Working Paper Managed floating: Understanding the new international monetary order

Transcription

1 econsor Der Open-Access-Publikaionsserver der ZBW Leibniz-Informaionszenrum Wirschaf The Open Access Publicaion Server of he ZBW Leibniz Informaion Cenre for Economics Bofinger, Peer; Wollmershäuser, Timo Working Paper Managed floaing: Undersanding he new inernaional moneary order Würzburg economic papers, No. 30 Provided in Cooperaion wih: Universiy of Würzburg, Chair for Moneary Policy and Inernaional Economics Suggesed Ciaion: Bofinger, Peer; Wollmershäuser, Timo (2001) : Managed floaing: Undersanding he new inernaional moneary order, Würzburg economic papers, No. 30 This Version is available a: hp://hdl.handle.ne/10419/48479 Nuzungsbedingungen: Die ZBW räum Ihnen als Nuzerin/Nuzer das unengelliche, räumlich unbeschränke und zeilich auf die Dauer des Schuzrechs beschränke einfache Rech ein, das ausgewähle Werk im Rahmen der uner hp:// nachzulesenden vollsändigen Nuzungsbedingungen zu vervielfäligen, mi denen die Nuzerin/der Nuzer sich durch die erse Nuzung einversanden erklär. Terms of use: The ZBW grans you, he user, he non-exclusive righ o use he seleced work free of charge, erriorially unresriced and wihin he ime limi of he erm of he propery righs according o he erms specified a hp:// By he firs use of he seleced work he user agrees and declares o comply wih hese erms of use. zbw Leibniz-Informaionszenrum Wirschaf Leibniz Informaion Cenre for Economics

2 W. E. P. Würzburg Economic Papers No. 30 Managed floaing: Undersanding he new inernaional moneary order Peer Bofinger and Timo Wollmershäuser Sepember 2001 (revised) Universiä Würzburg Lehrsuhl für Volkswirschafslehre, Geld und inernaionale Wirschafsbeziehungen Sanderring 2, D Würzburg Tel.: +49/931/

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4 Managed floaing: Undersanding he new inernaional moneary order Peer Bofinger and Timo Wollmershäuser Sepember 2001 Absrac Alhough here seems o be a broad consensus among economiss ha purely floaing or compleely fixed exchange raes (he so-called corner soluions) are he only viable alernaives of exchange rae managemen, many counries do no behave according o his paradigm and adop a sraegy wihin he broad specrum of exchange rae regimes ha is limied by he wo corner soluions. These inermediae regimes are characerized by significan foreign exchange marke inervenions of cenral banks and a cerain degree of exchange rae flexibiliy. We develop a new empirical mehodology ha idenifies hree differen forms of floaing on he basis of a cenral bank's inervenion aciviy: pure floaing (no inervenions), independen floaing (exchange rae smoohing), and managed floaing (exchange rae argeing). Our crosscounry sudy shows ha exchange rae argeing is a leas as imporan as exchange rae smoohing. Subsequenly we presen a moneary policy framework in which cenral banks use he exchange rae as an operaing arge of moneary policy. We explain he mechanics of inervenions and serilizaion and we explain why a cenral bank has an ineres of conrolling simulaneously he exchange rae and he shor-erm ineres rae. We derive he moneary policy rules for our wo operaing arges from a simple open economy macro model in which he uncovered ineres pariy condiion and he Moneary Condiions Index play a cenral role. JEL classificaion: E 52, F 31, F 33, F 41 Keywords: exchange rae regime, moneary policy, inervenions, serilizaion, floaing, Moneary Condiions Index iii

5 Conens 1 Inroducion Defining and idenifying hree forms of floaing Floaing : he predominan exchange rae regime in he New Millennium Three forms of floaing Governmens do no always ell he ruh A differen approach for idenifying hree varians of floaing A new mehod for measuring differen forms of floaing Daa descripion and proceeding Main resuls Wha can we learn from he lieraure? The Mundell-Fleming legacy Open economy inflaion argeing John Williamson s proposals A heoreical framework for managed floaing The exchange rae as an operaing arge of moneary policy The flow channel of inervenions maers Serilized inervenions can be effecive How can he coss of serilizaion be avoided Scope and limis of exchange rae argeing Inernal and exernal equilibrium under exchange rae argeing Inernal equilibrium Measuring he acual moneary policy sance: he concep of he acual MCI (MCI ) Deriving he opimal moneary policy sance: he concep of he opimal MCI (MCI op ) The inernal equilibrium rule Exernal equilibrium The privae invesor s exernal equilibrium The cenral bank s exernal equilibrium The overall exernal equilibrium and he cenral bank s inervenion response funcion A moneary policy framework for small open economies The advanages of managed floaing in comparison wih radiional exchange rae sraegies Absoluely fixed exchange raes Crawling pegs iv

6 1.4.3 Purely floaing exchange raes Overcoming he inconsisency riangle hrough managed floaing Unresolved issues of managed floaing In search of a new anchor for privae secor expecaions The conrol over he exchange rae is asymmeric Managed floaing and beggar-my-neighbor policies Seleced case sudies Slovenia Peru Poland Japan Conclusion...60 References...65 Appendix 1: Counry coverage...67 Appendix 2: Probabiliy disribuions...69 Appendix 3: The marke maker principle...73 Appendix 4: Derivaion of he opimal MCI based on he minimizaion of a cenral bank s loss funcion...75 Appendix 5: A simple framework for he explanaion of currency crises...76 Appendix 6: Seleced case sudies...78 v

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8 1 Inroducion In spie of heir prominence, he exchange rae regimes of floaing or managed floaing have so far received relaively lile academic ineres. Due o his fear of floaing of many researchers 1, unil oday even he cenral erms floaing and managed floaing lack a clear and widely shared definiion. We will show ha his can lead o some confusion which is especially problemaic for he opion of managed floaing. Above all a precise definiion would make clear ha his approach is concepually compleely differen from he exbook model of flexible exchange raes and also he more refined models of open economy inflaion argeing. In oher words, because of his semanic imprecision i has been overlooked ha managed floaing lacks a well-developed heoreical framework. As a consequence a cenral bank which wans o follow he popular approach of managed floaing can receive almos no guidance for is concree moneary and exchange rae policies. 2 The lack of a posiive as well as a normaive heory of managed floaing can also lead o negaive effecs a he inernaional level. While he inernaional moneary order is now dominaed by managed floaing, here has been no heoreical discussion wheher such uncoordinaed naional exchange rae and ineres rae policies will always lead o opimum oucomes for he global economy. The paper is organized as follows: In Chaper 2 we presen hree differen definiions of floaing: Pure floaing is an arrangemen where he exchange rae is almos always marke deermined; in oher words, he cenral bank normally refrains from exchange marke inervenions. As a benchmark for pure floaing, we use he exchange rae policy of he Unied Saes. Independen floaing is characerized by an acive inervenion policy which aims a a sabilizaion around a marke-deermined given rend of he exchange rae. Managed floaing is also characerized by an acive inervenion policy. In his case a cenral bank s inervenion policy follows an unannounced arge pah for he exchange rae. 1 While here was some discussion of his issue in he 1980s, in he las few years here are almos no publicaions wih a ile ha is direcly relaed o exchange rae sysem of floaing or managed floaing; for insance, in EconLi since 1990 only 17 publicaions can be found under managed floa and 21 publicaions under managed floaing. 2 See Fischer (2001, p. 7) abou foreign exchange marke inervenions in sysem of managed floaing: This is one of he remaining areas in which cenral bankers place considerable emphasis on he ouch and feel of he marke, and where sysemaic policy rules are no ye common. 1

9 On his basis we develop a simple mehod for idenifying hese hree differen forms of floaing. Compared wih he mehods by Calvo and Reinhar (2000), our approach has he advanage ha i allows a clear demarcaion beween he hree varians of floaing. In Chaper 3 we give a shor survey of he lieraure. We show ha he Mundell/Fleming model as well as he more refined models for open economy inflaion argeing are unable o explain he high inervenion aciviy of many cenral banks which is geared owards achieving a cerain exchange rae pah. In Chaper 4 we presen a simple heoreical framework for managed floaing. I is based on he somewha unfamiliar noion of using he exchange rae as an operaing arge of moneary policy in addiion o he shor-erm ineres rae. We analyze he condiions under which such an exchange rae argeing is possible. In he cenral par of his Chaper we show how in an open economy a cenral bank has o se is wo operaing arges in order o achieve simulaneously inernal equilibrium which defined by an MCI which minimizes a social loss funcion, exernal equilibrium which is defined by a combined ineres and exchange rae policy ha is compaible wih uncovered ineres pariy. The las par of Chaper 4 discusses he shorcomings and implicaions of managed floaing. As managed floaing is characerized by an unannounced exchange rae pah, a separae anchor for privae secor expecaions is required in small open economies. We argue ha in he same way as in large economies inflaion argeing can provide a subsiue for his funcion. A major shorcoming of managed floaing is he limied abiliy of cenral banks o defend an exchange rae pah in a siuaion of srong speculaive ouflows. Such shocks would require a policy-mix wih very high real ineres raes ha can lead o negaive effecs for he domesic secor of an economy. For his case credi faciliies in he form of he IMF s Coningen Credi Line are he only adequae soluion. Finally, under an uncoordinaed managed floaing counries can manipulae he exchange rae in order o improve heir inernaional compeiiveness. The srong increase in dollar reserves of emerging marke economies during he 1990s indicaes ha such consideraions have played an imporan role in he exchange rae managemen of hese counries. 2

10 In Chaper 5 we ake a deeper look a he acual moneary and exchange rae policy of a few counries in our sample ha we idenify as managed floaers in Chaper 2. Wih a raher descripive approach we invesigae wheher hese counries effecively pursue a policy according o he rules which we derive formally in Chaper 4. The las Chaper summarizes he main resuls and concludes. 2 Defining and idenifying hree forms of floaing 2.1 Floaing : he predominan exchange rae regime in he New Millennium In he las decade he inernaional moneary order has undergone a dramaic ransformaion. Inermediae regimes which had been he prevailing exchange rae arrangemen in he early 1990s are now only used by abou one hird of he IMF s member counries (see Table 1). In he group of developing and emerging marke economies he decline has been even more pronounced. For he counry groupings of all counries and of emerging marke economies floaing has been he preferred alernaive o inermediae regimes. Table 1 shows ha for all hree counry groupings floaing has become he predominan exchange rae arrangemen. Hard pegs could also profi from he vanishing middle, especially in developing counries, bu heir marke share remains much lower han he share of floaing. Table 1: Exchange rae arrangemens 1991 and 1999 Hard Pegs Inermediae Floaing Year All counries 16% 24% 62% 34% 23% 42% Emerging marke 6% 9% 64% 42% 30% 48% economies Developing and emerging marke economies 5% 25% 65% 27% 29% 47% Source: Fischer (2001) In he lieraure his hollowing ou has been widely welcomed and is even recommended as an opimum soluion for almos all counries (Fischer 2001, Frankel 1999, Summers 2000). Barry Eichengreen (1999, p. 105) has become a specially prominen promoer of his approach: Hence, he IMF needs o more forcefully encourage is members o move o policies of greaer exchange rae flexibiliy, and he sooner he beer. Wih few excepions i should pressure is members, in he conex of Aricle IV consulaions and program discussions, o 3

11 abandon simple pegs, crawling pegs, narrow bands and oher mechanisms for limiing exchange rae flexibiliy before hey are forced o do so by he markes. 2.2 Three forms of floaing As Table 1 shows, in many policy-relaed discussions he specrum for exchange rae arrangemens is reduced o he hree cenral opions of hard pegs, inermediae regimes, and floaing. While his gives some impression on he main choices, an undersanding of managed floaing requires a more deailed classificaion. In our view, he IMF s Inernaional Financial Saisics classificaion of exchange regimes is quie useful in his regard. I uses he following eigh caegories: a. Exchange rae arrangemens wih no separae legal ender (dollarisaion, membership in a currency union) b. Currency board arrangemens c. Oher convenional fixed peg arrangemens (formal or de faco peg wih a narrow margin of a mos ± 1 per cen around a cenral rae) d. Pegged raes wihin horizonal bands (formal or de faco peg wih margins ha are wider han ± 1 per cen around a cenral rae) e. Crawling pegs (he currency is adjused periodically in small amouns a a fixed, preannounced rae or in response o changes in selecive quaniaive indicaors) f. Crawling bands (he currency is mainained wihin cerain flucuaion margins around a cenral rae ha is adjused periodically in small amouns a a fixed, pre-announced rae or in response o changes in selecive quaniaive indicaors) g. Managed floaing (no pre-announced pah for he exchange rae; he moneary auhoriy influences he movemen of he exchange rae hrough acive inervenion in he foreign exchange marke wihou specifying, or pre-commiing o, a pre-announced pah for he exchange rae) h. Independen floaing (he exchange rae is marke deermined, wih any foreign exchange marke inervenion aimed a moderaing he rae of change and prevening undue flucuaions in he exchange rae, raher han esablishing a level for i) A leas from a heoreical poin of view i seems useful o add an addiional caegory: 4

12 i. Pure floaing (he exchange rae is marke deermined wih no foreign exchange marke inervenion a all; changes in foreign exchange reserves are due o echnical facors only). As already menioned, many auhors summarize he arrangemens g), h), and i) under he heading of floaing. This can creae he impression ha he economic raionale of hese hree arrangemens is more or less idenical. However, a careful reading of he IMF s descripion of g) and h) and of our caegory i) shows a very imporan difference: Managed floaing implies ha he exchange rae pah is deermined by he cenral bank (or he governmen). Pure and independen floaing imply ha he exchange rae pah is mainly marke deermined. In oher words, wha disinguishes managed floaing from he inermediae soluions e) and f) is no a differen form of exchange rae deerminaion, i is mainly he fac ha here is no preannounced pah for he exchange rae (see Figure 1). Figure 1: Exchange rae regimes classificaion of exchange rae regimes exchange rae is mainly marke deermined pure and independen floaing exchange rae is mainly deermined by he moneary auhoriies exchange rae argeing no preannounced arge managed floa preannounced arge variable arge crawling pegs consan arge fixed exchange raes wih cenral bank fixed peg wihou cenral bank currency board 5

13 As a consequence, for a heoreical undersanding of managed floaing i is no sufficien o rea i simply as a varian of independen or pure floaing, for which he elaborae heories of flexible exchange raes are available. The very fac, ha under managed floaing cenral banks ry o arge he exchange rae requires a posiive analysis of his policy, as well as a normaive heory designing policy rules for managed floaing. 2.3 Governmens do no always ell he ruh The need for a precise definiion of floaing exchange regimes applies no only o economiss. As he research by Calvo and Reinhar (2000) has shown, naional governmens and/or cenral banks do no seem o pay oo much aenion o he exac definiions in he IMF s forms. The saring poin for Calvo and Reinhar is he exbook model of flexible exchange raes (or our opion pure floaing ) which is characerized by a consan level of foreign exchange reserves. Therefore, Calvo and Reinhar idenify floaing (in our axonomy: pure floaing ) by a high probabiliy ha he monhly per cen change in foreign exchange reserves falls wihin a ± 1 or ± 2.25 per cen band. As here are always echnically deermined changes in reserves, Calvo and Reinhar use he daa of he Unied Saes and Japan as a benchmark. In oher words, a lower probabiliy for small reserve changes is regarded as an indicaion ha a counry is no following a policy of floaing (in or axonomy; pure floaing ). The polar case of fixed exchange raes is characerized by a low probabiliy ha he monhly per cen change in nominal exchange rae falls wihin a ± 1 or ± 2.25 per cen band. Again, he Unied Saes and Japan are used as a benchmark. Table 2 presens he main resuls of he sudy by Calvo and Reinhar Regime Table 2: Main resuls of he Calvo and Reinhar (2000) sudy Foreign exchange reserves volailiy +/- 1 +/ per cen band per cen band Exchange rae volailiy +/- 1 per cen band +/ per cen band Independen floaing Managed floaing Limied flexibiliy Fixed USA Japan Source: Calvo and Reinhar (2000) 3 Excluding Japan and he Unied Saes 6

14 The mos sriking resul of his sudy is he very small difference beween he polar opions of independen floaing and fixed raes as far as he changes in foreign exchange reserve volailiy are concerned. In addiion he independen floaers behave compleely differen han he wo benchmark counries. The same applies o he caegory managed floaing. In oher words, mos of he counries which classify hemselves as independen or managed floaers are acively inervening on he foreign exchange marke. The exchange rae volailiy of independen and managed floaers is also much lower han in he Unied Saes and Japan and if is analyzed wihin he ± 2.25 per cen band, he difference o fixed raes is no very pronounced, especially for managed floaing. In sum, he resuls of Calvo and Reinhar as well as of a relaed sudy by Levy-Yeyai and Surzenegger (2000) show ha i is imporan o make a clear disincion beween he exbook ideal of free floaing and he realiy of independen and managed floaing. 2.4 A differen approach for idenifying hree varians of floaing While he sudy by Calvo and Reinhard has conribued o a much beer undersanding of floaing, i has he imporan drawback ha i canno disinguish beween he hree differen forms of floaing. Anoher problem of his sudy is ha i analyses very long periods (up o February 1973 April 1999). This can have he disadvanage ha a singular srong inervenion aciviy or changes in inervenion behavior in he more recen pas canno no be idenified. Finally he Calvo/Reinhar sudy normalizes changes in reserves by relaing hem o reserve levels. This can be misleading if counries sar an inervenion period wih differen reserve levels alhough heir overall macroeconomic daa are roughly similar or if counries accumulae large reserve levels over ime A new mehod for measuring differen forms of floaing In order o avoid hese shor-comings, we presen a new mehodology for idenifying differen forms of floaing. We sar wih wo differen mehods o proxy he inervenion aciviy of a counry: 1. changes in foreign reserves minus gold (Res) as a raio of he exernal secor s size measured by a welve-monh moving-average of he arihmeic mean of impors (Im) and expors (Ex); 7

