How do alternative exchange rate regimes operate and how can they be identified?


Seminar Paper, 2013

19 Pages, Grade: 1,7


Excerpt

Inhaltsverzeichnis

I Introduction

II Theoretical background
11.1 Types of exchange rate regimes
11.2 De jure vs. de facto exchange rate regimes
11.3 Status quo European Union

III Central Bank’s toolbox to manage its exchange rate
111.1 Instruments
111.2 Analysis forthe Swiss National Bank

IV Conclusion

V Bibliography

VI Listofillustration

Introduction

The choice of the exchange rate regime is essentially for a country. According to the impossible trinity principle a country desires a fixed exchange rate, an autonomous monetary policy and full capital mobility simultaneously. Unfortunately only two features at the same time can be realized. A fixed exchange rate has two major benefits compared to a floating exchange rate. If stable it makes the trade of goods and assets between countries easier and less costly. Additionally a fixed exchange rate may improve monetary policy discipline as expansionary monetary policy is less available to maintain a fixed exchange rate. This may lead to a lower inflation rate in the long run. But the major disadvantage is that a fixed exchange rate regime removes the possibility to use monetary policy in a flexible way to deal with recessions (Abel, Bernanke and Croushore, 2011). Therefore many countries choose an exchange rate regime between both extreme cases (fixed or flexible exchange rate regime). In the second chapter I will give some important theoretical background concerning exchange rate regimes. In particular I will explain different types of exchange rate regimes and show the difference between ‘de jure’ and ‘de facto’ exchange rate regimes. In the last part of the second chapter I will illustrate the complex exchange rate regime of the European Union. In the third chapter I will show the toolbox of a central bank to influence its exchange rate. In the last part of the third chapter I will show briefly the different instruments using the example of Switzerland in the recent past. In my conclusion I will try to answer the question ‘how can different exchange rate regimes being identified’.

II Theoretical background

In this chapter I will give some theoretical background for the topic itself. First, I will explain the different types of exchange rate regimes in the world. Second, I will show the difference between ‘de jure’ and ‘de facto’ exchange rate regimes and discuss briefly the different attempts how to identify ‘de facto’ exchange rate regimes. Third, I will give an overview about the current situation in the European Union concerning the exchange rate regime. It is highly important to understand the theoretical background in order to assess the third chapter of this paper.

11.1 Types of exchange rate regimes

I will explain the differentiation of exchange rate regimes from the most flexible regime to the most fixed one although there does not exist one clear order in the literature.

Freely floating

The simplest form of an exchange rate regime is ‘freely floating’. The monetary authority declines to have any responsibility concerning its exchange rate and does not intervene in foreign exchange markets. The exchange rate is completely determined in foreign exchange markets. The main advantage of this regime is that the central bank is able to use its monetary policy to full capacity as the central bank does not look at its exchange rate. The main disadvantage is that the exchange rate may fluctuate a lot. High volatility of the exchange rate in a short period of time may disturb exporters and importers who generally prefer a solid base for their calculations.

Managed floating (dirty floating)

If central banks are concerned about excess volatility of the exchange rate, also called ‘fear of floating’, and if the central bank does not want to commit to a specific exchange rate target the central bank may use a managed floating exchange rate regime. In this exchange rate regime the central bank intervenes in foreign exchange markets from time to time. If the central bank thinks its exchange rate being too strong then the central bank sells the domestic currency and buys foreign exchange reserves. On the contrary, if the central bank thinks its exchange rate being too weak then the central bank buys the domestic currency and sells foreign exchange reserves. This kind of management is limited by the size of the central bank’s reserves. Practically speaking, in a managed floating exchange rate regime the central bank has a view about its exchange rate and acts accordingly.

Target zones and bands of fluctuation

In this regime the exchange rate is allowed to fluctuate within a specific range. If the central bank works with a target zone the endpoints of the zone are a policy goal and if the central bank operates with a band of fluctuation the endpoints are fixed. In both cases the central bank has to defend the regime with foreign exchange interventions (Gosh, Guide and Wolf, 2002). A band of fluctuation and a target zone give the central bank more flexibility concerning interventions as the central bank does not have to defend one particular exchange rate. In practice, in this regime the central bank may officially announce the range or target zone and act if the exchange rate moves closer to the endpoints. The difference between a managed floating and a target zone exchange rate is that in the first regime the central bank operates with hidden action and in the second one the central bank officially announces the target zone and commits to defend it.

Crawling peg

In a crawling peg regime the monetary authorities announce a central parity with an anchor currency and a band of fluctuation around it. The key characteristic of a crawling peg regime is that the endpoints of the band of fluctuation are allowed to slide regularly. Literally the endpoints crawl. The adjustment rate might depend on a specific rate e.g. monthly depreciation of 1% or might depend on current (or expected) inflation. The distinction between a target zone and a crawling peg is not clear but margins considered narrow enough to qualify as a pegged arrangement are typically less than +/- 5% around the official parity (Baldwin and Wyplosz, 2009).

