What is “speculative
attack”?
Exchange rate arrangements
of
IMF members, 2004Number
Exchange Arrangement of Countries
Use other nation’s currency or
Member of monetary union 41
Currency board arrangements 7
Conventional pegged (fixed) exchange rates
43
Pegged rates within horizontal bands 4
Crawling pegged exchange rates 5
Exchange rates within crawling bands 5
Managed floating exchange rates 47
Independently floating exchange rates 35
Fixed exchange rate
system
Fixed exchange rates ($1 = 8 yuan, 1 Krona = 1 Euro )
• Normally used by small developing nations to peg to a key currency
• To stabilize import/export prices with main trading partner
• To reduce inflationary expectations
Pegs can be established
• To a single currency To a trade-weighted basked of currencies
• To the special drawing right (SDR), a basket established by the IMF
Create a stabilization fund (accumulate foreign exchange
reserves) to defend this fixed rate
• Government must be ready to convert any amount of domestic
currency into foreign currency
• At some point, because of basic economic changes, fixed rate can
become impossible to defend and must be changed
Using Intervention To Fix Exchange
Rate
US $ vs Mexican Peso
Suppose policy makers in U.S.
or Mexico seek to keep ER fixed
Foreign Exchange Market Intervention
at $.08 = 1 peso ($1= 12.5 pesos) from the U.S. perspective
Suppose increase in Mexican e$/pesos
output raised money demand, S
led to higher interest rate and
appreciation of peso to $.10
How can they keep ER at $.08? $.10
Banco de México could create $.08
D
and sell pesos, buy $$
US Federal Reserve Bank could
sell reserves of pesos for $$ 0 100 200 250 350 Millions of Pesos
In either case, supply of pesos
increases, ER falls
Using Intervention To Fix Exchange
Rate
US $ vs Mexican Peso
Market for $ Market for Peso
The Foreign Exchange Market Intervention Foreign Exchange Market Intervention
from the Mexican Perspectivre from the U.S. perspective
epesos/$ e$/pesos
S
S $.15
12.5 S’
10
D’ $.10
$.08
D D
0 16 25 28 52 0 100 200 250 350 Millions of Pesos
Millions of Dollars
Exchange rate stabilization
under fixed rates
Demand for Pound increased Pound appreciated, $ depreciated
Central bank increases supply of Pounds sells Pounds, buys $$
Exchange rate stabilization
under fixed rates
Demand for $ increased (not shown), supply of Pounds shifted right
Pound depreciated, $ appreciated
Central bank increases demand for Pounds buys Pounds, sells $$
Adjustable pegged rates
Devaluation: making currency cheaper
Revaluation: making currency more expensive
Devaluation and
Revaluation
Devaluation: intentional one-time lowering of fixed value of a
currency under fixed exchange rate
• Example: from $1=1Peso to $1=2Pesos
• Effect on the economy:
– Lower balance of payments deficit, Ex < Im
– Rise in output (exports become cheaper, imports more expensive)
– Increases competitiveness of domestic economy, employment
– Rise in official reserves (in terms of home currency)
– Decrease the burden of domestic government debt
Revaluation: intentional one-time raising of fixed value of a
currency under fixed exchange rate
• Example: from $1=2Peso to $1=1Pesos
– Lower trade surplus, Ex > Im
– Reduces output (imports become cheaper, exports more expensive)
– Decreases competitiveness of domestic economy, employment
– Fall in official reserves (in terms of home currency)
– Increase the burden of domestic government debt
Variety of Exchange Rate
Arrangements
Commitment Flexibility
Adopt Another Currency Fixed with “Crawling” Managed
Currency Board Fixed ER a Band Peg Float Free Float
Ecuador Hong Kong Brazil EMS Poland Mexico U.S.
