Exchange Rate Arrangements: Various Options

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Exchange Rate Arrangements Various Options

• Choice before an authority
• Fixed Exchange Rate System
• Floating Exchange Rate System

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Exchange Rate Arrangements Various Options

• THE CASE FOR FLOATING EXCHANGE RATES
• 1. Monetary policy autonomy.
• If central banks were no longer obliged to
  intervene in currency markets to fix exchange
  rates, authorities would be able to use monetary
  policy to reach internal and external balance.
• Further, no country would be forced to import
  inflation (or deflation) from abroad.

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Exchange Rate Arrangements Various Options

• 2. Symmetry.
• Under a system of floating rates the inherent
  asymmetries of Bretton Woods would disappear and
  the United States would no longer be able to set
  world monetary condition all by itself.
• At the same time, the United States would have
  the same opportunity as other countries to
  influence its exchange rate against foreign
  currencies.

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Exchange Rate Arrangements Various Options

• 3. Exchange rates as automatic stabilizers.
• Even in the absence of an active monetary policy,
  the swift adjustment of market-determined
  exchange rates would help countries maintain
  internal and external balance in the face of
  changes in aggregate demand.
• The long and agonizing period of speculation
  preceding exchange rate realignments under the
  Bretton Woods rules would not occur under
  floating.

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Exchange Rate Arrangements Various Options

• THE CASE AGAINST FLOATING EXCHANGE RATES
• 1. Discipline.
• Central banks freed from the obligation to fix
  their exchange rates might embark on inflationary
  policies.
• In other words, the "discipline" imposed on
  individual countries by a fixed rate would be
  lost.

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Exchange Rate Arrangements Various Options

• 2. Destabilizing speculation and money market
  disturbances.
• Speculation on changes in exchange rates could
  lead to instability in foreign exchange markets,
  and this instability, in turn, might have
  negative effects on countries' internal and
  external balances.
• Further, disturbances to the home money market
  could be more disruptive under floating than
  under a fixed rate.

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Exchange Rate Arrangements Various Options

• 3. Injury to international trade and investment.
• Floating rates would make relative international
  prices more unpredictable and thus injure
  international trade and investment.

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Exchange Rate Arrangements Various Options

• 4. Uncoordinated economic policies.
• If the Bretton Woods rules on exchange rate
  adjustment were abandoned, the door would be
  opened to competitive currency practices harmful
  to the world economy.
• As happened during the interwar years, countries
  might adopt policies without considering their
  possible beggar-thy-neighbor aspects.
• All countries would suffer as a result.

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Exchange Rate Arrangements Various Options

• 5. The illusion of greater autonomy.
• Floating exchange rates would not really give
  countries more policy autonomy.
• Changes in exchange rates would have such
  pervasive macroeconomic effects that central
  banks would feel compelled to intervene heavily
  in foreign exchange markets even without a formal
  commitment to peg.
• Thus, floating would increase the uncertainty in
  the economy without really giving macroeconomic
  policy greater freedom.

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Exchange Rate Arrangements Various Options

• Various Alternatives Available Under Floating
  Exchange Rate System
• Free Float
• Dirty Float
• Floating Within A Band
• Sliding Band
• Crawling Band
• Crawling Peg
• Fixed but Adjustable
• Currency Board
• Dollarization

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Exchange Rate Arrangements Various Options

• Free Float
• Value of foreign exchange freely determined in
  the market.
• Actual and expected changes in demand/ supply of
  assets and goods reflected in exchange rate
  changes

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Exchange Rate Arrangements Various Options

• Dirty Float
• Sporadic central bank interventions in foreign
  exchange markets.
• Modes and frequency of intervention vary as do
  the objectives guiding the interventions.
• Active interventions results in changes in
  international reserves.
• Indirect interventions (through changes in
  interest rates, liquidity and other financial
  instruments) does not result in changes in
  reserves

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Exchange Rate Arrangements Various Options

• Floating Within A Band
• The exchange rate is allowed to fluctuate within
  a band.
• The center of the band is a fixed rate, either
  in terms of one currency or of a basket of
  currencies.
• The width of the band varies.
• Some band systems are the result of cooperative
  arrangements, other are unilateral
• Example
• (The Vietnam government announced a raft of
  plans, including widening the currency trading
  band, to help counter the nations fastest
  inflation in more than 12 years. It plans to
  widen the currencys trading band against the
  dollar to 2, up from the current 0.75. (7 March
  2008))

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Exchange Rate Arrangements Various Options

• Sliding Band
• There is no commitment by the authorities to
  maintain the central parity "indefinitely" .
• Instead it is clear at the outset that the
  central parity will be adjusted periodically
  (e.g. due to competitiveness considerations)
• The system is an adaptation of the band regime to
  the case of high inflation economies.

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Exchange Rate Arrangements Various Options

• Crawling Band
• A band system whereby the central parity crawls
  overtime.
• Different rules can be used to determine the rate
  of crawl.
• The two most common are backward looking crawl
  (e.g. based on past inflation differential ) and
• forward looking crawl (e.g. based on the expected
  or target, rate of inflation)

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Exchange Rate Arrangements Various Options

• Crawling Peg
• The normal exchange rate is adjusted periodically
  according to a set of indicator (usually lagged
  inflation differentials) and is not allowed the
  alternate beyond a narrow range (say two percent)
• One variant of the system consists of adjusting
  the nominal rate by a pre-announced rate set
  deliberately below ongoing inflation.

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Exchange Rate Arrangements Various Options

• Fixed but Adjustable
• The regime epitomized by the Bretton Woods
  System.
• The exchange rate is fixed but the central bank
  is not obliged to maintain the parity
  indefinitely.
• No tight constraints are imposed on the monetary
  and fiscal authorities regarding policies that
  are inconsistent with preserving the parity.
• Adjustments of the parity (devaluation) are a
  powerful policy instrument

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Exchange Rate Arrangements Various Options

• Currency Board
• Fixed exchange rate system with institutional
  (legal and even constitutional) constraints on
  monetary policy and no scope for altering the
  parity.
• The monetary authority can issue domestic money
  only when it is fully backed by inflows of
  foreign exchange

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Exchange Rate Arrangements Various Options

• Dollarization
• Generic name given to and extreme form of a
  currency board system where the country gives up
  completely its monetary autonomy by adopting
  another countries currency