If the exchange rate has depreciated, he will receive lower compensation than he had expected. The cost of this uncertainty can be measured precisely—it is the cost of hedging, that is the cost to the exporter of buying an exchange rate forward contract or futures contract to lock in a future exchange rate today. The alternative to floating exchange rates are exchange rate regimes that fix the value of the exchange rate to that of another country or countries.
There are two broad types of fixed exchange rates. The second category considered is fixed exchange rates, in which the link to the other currency or currencies is less direct, making them "soft pegs. At the opposite end of the spectrum from floating exchange rates are arrangements where a country gives up its exchange rate and monetary freedom entirely by tying itself to a foreign country's currency, what former IMF Deputy Director Stanley Fischer calls "hard pegs.
For example, Hong Kong has a currency board linked to the U. Argentina had a similar arrangement which it abandoned in , during its economic crisis. In Argentina, for every peso of currency in circulation the Argentine currency board held one dollar-denominated asset, and was forbidden from buying and selling domestic assets. Thus, the amount of pesos in circulation could only increase if there was a balance of payment surplus.
In effect, the exchange rate at which Argentina competed with foreign goods was set by the United States. Because exchange rate adjustment was not possible, adjustment had to come through prices i. Domestically, because the central bank could no longer alter the money supply to change interest rates, the economy could only recover from peaks and valleys of the business cycle through gradual price adjustment.
From an economic perspective, a currency union is very similar to a currency board. An example of a currency union is the euro, which has been adopted by 13 members of the European Union. The individual nations in the euro zone have no control over the money supply in their countries.
Instead, it is determined by two factors. First, the European Central Bank ECB determines the money supply for the entire euro area by targeting short-term interest rates for the euro area as a whole. Second, how much of the euro area's money supply flows to, say, Ireland depends upon Ireland's net monetary transactions with the rest of the euro area.
For this second reason, different countries in the euro area have different inflation rates despite the fact that they share a common monetary policy. In a currency union such as the euro arrangement, each member of the euro has a vote in determining monetary policy for the overall euro area. The countries of the euro also share in the earnings of the ECB, known as seigniorage, just as they would if they had their own currency.
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Not all currency unions give all members a say in the determination of monetary policy, however. From a macroeconomic perspective, a unilateral currency adoption and a currency board are indistinguishable. Between these two arrangements, there are only two minor differences of note. First, currency boards earn income on the dollar-denominated assets that they hold another example of seigniorage while currency adopters do not.
If this were the case, they would view the risks associated with investment in the former to be lower.
The primary economic advantage of a hard peg comes through greater trade with other members of the exchange rate arrangement. The volatility of floating exchange rates places a cost on the export and import-competing sectors of the economy. Greater trade is widely seen to be an engine of growth, particularly among developing countries.
In a perfectly competitive world economy without transaction costs, the cost of exchange rate volatility could be very large indeed. For instance, U. Until the domestic price level fell by one-third, U. All else was not equal—exports continued to rise in the s despite the dollar's appreciation. Under a system of fixed exchange rates, U. Between small countries, a hard peg is also thought to promote more efficient and competitive markets through lower barriers to entry and greater economies of scale. Hard pegs also encourage international capital flows. First, it allows more investment to take place in areas where saving is relatively scarce and rates of return are high, and investment is key to sustainable growth.
This makes both the borrower and the investor better off; the former because more investment, and hence growth, is possible than otherwise would be, the latter because they can now enjoy higher rates of return on their investment for a given amount of risk than if limited to home investment.
Fixed Exchange Rates and Floating Exchange Rates: What Have We Learned?
For developing countries, these investment gains can be quite large. Because these countries have much lower capital-labor ratios than the developed world, capital investment can yield relatively high returns for some time if a friendly economic environment is constructed. On the other hand, international capital flows can change rapidly in ways that can be destabilizing to developing countries, as will be discussed below.
Weighed against the gains of higher trade and international investment is the loss of the use of fiscal and monetary policy to stabilize the economy. For countries highly integrated with their exchange rate partners, this loss is small. For example, in the euro area, the business cycle of many of the "core" economies e. As long as Belgium does not face separate shocks from France, it does not lose any stabilization capabilities by giving up the ability to set policy independently of France.
By sharing a currency, their fiscal and monetary policy can still be adjusted to respond jointly to shared shocks to their economies, even if these shocks are not shared by the rest of the world—the euro is free to adjust against the rest of the world's currencies. Troubles only arise if shocks harm one of these countries, but not its partners in the euro. In that case, there cannot be policy adjustment for that country to compensate for the shock.