15 2. changes in foreign reserves minus gold (Res) as percenage of he level of reserves a he beginning of he underlying period. The firs normalizaion procedure has he advanage ha changes in reserves are relaed o he size of a counries exernal secor. To some exend his also akes ino accoun differences in he oal economic size. The second mehod was chosen o produce resuls ha are comparable o hose of he Calvo/Reinhar sudy. As a firs sep we wan o idenify he overall inervenion aciviy of a counry. For his purpose we add he absolue values of normalized changes in reserves for a period of n=6 and of n=12 monhs. Thus, we do no discriminae beween he monhly values of ne sales and ne purchases of foreign exchange reserves. The resuling variable is called sum of absolue changes (S abs1, S abs2 ): n abs1 Res i Res i 1 (1) S () n =, i= 0 Ex i + Im i Ex i 1 + Im i abs2 (2) S () n n Res i Res i 1 i= 0 =. Res n 1 The superscrips 1 and 2 refer o he mehod of normalizaion. If S abs is low (i.e. approaching zero), a counry s overall inervenion aciviy is low. As in Calvo and Reinhar (2000) we chose he U.S. as a benchmark which we assume o be a pure floaer. The difference beween he wo mehods of normalizaion can be illusraed quie easily wih he four chars of Figure 2. In he upper wo chars we depiced he proxies for he inervenion aciviy S abs1 and S abs2 for Japan and he US. While he wo lines differ only slighly in he case of he US, he differences in he conclusion ha one would draw in he case of Japan are sriking. According o he hin line (mehod 2) he Japanese exchange rae policy would be judged as a non-inervenionis one, similar o wha resuls for he US. In he sudy of Calvo and Reinhar (2000) which uses a similar echnique (monhly change in foreign exchange reserves as a percenage of he level of reserves) Japan is classified as even more independenly floaing han he US (see Table 2). The major problem wih his approach is he bias ha emerges wih an 8

16 increasing level of reserves. The same sale or purchase of foreign exchange measured in US dollars becomes less imporan he higher he base in erms of which he percenage change is measured. From he lower wo chars we can see ha he Japanese auhoriies accumulaed large amouns of foreign reserves during he las wo decades (he figures depiced are in millions of US dollars). The average rae of growh amouned o a muliple of he rae of growh of he exernal secor. In conras o his, he wo variables seem o have a common long-run rend in he US so ha he measuremen bias described above does no occur. This explains why he wo mehods approximaely yield he same resuls for he US. In order o eliminae such a bias, in he following we only use he second normalizaion mehod. Figure 2: Differen mehods of proxying inervenion aciviy Inervenion aciviy Japan mehod 1 mehod Inervenion aciviy USA mehod 1 mehod M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M1 1975M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M Japan (expors + impors) / 2 oal reserves minus gold USA (expors + impors) / 2 oal reserves minus gold 1975M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M1 1975M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M1 In a second sep we calculae he sum of effecive changes (S eff1, S eff2 ) of reserves again for a 6 and a 12 monh period: n eff1 (3) () Res i Res i 1 S n =, i= 0 Ex i + Im i Ex i 1 + Im i

17 2 (4) S eff () n n ( Res Res ) i i 1 i= 0 =. Res n 1 We hen divide he sum of effecive changes by he sum of absolue changes of reserves for each normalizaion mehod and for each ime horizon. The resuling raio allows us o differeniae beween independen floaers and managed floaers. We herefore labeled i index of floaing (I floa ): eff1 () () floa1 S n (5) I () n =, abs1 S n eff 2 () () floa2 S n (6) I () n =. abs2 S n I floa assumes values ranging from minus one o plus one. A value close o zero indicaes ha a cenral bank has no changed is oal level of reserves during an observaion period. As his is compaible wih a high value of he denominaor, a low value of I floa shows ha inervenions were mainly carried ou in order o smooh shor-erm flucuaions around an exogenously deermined rend. This behavior is ypical for a sraegy of independen floaing as i is defined by he IMF. A value of I floa close o plus or minus one implies ha he inervenion aciviy was associaed wih a change in reserves during he observaion period. This can be regarded as an indicaion ha a cenral bank has ried o influence he rend of he exchange rae. Thus, such values of I floa can be regarded as a marker for managed floaing. In addiion, he sign of his indicaor shows wheher he cenral bank has ried o inervene agains an appreciaion (a posiive sign: ne purchases of he cenral bank) or a depreciaion (a negaive sign: ne sales of he cenral bank) of is currency Daa descripion and proceeding Our sample consiss of 14 developed marke economies and 30 emerging marke economies 4 ha have been classified as independen or managed floaers according o he IMF s quarerly 4 We disinguish beween developed marke economies and emerging marke economies as in Fischer (2001). This resricion allows us o concenrae on he subse of developing counries which are inegraed wih world capial 10

18 Exchange Rae Arrangemens published in he Inernaional Financial Saisics (IFS). Our daa is monhly from January 1975 o November The variables used in our calculaions are all from he IFS. Reserves (Res) are measured by Toal Reserves minus Gold (line 1l.d), expors and impors by line 70 and 71. If he laer were denominaed in naional currency, we convered hem ino US dollars wih he average monhly dollar exchange rae (line rf). For each monh during he period ha a counry repors is exchange rae regime as an independen or a managed floaer we calculaed he wo variables of ineres S abs and I floa. The periods and he repored regimes are summarized in Table 8 (see Appendix 1: Counry coverage). Since some counries followed differen exchange rae sraegies in he whole period, we ge a oal of 65 cases for he 6-monh horizon and 62 cases for he 12-monh horizon. We hen compued he frequency disribuion of each variable for each period. For our classificaion of exchange rae regimes we proceed as follows. In a firs sep we ry o find ou wheher a counry is a pure floaer or no. For his purpose we look a he value of S abs of our benchmark counry, he Unied Saes. We see ha for boh ime horizons here is a 100 % probabiliy ha he sum of absolue reserve changes is less han he average of he sum of monhly impors and expors during he observaion periods (i.e. S abs 1.0, see Table 10 and Table 11 in Appendix 2: Probabiliy disribuions). For he 6-monh horizon he Unied Kingdom (09/92-11/00), Canada and Poland (04/00-11/00) can also be regarded as pure floaers. For he 12-monh horizon only he Unied Kingdom (09/92-11/00) can qualify as a pure floaer; for Poland he experience wih floaing is no long enough. For hose counries which canno be no classified as pure floaers we ry o idenify wheher heir inervenion policy can be classified as independen or managed floaing. For his purpose we use he index floaing. We assume ha a range of 0.33 < I floa < 0.33 describes independen floaing; he ranges of 1 I floa 0.33 and 0.33 I floa 1 are regarded as a policy of managed floaing. If he probabiliy of 0.33 I floa < 0.33 is a leas 50 %, we classify a counry as an independen floaer, if i is lower a counry is classified as a managed floaer. Since we lack a benchmark counry, he inervenions of he Unied Saes are o small o be used for his markes. As we were also ineresed in he exchange rae policy of he Easern European accession counries, we addiionally included Slovenia in our analysis. 11

19 purpose, we had o chose hese criical values somewha arbirarily. Figure 3 gives an overview of his classificaion procedure. Figure 3: A classificaion of floaing exchange rae sysems Disribuion of S abs Prob(S abs = 1) = 1 pure floaing Prob(S abs = 1) < 1 oher floaing Disribuion of I floa Prob(-0.33 < I floa < 0.33) 0.5 independen floaing (exchange rae smoohing) Prob(-0.33 < I floa < 0.33) < 0.5 managed floaing (exchange rae argeing) Main resuls A summary of he resuls of our classificaion is presened in Table 3 and Table 4 (for he deailed counry resuls see Table 12 and Table 13 in Appendix 2: Probabiliy disribuions). For he 6-monh observaion period hey show ha mos floaing counries can be regarded as managed floaers regardless wheher we focus on all regimes ha were in exisence in he whole period from 1975 unil 2000 or on hose here are sill in exisence. Only 23 % of he IMF s independen floaers are pure floaers or independen floaers according o our classificaion. For he 12-monh observaion period a more even disribuion beween independen and managed floaing emerges. Again here is no srong correlaion wih he IMF s classificaion: only 48 % of he IMF s independen floaers were rue independen floaers and only 46 % of he managed floaers were rue managed floaers. Thus, depending on he observaion period our analysis shows firs ha managed floaing is eiher he mos widely used form of floaing or a more or less equally imporan form of floaing as independen floaing. 12

20 IMF Table 3: IMF classificaion and our classificaion for floaing using 6-monh periods Our classificaion Sum Pure floa Independen Managed floa floa Independen floa 4 (4) 3 (2) 24 (15) 31 (21) classificaion Managed floa - 4 (0) 31 (10) 35 (10) Sum 4 (4) 7 (2) 55 (25) 66 (31) Noe: The figures in brackes indicae he number of regimes ha are sill in exisence. IMF Table 4: IMF classificaion and our classificaion for floaing using 12-monh periods Our classificaion Sum Pure floa Independen Managed floa floa Independen floa 2 (2) 11 (8) 14 (10) 27 (20) classificaion Managed floa - 19 (6) 17 (4) 36 (10) Sum 2 (2) 30 (14) 31 (14) 63 (30) Noe: The figures in brackes indicae he number of regimes ha are sill in exisence. The imporance of managed floaing becomes even more obvious if we use our mehodology for he analysis of ime series. Thus, we can observe for each counry how he values of S abs and I floa vary over ime. Of course his approach has he effec ha even wih a low overall probabiliy siuaions wih high values of S abs can be reached from ime o ime. The mos ineresing case is Japan. According o he cross-secion analysis which covers he period from 1975 o 2000 he probabiliy for high inervenions in Japan is relaively low so ha Japan is no very differen from he pure floaers (see Table 10 and Table 11 in Appendix 2: Probabiliy disribuions). However, he ime series for Japan show a quie differen picure (see Figure 2). Especially in he years 1999 and 2000 is inervenion aciviy is very high and i is associaed wih values of I floa ha exceed for mos of he ime which clearly indicaes ha he Japanese auhoriies argeed an exchange rae pah (see Figure 13 in Appendix 6: Seleced case sudies). In oher words, here has been a clear regime change which canno be deeced. wih he approach of Calvo and Reinhar or any oher forms of a cross-secion analysis. Thus, an analysis of ime series of he wo inervenion indicaors has he advanage o filer ou episodes of high inervenion aciviy and episodes of low inervenion aciviy wihin he whole period considered as well as episodes where exchange rae argeing (managed floaing) or exchange rae smoohing (independen floaing) prevailed. Moreover i allows us o idenify changes in he inervenion policy of a counry. In Chaper 5 we will presen some seleced case sudies of counries ha we idenified as managed floaers. 13

21 3 Wha can we learn from he lieraure? The empirical analysis shows ha here hree differen approaches under he general heading of floaing. While pure floaing and independen floaing are more or less discussed in he exensive lieraure on flexible exchange raes, here has been asonishingly lile heoreical discussion of managed floaing. Above all i is unclear why counries ry o arge he exchange rae direcly, how he exchange rae can be conrolled effecively, and how he exchange rae pahs should be deermined ha are argeed under managed floaing. The firs quesion leads o he old debae abou fixed versus flexible raes ha we do no wan o discuss here. In our view an imporan explanaion of he widespread use of managed floaing is he very weak saisical relaionship beween macroeconomic fundamenals and a floaing exchange rae. In he words of Jeffrey Frankel and Andrew Rose (1995, p. 1709): To repea a cenral fac of life, here is remarkably lile evidence ha macroeconomic variables have consisen srong effecs on floaing exchange raes, excep during exraordinary circumsances such as hyperinflaions. The low ineres in he second and hird quesion seems mainly due o he semanic confusion ha was already menioned. Since mos economiss do no differeniae beween he hree forms of floaing hey seem o believe ha he so-called inconsisency riangle provides already a sufficien framework for a analysis of he relevan arrangemens in exchange rae policy. According o his meaphor a counry can choose beween he following opions (see Figure 4): a fixed exchange rae wih a lack of an auonomous ineres rae policy and free capial mobiliy, an auonomous ineres rae policy wih a freely floaing exchange rae and free capial mobiliy, capial conrols and a combinaion of a fixed exchange rae and an auonomous ineres rae policy. 14

22 Figure 4: Inconsisency riangle capial mobiliy I II exchange rae fixiy III moneary auonomy I: fixed exchange raes II: pure floaing III: capial conrols As he effeciveness of conrols for capial inflows and ouflows is very limied, a leas on a susained basis (Ariyoshi e al. 2000), he menu is reduced o he firs wo opions. The main problem of his presenaion is is focus on he polar soluions of eiher absoluely fixed or absoluely flexible exchange raes (pure or independen floaing). In oher words i has nohing o say abou a policy of managed floaing where he exchange is neiher fixed, since i is argeed along an unannounced exchange pah, nor flexible in he sense of a marke-deermined rae, since he cenral bank inervenes in order o keep he exchange rae close o he arge pah. 3.1 The Mundell-Fleming legacy The heoreical framework for he inconsisency riangle is he well-known Mundell-Fleming model which is he workhorse for almos all exbooks on open economy macroeconomics. Bu in spie of is populariy he model is no very well designed for a world of managed floaing. As a comparaive-saic model i canno cope wih dynamic processes in exchanges raes, i.e. exchange rae pahs and exchange rae expecaions. In oher words, he polar view presened in he inconsisency riangle is no so much a resul of sound heoreical reasoning bu raher he 15

23 oucome of an oudaed economic model which by is very naure canno deal wih policy opions oher han absoluely fixed or absoluely flexible exchange raes. In addiion, he sandard exbook presenaion of he Mundell-Fleming model only focuses on a domesic moneary policy ha ries o follow a more expansionary ineres policy han in he anchor currency counry. Thus, i overlooks he more ineresing siuaion of a cenral bank ha follows a more resricive policy which leads o capial inflows and an increase in foreign exchange reserves. In his conex he scope for serilized inervenions is also no sufficienly analyzed. We will discuss his in more deail below. 3.2 Open economy inflaion argeing Managed floaing is a major challenge no only o he old fashioned bu also o more elaborae models of inernaional macroeconomics. Imporan models wih moneary policy rules for open economies have been presened by Ball (1999b) and Svensson (2000). Boh auhors base heir papers on a exbook view of free floaing. Svensson (2000) assumes ha he flexible exchange rae is deermined even in he shor-run by a varian of he absolue purchasing power pariy (PPP) and by he uncovered ineres rae pariy (UIP). As a resul, foreign exchange marke inervenions are no discussed as an independen moneary policy insrumen. However, boh exbook assumpions are no compaible wih he empirical evidence. I is wellknown ha pricing-o-marke can lead o srong deviaions from PPP in he shor-run (see Rogoff 1996). The sysemaic deviaions of exchange rae changes ( forward discoun bias ) from UIP have been discussed in many papers (see Froo and Thaler 1990). In oher words, if a cenral bank follows he policy rule prescribed by Svensson, i has o be aware of he fac ha i relies on unrealisic exchange rae heories. This discrepancy beween he Svensson model and he realiy can be regarded as an explanaion of why here is so much foreign exchange marke inervenion by cenral banks alhough he model implicily assumes ha such ransacions are no necessary. The paper by Ball (1999b) uses a raher simple srucure for he inernaional linkages of an open economy. Insead of he UIP i simply assumes a posiive relaionship beween he real exchange rae q and he domesic real ineres rae r which can be disurbed by shocks ν : 16

24 (7) q = θ r + ν. Of course, his descripion of he realiy is even more problemaic han he Svensson model since i disregards he foreign ineres rae. In addiion, for shor-erm foreign porfolio invesmens i is no he real bu he nominal ineres rae ha maers. Real ineres rae differenials are relevan for inernaional porfolio decisions only if PPP holds all he ime. Neverheless, he Ball paper provides an imporan building bloc for a heory of managed floaing. I presens a moneary policy rule for an open economy which is based on he Moneary Condiions Index (MCI) as a policy insrumen. In Chaper we will inroduce he MCI concep more formally. Ball defines he MCI as a weighed average of he real ineres rae and he real exchange rae and derives i from he minimizaion procedure of a cenral bank s loss funcion. He correcly saes: The raionale for using an MCI is ha i measures he overall sance of policy, including he simulus hrough boh r and e [he real exchange rae in his noaion; he auhors]. Policy makers shif he MCI when hey wan o ease or ighen. (Ball, 1999b, p. 131) Bu subsequenly he specifies his policy rule as follows: When here are shifs in he e/r relaion - shocks in equaion (3) [our equaion (7); he auhors] - r is adjused o keep he MCI a he desired level. In oher words, even hough he acceps he cenral role of he exchange rae for moneary policy in an open economy, he grounds his heory on a purely floaing exchange rae sysem where he only insrumen of moneary policy is he ineres rae. In sum, he models by Ball and Svensson canno provide a heory of managed floaing since hey do no ake ino accoun he lack of a sable relaionship beween macroeconomic fundamenals and he exchange rae which is he very raionale of managed floaing. As a consequence, boh models disregard he role of foreign exchange marke inervenions (in he sense of managed floaing) as an independen moneary policy insrumen. In Chaper we will come back o heir undersanding of moneary policy in small open economies and we will presen he sraegy of independenly floaing exchange raes and is major flaws wihin he scope of he open economy model ha we are going o inroduce in Chaper 4. 17

25 3.3 John Williamson s proposals John Williamson is he mos prominen promoer of inermediae exchange rae sysems, above all in he form of crawling peg (Williamson 1996), and more recenly in he BBC-varian (Williamson 2000) which calls for wide bands, a baske peg and a crawl. If managed floaing is inerpreed as a form of a non-announced exchange rae pah, Williamson s proposals come relaively close o i. However, here are also some imporan differences. Firs, Williamson proposes a very specific form of an exchange rae pah: he acive crawl, which is characerized by a rule ha depreciaes he domesic currency vis-à-vis he foreign currency (or a baske of foreign currencies) according o he difference beween he argeed domesic and he foreign inflaion rae minus a facor which akes ino accoun differences in he domesic and he foreign produciviy growh (Ricardo-Balassa-effec). We will see in Chaper ha he acive crawl is only a very specific varian of a managed floa which does no necessarily lead o opimum macroeconomic oucomes. A second difference beween he realiy of managed floaing and Williamson s proposals concerns he role of inervenions. Williamson favors a very cauious aiude owards exchange marke inervenions which becomes eviden in his preference for sof buffers. As our empirical analysis has shown, many cenral banks follow a much more offensive approach since hey do no hesiae o inervene for prolonged period of ime and wih large amouns of money. 4 A heoreical framework for managed floaing Our very shor survey of he lieraure has shown ha so far no comprehensive heory of managed floaing is available. In order o explain he acual inervenion behavior of cenral bank such a heory should be able o explain wo hings: he role of he exchange rae as an independen operaing arge of moneary policy (see Chaper 4.1); 18

