The Choice of Exchange Rate Regime: Does it affect Economic Growth - Research Paper Example

?The Choice of Exchange Rate Regime: Does it affect Economic Growth? In this globalized world, international trade becomes more efficient as technology further advances. The flow of the factors of production and exchange of goods and service are easier to be conducted. Buying goods and obtaining services from another country can be done by purchasing foreign currencies which is acceptable to the seller. Hence, the exchange rate of one currency to another is important in conducting global commerce. The exchange rate in the global economy is especially important since it serves as link between a country and the international community (Williamson, 2009). It is well established in the literature that when improperly administered and supervised, the exchange rate can adversely affect the growth of an economy (Rodrik 2008). Williamson (2009) explained, the prices within an economy have limited flexibility and thus, it is the nominal exchange rate that is being used to determine the real exchange rate which is one of the factors that determine economic stability. My aim in this inquiry is to look into the exchange rate regime as a factor of economic stability. Specifically, I would like to know if particular exchange rate regime affects the growth of an economy. Exchange Rate Regimes The two polar extremes that literature cites regarding the exchange rate systems are the floating and the fixed exchange rate which Williamson (2008, pp. 526-527) discussed well. In flexible or floating exchange rate the monetary and fiscal policy makers do not intervene in the determination of the nominal exchange rate as compared to the policy makers in an economy that adopts a fixed exchange rate. Fixed exchange rate system can be further classified into two: The hard pegs and the soft pegs. In hard peg system, a commitment to have a definite or fixed value of nominal exchange rate with respect to another is currency is for an indefinite future is given, while in soft peg, no long term commitment regarding the value of exchange rate to another currency is given. In soft pegs, periodic devaluations or increase of nominal exchange rate can occur or its counterpart, periodic revaluations. Prior to the late1990s, studies on the exchange rate regimes have been based on de jure classification or the one the type of exchange rate that countries declare to IMF that they use (Von Hagen and Zhou, 2009; Lovrinovic, Kordic, and Nakic, 2010; De Vita and Kyaw, 2012). However, as Von Hagen and Zhou (2009) have noted, the studies that followed afterwards reveal discrepancies of the country’s declared exchange rate system and the actions or interventions that they conduct regarding the subject. This made researchers explore the de facto classification also. It is therefore not a surprise that the study of the appropriate choice of exchange rate regime has captured a lot of attention from economists worldwide be they academicians or practitioners. But despite the numerous studies conducted, little consensus has been established so far and no conclusive answer have been reached yet (Huang and Malhotra, 2004; Lovrinovic et al., 2010; De Vita and Kyaw, 2012). Even empirical research has produced mixed results (De Vita and Kyaw, 2012). Having observed the above mentioned discrepancy between the declared exchange and the actions that governments make regarding it made the International Monetary Fund now use a classification that utilizes both the declared exchange rate systems of countries and the observations of the IMF officials on what these countries do (De Vita and Kyaw, 2012). The organization used the data available by April 2008 to classify exchange rate systems which they published in 2009. These classifications are as follows: Table 1 Current Exchange Rate Regimes in the World* Exchange Rate Regimes Number of Countries Percentage 1. Exchange arrangement with no separate 10 5.32 legal tender 2. Currency board arrangement 13 6.91 3. Other conventional fixed peg arrangement 68 36.17 4. Pegged exchange rate within horizontal bands 3 1.60 5. Crawling peg 8 4.26 6. Crawling band 2 1.06 7. Managed floating with no pre-determined path 44 23.40 for the exchange rate 8. Independently floating 40 21.28 *Source: International Monetary Fund, 2009 The following is the table that Appleyard, Field and Cobb (2008, p. 631) made which briefly but succinctly described these exchange rate classifications: Table 2 Description of Exchange Rate Regimes Being Used by the IMF Exchange Rate Regime Description 1. Exchange arrangement with no The currency of the country circulates as the sole separate legal tender legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the union. 2. Currency board arrangements A monetary regime based on an explicit legislative Commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligations. 3. Other conventional fixed peg The country pegs its currency (formally or de facto) arrangements at a fixed rate to a major currency or a basket of cu currencies where the exchange rate fluctuates within a narrow margin of less than ± 1 percent around a central rate. 4. Pegged exchange rates within The value of the currency is maintained within horizontal bands margins of fluctuation around a formal or de facto fixed peg that are wider than at least ± 1 percent around a central rate. 5. Crawling pegs The currency is adjusted periodically in small amounts at a fixed preannounced rate or in response to changes in selective quantitative indicators. 6. Crawling band** Allows more flexibility than crawling pegs. Here, The exchange rate can flow within a prescribed limits: the upper band limit and the lower band limit. 7. Managed floating with no The monetary authority influences the movements pre-determined path for exchange of the exchange rate through active intervention in rate the foreign exchange market without specifying, or pre-committing to, a pre-announced path for the exchange rate. 8. Independent floating The exchange rate is market determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing the undue fluctuations in the exchange rate, rather than at establishing a level for it. ______________________________________________________________________________ ** Source: "Economic risk." D&B Country Report: Costa Rica. Dun & Bradstreet, Inc., 2010. 14+. Obtained through Gale Power Search on Feb. 28, 2012. Related Studies on Exchange Rate Regime and Economic Growth The Bretton and Woods arrangement governed the international monetary relations, including the exchange rate policy after the World War II until 1971 (Williamson, 2008, p. 528). Here, the U.S. dollar was fixed with respect to gold and other countries fixed their exchange rate relative to dollar. Williamson (2008, p. 528) further added that when this collapsed, it was the International Monetary Fund that played the primary role in the determination of exchange rate regime. Extensive discussion and study regarding the exchange rates started when the Bretton Woods system collapsed as this triggered exchange rate fluctuations and financial integration processes (Lovrinovic et al., 2010). Inquiries regarding exchange rate systems and its effect to a country’s economic growth began to immerge. Among the popular studies conducted in the literature regarding this matter are those done by Levy-Yeyati and Sturzenegger in 2001 and 2003. In 2003, They examined a sample of 183 countries over the post Bretton Woods period. They looked into their exchange rate regimes and economic performance from 1974 to 2000. Their inquiry yielded a result which stated that the choice of exchange rate regime in advance countries did not significantly affect their economic growth, however in developing countries, a less flexible regime were associated with slower growth (Levy-Yeyati and Sturzenegger, 2003; de Vita and Kyaw, 2012). Levy-Yeyati and Sturnegger (2003) uses de facto data in their classification of exchange rates. Based on cluster analysis techniques, they grouped countries according to the behavior of three variables which are related to exchange rate policy: first is the exchange rate volatility, second is the volatility of exchange rate changes, and third is the volatility of reserves. “The first one is the average absolute monthly percentage changes in the nominal exchange rate with respect to an anchor currency; the second is the standard deviation of monthly percentage changes in the exchange rate; lastly the third is the calculated average of the absolute monthly change in dollar denominated international reserves relative to the dollar value of the monetary base in the previoud month” (Levy-Yeyati and Sturnezegger, 2003, p. 1175). Huang and Malhotra (2004) also inquired regarding the relationship of exchange rate regimes and economic growth. They examined economic data from developing Asian countries and advanced European economies, highlighting the role of the level of economic development achieved by a particular country. They discovered that choice of regime is irrelevant in advanced countries while in developing economies, the exchange rate regime that is employed affects their economic growth rate though non-linearly. For them, only the developing and emerging economies should give ample attention to the kind of regime that they will choose. In 2009, Chiu studied how government strength and exchange rate regime work in avoiding currency crises. The result he garnered was that the likelihood of having a currency crises are huge when the government is weak irrespective of the exchange rate regime that it employs. Another interesting study is that of Van Foreest and de Vries in 2003. They posited that the choice of exchange rate regime is not primarily affect an economy’s growth; rather it is the coherency of the monetary and fiscal policies that should primarily be targeted so economic growth can be achieved. The reason why such action should be opted is due to the fact that the stability of exchange rate is dependent on the monetary and fiscal policies of the economy concerned. Rodrik (2008) also studied the relationship o real exchange rate and economic growth. He argued that undervaluation of a currency or having a high exchange rate can stimulate economic growth. Such conclusion was yielded by his study, in particular, with respect to developing counties. What this implied was first, there was a government failure in the country under study, that is, there was an institutional weakness or second, a market failure existed. Rodrik (2008) recommended that actions to subsidize tradables production directly should be done than focusing on the indirect effect of the exchange rate. He reasoned out that this is more productive as spillovers to other countries can be avoided when direct subsidizing of tradables is done. Moreover, he said, through this, exports and imports can be boosted simultaneously, provided that the exchange rate and wages be allowed to adjust so equilibrium to the current account balance can be achieved. Through this way also, a trade surplus can be avoided. However, as production subsidies have their own problems too, he saw no easy alternative to exchange rate policy. Finally, the study of De Vita and Kyaw this 2012 critically examined whether the choice of exchange rate regime affects the economic growth of developing countries. They used data from 70 developing countries from 1981 to 2004. To make their analysis more comprehensive, they used three classification systems for their analysis. First, they used the IMF classification. Second, they used the classion done by Levy Yeyati and Sturzenegger in 2003, hence LYS classification. Here, LYS grouped the observations into flexible, intermediates, fixed and inconclusive or unclassifiable. Lastly, they also used the classification made by Reinhart and Rogoff in 2004, also known as the RR classification. This kind of classification uses “market determined” exchange rate which is either “the official rate (where no black market premium exists), the parallel rate (if market-determined) or the black market exchange rate if it exists” (De Vita and Kyaw, 2012, pp. 139-140). The three classifications do not tell the framework of the monetary policies drafted by these countries. So the researchers supplied the information regarding this subject with respect to the economies that they studied. The results that De Vita and Kyaw (2010) obtained showed that no significant relationship exists between the choice of exchange rate and the economic growth. Rather, the importance of monetary policy was further affirmed by their study. Discussion Establishing exchange rate is a must, especially in this present age that international trade is so robust. As the flow of factors of production as well as goods and services are easier and faster this day, the need for a means to exchange currencies is highly important. It is through exchange rate that selling and buying international commodities can be done. As established earlier, the real exchange rate is among the factors that contribute to economic stability, and consequently to economic growth. Since growth maximization is among the ultimate goals of economy, the interest in this particular subject is not so surprising. Countries will exercise measures that contribute to advancement of their economies. However, as to how exactly a particular exchange rate system contributes to this goal has been an on going discussion in the literature. What I found out in this inquiry was what previous researchers also noted: the existence of mixed results. The finding of Levy-Yeyati and Sturnegger (2003) as well as that of Huang and Malhotra (2004) supports on the claim that the choice of exchange rate regime affect countries, especially those whose economies are developing or emerging. However, the conclusions of the studies of Chiu (2009), Van Foreest and de Vries in 2003, Rodrik (2008) and the study of De Vita and Kyaw this 2012 were different. Their results of their studies mentioned that the choice of exchange rate regime has an insignificant effect to the economic growth. Rather, what was affirmed was the significant role that fiscal and monetary policies play in economic growth. The capacity of the government or of their policy making bodies in regulating and implementing rules are of utmost important in the determination of growth accumulation. The role of the International Monetary Fund as the last lender of capital is very important. It is an established knowledge in economics that they let economies borrow money, with strings attached, and they only allow those economies that they have confidence with. This means that economies, in the eyes of the institution have the potential to pay, implying that a growth in their economy is a huge likelihood. Otherwise, these countries will not be able to honor their obligations or debts. To achieve this, a strong and capable government must be present. This consequently means that monetary and fiscal polities are being drafted and implemented excellently, in a manner that optimizes growth. This type of strong and capable governance has the trust of the IMF. This serves as a safeguard for economies in times of shocks. Conclusions Upon observing the mixed data available, how should this be interpreted in such a way that this inquiry will contribute to the current body of knowledge? A cliche in economics is that one way to describe it is a study of choices. A study of choices that will yield the most returns. Analogous to this, this particular study yield two apparent choices: one that says that emerging and developing economies should carefully consider their choice of exchange rate regime, and the other that says focus on the causes that determines the stability of exchange rate namely monetary and fiscal policies. An economist will also see the other two implied choices: one that states you adopt both or you can adopt neither. These choices though not explicitly mentioned, are still present. As a student of international economics, let me first restate the stand of the most influential monetary institution in the world especially when it comes to global trade: consider an economy’s unique situation before opting for an exchange rate. Second, strengthening an economy’s monetary and fiscal policies are key determinants of economic growth. This is beneficial to both advance and developing or emerging economies. Greater economic efficiency and growth are desired by all. As for the choice of exchange rate regime to be adopted, it will be to the benefit of emerging and developing countries to consider their own situation before adapting one. Their resources are not as many as that of an advanced country and they economies are not as established also. Given a limited resources the most effective means in allocating these has to be thought over. If a careful consideration of an exchange rate regime to be adopted will yield positive results, it should be done then. A positive result, no matter how little is still positive. And it is better than having no improvement at all. When both choices are mutually beneficial and can be done also, then don’t just opt for one; rather, choose both. Since mixed results continue to be observed by studies, it is strongly recommended that further studies and deeper analysis be made. References Appleyard, D., Field, A. and Cobb, S. 2008. International Economics. 6th ed. NY: Mc Graw-Hill. Chiu, E, & Willett, T 2009, The Interactions of Strength of Governments and Alternative Exchange Rate Regimes in Avoiding Currency Crises, International Studies Quarterly, 53, 4, pp. 1001-1025. Available through: Academic Search Complete, EBSCOhost, [Accessed 26 February 2012].  D&B Country Report, Economic risk. Costa Rica: Dun & Bradstreet, Inc., 2010. 14+. Available through Gale Power Search, [Accessed on 28 Feb. 2012] Huang, H. and Malhotra, P. 2004. Exchange Rate Regimes and Economic Growth: Evidence from Developing Asian and Advanced European Economies.[pdf] California: Clairemont Graduate University. Available at [Accessed 25 February 2012]. International Monetary Fund, De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks – as of April 31, 2008, 2009 available at < www.imf.org> [Accessed on 29 Feb. 2012]. Levy-Yeyati, E. & Sturzenegger, F. 2001, Exchange rate regimes and economic performance" IMF Economic Review, vol. 47, no. 20414161, pp. 62-98. Levy-Yeyati, E. & Sturzenegger, F. 2003, To float or to fix: Evidence on the impact of exchange rate regimes on growth, The American Economic Review, vol. 93, no. 4, pp. 1173-1193. Lovrinovic, I, Kordic, G, and Nakic, M 2010. Choice of Exchange Rate Regimes: Case of Ex-Yugoslavia Countries, World Academy Of Science, Engineering & Technology, 66, pp. 766-771. Available through: Academic Search Complete, EBSCOhost, [Accessed 26 February 2012]. Rodrik, D. 2008, The Real Exchange Rate and Economic Growth/Comments and Discussion, Brookings Papers on Economic Activity, no. 2, pp. 365-439. Von Hagen, J. & Zhou, J. 2009, Fear of Floating and Pegging: A Simultaneous Choice Model of De Jure and De Facto Exchange Rate Regimes in Developing Countries, Open Economies Review, vol. 20, no. 3, pp. 293-315. Williamson, J. 2009, Exchange Rate Economics, Open Economies Review, vol. 20, no. 1, pp. 123-146. Williamson, S., 2008. Macroeconomics. 3rd ed. Boston: Pearson Education. Read More