exchange rates while at the same time retaining flexibility in
adjusting BOP disequilibria.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University

Leaning against the wind: authorities supply a portion of
international reserves in case of short run excess demand
(BOP deficit) to moderate depreciation, and absorb a portion
of short run excess supply (BOP surplus) to moderate
appreciation. This moderates short term fluctuations without
affecting the long run trend in exchange rates.

Stabilization of foreign exchange rate will depend on the size
of the nation’s international reserves, the greater the size, the
greater is the exchange rate stabilization it can achieve.

Rules of leaning against the wind must be clear, otherwise,
there is a danger that the nation may practice dirty floating,
the nation keeps exchange rates high to stimulate exports
(beggar-thy-neighbor), which invites retaliation by other
nations.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Key Terms:
•Optimum currency area or block.
•Adjustable peg system.
•peg system.
•Managed floating exchange rate system.
•Currency board arrangements (CBA).
•Dollarization.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University
FIGURE 2 Exchange Rates of the G-7 Countries and Effective Exchange Rate of the Dollar, 1971–2002.
Economics of International Finance
Prof. M. El-Saqqa
CBA. Kuwait University