Economics of International Finance Econ. 315

1. Economics of International FinanceEcon. 315 Chapter 7 Flexible Versus Fixed Exchange Rates, The European Monetary System, and Macroeconomic Policy Coordination

2. Introduction: Advocates of flexible exchange rate system argue that: • It is more efficient than fixed exchange rate system to correct for BOP disequilibria. • By allowing to achieve external balance, it facilitates the achievement of internal balance and other economic objectives of the nation. • Advocates of the fixed exchange rate system argue that flexible exchange rates: • Increases uncertainty and Reduces international trade and investment • More likely to lead to destabilizing speculation • Inflationary • Careful examination of the theoretical arguments raised by each side does not lead to any clear-cut conclusion that one system is superior to another and most of this is based on painful weaknesses systems adopted.

3. In this chapter we examine the case of fixed and flexible exchange rates, the debate on an optimum currency area, currency board arrangements, and dollarization. The case for flexible Exchange Rates: • We saw that under flexible exchange rates, a deficit or surplus is automatically corrected by a depreciation or appreciation, without any government intervention and loss or accumulation of international reserves. Fixing exchange rates may result in excess demand or supply of foreignexchange (due to overvaluation or undervaluation of the currency) that can be corrected by a change in economic variables other than the exchange rate, which may lead to policy mistakes and use of policies which do not achieve purely internal economic objectives.

4. A. Market Efficiency: • It is more efficient or less costly to change the exchange rate because: • A flexible exchange rate corrects BOP equilibria smoothly and continuously as they occur. • A flexible exchange rate stabilizes speculation which dampen fluctuations in exchange rates. Fixed exchange rates is likely to give rise to destabilizing speculations and forces the country to make a large discrete change in exchange rate. • Flexible exchange rates clearly identify the degree of comparative advantage and disadvantage of the nation in various commodities, while fixed exchange rates distorts the pattern of trade and prevent the most efficient allocation of resources throughout the world, e.g., leads the country to export a commodity in which it does not have a comparative disadvantage (because it is cheaper due to undervalued domestic currency). B. Policy Advantages • The nation does not have to concern itself with its external balance and can use all policies to achieve its domestic goals. The possibility of policy mistakes and delays would also be minimized under flexible exchange rate system.

5. Flexible exchange rate policy enhances the effectiveness of monetary policy, e.g., an anti-inflationary policy that improves BOP will result in an appreciation, which further reduces domestic inflationary pressures as by encouraging imports and discouraging exports. • Different nations can pursue domestic policies aimed at reaching their own inflation-unemployment trade-off. Under fixed exchange rates, different inflation rates in different nations results in BOP pressures (deficit in more inflationary nations and surplus in less inflation nations) that restrain each nation from achieving its optimum inflation-unemployment trade-off. • Flexible exchange rates prevent the government from setting exchange rates at a level other than equilibrium or to benefit one sector at the expense of another, e.g., LDCs usually keep exchange rate undervalued (overvaluation of their domestic currency) to encourage imports of capital goods, but this discourage their agricultural exports. • Flexible exchange rates does not impose the cost of government intervention in the foreign exchange market to maintain exchange rates fixed.

6. The Case for Fixed Exchange Rates • Less Uncertainty • Fixed exchange rates avoids the wild day-to-day fluctuations that occur under flexible exchange rate, and that discourages specialization and the flow of international trade and investment. Look at figure 1, shifts from D€ to D’€ or to D*€ cause the exchange rate to fluctuate from R’ to R*. If the supply curve is Less elastic (S’€), exchange rate fluctuates from R” to R**. Figure 2 also shows that exchange rates fluctuates widely on a daily basis.

7. FIGURE 1 Shifts in the Nation’s Demand Curve for Foreign Exchange and Uncertainty.

8. Excessive short run fluctuations in exchange rates under a flexible exchange rate system may be costly in terms of higher frictionalunemployment if they lead to over-frequent attempts at allocating domestic resources among the various sectors of the economy. We noted also that short run tendency of exchange rates overshoots its long term level. • Although fixed exchange rate may impose uncertainty and instability surrounding the periodical large discrete changes in par values, truly fixed exchange rate systems such as the gold standard keep exchange rates fixed and uncertainty would be absent.