26 he ineracion of he exchange rae and ineres rae policy which is required o guaranee simulaneously he achievemen of an inernal and an exernal equilibrium (see Chaper 4.2). 4.1 The exchange rae as an operaing arge of moneary policy The saring poin for a heory of managed floaing is he role of he exchange rae as an operaing arge of moneary policy. This role, which has no been acknowledged in he lieraure so far, can be explained in a very direc analogy o he operaing arge role of he shor-erm ineres rae: Wih open-marke operaions a cenral bank exchanges shor-erm domesic noes agains domesic cenral bank reserves in order o arge he shor-erm ineres rae. Wih foreign exchange marke inervenions a cenral bank exchanges foreign sigh deposis agains domesic cenral bank reserves in order o arge he exchange rae. In boh cases he operaing arge is conrolled direcly by inervenions in he relevan marke (domesic money marke, foreign exchange marke). While i is unconesed oday ha cenral banks are able o perfecly conrol shor-erm ineres raes, many economiss are in doub ha a direc conrol of he exchange rae is possible a all. They eiher argue ha his due o he sheer size of foreign exchange markes or ha a conrol of he exchange rae can only be achieved wih a limied conrol over he ineres rae which is normally no accepable (Schwarz 2000). Or, o pu i he oher way round, if boh insrumens are assumed o be independen from each oher due o complee serilizaion of he liquidiy effecs of foreign exchange marke inervenions, hen inervenions are deemed o be ineffecive. Finally serilized inervenion can be associaed wih ineres rae coss ha a cenral bank is no willing o accep. In he following Chapers we will discuss hese poins more in deail The flow channel of inervenions maers The effeciveness of foreign exchange marke inervenions has been discussed in many heoreical and empirical sudies. The resuls are mixed especially for he case of serilized inervenions (Samo and Taylor 2001). The mos serious flaw of his lieraure is ha almos all papers analyze he mark-dollar rae. As we have shown in he empirical par of our paper, 19

27 inervenions in his marke have been exremely small so ha he lack of a firm empirical evidence for he effeciveness of such inervenions can simply be explained wih an insufficien dose of inervenion. In oher words, analyses of he mark-dollar rae canno be aken as an evidence for he ineffeciveness of managed floaing in emerging marke economies and oher developed counries where he relaive amoun of inervenions is in some case several imes higher (see Table 10 and Table 11 in Appendix 2: Probabiliy disribuions). Figure 5: The flow channel of foreign exchange marke inervenions S Supply S 1 I = NFA > 0 S 0 S 2 I = NFA < 0 Demand Quaniy of foreign exchange The microeconomics of inervenion can be described wih a simple diagram for he foreign exchange marke (see Figure 5). On he y-axis is he price of foreign exchange in erms of he domesic currency. Thus, here is an upward-sloping supply curve and a downward-sloping demand curve for foreign exchange. The equilibrium exchange rae is S 0. Foreign exchange marke inervenion implies ha he cenral bank arges a higher or a lower exchange rae han he marke-clearing rae. If he cenral bank arges a rae S 1 ha is higher han he equilibrium rae, here is an excess supply of foreign exchange which i has o buy in exchange for domesic reserves. As a resul is ne foreign asses (NFA) will grow. In he case of a argeed rae S 2 below he marke-clearing rae, here is an excess demand for foreign exchange which he cenral 20

28 bank has o saisfy by selling foreign asses ou of is foreign exchange reserves ( NFA<0). As a consequence he commercial banks reserves decline. As far as he effeciveness of inervenions is concerned here is no doub ha he cenral bank can arge a differen exchange rae han S 0 as long as i is able o fill he gap beween he quaniy demanded and he quaniy supplied in disequilibrium. Of course he abiliy o arge S 1 is compleely differen han he abiliy o arge S 2. In he firs case which idenifies an inervenion policy ha ries o arge a weaker exchange rae han he marke rae he, cenral bank s foreign exchange reserve increase. In he second case which characerizes an aemp o keep he exchange rae a a sronger level han marke-clearing level, he cenral bank loses foreign exchange reserves. Thus, in he firs case here is no limi o he inervenion policy since he cenral bank can always increase he domesic liquidiy. In he second case, he cenral bank operaes under a hard budge consrain which makes i difficul o pursue such an inervenion policy over a prolonged period of ime. As far as he size of he foreign exchange marke is concerned, he figures of a daily ransacions volume of abou 2,000 billion dollar are relaed o he marke-maker principle by which he foreign exchange marke is organized. Due o his principle which generaes a ho poao effec (see Appendix 3: The marke maker principle), an individual ransacion can lead o a muliple of foreign exchange marke urnover. Thus, cenral bank inervenions a much smaller scales can be successful. For insance, in he period from June 1999 o June 2000 he Bank of Japan managed o sop a furher appreciaion of he yen wih a oal inervenion volume of abou 100 billion dollar, which is only 5 % of he daily global ransacions volume. This is also confirmed by he daa for local foreign exchange urnover. They show ha because of is role of a vehicle currency on he foreign exchange marke he dollar urnover is exremely high compared o he sock of oal foreign reserves or he size of he exernal secor of he Unied Saes. For many emerging marke economies, however, he relaive size of he urnover is considerably smaller so ha cenral banks can affec he exchange rae wih relaively small inervenion volumes (see Table 5, columns 2 and 3). We calculaed for example ha he urnover measured as a percenage of he exernal secor s size was on average more han hree imes higher in developed marke economies compared o emerging markes. 21

29 Table 5: Size of local foreign exchange markes Average daily urnover of local currency in he local foreign exchange marke in millions of US-$ (April 1998) Column 1 as a percenage of oal reserves minus gold (1998, end of year) Column 1 as a percenage of he exernal secor's size (1998) as defined in Chaper 2.4 Column 1 as a percenage of he GDP (1998, in US- $) Ausralia Ausria Belgium Canada Denmark Finland France Germany Hong Kong Ireland Ialy Japan Luxembourg Neherlands New Zealand Norway Porugal Singapore Spain Sweden Swizerland Unied Kingdom Unied Saes Argenina Bahrain Brazil Chile China Czech Republic Greece Hungary India Indonesia Malaysia Mexico Philippines Poland Russia Saudi Arabia Souh Africa Souh Korea Thailand Source: BIS (1999), IFS, own calculaions Serilized inervenions can be effecive This leads o he second argumen which is raised agains foreign exchange marke inervenions. If a cenral bank inervenes in order o keep is currency from appreciaing (depreciaing), i increases (reduces) domesic liquidiy which ceeris paribus is idenical wih a more expansionary (resricive) moneary policy sance. Due o his direc connecion i is ofen argued 22

30 ha any aemp o conrol he exchange rae is associaed wih a reduced conrol over he ineres rae. For insance, Anna Schwarz (2000, p. 26) concludes: (...) moneary policy can suppor eiher domesic or exernal objecives. Moneary policy canno serve boh. This argumen neglecs he fac ha mos cenral banks dispose over differen insrumens wih which hey can mop up he excess liquidiy ha is creaed by foreign exchange marke inervenions. As Table 6 shows such a policy of serilizaion is very common in hose counries ha we idenified as managed floaers (see Table 13 in Appendix 2: Probabiliy disribuions). For each counry we esimaed he following serilizaion equaion: (8) NDA = β 1 NFA + β 2 NDA -1 + u. Table 6: Serilizaion coefficien in managed floaing economies Dependen variable: NDA Explanaory variables Saisics NFA NDA -1 R 2 DW n Argenina (-17.64)*** 0.56 (14.42)*** Ausralia (-9.89)*** 0.13 (2.22)** Brazil (-19.95)*** (-2.50)** Brazil (-8.21)*** (-1.70)* Brazil (-4.39)*** (-2.00)* Bulgaria (-29.07)*** (-7.25)*** Chile (-3.87)*** (-3.06)*** Colombia (-10.20)*** (-5.02)*** Egyp (-18.24)*** (-0.87) Finland (-5.36)*** (-1.28) India (-3.57)*** (-2.53)** India (-1.65) (-1.26) Indonesia (-21.81)*** 0.00 (0.03) Israel (-3.85)*** 0.18 (1.19) Israel (-8.88)*** (-1.17) Japan (-4.91)*** (-9.55)*** Korea (-15.75)*** (-0.64) Malaysia (-4.96)*** 0.10 (0.84) Mexico (-16.11)*** (-2.64)*** Peru (-8.88)*** (-2.63)*** Poland (-13.36)*** (-3.23)*** Singapore (-16.88)*** 0.02 (0.44) Slovenia (-31.40)*** (-3.44)*** Sri Lanka (-18.95)*** (-4.78)*** Thailand (-1.20) 0.09 (0.53) UK (-15.00)*** (-0.81) Venezuela (-6.55)*** (-0.40) Noe: OLS esimaion, -values in parenheses, *** (**) [*] = significan a he 1 (5) [10] per cen level; for Bulgaria, Colombia 1 and UK 1 only quarerly daa was available for he whole period; 23

31 Under complee serilizaion he coefficien β 1 of he change in ne foreign reserves ( NFA ) is expeced o be -1, for ne domesic credi ( NDA ) is sysemaically varied o offse he effec of reserve acquisiions and losses on domesic liquidiy. 5 Ten of he 27 managed floaers had a serilizaion coefficien smaller han 0.90, and for 19 of hem i was less han How does serilizaion work in pracice? For he case of an inervenion ha increases domesic liquidiy he serilizaion can be achieved as follows: As long as he banking sysem is a ne debor of he cenral bank, credis o he banking sysem can be reduced in parallel wih foreign exchange marke inervenions. An insrumen which is especially suiable for ha purpose are he ECB s securiy repurchase agreemens wih a mauriy of up o wo weeks ha are conduced on a weekly basis. For he case of inervenions ha exceed his form of serilizaion a cenral bank has o issue ineres-bearing shor-erm noes wih which he excess liquidiy can be neuralized. A similar and even more simple insrumen is he deposi faciliy which has been esablished by he European Cenral Bank (see ECB 2000). Such an ineres bearing faciliy has he advanage ha i provides a serilizaion poenial ha is unlimied, a leas in principle. So far, his insrumen is no very common wih oher cenral banks, bu i is no a major echnical problem o esablish such a faciliy which is simply an addiional ineres-bearing accoun for each commercial bank wih he cenral bank. In his conex i is imporan o noe ha he lieraure uses wo differen definiions of serilizaion which depend on he domesic operaing arge of he cenral bank. If a cenral bank uses he moneary base as is operaing arge, serilizaion means ha he amoun of moneary base is no affeced by inervenions. Based on his definiion he esimaion presened in Table 6 was made. If a shor-erm ineres rae (overnigh rae, one or hree monh rae) serves as he domesic operaing arge, serilizaion has o guaranee an unchanged level of his rae. As almos all cenral banks in he world use he ineres rae as heir domesic operaing arge, we will use he second definiion of serilizaion. A firs sigh boh definiions seem almos idenical, bu in he siuaion of shocks o he domesic money marke, he wo conrol opions lead o very differen resuls (Bofinger 2001). 5 The lagged values of NDA were included o capure oher effecs han he serilizaion policy of he cenral banks. The daa is monhly and all aken from he IFS (lines 11 o 17). 24

32 Many economiss are in doub wheher serilized inervenion can have a direc effec on he exchange rae since wih such inervenions he relaive domesic money supplies remain consan. For insance Rosenberg argues: According o he moneary approach o exchange rae deerminaion, cenral bank inervenion ha does no aler he supply of money relaive o he demand for money will no have a percepible impac on exchange raes. (Rosenberg 1996, p. 298) 6 For an undersanding of serilized inervenion i is necessary o describe in more deail he ransacions and heir impac on he balance shees of he cenral bank, commercial banks and non-bank invesors. We sar wih a siuaion where a euro area commercial bank (CB) holds 100 reserves wih ECB which i has obained via a repo credi. A he same ime a euro area invesor (IN) holds a 100 $ deposi wih a Unied Saes commercial bank (CB$). We neglec from minimum reserves and assume ha he dollar/euro exchange rae is 1:1. 1 s round (inervenion): We now assume ha he invesor wans o exchange his dollar deposi ino a euro deposi. For his purpose he sells he deposi o CB which in urn sells i on he foreign exchange marke. We assume ha he ECB inervenes and purchases he dollar deposi from CB. The counervalue of he deposi is credied o he CB s accoun wih he ECB. Thus, he euro reserves increase. 2 nd round (serilizaion): The ECB serilizes he inervenion by reducing is repo credis o CB. As a resul, he moneary base in he euro area and in he Unied Saes (which we do no need o presen) has remained unchanged. The foreign deposis wih CB$ have also no changed, bu he ECB has become a deposior insead of IN. Thus, he dollar deposis held by non-cenral banks have declined. A he same ime, he euro deposis held by non-banks wih he CB have increased. In oher words: even wih consan moneary base in boh areas, he relaive amoun of deposis held by he public have changed. This has been compensaed by he ECB which holds more dollar asses and less euro asses since i has reduced is euro denominaed repo credis. 6 See also Samo and Taylor (2001, p. 6) 25

33 Thus, wih serilized inervenions a cenral bank eners an open posiion he foreign currency a long posiion if i purchases foreign exchange, a shor posiion if i sells foreign exchange. Seen from his perspecive serilized inervenion implies a cerain commimen by a cenral bank since in boh cases he risk of he open posiion is a leas parially deermined by he cenral bank s own acions. In he case of an appreciaing currency, he cenral bank runs he risk ha he domesic value of is foreign exchange reserves is reduced by an appreciaion of he domesic currency which he cenral bank is able o preven. In he case of a depreciaing currency he opposie applies bu he budge consrain of foreign exchange reserves makes he commimen less binding. As hese porfolio adjusmens are he driving force of serilized inervenions, he lieraure obviously suffers from an incorrec idenificaion of he relaive moneary bases wih he relaive amoun of deposis held by he public in he wo currencies. A very common assumpion in his regard is he assumpion of a perfec subsiuabiliy beween asses denominaed in differen currencies. In he words of Samo and Taylor (2001, p. 27): (...) i is emping o conjecure ha he porfolio balance channel will diminish in imporance over ime a leas among he major indusrial counries as inernaional capial markes become increasingly inegraed and he degree of subsiuabiliy beween financial asses denominaed in he major currencies increases. While his seems plausible for risk-neural invesors, i does no hold if invesors are risk-averse. The very fac ha invesors incur ransacions for exchanging a dollar deposi ino a euro deposi indicaes ha he wo asses are no regarded as perfec subsiues. Wih a perfec subsiuabiliy of dollar and euro asses i would be also difficul o explain he huge rading volume on foreign exchange markes. Why should banks rade asses of abou 2 billion dollar per day if hey are complee subsiues? In oher words, increasing capial mobiliy does no mean ha he asses raded are subsiues. On conrary, large capial flows are an indicaion ha invesors see imporan qualiaive differences in asses ha are denominaed in differen currencies or issued by debors from differen regions. 26

34 4.1.3 How can he coss of serilizaion be avoided Thus, we have shown ha a cenral bank is always able o avoid an unwarraned appreciaion of is currency wihou losing conrol over he domesic ineres rae. The remaining problem are he S coss of serilizaion ( C ). These coss ha are supposed o occur in period (defined per uni of domesic currency ha is supplied in inervenions in period -1) are made up of wo componens: he ineres rae coss (or earnings) ( C ) and he valuaion losses (or reurns) from foreign exchange reserves ( C ): V i (9) S i V C = C + C. The ineres rae componen of serilizaion is deermined by he difference beween he foreign and he domesic ineres rae: (10) C i 1 * 1 = i i. This is due o he fac ha a serilized inervenion ha ries o preven an appreciaion leads o an increase in foreign asses and a decrease in domesic asses; in he case of a deposi faciliy or he issuance of noes, domesic liabiliies increase. Thus, he cenral bank loses income from domesic asses (or has o pay ineres on domesic liabiliies) while i receives addiional income from an higher amoun of foreign asses. I is obvious ha serilized inervenions are associaed wih ineres coss (reurns) if he domesic ineres rae is higher (lower) han he foreign ineres rae. The valuaion coss (reurns) per uni of serilizaion depend on he percenage change of he exchange rae which we express by he difference of he log of he nominal exchange rae: C V = s s = s. (11) ( 1) If he domesic currency depreciaes, he value of foreign exchange reserves in erms of he domesic currency increases. The cenral bank makes a profi from serilized inervenion. Boh cos componens can be combined in order o define condiions under which serilized inervenions are free of charge:! S * (12) C 0= i i ( s s ) =, which leads o he ex pos formulaion of he ineres pariy condiion: 27

35 (13) ( ) * s s = i i In oher words, he coss of serilized inervenion are zero if a cenral bank arges he exchange rae in a way ha i follows a pah ha is deermined by he ineres rae differenial. This guaranees a he same ime ha here are no profi opporuniies for shor-erm oriened invesors which inves in he domesic currency. If he domesic ineres rae is higher han he foreign ineres rae his advanage is fully compensaed by a depreciaion of he domesic currency. Thus he condiion of zero coss for serilized inervenions is he mirror image of he condiion ha he mix of exchange rae and ineres policy should no provide profi opporuniies for shor-erm oriened invesors. In fac, he profis of hese invesors are o a large exen nohing else bu he serilizaion coss paid by he cenral bank Scope and limis of exchange rae argeing In sum, he exchange rae can argeed by he cenral bank wihou a budge consrain, wihou coss and wihou negaive side effecs on ineres rae policy, if he domesic currency is appreciaing vis-à-vis he foreign currency, is serilizaion poenial is unlimied, which can be arranged by offering a deposi faciliy, he argeed exchange rae pah is compaible wih he prevailing ineres rae differenial. A conrol over he exchange rae is more difficul, if a cenral banks ries o counerac a depreciaion and/or if i follows exchange rae pahs ha are associaed wih high serilizaion coss e.g. if he domesic currency is kep sable alhough he domesic ineres exceeds he foreign ineres rae. The limis of exchange rae argeing are reached in a siuaion wih srong capial ouflows ha can occur even hough he argeed exchange rae is compaible wih he prevailing ineres rae differenial. This can happen if he expeced depreciaion of he domesic currency exceeds he depreciaion ha is argeed by he domesic cenral bank. When he foreign exchange reserves are exhaused, a cenral bank has o abandon is argeed exchange rae pah. We will furher discuss his issue in Chaper As far as domesic commercial banks receive deposis denominaed in he domesic currency and gran credis in he foreign currency, hey also pay for he profis of shor-erm oriened invesors. 28

