A Theory of Managed Floating

Abstract

After the experience with the currency crises of the 1990s, a broad consensus has emerged among economists that such shocks can only be avoided if countries that decided to maintain unrestricted capital mobility adopt either independently exchange rates or very hard pegs (currency boards, dollarisation). As a consequence of this view which has been enshrined in the so-called impossible trinity all intermediate currency regimes are regarded as inherently unstable. As far as the economic theory is concerned, this view has the attractive feature that it not only fits with the logic of traditional open economy macro models, but also that for both corner solutions (independently exchange rates with a domestically oriented interest rate policy; hard pegs with a completely exchange rate oriented monetary policy) solid theoretical frameworks have been developed. Above all the IMF statistics seem to confirm that intermediate regimes are indeed less and less fashionable by both industrial countries and emerging market economies. However, in the last few years an anomaly has been detected which seriously challenges this paradigm on exchange rate regimes. In their influential cross-country study, Calvo and Reinhart (2000) have shown that many of those countries which had declared themselves as independent floaters in the IMF statistics were charaterised by a pronounced of floating and were actually heavily reacting to exchange rate movements, either in the form of an interest rate response, or by intervening in foreign exchange markets. The present analysis can be understood as an approach to develop a theoretical framework for this behaviour that - even though it is widely used in practice - has not attracted very much attention in monetary economics. In particular we would like to fill the gap that has recently been criticised by one of the few middle-ground economists, John Williamson, who argued that managed is not a regime with well-defined rules (Williamson, 2000, p. 47). Our approach is based on a standard open economy macro model typically employed for the analysis of monetary policy strategies. The consequences of independently and market determined exchange rates are evaluated in terms of a social welfare function, or, to be more precise, in terms of an intertemporal loss function containing a central bank's final targets output and inflation. We explicitly model the source of the observable fear of by questioning the basic assumption underlying most open economy macro models that the foreign exchange market is an efficient asset market with rational agents. We will show that both policy reactions to the fear of (an interest rate response to exchange rate movements which we call indirect floating, and sterilised interventions in the foreign exchange markets which we call direct floating) can be rationalised if we allow for deviations from the assumption of perfectly functioning foreign exchange markets and if we assume a central bank that takes these deviations into account and behaves so as to reach its final targets. In such a scenario with a high degree of uncertainty about the true model determining the exchange rate, the rationale for indirect is the monetary policy maker's quest for a robust interest rate policy rule that performs comparatively well across a range of alternative exchange rate models. We will show, however, that the strategy of indirect still bears the risk that the central bank's final targets might be negatively affected by the unpredictability of the true exchange rate behaviour. This is where the second policy measure comes into play. The use of sterilised foreign exchange market interventions to counter movements of market determined exchange rates can be rationalised by a central bank's effort to lower the risk of missing its final targets if it only has a single instrument at its disposal. We provide a theoretical model-based foundation of a strategy of direct in which the central bank targets, in addition to a short-term interest rate, the nominal exchange rate. In particular, we develop a rule for the instrument of intervening in the foreign exchange market that is based on the failure of foreign exchange market to guarantee a reliable relationship between the exchange rate and other fundamental variables.