Exchange Rate Targeting

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Targeting the exchange rate is a monetary policy strategy with a long history. It can take the form of fixing the value of the domestic currency to a commodity such as gold, the key feature of the gold standard described in Chapter 20. More recently, fixed exchange-rate regimes have involved fixing the value of the domestic currency to that of a large, low-inflation country like the United States or Germany (called the anchor country). Another alternative is to adopt a crawling target or peg, in which a currency is allowed to depreciate at a steady rate so that the inflation rate in the pegging country can be higher than that of the anchor country.

Advantages of Exchange -rate targeting has several advantages. First, the nominal anchor of an

Exchange-Rate exchange-rate target directly contributes to keeping inflation under control by tying

Targeting the inflation rate for internationally traded goods to that found in the anchor country.

It does this because the foreign price of internationally traded goods is set by the world market, while the domestic price of these goods is fixed by the exchange-rate target. For example, until 2002 in Argentina the exchange rate for the Argentine peso was exactly one to the dollar, so that a bushel of wheat traded internationally at five dollars had its price set at five pesos. If the exchange-rate target is credible (i.e., expected to be adhered to), the exchange-rate target has the added benefit of anchoring inflation expectations to the inflation rate in the anchor country.

Second, an exchange-rate target provides an automatic rule for the conduct of monetary policy that helps mitigate the time-consistency problem. As we saw in Chapter 20, an exchange-rate target forces a tightening of monetary policy when there is a tendency for the domestic currency to depreciate or a loosening of policy when there is a tendency for the domestic currency to appreciate, so that discretionary, time-consistent monetary policy is less of an option.

Third, an exchange-rate target has the advantage of simplicity and clarity, which makes it easily understood by the public. A "sound currency" is an easy-to-understand rallying cry for monetary policy. In the past, this aspect was important in France, where an appeal to the "franc fort" (strong franc) was often used to justify tight monetary policy.

Given its advantages, it is not surprising that exchange-rate targeting has been used successfully to control inflation in industrialized countries. Both France and the United Kingdom, for example, successfully used exchange-rate targeting to lower inflation by tying the value of their currencies to the German mark. In 1987, when France first pegged its exchange rate to the mark, its inflation rate was 3%, two percentage points above the German inflation rate. By 1992, its inflation rate had fallen to 2%, a level that can be argued is consistent with price stability, and was even below that in Germany. By 1996, the French and German inflation rates had converged, to a number slightly below 2%. Similarly, after pegging to the German mark in 1990, the United Kingdom was able to lower its inflation rate from 10% to 3% by 1992, when it was forced to abandon the exchange rate mechanism (ERM, discussed in Chapter 20).

Exchange-rate targeting has also been an effective means of reducing inflation quickly in emerging market countries. For example, before the devaluation in Mexico in 1994, its exchange-rate target enabled it to bring inflation down from levels above 100% in 1988 to below 10% in 1994.

Disadvantages of Despite the inherent advantages of exchange-rate targeting, there are several serious

Exchange-Rate criticisms of this strategy. The problem (as we saw in Chapter 20) is that with capital

Targeting mobility the targeting country no longer can pursue its own independent monetary policy and so loses its ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country. Furthermore, an exchangerate target means that shocks to the anchor country are directly transmitted to the targeting country, because changes in interest rates in the anchor country lead to a corresponding change in interest rates in the targeting country.

A striking example of these problems occurred when Germany reunified in 1990. In response to concerns about inflationary pressures arising from reunification and the massive fiscal expansion required to rebuild East Germany, long-term German interest rates rose until February 1991 and short-term rates rose until December 1991. This shock to the anchor country in the exchange rate mechanism (ERM) was transmitted directly to the other countries in the ERM whose currencies were pegged to the mark, and their interest rates rose in tandem with those in Germany. Continuing adherence to the exchange-rate target slowed economic growth and increased unemployment in countries such as France that remained in the ERM and adhered to the exchange-rate peg.

A second problem with exchange-rate targets is that they leave countries open to speculative attacks on their currencies. Indeed, one aftermath of German reunification was the foreign exchange crisis of September 1992. As we saw in Chapter 20, the tight monetary policy in Germany following reunification meant that the countries in the ERM were subjected to a negative demand shock that led to a decline in economic growth and a rise in unemployment. It was certainly feasible for the governments of these countries to keep their exchange rates fixed relative to the mark in these circumstances, but speculators began to question whether these countries' commitment to the exchange-rate peg would weaken. Speculators reasoned that these countries would not tolerate the rise in unemployment resulting from keeping interest rates high enough to fend off attacks on their currencies.

