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World Economy: Fixed Exchange Rates

The document discusses fixed exchange rate regimes. It provides tables showing different exchange rate arrangements used by countries, and the durability of different regimes over time. It then presents a model of fixed exchange rates, where a country fixes its exchange rate to another currency. It explains how an overvaluation or undervaluation of the fixed currency can be addressed through interest rates, reserves, or devaluations/revaluations. Maintaining credibility of the fixed rate over time is also discussed. Currency boards, which fully back domestic currency with foreign reserves, are presented as an alternative fixed regime.

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Najafova Narmin
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31 views

World Economy: Fixed Exchange Rates

The document discusses fixed exchange rate regimes. It provides tables showing different exchange rate arrangements used by countries, and the durability of different regimes over time. It then presents a model of fixed exchange rates, where a country fixes its exchange rate to another currency. It explains how an overvaluation or undervaluation of the fixed currency can be addressed through interest rates, reserves, or devaluations/revaluations. Maintaining credibility of the fixed rate over time is also discussed. Currency boards, which fully back domestic currency with foreign reserves, are presented as an alternative fixed regime.

Uploaded by

Najafova Narmin
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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WORLD ECONOMY

Lecture 11a:
Fixed Exchange Rates

1
Analytical Elements

 Alternative Exchange Rate Regimes


 A Model of Fixed Exchange Rates
 Interest Rates and Exchange Rates
Alternative Exchange Rate
Regimes
 Alternative exchange rage regimes are presented in
Table 11.1
 Flexible or (clean) float
 Managed (dirty float)
 Crawling bands
 Crawling pegs
 Fixed
 Currency board
 No separate legal tender
 One issue that has arisen is the durability of alternative
exchange rate regimes
 This is considered in Table 11.2
Table 11.1: Exchange Rate
Arrangements, 2008 (Source:
www.imf.org)
Arrangement Description Number of
Countries
Flexible or The exchange rate is market determined 40
(clean) float
Managed The exchange rate is primarily market determined, but the country’s monetary 44
(dirty) float authority intervenes in the currency market to influence the movements of the
exchange rate
Crawling The country’s monetary authority intervenes to maintain the exchange rate in a 2
bands band around a central rate, and these bands are periodically adjusted

Crawling pegs The exchange rate is fixed in value to another currency or to a “basket” of other 8
currencies, but adjusted periodically by small amounts

Fixed The exchange rate is fixed in value to another currency or to a “basket” of other 71
currencies
Currency The exchange rate is fixed in value to another currency, and domestic currency is 13
board fully backed by reserves of this foreign currency

No separate The legal tender of the country is a currency of another country 10


legal tender
Table 11.2: The Durability of
Exchange Rate Regimes, 1975-
2001 (years)
Countries All regimes Pegs Intermediate Floats
All countries 11.4 23.2 18.4 14.3
Advanced 19.4 46.0 26.8 88.0
countries
Emerging 8.6 8.4 16.5 11.0
markets
Developing 10.7 27.3 16.2 5.5

Source: Husain, Mody and Rogoff (2005) based on Reinhart and


Rogoff (2004)
A Model of Fixed Exchange
Rates
 In contrast to flexible or floating exchange rate regime,
we will consider the polar opposite case of a fixed
exchange rate regime
 Mexico will be our home country
 United States will be our foreign country
 Under a fixed exchange rate regime, when Mexican
government raises (lowers) e and thereby decreases
(increases) value of peso
 Called a devaluation (revaluation) of peso
 Contrasts with a market-driven, upward movement in e under a
flexible exchange rate regime known as a(n) depreciation
(appreciation)
 In practice, devaluations are more common than
revaluations
Table 11.3: Mexican Balance of
Payments, 2007 (billions of US
dollars)
Item Current Account
Gross Net Major Balance
Current Account
1. Goods exports 271.9
2. Goods imports -281.9
3. Goods trade balance -10.0
4. Service exports 17.6
5. Service imports -24.1
6. Goods and services trade balance -16.5
7. Net income -18.3
8. Net transfers 26.4
9. Current account balance -8.4
Table 11.3: Mexican Balance of
Payments, 2007 (billions of US
dollars)
Item Other Accounts
Gross Net Major Balance
Capital/Financial Account
10. Direct investment 18.8
11. Portfolio investment 11.3
12.Other investment -10.6
13. Capital/financial account balance 19.5
Official Reserve Transactions
14. Official reserves balance -10.3
Errors and Omissions
15. Errors and omissions -0.8
Overall Balance
16. Overall balance 0
Table 11.4: Exchange Rate
Terminology Revisited
Case e Value Term
of
Peso
Flexible ↑ ↓ Depreciation
e
Flexible ↓ ↑ Appreciation
e
Fixed e ↑ ↓ Devaluation
Fixed e ↓ ↑ Revaluation
A Model of Fixed Exchange
Rates
 Consider Figure 11.1
 e0 represents the equilibrium exchange rate
 This is where the supply of pesos given by the trade deficit
equals the demand for pesos given by foreign savings
 The supply of pesos is the negative of item 6, the goods
and services trade balance
 It excludes net income (item 7) and net transfers (item 8).
 The demand for pesos relates to item 13, the
capital/financial account balance
 The demand for pesos is therefore the non-official capital
account balance.
 This excludes the actions of central banks (item 14)
Figure 11.1: The Peso Market
A Model of Fixed Exchange
Rates
 Suppose that the Mexican government chooses to fix the

