Exchange Rate Systems and Currency Crises

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INTERNATIONAL ECONOMICS SEVENTEENTH EDITION

ROBERT J. CARBAUGH

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Chapter 14: Exchange- Rate Systems and Currency Crises

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Chapter Outline (1 of 2)

Exchange-Rate Practices

Choosing an Exchange-Rate System: Constraints Imposed by Free-Capital Flows

Fixed Exchange-Rate System

Floating Exchange Rates

Managed Floating Rates

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Chapter Outline (2 of 2)

The Crawling Peg

Currency Manipulation and Currency Wars

Capital Controls

Increasing the Credibility of Fixed Exchange Rates

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Exchange-Rate Practices (1 of 5)

In choosing an exchange-rate system, a nation must decide whether to allow its currency to be determined by market forces (floating rate) or be fixed (pegged) against some standard of value

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Exchange-Rate Practices (2 of 5)

Floating exchange-rate system

Nation must decide whether currency should float independently, float in unison with other currencies, or crawl according to predetermined formula

Pegged exchange-rate system

Fixed against some standard of value; nation must decide whether to

Anchor to single currency, basket of currencies, or gold

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Exchange-Rate Practices (3 of 5)

Members of the IMF

Exchange rates should not be manipulated

To prevent effective balance-of-payments adjustments

To gain unfair competitive advantage over other members

Members should act to counter short-term disorderly conditions in exchange markets

When members intervene in exchange markets, must take into account interests of other members

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Exchange-Rate Practices (4 of 5)

TABLE 14.1 Exchange-Rate Arrangements of IMF Members,* 2015

	Exchange Arrangement	Percentage of IMF Members
Hard pegs
	No separate legal tender	6.8
	Currency board	5.8
Soft pegs
	Conventional pegged (fixed) exchange rates	23.0
	Stabilized arrangement	11.5
	Crawling peg	1.6
	Crawling-like arrangement	10.5
	Pegged exchange rate within horizontal bands	0.5
Floating
	Managed floating	19.4
	Free floating	15.7
	Other	5.2
		100.0

*Includes 188 member countries.

Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, 2015. See also International Monetary Fund, Classification of Exchange Rate Arrangements and Monetary Policy Frameworks, available at http://www.imf.org/.

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Exchange-Rate Practices (5 of 5)

TABLE 14.2 Choosing an Exchange-Rate System

Characteristics of Economy	Implication for the Desired Degree of Exchange-Rate Flexibility
Size and openness of the economy	If trade is a large share of national output, then the costs of currency fluctuations can be high. This suggests that small, open economies may best be served by fixed exchange rates.
Inflation rate	If a country has much higher inflation than its trading partners, its exchange rate needs to be flexible to prevent its goods from becoming uncompetitive in world markets. If inflation differentials are more modest, a fixed rate is less troublesome.
Labor-market flexibility	The more rigid wages are, the greater the need for a flexible exchange rate to help the economy respond to an external shock.
Degree of financial development	In developing countries with immature financial markets, a freely floating exchange rate may not be sensible because a small number of foreign exchange trades can cause big swings in currencies.
Credibility of policy makers	The weaker the reputation of the central bank, the stronger the case for pegging the exchange rate to build confidence that inflation will be controlled.
Capital mobility	The more open an economy to international capital, the harder it is to sustain a fixed rate.

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Choosing an Exchange-Rate System: Constraints Imposed by Free Capital Flows (1 of 2)

Allowing free capital flows

Constrains a country’s

Choice of exchange-rate system

Ability to operate independent monetary policy

Impossible trinity

A country can maintain only two of the following three policies:

Free capital flows

Fixed exchange rate

Independent monetary policy

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Choosing an Exchange-Rate System: Constraints Imposed by Free Capital Flows (2 of 2)

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Fixed Exchange-Rate System (1 of 9)

Use of fixed exchange rates

Used primarily by small, developing nations with currencies anchored to key currency

Key currencies

Widely traded on world money markets

Have demonstrated relatively stable values over time

Widely accepted as means of international settlement

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Fixed Exchange-Rate System (2 of 9)

TABLE 14.3 Key Currencies: Currency Composition of Official Foreign Exchange Reserves of the Member Countries of the International Monetary Fund, 2016

Key Currency	Composition of Official Foreign Exchange Reserves
U.S. dollar	63.9%
Euro	19.7
British pound	4.4
Japanese yen	4.2
Canadian dollar	2.0
Australian dollar	1.8
Chinese yuan	1.1
Other	2.9
	100.0

Source: From Currency Composition of Official Foreign Exchange Reserves (COFER), International Monetary Fund, 2017, available at www.imf.org.