9. B. Stabilizing Speculation • Under flexible exchange rates, with destabilizing speculations, speculators purchase a foreign currency when the exchange rate is rising, in the expectation that the exchange rate will rise even more, and sell when the rate is falling in the expectation that the rate will fall even more. Fluctuations in exchange rates resulting from business cycles will be amplified. The opposite is under stabilizing fluctuations. Look at figure 3 which shows the larger fluctuations under destabilizing expectations, which is more likely to occur under flexible exchange rates system. But Advocates of flexible exchange rate system argue that destabilizing speculations can also occur under fixed exchange rate system (Bretton woods system).

10. FIGURE 3 Fluctuations in Exchange Rate in the Absence of Speculation and with Stabilizing and Destabilizing Speculation.

11. C. Price Discipline: • Fixed exchange rates impose a price discipline on the nation not present under flexible exchange rates. A nation with a higher inflation rate is likely to face persistent deficit in its BOP and a loss of reserves under a fixed exchange rate system. Since deficits and reserve loss can’t continue forever, the nation needs to restrain its excessive rate of inflation and thus facing some price discipline. Flexible exchange rates can be more inflationary than fixed exchange rates. Advocates of flexible exchange rates argue that flexible exchange rates can insulate the economy from external shocks much more better than under fixed exchange rates. But fixed exchange rates provide more stability to an open economy subject to large internal shocks. • In general, fixed exchange rate system is preferable for a small open economy that trades mostly with one or a few larger nations and in which disturbances are primarily of a monetary nature.

12. Optimum Currency Areas (OCA) • Developed by Mundell and Mckinnon during 1960s. An OCA or block refers to a group of nations whose national currencies are linked through permanently fixed exchange rates and the conditions that make such an area optimum. Advantages: • The formation of an OCA eliminates the uncertainty that arises when exchange rates are not permanently fixed, thus stimulating specialization in production and the flow of trade and investment among member regions or nations. • The formation of an OCA also encourages producers to view the entire area as a single market and to benefit from greater economies of scale in production. • With permanently fixed exchange rats, OCA is likely to experience greater price stability than if exchange rates could change between the various member nations. This encourages the use of money as a store of value and as medium of exchange and discourages barter deals arising under more inflationary circumstances.

13. An OCA also saves the cost of official intervention into the foreign exchange market involving the currencies of the member countries, the cost of hedging, the cost of exchanging one currency for another to pay for goods and services. Disadvantages: • Each nation can not pursue their own independent stabilization and growth policy, e.g., a depressed nation with high unemployment may need to expansionary fiscal and monetary policies, while a more prosperous nation may need contractionary policies. But intra-flows of trade and labor from excess supply to excess demand areas reduce the costs of an OCA. Conditions for an OCA: An OCA is likely to be beneficial under the following conditions: • The greater is the mobility of resources among various member nations • The greater are their structural similarities • The more willing they are to closely coordinate their fiscal, monetary and other policies.

14. Currency Boards Arrangements (CBAs): • Are the most extreme form of exchange rate peg (fixed exchange rate system). Under CBA’s the nation rigidly fixes (often by law), its currency to a foreign currency. The central bank gives up: • control over money supply. • Its function of conducting an independent monetary policy. Money supply increases only in response to BOP surplus (increase in MS) and deficit (decrease in MS). • Control over Inflation and interest rate, as these are determined by the country against whose currency is pegged or fixed (e.g., inflation of US). • Countries usually adopt this system in times of a deeper crisis in order to control inflation. • Conditions of successful CBA. • Sound banking system: the central bank can’t be a lender of the last resort (No control over MS) • Prudent fiscal policy: the central bank can’t lend the government (by increasing the M. base). • Main disadvantage: the country can’t conduct its own monetary policy.

