Exchange rate systems - Essay Example

Running Head: exchange rate is determined How the exchange rate is determined under a floating exchange rate system. Under which conditions it is possible to control both the exchange rate and the money supply? Are these conditions likely to be fulfilled in the UK at present? [Writer’s Name] Institution’s Name] How the exchange rate is determined under a floating exchange rate system. Under which conditions it is possible to control both the exchange rate and the money supply? Are these conditions likely to be fulfilled in the UK at present? The traditional debate on exchange rate systems focused on insulating properties of flexible exchange rates as in Friedman (1953) and Meade (1955). The subsequent literature showed that insulating properties depend on some structural characteristics1 (e.g., openness, capital mobility), as well as the types and the sources of shocks impinging on the domestic economy. The monetary theory of the balance of payments emphasized the differences in macroeconomic adjustment under fixed versus flexible exchange rates. One consequence of fixed exchange rates is that nations may not be able to pursue independent monetary policies. Specifically, an external imbalance has to be offset by a change in the net reserve position which can affect the domestic money supply. Commitment to a fixed rate also entails buying or selling domestic currency in exchange for foreign currencies at declared parities to satisfy autonomous changes in currency demands, which unless successfully sterilized, makes the money supply endogenous. Another aspect of the exchange rate system is the different operating procedures of macroeconomic policies under alternative exchange rate systems. The Mundell-Fleming framework compares the effectiveness of monetary and fiscal policy under fixed and flexible exchange rate systems. The textbook version of the model (e.g., Mankiw, 1997, pp. 308-323; Blanchard, 1997, pp. 250-267) predicts that under high capital mobility, fixed exchange rates render fiscal policy powerful in altering aggregate demand while monetary policy is impotent. Under flexible rates the contrary holds. More recent work on exchange rate systems emphasizes the disciplining effects of fixed rates and the discretion afforded to policymakers by flexible rates. The "rules versus discretion" debate has been partially revitalized by the literature on the European monetary integration. Simply stated, this approach views fixed rates as a pledge not to follow inflationary policies, which has been interpreted as a commitment mechanism that "ties ones hands" (Giavazzi & Pagano, 1988), and solves the time consistency problem initially analyzed by Kydland and Prescott (1977). However, a pledge not to inflate may not be desirable when the policymaker faces an emergency. This raises the possibility that the choice of the exchange rate system may not be independent of the macroeconomic environment. Indeed some interpret historical alternating periods of fixed and floating exchange rates as a rule with an escape clause (De Kock & Grilli, 1989; Giovannini, 1993). Analysis of historical macroeconomic data has provided little conclusive evidence on the role of the exchange rate system.[ 2] There have been some attempts to analyze the incidence of aggregate demand and aggregate supply shocks under alternative exchange rate systems (Bordo, 1993; Eichengreen, 1993). The objective of this paper is to reexamine empirical evidence on the exchange rate system by focusing on the distinction between nominal demand (monetary) shocks, which the exchange rate system can be expected to influence, and real shocks, which may be irrelevant because they are not caused by the exchange rate system. We also analyze the effects of macroeconomic disturbances and try to evaluate money supply behavior under alternative exchange rate arrangements. Using historical annual data and more recent quarterly data, we impose a combination of long-run and short-run restrictions to distinguish between real demand (IS) shocks, monetary shocks, and supply shocks within a structural VAR framework. We then analyze the incidence and effects of these shocks to evaluate any possible effect that can be traced to the exchange rate system. To preview our results, the data seem to support the notion that fixed rate systems set limits to monetary discretion and constrain expansionary demand policies. Moreover, there seems to be an increase over time in the effectiveness of real aggregate demand policies. Section II contains a brief discussion of the International Monetary System and related propositions to be evaluated empirically. Section III presents a simple model and the identification methodology. Section IV presents empirical results, limitations, and suggestions for future research, while Section V concludes. The International Monetary System Although the history of the Gold Standard can be traced back many centuries, the period 1870-1913 is regarded as the most prosperous period of the Gold Standard, and is referred to as the "Classical Gold Standard." Many countries operated under gold covertibility at a pre-declared parity. The period is also known for virtually no capital controls and extensive capital movements. The United States restored gold convertibility de facto in 1873 which was suspended at the outbreak of the Civil War; the greenbacks officially were convertible in 1879. The system lasted until many countries suspended gold convertibility with the First World War. The period thereafter, the interwar period, had many exchange rate arrangements: floating exchange rates until the middle 1920s, followed by a resumption of the Gold Standard. However, runs on the banking systems in Austria and Germany in 1931 brought a collapse of the Gold Standard in Austria, Germany, and later in England. The United States suspended gold convertibility in 1933, and many European countries followed suit in the mid1930s. The