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Fixed Exchange-Rate System (3 of 9)

Anchoring to single currency

Generally done by developing nations whose trade and financial relations are mainly with a single industrial-country partner

Some nations anchor to special drawing right (SDR)

Basket of four currencies established by IMF

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Fixed Exchange-Rate System (4 of 9)

Par value and official exchange rate

In terms of gold or other key currencies

Official exchange rate

Can be determined by comparing par values of two currencies

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Fixed Exchange-Rate System (5 of 9)

Exchange-rate stabilization

Exchange stabilization fund

Used to defend official rate through purchases and sales of foreign currencies

Fundamental disequilibrium

Long-term, official exchange rate and the market exchange rate may diverge, reflecting changes in fundamental economic conditions like income levels, tastes, preferences, and technological factors

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Fixed Exchange-Rate System (6 of 9)

Devaluation and revaluation

Devaluation-counteracting payments deficit

Revaluation-counteracting payments surplus

Depreciation and appreciation

Actual impact on market exchange rate caused by

A redefinition of par value

Changes in exchange rate

Changes in the supply or demand of foreign exchange

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Fixed Exchange-Rate System (7 of 9)

Bretton Woods System of Fixed Exchange Rates

Semi-fixed exchange-rate system

Adjustable pegged exchange rates

Currencies tied to each other

Nation could repeg its exchange rate via devaluation or revaluation policies

Use fiscal and monetary policies first to correct payment imbalances

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Fixed Exchange-Rate System (8 of 9)

Bretton Woods System (cont.)

Agree to defend existing par values

Correct fundamental disequilibrium by repegging currencies

Up to 10% without permission from IMF

By greater than 10% with the fund’s permission

Par value set in terms of gold or gold content of U.S. dollar in 1944

Market exchange rates were almost but not completely fixed

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Fixed Exchange-Rate System (9 of 9)

Bretton Woods System (cont.)

Operational problems (cont.)

Currency devaluation indicated failure of domestic policies

Currency revaluations unacceptable to exporters

Repegging exchange rates only as a last resort

Difficult because of adjustable pegged rates

Speculators had incentive to move out of weakening currency

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Floating Exchange Rates (1 of 4)

Floating exchange rates (flexible)

Currency prices established daily in foreign-exchange market

Without restrictions imposed by government policy

Equilibrium exchange rate

Demand for and supply of home currency

Changes in exchange rate

Correct a payments imbalance

Shifts in imports and exports of goods, services, and short-term capital movements

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Floating Exchange Rates (2 of 4)

Trade restrictions, jobs, and floating exchange rates

During economic downturns, labor unions lobby for import restrictions to save jobs of domestic workers

Implementation of import restrictions

Helps one industry

Shifts jobs from other industries to protected industry

Has no significant impact on aggregate employment

Leads to short-term employment gains in protected industry being offset by long-term employment losses in other industries

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Floating Exchange Rates (3 of 4)

Arguments for floating rates

Respond quickly to changing supply and demand conditions

Clear the market of shortages or surpluses of a given currency

Simplified institutional arrangements that are relatively easy to enact

Continuous adjustment in the balance of payments

Partially insulate home economy from external forces

Nations have greater freedom to pursue policies that promote domestic balance

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Floating Exchange Rates (4 of 4)

Arguments against floating rates

Unregulated market may lead to wide fluctuations in currency values and discourage foreign trade and investment

Inflationary bias; monetary authorities may lack financial discipline

Greater freedom for domestic financial management

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Managed Floating Rates (1 of 6)