15. Dollarization. • Adopting another nation’s currency (US $ or another currency) as its own legal tender (currency). • Benefits of Dollarization. • Avoiding the cost of exchanging the domestic currency for dollars and the need to hedge foreign exchange risks • Facing a rate of inflation similar to that of the US (or that of the currency used instead of the domestic currency), (also similar interest rates and commodity arbitrage). • Avoiding foreign exchange crises, the need for foreign exchange and trade controls, fostering budgetary discipline and encouraging more rapid and full international financial integration.

16. Costs of Dollarization • Cost of replacing the domestic currency to the dollar (about 4-5% of GDP, paid once). • The loss of independent monetary and exchange rate policies. • Loss of the CB as a lender of the last resort when financial institutions face a crisis. • Good candidates for dollarization are small open economies for which the US (or Europe) is the dominant economic partner and which have a history of poor monetary performance.

17. List of Officially Dollarized Economies. U.S. dollar. • British Virgin Islands East Timor • Ecuador (uses its own coins) El Salvador • Marshall Islands Micronesia • Palau Panama (uses its own coins) • Pitcairn Islands (also uses the New Zealand dollar) • Turks and Caicos Islands Euro. • Kosovo • Monaco (formerly French franc; issues own coins) • Andorra (formerly French franc and Spanish peseta) • San Marino (formerly Italian lira; issues own coins) • Vatican City (formerly Italian lira; issues its own coins) • Montenegro

18. New Zealand dollar. • Niue • Tokelau • Pitcairn Island (also uses U.S. dollar) Others. • Cyprus, Northern (Turkish lira) • Liechtenstein (Swiss franc) • Tuvalu (Australian dollar, prints its own notes)

19. Exchange Rate Bands. • Allowing fixed exchange rate to fluctuate within narrowly defined limits, i.e.,: • The nation decide the par value of its currency. • Allow a band of fluctuations above and below the par value. • Actual exchange rate “within bands” is then determined by market forces, but it is prevented from moving outside the band by official intervention in foreign exchange markets. • The advantage of the small band of fluctuation is that monetary authorities will not have to intervene constantly to maintain the par value, but to prevent the rate from moving outside the allowed limit of fluctuations.

20. The nation could increase the width of the band to eliminate official intervention in the foreign exchange market. This would represent a flexible exchange rate system. • A preference of fixed exchange rate would allow only a very narrow band, while a preference for flexible exchange rates would make the band very wide.

21. Upper limit Lower limit FIGURE 4 Exchange Rate Band

22. Adjustable Peg Systems • Adjustable peg system requires defining the par vale and the allowed band of fluctuation, with the stipulation that the par value will be changed periodically and the currency devalued to correct a BOP deficit or revalue to correct a surplus. • A truly adjustable peg system would be the one under which the nations with BOP disequilibria would take the advantage of the flexibility provided by the system to change the par value without waiting for the exchange market pressure would be unbearable if faced with a deficit or a surplus (see figure 5). • To work as intended, an objective rule would have to be agreed upon and enforced to determine the timingof the par value adjustment, e.g., when the international reserves falls by a certain percentage. A potential problem would be that speculators may know the rule and engage in destabilizing speculations to make profits.

23. FIGURE 5 Adjustable Pegs

24. Crawling Pegs • Crawling pegs “sliding practices”, is advised to avoid relatively large changes in par values and possible destabilizing speculations. The par values are changed by small pre-announced amounts at specified intervals until equilibrium exchange rate is reached. • Look at figure 6. instead of a single devaluation of 6%, there are 3 mini devaluations of 2% each. Note that if the upper band before the mini devaluation coincide with (or perhaps can be greater than) the lower band of the next mini devaluation, there will be no change in the actual spot rate. • The country can neutralize scheduled speculation profits by equal rises in short term interest rates (net speculation profit = zero).

