Exchange Rate Regimes - Essay Example

Exchange Rate Regimes Introduction The impact of the inherent volatility and unpredictability of exchange rates on macroeconomic conditions is central to the debate about fixed and flexible exchange rates. Real exchange rates are defined as nominal rates adjusted for price levels. Since prices for individual countries, when expressed in a common currency, are subject to the variability of exchange rates, bilateral real exchange rates based on individual-country price levels may be infected with measurement errors. The use of one reference country, such as the USA, gives rise to asymmetries. By definition, the exchange rate is a relative price of two assets and, like other asset prices, is determined in a forward-looking manner in which expectations concerning the future course of events play a key role. Consequently, exchange rates are very sensitive to the receipt of new information (Swan, 1993, p 67-69). The large and sustained changes in nominal and real exchange rates were among the most significant developments in the world economy in the 1980s. For example, in the first half of the decade, the US dollar appreciated by about 40 per cent against most other major currencies and then, in the second half of the decade, declined, reversing all the previous appreciation. These changes gave rise to international pressures associated with rapidly changing competitiveness of exports; intervention by central banks in foreign exchange markets; and intense debate regarding the extent to which these exchange rate changes interact with current account imbalances. International Trade and Economic Growth The ultimate purpose of economics is to increase economic welfare. So far we have concentrated almost entirely on the optimal allocation of a given bundle of resources, but it is obvious that welfare may also be improved either by increasing the quantity of resources available or by learning to do more with a given bundle. Both of these possibilities represent economic growth—the first through factor augmentation and the second through technical progress. Some economists feel that conventional measures of economic growth based on the output of goods and services (gross national product) do not satisfactorily reflect economic welfare, arguing that they ignore factors such as pollution and the negative externalities from congestion. We shall ignore this controversy here, however, and assume that increased productive capabilities represent improved opportunities for economic welfare (Markham, 1987, p 156-160)). Exchange rate regimes The exchange rate—the price of foreign currency—is determined by supply and demand. The demand for foreign currency arises from debit items on the balance of payments, i.e. from spending abroad; the supply arises from credit items. Any tendency towards surplus on the balance of payments creates an excess supply of foreign currency, driving down its price in terms of domestic currency or driving up (appreciating) the value of domestic currency in terms of foreign currency (Baxter, Marianne, Alan C., 1988, p 187-192). Hence if, at any given exchange rate, credits exceed debits, the exchange rate is forced above that level. Equilibrium can occur only where excess supply is zero, i.e. where credits equal debits, and the exchange rate must move to bring this about. There are two polar ways of bringing about this equality. First, under a system of perfectly flexible exchange rates (or ‘clean floating’), the monetary authorities keep out of the foreign exchange market entirely. Official finance is thus set to zero, and the balance of the remaining accounts must also be zero, since total credit and debits are equalized. For such a market to be useful it must be stable: the excess supply of foreign currency must be eliminated by the appreciation of the home currency that it induces. In the long run this occurs through items in the basic balance. An appreciation of sterling raises the dollar price of goods and assets priced in sterling. Hence British goods and assets lose competitiveness abroad and net credits fall, so reducing the excess supply of foreign currency. These processes take time, however, and so, in the short run, stability depends on the short-term capital account. The main mechanism assumed is as follows: if people have some expected level of the exchange rate in mind, rises above that level are expected to be followed by falls (Obstfeld, 1985, p 234-238). To hold sterling while expecting a fall is to expect losses, so, once the rate has risen above your expected level, it pays to sell and move your capital into foreign currency. If everyone does so, however, the excess supply of foreign currency disappears, and the rise in sterling stops or reverses itself. The second polar approach to equalizing total credits and debits is a system of faced exchange rates. Here the authorities are committed to maintaining a particular exchange rate—or rather a narrow band of exchange rates. They do this by being always prepared to buy pounds for dollars at $2.38 and sell them at $2.42 (Hutchinson, 1980, p 217-218). Their purchases and sales show up as official finance. Disequilibrium now appears as movements in the reserves rather than as changes in the exchange rate. In other words, whereas previously price bore the adjustment in the exchange market, here quantity does. The only limits to this process are the extent of the official finance available, and the ability of the economy to balance the current and capital accounts in the long run without exchange rate changes. Between these polar cases lie a number of exchange rate regimes that try to combine the advantages of both systems. Under the adjustable-peg system—or Bretton Woods system (named after the international conference at which it was devised)—countries generally maintain fixed rates, but at times of ‘fundamental disequilibrium’ the parity, or peg rate, may be altered. This system was used from 1945 to 1971 (Mussa, 1986, p 145-149). Although it was basically successful, it