The Limited Viability of Dual Exchange-Rate Regimes

1986

The World Bank does not accept responsibility for the views expressed herein which are those of the author(s) and should not be attributed to the World Bank or to its affiliated organizationso The findings, interpretations~ and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Banko The designations employed 9 the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country~ territory~ city, area, or of its authorities~ or concerning the del!mitations of its boundaries~ or national affiliationa

Journal of International Money and Finance, 1985

This paper analyzes exchange rate management in a simple overlapping generations model. This framework is used to evaluate alternative policies in terms of their implications for the welfare of individuals in the economy. The analysis identifies two objectives of monetary policy, providing a desirable store of value and collecting seigniorage. When the chief concern is to provide a desirable store of value (as when the monetary authority's major constituency consists of the asset holders of the economy), a policy of fixing the exchange rate does better when shocks are primarily of domestic origin while floating becomes more desirable when foreign shocks predominate. When seigniorage concerns are paramount (as when the authority's constituency is the young generation) flexible rates do better. When seigniorage concerns are paramount and when the monetary authority cannot establish a reputation for conducting monetary policy in a way that makes the currency a desirable store of value, a national currency may not be viable in the absence of exchange controls. Such controls may be justified in this situation.

1986

The paper first reviews the budget identities of the fiscal and monetary authorities and the solvency constraint or present value budget-constraint of the consolidated public sector, for closed and open economies. It then discusses the new conventional wisdom concerning the fiscal roots of inflation and the budgetary prerequisites for generating and stopping hyperinflation. The popular rational expectations "Unpleasant Monetarist Arithmetic" model of Sargent and Wallace has ambiguous inflation implications from an increase in the fundamental deficit and is incapable of generating hyperinflatior,. The only runaway, explosive or unstable behavior it can exhibit is "hyperdeflation"! In the open economy, the need to maintain a managed exchange rate regime does not impose any constraint on the growth rate of domestic credit, arising through the government's need to remain solvent. Obstfeld's proposition to the contrary is due to the omission of government bonds and borrowing. There is not yet any "deep structural" theory justifying the (exogenous) lower bounds on the stock of foreign exchange reserves characteristic of the collapsing exchange rate literature. Absent such a theory of "international liquidity," one cannot model satisfactorily a foreign exchange crisis that is not at the same time a government solvency crisis. Given such a lower bound, the existence or absence of a pecuniary opportunity cost to holding reserves is shown to condition the fiscal and financial actions consistent with prolonged survival of the managed exchange rate regime.

Wisselkoersen in een Veranderende Wereld, Preadvies van de Vereniging voor de Staathuishoudkunde, Stenfert Kroese, Leiden, Antwerpen, 1986, pp. 99-117, 1986

The paper first reviews the budget identities of the fiscal and monetary authorities and the solvency constraint or present value budget constraint of the consolidated public sector, for closed and open economies. It then discusses the new conventional wisdom concerning the fiscal roots of inflation and the budgetary prerequisites for generating and stopping hyperinflation. The popular rational expectations "Unpleasant Monetarist Arithmetic" model of Sargent and Wallace has ambiguous inflation implications from an increase in the fundamental deficit and is incapable of generating hyperinflatior. The only runaway, explosive or unstable behavior it can exhibit is "hyperdeflation"! In the open economy, the need to maintain a managed exchange rate regime does not impose any constraint on the growth rate of domestic credit, arising through the government's need to remain solvent. Obstfeld's proposition to the contrary is due to the omission of government bonds and borrowing. There is not yet any "deep structural" theory justifying the (exogenous) lower bounds on the stock of foreign exchange reserves characteristic of the collapsing exchange rate literature. Absent such a theory of "international liquidity," one cannot model satisfactorily a foreign exchange crisis that is not at the same time a government solvency crisis. Given such a lower bound, the existence or absence of a pecuniary opportunity cost to holding reserves is shown to condition the fiscal and financial actions consistent with prolonged survival of the managed exchange rate regime.

1989

The paper develops an analytical framework which demonstrates that the various forms of exchange-rate management are equivalent to corresponding tax policies. To highlight the salient issues, we consider two specific categories of exchange-rate policies. The first is a dual exchange-rate regime, which separates exchange rates for commercial and for financial transactions, and the second is a unified exchange-rate system in which the country unilaterally pegs its exchange rate at the same rate for all transactions. We show that the dual exchange rate policies can be usefully cast as distortionary taxes on international borrowing, and a unified pegged exchange-rate policies can be usefully cast as lump-sum tax cum subsidy policies. The equivalence between the various characteristics of exchange-rate management and tax management suggests that exchange-rate analysis could be usefully incorporated into the broader framework of the analysis of fiscal policies. A two-country model of the world economy is used to demonstrate the international transmission mechanism of these policies.

