This Learning Path is a bit more of a mixed bag than the previous one, finishing off our consumer choice problem, looking at the some useful implications of this in demand theory before moving on to other types of demand theories.
We first pick up where we left off in our previous LP and turn the tables on our consumer choice problem in:
Consumption duality II:
Cost minimisation, the mirror image of utility maximisation,
Consumption duality, looking at both problems together before going on to…
In this Learning Path, the first one about microeconomics, we will look at consumer behaviour from a theoretical perspective, trying to solve the basic problem we all face every day: how to get as much of what we want or need without blowing our budget.
Since the main tools needed in order to understand consumer theory are quite a few, we present them in two LPs. The contents of this first half are:
The basics:
Preferences, which govern what we choose, and then move onto
Goods, which we blow our budget on, before putting it all together in
Utility and budget:
Utility functions, which show how much satisfaction we derive from what we consume.
Then, the relationship between the utility different goods provide us through the marginal rate of substitution, before moving on to
Indifference curves, the graphical representation of the utility we assign to the different goods.
We must also introduce the second side of our problem: our budget constraint.
Consumption duality I:
Finally, we’ll put it all together and look for a solution to our utility maximisation problem.
Exchange rates can be understood as the price of one currency in terms of another currency. However, just like for goods and services, we must take into account what determines that price, since governments can influence it, and even fix it. Exchange rate regimes (or systems) are the frame under which that price is determined. From a purely floating exchange rate, to a central bank determined fixed exchange rate, this Learning Path explains the basics of each of these regimes.
We’ll start by learning about the concept itself, and will continue with each regime type, starting with the ones with highest monetary policy independence, and moving to less independent regimes.
Definition:
Exchange rate regimes, a simple definition and a list of types.
High independence:
Flexible exchange rate, with two different subtypes:
Free (clean) float, where market forces determine the price;
Managed (dirty) float, when some governmental intervention happens.
Decreasing independence:
From higher to lower monetary policy independence, we have:
Crawling peg, Target zone arrangement, Fixed exchange rate, and Currency board.
Low independence:
No separate legal tender, such as dollarization.
Monetary union, such as the Euro zone.
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:
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.
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:
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.
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:
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.
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:
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:
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.
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:
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.
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:
