Exchange Rate Regimes

Before the collapse of the Bretton Woods system of fixed but adjustable exchange rates in 1971, most countries had declared par (fixed) values for their currencies against the US dollar, with a margin of 1 per cent above and below the par values. They also had the obligation to maintain the par values unless they could demonstrate the presence of a ‘fundamental disequilibrium’ (as opposed to temporary or transitory disequilibrium) in the balance of payments, in which case the par values could be changed subject to the approval of the International Monetary Fund (IMF). The UK, for example, utilized this scheme twice by devaluing the pound in 1949 and 1967. The word ‘most’ is used here because a small number of countries did not maintain fixed par values. Some countries in Latin America experienced high inflation rates that made it necessary for them to pursue a policy of gradual depreciation (what has become to be known as a crawling peg), and both Lebanon and Canada had extensive experience with floating exchange rates (the Canadian experiment with floating lasted between 1950 and 1962).

The exchange rate provides a key macroeconomic linkage between the domestic economy and the rest of the world that takes place through the goods and asset markets. In the goods market, the exchange rate establishes linkages between domestic and foreign prices through the relationship where P is domestic prices, P* is foreign prices and the exchange rate is expressed as the domestic currency price of one unit of the foreign currency. The parameters that reflect transaction costs and other market imperfections are α and β. This is a linear relationship between domestic prices and foreign prices expressed in domestic currency terms. It shows that the higher the exchange rate, other things being equal, the higher the price of foreign goods in the home country (δP/δE>0). The same relationship can be seen in Figure 2.1, which depicts P as a function of P*. As the exchange rate rises (the domestic currency depreciates) the line P = α + βEP* rotates upwards, leading to higher P for the same level of P*. This happens either directly (because the domestic price of imported goods rises) or indirectly (because domestic firms can afford to raise their prices when competitors’ prices rise). Some of the effect is transmitted through the labour market, as workers may demand wage increases when higher import prices raise the cost of living. Governments that are aware of this connection would prefer to stop depreciation but if they do so in the face of domestic inflation they risk a loss in competitiveness.

The origin of the debate on fixed versus flexible exchange rates in its modern form is arguably Friedman’s (1953) piece ‘The Case for Flexible Exchange Rates’. Friedman strongly rejected the conventional wisdom of the time, arguing that flexible exchange rates are ‘absolutely essential for the fulfillment of our basic economic objectives: the achievement and maintenance of a free and prosperous world community engaging in unrestricted multilateral trade’. On the other hand, he argued against fixed exchange rates by asserting that ‘there is scarcely a facet of international economic policy for which the implicit acceptance of a system of rigid exchange rates does not create serious and unnecessary difficulties’. It must be emphasized, however, that Freidman distinguished between ‘flexible’ and ‘unstable’ exchange rates. In this sense, he advocated as the ‘ultimate objective’ what he described as ‘a world in which exchange rates, while free to vary, are in fact highly stable’. However, he argued that the elimination of exchange rate instability by ‘administrative freezing’ of exchange rates cures none of the underlying difficulties and only makes adjustment to them more painful.

This chapter deals with the theoretical and practical classification schemes of exchange rate arrangements. What we mean by ‘theoretical classification’ is the theoretical spectrum of exchange rate arrangements falling between the two extremes of perfectly fixed and perfectly flexible exchange rates. The classification is ‘theoretical’ in two senses, the first of which is that any of the classified arrangements may or may not have been tried in practice. In another sense, the classification is ‘theoretical’ because the underlying concepts are abstract and generic, unlike what we find in the ‘practical’ classification. For example, we find the abstract and generic concept of fixed exchange rates in the theoretical classification, but in the practical classification we find the concepts of hard pegs, soft pegs, single-currency pegs and multicurrency pegs, all of which being different kinds of fixed exchange rates that have been tried in practice.

This chapter deals with the official and behavioural classifications of exchange rate regimes. The official classification of the IMF is the most common practical classification. This classification scheme is based on what individual member countries tell the IMF about the exchange rate arrangements they have in place. In recent years, economists started to develop systems of behavioural classification of exchange rate arrangements based on the observed behaviour of exchange rates and related variables, such as international reserves. One motivation for these efforts is the desire to find out if the exchange rate regime is irrelevant for economic performance, an issue that will be discussed in Chapter 7 and also in Chapter 8. Distinction is, therefore, made between the announced (de jure) and the actually practised (de facto) arrangements. Several studies that have made this attempt will be discussed in this chapter.

In Chapters 4 and 5 we examined exchange rate arrangements from theoretical and practical perspectives. Most of these exchange rate arrangements have been experimented with in various shapes and forms in the past 150 years or so as the world went through various international monetary systems. The international monetary system refers to the framework of rules, regulations and conventions that govern the financial relations between countries. The importance of the international monetary system is implied by Adam Smith’s (1776) description of it as the ‘Great Wheel’ because ‘when it does not turn well it adversely affects the welfare of nations’.

In this chapter we examine the issue of whether macroeconomic performance is affected by the underlying exchange rate regime. It is arguable that the way in which monetary and fiscal policies affect inflation and growth depend on the exchange rate regime. Macroeconomic performance under various exchange rate regimes depends on macroeconomic policy as well as external effects. A study conducted by the International Monetary Fund (1984) lists four criteria for evaluating an exchange rate regime with respect to its effect on the economy. These criteria are the following:

Empirical regime choice models are used to explain how the underlying exchange rate regime is related to the economic, financial and political characteristics of the country in question. In these models, the dependent variable can be either discrete, taking values representing the exchange rate regime (for example, zero for fixed and one for flexible) or it could be continuous, taking the form of a measure of exchange rate flexibility (like what we came across in Chapter 3). These values can be based on de jure or de facto classifications and they can be more disaggregated (for example, fixed, intermediate and floating, or even more classification categories). The explanatory variables, on the other hand, are numerous, but they can be classified under the headings: (i) optimum currency area (OCA) factors, (ii) other economic and monetary factors, (iii) fear of floating factors, and (iv) political economy factors. Some of these variables can be classified under more than one of these headings. Table 8.1, which is by no means exhaustive, lists the potential determinants of exchange rate regime choice (explanatory variables) classified under the four headings.

This case study draws heavily on Moosa (2004a, 2004b). Iraq is a case of a postwar country that experienced hyperinflation resulting from excessive currency printing. Between 1991 and 1995, the nominal value of the currency in circulation jumped from 22 billion to 584 billion, giving rise to an average annual inflation rate of 250 per cent. Monetary reform in post-Saddam Iraq is an issue that has been dealt with in the academic literature (for example, Hanke, 2003a; Roubini and Sester, 2003), in the media (for example, Hanke, 2003b) and in policy documents (for example, Sanford, 2003). King (2004) used the case of Iraq to demonstrate that expectations of future collective decisions can have a major impact on the value of a currency, irrespective of the policies pursed by the current government.