At this stage, speculators were, in effect, presented with a one-way bet, because the currencies of countries like France, Spain, Sweden, Italy, and the United Kingdom could go only in one direction and depreciate against the mark. Selling these currencies before the likely depreciation occurred gave speculators an attractive profit opportunity with potentially high expected returns. The result was the speculative attack in September 1992 discussed in Chapter 20. Only in France was the commitment to the fixed exchange rate strong enough so that France did not devalue. The governments in the other countries were unwilling to defend their currencies at all costs and eventually allowed their currencies to fall in value.

The different response of France and the United Kingdom after the September 1992 exchange-rate crisis illustrates the potential cost of an exchange-rate target. France, which continued to peg to the mark and was thus unable to use monetary policy to respond to domestic conditions, found that economic growth remained slow after 1992 and unemployment increased. The United Kingdom, on the other hand, which dropped out of the ERM exchange-rate peg and adopted inflation targeting (discussed later in this chapter), had much better economic performance: economic growth was higher, the unemployment rate fell, and yet its inflation was not much worse than Frances.

In contrast to industrialized countries, emerging market countries (including the so-called transition countries of Eastern Europe) may not lose much by giving up an independent monetary policy when they target exchange rates. Because many emerging market countries have not developed the political or monetary institutions that allow the successful use of discretionary monetary policy, they may have little to gain from an independent monetary policy, but a lot to lose. Thus, they would be better off by, in effect, adopting the monetary policy of a country like the United States through targeting exchange rates than by pursuing their own independent policy. This is one of the reasons that so many emerging market countries have adopted exchangerate targeting.

Nonetheless, exchange-rate targeting is highly dangerous for these countries, because it leaves them open to speculative attacks that can have far more serious consequences for their economies than for the economies of industrialized countries. Indeed, as we saw in Chapters 8 and 20, the successful speculative attacks in Mexico in 1994, East Asia in 1997, and Argentina in 2002 plunged their economies into full-scale financial crises that devastated their economies.

An additional disadvantage of an exchange-rate target is that it can weaken the accountability of policymakers, particularly in emerging market countries. Because exchange-rate targeting fixes the exchange rate, it eliminates an important signal that can help constrain monetary policy from becoming too expansionary. In industrialized countries, particularly in the United States, the bond market provides an important signal about the stance of monetary policy. Overly expansionary monetary policy or strong political pressure to engage in overly expansionary monetary policy produces an inflation scare in which inflation expectations surge, interest rates rise because of the Fisher effect (described in Chapter 5), and there is a sharp decline in long-term bond prices. Because both central banks and the politicians want to avoid this kind of scenario, overly expansionary, time-consistent monetary policy will be less likely.

In many countries, particularly emerging market countries, the long-term bond market is essentially nonexistent. Under a flexible exchange-rate regime, however, if monetary policy is too expansionary, the exchange rate will depreciate. In these countries the daily fluctuations of the exchange rate can, like the bond market in United States, provide an early warning signal that monetary policy is too expansionary. Just as the fear of a visible inflation scare in the bond market constrains central bankers from pursuing overly expansionary monetary policy and also constrains politicians from putting pressure on the central bank to engage in overly expansionary monetary policy, fear of exchange-rate depreciations can make overly expansionary, time-consistent monetary policy less likely.

The need for signals from the foreign exchange market may be even more acute for emerging market countries, because the balance sheets and actions of the central banks are not as transparent as they are in industrialized countries. Targeting the exchange rate can make it even harder to ascertain the central bank's policy actions, as was true in Thailand before the July 1997 currency crisis. The public is less able to keep a watch on the central banks and the politicians pressuring it, which makes it easier for monetary policy to become too expansionary.

Given the above disadvantages with exchange-rate targeting, when might it make sense?

