Exchange Rate Regimes

An exchange rate regime is the framework a country’s central bank or government employs to determine its currency’s relative value in the international market. This regime influences the country’s trading relationships and capital flows.

The chosen regime is based on factors such as the country’s relative economic stability, efficiency, and trading volatility. For example, countries experiencing higher volatility might adopt a different exchange rate regime compared to those with more stable economies.

The design and implementation of the exchange rate regime framework is essential as it can impact real economic activity, investment decisions, and the risk profile of foreign assets.

The “Ideal” Currency Regime and Its Challenges

The concept of an “ideal” currency regime involves three primary requirements:

1. Credibly fixed exchange rates between currencies, thereby reducing uncertainties related to pricing in terms of goods, services, and financial assets.
2. Full convertibility of currencies i.e free exchange of currencies for any purpose and in any amount, thereby facilitating unrestricted capital movement.
3. Individual countries having the autonomy to pursue independent monetary policies in line with domestic objectives, such as economic growth and inflation control.

Achieving all three conditions simultaneously is complex because they are inconsistent. If the exchange rate between currencies is credibly fixed and all currencies are convertible, then there would only be a single global currency, eliminating the need to convert from one national currency to another. Attempts to control interest rates, asset prices, or inflation by manipulating the supply of one currency relative to another would also be ineffective.

As a result, the concept of an independent monetary policy is unworkable, meaning that there can never be an ideal currency regime.

Currency Regime Impact on Independent Monetary Policies

The interplay between currency regimes and a country’s ability to implement independent monetary policies is a central issue in open-economy macroeconomics. In a hypothetical scenario with perfectly mobile capital, attempting to decrease interest rates independently in one country below those in another country (i.e expansionary monetary policy) could trigger an outflow of capital seeking higher returns in the other country. This movement of capital would necessitate central banks to buy back domestic currency and sell foreign currency to maintain fixed exchange rates. Such actions could undermine the effectiveness of independent monetary policies.

Flexibility of Floating Exchange Rates

A floating exchange rate system provides greater flexibility in responding to economic changes. If a country decreases its domestic interest rates, the resulting depreciation of its currency can shift demand to domestically produced goods, boosting exports and decreasing imports thereby reinforcing the expansionary impact of the interest rate change. Raising interest rates will have the opposite effect. This flexibility allows countries to adjust to economic shifts more effectively.

Enhancing Central Bank Effectiveness through Exchange Rate Flexibility

Allowing exchange rates to fluctuate and imposing controls on convertibility can empower central banks to pursue macroeconomic objectives more effectively. Central banks can better address domestic economic challenges by having the freedom to adjust exchange rates and enact monetary policy measures. While greater exchange rate flexibility enhances a central bank’s efficacy, it also brings potential drawbacks, which include:

• Increased exposure to exchange rate risk faced by businesses engaged in international trade or investment.
• Misallocation of financial capital, potentially impacting economic efficiency and stability.

Achieving the right balance between policy effectiveness and potential economic distortions is a key challenge in managing exchange rates and their impact on economies.

Historical Perspective on Currency Regimes

Throughout history, different currency exchange systems have existed alongside each other, with one usually emerging as the dominant system. This has significantly influenced how the world economy approaches the valuation and exchange of currencies.

The Classical Gold Standard and Price-Specie-Flow Mechanism

During the 19th and early 20th centuries until World War I, the “classical gold standard” prevailed. Major currencies like the US dollar and the British pound were tied to fixed gold quantities. Gold acted as the numeraire – the standard unit for pricing goods and assets through the “price-specie-flow mechanism.” Trade surpluses led to the accumulation of gold as payments, increasing gold reserves, expanding money supply and prices and decreasing exports. On the contrary trade deficits caused gold outflows, fall in prices and increased exports. National currencies were backed by gold, and a country could only print as much money as its gold reserves allowed.

Note: A country could increase its gold reserves through trade surpluses, discovering new gold, or using more efficient methods to refine gold.

Bretton Woods System and Transition to Flexible Rates

A new system called the Bretton Woods system was introduced in 1944, during the latter stages of World War II. This system featured fixed exchange rates with occasional realignments. The United States, Japan, and many European industrial countries adhered to this framework. When exchange rate parities deviated significantly from supply-demand equilibrium, periodic realignments were executed to correct the imbalances. These realignments were integrated into standard monetary policy practices.