(’94 - ’99) (’87 - ’92) (’92 - 00) (’94 + )
Euro zone Argentina Poland Bretton Chile Brazil
(‘90’01) (’90 - ’92) Woods (1990s) (’99 + )
Estonia Mexico
(’87 - ’94)
Crawling peg
fixed rate frequently adjusted to account for inflation
• Alternative to fixed exchange rate for an economy with high inflation
• Frequent changes keep pegged rates from becoming unrealistic
• Unannounced changes keep speculators at bay
Currency Boards
= monetary authority that issues domestic currency which can be
converted at a fixed exchange rate
• rate is usually set by law
• must have foreign exchange reserves large enough to cover domestic
currency in circulation- domestic money supply is limited by the
amount of foreign reserves on hand
• currency boards do not make loans or finance government deficits
Advantages:
• popular as a solution for countries which have not been able to
control inflation or hold to a fixed exchange rate
• boards guarantee stability, and political independence
Disadvantages:
• leave no flexibility in monetary policy to respond to changing
circumstances
• require large foreign exchange reserves
Experience has been mixed
Dollarization
Residents of a country use US dollar with or instead of local
currency
Unofficial dollarization: residents hold assets and bank
accounts denominated in dollars
Official dollarization: US dollar replaces local currency
• To reduce risks for investors and avoid problems with
domestic inflation and devaluations
• Implies acceptance of monetary policy set in US by Federal
Reserve
• Less subject to domestic politics
• Cannot respond to local problems, or run deficits
• US Federal Reserve would not be a lender of last resort
Good or bad for the US?
• By holding dollars rather than US government bonds, the
country gives an interest-free loan to the US
• US collects seniorage = inflation tax
U.S. Experience with Fixed and
Flexible Exchange Rates
• After WWII, world operated under fixed exchange
rate system known as Bretton Woods
• all countries fixed currencies to U.S. dollar
• countries agreed to intervene in foreign exchange
market to keep their exchange rate within 1% of the peg
• use monetary policies to keep exchange rate fixed
• pegs could be adjusted in exceptional circumstances of a
fundamental disequilibrium
• In practice, countries were reluctant to adjust their
exchange rates
• In 1973, adjustable peg system was replaced with a
“managed float” system
• Use government intervention in exchange markets to
stay close to a target exchange rate
Convertibility and Capital
Controls
Convertibility
• ease with which a country's currency can be converted into gold or
another currency
Government restrictions result in a currency with a low
convertibility
Government with low reserves of hard foreign currency may restrict
convertibility because the government would not be in a position to
intervene in foreign exchange market (i.e. revalue, devalue) to
support their own currency if and when necessary
• Extreme: government monopoly over buying/selling foreign
exchange, capturing export income and limiting import expenditures
• Multiple exchange rates: different rates for more or less desired
transactions (e.g. discouraging imports)
Exchange rate problems:
Currency crises
In a currency crisis (speculative attack), a weak currency
experiences heavy selling pressure
• Shrinking foreign exchange reserves
• Falling rates in forward markets
• In extreme cases, capital flight
Two factors necessary:
• A fixed exchange rate
• Central bank unable to maintain the fixed rate
– Ran out of reserves
– Unwilling to raise/reduce interest rates
Efforts to stop the selling include:
• Devaluation
• Floating the currency
• Imposing capital controls
• Obtaining foreign loans
• Making domestic policy changes
What Causes a Currency
Crisis?
Budget deficits financed by inflation
Weak financial systems
• Mismanaged banks are guaranteed bail-outs
Faltering economy, raising doubts about the course of
monetary policy (inflationary pressures)
Political crises and uncertainty
External shocks
Financial & Currency Crises:
Argentina 2001-02
1970 – 1991:
• high rates of inflation, rapidly depreciating currency
• monetary and currency reforms: peso to austral to new
austral to new peso
1991: Currency board fixes peso 1:1 to the US$
• Gives up ability to conduct independent monetary policy
• Stabilizes prices and exchange rate, increase exports
1991-2001:
• Unsustainable fiscal deficits - too much accumulated
public debt
• Appreciation of US$ leads to export decline, fall in real
GDP
2001:
• Suspended payments on its external debts
• Restricted withdrawals of deposits from banks in order
to stem the run on the peso
Financial & Currency Crises:
Argentina 2001-02
2002: Currency board abandoned in favor of flexible
exchange rates
• Large depreciation in peso
• Consequences:
–Large increase in external debt burden (mostly in $)
–Decline in real wealth
–Instability in banking system
–Increases in unemployment, weak economy
Lesson: Rigid peg of peso to $ proved painful as $
appreciated
Exchange rate system alternatives
Advantages Disadvantages
Fixed Simplicity and clarity of Loss of independent
exchange exchange-rate target monetary policy
rates Automatic rule for the Vulnerable to speculative
conduct of monetary policy attacks
Keeps inflation under control
Floating Continuous adjustment in the Conducive to price inflation
exchange balance of payments Disorderly exchange
rates Operate under simplified markets can disrupt trade
institutional arrangements and investment patterns
Allow governments to set Encourage reckless financial
independent monetary and policies on the part of
fiscal policies government