Fixed Rate Regime Research Articles

Classifying Exchange Rate Regimes: Deeds vs. Words

Most of the empirical literature on the relative merits of alternative exchange rate regimes uses the IMF 'de jure' classification based on the regime that governments claim to have, abstracting from the fact that many countries that in theory follow flexible regimes intervene in the exchange market to an extent that in practice makes them indistinguishable from fixed rate regimes, and vice versa. To address this problem, in this paper we construct a 'de facto' classification of exchange rate regimes. Using cluster analysis techniques, we group different regimes according to their behavior along three classification dimensions: the nominal exchange rate, changes in the nominal exchange rate, and international reserves. We compare our results with the IMF classification, and discuss the main discrepancies. Among other things, our classification finds no support for the hypothesis that intermediate regimes has been disappearing in recent years, and highlights the fact that in practice flexible regimes are restricted to cases of relatively minor exchange rate volatility.

Explaining Forward Exchange Bias…Intraday

Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixedrate crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out. THIS ARTICLE EXAMINES IMPLICATIONS of the fact that interest rates are zero intraday.' In particular, we focus on the foreign exchange (FX) market, and ask whether trading strategies might be affected. The answer to this question is of greater import than might first appear. For example, in times of fixed-rate crisis, central banks typically employ an interest rate defense, raising domestic rates to attract a capital inflow and punish short-sellers. But, if dealers are immune to this defense-at least on an intraday basis-then perhaps the viability of fixed rate regimes is undermined. (Goldstein et al. (1993) provide an overview of how central banks defended their currencies during the 1992 currency crisis.) A simple example helps. With intraday interest rates of zero, a dealer can short a high interest rate currency in the morning, close her position in the afternoon, and never face an interest cost. If there is any likelihood of an intraday devaluation, this appears to be an attractive strategy, other things equal, since the dealer is immune to the interest cost of an overnight short position. Other things should not be equal in equilibrium, however. Buyers of the vulnerable currency must be compensated on average with an intraday capital gain, as long as no devaluation occurs. That is, devaluation risk is offset by systematic appreciation. Further, the greater the probability and size of the devaluation, the greater the implied appreciation. Thus, the absence of a role

Interest rate linkages within the EMS and bank credit supply

AbstractThe exchange rates between the currencies of European Monetary System (EMS) members are essentially fixed between narrow bands mandated by the Exchange Rate Mechanism (ERM). the intent of such a fixed rate regime is to enhance policy co‐ordination within the EMS. However, it has instead led to German policy dominance within the system according to several recent studies. We examine the optimal dynamic credit policy of a bank in an EMS country that is subject to such German ‘dominance’. Our stochastic control model reveals conditions under which German monetary policies can influence domestic bank lending behaviour. It also suggests that banks may be able to hedge such risk exposure by increasing in size. the model offers ‘credit supply' based explanations for recent regulatory reforms in Europe towards unified banking and the attempts of several EMS members to de‐link their policies from that of the German Bundesbank.

Reducing real exchange rate variability and drift: Mexico on the way to North American monetary union?

This article seeks to identify the optimal type of currency and exchange arrangement for Mexico to the extent this can be done from a study of the past and prospective behavior of its real exchange rate with the U.S. dollar alone. Analyzing five distinct episodes from 1957 to 1992 and the transition crises between them, we first decisively reject the now fashionable view that the nature of the regime governing the nominal exchange rate is immaterial to the variability of the real rate. Rather, fixed or preannounced exchange-rate paths have a clear advantage in this regard over floating. Indeed, during one recent episode of fixing, the variability of the real exchange rate between Mexico and the United States was about as low as within the United States, between Chicago and Los Angeles. Nevertheless, within any fixed-rate regime, whether exchange rates are rigidly pegged or, as now, set on a sliding scale beforehand, there has been a recurring tendency for progressive real appreciation until the peg breaks. Within any such regime, real exchange-rate drifts thus appear to have been destabilizing. Monetary union and seignorage sharing with the United States and Canada, as the capstone of the North American Free Trade Agreement (NAFTA), may prove to be a superior arrangement although the desirability of monetary union for either Canada or the United States is not analyzed.