25. Three mini devaluations Instead of a 6% Single devaluation FIGURE 6 Crawling Pegs.

26. Advantages • Eliminates the political risks attached to a large devaluation • Prevents destabilizing speculations. • If combined with wider bands, it can create greater flexibility • Crawling peg seems best suited for a developing country that faces real shocks and differential inflation rates • Managed Floating • Under managed floating, the monetary authorities are responsible for intervention in the foreign exchange market to smooth out short term fluctuations without affecting long term trend in exchange rates. • If successful, the country enjoys most of the benefits of fixed exchange rates while at the same time retaining flexibility in adjusting BOP disequilibria.

27. Leaning against the wind: authorities supply a portion of international reserves in case of short run excess demand (BOP deficit) to moderate depreciation, and absorb a portion of short run excess supply (BOP surplus) to moderate appreciation. This moderates short term fluctuations without affecting the long run trend in exchange rates. • Stabilization of foreign exchange rate will depend on the size of the nation’s international reserves, the greater the size, the greater is the exchange rate stabilization it can achieve. • Rules of leaning against the wind must be clear, otherwise, there is a danger that the nation may practice dirty floating, the nation keeps exchange rates high to stimulate exports (beggar-thy-neighbor), which invites retaliation by other nations.

28. Key Terms: • Optimum currency area or block. • Adjustable peg system. • peg system. • Managed floating exchange rate system. • Currency board arrangements (CBA). • Dollarization.

30. FIGURE 2 Exchange Rates of the G-7 Countries and Effective Exchange Rate of the Dollar, 1971–2002.

31. Common (single) Currency. The GCC project • GCC countries decided in 2000 that they will unify their currencies by the year 2010 • As a preliminary step towards a unified currency they adopted a common peg to the US dollar policy. By 2003 all GCC pegged to the US$ • In 2005 the criteria of convergence (to join the common currency) was agreed upon Why the GCC want to establish a common currency? Advantages of the common currency 1. Common currency: trade and investment • the reduction in transaction costs: currency conversion costs, exchange rate prediction costs and in-house costs of maintaining separate foreign currency expertise • removing volatility in exchange rates • removing the pressures on hedging exchange rate risk • companies will charge a single price rather than price discrimination • lower pressures on price arbitrage

32. 2. Common currency and growth • restructuring industrial facilities to be placed in the most efficient location instead of having facilities in different location. • Improved allocation of market capital. • Intensify cross-border competitive pressures. 3. Common currency and capital markets • break down barriers between national capital markets. • companies will be able to raise capital in different capital markets. • pressure on firm managements to perform better will increase.

33. Convergence criteria In 2005 GCC agreed upon the convergence criteria for member states to join the common currency. These are: • Short-term interest rates for each member will be no higher than 2 percentage points over the average of the three lowest countries. • Inflation will be no higher than 2 percentage points above the maximum weighted average for the six countries. • The fiscal deficit will be no higher than 3 percent of GDP; and no more than 5 percent of GDP when oil prices are weak • Government debt will not exceed 60 percent of GDP. • Foreign exchange reserves/import coverage will be at least 4 months.

40. The 2010 Deadline: Can the GCC meet the 2010 deadline? • Oman’s decision • Kuwait abandons the common peg • The common market stage 2007 • The common currency could be a threat to cooperation and integration among GCC countries. More urgent issues: • Diversification and broader production base • Enhance intra trade • Fight Inflation. Inflation is a very critical issue for countries like Kuwait • Better coordination of policies and more political responsibility towards the council • Enhancing the institutional structure of the GCC • Enhance and upgrade the statistical data base "GULFSTAT"

41. Kuwaiti Dinar fixed band 5/1/2003: • Par rate was 299.63 fils per dollar • Band is ±3.5%, i.e., • 310.11 fils/$ maximum R (devaluation of KD) • 289.14 fils/$ minimum R (revaluation of KD) 11/5/2006: • 289.14 fils/dollar (minimum limit was exhausted due to the weak dollar). 20/5/2007: • De-linking the KD to the $ and the return to currency basket peg. • 288.06 fils/dollar