Download Exchange-Rate Systems and Currency Crises

Exchange-Rate Systems
and Currency Crises
Exchange Rates Regimes of the
World, 1870–2000
Feenstra and Taylor: International Economics, First Edition
Copyright © 2008 by Worth Publishers
Exchange-Rate Practices
• Floating or Fixed?
• IMF principles for member nations:
• No manipulation to prevent effective balance-ofpayments adjustments or unfair competitive gains
• Act to counter short-term exchange market disorders
• When members intervene in markets, they should
take into account the interests of other members.
• Exchange-rate practices of IMF members (Table 15.1)
• Choosing an exchange-rate system (Table 15.2)
Choosing an Exchange-Rate
System
• Constraints imposed by free capital flows
• Countries can maintain only two of the
following three policies:
• Free capital flows
• A fixed exchange rate
• An independent monetary policy
• The impossible trinity (Figure 15.1)
Figure 19.6 The Trilemma in Action
Feenstra and Taylor: International Economics,
First Edition
Copyright © 2008 by Worth Publishers
Figure 19.7 Exchange Rate Regimes and Output Volatility
Feenstra and Taylor: International Economics, First Edition
Copyright © 2008 by Worth Publishers
Figure 19.4 A Theory of Fixed Exchange Rates
Feenstra and Taylor: International Economics, First Edition
Copyright © 2008 by Worth Publishers
Fixed Exchange-Rate System
• General practice until the 1970s
• Primarily used by small, developing
nations
• Currencies are anchored to a key currency
• Developing nations can stabilize the domesticcurrency prices of their imports and exports
• Exerts restraint on domestic policies and reduces
inflation
• Major key currencies of the world (Table 15.3)
Fixed Exchange-Rate System
Continued
• Anchor to a single currency
• Developing nations with a single industrial-country
partner
• Anchoring to a group or basket of currencies
• Developing nations with more than one major trading
partner
• Helps to average out fluctuations
• Anchoring to the special drawing right (SDR)
• Basket of four currencies (Table 15.4)
• Increased stability
Fixed Exchange-Rate System
Continued
• Par value and official exchange rate
• Governments assign their currencies a par
value in terms of gold or other key currencies
• Determining official exchange rate
• Exchange-rate stabilization fund
• Set up to defend the official rate
• Purchases and sales of foreign currencies to
iron out short-term fluctuations (Figure 15.2)
• Fundamental disequilibrium
Fixed Exchange-Rate System
Continued
• Devaluation
• Home currency’s exchange value depreciates,
counteracting a payments deficit
• Revaluation
• Home currency’s exchange value appreciates,
counteracting a payments surplus
• Decisions to be made before implementation
• Necessity of the step
• Timing of adjustment
• Magnitude of adjustment
• Advantages and disadvantages of fixed rates (Table 15.5)
Bretton Woods System of Fixed
Exchange Rates
• Adjustable pegged exchange rates (1946-1973)
• Currencies tied to each other
• Disequilibrium: Repegging up to 10 percent allowed
• Par value fixed in terms of gold or the gold content of the
U.S. dollar in 1944
• Band limits
• Operational difficulties
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Conflicting objectives
Magnitude of adjustments
Difficulties in estimating equilibrium rates
Speculation
Floating Exchange Rates
• Currency prices established in the foreignexchange market
• Without restrictions imposed by government
policies
• Equilibrium exchange rate equates the
demand for and supply of the home currency
Floating Exchange Rates
Continued
• Achieving market equilibrium
• Example: Foreign-exchange market in Swiss
francs in the United States (Figure 15.3)
• Market equilibrium will be established at a
point where the quantities of foreign exchange
supplied and demanded are equal
Floating Exchange Rates
Continued
• Trade restrictions, jobs, and floating
exchange rates
• Import restrictions will gradually shift jobs from
other industries to the protected industry
• No significant impact on aggregate employment
• Short-run employment gains in the protected
industry will be offset by long-run employment
losses in other industries
Arguments For and Against
Floating Rates
• Advantages
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Simplicity
Continuous adjustment in the balance of payments
Adverse effects of prolonged disequilibriums are minimized
Partially insulates the home economy from external forces
Freedom to pursue policies that promote domestic balance
• Disadvantages
• Unregulated market leads to wide fluctuations in currency values
• Prohibitively high cost of hedging
• Flexibility to set independent policies leading to inflationary bias
• Summarized in Table 15.5
Managed Floating Rates
• Informal guidelines established by IMF (1973)
• Based on two concerns
• Nations intervening in exchange markets
– Clean float and dirty float
• Disorderly markets with erratic fluctuations
• Under managed floating, a nation:
• Can alter the degree of intervention
• Can intervene to reduce short-term fluctuations: Leaning
against the wind
• Should not act aggressively with respect to their currency
exchange rates
• Can choose target rates and intervene to support them
Managed Floating Rates in the
Short Run and Long Run
• Under a managed float
• Market intervention is used to stabilize
exchange rates in the short run
• In the long run, a managed float allows
market forces to determine exchange rates
• Example: Theory of a managed float in a twocountry framework (Figure 15.4)
Exchange-Rate Stabilization and
Monetary Policy
• Stabilization requires the central bank to adopt:
• An expansionary monetary policy to offset currency
appreciation
• A contractionary monetary policy to offset currency
depreciation
• Example: Exchange-rate stabilization and monetary policy
(Figure 15.5)
• Long-run effectiveness of using monetary policy to
stabilize the exchange value of the currency is limited
Is Exchange-Rate Stabilization
Effective?
