ECON 511 International Finance & Open Macroeconomy CHAPTER FOUR The Choice of Exchange Rates

I. Introduction At the Bretton Woods Conference in 1944, the leaders of 44 countries discussed issues related to international economics and finance. However, due to the inflation pressure in the late 1960s, the United States officially abandoned its dollar pegged to the gold standard in Since 1973, there has been a collapse of the Bretton Woods system.

Since the collapse of the Bretton Woods system, economists have been analyzing the implementation of various exchange rate policies adopted by different countries. Many industrialized countries abandoned their fixed exchange rate regime to adopt a more flexible exchange rate regime. Developing countries followed suite and also chose to implement different exchange rate regimes since the collapse of the Bretton Woods system.

II. Exchange Rate Choice The currency crises in Mexico (1994), Asia (1997), Russia (1998),& Brazil (1999) have fueled the debate on the optimal choice of exchange rate regimes. The determinants of exchange rate policy have been examined empirically using models based on the theory of Optimal Currency Areas (OCA). Countries’ circumstances, economic and institutional factors play an important role in determining the choice of the exchange rate regime.Recently, political economy aspects have been the focus of determining the optimal choice of the exchange rate policy.

This theory stresses that there is no single exchange rate policy that performs best for all countries (Mundell, 1961). Mckinnon (1963) argues that the size and the openness of the economy are central to the choice of exchange rate policy. He stresses that a fixed exchange rate regime is the preferable arrangement when a country has a small and open economy compared to a large and (relatively) closed economy.

Boyer (1978), Henderson (1979), and Mckinnon (1981) argue that in the presence of monetary shocks (monetary and financial market disturbances) in the economy, a fixed exchange rate regime is the most appropriate policy in order to maintain output stability. However, in the presence of real shocks (large supply side shocks), a flexible exchange rate regime is more appropriate. In the 1980s, literature on the OCA highlighted the importance of monetary policy credibility in determining the exchange rate policy.

During the 1990s currency crises in Mexico, Asia, Russia, Brazil, and Argentina, numerous studies emphasized on effect of high capital flows on the fixed exchange rate regime. Van Hagen and Zhou (2005) highlighted the role of the degree of financial development in the economy in determining the choice of exchange rate regime.

Recent literature considers the influence of economic, institutional and political factors on the determinants of exchange rate regime to be important. Most of the recent existing literature uses the standard political economy argument regarding choices in exchange rate policy: the trade-off between credibility and competitiveness. A country may gain anti-inflationary credibility through pegging its local currency to a low-inflation anchor currency. The substantial trade off between credibility and competitiveness depends on the existing inflation level in the economy.

The trade off between competitiveness and credibility is examined in Blomberg, Frieden, and Stein’s (2005). They posit an argument that, in order to achieve credibility, a country may adopt a fixed exchange rate policy by pegging to a zero-inflation anchor currency.

III. Determinants of Exchange Rate Existing studies have identified many factors that might make a specific exchange rate regime preferable to some countries but not others. These factors influence the exchange rate choices through four categories of circumstances: factors of the optimal currency area, currency crisis risks, political economy, and the tradable sectors.

III.i OCA Criteria OCA theory suggests that the openness of the economy, inflation rate differential, economic size, degree of economic development, and degree of financial development are important determinants for the choice of exchange rate policy. The more open the economy, the more likely a fixed exchange rate will be adopted. (Why?) Inflation levels would increase the political cost of giving up the peg and increase the possibility of abandoning the peg. (Why?)

The larger the economy, the lower the probability for adopting a fixed exchange rate regime. (Why?) Countries with greater economic development are more likely to have more developed and efficient goods and factor markets, greater the tendency there is to choose a flexible exchange rate arrangement. (Why?) Counties with lower levels of financial development are more likely to choose a fixed exchange rate policy.(Why?)

III.ii Risk of currency crisis Existing empirical studies have considered the effect of currency crisis risk in selecting an exchange rate regime. Many studies have identified the lack of international reserve to be a proxy for the risk of currency crisis. The lack of international reserves should decrease the likelihood of adopting a fixed exchange rate policy. (Why?) Several existing studies find strong evidence that the availability of foreign exchange reserves increases the probability of adopting fixed regimes.

III.iii Political economy factors The trade off between credibility and competitiveness, as discussed previously, encourages the government to decide on a political economy base. The relative importance of the tradable producers, represented by the tradable sector, and the consumer voters are crucial to the argument of the political economy of exchange rate commitments. The tradable producers would influence the government to not stay on the peg avoiding any appreciation in the real exchange rates. (Why?) Consumer voters may support the peg being sustained by the government, which can lead to a real appreciation in the exchange rate. (Why?)

Sustaining a fixed exchange rate policy is usually seen before elections rather than after elections. (Why?) On the empirical side, a body of empirical studies uses measures of the degree of political instability to reflect the political economy of a country in regressions. The frequency of government changes and/or the frequency of transfers of power to an opposition party are used as two alternative measures of political instability.

III.iv Tradable Sectors Industrial producers try to pressure the government to adopt a more flexible exchange rate.(Why?) The industrial producers will attempt to avoid any appreciation in the exchange rate by lobbing against a fixed exchange rate policy.(Why?) However, it is expected that countries with a strong oil sector will pressure the government to adopt a fixed exchange rate regime.(Why?)

IV. Classification of Exchange Rate Arrangements The existing literature on regime choices has usually used the International Monetary Fund’s classification of exchange rate regimes. Prior to 1999, member countries of the IMF declared their exchange rate policies to the IMF according to their official or de jure exchange rate arrangements. The former IMF classification identifies three major exchange rate arrangements: fixed policies, limited flexibility policies (fluctuated within a range), and more flexible policies (either managed or free float).

However, the former IMF exchange rate classification does not distinguish between the announced exchange rate policy (de jure exchange rate) and the actual exchange rate policy (de facto exchange rate) undertaken by the country. Another drawback of the pre-1999 classification is that it does not distinguish between the varieties of fixed exchange rate regimes.

The new IMF classification distinguishes between various pegging policies and also distinguishes between eight categories ranging from hard peg regimes to free floating regimes: Exchange Rate RegimeDescription 1. No Separate Lender Tenderi.e., Formal dollarization 2. Currency Board Fixed to a specific foreign currency at a fixed rate 3. Conventional Fixed Pegs Fixed to a single currency or a basket of currencies as with band at most +/- 1% 4. Fixed Within Horizontal BandsFixed with bands at least +/- 1% 5. Crawling Pegs Fixed with central parity periodically adjusted in small amount at fixed rate or in response to changes in selective quantitative indicators 6. Crawling Bands Crawling peg associated with bands at least +/- 1% 7. Managed Floating Influencing the exchange rate without a specific target or pre- announced path of the exchange rate 8. Independently Floating Determining exchange rate through the market Table: The Revised IMF Classification of Exchange Rate Arrangements Source: IMF Exchange Rate Classification (1999)

Differences between the de jure and de facto exchange rates play an important role in analyzing exchange rate choices. (Why?) Several studies have re-examined interesting hypotheses using de-facto exchange rate arrangements data, often concluding the opposite results shown with de jure data.