36 4.2 Inernal and exernal equilibrium under exchange rae argeing We have shown ha a cenral bank is o a cerain degree able o conrol he exchange rae ogeher wih domesic ineres rae. The ineresing quesion for a normaive heory of managed floaing is how o combine hese wo operaing arges of moneary policy. A useful saring poin is he logic of he Mundell-Fleming model. I is designed for idenifying combinaions of fiscal policy, moneary policy, and exchange rae policy 8 ha allow he simulaneous achievemen of inernal and exernal equilibrium. Inernal equilibrium is defined as an oupu level ha implies full employmen. Exernal equilibrium is defined as a siuaion where he cenral bank s foreign exchange reserves remain consan. In he Mundell-Fleming model, capial mobiliy implies ha he domesic ineres rae equals he foreign ineres rae. In oher words, exernal equilibrium is reached if he domesic ineres rae policy is compaible wih UIP since he expeced exchange rae change E[ s ] equals by assumpion always zero. For a heory of managed floaing his basic logic can be also applied. In oher words, he policy insrumens have o be se in order o allow a simulaneous achievemen of inernal and exernal equilibrium. The main difference o he Mundell-Fleming model is ha in he laer here are hree policy insrumens: he exchange rae, he ineres rae, and fiscal policy. While i may be ineresing o develop a model o includes all hree insrumens, for he sake of simpliciy i is useful o discuss a model ha deals wih he ineres rae and he exchange rae only. Thus, we will show how he exchange rae and he ineres rae have o be argeed in order o achieve boh equilibria. In his sense, our model is limied o moneary policy aspecs, and accordingly he sraegy of managed floaing has o be inerpreed as a comprehensive moneary policy sraegy wihin he wo exreme cases of absoluely fixed and independenly floaing exchange raes Inernal equilibrium In order o derive he inernal equilibrium condiion, we sar wih he ransmission channels of moneary impulses in a small open economy. For he conduc of moneary policy i is imporan o differeniae beween wo channels: he exchange rae channel and he ineres rae channel (see Svensson 2000). 8 Remember ha he Mundell-Fleming model only capures he wo polar cases of eiher compleely fixed or independenly floaing exchange raes (see Chaper 3.1). 29

37 Wih he ineres rae channel, moneary policy affecs aggregae demand via is effec on he shor-erm real ineres rae (and possibly on he availabiliy of credi). Subsequenly, aggregae demand affecs inflaion via he supply-side of an economy which is ofen described by a Phillips-curve relaion. In his respec we follow he curren mainsream in moneary macroeconomics according o which he money sock only plays a minor role in describing moneary policy effecs (see Romer 2000 for an illusraive paper). Moneary policy is hus assumed o follow an ineres rae policy raher han a money supply policy. We will come back o his issue a he end of his Chaper. The exchange rae channel can be divided ino a direc and an indirec channel. The direc channel explains inflaion flucuaions via he pass-hrough of exchange rae flucuaions o impor prices. The inflaion rae of a small open economy π (measured by consumer price inflaion) wih a share of impored goods ω is a weighed sum of domesic inflaion π d and impored foreign inflaion (expressed in domesic currency erms) d f (14) = ( ω) π + π. 1 ωπ f π : The foreign inflaion * π is assumed o be ransmied o domesic inflaion via changes of he exchange rae s : f * (15) π = π + s. Insering equaion (15) ino equaion (14) finally describes he direc exchange rae channel in a simple way: d * (16) = ( 1 ω) π + ω( π + s ) π. Indirecly, a change in he real exchange rae affecs he relaive price beween domesic and foreign goods, which in urn has an impac on boh, domesic and foreign demand for domesic goods, and hence conribues o he aggregae demand channel for he ransmission of moneary policy. From sandard macroeconomics we know ha he naional income Y can be separaed ino consumpion C, invesmen I, governmen purchases G, and ne expors NX: * (17) Y C( Y ) + I( Y, r ) + G + NX( Q,Y, Y ) =. 30

38 The inclusion of ne expors exends a closed economy analysis (where cenral moneary policy variable is he real ineres rae r which deermines planned invesmen) o he open economy. 9 The key deerminan of ne expors is he real exchange rae Q (18) S P * Q = P, where S is he nominal exchange rae and P P is he price of foreign (impor) goods in * relaion o (home) expor goods. Sandard exbooks in moneary economics now reduce he definiion of aggregae demand o he relevan variables r and Q. I is common o adop a relaionship ha is linear in hese wo variables. We herefore solve our aggregae demand equaion for oupu and wrie i in logarihms (excep for he real ineres rae). This finally yields he following open economy IS funcion: (19) y = δ δ r + δ q + ε D y is he log of oupu, q he log of he real exchange rae, and ε D a random whie noise disurbance (demand shock) which capures shocks in domesic governmen spending, domesic saving and invesmen behavior, and foreign income. The parameer δ 0 incorporaes all auonomous componens of aggregae demand. δ 1 is he ineres rae elasiciy of aggregae demand, and δ 2 he exchange rae elasiciy. All hree parameers are assumed o be posiive. Alhough mos ofen inroduced ha way, for our purposes he IS equaion (19) suffers from is inabiliy o capure he effecs of exchange rae changes which is cenral for a heory of managed floaing. For his reason we modified he IS funcion as follows. Due o he flow characer of aggregae demand, he ime subscrip refers o a period of ime, say a quarer of a year. Thus, for quanifying how much aggregae demand is affeced by he real exchange rae, i is imporan o ake ino accoun he percenage change of he real exchange rae q from he beginning of he period o is end, and he average level of he real exchange rae q during ha period. Accordingly, a modified descripion of he IS funcion in an open economy is given by 9 Anoher deerminan is real income abroad ( Y ). * 31

39 (20) y = δ δ r + δ q + δ q + ε D In a nex sep, o ge an expression for he oupu gap from boh sides of equaion (20): y~, we subrac he naural rae of oupu ŷ (21) y~ = y ŷ = δ δ r + δ q + δ q ŷ + ε D This allows us o eliminae he neural componens of aggregae demand, i.e. hose which are deermined by (long-run) facors oher han moneary policy ones: (22) = δ δ rˆ + qˆ, ŷ 0 1 δ3 where rˆ denoes he neural real shor-erm ineres rae and qˆ is he log of he neural real exchange rae. Thus, he oupu gap in equaion (21) can be wrien as D (23) y~ δ ( r ) + δ q + δ ( q ) + ε = rˆ qˆ For he sake of simpliciy, we now normalize rˆ o zero. qˆ is assumed o adop he value of q so ha we arrive a he final definiion of he oupu gap: (24) y~ = δ r + δ q + ε. 1 2 D The reason for he differen reamen of he neural values will be explained in he nex paragraph Measuring he acual moneary policy sance: he concep of he acual MCI (MCI ) If one aims a concenraing on he demand-side effecs of moneary policy (ineres rae channel and exchange rae channel), a comprehensive measure of he acual policy sance of he cenral bank s wo operaing arges is provided by he so-called Moneary Condiions Index (MCI) which can be defined in a simple form as follows: (25) MCI = δ 1 r - δ 2 q. If he moneary policy sance is abou o ighen, he MCI rises, and in he opposie case, he index falls. Wih posiive elasiciies δ 2 and δ 2, a igher MCI can be achieved by raising he 32

40 ineres rae, by a real appreciaion, or by a combinaion of boh. 10 In paricular, we refer o his MCI as o he acual MCI (wih he subscrip ) as i perfecly reflecs he acual moneary policy sance. In conras o he MCI ha Ball (1999b) uses in his paper (see also Chaper 3.2) our index is a linear combinaion of he real shor-erm ineres rae r and he change of he real exchange rae q. The reasoning behind his modificaion can be explained as follows: Firs, as already poined ou by McCallum (1999) who defined he MCI in a similar way, i can be argued ha, in order o ge a dimensionally coheren definiion of he MCI, he level of he real exchange rae q is no an adequae measure as i does no refer o a period of ime (like ineres raes do). This poin becomes even more obvious when he real variables are ransformed ino heir nominal counerpars. For he level of he real exchange rae i suffices o know he acual price level (see equaion (18)), whereas he change in he real exchange rae has o be ransformed ino s via he inflaion rae, similar o wha he Fisher equaion posulaes for ineres raes (see equaions (45) and (46) in Chaper 4.3). Second, various economeric sudies show ha q and r are of differen orders of inegraion. While r is a saionary variable, q is generally found o be inegraed of order one. Here again, coherence is required o avoid undesirable properies of he MCI (see Eika e al. 1996, p. 784 who emphasize his poin). Thus, he firs difference of he real exchange rae variable seems o be a more suiable measure of he exchange rae channel. Of course his formulaion of he MCI neglecs he fac ha, for example, an already overvalued real exchange rae sill has effecs on aggregae demand even hough i remains unchanged. Hence, by seing qˆ equal o q, we always assume ha our moneary policy analysis sars in a siuaion where he real exchange rae is on is neural level. As a compromise he empirical lieraure on aggregae demand in small open economies ofen uses a relaively long wih up o eigh quarers. The coefficiens δ 1 and δ 2 are equal o he esimaed effecs of hese wo financial variables on aggregae demand, and hence, on inflaion (for a comprehensive overview of he use of MCIs see Mayes and Virén 2000). The MCI is hus condiional on he srucural characerisics and on he underlying model of he economy. 10 Noe ha a negaive change in he real exchange rae is a real appreciaion. Of course cenral banks are only able o direcly conrol he nominal values of heir operaing arges i and s. Bu under he imporan assumpion of price sickiness, r and q are perfecly correlaed wih heir nominal counerpars i and s, he operaing arges of he cenral bank. We will furher discuss his issue in Chaper

41 Deriving he opimal moneary policy sance: he concep of he opimal MCI (MCI op ) For he moneary policy maker i is now crucial o know which acual MCI (MCI ) he has o realize. The purpose of his Chaper is o derive he opimal moneary policy sance. We asume a model of a small open economy similar o he one applied by Gerlach and Smes (2000) where he so-called opimal MCI ( MCI op ) is he resul of he minimizaion procedure of an ineremporal loss funcion. The behavior of he privae secor is described wih wo equaions: (26) ( ) S y~ p + ε = β p E 1 (27) y~ = δ r + δ q + ε. 1 2 D Equaion (26) is a simple Phillips curve relaion for he supply side wih a random whie noise disurbance S ε (supply shocks). y~ denoes he oupu gap and he erm in brackes is he deviaion of he acual price level from he expeced price level. Equaion (27) describes he demand side of an economy wih a radiional IS relaion. ε D is again a random whie noise disurbance (demand shock). Equaing (26) and (27) and solving for a linear combinaion of r and q defines an expression for he real MCI as inroduced in equaion (25): D S (28) r δ q = MCI = ( ε ε ) β( p E ) δ p To simplify hings, we divide equaion (28) by δ 1 and we replace δ 2 /δ 1 by δ: 11 D S (29) r δ q = MCI = 1 δ ( ε ε ) β δ ( p E p ). 1 1 The opimal MCI is hen generaed hrough he minimizaion of a cenral bank s loss funcion which is given by S 2 T (30) L χ ( ε ) + χ ( π π ) 2 =. ~ 1 y 2 π T is he inflaion arge se by he cenral bank. χ 1 and χ 2 denoe he relaive weighs assigned o oupu deviaions from equilibrium and inflaion deviaions from arge. Wih he firs-order condiion of equaion (30) and a few assumpions (full informaion and raional expecaions) Gerlach and Smes derive he following expression for he price forecas error 1 34

42 T T (31) p E p = γ( π E π ) 1 1, 2 where γ = χ ( χ β + ) MCI: 2 1 χ2. 12 Insering equaion (31) ino equaion (29) finally yields he opimal op D S T T (32) MCI 1 δ ( ε ε ) ( βγ) δ ( π E π ) = According o equaion (32) he opimal MCI changes due o changes of he parameers on he righ-hand side of he equaion. Accordingly, if he opimal MCI shall be exogenous o he moneary auhoriies, hen we have o assume ha heir inflaion arge is fully credible so ha T T π E π = 0. Thus, he opimal MCI depends solely on real shocks affecing he economy The inernal equilibrium rule The inernal equilibrium condiion can finally be described as follows:! op D S T T (33) r δ q = MCI = MCI = 1 δ ( ε ε ) ( βγ) δ ( π E π ) 1 In oher words, he MCI serves as combined measure of he moneary policy sance which has o be conrolled and adjused in response o changing macroeconomic condiions. As a simple rule he acual MCI shall rise (he moneary policy sance becomes more resricive) if he domesic economy is affeced by excess demand shocks (he opimal MCI rises); in he opposie case, when he domesic economy signalizes deflaionary pressures (he opimal MCI declines), he acual MCI shall decline (he moneary policy sance becomes more expansionary). The domesic consrain o moneary policy herefore is he sric observaion of his rule, independenly of he exchange rae regime chosen. A deviaion from his rule leads o eiher an overheaing or a recession of he domesic economy. 1 1 The idea behind such a rule is similar o he well-known and widely acceped moneary policy rules for closed economies. This ype of rules is mosly formulaed in erms of a shor-erm (real or nominal) ineres rae. A common feaure is ha he opimal ineres rae policy of a cenral bank responds posiively o oupu gaps and deviaions of he inflaion rae from is arge value (for a heoreical derivaion see Ball 1999a and Svensson 1997; for an empirical applicaion see 11 Noe ha he MCI in equaion (29) formally differs from ha in equaion (28) (by a facor δ 1 ). Bu as he MCI is an index, is informaion conen is resisan o linear ransformaions. We herefore hold on using he expression MCI and keep in mind ha from now on we refer o he definiion in equaion (29). 35

43 Clarida e al. 1998). For our purpose, i is sufficien o reduce he rule o a linear equaion which is given, in a general form, as follows: op T (34) r f ( π, ) = + a( π π ) + b = y~ rˆ ~ y, where rˆ represens he equilibrium (or neural) real ineres rae, and he coefficiens a and b incorporae srucural parameers of he economy as well as he moneary policy maker s weighs χ 1 and χ 2 (see equaion (30)). 13 Transforming our open economy rule of equaion (33) ino a rule similar o he closed economy formulaion of equaion (34) yields op T (35) MCI f ( π, ) = MĈI + a( π π ) + b = y~ ~ y. Such a ransformaion is allowed as long as one assumes ha he real shocks ε D and ε S of equaion (33) are refleced in oupu gaps unequal zero and/or deviaions of he inflaion rae from is arge value. As he MCI is simply an index, he neural level MĈI can be se o zero. The major difference o a closed economy rule is hus he exension of he cenral bank s insrumens by inervenions in he foreign exchange marke, and consequenly, he consideraion of a double-operaing-arge framework Exernal equilibrium For he discussion of he exernal equilibrium in an open economy we assume free capial mobiliy. This assumpion can be jusified wih he very weak evidence for he effeciveness of capial conrols (see Ariyoshi e al. 2000) and wih he high allocaive and adminisraive coss of a comprehensive sysem of capial conrols. As already menioned, in such a world of free capial mobiliy he exernal equilibrium is characerized by an equilibrium in he balance of paymens which means ha he curren accoun is fully financed by he capial accoun so ha he foreign exchange reserves of he cenral bank remain consan. Tha is o say, foreign exchange marke inervenions by he cenral bank do no occur. In he following we will derive he condiion under which his equilibrium holds. We will furher see ha each ime when deviaions ake place here is a case for foreign exchange marke inervenions of he cenral bank. For his 12 See Appendix 4: Derivaion of he opimal MCI based on he minimizaion of a cenral bank s loss funcion. 13 The mos famous ype of his kind of rules is he Taylor rule where he coefficiens a and b are supposed o be equal o

44 purpose i is imporan o ake a deeper look a he behavior of he wo major paricipans of he foreign exchange marke: he privae invesors and he domesic cenral bank The privae invesor s exernal equilibrium The privae secor s equilibrium condiion is capured by he well-known uncovered ineres pariy: (36) i = i * + E[ s ] + α. According o UIP, in equilibrium he reurn on domesic invesmen i equals he expeced reurn on foreign invesmen which iself is he sum of he foreign ineres rae i *, he expeced exchange rae change E[ s ] and, depending on he underlying moneary and exchange rae regime, a ime-varying risk premium α. If his condiion is me, privae marke paricipans should be indifferen beween he domesic and he risky foreign invesmen. Hence, shor-erm 15 capial flows do no occur The cenral bank s exernal equilibrium The equivalen of he privae invesor s arbirage condiion is he cenral bank s zero-coscondiion. In Chaper 4.1 we explained he mechanics of serilized foreign exchange marke inervenions. One basic resul was ha if cenral banks wan o make independen and efficien use of he shor-erm ineres rae and he exchange rae as operaing arge, he coss of serilizaion have o be zero. This led o he ex pos ineres pariy condiion which we formulaed in equaion (13). By augmening he ime subscrip by 1 we can now derive he cenral bank s exernal equilibrium condiion: (37) i i = s. * T 14 We will see laer on ha he foreign cenral bank also has an imporan impac on our equilibrium condiions, mainly by seing he foreign shor-erm ineres rae i *. Bu as his will be reaed as being exogenous o he domesic cenral bank s policy decision, i is sufficien o concenrae on hese wo paricipans. 15 In our conex he shor erm refers o a period of one or a mos hree monhs which corresponds o he mauriy of he ineres raes ha is normally assumed o be under he conrol of he cenral bank. 37

