Download III. Determinants of Exchange Rate

ECON 511
International Finance & Open
Macroeconomy
CHAPTER FOUR
The Choice of Exchange
Rates
I. Introduction
• At the Bretton Woods Conference in 1944, the leaders
of 44 countries discussed issues related to
international economics and finance.
• However, due to the inflation pressure in the late
1960s, the United States officially abandoned its
dollar pegged to the gold standard in 1973.
• Since 1973, there has been a collapse of the Bretton
Woods system.
• Since the collapse of the Bretton Woods system,
economists have been analyzing the implementation
of various exchange rate policies adopted by different
countries.
• Many industrialized countries abandoned their fixed
exchange rate regime to adopt a more flexible
exchange rate regime.
• Developing countries followed suite and also chose to
implement different exchange rate regimes since the
collapse of the Bretton Woods system.
II. Exchange Rate Choice
• The currency crises in Mexico (1994), Asia (1997),
Russia (1998),& Brazil (1999) have fueled the debate
on the optimal choice of exchange rate regimes.
• The determinants of exchange rate policy have been
examined empirically using models based on the
theory of Optimal Currency Areas (OCA).
• Countries’ circumstances, economic and institutional
factors play an important role in determining the
choice of the exchange rate regime.Recently, political
economy aspects have been the focus of determining
the optimal choice of the exchange rate policy.
• This theory stresses that there is no single exchange
rate policy that performs best for all countries
(Mundell, 1961).
• Mckinnon (1963) argues that the size and the openness
of the economy are central to the choice of exchange
rate policy. He stresses that a fixed exchange rate
regime is the preferable arrangement when a country
has a small and open economy compared to a large and
(relatively) closed economy.
• Boyer (1978), Henderson (1979), and Mckinnon
(1981) argue that in the presence of monetary shocks
(monetary and financial market disturbances) in the
economy, a fixed exchange rate regime is the most
appropriate policy in order to maintain output stability.
However, in the presence of real shocks (large supply
side shocks), a flexible exchange rate regime is more
appropriate.
• In the 1980s, literature on the OCA highlighted the
importance of monetary policy credibility in
determining the exchange rate policy.
• During the 1990s currency crises in Mexico, Asia,
Russia, Brazil, and Argentina, numerous studies
emphasized on effect of high capital flows on the fixed
exchange rate regime.
• Van Hagen and Zhou (2005) highlighted the role of the
degree of financial development in the economy in
determining the choice of exchange rate regime.
• Recent literature considers the influence of economic,
institutional and political factors on the determinants of
exchange rate regime to be important. Most of the
recent existing literature uses the standard political
economy argument regarding choices in exchange rate
policy: the trade-off between credibility and
competitiveness.
• A country may gain anti-inflationary credibility
through pegging its local currency to a low-inflation
anchor currency.
• The substantial trade off between credibility and
competitiveness depends on the existing inflation level
in the economy.
• The trade off between competitiveness and credibility
is examined in Blomberg, Frieden, and Stein’s (2005).
They posit an argument that, in order to achieve
credibility, a country may adopt a fixed exchange rate
policy by pegging to a zero-inflation anchor currency.
III. Determinants of Exchange Rate
• Existing studies have identified many factors that
might make a specific exchange rate regime
preferable to some countries but not others.
• These factors influence the exchange rate choices
through four categories of circumstances: factors of
the optimal currency area, currency crisis risks,
political economy, and the tradable sectors.
III.i OCA Criteria
• OCA theory suggests that the openness of the economy,
inflation rate differential, economic size, degree of
economic development, and degree of financial
development are important determinants for the choice
of exchange rate policy.
• The more open the economy, the more likely a fixed
exchange rate will be adopted. (Why?)
• Inflation levels would increase the political cost of
giving up the peg and increase the possibility of
abandoning the peg. (Why?)
• The larger the economy, the lower the probability for
adopting a fixed exchange rate regime . (Why?)
