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 are 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 attributes.

1. Establishing credibly fixed exchange rates between currencies, thereby reducing uncertainties related to pricing in terms of goods, services, and financial assets.
2. Allowing full convertibility of currencies and facilitating unrestricted capital movement.
3. It envisions each country having the autonomy to pursue independent monetary policies in line with its 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 be a single global currency. In such a context, converting one national currency to another would be as simple as choosing between carrying coins or paper money in your pocket.

Under these conditions, attempts to control interest rates, asset prices, or inflation by manipulating the supply of one currency relative to another are ineffective. As a result, the concept of an independent monetary policy is unworkable. In conclusion, there is no one-size-fits-all 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 could trigger an outflow of capital seeking higher returns elsewhere. 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 boost exports and decrease imports, thereby reinforcing the expansionary impact of the interest rate change. Similarly, raising interest rates can lead to currency appreciation, affecting trade dynamics. 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:

• One significant concern is the increased exposure to exchange rate risk faced by businesses engaged in international trade or investment.
• Additionally, excessive exchange rate volatility can lead to 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 standard unit for pricing goods and assets through the “price-specie-flow mechanism.” Trade surpluses led to increased gold reserves, expanding money supply and prices, while deficits caused gold outflows, decreasing prices and boosting exports. National currencies were backed by gold, maintaining supply limitations.

Bretton Woods System and Transition to Flexible Rates

After World War II, a new system called the Bretton Woods system was introduced in 1944. 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. Flexible rates led to unforeseen exchange rate volatility, partly due to investment-driven foreign exchange transactions.

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 Western European countries, enhancing transparency and competition. This aimed to streamline pricing transparency, encourage market competition, and optimize resource allocation. However, it also led to trade-offs as member states surrendered independent exchange rate control for economic integration.

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 encompass a spectrum of currency arrangements. They include:

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, where countries don’t have their own currency and use foreign currencies. The other is when a country is part of a monetary union. In these countries, they can’t 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. However, a monetary union alone does not guarantee creditworthiness, as evident from the 2010 EMU sovereign debt crisis. Moreover, the member countries cannot perform independent monetary policy. However, 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 limited non-traded sectors.

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.

Moreover, 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. If market participants believe that FX reserves are insufficient to sustain the parity, this can lead to a speculative attack, 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. 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.

5. 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.

6. Worked 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.

7. 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.

Effects of Exchange Rates on Countries’ International Trade and Capital Flow

There are many effects of exchange rates on countries’ international trade and capital flow. Most of them are listed below.

Changing Prices of Currencies

While shifts in supply and demand of products change the prices of those products, constant shifts in supply and demand for foreign currencies cause changes in the prices of currencies. Likewise, as prices of money change, demand for foreign currencies changes.

Increase in Demand for Imports

An increase in the demand for imported goods happens when products of a foreign nation sell at lower prices than domestic products. When domestic income rises, demand for imports rises. Moreover, in capital markets, when returns on a nation’s investments are higher than the domestic interest rate, individuals choose to invest in other nations’ securities.

Expensive Products

Many countries depend more on imports than domestically produced goods. This is because exchange rates play a significant role in the determination of the prices of imported products. If the domestic currency is weaker, consumers will have to pay higher prices in domestic currency for foreign goods.

They are Self-correcting over Time

When the supply of dollars in the international market grows, their values depreciate. As time goes by, imports become unattractive, and exports become more attractive. The converse is also true.

Development of a Trade Deficit

If the interest rates of other nations are higher than those of dollar nations, the demand for foreign countries automatically falls. However, a stronger dollar means decreased exports because they seem expensive to foreign consumers. This leads to a trade deficit.

Effect on Standard of Living

Differences in currency values affect our ability to buy imported goods and export domestic goods. A currency crisis affects the lives and well-being of the citizenry in significant ways. For example, take Argentina, a country that has defaulted on its debt five times in the last 200 years. Every time this happens, their currency gets devalued. As a result, Argentineans cannot import goods from other countries cheaply for a few years. This hurts Argentina’s economic growth and its citizenry’s standard of living.

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.

Using 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 equate to 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 from 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 holdings from 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. Anticipated exchange rate changes drive capital flows, but adjustments primarily occur in financial markets due to their faster pace compared to goods prices.

Fixed exchange rate regimes involve central bank intervention to maintain pegs adjusting other asset prices. Floating exchange rates entail rapid exchange rate shifts that affect investor conviction. In the short to intermediate term, capital flows mainly drive exchange rate movements, with trade flows becoming increasingly influential over the long term.

Question

Which of the following is least likely an effect of strengthening a domestic country’s exchange rate?

1. A fall in demand for imports.
2. Development of a trade deficit.
3. A rise in the general price level.

Solution

The correct answer is A.

Exchange rates cause an increase in the demand for imports, as well as the development of a trade deficit. It also leads to a general rise in price levels.

Strengthening of the domestic currency means that imports are more attractive while exports are less attractive for the citizenry of a country.