Exchange-Rate Systems

and Currency Crises

Exchange Rates Regimes of the

World, 1870–2000Feenstra 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-of-

payments 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 EditionCopyright © 2008 by Worth Publishers

Figure 19.7 Exchange Rate Regimes and Output VolatilityFeenstra and Taylor: International Economics, First Edition

Copyright © 2008 by Worth Publishers

Figure 19.4 A Theory of Fixed Exchange RatesFeenstra 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 domestic-

currency 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

• 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

Continued

Fixed Exchange-Rate System

• 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

Continued

Fixed Exchange-Rate System

• 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)

Continued

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

• Conflicting objectives

• Magnitude of adjustments

• Difficulties in estimating equilibrium rates

• Speculation

Floating Exchange Rates

• Currency prices established in the foreign-

exchange market

• Without restrictions imposed by government

policies

• Equilibrium exchange rate equates the

demand for and supply of the home currency

Floating Exchange Rates

• 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

Continued

Floating Exchange Rates

• 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

Continued

Arguments For and Against

Floating Rates• Advantages

• 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 two-

country 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• 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

• 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

Continued

Sources of Currency Crises

• 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 long-

term 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

• 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

• 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

Continued

Dollarization

• Implications of Dollarization for the U.S.

• For each dollar sent abroad, Americans enjoy a one-

time 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

Continued