45 According o equaion (37) he cenral bank arges an exchange rae pah ( T s ) ha is equal o he difference of he domesic ineres rae i (se by he cenral bank as well) and he exogenous foreign ineres rae i * The overall exernal equilibrium and he cenral bank s inervenion response funcion The overall equilibrium condiion can be obained by insering equaion (36) ino equaion (37): T (38) s = E[ s ] + α. Tha is o say, if he cenral bank s argeed exchange rae pah equals he privae secor s expeced exchange rae change plus he acual risk premium, hen here is no need for he cenral bank o inervene in he foreign exchange marke, and he balance of paymens is in equilibrium as defined in he inroducion of Chaper Oherwise, here is a case for cenral bank inervenions. Two basically differen siuaions have o be disinguished: In he firs case, privae invesors expec o make a surplus hrough an invesmen in he domesic economy which leads o capial inflows. The sum of he privae secor s expecaions abou he fuure exchange rae pah and he required risk premium are more han compensaed by he given acual ineres differenial and he given acual spo rae: i i = s > E s + α. * T (39) [ ] The cenral bank now inervenes in he foreign exchange marke in order o absorb he excess supply of foreign exchange. This guaranees ha he cenral bank achieves he desired exchange rae pah T s. A he same ime, i is able o keep he ineres rae a is level i because of he immediae serilizaion of he accumulaed foreign reserves. I is imporan o underline ha in his case he cenral bank is neiher resrained by is sock of foreign reserves (he bank is able o buy unlimied amouns of foreign reserves) nor by any coss of serilizaion (by achieving he bank perfecly fulfills he zero-cos-condiion). T s, The second case is characerized by capial ouflows which can be described as follows: i i = s < E s + α. * T (40) [ ] 38

46 The acual ineres rae differenial does no compensae for he expeced exchange rae change and he required risk premium, and hence, inernaional invesors prefer he foreign invesmen. As he cenral bank s objecive is o realize T s, i has o sell foreign asses in order o saisfy he excess demand for foreign exchange. Here again, he serilizaion issue is no a problem as long as he desired exchange rae pah is achieved. Bu in conras o he firs case (he capial inflow case), now he cenral bank is resrained by is sock of foreign reserves. In Chaper we labelled his he hard budge consrain. Bu his does no mean ha he cenral bank is no able o realize T s a all. As long as is reserves exceed a criical hreshold, say NFA c, he cenral bank can credibly achieve he desired pah hrough serilized inervenions. Bu as soon as he curren sock of foreign reserves is perceived as oo low by he inernaional invesors, capial ouflows will accelerae and he cenral bank looses is inervenion insrumen. In sum, serilized foreign exchange marke inervenions can be described by he following implici funcion: ( α ) T (41) I NFA = f s E[ s ] =, where f(0) is equal o zero and where he firs derivaive f is always posiive. Theoreically, I can adop values ranging from NFA c o infiniy. Thus, equaion (41) complees our flow channel analysis of foreign exchange marke inervenions in Chaper In mos of he cases described above (he capial inflow case, he case wihou inervenions, and he capial ouflow case wih sufficien foreign reserves) he cenral bank is able o realize is exernal equilibrium: (42) i i = s. * T We call his he conrol siuaion. There is only one case in which he cenral bank looses he conrol over is operaiong arge: he capial ouflow case wih foreign reserves falling below a criical hreshold. In his siuaion which we call ou-of-conrol siuaion, he cenral bank is no longer able o arge he exchange rae hrough serilized inervenions. I raher has o adjus is ineres raes in order o sop he capial ouflow. This adjusmen can be achieved by eiher reducing he domesic par of he moneary base, or by non-serilized foreign exchange marke inervenions which lowers he foreign par of he moneary base. Independenly of how 39

47 domesic ineres raes are raised, he exernal equilibrium condiion in he ou-of-conrol siuaion becomes (43) i = i * + E[ s ] + α. We will furher discuss he consequences of his siuaion for he overall moneary policy sraegy of managed floaing in he end of he nex Chaper. Figure 6 summarizes again he major relaionships underlying he exernal equilibrium of our sraegy. Figure 6: The exernal equilibrium * privae invesors: i i = E[ s ] + α cenral bank: i i * = s T i * T * T * T i = s > E[ s ] + α i i = s = E[ s ] + α i i = s < E[ s ] + α capial inflows I = NFA > 0 no inervenions I = NFA = 0 capial ouflows I = NFA < 0 NFA < NFA c NFA < NFA c i * T * i = s i i = E[ s ] + α conrol siuaion ou-of-conrol siuaion 4.3 A moneary policy framework for small open economies In he following we develop a simple policy framework for managed floaing which is based on he dual requiremen of inernal and exernal equilibrium. Is main srucure is presened in Figure 7. I shows he insrumens, he operaing arges and he final arges of moneary policy. While he exernal equilibrium is by iself no a final arge of moneary policy, one can assume ha a violaion of his condiion will lead o a currency crisis and hus o oupu losses in he fuure. 40

48 Figure 7: Moneary policy in small open economies inervenions in he foreign exchange marke inervenions in he domesic money marke s q i r MCI UIP inernal equilibrium exernal equilibrium Our framework is a ypical example for he analysis of economic policy by Tinbergen (1952) who has shown ha in order o mee wo independen arges wo insrumens are required ha need o be efficien and independen from each oher. This framework can now be analyzed wih a very simple se of equaions: The wo equaions for exernal and inernal equilibrium have o be solved for he wo policy variables: he nominal ineres rae and he arge pah for he nominal exchange rae. For reasons of simpliciy we omi he T superscrip for he exchange rae arge since for he ineres rae arge his is also no he common pracice. Moreover, for he momen, we only analyze siuaions where he exchange rae pah and he ineres rae are under perfec conrol of he cenral bank. The oher case, when he cenral bank runs ou of foreign reserves, is discussed in deail in he end of his Chaper. Inernal equilibrium is defined by a combinaion of he wo operaing arges ha generae he opimum MCI which has been derived as menioned above: op (44) MCI = r δ q. 41

49 Using he definiion of he real exchange rae (variables for he foreign counry are marked wih an aserisk) (45) q = q + 1 q = s + π π and he Fisher equaion * (46) r = i π and * r = i * π * we can show how he wo operaing arges have o be se in order o generae he opimum MCI: op * (47) MCI ( i π ) + δ( s + π π ) =. Exernal equilibrium is defined by equaion (48) which also has o be me by he seing of he operaing arges: (48) s = s + s = i i. 1 * All variables in hese wo equaions wih he excepion of he wo operaing arges (i and s ) are eiher exogenous or predeermined. For he framework of managed floaing which applies above all o smaller counries, i is obvious ha he domesic cenral bank has no influence on he * * * foreign variables ( i, π, r ). The same applies o he srucural parameer of he domesic economy (δ) a leas in he shor-run. We assume ha in he shor-run π is predeermined because of price rigidiies. Finally, a he level of operaing arges he opimum MCI which has been derived according o equaions (32) and (35) can also be regarded as an exogenous variable. Wihin he limis discussed in he previous Chaper he insrumen variables of moneary policy (i and s ) are direcly conrollable by he cenral bank. Wih equaions (45) and (46) and he assumpion of shor-erm price rigidiies, we can also consider heir real counerpars r and q as insrumens. The model which consiss of he wo equaions for inernal and exernal equilibrium can now be solved for he opimum values of he wo operaing arges. This can be obained by insering equaions (45), (46) and (48) ino equaion (44) which yields he opimum MCI ha is compaible wih he exernal equilibrium condiion: op * (49) ( ) ( ) MCI = 1 δ i 1 δ π + δr. 42

50 From his we can calculae he opimum ineres rae: 1 =. 1 δ op * (50) i ( MCI δr ) + π Insering equaion (50) ino equaion (48) and solving for s yields an MCI dependen expression of he policy rule for he second insrumen: 1 s = MCI r + π π. 1 δ op * * (51) ( ) Thus, our model provides wo simple rules for he choice of he operaing arges under a sysem of managed floaing. I shows ha he wo domesic policy variables are deermined by he required degree of moneary policy resrain according o op MCI, he real ineres rae in he anchor currency counry (or in he baske currency counries), he domesic inflaion rae, and he srucural parameers of he economy. The arge pah for he exchange rae is addiionally dependen on he foreign inflaion rae (or he inflaion differenial) vis-à-vis he anchor counry. The wo equaions show ha he sign wih which he opimum MCI and he foreign real ineres rae influence he wo operaing arges depends on he value of he srucural parameers δ. Is concree value depends on he relaive weigh of he ineres rae and he exchange rae channel in an open economy. Empirical esimaes show ha in mos cases δ 1 exceeds δ 2 (hus δ<1) while he opposie holds only for very small economies (δ>1) (see Mayes and Virén 2000 and he lieraure cied here). Thus, for he sandard cases, he nominal ineres rae has o be increased wih he opimum MCI, he domesic inflaion rae, and reduced wih he foreign real ineres rae; he nominal exchange rae has o be depreciaed ( s >0) wih he opimum MCI, he domesic inflaion rae, and appreciaed ( s <0) wih he foreign real ineres rae and he foreign inflaion rae. The laer is he mos imporan resul of his simple model. I shows ha he opimum exchange rae sraegy is a policy where he exchange arge pah is deermined on a ongoing basis 43

51 depending on he domesic and foreign deerminans of equaion (51). In oher words, managed floaing as a sraegy where he cenral bank arges he exchange rae along a non-announced and adjusable pah is exacly he opimum approach ha is required o achieve inernal and exernal equilibrium in a world of capial mobiliy. A somewha confusing resul is he sign of he firs parial derivaives of i and s wih respec o * r : (52) i r * = δ 1 δ ; (53) s r * 1 =. 1 δ This shows ha he effec of a change of he foreign real ineres rae depends on he size of he srucural parameer δ. If δ<1, which seems o be he case for mos counries, a decline of he foreign real ineres rae requires a change in he policy wih a higher domesic ineres rae and a sronger argeed depreciaion of he domesic currency. For insance, in he case of he srong reducion in he dollar real ineres rae in 1992/1993 he Asian counries should have reaced wih a higher argeed depreciaion of he currencies (which would have implied ha he de faco fixed pegs had o be abandoned) while raising he domesic ineres rae. This change in he policy mix would have allowed hem o mainain a consan opimum MCI. The opimum moneary policy response is more difficul o implemen in he case of a more han emporary increase of he foreign real ineres rae. In order o mainain a given MCI, his would require a shif o lower ineres raes and o an appreciaion or a reduced depreciaion of he domesic currency. Bu his policy response is limied by he cenral bank s sock of foreign reserves. Thus, i could addiionally increase he risk premium which acceleraes he capial ouflow (see equaion (41)). In oher words, a counry could be forced o accep a policy mix ha sops he capial ouflow and ha resores exernal equilibrium by increasing he domesic ineres raes. In he preceding Chaper we called his an ou-of-conrol siuaion. To illusrae he overall macroeconomic consequences of such a siuaion, le us firs recall he opimal MCI ha can be achieved under perfec conrol: op * (54) ( ) 44 MCI = 1 δ r + δr.

52 The opimal ineres rae r, and hus he opimal nominal ineres rae i = r + π sricly fulfills he cenral bank s exernal equilibrium condiion: (55) i = i + s. * T The ou-of-conrol siuaion was characerized by he following exernal equilibrium condiion: ou * (56) i i + E[ s ] + α =, where ou i ypically exceeds he opimal i in order o sop he ongoing capial ouflow. The resuling MCI of he ou-of-conrol siuaion is finally defined by 16 ou ou * (57) MCI ( 1 δ) r + δr =. We can now compare he ou-of-conrol siuaion wih he opimal siuaion by simply subracing equaion (54) from equaion (57): ou op ou (op) (58) MCI MCI = ( 1 δ)( r r ). ou (op) This shows ha in general, wih ( r r ) > 0 and δ 1 an overly resricive MCI. <, he ou-of-conrol siuaion leads o 4.4 The advanages of managed floaing in comparison wih radiional exchange rae sraegies The advanages of managed floaing can be demonsraed if we use our model for an analysis of radiional exchange rae sraegies: fixed nominal exchange raes, an acive and a passive crawl and pure floaing. We proceed as follows. We assume ha a counry always ries o mainain exernal equilibrium. Thus, for each exchange rae sraegy we use he UIP equaion and calculae he required domesic ineres rae. Wih his rae and he exchange rae arge defined by he exchange rae sraegy we can calculae an acual MCI. I obvious ha he acual MCI in his conex is no necessarily idenical wih he opimum MCI ha we have used so far. Finally his exercise allows us o idenify he main deerminans of he acual MCI under differen exchange rae regimes and o show why no single currency regime is righ for all counries and a all imes (Frankel 1999) excep for managed floaing. 45

53 4.4.1 Absoluely fixed exchange raes For absoluely fixed exchange raes, he policy rule for he exchange rae is: (59) s = s or s =. The ineres rae rule is obained by using he UIP condiion of equaion (36). In a ypical fixed rae sysem here is no room for serilized inervenions, and hus, he cenral bank s exernal equilibrium is subordinaed o he privae secor s equilibrium condiion. Insering equaion (59) ino equaion (36)yields he equilibrium domesic ineres rae (60) i = α + r + π. * * The wo insrumen rules given in equaions(59) and (60) finally yield he acual MCI: fix * * (61) ( )( ) MCI = 1 δ π π + α + r. This shows ha under a sysem of fixed exchange raes he acual MCI is enirely deermined by facors ha are exogenous o he moneary auhoriies: he acual inflaion differenial, he risk premium, and he foreign real ineres rae. Of course, his policy mix does no guaranee ha he cenral bank achieves he opimal MCI which is irrespecive of he currency regime chosen. A general expression was derived in Chaper as follows: op T (62) MCI a( π π ) + b = ~ y. By subracing equaion (62) from equaion (61) we can now analyze siuaions in which he MCI of a fixed rae regime corresponds o he opimal MCI:! = fix op * * T (63) MCI MCI = ( 1 δ)( π π ) + α + r a( π π ) 0 by ~. For our calculaion of he MCI we have assumed ha he anchor currency cenral bank ses is nominal ineres rae according o he Fisher equaion. In realiy however, he nominal ineres rae can be higher or lower depending on he cyclical siuaion in he anchor counry. If we assume ha he anchor counry follows a real ineres rae rule for a relaively closed economy (see equaion (34) wih rˆ se o zero for simpliciy 17 ), equaion (63) becomes: 16 We assume ha he expeced exchange rae change E[ s ] yields a real exchange rae change q. 17 This simplificaion is analogous o he simplificaion ha he neural M ĈI is zero (see equaion (35)). 46

54 y~ by ~! = fix op * * * *T * * T (64) MCI MCI = ( 1 δ)( π π ) + α + a ( π π ) + b a( π π ) 0 where *T π is he inflaion arge of he anchor currency and * y~ is he log of is oupu gap. Based on his condiion, we can now examine wo siuaions where he fixed exchange rae sraegy seems o be an opimal sraegy in he sense of our opimaliy condiion presened in Chaper 4.2., A firs case can ofen be observed in counries ha are in he early sages of a sabilizaion program. As he inflaion differenial o he anchor counry is high, he cyclical componens of equaion (64) (he erms ha are proceeded by a*, b*, a or b) are of minor imporance. Accordingly, a sraegy of fixed exchange raes can be applied if δ exceeds 1, as long as here is a high risk premium. The condiion of δ>1 is only me in he case of very open and/or lile moneizised economies. Table 7 presens he degree of openness and he moneizaion of several counries ha adoped a fixed exchange rae regime in recen years. I is imporan o noe, however, ha equaion (64) also prescribes ha an exi sraegy is needed as soon as he risk premium declines faser han he inflaion differenial. Table 7: Srucural characerisics of fixed exchange rae regimes Dae of inroducion Inflaion rae in he year of inroducion Degree of openness Moneizaion Currency Boards Argenina 03/91 172% 5% 11% Esonia 06/ % 41% 30% Lihuania 04/94 72% 52% 26% Bulgaria 07/ % 48% 34% Fixers Czech Republic 12/90 57% (91) 42% (93) 70% (93) Mexico 11/91 23% 10% 25% Euro area 13% (99) 70% (99) Sources: IFS, EBRD (1999) The second case can bes be illusraed by he successful exchange rae policy of he Neherlands and Ausria in he 1980s and he 1990s which mainained a fixed exchange rae vis-à-vis he D- mark and which had similarly low inflaion raes as Germany. Accordingly we assume ha he 47

55 anchor counry and he small open economy have similar inflaion arges ( π *T = π T ). Moreover, he parameers a and b are also assumed o be similar in boh counries. This finally reduces equaion (64) o! = fix op * * (65) MCI MCI = ( 1 δ + a)( π π ) + b( ) + α 0 y~ y~. Under hese assumpions fixed exchange raes seem o be he opimal sraegy if here is no inflaion differenial, he counries have he same oupu gap, here is no risk premium. The firs wo condiions are perfecly me if he counries have relaively similar economic cycles and if hey are subjec o he same real disurbances. In his respec Ausria and he Neherlands wih heir srong economic ies wih Germany are good examples for a successful fixed peg. However, if one of hese condiions is violaed, hen counries have a real incenive o deviae from he rules prescribed by our moneary policy framework. In he Appendix (Appendix 5: A simple framework for he explanaion of currency crises) we show ha our model is able o capure hese macroeconomic reasons ha led o he oubreak of currency crises Crawling pegs A crawling peg sysem is characerized by he fac ha he pah of he exchange rae is deermined by a formula ha in mos cases includes he domesic and he foreign inflaion rae. In he case of an acive crawl he exchange rae pah is deermined by he difference beween a arge value for he domesic inflaion rae (π T ) and he acual foreign inflaion rae ( π ): * (66) T * s = π π. A passive crawl is defined by an exchange rae policy ha compensaes for he acual inflaion differenial: (67) s = π π. * Here again, he ineres rae rule is he sric observance of he privae secor s exernal equilibrium condiion. A crawling peg where he fuure exchange rae pah is ypically 48

56 preannounced is herefore under his respec quie similar o a fixed rae sraegy. For an acive crawl he acual MCI becomes acive T * (68) ( )( ) MCI = 1 δ π π + α + r. For a passive crawl he acual MCI is: (69) MCI = α + r. passive * Thus, we can see ha also under a crawling peg domesic moneary condiions are o a large exen deermined by he real ineres rae in he anchor counry. Again we can compare he acual and he opimum MCI:! = passive op * * *T * * T (70) MCI MCI = α + a ( π π ) + b a( π π ) 0 y~ by ~, y~ by ~! = acive op T * * *T * * T (71) MCI MCI = ( 1 δ)( π π ) + α + a ( π π ) + b a( π π ) 0 The main difference beween he fixed rae and he crawls is he em preceding. α which is * T ( 1 δ)( π π ) in he case of fixed exchange raes, 0 for he passive crawl, and ( 1 δ)( π π ) for he acive crawl Purely floaing exchange raes The currency crises ha occurred under fixed and crawling pegs have led many economiss o favor a sysem of flexible exchange raes. As pronounced by he floaing corner of he inconsisency riangle, he advanage of his sysem is ha ineres raes can be se auonomously. Thus, if he exchange rae behaved as prediced by economic heory (e.g. s = f (i, π,...), he degree of moneary resricion would be perfecly conrollable by he cenral bank s ineres rae policy. However, he experience wih freely floaing exchange raes since 1973 has led o he clear resul ha in he shor and medium-run here is no sysemaic relaionship beween economic fundamenals (however defined) and he developmen of he exchange rae. Isard (1995, p. 138) summarizes his evidence as follows: In shor, neiher he behavioral relaionships suggesed by heory, nor he informaion obained hrough auoregression, provided a model ha could forecas significanly beer 49

57 han a random walk. And furhermore, while he random walk model performed a leas as well as oher models, i prediced very poorly. In paricular, empirical sudies do no find any sysemaic relaionship beween he volailiy of exchange raes and he underlying fundamenal volailiy (see Flood and Rose 1995). For he conduc of moneary policy in a small open economy he unpredicable behavior of he exchange rae represens an imporan, bu random deerminan of is moneary condiions. 18 If we apply he insiuional seing of freely floaing exchange raes (i.e. no inervenions in he foreign exchange marke) ogeher wih he open economy aspecs of Chaper o our moneary policy framework, we ge he following MCI-based policy rule: op (72) r = MCI + δ q. The cenral bank ses he ineres rae according o changing domesic macroeconomic condiions ( MCI op, see equaion (35)), and he assumed relaionship beween ineres raes and exchange raes (see for example equaion (7) in Chaper 3.2). However, he crucial variable in equaion (72) is q. If he relaionship beween r and q is sable and predicable, hen he moneary policy makers have complee moneary auonomy, in he sense ha hey can always generae he moneary condiions ha are opimal. Oherwise, and somewha more realisic, he auonomy of independenly floaing exchange raes can be doubed. To show his we follow he lieraure and assume ha he exchange rae follows a random walk in he shor-run: (73) ~ q 1 = q + 1, + η + where η +1 is independenly and idenically disribued wih E[η +1 ]=0 and a consan variance 2 η Var[η +1 ]= σ. The ilde on q +1 signifies ha i is a random variable. Insering equaions (72) and (73) ino he basic MCI equaion yields he following expression for he acual MCI: ~ op (74) MCI r δ( q q ) = MCI + δ( q q + q ) = ~ 18 Noe ha one of he major failures of exchange rae heory is he well known fac ha real exchange rae movemens are largely deermined by nominal exchange rae changes. 50

58 Thus, he apparen advanage of an independen moneary policy is quesionable and decreases wih a rising impac of real exchange rae changes on domesic moneary condiions. Insead of achieving full conrol over he MCI, he acual MCI becomes a random variable for he moneary policy auhoriy ha has he following properies: op 2 2 (75) [ ] [ ] E MCI = MCI and Var MCI = δ σ. η Such an oucome can have differen implicaions for he conduc of moneary policy. If he cenral bank acceps he randomness of he MCI, his leads o a violaion of he inernal equilibrium since he opimal MCI is only achieved randomly. On he oher hand he cenral bank can also reac o changes of he acual MCI caused by exchange rae variaions. This requires ha he ineres rae is adjused so ha domesic equilibrium can be aained. Bu his implies ha he cenral bank has o give up is auonomous ineres rae policy. Alernaively, he cenral bank could emporarily adjus is inflaion arge (see equaion (32)). 19 Bu a discreionary deviaion of he inflaion arge from is long-erm value is only a synonym for he inabiliy of minimizing he cenral bank s loss funcion, and hence a violaion of he inernal equilibrium. 4.5 Overcoming he inconsisency riangle hrough managed floaing As already menioned, he inconsisency riangle posulaes ha a counry can only aain one side (i.e. one pair of aribues) of he riangle: capial conrols, fixed exchange raes or pure floaing. Bu i says nohing abou he possibiliy of adoping some sor of inermediae regime. Frankel (1999, p. 7) has menioned his flaw of he curren debae: There is nohing in exising heory, for example, ha prevens a counry from pursuing a managed floa in which half of every flucuaion in demand for is currency is accommodaed by inervenion and half is allowed o be refleced in he exchange rae. 19 This opion was perceived by he lieraure on inflaion argeing in open economies. Ball (1999b, p. 139) wries: In pracice, counries wih inflaion arges do no formally adjus for exchange raes in he way suggesed here. However, adjusmens may occur implicily. For example, a cenral-bank economis once old me ha inflaion was below his counry s arge, bu ha his was desirable because he currency was emporarily srong, and policy needed o leave room for he effecs of depreciaion. Unforunaely, auhors like Svensson and Ball never discuss he possibiliy of foreign exchange marke inervenions in cases of fundamenally no jusified deviaions of he exchange rae pah. This relucance seemingly sems from he convicion ha he sraegy of inflaion argeing is characerized by he abandonmen of radiional inermediae arges, and ha every aemp o arge a cerain kind of exchange rae or exchange rae pah would undermine his sraegy. 51

59 Our discussion has shown ha he soluion o he inconsisency riangle is no a halfway house beween half-sabiliy and half-independence. Insead an inegraed approach is required where he opimum ineres rae level and he opimum exchange rae pah are deermined simulaneously. Thus, managed floaing allows o conver he inconsisency riangle ino a consisency riangle wih he following hree corners: capial mobiliy, an auonomously deermined moneary condiions index and an exchange rae pah which follows he ineres rae differenial. Figure 8: Consisency riangle capial mobiliy exchange rae pah UIP moneary auonomy MCI = MCI op 4.6 Unresolved issues of managed floaing While managed floaing offers several imporan advanages compared wih radiional exchange rae sraegies, i is cerainly no a panacea which could solve all problems of he inernaional moneary order. The main weaknesses of his framework are he following: As he cenral bank does no announce an exchange rae pah, he exchange rae can no longer be used as an anchor for privae secor expecaions which is especially useful in he siuaion of a disinflaion. As a he conrol over he exchange rae is asymmeric, a cenral bank can lose he conrol over he macroeconomic siuaion if i is confroned wih very srong capial ouflows. As each cenral bank or governmen decides auonomously over he exchange rae, here is a serious risk ha managed floaing is misused for a beggar-my-neighbor policy which can undermine he aims of he WTO. 52

60 We will shorly discuss hese hree opics In search of a new anchor for privae secor expecaions In he 1980s moneary argeing and exchange rae argeing were regarded as ideal devices for esablishing a ransparen and credible moneary framework in larger and smaller currency areas respecively. As far as moneary argeing is concerned, many cenral banks decided o subsiue i by inflaion argeing as a more comprehensive sraegic approach (Bernanke e al 1999, Bofinger 2001). Our analysis of radiional exchange rae sraegies has shown ha he condiions under which a fixed or a crawling peg can consiue an opimum policy sraegy are raher resricive. Especially as an approach for disinflaion a fixed rae can be applied only as long as here is a sufficienly high risk premium. Bu if he risk premium declines faser han he inflaion differenial, a fixed rae offers a poenial for speculaive inflows and makes i a he same ime very cosly for a cenral bank o defend he peg wih serilized inervenions. This was exacly he siuaion wih which many emerging marke counries were confroned in he 1990s. While managed floaing can avoid such problems, by is very naure i canno provide an anchor for privae secor expecaions. Thus, if managed floaing is regarded as an opimum soluion in erms of achieving inernal and exernal equilibrium, an addiional insiuional device is required. The mos obvious soluion is inflaion argeing which provides an anchor for expecaions by a public announcemen of he inflaion arge ha he cenral bank inends o achieve. There is nohing ha prevens a combinaion of managed floaing and inflaion argeing. As shown by Ball (1999b), inflaion argeing in an open economy requires ha he cenral bank ses moneary condiions in way ha a given inflaion arge can be achieved. Managed floaing provides a framework ha allows o generae such moneary condiions in way ha is compaible wih exernal equilibrium. As Schaecher e al. (2000) have shown here are already several emerging marke counries ha have adoped his approach: Brazil, Chile, he Czech Republic, Israel, Poland, and Souh Africa. All of hem are now independen or managed floaers according o he IMF s classificaion. 53

61 4.6.2 The conrol over he exchange rae is asymmeric The mos serious flaw of managed floaing as we have described i here is he asymmeric conrol over he exchange rae. As we have shown in he previous Chapers, a cenral bank s abiliy o avoid an unwaned depreciaion is limied by he sock of is exchange reserves (and he availabiliy of balance of paymens credis). Thus, a cenral bank could always be confroned wih a siuaion of a major crisis of confidence which forces i o accep a depreciaion ha exceeds is exchange rae arge pah by far. An example for such a crisis is he depreciaion of he rupiah in 1997/98 from 2,500 rupiah per US-dollar in July 1997 o over 15,000 rupiah per US-dollar in mid-july The moneary condiions index shows ha a very srong depreciaion leads by iself o an inflaionary sance of moneary policy. From he logic of he MCI such a shock mus be couneraced by a srong increase of he ineres rae. As he MCI is consruced under he assumpion of a perfec subsiuabiliy of he ineres rae and he exchange rae lever, such a policy swich would no be problemaic. In realiy, his subsiuabiliy is quesionable, above all if he required degree of subsiuion is very high. While he exchange rae mainly affecs he inernaional secor of he economy (exporers and impor subsiuion), he ineres rae affecs he whole economy. A policy shif leading o a srong real depreciaion and a very high real ineres raes implies an exremely resricive impulse for he domesic secors of he economy (he banking sysem because of is mauriy ransformaion, he services and he consrucion secor, and he governmen which is ofen heavily indebed and ofen also in a foreign currency). As he Asian crises has shown, such an overly resricive effec on he domesic secors of he economy can ransform a currency crisis ino a financial secor crisis. Thus, under managed floaing counries remain vulnerable o crises of confidence which can be generaed simply by conagion effecs. The newly creaed IMF credi faciliies (he Supplemenal Reserve Faciliy and as a precauionary device he Coningen Credi Line) can provide counries wih financial resources ha are no subjec o he usual limis bu are based on he acual financing needs. However, a surcharge of 300 up o 500 basis poins is applied for such funds and he member counry has o repay hese credis wihin 2 ½ years a he very laes. Given he 54

62 raher sric eligibiliy crieria for he CCL 20 one could ask wheher counries ha are qualified for CCL could be compleely or parially dispensed from he repaymen of such credis if a clear conagion effec can be diagnosed Managed floaing and beggar-my-neighbor policies Wih he widespread pracice of managed floaing by IMF member counries he inernaional moneary order has experienced a profound change. By is very naure managed floaing implies unilaerally decided exchange rae policies ha are no discussed in he public domain. This gives governmens ample scope for exchange rae policies ha are no only designed by macroeconomic consideraions bu also by rade-relaed aspecs. Since exchange rae changes have similar effecs as ariffs, managed floaing makes i possible o circumven he regulaions of he WTO. The very fac ha he foreign exchange reserves of developing counries have increased from 330 billions of US-dollar in 1990 o 1,170 billions of US-dollar in shows ha in he longer run exchange rae policies were dominaed by he desire o keep he naional currencies on an undervalued basis. The increasing Unied Saes curren accoun deficis reflecs he risks for hose counries which follow a unilaeral policy of benign neglec in a world where mos oher counries have clear arges for heir exchange rae vis-à-vis he dollar. Thus, managed floaing requires a comprehensive surveillance of naional exchange rae policies by he Inernaional Moneary Fund or even by he WTO. Wihou a clear heoreical framework for managed floaing and a neural exchange rae policy i will be no easy o deec sraegic exchange rae policies. We hope ha he empirical mehods and he heoreical consideraions presened in his paper can provide a basis for such an approach. 20 See IMF (2000, p. 67): (...) he eligibiliy crieria confine poenial candidaes for a CCL o hose members implemening policies considered unlikely o give rise o a need o use IMF resources; whose economic performance and progress in adhering o relevan inernaionally acceped sandards has been assessed posiively by he IMF in he laes Aricle IV consulaion and hereafer; and which have consrucive relaions wih privae secor crediors wih a view o faciliaing appropriae privae secor involvemen. 21 These figures are aken from he IFS (line 1l s, counry code 200). As hey were lised in SDRs, we muliplied hem by he average annual US-dollar/SDR exchange rae. 55

63 5 Seleced case sudies In he preceding Chaper we presened a raher normaive approach for explaining he behavior of cenral banks ha operae wihin he wo exremes of he broad specrum of exchange rae regimes. Our managed floaing framework considered he exchange rae as an independen moneary policy ool in addiion o he radiional shor-erm ineres rae. Moreover, we defined wo equilibrium condiions ha shall be guaraneed by he conemporaneous ineracion of he cenral bank s exchange rae and ineres rae policy. However, one quesions sill remains unanswered: Do counries really behave he way we propose? In Chaper 2 a cenral resul of our cross-counry sudy was, ha an imporan number of counries makes inensive use of is foreign reserves o manage a cerain pah for he exchange rae. Chaper 4.1 showed ha mos of he managed floaers ha we idenified as such wih our mehodology, indeed conrolled boh operaing arges a he same ime. We found ha he overwhelming par of he liquidiy effecs of inervenions were serilized by he moneary policy auhoriy. In Chaper 4.2 we finally specified he condiions ha he exchange rae pah and he ineres rae have o mee. Thus, in his Chaper we concenrae on hese wo remaining aspecs: do he counries really follow an exchange rae pah ha is compaible wih UIP, and do he counries manage heir insrumens in order o creae he appropriae domesic moneary condiions? In he following, we pick ou four of he mos ineresing managed floaers and presen heir sraegies in a descripive approach. Clearly, our choice is somewha arbirary, bu for he purpose of demonsraing our ideas mos convincingly, Slovenia, Peru, Poland, and Japan appeared o be quie insrucive. The figures ha we refer o can all be found in Appendix 6: Seleced case sudies. 5.1 Slovenia The Slovenian moneary and exchange rae policy is an excellen example for a sraegy of managed floaing. Since he beginning of he ransiion process he Bank of Slovenia followed a kind of shadow argeing of he olar wih an undeclared pah and margin and he German mark as reference currency. In June 1993 i officially appeared as a managed floaer for he firs ime in he IMF classificaion. As can be seen from he UIP char in Figure 11, he depreciaion pah 56

64 D(s) of he Slovenian currency was for he mos par of he period under consideraion in line wih he ineres rae differenial vis-à-vis Germany, adjused by a posiive, bu small risk premium. As long as here was an excess supply of foreign currency in he foreign exchange marke, he Bank of Slovenia inervened wih a view o realizing he desired exchange rae pah. Our index of floaing characerizes hese periods wih a value of around In he second half of 1995 he olar sared o depreciae subsanially. Inervenion aciviy was reduced, and he ineres rae differenial was widened so as o sop a furher depreciaion. Bu his change in he policy mix ha was riggered by he asymmeric conrol opion over he exchange rae, did no lead o a violaion of he inernal equilibrium condiion. Even hough real ineres raes rose, his resricive sance was couneraced by a real effecive depreciaion so ha he MCI sill refleced he underlying macroeconomic siuaion (see he MCI char in Figure 11). From 1999 on he rae of depreciaion of he olar exceeded he ineres rae differenial for he firs ime. Being aware of he limied effeciveness of prolonged foreign exchange marke inervenions in such circumsances, he Bank of Slovenia again sharply reduced is inervenion aciviy wih a endency of ne sales of foreign reserves. The nominal depreciaion direcly resuled in an expansionary impulse from he exchange rae channel of moneary ransmission which is refleced in a decline of he MCI. As a consequence, inflaion raes immediaely rose from 5 o over 10 per cen, and real growh was simulaed. In erms of our model presened in Chaper 4, boh equilibrium condiions, he inernal equilibrium and he exernal equilibrium, were clearly violaed. Bu wha would have been he appropriae policy response, given he inabiliy of he cenral bank o direcly sop he depreciaion of he domesic currency? In our view he Bank of Slovenia should have raised is ineres raes as i has done likewise in 1995/96. Such a sep would direcly balance he exernal disequilibrium hrough an increase of he demand for domesic currency. Bu also domesic moneary condiions would become more resricive. 5.2 Peru Peru sared is sabilizaion program in he early 1990s afer several years of exremely high inflaion raes. The official Peruvian exchange rae sraegy according o he IMF publicaions was an independen floa since June Bu a shor look a he inervenion aciviy char in Figure 12 indicaes wih no doub ha he managemen of he exchange rae played a major role in he moneary policy sraegy of he Cenral Reserve Bank of Peru. From 1994 on, as inflaion 57

65 raes fell back on moderae levels, he ineres rae policy and he exchange rae pah were permanenly in accordance wih he requiremens of he exernal equilibrium condiion. The difference beween he wo lines in he UIP char of Figure 12 can be inerpreed as a rough proxy for he risk premium ha invesors demand for Peruvian asses as opposed o US invesmens. The index of floaing shows ha he inervenion insrumen was mainly used o realize he desired exchange rae pah. The peak in he ineres rae differenial in 1998 is again a good example for he asymmeric abiliy of cenral banks o conrol he exchange rae. Capial ouflows (riggered by he Russian and Brazilian crisis which exacerbaed he anxiey of invesors owards emerging marke economies) induced a srong depreciaion of he sol which could only be sopped by raising shor-erm ineres raes. As soon as he depreciaion came o res, he ineres raes were reurned o old levels. Ineresingly, i seems ha since ha ime inervenions were mainly used o smooh exchange rae movemens since I floa hardly lef he ± 0.33 band. 5.3 Poland Poland is also a very ineresing example of an analysis of a cenral bank s exchange rae policy. The underlying sample of our sudy covers wo de jure exchange rae regimes: From December 1991 o March 2000 Poland officially declared is exchange rae regime as managed floaing (Poland 1 in our classificaion), whereas from April 2000 on he Polish auhoriies decided o le he Polish currency floa freely wihou any foreign exchange marke inervenions (Poland 2). Wihin he managed floaing period, Poland sared wih a crawling peg agains a baske of five currencies. In May 1995, i inroduced a crawling band which was gradually widened from ± 7 per cen o finally ± 15 per cen. This increased flexibiliy of he exchange rae sysem is direcly refleced in he behavior of he exchange rae of he Polish zloy vis-à-vis he currency baske (see Figure 13, lower char) which sared o flucuae considerably from 1998 on. Bu also he chars of our wo indices S abs and I floa yield he same resuls. Afer a period of heavy inervenion aciviy in he mid 1990s which was aimed a perfecly conrolling he depreciaion pah of he Polish currency, inervenions seemed o be more and more a ool o simply smooh ou undue exchange rae swings. Finally, from lae 1998 on, inervenion policy was enirely banned from he cenral bank s se of insrumens so ha he de faco swich o a purely floaing exchange rae regime was already compleed more han one year before he official change. 58