The previous explanation described the economic reasons for establishing currency boards or currency unions. But it is probable that the primary reason for establishing them in developing countries is based more on political reasons. As has been shown, these monetary arrangements tie the hands of their country's policymakers. For some countries, this is precisely what their policymakers are trying to achieve—a way to prevent the reinstatement of policies from the "bad old days.
Stable growth is impossible when the price mechanism has broken down in this way. The currency board quickly brought the inflation rate in Argentina down to single digits. Whenever a country's inflation rate gets extremely high, it is a reflection of its fiscal policy. Large budget deficits cannot be financed through the sale of debt instruments, so they are instead financed through the printing of money.
Thus, a currency board prevents irresponsible fiscal policy by preventing monetary policy from supporting it.
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Similarly, Ecuador "dollarized" in —adopting the U. Although extremely high inflation had not yet become a problem, events leading up to dollarization appeared to be pointing in that direction.
Which Is Better: Fixed or Floating Exchange Rates?
Investors had become very concerned that inflationary monetary policy would be used to solve its fiscal problems, and dollarization quelled these fears by eliminating that policy option. Economic analysis sheds little light on the choice between floating exchange rates and a currency board arrangement when the decision is motivated by the desire to find a political arrangement that will prevent the pursuit of bad policies.
Economic analysis can identify bad policy; it cannot explain why it is pursued or how to prevent its recurrence. A currency board is not the only way to tie the hands of policymakers; various rules and targets have been devised to eliminate policy discretion that could be used with a floating exchange rate. A currency board may be a more final commitment, and hence harder to renege on, than rules and targets, however. Then again, Argentina proved that even currency boards are not permanent.
In any case, the political problem of countries monetizing budget deficits seems to be waning. If current trends continue, in the future there may be fewer countries who find it advantageous to accept the harsh medicine of hard pegs to solve their political shortcomings.
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Hard pegs are also seen by both proponents and opponents as a means to foster political integration, a topic beyond the scope of this report. This was a primary consideration behind the adoption of the euro. In a traditional fixed exchange rate regime, the government has agreed to buy or sell any amount of currency at a predetermined rate.
That rate may be linked to one foreign currency or unlike a currency board it may be linked to a basket of foreign currencies. In theoretical models, where capital is perfectly mobile and investors consider all countries to be alike, fixed exchange rates would necessarily be functionally equivalent to a currency board.
Any attempt to unilaterally influence one's interest rates, through monetary or fiscal policy, would be unsustainable because capital would flow in or out of the country until interest rates had returned to the worldwide level. In reality, results are not quite so stark. There are transaction costs to investment. Investors demand different risk premiums of different countries, and these risk premiums change over time. There is a strong bias among investors worldwide, particularly in developed countries, to keep more of one's wealth invested domestically than economic theory would suggest.
The Economics of Exchange Rates and the Dollarization Debate
For instance, interest rates in France and Germany should entail similar risks. Thus, anytime French interest rates exceeded German rates, capital should flow from Germany to France until the rates equalized again. Yet the commercial interest reference rate, as measured by the OECD, between these two countries has varied by as much as 1. As a result, countries with fixed exchange rates have limited freedom to use monetary and fiscal policy to pursue domestic goals without causing their exchange rate to become unsustainable.
By contrast, countries that operate currency boards or participate in currency unions have no monetary or fiscal autonomy. For this reason, fixed exchange rates can be thought of as "soft pegs," in contrast to the "hard peg" offered by a currency board or union. But compared to a country with a floating exchange rate, the ability of a country with a fixed exchange rate to pursue domestic goals is highly limited.
If a currency became overvalued relative to the country to which it was pegged, then capital would flow out of the country, and the central bank would lose reserves. When reserves are exhausted and the central bank can no longer meet the demand for foreign currency, devaluation ensues, if it has not already occurred before events reach this point. Interest rates can almost always be increased to a point where capital no longer flows out of the country, but a great contraction in the economy may accompany those rate increases.
It is not uncommon to see interest rates reach triple digits at the height of an exchange rate crisis. Crises ensue because investors do not believe that the government will have the political will to accept the economic hardship required to maintain those interest rates in defense of the currency.
Related Flexible Exchange Rates for a Stable World Economy
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