Exchange-Rate Systems and Currency Crises

Exchange-Rate Practices Floating or Fixed? IMF principles for member nations: No manipulation to prevent effective balance-ofpayments adjustments or unfair competitive gains Act to counter short-term exchange market disorders When members intervene in markets, they should take into account the interests of other members. Exchange-rate practices of IMF members (Table 15.1) Choosing an exchange-rate system (Table 15.2)

Choosing an Exchange-Rate System Constraints imposed by free capital flows Countries can maintain only two of the following three policies: Free capital flows A fixed exchange rate An independent monetary policy The impossible trinity (Figure 15.1)

Fixed Exchange-Rate System General practice until the 1970s Primarily used by small, developing nations Currencies are anchored to a key currency Developing nations can stabilize the domesticcurrency prices of their imports and exports Exerts restraint on domestic policies and reduces inflation Major key currencies of the world (Table 15.3)

Fixed Exchange-Rate System Anchor to a single currency Developing nations with a single industrial-country partner Anchoring to a group or basket of currencies Developing nations with more than one major trading partner Helps to average out fluctuations Anchoring to the special drawing right (SDR) Basket of four currencies (Table 15.4) Increased stability Continued

Fixed Exchange-Rate System Continued Par value and official exchange rate Governments assign their currencies a par value in terms of gold or other key currencies Determining official exchange rate Exchange-rate stabilization fund Set up to defend the official rate Purchases and sales of foreign currencies to iron out short-term fluctuations (Figure 15.2) Fundamental disequilibrium

Fixed Exchange-Rate System Continued Devaluation Home currency s exchange value depreciates, counteracting a payments deficit Revaluation Home currency s exchange value appreciates, counteracting a payments surplus Decisions to be made before implementation Necessity of the step Timing of adjustment Magnitude of adjustment Advantages and disadvantages of fixed rates (Table 15.5)

Bretton Woods System of Fixed Exchange Rates Adjustable pegged exchange rates (1946-1973) Currencies tied to each other Disequilibrium: Repegging up to 10 percent allowed Par value fixed in terms of gold or the gold content of the U.S. dollar in 1944 Band limits Operational difficulties Conflicting objectives Magnitude of adjustments Difficulties in estimating equilibrium rates Speculation

Floating Exchange Rates Currency prices established in the foreignexchange market Without restrictions imposed by government policies Equilibrium exchange rate equates the demand for and supply of the home currency

Floating Exchange Rates Achieving market equilibrium Continued Example: Foreign-exchange market in Swiss francs in the United States (Figure 15.3) Market equilibrium will be established at a point where the quantities of foreign exchange supplied and demanded are equal

Floating Exchange Rates Continued Trade restrictions, jobs, and floating exchange rates Import restrictions will gradually shift jobs from other industries to the protected industry No significant impact on aggregate employment Short-run employment gains in the protected industry will be offset by long-run employment losses in other industries

Arguments For and Against Floating Rates Advantages Simplicity Continuous adjustment in the balance of payments Adverse effects of prolonged disequilibriums are minimized Partially insulates the home economy from external forces Freedom to pursue policies that promote domestic balance Disadvantages Unregulated market leads to wide fluctuations in currency values Prohibitively high cost of hedging Flexibility to set independent policies leading to inflationary bias Summarized in Table 15.5

Managed Floating Rates Informal guidelines established by IMF (1973) Based on two concerns Nations intervening in exchange markets Clean float and dirty float Disorderly markets with erratic fluctuations Under managed floating, a nation: Can alter the degree of intervention Can intervene to reduce short-term fluctuations: Leaning against the wind Should not act aggressively with respect to their currency exchange rates Can choose target rates and intervene to support them

Managed Floating Rates in the Short Run and Long Run Under a managed float Market intervention is used to stabilize exchange rates in the short run In the long run, a managed float allows market forces to determine exchange rates Example: Theory of a managed float in a twocountry framework (Figure 15.4)

Exchange-Rate Stabilization and Monetary Policy Stabilization requires the central bank to adopt: An expansionary monetary policy to offset currency appreciation A contractionary monetary policy to offset currency depreciation Example: Exchange-rate stabilization and monetary policy (Figure 15.5) Long-run effectiveness of using monetary policy to stabilize the exchange value of the currency is limited

Is Exchange-Rate Stabilization Effective? Volatility of foreign-exchange markets Intervention by central banks Intervention supported by central bank interest rate changes Coordinated intervention Proponents of intervention: Useful when the exchange rate is under speculative attack May be helpful in coordinating private-sector expectations

The Crawling Peg Small, frequent changes in the par value of currency Correct balance-of-payments disequilibriums Used primarily by nations having high inflation rates Proponents Flexibility of floating rates with stability of fixed rates More responsive to changing competitive conditions Avoids changes that are frequently wide of the mark Frustrates speculators with their irregularity IMF view Hard to apply this system to industrialized nations whose currencies serve as a source of international liquidity

Currency Crises Currency crises or speculative attack A weak currency experiences heavy selling pressure Indications of selling pressure include: Sizable losses in the foreign reserves held by a country s central bank Depreciating exchange rates in the forward market Widespread flight out of domestic currency into foreign currency or into goods Examples of currency crises (Table 15.6)

Currency Crises Continued Crisis ends when selling pressure stops Ways to end pressure Devalue the currency Adopt a floating exchange rate Currency crashes: Crises that end in devaluations or accelerated depreciations Avoiding a currency crash Impose restrictions on the ability of people to buy and sell foreign currency Obtain a loan to bolster the foreign reserves Restore confidence in the existing exchange rate

Sources of Currency Crises Budget deficits financed by inflation Weak financial systems Weak economy Political factors External factors Choice of an exchange-rate system

Speculators Attack East Asian Currencies Southeast Asian currency decline led by the Thai Baht Resistance offered to the depreciation pressure and raising interest rates to make the Baht attractive Abandoning the dollar peg in July 1997 Long-term effects of abandoning the fixed rate

Capital Controls Government-imposed barriers To foreign savers investing in domestic assets To domestic savers investing in foreign assets Also known as exchange controls

Capital Controls: Advantages Government can influence its payments position Encourage or discourage certain transactions by offering different rates for foreign currency for different purposes Can give domestic monetary and fiscal policies greater freedom in their stabilization roles

Capital Controls: Disadvantages Disadvantages of capital outflows Outflows may increase since confidence in the government is weakened Restrictions often result in evasion False sense of security for officials Controls on capital inflows often receive more support

Should Foreign-Exchange Proponents Transactions Be Taxed? Tax would give traders an incentive to look at longterm economic trends Increased cost of transactions Dampen excess volatility Drawbacks Difficult to determine excesses Burden on countries that are quite rationally borrowing overseas Difficult to implement

Increasing the Credibility of Fixed Currency boards Exchange Rates Issues notes and coins convertible into a foreign anchor currency at a fixed exchange rate Backing of the domestic currency must be at least 100 percent: Monetary policy on autopilot Benefits of a currency board system (Figure) Concerns Prevents a country from pursuing a discretionary monetary policy Susceptible to financial panics - lacks a lender of last resort Creates a colonial relationship with the anchor currency

Currency Board - Argentina Shift to fixed exchange rate and currency board following hyperinflation in 1970s and 80s Economy hit during the late 1990s Appreciation of the dollar Rising U.S. interest rates Falling commodity prices on world markets The depreciation of Brazil s real Borrow to finance deficits Defaults ended convertibility of pesos into dollars

Dollarization Usage of the U.S. dollar alongside or instead of the local currency Partial dollarization and full dollarization Why Dollarize? Credibility and policy discipline Avoiding capital outflows that often precede or accompany an embattled currency situation Decrease in transaction costs Lower inflation Greater openness

Dollarization Continued Effects of Dollarization Ecuador Accepting the monetary policy of the Federal Reserve Risk that business cycles might not coincide Federal Reserve is not their lender of last resort Loss of seigniorage Freedom to decide how to spend its tax dollars Ecuador could establish its own tariffs, subsidies, and trade policies Constraint: No recourse to printing local currency

Dollarization Continued Implications of Dollarization for the U.S. For each dollar sent abroad, Americans enjoy a onetime increase in the amount of goods and services they are able to consume Effect of opting to hold dollars rather than debt: An interest-free loan from Ecuador Use of U.S. currency abroad might hinder the formulation and execution of monetary policy More pressure on the Federal Reserve to conduct policy according to the interests of Ecuador