Single currency peg (fixed and adjustable)

In this regime the central bank declares a central parity against an anchor currency. Therefore the exchange rate is pegged to a fixed value to a single foreign currency. The central bank has to act accordingly; meaning the central bank has to defend the central parity with interventions. Typically the regime allows small margins of fluctuation around the central parity. Realignments of the central parity are possible and may happen in the case of a violation of the equilibrium e.g. due to price shocks. Generally the level of credibility of this exchange rate regime to maintain the central parity depends on the size of foreign exchange reserves of the central bank. The key disadvantage of a single currency peg is that the central bank has to give up its autonomous monetary policy to maintain the fixed exchange rate. Typically the monetary policy of the fixed exchange rate regime has to converge to the monetary policy of the anchor currency.

Currency boards

A currency board is a relatively extreme case of a fixed exchange rate regime. In a currency board the central bank declares a central parity against an anchor currency and guarantee that it will exchange the domestic currency against the anchor currency at any time at the central parity exchange rate. No realignments are possible and it implies that in a currency board the central bank can only issue domestic money when it accumulates enough foreign exchange reserves before. Therefore a country using a currency board abandons its own independent monetary policy completely. A lack of credibility concerning the monetary policy of the central bank in the past is the main reason why countries choose such an extreme exchange rate regime.

Dollarization and currency unions

Dollarization means to substitute the domestic currency with all its different functions into a foreign currency and is the most extreme case of an exchange rate regime. The abandonment of its domestic currency also implies the abandonment of its monetary policy. The money supply (here the US Dollar) is completely determined by the Federal Reserve in the United States. The main advantage of a dollarization is an increase of credibility of the country as the country is not able to misuse monetary policy.

A currency union is a special case of an exchange rate regime. Several countries use the same currency which is issued by one regional central bank. Internally exists one (once) fixed exchange rate and externally the regional central bank may use any exchange rate policy e.g. freely floating or managed floating.

11.2 De jure vs. de facto exchange rate regimes

As previously discussed many different exchange rate regimes exist and it is not trivial to determine in which exchange rate regime a country operates. The determination of the ‘de jure’ exchange rate regime according to the IMF classification is an easy task. The national central banks and monetary authorities’ officially declare in which exchange rate regime they operate e.g. pegged to the US

Dollar or freely floating, the IMF adopts the official announcement concerning the declared exchange rate regime and publishes it. That does not imply that the ‘de jure’ exchange rate regime is equal to the true or ‘de facto’ exchange rate regime. For instance, a central bank officially declares that they operate in a freely floating exchange rate regime and do not intervene in financial markets concerning their exchange rate. Simultaneously the central bank is concerned about the effect on the economy due to a volatile exchange rate (fear of floating). To soften the volatility the central bank intervenes in foreign exchange markets in a hidden way. Officially or ‘de jure’ the exchange rate regime is freely floating but unofficially or ‘de facto’ the exchange rate regime is rather managed floating (Harms, 2008).

The determination of the ‘de facto’ exchange rate regime of a country is not easy compared to the IMF classification. There exist a couple of theories how to define the ‘de facto’ exchange rate regime. One attempt by Reinhart and Rogoff differentiates if a country has not just one unified exchange rate but also parallel exchange rates e.g. rates on black markets due to capital control. They use statistical methods to measure the correctness of the ‘de jure’ classification. The base for the analysis is data on exchange rate variability compared to the officially announced bands of fluctuation and inflation in the country. The clear objective behind is to figure out the true monetary policy behind it. Levy-Yeyati and Sturzenberger determine exchange rate regimes based on data of the volatility of the nominal exchange rate, the variability of its rate of change and the volatility of international reserves. Often international reserves are published by the central bank and it might be possible to figure out by looking at the numbers if a central bank is active (intervenes) in foreign exchange markets. Bubula, Ötker-Robe and Anderson determine the ‘de facto’ exchange rate regime by using actual exchange rates and adding information from the IMF and other sources concerning the country e.g. country reports, press reports or other relevant papers (Eichengreen and Razo-Garcia, 2011). Klein and Shambaugh classify the exchange rate regime of a country as pegged if its official exchange rate has changed by less than +/-2% over the last two years. In the contrary the country’s exchange rate is not pegged (Rose, Andrew K., 2011). This is a relatively rough determination of ‘de facto’ exchange rate regimes.

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Details

Title
How do alternative exchange rate regimes operate and how can they be identified?
College
Johannes Gutenberg University Mainz
Course
Seminar International Economic Policy
Grade
1,7
Author
Year
2013
Pages
19
Catalog Number
V271201
ISBN (eBook)
9783656632535
ISBN (Book)
9783656632504
File size
460 KB
Language
English
Quote paper
Malte Vieth (Author), 2013, How do alternative exchange rate regimes operate and how can they be identified?, Munich, GRIN Verlag, https://www.grin.com/document/271201

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