The system collapsed due to chronic inflation, transitioning to flexible exchange rates in 1973—this shift, influenced by economists like Milton Friedman, aimed to counter speculator disruptions.

However, the transition to flexible exchange rates brought unforeseen consequences, including heightened exchange rate volatility. This was attributed to investment-driven FX transactions, both for long-term investments and short-term speculation. These transactions played a more substantial role in determining spot exchange rates than previously acknowledged.

European Exchange Rate Mechanism (ERM) and Euro Creation

The European Economic Community introduced the European Exchange Rate Mechanism (ERM) to instill a degree of stability in exchange rates. Initially, currency values were expected to fluctuate within a narrow range known as “the snake.”

However, the ERM’s vulnerability became apparent in the early 1990s. Speculative attacks and macroeconomic disparities led to deviations from the ERM’s framework, ultimately culminating in the UK’s forced exit from the system.

Despite challenges, the euro emerged in the late 20th century for most Western European countries (except Switzerland and the UK). The Euro emerged to increase pricing transparency across the borders of memeber countries, encourage market competition, and optimize resource allocation.

One disadvantage of the introduction of the Euro is that member countries lost their ability to manage their exchange rates and, by extension, manage their monetary policies independently.

Continuing Exchange Rate Historical Evolution

The historical shifts in currency regimes have been driven by a complex interplay of economic, geopolitical, and policy factors. These transitions have shaped how countries value and exchange currencies, often reflecting a delicate balance between stability, policy objectives, and market forces.

Taxonomy of Currency Regimes

In the ongoing discussions about fixed and flexible exchange rates, many countries have adopted intermediary systems that sit between these two extremes.

Drivers for Intermediate Regimes

• In some cases, a lack of credibility in terms of sound monetary policy drives the adoption of intermediate regimes. Nations with a history of hyperinflation might resort to a form of fixed-rate regime due to credibility concerns in maintaining a stable currency under a floating regime.
• In other cases, political motivations influence currency regime choices. For instance, the creation of the euro aimed to foster political unity among European Community members with a history of conflicts.

As of April 2008, the IMF categorized exchange rate regimes into eight distinct categories, each representing a different approach to managing a nation’s currency value. These categories as discussed below encompass a spectrum of currency arrangements.

1. Arrangement with No Separate Legal Tender

According to the IMF, countries with no legal tender can be seen in two ways. One is dollarization. The other is when a country is part of a monetary union. Countries with no separate legal tender currency arrangement cannot carry out their own monetary policies.

Dollarization involves adopting another nation’s currency as the medium of exchange, granting currency credibility but not creditworthiness. Note that a country can adopt any currency, but the obvious choice might be the US dollar since it is the main reserve currency. Examples of dollarized countries include East Timor, El Salvador, Ecuador, and Panama.

The European Economic and Monetary Union (EMU) exemplifies a monetary union where member countries share the euro. A monetary union alone does not guarantee creditworthiness, as evident from the 2010 EMU sovereign debt crisis.

Member countries cannot perform independent monetary policy. The monetary union determines the monetary policy through their representatives in the European Central Bank.

2. Currency Board System (CBS)

A CBS, or Currency Board System, is a monetary arrangement where the government commits to exchanging its domestic currency for a specified foreign currency at a fixed rate. It comes with restrictions to make sure the government can meet this commitment. In this system, the local currency is only issued when there’s an equivalent amount of foreign currency held in reserves, making it fully backed by foreign assets.

The currency board system is seen in Hong Kong, where US dollar reserves back the entire Hong Kong dollar monetary base.

Similar to the gold standard, CBS links monetary base expansion and contraction to trade and capital flows, assuming flexible domestic prices and that the non-traded sectors of an economy are very few.

Using the currency board system, the monetary authority can earn a profit called seigniorage. It can earn this profit by paying zero or little interest on its liability (the monetary base) and earning a market rate on its asset, the foreign currency reserves. This is an advantage of the CBS over the dollarization system as in the dollarization system, the seigniorage is received by the monetary authority of the country whose currency is being used.

3. Fixed Parity

A fixed parity system involves pegging the exchange rate to a single currency or a basket of currencies but without any legislative commitment to maintain it, allowing a country to adjust or abandon the parity if necessary.

