Nov 24

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.

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 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 13

Lope Gallego

Flexible exchange rate

Flexible exchange rates can be defined as exchange rates determined by global supply and demand of currency. In other words, they are prices of foreign exchange determined by the market, that can rapidly change due to supply and demand, and are not pegged nor controlled by central banks. The opposite scenario, where central banks intervene in the market with purchases and sales of foreign and domestic currency in order to keep the exchange rate within limits, also known as bands, is called fixed exchange rate.

Within this pure definition of flexible exchange rate, we can find two types of flexible exchange rates: pure floating regimes and managed floating regimes. On the one hand, pure floating regimes exist when, in a flexible exchange rate regime, there are absolutely no official purchases or sales of currency. On the other hand, managed (also called dirty) floating regimes, are those flexible exchange rate regimes where at least some official intervention happens.

Flexible exchange rate regimes were rare before the late twentieth century. Prior to World War II, governments used to purchase and sell foreign and domestic currency in order to maintain a desirable exchange rate, especially in accordance with each country’s trade policy. After a few experiences with flexible exchange rates during the 1920s, most countries came back to the gold standard. In 1930, before a new wave of flexible rate regimes started, prior to the war, over 50 countries were on the gold standard. However, most countries would abandon it just before World War II started.

In 1944, with the war almost over, international policy coordination was starting to make sense in everybody’s mind. Along with other international organisations created during those years, the Bretton Woods agreement was signed, putting in place a new pegging system: currencies were pegged to the dollar, which in turn was pegged to gold. It was not until 1973, when Bretton Woods completely collapsed, that countries started to implement flexible exchange rate regimes.

Milton Friedman was a great advocate for floating exchange rates. In his article “The Case for Flexible Exchange Rates”, 1953, he pointed out the extent to which flexible exchange rates would improve the global economy, by means of monetary independence. Also, economists Robert Mundell and Marcus Fleming, as demonstrated by the IS-LM-BoP model that derives from their works, pointed out how hurtful fixed exchange rates can be. All this relates to the “impossible trinity” concept.

Nov 11

Lope Gallego

Fixed exchange rate

A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate regime under which the currency of a country is fixed, either to another country’s currency, a basket of currencies or another measure of value, such as gold. A country’s monetary authority determines the exchange rate and commits itself to buy or sell the domestic currency at that price. To maintain it, the central bank intervenes in the foreign exchange market and changes interest rates.

The best known example can be found in the Gold Standard, going from 1879 to 1914, where the value of most currencies was denominated and expressed in terms of gold. We find another example in the Bretton Woods system, from 1944 to 1973, where the U.S. dollar was the official reserve asset, and currencies were paired to it.

Fixed exchange regimes usually bring stabilization to the real economic activity as it reduces volatility and fluctuations in relative prices. Furthermore, it eliminates the exchange rate risk. On the contrary the main disadvantage is the impossibility of adjusting the balance of trade and the need for governments to have a foreign asset reserve in order to defend the fixed exchange rate.

Nov 7

Lope Gallego

Exchange rate regime

An exchange rate regime is the system that a country’s monetary authority, -generally the central bank-, adopts to establish the exchange rate of its own currency against other currencies. Each country is free to adopt the exchange-rate regime that it considers optimal, and will do so using mostly monetary and sometimes even fiscal policies.

The distinction amongst these exchange rates regimes is generally just made between fixed and flexible exchange rate regimes, but we find there are many other different regimes, some of which are in between these extreme cases:

–Monetary Union, with a shared currency, such as the Eurozone;

–No separate legal tender, where the use of the currency of another country takes place;

–Currency Board, an explicit agreement on a fixed exchange rate between two or more currencies;

–Target zone arrangement, where the exchange rate is allowed to fluctuate within certain bands;

–Crawling Peg, with a periodically adjusted exchange rate;

–Managed (dirty) float, a flexible exchange rate regime with some government intervention;

–Free (clean) float, the exchange rate is market determined.