In industrialized countries, the biggest cost to exchange-rate targeting is the loss of an independent monetary policy to deal with domestic considerations. If an independent, domestic monetary policy can be conducted responsibly, this can be a serious cost indeed, as the comparison between the post-1992 experience of France and the United Kingdom indicates. However, not all industrialized countries have found that they are capable of conducting their own monetary policy successfully, either because of the lack of independence of the central bank or because political pressures on the central bank lead to an inflation bias in monetary policy. In these cases, giving up independent control of domestic monetary policy may not be a great loss, while the gain of having monetary policy determined by a better-performing central bank in the anchor country can be substantial.

Italy provides an example: It was not a coincidence that the Italian public was the most favorable of all those in Europe to the European Monetary Union. The past record of Italian monetary policy was not good, and the Italian public recognized that having monetary policy controlled by more responsible outsiders had benefits that far outweighed the costs of losing the ability to focus monetary policy on domestic considerations.

A second reason why industrialized countries might find targeting exchange rates useful is that it encourages integration of the domestic economy with its neighbors. Clearly this was the rationale for long-standing pegging of the exchange rate to the deutsche mark by countries such as Austria and the Netherlands, and the more recent exchange-rate pegs that preceded the European Monetary Union.

To sum up, exchange-rate targeting for industrialized countries is probably not the best monetary policy strategy to control the overall economy unless (1) domestic monetary and political institutions are not conducive to good monetary policymak-ing or (2) there are other important benefits of an exchange-rate target that have nothing to do with monetary policy.

In countries whose political and monetary institutions are particularly weak and who therefore have been experiencing continued bouts of hyperinflation, a characterization that applies to many emerging market (including transition) countries, exchangerate targeting may be the only way to break inflationary psychology and stabilize the economy. In this situation, exchange-rate targeting is the stabilization policy of last resort. However, if the exchange-rate targeting regimes in emerging market countries are not always transparent, they are more likely to break down, often resulting in disastrous financial crises.

Are there exchange-rate strategies that make it less likely that the exchange-rate regime will break down in emerging market countries? Two such strategies that have received increasing attention in recent years are currency boards and dollarization.

One solution to the problem of lack of transparency and commitment to the exchangerate target is the adoption of a currency board, in which the domestic currency is backed 100% by a foreign currency (say, dollars) and in which the note-issuing authority, whether the central bank or the government, establishes a fixed exchange rate to this foreign currency and stands ready to exchange domestic currency for the foreign currency at this rate whenever the public requests it. A currency board is just a variant of a fixed exchange-rate target in which the commitment to the fixed exchange

Exchange-Rate Targeting Desirable for Industrialized Countries?

When Is Exchange-Rate Targeting Desirable for Emerging Market Countries?

Currency Boards

http://users.erols.com /kurrency/intro.htm

A detailed discussion of the history, purpose, and function of currency boards.

rate is especially strong because the conduct of monetary policy is in effect put on autopilot, taken completely out of the hands of the central bank and the government. In contrast, the typical fixed or pegged exchange-rate regime does allow the monetary authorities some discretion in their conduct of monetary policy because they can still adjust interest rates or print money.

A currency board arrangement thus has important advantages over a monetary policy strategy that just uses an exchange-rate target. First, the money supply can expand only when foreign currency is exchanged for domestic currency at the central bank. Thus the increased amount of domestic currency is matched by an equal increase in foreign exchange reserves. The central bank no longer has the ability to print money and thereby cause inflation. Second, the currency board involves a stronger commitment by the central bank to the fixed exchange rate and may therefore be effective in bringing down inflation quickly and in decreasing the likelihood of a successful speculative attack against the currency.

Although they solve the transparency and commitment problems inherent in an exchange-rate target regime, currency boards suffer from some of the same shortcomings: the loss of an independent monetary policy and increased exposure of the economy to shocks from the anchor country, and the loss of the central bank's ability to create money and act as a lender of last resort. Other means must therefore be used to cope with potential banking crises. Also, if there is a speculative attack on a currency board, the exchange of the domestic currency for foreign currency leads to a sharp contraction of the money supply, which can be highly damaging to the economy.

Currency boards have been established recently in countries such as Hong Kong (1983), Argentina (1991), Estonia (1992), Lithuania (1994), Bulgaria (1997), and Bosnia (1998). Argentina's currency board, which operated from 1991 to 2002 and required the central bank to exchange U.S. dollars for new pesos at a fixed exchange rate of 1 to 1, is one of the most interesting. Box 1 describes Argentina's experience with its currency board.