floating period that followed the collapse of the Gold Standard in 1930s was characterized by massive interventions to limit exchange rate flexibility and beggar-thyneighbor policies. The Bretton Woods system that followed the Second World War was designed to limit intervention in the foreign exchange market and avoid the destabilizing effects of arbitrary exchange rate changes. The Bretton Woods System was inaugurated in 1944 with the signing of Articles of Agreement of the International Monetary Fund (IMF). The system called for fixed exchange rates against the US dollar which itself was pegged to gold. Member countries held their international reserves largely in dollar assets making the dollar the main reserve asset. Most countries maintained the official par values of their currencies by intervening in the foreign exchange market. The Bretton Woods system was characterized by massive capital controls; current account transactions were inconvertible until 1958, while controls remained in place for capital account transactions for the entire period. Since the dollar was the principal reserve asset, other countries could accumulate dollars through US balance of payments deficits. A commonly held view is that the expansionary domestic programs in the US along with Vietnam era defense spending brought inflation, and eroded competitiveness of US exports. The ensuing balance of payments deficits made it difficult to sustain gold convertibility at the official parity value. Finally in August 1971, the US suspended redeeming dollar assets into gold, ending the last official link between the dollar and gold. With the Smithsonian Agreement, the dollar was devalued but that did not ease the pressure on the US dollar. Finally in March 1973, the currencies of all major industrial countries started to float against the dollar. The floating period that followed is characterized as "dirty floating" due to occasional intervention in the foreign exchange market by the authorities and was officially sanctioned by an amendment to the IMF Articles of Agreement in 1976. After the breakdown of the Bretton Woods system, some European countries continued their efforts to coordinate their monetary policies and prevent intra-European exchange rate fluctuations. In March 1979, Germany, France, Italy, Belgium, Netherlands, Luxembourg, Denmark, and Ireland agreed to fix their mutual exchange rates within certain bands, and let their currencies fluctuate join fly against the US dollar within the "European Monetary System" (EMS). The Exchange Rate Mechanism (ERM) of the EMS grew to include Spain in 1989, the UK in 1990, and Portugal in 1992. Finally in September 1992 a major speculative attack forced the UK and Italy out of the ERM, and in August 1993, the remaining members agreed to widen their exchange rate margins. It is known that theoretical considerations may not be sufficient to ascertain the optimality of a given exchange rate arrangement and empirical work may provide some insights on the issue. An interesting question is to examine the incidence of macroeconomic shocks under alternative exchange rate systems and investigate whether i) the incidence of monetary shocks under fixed rate systems is lower as fixed rates set limits to monetary discretion, ii) the behavior of the money stock is different under fixed versus flexible exchange rates, iii) fixed exchange rates prevail in stable macroeconomic environments, and iv) the switch to flexible rates was prompted by an unusual incidence of real demand or supply shocks that make maintaining fixed rates costly. It is also possible to evaluate whether policy effectiveness varies with the exchange rate system as predicted by the Mundell-Fleming model. In our empirical analysis, we use historical annual data from the Classical Gold Standard (1870-1913) pertaining to Canada, Italy, Japan, UK, and the US, and quarterly data from the Bretton Woods (1957.I-1971.IV) and the Modern float (1973.I1-1996.1) pertaining to the G-7 countries. We also try to evaluate the experience of Germany, France, and Italy under the European Monetary System (1979.II-1996.I). Degrees of freedom considerations and data availability makes it difficult to adhere strictly to this designation of exchange rate arrangements in that some countries may not have fully participated in a particular exchange rate arrangement. For example, the Canadian dollar floated in the 1950s and the US dollar was not convertible to gold at the beginning of our Gold Standard sample period in 1870s. When this is the case, the results should be interpreted accordingly. References Blanchard, O. (1997). Macroeconomics. Upper Saddle River, NJ: Prentice-Hall, Inc. Bordo, M. (1993). The gold standard, Bretton Woods and other monetary regimes: A historical appraisal. Federal Reserve Bank of St Louis Review, 75, 103-191. De Kock, G., & Grilli, V. (1989). Endogenous exchange rate regime switches. NBER Working Paper No. 3066. Cambridge, MA. Eichengreen, B. (1993). Epilogue: three perspectives on the Bretton Woods system. In M. Bordo, & B. Eichengreen (Eds.), A retrospective on the Bretton Woods system. Chicago: University of Chicago Press. Friedman, M. (1953). The case for flexible exchange rates. In M. Friedman (Ed.), Essays in positive economics. Chicago: University of Chicago Press. Giavazzi, F., & Pagano, M. (1988). The advantage of tying ones hands: EMS discipline and central bank credibility. European Economic Review, 32, 1055-1082. Giovannini, A. (1993). Bretton Woods and its precursors: Rules versus discretion in the history of the international monetary system. In M. Bordo & B. Eichengreen (Eds.), A retrospective on the Bretton Woods system. Chicago: University of Chicago Press. Kydland, F. E. & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85, 473-491. Mankiw, N. G. (1997). Macroeconomics, 3rd ed. New York, NY: Worth Publishers. Meade, J. (1955). The case for variable exchange rates. Three Banks Review, 3-27. Read More