The “impossible trinity”, also referred to as “trilemma”, states that any exchange rate regime will only have two of the following three characteristics: free capital flow, fixed exchange rate regime; and sovereign monetary policy; and thus, one is always left out.

Every exchange rate regime obviously has its particularities, virtues and flaws. To determine the most appropriate exchange-rate regime for a certain country is not a simple task as much will be at stake. A country’s economy is hugely affected by this decision. 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 6

Lope Gallego

Battle of the Bismarck Sea

The Battle of the Bismarck Sea was a battle fought in February 1943 in Southeast Asia during World War II, between the Japanese Navy and the US Air Force. In game theory, its modeling was done by O. G. Haywood, Jr. in his article “Military Decision and Game Theory”, 1954. It’s a game used in game theory to analyze zero-sum games with two players.

The game, based on the actual military operation, is based on the decision General Kenney had to make. General Kenney, as Commander of the Allied Forces in the South-west Pacific Area, received intelligence reports indicating part of the Japanese Navy was about to sail from Rabaul, in the island of New Britain, to Lae, in New Guinea. Knowing this, General Kenney decided to make his five-step “Estimate of the Situation”, a technique used in US military operations.

Step 1: The Mission

General Kenney’s mission was to intercept the convoy and inflict the maximum possible amount of damage.

Step 2: Situation and Courses of Action

In addition to the intelligence report on Japanese troop movements, Kenney received weather reports indicating that rain and poor visibility was predicted for the area north of New Britain, while south of the island visibility would be good.

The Japanese commander had two possible courses of action: he could sail his convoy north of the island, or go south of the island. Any of these routes would take three days to sail.

General Kenney had therefore two possible courses of action: concentrate most of his reconnaissance aircrafts (but not all) along the northern route or along the southern route.

Step 3: Analysis of the Opposing Courses of Action

Since both commanders have two possible strategies, there are four possible outcomes.

Step 4: Comparison of Available Courses of Action

Obviously, General Kenney had to look for the best possible outcome. These are the four possible outcomes:

The first scenario (or set of opposing courses of action) shows the US Air Force’s bulk of airplanes north of New Britain, and the Japanese Navy taking the northern route. Because of poor visibility, the convoy wouldn’t be discovered until the second day, allowing for two days of bombing.

The second scenario shows again the US Air Force’s bulk of airplanes north of New Britain, but in this case the Japanese take the southern route. Because of limited reconnaissance south of the island, the convoy could be missed during the first day, allowing once again for two days of bombing.

The third scenario shows the main part of the US Air Force south of the island, and the Japanese Navy taking the northern route. Considering the poor visibility north of the island, plus limited reconnaissance, the convoy would be missed for two days, allowing for just one day of bombing.

The fourth and last scenario shows the US Air Force’s bulk of airplanes south of the island, and the Japanese taking the southern route. In this case, having the majority of airplanes in the area and having good visibility, General Kenney could hope for three days of bombing.

Step 5: The Decision

General Kenney decided to concentrate his reconnaissance airplanes north of New Britain.

In game theory, the Battle of the Bismarck Sea would be considered a simultaneous game, since both players have to make a decision at the same time, without knowing his opponent’s decision. Therefore, it can be depicted using the strategic form, by means of a matrix such as the following one.

We can solve this game analyzing the dominant and dominated strategies. The way to proceed is to eliminate for each player every strategy that seems ‘unreasonable’, which will greatly reduce the number of equilibria. This method is quite easy to use when only strictly dominated strategies are in place.

In this game, Kenney has no dominant strategy (the sum of the payoffs of the first strategy equals the sum of the second strategy), but the Japanese do have a weakly dominating strategy, which is to go North (the payoffs are equal for one strategy but strictly better for the other). Since only one of them has a dominant strategy, there is no dominant strategy equilibrium. We must then proceed by eliminating dominated strategies. As we’ve already mentioned, for the Japanese the strategy ‘go North’ weakly dominates strategy ‘go South’. Therefore, we eliminate the strategy ‘go South’ for the Japanese, who will go North. Now that we only consider the Japanese going North, Kenney’s strategy ‘go North’ is strictly dominant over strategy ‘go South’, which will be eliminated. Therefore, North-North is the weak-dominance equilibrium.