Macroeconomic adjustment and inconvertible currencies in the third world

In 1987, Zimbabwe experienced serious difficulties in expanding mineral production, notably gold, due to a shortage of foreign exchange for the importation of spare parts and mining equipment ["Zimbabwe Survey," 1987]. Since gold can easily be converted into foreign currency, this may seem rather startling and paradoxical on a superficial level. Foreign exchange production declined as a result of a foreign exchange shortage. Similarly, in 1979, a World Bank Program loan was used to fmance the foreign exchange requirements of Jamaica's export industries. In theory, the profitable production of exports should generate more foreign exchange than it requires. The World Bank loan should have been completely unnecessary ['Report and Recommendation, ~ 1979]. Throughout the Developing World, there are many more examples of such self-perpetuating foreign exchange shortages. Often such countries undergo what is known in the local press as a "foreign exchange crisis:" a catastrophic collapse of the economy's ability to maintain the flow of essential imports resulting in draconian trade and exchange controls. Although terms of trade fluctuations or disturbances in world markets may play a role, "foreign exchange crises" typically arise when governments allow their domestic currencies to become seriously overvalued but resist devaluation because they feel that it will fan the flames of inflation. For a period of time, external borrowing or reserve depletion can maintain import levels, but sooner or later these wells run dry. Then the government must resort to foreign exchange or import controls if the authorities still cannot accept a devaluation. This creates a new foreign exchange regime-one where quotas are used to reduce import levels to the available supply of foreign exchange. Because such regimes involve a fixed exchange rate at which the Central Bank buys foreign exchange and sells rationed amounts of foreign exchange, they can be confused with standard, fixed exchange rate regimes. But there is a vital difference between these two types of regimes. Under a standard, fixed rate regime, the Central Bank buys and sells foreign exchange to equilibrate the supply and demand for foreign exchange. By contrast, in an import control regime, the Central Bank does not have usable foreign exchange reserves to sell. It must ration imports in order to reduce the level of demand for foreign exchange. Many attempts to model the effects of import controls, such as Occampo [1987] are not as useful as they first appear because they treat import controls as exogenous, rather than determining the quotas as a result of foreign exchange availability. Consequently, they are not true general equilibrium models. Although they are common in the Third Wodd, there is little good general equilibrium literature on this topic. McKinnon [1979, p. 440], in a review of the multiple volume NBER study, Foreign Trade Regimes and Economic Development, headed by Bhagwati and Krueger, pointed out that "Devaluation in the presence of exchange controls and other QRs has not been well worked out in

Empirical evidence on the insulation properties of fixed and flexible exchange rates: The Japanese experience

This paper investigates whether Japanese output stability since the mid-1970s is attributable to the change in exchange rate regime or to the changing nature of underlying disturbances. We decompose foreign and domestic influences on output movements using restrictions on the long- run dynamics to identify the disturbances. We find that the flexible exchange rate regime is more effective in insulating the economy from foreign disturbances than is the fixed rate regime. However, in the case of Japan, it is primarily the changing nature of the fundamental disturbances to the economy that is responsible for greater output stability since the mid-1970s.

Real exchange rate effects of monetary shocks under fixed and flexible exchange rates

We analyze how the real exchange rate effects of monetary and real shocks depend on the exchange rate regime within a two-country rational expectations model with confusion about money and real shocks. The model demonstrates that the real exchange rate effect of unanticipated monetary shocks is negatively related to the variance of the domestically-created money supply growth, and that the effects of increasing domestic money variance on the real exchange rate are less under a fixed rate regime than under a flexible rate regime.