Using a model of a small open economy operating under dual foreign exchange markets, free exchange rate for financial transactions and quasi-fixed exchange rate for commercial transactions, this paper analyses the dynamic adjustment of the foreign exchange rates, when terms of trade, and monetary disturbance shocks hit the economy. The results indicate that under such a dual foreign exchange system, the stability of a foreign exchange system requires a sufficient level of official reserves that can accommodate adverse terms of trade and monetary disturbance shocks. Under insufficient reserves, adverse shocks can lead to official reserve depletion and exchange rates divergence.

Journal of International Economics, 1982

This paper analyzes aspects of the economics of the optimal management of exchange rates. It shows that the choice of the optimal exchange rate regime depends on the nature and the origin of the stochastic shocks that affect the economy. Generally, the higher is the variance of real shocks which affect the supply of goods, the larger becomes the desirability of fixity of exchange rates. The rationale for that implication is that the balance of payments serves as a shock absorber which mitigates the effect of real shocks on consumption. The importance of this factor diminishes the larger is the economy's access to world capital markets. On the other hand, the desirability of exchange rate flexibility increases the larger are the variances of the shocks to the demand for money, to the supply of money, to foreign prices and to purchasing power parities. All of these shocks exert a similar effect and their sum is referred to as the "effective monetary shock." It is also shown that the desirability of exchange rate flexibility increases the larger is the propensity to save out of transitory income. When the analysis is extended to an economy which produces traded and non-traded goods it is shown that the desirability of exchange rate flexibility diminishes the higher is the share of non-traded goods relative to traded goods and the lower are the elasticities of demand and supply of the two goods.

ЗБОРНИК РАДОВА ЕКОНОМСКОГ ФАКУЛТЕТА У ИСТОЧНОМ САРАЈЕВУ, 2014

Exchange rate of one currency is the price of the currency expressed in units of other currency. It is formed by the interaction of supply and demand in the foreign exchange market. Given that the exchange rate has a direct impact on the competitiveness of a country in terms of features of its exports and imports, in its balance of payments, and indirectly the overall economic and social development, in addition to acting in market principles-supply and demand in the formation of the equilibrium exchange rate, exchange rate is subject to different, stronger or weaker, more or less, forms of intervention. In the search for the optimal exchange rate policy of the national currency, the monetary authorities are positioned between the two extremes-the complete abandonment of the exchange rate to the market laws of supply and demand, or fixing the exchange rate for any of the selected anchor currency.

American Economic Review, 2000

2010

During the birth and infancy of the Bretton Woods system, the debate on exchange rate regimes was dominated by systemic arguments and concerns. The fathers of Bretton Woods believed that a centrally supervised system of fixed exchange rates was key to postwar prosperity, as it would shield international trade both from exchange rate volatility and from exchange rate manipulation by individual countries. Against this view, a classic 1953 article by Milton Friedman argued that exchange rate volatility was a symptom rather than a cause of economic imbalances. Fixing the exchange rate would not remove these problems but merely suppresses them, until they became so virulent that they erupted, in the form of a currency crisis, or painful domestic adjustment. Flexible exchange rates, in contrast, provided a mechanism for adjustment on an ongoing basis. "Changes in it occur rapidly, automatically, and continuously and so tend to produce corrective movements before tensions can accumulate and a crisis develop." Friedman also argued that with good macroeconomic management, exchange rates were unlikely to be very volatile, and very unlikely to burden trade in goods and services, which in any case could avail itself from futures markets to hedge exchange rate risk. More than half a century after Friedman's article, and over 30 years after the end of the Bretton Woods era, many of Friedman's claims have been clearly proven either right or wrong. One the one hand, floating exchange rates did in fact turn out to be much more volatile than Friedman anticipated. A celebrated article by Michael Mussa (1986) documented conclusively that flexible exchange rate regimes do indeed display much higher real exchange rate variability than pegged regimes-especially for advanced economies, where exchange rates were driven mainly by capital flows. On the other hand, Friedman turned out to be right in his conjecture that flexible exchange rates would, at most, impose a modest burden on trade. Though currency unions retained their fans and triumphed in 1 The views in this paper are the authors' only, and should not be attributed to the International Monetary Fund. We thank, without implication, Olivier Jeanne, Jonathan Ostry, Charles Wyplosz, and seminar participants at the IMF and the Geneva Graduate Institute for International and Development Studies for comments and discussions. This paper is part of a larger project examining the macroeconomic implications of exchange rate regimes.