The fixed parity regime system allows the central bank to perform traditional functions while maintaining a discretionary level of foreign exchange (FX) reserves. Private sector demand for the country’s currency can affect the fixed parity, with excess demand leading to an increase in FX reserves and inflation and deficient demand leading to a depletion of FX reserves and deflation. A speculative attack can occur if market participants believe that FX reserves are insufficient to sustain the parity, draining the reserves and forcing an immediate devaluation. Hence, maintaining an adequate level of reserves is crucial for the credibility of a fixed exchange rate regime.

4. Active and Passive Crawling Pegs

Active crawl is when the exchange rates are pre-announced for the coming weeks with the changes taking place in small steps to manipulate the expectations of inflation.

On the other hand, passive crawl is when exchange rates are frequently adjusted (on a daily or weekly basis), usually against a single currency such as the US Dollar, to keep pace with the inflation rate.

5. Fixed Parity with Crawling Bands

A country may initially peg its currency to a foreign currency to stabilize inflation expectations. Over time, it can introduce more flexibility by gradually widening a pre-defined range around this fixed rate. This system provides an incremental way to transition away from a fixed currency rate, especially if the country is not yet equipped for full monetary flexibility due to a lack of credibility or financial infrastructure.

6. Target Zone Regimes

A target zone system maintains a set parity but comes with broader intervention bands, potentially extending up to ±2 percent around the established parity, compared to a basic fixed parity model. This expanded bandwidth allows the monetary authority increased flexibility for discretionary actions.

7. Managed Float

A managed float involves policy interventions to achieve internal or external targets, potentially creating instability in FX markets. Exchange rate targets may not be explicitly defined.

8. Independently Floating Rates

Independently floating rates leave exchange rates to market determination, allowing the central bank to pursue autonomous monetary policy goals while also acting as a lender of last resort.

Exchange Rates and the Trade Balance

A nation’s trade balance and capital account are interrelated; a trade deficit/surplus must correspond to a capital account surplus/deficit. Factors affecting trade balance have an equal and opposite impact on the capital account and vice versa, highlighting their interdependence.

Consider the following fundamental equation from macroeconomics:

$$X – M =(S-I)+(T – G)$$

Where:

\(X\)= Exports.

\(M\)= Imports.

\(S\)= Private savings.

\(I\)= Investment.

\(T\)= Taxes net of transfers.

\(G\)= Government expenditure.

From the above equation, it’s evident that a trade surplus (X > M) necessitates either a fiscal surplus (T > G), a surplus of private savings over investment (S > I), or both. Given that fiscal surplus can be viewed as government saving, it can be concisely stated that a trade surplus indicates a nation’s savings surpasses what’s needed for its infrastructure investments (I). This surplus in savings is then channeled towards accumulating financial claims on other countries.

On the flip side, a trade deficit signifies the country’s savings fall short of its investment requirements (I), leading to a decrease in its financial claims on other countries.

While this equation connects real expenditure and savings decisions with financial asset flows, it doesn’t specify the type or currency of exchanged assets. Asset prices and exchange rates adjust to align with investors’ preferences. If investors anticipate a change in exchange rates, they will sell (buy) the currency that is expected to depreciate (appreciate), and this will mean a flow of capital from one country to another, that occurs with a shift in the trade balance or that is discouraged by asset prices and exchange rate changes. However, most of these changes occur in the financial markets since expenditure and saving decisions and the prices of goods change at a slower rate compared to financial investment decisions and asset prices.

Fixed exchange rate regimes involve central bank intervention to maintain pegs resulting in adjustments in other asset prices, for instance interest rates.

Floating exchange rates regimes’ adjustsments entail rapid changes in exchange rates that discourage investors from expecting further movements. In the short to intermediate term, exchange rate movements are mainly determined potential and actual capital movements. In teh long run, as expenditure/savings decisions and the prices of goods and services adjust, trade flows become more important.

Question

In which of the following currency arrangements does a nation adopt another nation’s currency as its medium of exchange?

1. Fixed Parity.
2. Dollarization.
3. Fixed Parity with Crawling Bands.

Solution

The correct answer is B.

Dollarization is a currency arrangement in which a nation adopts another nation’s currency as its medium of exchange.

A is incorrect. A fixed parity system involves pegging the exchange rate to a single currency or a basket of currencies but without any legislative commitment to maintain it, allowing a country to adjust or abandon the parity if necessary.

C is incorrect. A fixed parity with crawling bands is when a country that had initially pegged its currency to a foreign currency to stabilize inflation gradually widens a pre-defined range around the fixed rate to introduce more flexibility.