Managed floating system

Informal guidelines established by IMF for coordination of exchange-rate policies

Nations might intervene in exchange markets to avoid exchange-rate alterations that would weaken their competitive position

Concern that floats over time might lead to disorderly markets with erratic fluctuations in exchange rates

Nation can alter degree to which it intervenes in foreign-exchange market

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Managed Floating Rates (2 of 6)

When U.S. suspended gold convertibility & allowed overvalued dollar to float, hoped free market adjustment would result in depreciation of dollar against undervalued currencies

Clean float

Market solution; but foreign central banks refused to permit and intervened in exchange market

Dirty float

Interference in market; forces of supply & demand not allowed to play equilibrating role

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Managed Floating Rates (3 of 6)

Leaning against the wind

Intervene to reduce short-term fluctuations in exchange rates without attempting to adhere to any particular rate over long term

Target exchange rates

To reflect long-term economic forces that underlie exchange-rate movements

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Managed Floating Rates (4 of 6)

Managed floating rates in the short run and long run

Market intervention stabilizes exchange rates in short term; allows market forces to determine exchange rates in long term

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Managed Floating Rates (5 of 6)

Exchange-rate stabilization & monetary policy

To stabilize a currency’s exchange value; expansionary/contractionary monetary policy

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Managed Floating Rates (6 of 6)

Is exchange-rate stabilization effective?

May be useful when exchange rate is under speculative attack

May be helpful in coordinating private-sector expectations

Research provides some support for short-term effectiveness

Does not support long-term intervention

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The Crawling Peg

Crawling peg system

Small, frequent changes in par value of currency to correct balance-of-payments disequilibrium

Process of exchange-rate adjustment is continuous for all practical purposes

Used by nations with high inflation rates

Combines flexibility of floating rates with stability usually associated with fixed rates

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Currency Manipulation and Currency Wars (1 of 3)

Currency manipulation

Purchase or sale of currency by fiscal or monetary authority to influence its value

In 2000s, U.S. accused Japan, China, South Korea, Singapore, and other countries of keeping the exchange values of their currencies artificially low in order to boost international competitiveness and trade surpluses.

U.S. has been doing the same thing

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Currency Manipulation and Currency Wars (2 of 3)

Is China a currency manipulator?

U.S.: China manipulates the yuan

Yuan significantly undervalued relative to dollar

U.S. exports to China more expensive

Harms U.S. production and employment

Chinese goods cheaper for American consumers

More imports

Huge trade surplus with United States

Large accumulation of dollar reserves

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Currency Manipulation and Currency Wars (3 of 3)

Is China a currency manipulator?

Others say there’s little or no connection between yuan and health of U.S. manufacturing

Other analysts contend that China’s currency intervention yields positive results for the U.S. economy

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Currency Crises (1 of 4)

Major currency crises have been common in recent years

Currency crisis (speculative attack)

Weak currency experiences heavy selling pressure

Some reasons: sizable losses in foreign reserves held by country’s central bank

Depreciating exchange rates in forward market

Currency crisis can decrease growth of GDP by 6% or more

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Currency Crises (2 of 4)

Crisis ends when selling pressure stops; ways to end pressure include:

Devaluation: establish new exchange rate at sufficiently depreciated level

Adoption of floating exchange rate

Imposition of restrictions on ability of people to buy and sell foreign currency

Use of loan to bolster foreign reserves of monetary authority

Restoration of confidence in existing rate

Crisis ending in devaluation: currency crash

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Currency Crises (3 of 4)

Sources of currency crises

Currency speculators

Budget deficits financed by inflation

Weak financial systems

Recently deregulated financial systems

A weak economy

Political factors

External factors

Choice of an exchange-rate system

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Currency Crises (4 of 4)

Speculators attack East Asian currencies

July 1997: Thai abandoned baht’s peg to USD

October 1997: Baht depreciated by 60% against USD

Triggered wave of speculation against other Southeast Asian currencies

Some economists argue abandoning fixed exchange rates not in long-term interest

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Capital Controls (1 of 5)

Capital controls (exchange controls)