• Countries with greater economic development are more
likely to have more developed and efficient goods and
factor markets, greater the tendency there is to choose a
flexible exchange rate arrangement. (Why?)
• Counties with lower levels of financial development are
more likely to choose a fixed exchange rate
policy.(Why?)
III.ii Risk of currency crisis
• Existing empirical studies have considered the effect of
currency crisis risk in selecting an exchange rate regime.
• Many studies have identified the lack of international
reserve to be a proxy for the risk of currency crisis.
• The lack of international reserves should decrease the
likelihood of adopting a fixed exchange rate policy.
(Why?)
• Several existing studies find strong evidence that the
availability of foreign exchange reserves increases the
probability of adopting fixed regimes.
III.iii Political economy factors
• The trade off between credibility and competitiveness,
as discussed previously, encourages the government to
decide on a political economy base.
• The relative importance of the tradable producers,
represented by the tradable sector, and the consumer
voters are crucial to the argument of the political
economy of exchange rate commitments.
• The tradable producers would influence the government
to not stay on the peg avoiding any appreciation in the
real exchange rates. (Why?)
• Consumer voters may support the peg being sustained
by the government, which can lead to a real appreciation
in the exchange rate. (Why?)
• Sustaining a fixed exchange rate policy is usually seen
before elections rather than after elections. (Why?)
• On the empirical side, a body of empirical studies uses
measures of the degree of political instability to reflect
the political economy of a country in regressions.
• The frequency of government changes and/or the
frequency of transfers of power to an opposition party
are used as two alternative measures of political
instability.
III.iv Tradable Sectors
• Industrial producers try to pressure the government to
adopt a more flexible exchange rate.(Why?)
• The industrial producers will attempt to avoid any
appreciation in the exchange rate by lobbing against a
fixed exchange rate policy.(Why?)
• However, it is expected that countries with a strong oil
sector will pressure the government to adopt a fixed
exchange rate regime.(Why?)
IV. Classification of Exchange Rate
Arrangements
• The existing literature on regime choices has usually
used the International Monetary Fund’s classification
of exchange rate regimes.
• Prior to 1999, member countries of the IMF declared
their exchange rate policies to the IMF according to
their official or de jure exchange rate arrangements.
• The former IMF classification identifies three major
exchange rate arrangements: fixed policies, limited
flexibility policies (fluctuated within a range), and
more flexible policies (either managed or free float).
• However, the former IMF exchange rate classification
does not distinguish between the announced exchange
rate policy (de jure exchange rate) and the actual
exchange rate policy (de facto exchange rate)
undertaken by the country.
• Another drawback of the pre-1999 classification is
that it does not distinguish between the varieties of
fixed exchange rate regimes.
• The new IMF classification distinguishes between
various pegging policies and also distinguishes
between eight categories ranging from hard peg
regimes to free floating regimes:
Exchange Rate Regime
Description
1. No Separate Lender Tender
i.e., Formal dollarization
2. Currency Board
Fixed to a specific foreign currency at a fixed rate
3. Conventional Fixed Pegs
Fixed to a single currency or a basket of currencies as with band at
most +/- 1%
4. Fixed Within Horizontal Bands
Fixed with bands at least +/- 1%
5. Crawling Pegs
Fixed with central parity periodically adjusted in small amount at fixed
rate or in response to changes in selective quantitative indicators
6. Crawling Bands
Crawling peg associated with bands at least +/- 1%
7. Managed Floating
Influencing the exchange rate without a specific target or preannounced path of the exchange rate
8. Independently Floating
Determining exchange rate through the market
Table: The Revised IMF Classification of Exchange Rate Arrangements
Source: IMF Exchange Rate Classification (1999)
• Differences between the de jure and de facto
exchange rates play an important role in analyzing
exchange rate choices. (Why?)
• Several studies have re-examined interesting
hypotheses using de-facto exchange rate
arrangements data, often concluding the opposite
results shown with de jure data.