broke down because countries were reluctant to make parity changes and because, since all countries pegged their currencies to the dollar, there was nothing the USA could do about its exchange rate. The Foreign Exchange Rate One of the most obvious features of most international trade is that the partners wish to work in different currencies. A British manufacturer buys most of his inputs and consumes his profits in Britain—paying in terms of sterling. If he sells his wares in France, however, his purchasers will normally have only francs to offer. Some exchange is therefore necessary between sterling and francs, and this defines the rate of exchange or exchange rate. Quite simply, the exchange rate is the price of one money in terms of another, and, like other prices, it is determined by supply and demand in the market (Williamson, 1982, 25-28). Some terminology The exchange rate may be expressed in two ways: $2.00 per £1.00 or, equivalently, £0.50 per $1.00. The former—the foreign currency price of one unit of domestic currency—is the UK’s convention. Most countries, and many journal articles, however, use the latter—the local currency price of one unit of foreign currency (Williamson, 1982, p31-35). With many currencies in the world, there must be many exchange rates, e.g. $:£, $:DM, DM:£, etc. We refer to each individual rate as a nominal exchange rate. Often, however, it is useful to have a summary measure of, say, the value of sterling relative to the value of all other currencies. This is particularly so when exchange rates are flexible, because sterling may appreciate relative to some and depreciate relative to others. This summary measure is known as the effective exchange rate. It is really no more than an index number, and the only problem about it is the weights with which to combine the rates against each currency. If we were interested in imports, we might use weights based on the value of imports denominated in each currency. Obviously depreciation relative to the US dollar (supplying at least 10 per cent of UK imports) is more important than depreciation, relative to the Swedish krona (3 per cent of imports), so the dollar gets more weight (Hentschel, L. & Smith Jr., 1997, p 143-147). Economists have recently started referring to the ‘real exchange rate’. This measures not the price of two monies, but the relative prices of two nations’ bundles of output. It is no use being able to buy more dollars per pound if each dollar now buys fewer goods (Dalton, John M. 2001, p 213-217). If we express things relative to some base date, and if the nominal $:£ exchange rate is r and the USA and UK price indices p s and p k respectively, the ‘real sterling exchange rate’ is rp k / p s. A ‘real’ appreciation occurs either through a nominal appreciation (rising r ), or through a relative rise in UK local currency prices (a rise in p k / p s ). The ‘real exchange rate’ is no more than the ratio of UK to USA prices measured in dollars—the sterling value of p k is converted to dollars by means of r —and hence it reflects relative UK:US competitiveness (Mitchell, 1992, p 165-168). Clearly, by simultaneously considering many exchange rates and price levels, one could construct real effective exchange rates. We have considered the determinants of flexible exchange rates and their impact on economic policy. We now tackle the major normative issue in this area. The following section compares flexible and fixed exchange rate regimes in terms of their insulating properties, stability in the face of speculation, effects on world trade and a variety of other properties. Fixed Vs. Flexible Exchange Rates This section considers the pros and cons of flexible exchange rates from the points of view of both individual countries and the world as a whole. It covers the insulating properties of flexible rates, the stabilizing (or otherwise) effects of speculation, the effect of exchange rate fluctuations on trade, the ease of adjustment under different exchange rate regimes, and the possible inflationary biases of flexible exchange rates. Transmission and insulation The simplest transmission mechanism for economic shocks is the international trade. Assuming fixed exchange rates and ignoring all capital flows, it shows that economic activity in one country spills over (positively) to another via the trade balance. For example, an investment boom in France stimulates demand for both French and British output and causes expansion in both. Under fixed rates, therefore, British income is sensitive to activity in France. Now repeat the exercise with flexible rates. If the exchange rate always adjusts to keep the trade balance at zero, it would seem that Britain is insulated from France. Moreover, since Britain can no longer provide net resources to France (because trade is always balanced), all the extra investment must be supplied locally and so the expansion of French income will be correspondingly greater. Thus flexible rates, it seems, reduce the impact of foreign demand shocks and increase the effects of local demand shocks (Crockett, Andrew, & Morris Goldstein, 1976, 132-136). . Even this is too simple, however, and we now turn to the full open IS-LM model to examine the impact of various shocks. It could be argued that concern with insulation is misplaced, since shocks could always be met by countervailing policy shocks. This is forceful in theory, but not wholly convincing in practice, because it ignores the information and execution problems of conducting policy so precisely. In other words, an automatically stable regime is likely to save time, effort and mistakes (Taylor, 1996, p 143-148). Domestic expenditure shocks are precisely equivalent to fiscal policy. With capital mobility, flexible rates offer more stability; in the simple model, flexible rates prevent any fiscal impact, but even in subtler models we would expect less than under fixed rates. With no capital mobility, however, fixed rates are more stable. Similarly, domestic monetary shocks are akin to monetary policy, and hence