A collapse of a fixed rate regime with a discrete realignment of the exchange rate

A collapse of a fixed exchange rate regime is often characterized by the monetary authorities' loss of reserves at an astronomical rate and a discrete exchange rate realignment. The existing literature explains the former but not the latter. This paper advances a mechanism of a collapse that explains both. Uncertainty over the monetary authorities' decision on abandoning a fixed rate gives the exchange market intervention a cumulative nature which ultimately manifests itself in a collapse with a loss of reserves at an astronomical rate, namely, a speculative attack. The uncertainty permits a discrete realignment by keeping arbitrage from equating the pre- and post-collapse exchange rates.

Automatic Control of Supplemental Chemical Addition for Primary Treatment Enhancement

Abstract Chemical coagulation can be used to improve the efficiency of a primary wastewater treatment plant. Using statistical and fuzzy mathematical techniques, models of this process were developed from data gathered at a plant which was using liquid alum and a polymeric coagulant aid to reduce its primary effluent strength. Mathematical simulation of on-line process control using these models and fixed and variable chemical feed rate regimes were conducted using “typical day” influent strength and flow rate data. The results of these simulations show that on-line process control with a variable feed regime adjusted on the basis of current and projected conditions would generally provide a more effective use of chemicals than a fixed feed rate regime. Only at higher target efficiencies did the fixed feed rate regime approach the effectiveness of the variable fixed rate regime.

Real aspects of exchange rate regime choice with collapsing fixed rates

Typical evaluations of the choice of exchange rate regime examine the performance of the real economy and assume that the regimes last indefinitely. In contrast, actual regimes are quite transitory. This paper examines how the predictions of two popular models for the determination of some real economic variables must be modified when agents rationally perceive that a fixed rate regime will be transitory. The models studied are simple stochastic versions of the models in Dornbusch (1976) and Flood and Marion (1982).

Adjustment to monetary policy and devaluation under two-tier and fixed exchange rate regimes

The purpose of this paper is to determine whether a two-tier exchange rate regime is more effective than a fixed rate regime in increasing a country's ability to pursue an independent monetary policy. The analysis compares adjustment to a monetary policy and to a devaluation in the two exchange rate regimes in a portfolio model under imperfect assets substitutability. It is shown that a two-tier exchange rate regime is capable of reducing the current account effects of monetary injection or devaluation only in the long run. In the short run, however, we can get a larger current account response under a two-tier regime. These results reflect the trade-off between quantity and price adjustment.

International risk sharing and the choice of exchange-rate regime

This paper examines the argument that the fixed exchange-rate regime should be preferred to the flexible rate regime because the former allows risk sharing across countries while the latter does not. The analysis is performed in a two-country overlapping generations model, where markets are incomplete under all exchange regimes. It is shown that risks are pooled across countries when the equilibrium exchange rate is constant across states of nature, which arises under the fixed rate regime with or without capital restriction, and under the flexible rate regime without capital restriction. Risks are not pooled across countries when the equilibrium exchange rate is different across states of nature, which arises under the flexible rate regime with capital restriction. But in a model with incomplete markets, the ability to share risk across countries in the regimes with constant exchange rates does not necessarily lead to higher welfare than the inability to share risk in the regime with random exchange rates.

Balance-of-Payments Crises and Devaluation

The collapse of a fixed exchange rate is typically marked by a sudden balance-of-payments crisis in whichspeculators fleeing from the domestic currency acquire a large portion of the central bank's foreign exchange holdings.Faced with such an attack, the central bank often withdraws temporarily from the foreign exchange market, allowing the exchange rate to float freely before devaluing and returning to a fixed-rate regime. This paper links the timing of the initial speculative attack to the magnitude of the expected devaluation and to the length of the transitional period off loating. An implication of the analysis is that there exist devaluations so sharp and transition periods so short that acrisis must occur the moment the market first learns that the current exchange parity will eventually be altered. For sufficiently long transition periods, the floating exchange rateovershoots its new peg before appreciating back toward it;for shorter periods, the rate depreciates monotonically to its new fixed level. Accordingly, the central bank's return tothe foreign exchange market can occasion a capital outflow or a capital inflow.