Government-imposed barriers

To foreign savers investing in domestic assets

To domestic savers investing in foreign assets

Government directly bypasses market forces

Direct controls on international transactions

Government allocates foreign exchange among traders and investors

Government sets prices

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Capital Controls (2 of 5)

Advantages

Enables government to influence its payments position by regulating amount of foreign exchange allocated to imports or capital outflows

Enables government to encourage or discourage certain transactions by offering different rates for foreign currency for different purposes

Gives domestic monetary and fiscal policies greater freedom in their stabilization roles

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Capital Controls (3 of 5)

Disadvantages

Capital outflows may further increase after controls are implemented

Result in evasion

Provide government officials false sense of security that they do not have to reform their financial systems to ameliorate crisis

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Capital Controls (4 of 5)

Controls on capital inflows receive more support

If speculative capital cannot enter country, it cannot suddenly leave and create crisis

But problematic

Can prevent funds that would be used to finance productive investment opportunities from entering

Are seldom effective because private sector finds ways to evade them and move funds into country

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Capital Controls (5 of 5)

Should foreign-exchange transactions be Taxed?

A tax would increase cost of these transactions

Discourage massive responses to minor changes

Dampen volatility of exchange rates

Drawbacks:

We do not know how much volatility is excessive or irrational

Tax could impose burden on countries rationally borrowing overseas

Difficult to implement

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Increasing the Credibility of Fixed Exchange Rates (1 of 8)

Currency board

Monetary authority that issues notes and coins convertible into foreign anchor currency at fixed exchange rate

Can operate in place of central bank or as a parallel issuer alongside central bank

Takes over role of central bank in strengthening currency of developing countries

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Increasing the Credibility of Fixed Exchange Rates (2 of 8)

Currency board (cont.)

Has no discretionary powers

Sole function: to exchange its notes and coins for the anchor at fixed rate

Does not lend to government, which can finance spending only by taxing or borrowing, not by printing money and thereby creating inflation

Results from stipulation that backing of domestic currency must be 100%

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Increasing the Credibility of Fixed Exchange Rates (3 of 8)

Currency board (cont.)

Monetary policy on autopilot

When anchor currency flows in, Board issues more domestic currency

Interest rates fall

When anchor currency flows out,

Interest rates rise

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Increasing the Credibility of Fixed Exchange Rates (4 of 8)

Benefits of currency board system

Making nation’s currency & exchange-rate regimes more rule bound & predictable

Placing upper bound on nation’s base money supply

Arresting inflationary tendencies

Forcing government to restrict borrowing to what foreign and domestic lenders are willing to lend at market interest rates

Engendering confidence in soundness of nation’s money

Creating confidence & promoting trade, investment, & economic growth

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Increasing the Credibility of Fixed Exchange Rates (5 of 8)

Objections to currency board system:

Prevents country from pursuing a discretionary monetary policy

Reduces economic independence

Renders country susceptible to financial panics

Lacks lender of last resort

Creates colonial relation with anchor currency

Example=Argentina

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Increasing the Credibility of Fixed Exchange Rates (6 of 8)

Dollarization

When residents of foreign country use dollar alongside or instead of domestic currency; can be full or partial

Benefits of dollarization

Credibility and policy discipline

Avoids capital outflows

Decreased transaction costs

Lower rate of inflation

Greater openness

Balance-of-payments crises minimized

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Increasing the Credibility of Fixed Exchange Rates (7 of 8)

Effects of dollarization on foreign country

Country must be treated like one of 50 states

Monetary policy of Federal Reserve national in scope

Federal Reserve

Not a lender of last resort for foreign nations

No seigniorage from its monetary system

State expenditures not affected

Can establish own trade policies

Cannot print more domestic currency to finance budget deficits; must exercise caution in spending

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Increasing the Credibility of Fixed Exchange Rates (8 of 8)

Effects of dollarization on U.S.

For each dollar sent abroad, Americans enjoy one-time increase in amount of goods and services they can consume

U.S. gets an interest-free loan from foreign country

Might hinder formulation and execution of monetary policy by Federal Reserve

Could result in more pressure on Federal Reserve to conduct policy according to interests of foreign country

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