E. Exchange Rate Systems
- Should exchange rate be fixed or flexible?
1. Choosing an exchange-rate system
a. Exchange rate practices
(1) Floating exchange-rate system
(a) Float independently
(b) Float in unison with a group of other currencies
(c) Crawl according to a predetermined formula
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(2) Pegged exchange-rate system
(a) Anchor to a single currency
(b) Anchor to a basket of currencies
(c) Anchor to gold (not used since 1971)
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(3) International Monetary Fund (IMF)
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Exchange rates should not be manipulated to prevent
balance-of-payments adjustments or gain unfair competitive advantage over
other members
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Members should act to counter short-term disorderly
conditions in exchange markets
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When members intervene, they must take into account the
interests of other members
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(4) Exchange rate arrangements of IMF members
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No separate legal tender - 13
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Currency board arrangements - 12
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Conventional pegged (fixed) exchange rates - 59
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Pegged exchange rates within horizontal bands - 1
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Crawling pegged (band) exchange rates - 16
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Managed floating exchange rates - 44
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Independently floating exchange rates - 43
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b. Factors affecting choice of an
exchange-rate system
(1) Size and openness of economy
- Trade a large share of economy => cost of
currency fluctuation high => fixed exchange rate
(2) Inflation rate
- Goods would be more expensive and less
competitive with a fixed rate => flexible exchange rate
(3) Labor market flexibility
- Rigid wages => labor market can't help
economy adjust to shocks => flexible exchange rate
(4) Degree of financial development
- Immature financial markets => could have
big swings in currency => fixed exchange rate
(5) Credibility of policymakers
- Weak reputation for central bank => lack
of confidence in ability to control inflation => fixed exchange
rate
(6) Capital mobility
- Economy open to international capital
flows => flexible exchange rate
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c. Impossible trinity
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2. Fixed exchange-rate systems
a. Mechanics
- Key currency - currency to which a
country's currency is anchored
- Widely traded on world markets, relatively
stable values over time, widely accepted as a means of international
settlement
- U.S. dollar (62%), Euro (24%), Japanese
yen (4%), British pound (4%), Canadian dollar (2%), Australian
dollar (1%), other (3%)
- Helps facilitate international settlement of
transactions
- Domestic-currency price of imports and
exports stabilized
- Can reduce inflation in high-inflation
countries by reducing inflationary expectations
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- Could anchor to a basket of currencies
- Special drawing rights (SDRs) - bundle of
U.S. dollar, Japanese yen, British pound, Euro, Chinese renminbi established by
the IMF
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- Par value - value of a currency in
terms of gold or a key currency
- Official exchange rate (cross rate) determined by
comparing par values
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- Exchange-stabilization fund - fund of
foreign currencies used to defend the official rate
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b. Exchange-rate stabilization
(1) Depreciation
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(2) Appreciation
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c. Devaluation and revaluation
- Fundamental disequilibrium may develop where
official exchange rate is far out of line with market exchange rate
- Due to changes in fundamental economic conditions
- income levels, tastes and preferences, technological factors
- Cost of defending existing official rate may be
prohibitive
- Devaluation - decrease the official
value of a currency, counteracts a balance-of-payments deficit
- Revaluation - increase the official
value of a currency, counteracts a balance-of-payments surplus
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3. Floating exchange rates
- Let market determine exchange rate
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a. Pros
- Continuous adjustment of balance of payments
- Partially insulate home economy from external
forces
- Can have independent monetary and fiscal
policies
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b. Cons
- Wide fluctuations in currency values can
disrupt trade and investment
- Could lead to lack of financial discipline by
governments
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4. Other exchange rate systems
a. Managed floating rates
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Allow market forces to determine exchange rate, but
intervene to deal with erratic fluctuations
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Clean float - no intervention
at all
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Dirty float - interference in
the market
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Leaning against the wind -
intervene to reduce short-term fluctuations
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Some countries intervene to achieve a target exchange rate
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- Expansionary monetary policy => increase money supply,
decrease interest rates, offset currency appreciation
- Contractionary monetary policy => decrease money supply,
increase interest rates, offset currency depreciation
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b. Crawling peg
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Small, frequent changes in par value of currency -
virtually continuous
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Used when inflation is high
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Flexibility of floating rates with stability of fixed
rates
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5. Currency manipulation and currency wars
- Expansionary monetary policy => low interest rates, weak
currency
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6. Currency crises
Ex. - Mexico (1994 - 1995), East Asia (1997 - 1998), Russia
(1998), Turkey (2001)
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a. End of crisis
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Devaluation (currency crash)
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Floating exchange rate adopted
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Restrictions on ability to buy and sell foreign currency
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Loans to bolster foreign reserves
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Restore confidence in existing exchange rate
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b. Sources of currency crises
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Currency speculators
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Budget deficits financed by inflation
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Weak financial systems
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Recently deregulated financial systems
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Weak economy
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Political factors
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External factors
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Choice of an exchange rate system (fixed exchange rates)
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7. Capital controls (exchange controls)
- On foreign savers investing in domestic assets
- On domestic savers investing in foreign assets
- Controls on international transactions
- Government allocate foreign exchange
- Government sets prices
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a. Benefits
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Government can influence its payments position
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Government can encourage or discourage certain
transactions
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More freedom for fiscal and monetary policies
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b. Problems
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8. Increasing the credibility of fixed exchange rates
a. Currency board
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Monetary authority that issues notes and coins convertible
into a foreign anchor currency at a fixed exchange rate
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Takes over role of a central bank in strengthening the
currency of a developing country
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Has no discretionary powers
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Can't print currency to finance budget deficits
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Monetary policy on autopilot
- Anchor currency flows in => issue more domestic currency =>
interest rates fall
- Anchor currency flows out => withdraw domestic currency =>
interest rates rise
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(1) Benefits
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Currency and exchange rate regimes more rule-bound and
predictable
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Upper bound placed on nation's money supply
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Tendency towards inflation curtailed
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Financial discipline needed on budget
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Confidence in soundness of a country's money - currency
can always be exchanged for stronger currency
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Creating confidence => trade, investment, growth
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(2) Problems
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No discretionary monetary policy - reduces economic
independence
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Susceptible to financial panics - no lender of last resort
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Creates colonial relationship with anchor currency
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b. Dollarization
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(1) Benefits
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Credibility and policy discipline
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Avoid capital outflows
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Decrease in transactions costs
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Lower rate of inflation (same as U.S.)
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Greater openness
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Balance-of-payments crises are minimized
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(2) Effects on foreign country
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No monetary policy - affected by Federal Reserve action
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Fed not the lender of last resort for this country
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Loss of seigniorage (income from securities) if securities
have to be sold to get U.S. dollars
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Expenditures and trade policies not affected
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Cannot print more domestic currency to finance budget
deficits
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(3) Effects on U.S.
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One time increase in goods and services as dollars are
accumulated
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Interest free loan if country holds dollars instead of
Treasury securities
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Might hinder Federal Reserve monetary policy
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Pressure to conduct policy according to interests of
foreign country
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