• Volatility of foreign-exchange markets
• Intervention by central banks
• Intervention supported by central bank
interest rate changes
• Coordinated intervention
• Proponents of intervention:
• Useful when the exchange rate is under
speculative attack
• May be helpful in coordinating private-sector
expectations
The Crawling Peg
• Small, frequent changes in the par value of currency
• Correct balance-of-payments disequilibriums
• Used primarily by nations having high inflation rates
• Proponents
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Flexibility of floating rates with stability of fixed rates
More responsive to changing competitive conditions
Avoids changes that are frequently wide of the mark
Frustrates speculators with their irregularity
• IMF view
• Hard to apply this system to industrialized nations whose
currencies serve as a source of international liquidity
Currency Crises
• Currency crises or speculative attack
• A weak currency experiences heavy selling
pressure
• Indications of selling pressure include:
• Sizable losses in the foreign reserves held by a
country’s central bank
• Depreciating exchange rates in the forward market
• Widespread flight out of domestic currency into
foreign currency or into goods
• Examples of currency crises (Table 15.6)
Currency Crises
Continued
• Crisis ends when selling pressure stops
• Ways to end pressure
• Devalue the currency
• Adopt a floating exchange rate
• Currency crashes: Crises that end in devaluations or
accelerated depreciations
• Avoiding a currency crash
• Impose restrictions on the ability of people to buy and sell
foreign currency
• Obtain a loan to bolster the foreign reserves
• Restore confidence in the existing exchange rate
Sources of Currency Crises
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Budget deficits financed by inflation
Weak financial systems
Weak economy
Political factors
External factors
Choice of an exchange-rate system
Speculators Attack East Asian
Currencies
• Southeast Asian currency decline led by
the Thai Baht
• Resistance offered to the depreciation
pressure and raising interest rates to make
the Baht attractive
• Abandoning the dollar peg in July 1997
• Long-term effects of abandoning the fixed rate
Capital Controls
• Government-imposed barriers
• To foreign savers investing in domestic assets
• To domestic savers investing in foreign assets
• Also known as exchange controls
Capital Controls: Advantages
• Government can influence its payments
position
• Encourage or discourage certain transactions
by offering different rates for foreign currency
for different purposes
• Can give domestic monetary and fiscal
policies greater freedom in their stabilization
roles
Capital Controls: Disadvantages
• Disadvantages of capital outflows
• Outflows may increase since confidence in
the government is weakened
• Restrictions often result in evasion
• False sense of security for officials
• Controls on capital inflows often receive
more support
Should Foreign-Exchange
Transactions Be Taxed?
• Proponents
• Tax would give traders an incentive to look at longterm economic trends
• Increased cost of transactions
• Dampen excess volatility
• Drawbacks
• Difficult to determine excesses
• Burden on countries that are quite rationally
borrowing overseas
• Difficult to implement
Increasing the Credibility of Fixed
Exchange Rates
• Currency boards
• Issues notes and coins convertible into a foreign
anchor currency at a fixed exchange rate
• Backing of the domestic currency must be at least
100 percent: Monetary policy on autopilot
• Benefits of a currency board system (Figure)
• Concerns
• Prevents a country from pursuing a discretionary monetary
policy
• Susceptible to financial panics - lacks a lender of last resort
• Creates a colonial relationship with the anchor currency
Currency Board - Argentina
• Shift to fixed exchange rate and currency board
following hyperinflation in 1970s and 80s
• Economy hit during the late 1990s
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Appreciation of the dollar
Rising U.S. interest rates
Falling commodity prices on world markets
The depreciation of Brazil’s real
• Borrow to finance deficits
• Defaults ended convertibility of pesos into dollars
Dollarization
• Usage of the U.S. dollar alongside or instead of
the local currency
• Partial dollarization and full dollarization
• Why Dollarize?
• Credibility and policy discipline
• Avoiding capital outflows that often precede or
accompany an embattled currency situation
• Decrease in transaction costs
• Lower inflation
• Greater openness
Dollarization
Continued
• Effects of Dollarization – Ecuador
• Accepting the monetary policy of the Federal Reserve
• Risk that business cycles might not coincide
• Federal Reserve is not their lender of last resort
• Loss of seigniorage
• Freedom to decide how to spend its tax dollars
• Ecuador could establish its own tariffs, subsidies, and trade
policies
• Constraint: No recourse to printing local currency
Dollarization
Continued
• Implications of Dollarization for the U.S.
• For each dollar sent abroad, Americans enjoy a onetime increase in the amount of goods and services
they are able to consume
• Effect of opting to hold dollars rather than debt:
• An interest-free loan from Ecuador
• Use of U.S. currency abroad might hinder the
formulation and execution of monetary policy
• More pressure on the Federal Reserve to conduct
policy according to the interests of Ecuador