Nov 29

Crawling peg

A crawling peg is an exchange rate system mainly defined by two characteristics: a fixed par value of the currency which is frequently revised and adjusted due to market factors such as inflation; and a band of rates within which it is allowed to fluctuate.

As the IMF puts it, in crawling pegs “the currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis-à-vis major trading partners, differentials between inflation target and expected inflation in major trading partners”. The crawling rate can be set in a backward-looking manner (adjusting depending on inflation or other indicators), or in a forward-looking manner (adjusting depending on preannounced fixed rate and/or the projected inflation). It must be noted that maintaining a crawling peg limits monetary policymaking, to a similar degree than for target zone arrangements.

These characteristics allow for progressive devaluation of the currency which has a less traumatic effect in the country’s economy. Furthermore, this technique helps prevent, or at least soften, speculation over the currency. For these reasons, this type of exchange rate system is most commonly used with “weak” currencies. Latin American countries are known for being prone to use the crawling peg exchange system against the United States dollar, where in some cases devaluation can be seen occurring on a daily basis.

The following figure shows the different exchange rate regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:

Nov 29

Lope Gallego

Target zone arrangement

A target zone arrangement is an agreed exchange rate system in which certain countries pledge to maintain their currency exchange rate within a specific fluctuation margin or band. This margins can be set vis-à-vis another currency, a cooperative arrangement (such as the ERMII), or a basket of currencies. The spread of this margin can however vary, giving way to two different versions:

Strong version: also known as conventional fixed peg arrangements. The exchange rate, fluctuates within margins of ±1% or less, and is revised quite infrequently. The monetary authority can maintain the exchange rate within margins through direct intervention (for instance, purchasing and selling domestic and foreign currency in the market) or through indirect intervention (for instance influencing on interest rates). The flexibility of monetary policy is larger than for exchange arrangements with no separate legal tender.

Weak version: also known as pegged exchange rates within horizontal bands. In this case, the exchange rate fluctuates more than ±1% around the fixed central rate. Here, there is a limited degree of monetary policy discretion.

Target zone arrangements can be seen as being half way between fixed and flexible exchange rates. This kind of exchange rate system therefore allows for relatively stable trading conditions to prevail between countries, and at the same time allows some fluctuation in foreign exchange rates depending on relative economic conditions and trade flows.

Nov 28

Lope Gallego

No separate legal tender

Under a no separate legal tender regime, a country uses another one’s currency and thus gives away its capacity of using monetary policies. As stated by the IMF, under an exchange arrangement with no separate legal tender, “the currency of another country circulates as the sole legal tender, or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union”. Following this definition, we could include every country in the Eurozone. However, since in that case a new central governing entity, the European Central Bank, was created, it is considered as a pure monetary union.

The most widely used example of an exchange arrangement with no separate legal tender is a formal dollarization. In this case, the country adopts the dollar as its currency. The most common examples are the cases of Ecuador, Panama and El Salvador. El Salvador is a rare case since dollars coexist with the former domestic currency, the colón. However, the printing of new colones is prohibited, so they will coexist with dollars until all colón notes wear out physically.

The main implication for a country to adopt an exchange arrangement with no separate legal tender is that it completely surrenders its control over monetary policy. Therefore, usually this regime is adopted by governments that are considered as non-reliable, substituting their currency in favour of a currency of another country considered to be stable and with an effective monetary policy.

The following figure shows the different regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:

Nov 24

Lope Gallego

Currency board

A currency board is an exchange rate regime based on the full convertibility of a local currency into a reserve one, by a fixed exchange rate and 100 percent coverage of the monetary supply backed up with foreign currency reserves. Therefore, in the currency board system there can be no fiduciary issuing of money. As defined by the IMF, a currency board agreement is “a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority”. For currency boards to work properly, there has to be a long-term commitment to the system and automatic currency convertibility. This includes, but is not limited to, a limitation on printing new money, since this would affect the exchange rate.

The first currency boards appeared during the nineteenth century in Britain and France’s colonies. Since for locals of those colonies using the metropolitan currency was risky (loss or destruction of notes and coins, resources being permanently locked into the currency), the implementation of currency boards in the colonies made sense. The principle of the currency board was thus created in 1844 by the British Bank Charter Act.

The advantages of using a currency board includes low inflation, economic credibility, and lower interest rates. However, there is practically no monetary independence as monetary policies will focus in maintaining the coverage of the reserve’s monetary supply in detriment of other domestic considerations. The central bank will no longer act as a lender-of-last-resort, and monetary policy will be strictly limited to that allowed by the banking rules of the currency board arrangement.