66 From he UIP char we can see ha he exernal equilibrium condiion was violaed for mos par of he period considered. The average rae of depreciaion of he zloy exceeded he ineres rae differenial vis-à-vis Germany significanly unil mid Inervenion aciviy remained raher low during ha ime which again reflecs he asymmery already menioned earlier. Bu also ineres raes remained low if one judges his on he basis of he real raes from he upper righ hand char in Figure 13. Thus, he overall policy sance as measured by he MCI was quie expansionary which was cerainly due o he low growh performance in he firs years. The siuaion changed wih he beginning of he second half of 1994 as capial flows discovered Poland. The Naional Bank absorbed only a par of he foreign exchange excess and herefore oleraed a gradual reducion of he depreciaion of he zloy. As a resul, moneary condiions became more resricive, he disinflaion process sped up, and oupu losses occurred in he firs wo quarers of From lae 1996 on, wih he beginning of a capial flow reversal, he cenral bank ried o counerac he depreciaion pressure by augmening is nominal ineres raes. The MCI furher rose and real growh dropped. In 1998, he siuaion urned again, and as before, he Polish auhoriies acceped he appreciaing pressure on he zloy. From lae 1998 on, he Naional Bank even sopped all inervenion aciviy. Since ha ime, he UIP char addiionally reveals anoher ypical feaure of purely floaing exchange rae sysems: The relaionship beween he ineres rae differenial and he exchange rae pah became very unsable, and someimes, even hough he ineres rae differenial remained posiive in he order of 10 o 15 per cen, he nominal exchange rae of he zloy appreciaed vis-à-vis he baske currencies. To summarize, in our view he major defici of he Polish sraegy was simply he disregard of he exernal consrain. Each ime when capial inflows exered appreciaing pressure on he zloy (1995, firs half of 1998), he Naional Bank made no aemps o guaranee a UIP compaible exchange rae pah. The correc policy mix according o our framework would have been eiher a reducion of he ineres rae differenial wihou direcly influencing he exchange rae pah or he mainenance of an exchange rae pah via susained inervenions (purchases of foreign exchange) ha is compaible wih a risk premium adjused ineres rae differenial or a mixure of boh. 59

67 In all cases, he change in he policy mix should have avoided he overly resricive moneary policy sance ha is refleced in our MCI line. 5.4 Japan As las example for managed floaing aciviy we shorly presen Japan (see Figure 14). As we already menioned in Chaper 2.4.3, a closer analysis of he ime series of our wo indices can lead o ineresing resuls, especially if he underlying observaion period is long. In he righ hand char of Figure 14 we depiced he index of floaing only if he overall inervenion aciviy exceeded The resuls are sriking: Each ime when he Bank of Japan decided o inervene in he foreign exchange marke, eiher o sop an appreciaion of he yen (I floa > 0) or o avoid a depreciaion (I floa < 0), i mainained his policy over period of a leas several monhs so ha he absolue value of I floa almos always exceeded In oher words, if he Bank of Japan made use of is inervenion insrumen, is objecive was clearly o arge a cerain pah of he exchange rae raher han smoohing some form of excessive volailiy. These findings are clearly in conras o he resuls of he Calvo and Reinhar (2000) sudy who classified he Japanese exchange rae policy as independenly floaing, ha is o say wih a very low overall inervenion aciviy. 6 Conclusion Afer he experience wih he currency crises of he 1990s, a broad consensus has emerged among economiss ha such shocks can only be avoided and capial mobiliy be mainained if counries adop eiher floaing exchange raes or very hard pegs (currency boards, dollarizaion). As a consequence of his view which has been enshrined in he so-inconsisency riangle (or unholy riniy ) all inermediae currency regimes are now regarded as inherenly unsable. As far as economic heory is concerned, his view has he aracive feaure ha i no only fis nicely wih he logic of he radiional Mundell-Fleming model bu also ha for boh corner soluions (flexible exchange raes wih a domesically oriened ineres rae policy; hard pegs wih a compleely exchange rae oriened moneary policy) solid heoreical frameworks have been developed. Finally he IMF s saisics seem o confirm ha indeed inermediae regimes are less and less in fashion by boh indusrial counries and emerging marke economies. 60

68 However, in he las few years an anomaly has been deeced which seriously challenges his new paradigm on exchange rae regimes. In heir influenial cross-counry sudies, Calvo and Reinhar (2000) and Levy-Yeyai and Surzenegger (2000) have shown ha many of hose counries which had declared hemselves as independen floaers in he IMF saisics were indeed heavily inervening on foreign exchange markes. Thus, in mos cases floaing means managed floaing. This insigh and he lack of lieraure abou managed floaing was he saring poin for our sudy. We firs developed a se of indicaors ha allows us o differeniae furher beween hree forms of floaing: Pure floaers compleely refrain from foreign exchange marke inervenion. Independen floaers inervene in order o smoohen shor-erm swings in exchange raes bu hey allow he marke o deermine he pah of he exernal value of heir currency. Managed floaers are characerized by he fac ha also he exchange rae pah is mainly deermined by he cenral bank. Our empirical analysis which exends and refines he Calvo/Reinhar approach comes o he resul ha many developed and emerging marke economies can be regarded as managed floaers. In oher words, he inernaional moneary order is currenly dominaed by managed floaing. This has imporan implicaions for economic heory and economic policy. As far as heory is concerned, managed floaing is very differen from he exbook versions of boh fixed and flexible exchange raes. Compared wih flexible exchange raes (or pure floaing) he cenral inervenes someimes very ofen and also wih high quaniies on he foreign exchange marke in order o arge a pah for he exchange rae. Compared wih fixed exchange raes (or also crawling pegs) he cenral bank does no announce is arge pah. In oher words, here is no pre-commimen in he exchange rae policy. Insead of such a rule-based approach, a compleely discreionary exchange rae managemen is adoped. 61

69 Thus, managed floaing can no longer be explained wih he Mundell-Flemig model (above all because i is a comparaive saic model) nor wih sandard heories of fixed exchange raes or flexible exchange raes (including he more refined models of open economy inflaion argeing). Therefore, we have ried o develop a simple heoreical framework for managed floaing. A he level of a cenral bank s operaing arges i is based on he assumpion ha o some exen a simulaneous argeing of he nominal shor-erm ineres rae and he nominal exchange rae is possible. Since he laer is raher conroversial, above all because of he lieraure on serilized inervenions, we show in deail under which condiions a argeing of he exchange rae is possible. This is he case above all, if he currency is under a pressure of srong inflows, i.e. i is appreciaing by more han a arge rae se by he cenral bank; he cenral bank disposes over a large serilizaion poenial; he coss of inervenion are low; his is he case if he arge pah for he exchange rae is compaible wih he ineres rae differenial. In he nex sep we develop a moneary and exchange rae policy framework which is grounded on he general logic of he Mundell-Fleming, bu which neglecs fiscal policy. I is based on he assumpion ha he wo levers of a cenral bank (exchange rae, ineres rae) have o be so as o fulfill inernal and exernal equilibrium simulaneously: As for he inernal equilibrium, boh operaing arges have o be se in a way ha minimizes a ypical loss funcion of a cenral bank. We inroduced an MCI as a combined measure of he acual moneary policy sance ha resuls from boh, he real ineres rae and he real exchange rae. 22 More precisely, we define he inernal equilibrium condiion as an MCI rule which we derive in accordance wih a real ineres rae rule for a closed economy. In oher words, inernal equilibrium requires ha he shor-ineres rae and he exchange rae pah are se in way ha an opimum MCI is realized. As for he exernal equilibrium, he exchange rae pah and he ineres rae have o be se in a way ha hey correspond wih he ineres rae differenial vis-à-vis he anchor currency. This avoids shor-erm profi opporuniies of inernaional invesors and hus 22 As we assume sicky prices in he shor-run, we assume ha he real exchange rae and he real ineres rae can be perfecly conrolled by he nominal ineres rae and he nominal exchange rae 62

70 helps o preven speculaive inflows (which can ofen urn ino ouflows). A same ime his rule keeps he cos of serilizaion as low as possible. Thus, given wo equaions and wo endogenous policy variables we can derive arge values for he exchange rae pah and he ineres rae. They show above all ha he opimum pah for he exchange rae depends on he foreign real ineres rae, he inflaion differenial, he opimum MCI and he risk premium. In oher words, exchange rae pahs deermined by a simple rule (fixed raes, acive or passive crawls) as well as pure floaing are always inferior o such a discreion in exchange rae policy. We show his by comparing he sraegy of managed floaing o absoluely fixed exchange raes and purely floaing. We come o he resul ha boh exreme cases are only opimal (in he sense of our inernal equilibrium condiion) under counry-specific condiions. In conras o his, managed floaing offers an inegraed approach where he advanages of boh corner soluions, namely conrol over he exchange rae and conrol over domesic moneary condiions, can be combined. In a final secion we discuss several unresolved issues of managed floaing. Firs, as he cenral bank does no announce an exchange rae pah, he exchange rae can no longer be used as an anchor for privae secor expecaions. Thus, in he same way as he abandonmen of rules for he money supply has paved he way for inflaion argeing, a discreionary approach owards exchange rae argeing could also be accompanied wih a swich o inflaion argeing. In fac, same of he counries which manage heir exchange rae have already inroduced inflaion argeing. Second, as a he conrol over he exchange rae is asymmeric, a cenral bank can lose he conrol over he macroeconomic siuaion if i is confroned wih very srong capial ouflows. This shows ha managed floaing is no a complee subsiue for inernaional cooperaion in exchange rae policy. The newly inroduced credi lines (coningen credi line) of he IMF can be regarded as an imporan sep ino his direcion. Third, as each cenral bank or governmen decides auonomously over he exchange rae, here is a serious risk ha managed floaing is misused for a beggar-my-neighbor policy which can undermine he aims of he WTO. The very srong increase in he foreign exchange reserves of developing counries in he 1990s is a srong indicaion ha such incenives are raher srong. A he same ime he growing curren accoun surplus of he Unied Saes shows he negaive consequences for hose counries ha follow a compleely passive exchange rae policy in an environmen ha is dominaed by 63

71 managed floaing. Thus, managed floaing is also no a prefec subsiue for inernaional coordinaion of exchange rae polices. On conrary, i makes his even more urgen han fixed raes or purely flexible raes. 64

72 References Ariyoshi, Akira, Karl Habermeier, Bernard Laurens, Inci Oker-Robe, Jorge Ivan Canales- Kriljenko, and Andrei Kirilenko (2000), Capial Conrols: Counry Experiences wih Their Use and Liberalizaion, IMF Occasional Paper No. 190 Ball, Laurence (1999a), Efficien Rules for Moneary Policy, in: Inernaional-Finance, 2(1), pp Ball, Laurence (1999b), Policy Rules for Open Economies, in: Taylor, John B. (ed.), Moneary Policy Rules, The Universiy of Chicago Press, pp Bernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and Adam Posen (1999), Inflaion Targeing: Lessons from he Inernaional Experience, Princeon Universiy Press Bofinger, Peer (2001), Moneary Policy: Goals, Insiuions, Sraegies, and Insrumens, Oxford Universiy Press, forhcoming Calvo, Guillermo A., and Carmen M. Reinhar (2000), Fear of Floaing, inerne: hp:// Clarida, Richard, Jordi Gali, and Mark Gerler (1998), Moneary Policy Rules in Pracice: Some Inernaional Evidence, in: European Economic Review, 42, pp EBRD (1999), Transiion Repor, European Bank of Reconsrucion and Developmen, London ECB (2000), The single moneary policy in Sage Three: General documenaion on Eurosysem moneary policy insrumens and procedures, European Cenral Bank, Frankfur am Main Eika, Kari H., Neil R. Ericsson, and Ragnar Nymoen (1996), Hazards in Implemening a Moneary Condiions Index, in: Oxford Bullein of Economics and Saisics, 58 (4), pp Eichengreen, Barry (1999), Toward a New Inernaional Financial Archiecure: A Pracical Pos-Asia Agenda, Insiue for Inernaional Economics Fischer, Sanely (2001), Exchange Rae Regimes: Is he Bipolar View Correc?, inerne: hp:// Flood, Rober P., and Andrew K. Rose (1995), Fixing exchange raes: A virual ques for fundamenals, in: Journal of Moneary Economics, 36, pp Frankel, Jeffrey A., and Andrew K. Rose (1995), Empirical Research on Nominal Exchange Raes, in: Grossman, Gene M., and Kenneh Rogoff, Handbook of Inernaional Economics, Volume III, Elsevier Frankel, Jeffrey A. (1999), No Single Currency Regime is Righ for all Counries or a all Times, NBER Working Paper, No Froo, Kenneh A., and Richard H. Thaler (1990), Anomalies: Foreign Exchange, in: Journal of Economic Perspecives, 4 (3), pp IMF (2000), Annual Repor of he Execuive Board for he Financial Year Ended April 30, 2000 Krugman, Paul (1979), A Model of Balance of Paymens Crises, in: Journal of Money, Credi, and Banking, 11, pp Levy-Yeyai, Eduardo, and Federico Surzenegger (2000), Classifying Exchange Rae Regimes: Deeds vs. Words, inerne: hp:// Gerlach, Sefan, and Frank Smes (2000), MCIs and moneary policy, in: European Economic Review, 44, pp Isard, Peer (1995), Exchange Rae Economics, Cambridge Universiy Press Mayes, David G., and Mai Virén (2000), The Exchange Rae and Moneary Condiions in he 65

73 Euro Area, in: Welwirschafliches Archiv, 136 (2), pp McCallum, Benne T. (1999), Theoreical Analysis Regarding a Zero Lower Bound on Nominal Ineres Raes, inerne: hp:// Rogoff, Kenneh (1996), The Purchasing Power Pariy Puzzle, in: Journal of Economic - Lieraure, 34, pp Romer, David (2000), Keynesian Macroeconomics wihou he LM Curve, in: Journal of Economic Perspecives, 14 (2), pp Rosenberg, Michael R. (1996), Currency Forecasing: A Guide o Fundamenal and Technical Models of Exchange Rae Deerminaion, McGraw-Hill Samo, Lucio, and Mark P Taylor (2001), Official Inervenion in he Foreign Exchange Marke: Is i Effecive, and, if so, How Does i Work?, CEPR Discussion Paper No Schaecher, Andrea, Mark R. Sone, and Mark Zelmer (2000), Adoping Inflaion Targeing: Pracical Issues for Emerging Marke Counries, IMF Occasional Paper No. 202 Schwarz, Anna J. (2000), The Rise and Fall of Foreign Exchange Marke Inervenions, NBER Working Paper No Summers, Laurence H. (2000), Inernaional Financial Crises: Causes, Prevenion, and Cures, in: American Economic Review, Papers and Proceedings, 90 (2), pp Svensson, Lars-E.-O (1997), Inflaion Forecas Targeing: Implemening and Monioring Inflaion Targes, in: European Economic Review; 41(6), pp Svensson, Lars E.O. (2000), Open-economy inflaion argeing, in: Journal of Inernaional Economics, 50, pp Szapáry, György, and Zolán M. Jakab (1998), Exchange Rae Policy in Transiion Economies: The Case of Hungary, Journal of Comparaive Economics, 26, pp Tinbergen, Jan (1952), On he Theory of Economic Policy, Norh-Holland, Amserdam Viale, Paolo (1997), Serilized Cenral Bank Inervenion in he Foreign Exchange Marke, inerne: hp://fmg.lse.ac.uk/download/fmgdps/dp0259.pdf Wadhwani, Sushil B (1999), Currency Puzzles, Speech delivered a he London School of Economics on 16 Sepember 1999, inerne: hp:// Williamson, John (1996), The crawling band as an exchange rae regime: Lessons from Chile, Colombia and Israel, Insiue for Inernaional Economics Williamson, John (2000), Exchange Rae Regimes for Emerging Markes: Reviving he Inermediae Opion, Insiue for Inernaional Economics 66

74 Appendix 1: Counry coverage Table 8: IMF exchange rae classificaion of developed and emerging marke economies Counry Period IMF daa availabiliy Counry Period IMF daa availabiliy Argenina 10/78-12/90 if Mexico 3 12/94-11/00 if 12/94-09/00 Ausralia 1 07/82-11/83 mf Morocco 09/80-03/90 mf Ausralia 2 12/83-11/00 if New Zealand 04/85-11/00 if 04/85-10/00 Brazil 1 03/90-09/94 if Nigeria 1 07/82-08/86 mf Brazil 2 10/94-09/98 mf Nigeria 2 09/86-12/93 if Brazil 3 01/99-11/00 if Nigeria 3 03/98-11/00 mf no available Bulgaria 02/91-06/97 if 06/94-06/97 Norway 1 12/92-06/95 if Canada 01/75-11/00 if Norway 2 09/95-11/00 mf Chile 1 09/82-06/99 mf Pakisan 02/82-09/99 mf 02/82-04/99 Chile 2 09/99-11/00 if Peru 06/90-11/00 if Colombia 1 01/75-06/99 mf Philippines 1 10/78-12/84 mf Colombia 2 09/99-11/00 if Philippines 2 12/84-11/00 if 12/84-10/00 Czech Republic 06/97-11/00 mf 06/97-10/00 Poland 1 12/91-09/98 mf Ecuador 1 03/89-11/95 mf Poland 2 04/00-11/00 if Ecuador 2 12/95-01/99 mf Porugal 01/75-03/92 mf Ecuador 3 04/99-01/00 if Russia 1 07/92-06/95 if no available Egyp 06/87-09/98 mf Russia 2 07/95-12/97 mf Finland 09/92-09/96 if Russia 3 09/99-11/00 if Greece 1 12/82-12/95 mf Singapore 12/87-11/00 mf Greece 2 01/96-12/97 mf Slovenia 06/93-11/00 mf Hungary 06/95-08/00 mf 06/95-08/00 Souh Africa 01/83-11/00 if India 1 02/79-02/93 mf Spain 07/82-12/87 mf India 2 03/93-11/00 if Sri Lanka 10/78-11/00 mf 10/78-10/00 Indonesia 1 05/83-06/97 mf Sweden 12/92-11/00 if Indonesia 2 09/97-11/00 if 09/97-04/00 Swizerland 04/79-11/00 if 04/79-10/00 Israel 1 03/84-03/87 mf Thailand 1 06/97-03/98 mf Israel 2 12/91-11/00 mf 12/91-09/00 Thailand 2 03/98-11/00 if Ialy 09/92-09/96 if Turkey 01/80-11/00 mf 01/80-09/00 Japan 01/75-11/00 if Unied Kingdom 1 01/75-09/90 if Korea 1 03/80-10/97 mf Unied Kingdom 2 09/92-11/00 if 09/92-09/00 Korea 2 12/97-11/00 if Unied Saes 01/75-11/00 if Malaysia 06/93-03/98 mf Venezuela 1 03/89-03/93 if Mexico 1 02/83-10/91 mf Venezuela 2 06/93-06/94 mf Mexico 2 11/91-11/94 mf Venezuela 3 06/96-11/00 mf 06/96-08/00 67

75 Table 9: Number of observaions n = 6 n = 12 n = 6 n = 12 normalizaion mehod normalizaion mehod Argenina Mexico Ausralia Mexico Ausralia Morocco Brazil New Zealand Brazil Nigeria Brazil Nigeria Bulgaria Norway Canada Norway Chile Pakisan Chile Peru Colombia Philippines Colombia Philippines Czech Republic Poland Ecuador Poland Ecuador Porugal Ecuador Russia Egyp Russia Finland Singapore Greece Slovenia Greece Souh Africa Hungary Spain India Sri Lanka India Sweden Indonesia Swizerland Indonesia Thailand Israel Thailand Israel Turkey Ialy Unied Kingdom Japan Unied Kingdom Korea Unied Saes Korea Venezuela Malaysia Venezuela Mexico Venezuela

76 Appendix 2: Probabiliy disribuions Table 10: Probabiliy disribuion of S abs1 (6) S 0.5 S 1.0 S 1.5 S 2.0 S 0.5 S 1.0 S 1.5 S 2.0 Unied Saes India Unied Kingdom Ecuador Canada Colombia Poland Swizerland Unied Kingdom Spain Japan New Zealand Colombia Chile Souh Africa Philippines Korea Philippines Singapore Pakisan Mexico Porugal Malaysia Chile Ausralia Hungary Indonesia Venezuela Slovenia Russia Czech Republic Mexico Egyp Finland Bulgaria Israel Indonesia India Thailand Ausralia Ialy Peru Israel Nigeria Norway Venezuela Greece Norway Sri Lanka Ecuador Russia Venezuela Mexico Argenina Poland Brazil Sweden Brazil Nigeria Brazil Turkey Ecuador Morocco Greece Korea Thailand

77 Table 11: Probabiliy disribuion of S abs1 (12) S 0.5 S 1.0 S 1.5 S 2.0 S 0.5 S 1.0 S 1.5 S 2.0 Unied Saes Colombia Unied Kingdom Pakisan Japan Israel Unied Kingdom Philippines Canada Porugal Souh Africa India Korea Chile Egyp Hungary Indonesia Spain Mexico Philippines Ausralia Mexico Singapore Finland Malaysia Swizerland Slovenia Nigeria Greece Russia Sri Lanka India Sweden Peru Morocco Venezuela Korea Ausralia Czech Republic Norway Colombia Argenina Ialy Brazil Nigeria Brazil Ecuador Chile Poland Russia Bulgaria Brazil Thailand Ecuador Indonesia Greece Turkey Israel Mexico Venezuela New Zealand Venezuela Norway

78 Table 12: Probabiliy disribuion of I floa1 (6) I - I 0 I + rank resul IMF I - I 0 I + rank resul IMF Thailand 1 (*) if mf Chile mf mf Swizerland if if Philippines mf if Morocco if mf Greece mf mf Ecuador if mf Israel mf mf Mexico if if Ausralia mf if Ialy if if Argenina mf if Philippines if mf Sri Lanka mf mf Turkey mf mf Bulgaria mf if Sweden mf if Peru mf if Nigeria mf mf Spain mf mf Slovenia mf mf Poland mf mf New Zealand mf if UK mf if Norway mf mf India mf if Nigeria mf if Finland mf if Ecuador mf mf Colombia mf mf Brazil mf if Egyp mf mf Russia mf mf Singapore mf mf Greece mf mf Venezuela 2 (*) mf mf Souh Africa mf if Mexico mf mf Pakisan mf mf Brazil mf mf Mexico mf mf Israel mf mf Korea mf mf Japan mf if Colombia 2 (*) mf if Venezuela mf if Hungary mf mf Ausralia 1 (*) mf mf Czech Republic mf mf Korea mf if Norway mf if Indonesia mf if Indonesia mf mf Malaysia mf mf Porugal mf mf Thailand mf if Venezuela mf mf Russia 3 (*) mf if India mf mf Ecuador 3 (*) mf if Brazil mf if Chile 2 (*) mf if Noe:! An aserisk (*) behind he counry s name indicaes a limied number of observaion (see Table 9).! I -, I 0 and I + sand for Prob(I floa1-0.33), Prob(0.33 < I floa1 < 0.33) and Prob(I floa1 0.33) respecively.! The ranking was made according o I 0. 71

79 Table 13: Probabiliy disribuion of I floa1 (12) I - I 0 I + rank resul IMF I - I 0 I + rank resul IMF Morocco if mf Brazil mf if Czech Republic if mf Brazil mf mf Nigeria if mf Israel mf mf Swizerland if if Singapore mf mf Ecuador if mf Sri Lanka mf mf Norway if mf Ausralia mf if Mexico if mf India mf mf Greece if mf Argenina mf if Turkey if mf Poland mf mf Ialy if if Mexico mf mf Souh Africa if if Slovenia mf mf Russia if mf Peru mf if New Zealand if if Israel mf mf Porugal if mf Finland mf if Korea if mf Colombia mf mf Venezuela if mf India mf if Canada if if Egyp mf mf Pakisan if mf Venezuela mf if Greece if mf UK mf if Sweden if if Japan mf if Hungary if mf Brazil mf if Ecuador if mf Malaysia mf mf Norway if if Thailand mf if Mexico if if Indonesia mf if Philippines if if Bulgaria mf if Philippines if mf Korea mf if Indonesia if mf Ausralia 1 (*) mf mf Nigeria if if Russia 3 (*) mf if Spain if mf Chile 2 (*) mf if Colombia if if Venezuela 2 (*) mf mf Chile mf mf Noe:! An aserisk (*) behind he counry s name indicaes a limied number of observaion (see Table 9).! I -, I 0 and I + sand for Prob(I floa1-0.33), Prob(0.33 < I floa1 < 0.33) and Prob(I floa1 0.33) respecively.! The ranking was made according o I 0. 72

80 Appendix 3: The marke maker principle For a clear undersanding of daily urnover figures on foreign exchange markes i is imporan o know how hese markes are organized. The mos imporan feaure is he marke-maker principle. I means ha all paricipans a he inerbank foreign exchange marke are ready o buy and sell foreign exchange wihou limi a any momen, irrespecive wheher hey are acually in need of addiional posiions in foreign or domesic currency. As each paricipan is able o ge rid of an unwaned posiion immediaely, he risks of being a marke maker is very limied. This organizaion of he foreign exchange marke has he effec ha i blows up he oal urnover. As he char below shows, he order e.g. of a German firm ha wans o sell 100 euro for dollars can lead o many inermediae ransacions beween he marke markers unil his posiion reaches a bank ha needs euro deposis for is cusomer. Figure 9: Illusraion of he marke maker principle Bank A Bank H Bank B Company 2 Company 1 Bank G Bank C wans 100 euro wans Bank F Bank D 100 US $ Bank E Sequence: Company 1 G H D F A C E H B Company 2 Muliplier: 9 Turnover: 900 US $ Because of he speed wih which he inermediae ransacions are carried ou, he muliplier beween an ouside ransacion and he inernal ransacions can be very high. By he same oken, any foreign exchange inervenion by a cenral bank will also have a srong muliplier effec See Viale (1997, p. 7): In he week 3-7 Augus 1992, in which paricular evens were no repored in he press, he average daily volume of ransacions wih cliens of Merrill Lynch in D-marks for dollars was around $ 1 73

81 Thus, i makes very lile sense o compare he sock of foreign exchange reserves wih daily urnover on foreign exchange markes. 74 billion, while heir average size was abou $ 4 million. These figures indicae ha wih a relaively small marke order he cenral bank can affec he quoes of a single marke maker. Then, if his marke maker has he repuaion of receiving marke orders form he cenral bank, iner-dealer ransacions will propagae his effec on he quoes of oher dealers.

82 Appendix 4: Derivaion of he opimal MCI based on he minimizaion of a cenral bank s loss funcion The loss funcion was defined in equaion (30) as follows: S 2 T (76) L χ ( ε ) + χ ( π π ) 2 =. ~ 1 y 2 Under full informaion we can replace y~ ε by ( p E p ) S β (see equaion (26)). The loss 1 funcion becomes 2 2 T T (77) L χ β ( p E p ) + χ ( π π ) = χ β ( π E π ) + χ ( π π ) 2 = From he firs-order condiion of equaion (77) we ge T (78) = ( 1 γ) π + γπ π, E 1 2 where γ = χ ( χ β + ) rae is 2 1 χ2 op T T T (79) π = E π + γ( π E π ) 1 1. The associaed price forecas error is T T (80) p E p = γ( π E π ) 1 1. Thus he opimal MCI is defined as op D S T T (81) MCI 1 δ ( ε ε ) ( βγ) δ ( π E π ) 1. Assuming raional expecaions (E -1 π = E -1 π T ) he opimal inflaion =

83 Appendix 5: A simple framework for he explanaion of currency crises Our model provides relaively simple explanaions for he emergence of currency crises under a framework of fixed exchange raes. An obvious reason for a crisis is a moneary policy ha violaes he exernal equilibrium by pursuing an ineres rae policy ha leads o a domesic ineres rae ha is lower han he rae required by UIP. The resul are capial ouflows and a loss of reserves. As soon as he cenral bank s reserve sock is exhaused he peg has o be abandoned. Since his can be anicipaed by he markes, a speculaive aack will occur and require a premaure exi. All his is capured in he firs generaion currency crisis models (see Krugman 1979) wih he only difference ha hese models are normally wrien for he moneary base (or ne domesic asses) as he operaing arge of he cenral bank. An alernaive explanaion refers o he inernal equilibrium. We can see from equaion (61) ha under fixed raes he acual moneary condiions index of a counry is given by fix * * (82) ( )( ) MCI = 1 δ π π + α + r. Thus, he sance of moneary policy depends on he inflaion differenial, he risk premium, and he cyclical siuaion in he anchor currency. If we look a he shor-erm real ineres rae in he Unied Saes which reflecs such cyclical effecs we can see ha in he early 1970s and he years he sance of he Federal Reserve s moneary policy was exremely expansionary (see Figure 10). In oher words, counries pegging o he dollar were in principle forced o pursue a similarly lax moneary policy. However, one can observe ha e.g. he Bundesbank in and several Asian counries in ried o keep heir ineres raes a higher levels by serilized inervenions. As a resul a compromise soluion emerged which violaed boh equilibria simulaneously: ineres raes were oo low for domesic macroeconomic sabiliy, hey were oo high for avoiding speculaive inflows. This made he pegs highly vulnerable, especially since in he Asian cases domesic invesors used he low dollar raes for he financing of invesmen expendiures. A similar logic, bu in he opposie direcion was a work in he European Exchange Rae Mechanism (ERM) crises in 1992/93. Because of German unificaion he Bundesbank pursued a very resricive ineres rae policy. The oher ERM members gave prioriy o exernal equilibrium, since an auonomous ineres rae policy wih lower raes would have led o reserve 76

84 losses (see Table 14). The resul was a severe violaion of he inernal equilibrium since he oher members had much less cyclical overheaing han Germany. The markes realized ha his policy sance was unsusainable and increased he risk premium for counries like France and Belgium. This caused a furher divergence beween he acual and he opimum MCI and made he peg even less susainable. In he lieraure hese processes are described in he second generaion currency crisis models. Figure 10: US shor-erm real ineres raes M1 1959M1 1961M1 1963M1 1965M1 1967M1 1969M1 1971M1 1973M1 1975M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M1 Source: IFS Table 14: Taylor ineres raes and acual shor-erm ineres raes in 1991 Counry Taylor ineres rae Acual ineres rae Belgium Denmark France Germany Ireland Ialy Neherlands Noe: Taylor ineres rae calculaed wih he original Taylor formula i = 2 + π + 0.5( π 2) ~ y. Daa source: OECD, Economic Oulook 77

85 Appendix 6: Seleced case sudies Figure 11: The case of Slovenia Slovenia - UIP pah 25 D(s) (i-i*) Slovenia Real lending rae Real effecive appreciaion MCI (1:1) 1994M1 1994M7 1995M1 1995M7 1996M1 1996M7 1997M1 1997M7 1998M1 1998M7 1999M1 1999M7 2000M1 2000M7 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Slovenia - Inervenion aciviy 8 6 Slovenia - Real growh rae M1 1994M7 1995M1 1995M7 1996M1 1996M7 1997M1 1997M7 1998M1 1998M7 1999M1 1999M7 2000M1 2000M7 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Inflaion raes Slovenia Germany Slovenia - Index of floaing M1 1994M7 1995M1 1995M7 1996M1 1996M7 1997M1 1997M7 1998M1 1998M7 1999M1 1999M7 2000M1 2000M7 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Slovenia Tolar/DEM (lef scale) Foreign reserves (righ scale) M1 1994M7 1995M1 1995M7 1996M1 1996M7 1997M1 1997M7 1998M1 1998M7 1999M1 1999M7 2000M1 2000M7 Sources and daa descripion: see noe afer Figure 14 78

86 Figure 12: The case of Peru Peru - UIP pah D(s) (i-i*) Peru Real lending rae Real bilaeral appreciaion MCI (3:1) 1992M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 1992Q1 1992Q3 1993Q1 1993Q3 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Peru - Real growh rae Peru - Inervenion aciviy M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 1992Q1 1992Q4 1993Q3 1994Q2 1995Q1 1995Q4 1996Q3 1997Q2 1998Q1 1998Q4 1999Q3 2000Q Inflaion rae Peru USA Peru - Index of floaing M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 1992M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M Peru Nuevo sol/usd (lef scale) Foreign reserves (righ scale) M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 Sources and daa descripion: see noe afer Figure 14 79

87 Figure 13: The case of Poland Poland - UIP pah (baske) 20 D(s) (i-i*) Poland M M6 1992M M6 1993M M6 1994M M6 1995M M6 1996M M6 1997M M6 1998M M6 1999M M Real lending rae Real effecive appreciaion MCI (2:1) 1992Q1 1992Q3 1993Q1 1993Q3 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Poland - Inervenion aciviy M M6 1992M M6 1993M M6 1994M M6 1995M M6 1996M M6 1997M M6 1998M M6 1999M M6 9.0 Poland - Real growh rae Q1 1992Q3 1993Q1 1993Q3 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Inflaion raes Poland Germany Poland - Index of floaing M M6 1992M M6 1993M M6 1994M M6 1995M M6 1996M M6 1997M M6 1998M M6 1999M M Q1 1992Q3 1993Q1 1993Q3 1994Q1 1994Q3 1995Q1 1995Q3 1996Q1 1996Q3 1997Q1 1997Q3 1998Q1 1998Q3 1999Q1 1999Q3 2000Q1 2000Q Poland 5000 Foreign reserves (lef scale) 0 Zloy/baske (daily, righ 1993M1 1993M7 1994M1 1994M7 1995M1 1995M7 1996M1 1996M7 1997M1 1997M7 1998M1 1998M7 1999M1 1999M7 2000M1 2000M Sources and daa descripion: see noe afer Figure 14 80

88 Figure 14: The case of Japan Japan - Inervenion aciviy Japan - Index of floaing 1975M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M1 1975M1 1977M1 1979M1 1981M1 1983M1 1985M1 1987M1 1989M1 1991M1 1993M1 1995M1 1997M1 1999M1 Sources and daa descripion of Figure 11 o Figure 14: Mos of he daa are aken from he IFS. Excepions from his are: - Slovenia, Real effecive appreciaion (Insiue of Macroeconomic Analysis and Developmen, Ljubljana); - Poland, Real growh rae (Oeserreichische Naionalbank, Vienna, Focus on Transiion, various issues); noe ha he figures from 1992 o 1995 are yearly averages; - Poland, Daily Zloy/baske exchange rae (Naional Bank of Poland, Warsaw). The char labelled UIP pah shows he nominal depreciaion of he domesic exchange rae in he las 12 monhs and he difference beween he acual domesic money marke rae and he acual foreign money marke rae. As foreign counry we chose Germany for Slovenia, he US for Peru and he baske (45% US, 35% Germany, 10% UK, 5% France and 5% Swizerland unil December 1998; 45% US and 55% Euro area since January 1999) for Poland. In he case of Peru, we ook he cenral bank s discoun rae insead of he money marke rae. The MCI in he upper righ hand char of Figure 11 o Figure 13 was consruced as follows: In all hree cases we weighed he real ineres rae relaive o he real appreciaion according o he degree of openness. As Slovenia is he mos open economy (exernal secor s size relaive o GDP in 1998: 49%) he weighs are assumed o be he same (1:1). For Poland wih a degree of openness of 23% we applied a relaive weigh of 2:1 (real ineres rae o real exchange rae), and for Peru wih a degree of openness of only 11% 3:1. In order o calculae he real ineres rae we subraced he acual inflaion rae from he nominal lending rae. The lending rae was chosen as i is assumed o be more informaive as a measure of he influence of moneary insrumens on macroeconomic variables in he ransmission process as for example described by he bank 81

89 lending lieraure. The real exchange rae lever was calculaed as a one year aback change of he real exchange rae. In he cases of Poland and Slovenia we used real effecive exchange raes, in he case of Peru he bilaeral US-Peruvian real exchange rae. All real exchange raes are CPI based. Noe ha in he chars labelled Index of floaing we only depiced he bars if he overall inervenion aciviy was higher han 1.0. As we defined an aciviy index of below 1.0 as noninervenionis, a disincion beween exchange rae argeing and exchange rae smoohing on he basis of he index of floaing appeared o make no sense. This is especially relevan in he case of Japan and Poland. 82