Dollarization Another solution to the problems created by a lack of transparency and commitment to the exchange-rate target is dollarization, the adoption of a sound currency, like the U.S. dollar, as a country's money. Indeed, dollarization is just another variant of a fixed exchange-rate target with an even stronger commitment mechanism than a currency board provides. A currency board can be abandoned, allowing a change in the value of the currency, but a change of value is impossible with dollarization: a dollar bill is always worth one dollar whether it is held in the United States or outside of it.

Dollarization has been advocated as a monetary policy strategy for emerging market countries: It has been discussed actively by Argentine officials in the aftermath of the devaluation of the Brazilian real in January 1999 and was adopted by Ecuador in March 2000. Dollarization's key advantage is that it completely avoids the possibility of a speculative attack on the domestic currency (because there is none). (Such an attack is still a danger even under a currency board arrangement.)

Dollarization is subject to the usual disadvantages of an exchange-rate target (the loss of an independent monetary policy, increased exposure of the economy to shocks from the anchor country, and the inability of the central bank to create money and act as a lender of last resort). Dollarization has one additional disadvantage not characteristic of currency boards or other exchange-rate target regimes. Because a country adopting dollarization no longer has its own currency it loses the revenue that a government receives by issuing money, which is called seignorage. Because governments

Argentina's Currency Board

Argentina has had a long history of monetary instability, with inflation rates fluctuating dramatically and sometimes surging to beyond 1,000% a year. To end this cycle of inflationary surges, Argentina decided to adopt a currency board in April 1991. The Argentine currency board worked as follows. Under Argentina's convertibility law, the peso/dollar exchange rate was fixed at one to one, and a member of the public can go to the Argentine central bank and exchange a peso for a dollar, or vice versa, at any time.

The early years of Argentina's currency board looked stunningly successful. Inflation, which had been running at an 800% annual rate in 1990, fell to less than 5% by the end of 1994, and economic growth was rapid, averaging almost 8% at an annual rate from 1991 to 1994. In the aftermath of the Mexican peso crisis, however, concern about the health of the Argentine economy resulted in the public pulling money out of the banks (deposits fell by 18%) and exchanging pesos for dollars, thus causing a contraction of the Argentine money supply. The result was a sharp drop in Argentine economic activity, with real GDP shrinking by more than 5% in 1995 and the unemployment rate jumping above 15%. Only in 1996 did the economy begin to recover.

Because the central bank of Argentina had no control over monetary policy under the currency board system, it was relatively helpless to counteract the contractionary monetary policy stemming from the pub lic's behavior. Furthermore, because the currency board did not allow the central bank to create pesos and lend them to the banks, it had very little capability to act as a lender of last resort. With help from international agencies, such as the IMF, the World Bank, and the Interamerican Development Bank, which lent Argentina over $5 billion in 1995 to help shore up its banking system, the currency board survived.

However, in 1998 Argentina entered another recession, which was both severe and very long lasting. By the end of 2001, unemployment reached nearly 20%, a level comparable to that experienced in the United States during the Great Depression of the 1930s. The result has been civil unrest and the fall of the elected government, as well as a major banking crisis and a default on nearly $150 billion of government debt. Because the Central Bank of Argentina had no control over monetary policy under the currency board system, it was unable to use monetary policy to expand the economy and get out of its recession. Furthermore, because the currency board did not allow the central bank to create pesos and lend them to banks, it had very little capability to act as a lender of last resort. In January 2002, the currency board finally collapsed and the peso depreciated by more than 70%. The result was the full-scale financial crisis described in Chapter 8, with inflation shooting up and an extremely severe depression. Clearly, the Argentine public is not as enamored of its currency board as it once was.

(or their central banks) do not have to pay interest on their currency, they earn revenue (seignorage) by using this currency to purchase income-earning assets such as bonds. In the case of the Federal Reserve in the United States, this revenue is on the order of $30 billion per year. If an emerging market country dollarizes and gives up its currency, it needs to make up this loss of revenue somewhere, which is not always easy for a poor country.

Study Guide As a study aid, the advantages and disadvantages of exchange-rate targeting and the other monetary policy strategies are listed in Table 1.

■mummi»'« Table 1 Advantages and Disadvantages of Different Monetary Policv Strategies

Exchange-Rate

Monetary

Inflation

Implicit Nominal

Targeting

Targeting

Targeting

Anchor

Advantages

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