Examples include the Bulgarian lev against the Euro, or the Hong Kong dollar against the U.S. dollar.

Nov 20

Lope Gallego

Free float

A free floating exchange rate, sometimes referred to as clean or pure float, is a flexible exchange rate system solely determined by market forces of demand and supply of foreign and domestic currency, and where government intervention is totally inexistent. Clean floats are a result of laissez-faire or free market economics.

Clean float is, theoretically, the best way to go. It allows countries to retain their monetary independence, which basically means they can focus on the internal aspects of their economy, and control inflation and unemployment without worrying about external aspects. However, we must take into consideration external shocks, such as oil price rises or capital flights, which can make it impossible to maintain a purely clean floating exchange rate system.

In reality, almost none of the currencies of developed countries have a clean float, as they all have some degree of support from their corresponding central bank, and so have a managed float. In fact, since most countries intervene in foreign exchange markets to some extent from time to time, these can be considered managed floating systems. The International Monetary System, which oversees the correct functioning of the international monetary system and monitors its members’ financial and economic policies, “allows” for exchange rate intervention when there are clear signs of risk to any of its member’s economy.

Nov 18

Lope Gallego

Managed float

A managed or dirty float is a flexible exchange rate system in which the government or the country’s central bank may occasionally intervene in order to direct the country’s currency value into a certain direction. This is generally done in order to act as a buffer against economic shocks and hence soften its effect in the economy.

A managed float is halfway between a fixed exchange rate and a flexible one as a country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. For example, if a currency’s value increases or decreases too rapidly, the central bank may decide to intervene in order to minimize any harmful effects that might result from the otherwise radical fluctuation. This is especially the case when international trade might be affected: central banks might act to counter a large appreciation of their currency, in order to maintain net exports. For instance, in 1994 the American government decided to buy large amounts of Mexican pesos with the objective of stopping the rapid loss in value of the peso, so to keep the trade status quo.

Even though most developed countries use a flexible exchange rate regime, in truth, they all use it to a limit. In fact, since most countries intervene in foreign exchange markets to some extent from time to time, these can be considered managed floating systems. The International Monetary System, which oversees the correct functioning of the international monetary system and monitors its members’ financial and economic policies, “allows” for exchange rate intervention when there are clear signs of risk to any of its member’s economy.

Nov 17

Lope Gallego

Inflation & Unemployment III

Inflation and unemployment can be very harmful to the economy, and so governments will always try to control them by implementing economic policies. However, knowing how a problem originates is always helpful when trying to fix it. This is the reason why economists have created an incredible amount of theories and economic models that try to explain how these inflation and unemployment behave.

In this Learning Path we’ll take a look at a few economic models that explain, at least to some extent or in some given context, inflation and unemployment.

NCM’s view:

NCM, an economic doctrine that appeared in the early 1970s;

NCM’s Phillips curve, which incorporates rational expectations;

Cahuc’s adjustment costs model, which analyses adjustments in employment levels.

NKE’s view:

NKE, which appeared in the late 1970s, and focused on the analysis of inflation;

NAIRU, the non-accelerating inflation rate of unemployment;

Layard-Nickell NAIRU model, based on wage determination.

Prices and growth:

Menu costs are costs that result from price changes;

Mankiw’s menu costs model, Gregory Mankiw’s view on the issue;

Business cycles, which also explain the level of unemployment.

Nov 17

Lope Gallego

Inflation & Unemployment III: NCM

New Classical Macroeconomics (NCM) arise from the development of the neoclassical economics principles, such as market clearing and optimization behavior by economic agents, which relate this school to monetarism. Its rise as a doctrine can be traced to the work in the early 1970s of its lead economist Robert Lucas (Chicago School).

Indeed, Lucas developed in 1973 what is known as rational expectations, an improvement on the adaptive expectations hypothesis used by monetarists, which changed the way macroeconomic analysis (and econometric analysis) is undertaken. These rational expectations are still used nowadays in macroeconomics.

Regarding policymaking, the NCM believes that no government intervention concerning demand is beneficial for the economy, not even in the short run. They argue that government can promote growth and stabilize the economy only through supply-side policies.

Economists such as Thomas Sargent, Edward Prescott, Neil Wallace and Robert Barro are amongst the most renowned NCM economists, whose theories are usually opposed to those of the followers of New Keynesian Economics.