exchange rate at e1
 The value of the peso, 1/e1, is therefore above the equilibrium
value of the peso, 1/e0
 This situation is known as an overvaluation of the peso
 An overvaluation of the peso implies an excess supply of
pesos or an excess demand for dollars
 The additional demand for pesos or supply of dollars can
come from three sources (Table 11.3)
 positive net income (item 7)
 positive net transfers (item 8)
 positive net official reserve transactions (item 14) or drawing
down foreign reserves
A Model of Fixed Exchange
Rates
 Suppose that the Mexican government chooses to fix the
exchange rate at e2
 The value of the peso, 1/e2, is therefore below the equilibrium
value of the peso, 1/e0
 This situation is known as an undervaluation of the peso
 An undervaluation of the peso implies an excess
demand for pesos or an excess supply of dollars
 The additional supply of pesos or demand for dollars can
come from three sources (Table 11.3)
 negative net income (item 7)
 negative net transfers (item 8)
 negative net official reserve transactions (item 14) or building up
foreign reserves
A Model of Fixed Exchange
Rates
 Summarize
 Overvaluation  Excess supply of pesos (demand
for dollars)  Central bank draws down foreign
reserves
 Undervaluation  Excess demand for pesos
(supply of dollars)  Central bank builds up foreign
reserves
Interest Rates and Exchange
Rates
 Another approach to maintaining a fixed exchange rate
is to affect the equilibrium exchange rate
 We can analyze this by using the interest rate parity
condition

rM  rUS 

e e e

e
 Suppose that the Mexican government successfully
ensures that a fixed rate 1/e3 is an equilibrium rate
 This implies that e3 = ee
 Therefore rm = rUS
Interest Rates and Exchange
Rates
 By increasing or decreasing rm into equality with rUS, the
Mexican government can move the SF graph in Figure
11.2 to the left or right until the equilibrium e and ee are
identical
 If a home country wants to maintain an equilibrium fixed
exchange rate, it must set its interest rate equal to that
prevailing in the foreign country whose currency serves
as a peg for the home country currency
 In practice, fixed exchange rates are maintained with
combinations of net income, net transfers, official
reserve transactions, and interest rates
Figure 11.2: An Equilibrium
Fixed Exchange Rate
The Role of Credibility
 Expectations regarding the future exchange rate can be
volatile and subject to a host of economic and political
events
 If a fixed exchange rate comes under pressure from an
incipient fall in demand (shift of SF to the left), this
pressure must be alleviated via an increase in the home-
country interest rate
 There are two difficulties here
 Increases in interest rates are recessionary in that they suppress
domestic investment
 Increases in interest rates can potentially play havoc in fragile
domestic financial systems, particularly when capital can leave
the country in the form of capital flight
The Role of Credibility

 Investors know what the potentially-negative


impacts of an interest rate can be, and this
information feeds back into expectations
 If investors begin the question the willingness and
ability of the home country government to defend
the fixed peg with interest rate increases, the
expected rate of depreciation again becomes
positive and the peg is no longer credible
Currency Boards
 Currency boards are a fixed exchange rate regime with
two characteristics
 The fixed rate is presented as an inviolable commitment with
legal backing in domestic legislation
 The central bank serving as the currency board fully backs up its
base money (cash and commercial bank reserves) with foreign
reserves stands ready to exchange the domestic currency and
the foreign currency in either direction to any such request
 The most well-known example of a currency board was
the Convertibility Plan of Argentina in place between
1991 and 2001 and ending in a crisis
 The usefulness of currency boards seems to be limited
to certain small and very open economies

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