fixed rates are preferable regardless of the degree of capital mobility (Stone, 1994, p 111-118). Consider now a foreign expenditure shock, raising the demand for local goods. This raises output and creates a current account surplus. Under flexible exchange rates, this surplus generates an appreciation that tends to offset the initial shock. Under fixed exchange rates, the surplus raises the money supply and this validates the output rise. Hence, flexible rates are more stable. A foreign monetary shock lowers the world rate of interest. Without capital mobility this presents no shock, but under perfect mobility it generates a huge potential inflow of funds. Under fixed rates, this expands the money supply and raises income. With flexible rates, on the other hand, it produces an appreciation, dragging the IS curve back and reducing income. These two outcomes cannot strictly be ranked in terms of stability, but, since foreign monetary expansion is likely to be coupled with a foreign demand stimulus, it is likely that flexible rates result in less change in local incomes (Elliott, Rothenberg, & Stock, 1996, p 267-269). These simple exercises are not unambiguous, but they tend to confirm the earlier result that for foreign shocks flexible rates probably offer most insulation, whereas for domestic shocks fixed rates do. Intuitively, flexible rates bottle-up a disturbance in its country of origin, whereas fixed rates spread it around the world economy. Empirically, therefore, we would expect floating to be reflected in a weakening of the synchronization of trade cycles around the world. In fact, synchronization has increased since 1973, although this may well be due to economies experiencing common shocks (e.g. oil) rather than to causal links between them. Alternatively it may be that the exchange rate fluctuations necessary to ensure complete insulation were larger than governments could tolerate, and hence that only incomplete insulation was permitted. Hence, even relatively modest fluctuations in incomes may need large exchange rate changes to offset them (Peck, 1985, p 122-125). In particular, a flexible rate may allow a country to avoid importing inflation, via either the rising import prices or the pressures to cure payments surpluses that arise under fixed rates. On the other hand, the translation of random exchange rate fluctuations into local prices could increase the price variability associated with floating. Conclusions The implications for the real exchange rate and the current account of economic transformation have been examined in terms of a model focusing on investment and the sectoral allocation of capital. During the initial phases of such programs, when investment, manifest mainly through increased expenditures, dominates the transition, movements in the real exchange rate and in the current account reflect associated demand shocks in both tradable and non-tradable sectors. In subsequent periods, when additional capacity comes online and when the growth of national income raises domestic consumption, changes in both the real exchange rate and the current account may reverse direction. The pattern is one of cycles in the real exchange rate and the current account during the course of the transformation program. Developments in the part of the economy that is sheltered from the world market play a major role in determining the behavior of the real exchange rate and hence of the current account. Among the important components of this sector are certain types of capital goods and a variety of construction goods and services. Several countries in the world have not been able to control domestic inflation, fixing nominal exchange rates means that domestic non-tradable prices--including prices of a variety of public goods and services-must be made to rise less rapidly than similar prices abroad, whenever the pressures emanating from the restructuring program call for real currency depreciation. That may be a requirement that is beyond the reach of many governments. The current account, too, is subject to cycles over the course of a restructuring program. The importance of current account deficits is that they provide access to foreign resources, thereby expanding the range of restructuring options. But current account deficits need capital inflows to finance them and hence touch on the question of convertibility. Many policymakers have expressed concerns about the possibility that capital inflows may "cause" real appreciation. The foregoing analysis suggests that capital inflows cannot be a cause of appreciation: the cause is to be found in movements in non-tradable demand and supply and those movements are governed by the details of the restructuring program. Capital inflows merely facilitate the implementation of a transformation program. Hence, policy decisions about capital controls and convertibility cannot be made independently of the restructuring strategy. Reference: Baxter, Marianne, and Alan C., 1988. 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International Historical Statistics: Europe 1750-1988, 3rd edition. New York: Stockton Press. Mussa, Michael, 1986."Nominal Exchange Rate Regimes and the Behavior of Real Exchange Rates, Evidence and Implications," in Real Business Cycles, Real Exchange Rates, and Actual Policies, (Amsterdam: North-Holland). Nicholas Dunbar. 2000. Inventing Money : The Story of Long-Term Capital Management and the Legends Behind It. John Wiley and Sons. Obstfeld, Maurice, 1985. "Floating Exchange Rates: Experience and Prospects," Brookings Papers on Economic Activity: 2. Peck, Anne E. (ed.). 1985. Futures Markets: Their Economic Role. American Enterprise Institute. Washington, D.C. Swan, Edward J. 1993. Law of Financial Services. Cavendish Publishing Taylor, Francesca. 1996. Mastering Derivatives Markets, A step-by-step guide to the products, applications and risks. Pitman Publishing. London, England. Williamson, John, 1982. "A Survey of the Literature on the Optimal Peg," Journal of Development Economics, Vol. 2. Read More