Nov 17

Lope Gallego

Inflation & Unemployment III: NCM’s Phillips curve

New Classical Macroeconomics takes expectations one step further than monetarists did when using adaptive expectations. Rather than supposing that agents will learn to adjust their behaviour based on past experiences, they apply rational expectations, and directly assume that:

All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;
All agents assume that markets naturally reach an equilibrium;
Information is perfect: market force drivers are ‘common knowledge’.

This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:

As New Classical Macroeconomics views it, agents are able to anticipate future events without needing to have experienced them previously. This time around, agents will anticipate expansionist monetary policies, and therefore skip point B. Agents have sufficient working knowledge of the economy and monetary policy is transparent enough for agents to directly associate a fall in interest rates with a rise in inflation. Therefore, they waste no time in asking for salary raises (the change on inflation expectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever reached. Expansionist monetary policy is not even effective in the short term. In the very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.

The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.

Nov 17

Lope Gallego

Inflation & Unemployment III: Cahuc’s adjustment costs

The static theory of labour demand does not specify how, or how long adjustments between production factors take. It is therefore necessary to consider the notion of adjustment costs, such as costs incurred by a company to change the number of factors.

We will follow the lines followed in the model of adjustment costs seen in “Le marché du travail”, 2001, by Pierre Cahuc. These adjustments involve production costs that do not correspond to the activity itself. There are two kinds of adjustment costs:

-Internal adjustment costs: those caused by the loss of efficiency due to reorganization within the company (for example, training for use of new machinery, training of new employees to existing machinery, etc.).

-External adjustment costs: those who can be differentiated from production variations (for example, hiring experts to implement the changes, layoff payments, etc.).

As Cahuc explains, previous studies on the labour markets in the United States and France allow us to compare the situation of two types of markets:

-Recruitment costs are higher than firing costs in the U.S.;

-Firing costs are higher than recruitment costs in France;

-Recruitment costs in the U.S. are higher than in France;

-Firing costs are higher in France than in the U.S.

Furthermore, these studies conclude that these costs increase with the level of wage and/or training.

Employment protection by the public sector is less rigorous in the U.S., Canada or the U.K. than in France, Germany and southern Europe. Furthermore, these studies conclude that much of the higher cost of firing in Europe is due to administrative or regulatory costs (due to the legislation of each country).

LINEAR FORMULATION:

In most jobs, costs are represented by a symmetric convex function (usually quadratic). However, this does not explain asymmetrical adjustments and discontinuous employment. Thus, we see the linear formulation, which is commonly used nowadays.

This representation will show us how companies sometimes hire or fire employees, or remain as they are.

c_h and c_f represent hiring costs (h) and firing costs (f). Adjustment of employment will therefore be asymmetricif c_h≠ c_f.

EMPLOYMENT ADJUSTMENT:

It is possible to differentiate the effects of c_h and c_f when adopting a linear function. Furthermore, the linearity will see how the adjustment in the levels of labour can be immediate.

We define the adjustment cost function as:

The producer’s problem is choosing the level of labour that maximises its profits:

(r=is the rate at which future profits are actualised to present value)

The employment level is given by the equation:

which translates into the following conditions:

The producer will hire labour as long as its productivity is higher than the adjustment costs of hiring.

Producer will start firing employees as soon as productivity falls to the point where firing employees becomes profitable.

In all other cases, the producer maintains its level of staff. As we assume w, r, c_h and c_f constant, we can define employment levels L_h and L_fas:

The company adjusts its level of workers L_h (respectively L_f) if this is higher (respectively lower) than the initial level of employment L₀. If not, it means that L₀ is maintained between L_h and L_f, its optimal level:

GRAPHICAL ANALYSIS:

The curves in the lower half of the adjacent figure represent the relationship between initial employment and final employment levels. The conclusions we can derive from this model are:

-↑c_f: An increase in firing costs (U.S. spending levels to levels of FR.) Prevents staff adjustment downwards, and no incentive to hire;

-↑c_h: Increased recruitment costs (FR. spending levels to U.S. levels) prevents new hires;

-↓c_h: A lower recruitment cost always has positive effects on employment because it increases the optimal level of employment L_h;

Therefore, this model explains:

· higher unemployment in France (for little flexibility when firing);

· when wages are equal in both economies, U.S. production levels will be higher;

· in recessions, the situation is worse in France because it’s hard to fire employees;

· in times of expansion, the situation is worse in the U.S. because it’s hard to hire.

The main conclusion that can be derived from this model is that proper management of the costs of hiring and firing ensures greater stability in the demand for labour.