General Kenney made the right decision: he won the battle.

Oct 30

Lope Gallego

Richard Lipsey

Richard Lipsey
Richard George Lipsey is a Canadian economist born in 1928, who has been Professor at Simon Fraser University for most of his academic career. He has also held professorial posts at the London School of Economics, Essex University and Queen’s University in Kingston, as well as visiting professorships at Yale, the University of California at Berkeley, Manchester, and the University of British Columbia.

Richard Lipsey is mostly known for his article, co-authored with Kelvin Lancaster “The General Theory of Second Best”, 1956, in which they postulated the theory of second best, which aims at finding an optimum when Pareto optimality cannot be found. The main idea in their article is that, when a constraint prevents the fulfilment of one of the conditions required to obtain an optimum equilibrium, the other conditions are in general no longer desirable. The optimum situation in this case can be attained only by neglecting the other conditions. Indeed, this new optimum is called “second best” because a Paretian optimum cannot be attained.

Other of his notorious contributions to economic science includes expanding on the mathematics concerning the Phillip’s curve as well as carrying out further econometrical tests. However, for the most part of his career, Richard Lipsey has centred his work on welfare economics, especially on the analysis of positive economics.

Oct 28

Lope Gallego

Lagrangian

The Lagrange function is used to solve optimization problems in the field of economics. It is named after the Italian-French mathematician and astronomer, Joseph Louis Lagrange. Lagrange’s method of multipliers is used to derive the local maxima and minima in a function subject to equality constraints.

The existence of constraints in optimization problems affects the optimal value of the function since it implies a reduction of the feasible solutions space. Lagrange’s method multiplier is precisely used to measure how the correspondent restriction affects the optimal value of the objective function. In other words, they measure the degree of responsiveness of the problem’s optimal value due to changes in the constraints.

Mathematically, it is equal to the objective function’s first partial derivative regarding its constraint, and multiplying this last one by a lambda scalar (λ), which is an additional variable that helps to sort out the equation.

Let’s consider the following optimization problem:

The objective is to maximize (or minimize) a function with several variables

subject to the equality constraints

And we introduce the Lagrangian function,

Constrained optimisation plays a central role in Economics. For example, the consumer’s choice problem can be represented by either fixing a budget and obtaining its maximum utility (primal demand), or by setting a level of utility we want to achieve and minimise cost (dual demand). Other examples include profit maximization, along with various macroeconomic applications. Similarly to the previous example, the firm’s input decision has a dual nature. This is, it should find the optimal level of output given the resources available (minimising cost) or, having a budget constraint, solve the inputs allocation that results in the highest output (maximising production).

Oct 23

Lope Gallego

Normative economics

Economic science makes a distinction between normative and positive economics. Positive economics is the branch of economics that focuses in the description and explanation of economic phenomena, while normative is concerned with the application of positive economics with the purpose of giving advice on practical problems including those regarding public policy.

We can easily make the distinction between positive and normative economics by asking two very different questions: “What is?” and “What ought to be?”. As stated before, positive economics focuses on analysing economic phenomena, on answering the question “What is?”. Normative economics wants to answer the question “What ought to be?”. In other words, how can I apply something I found out (positive economics) to the real world (normative economics)? Thus, we can think of positive economics as being the purely scientific part of the economic discipline being objective and fact-based, while normative economics is more subjective to values and hence considered non-scientific.

Normative economics analyses can be found both at a microeconomic and macroeconomic level. For instance, welfare economics has a purely normative branch, which aims at finding better ways of arriving to optimum conditions and equilibriums to benefit a greater amount of people. Also, at the macro level, all related to policymaking is considered to be part of the normative economics branch.