외환론

Foreign Exchange Theory

Lecture 3

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Exchange Rate Arrangements across
Countries

• Reading
– Bekaert and Hodrick, Chapter 5
– Ilzetzki, Reinhart, and Rogoff (2019)

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What we will learn

• Exchange rate classifications

• Empirical observations
– Do the majority of countries adopt a flexible exchange rate
regime?
– Is the US dollar still a dominant currency?

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 Modern Era

• Bretton Woods system collapsed in early 1970s

• Since then free float among major currencies
• (e.g., USD, GBP, DEM/EUR, JPY, SWF)
• Smaller countries have frequently pegged to bigger
countries
• European Exchange Rate Mechanism
• Asian countries pegged to US dollar
• Currency crises have been common

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Questions

• Exchange rate arrangements

• What do countries do?
– Ilzetzki,Reinhart, and Rogoff (2019), Reinhart and Rogoff (2004)

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Exchange Rate Arrangement

• Floating currencies : determined by the market forces of

supply and demand
– i.e., U.S., Japan, Australia, and Sweden
– What can we say about European Union?
• According to IMF, it is floating, but according to Reinhart and Rogoff (2017)
it is fixed.

• Managed floating: countries whose Central Banks

intervene enough that the IMF can’t classify them as
freely floating
– i.e., Argentina, Brazil, Columbia, Indonesia, Israel, Mexico and
South Africa

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Exchange Rate Arrangement

• Crawling pegs : the exchange rate is not fixed, but rather

allowed to gradually move in one direction
• Target zone – forex rate is kept within band
• Fixed/pegged currencies – “pegging” a currency to
another or a basket of currencies
– Often implemented by currency boards
• No separate legal tender – adopt a foreign currency
– i.e., Ecuador, El Salvador and Panama have adopted the U.S.
dollar

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Central Banks

• To understand how exchange rate systems operate, you

must first understand how central banks function.
• The central bank’s balance sheet

Sum of these two is called

Influences money supply The “monetary base” or “base money”
Through open market
operations

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Central Banks

• Official Reserves
– Foreign exchange reserves (86%)
– Gold reserves (10%)
– IMF-related reserve assets (4%)
• Money creation and inflation
– Seigniorage – the value of the real resources that the central
bank obtains through the creation of base money
– Setting money supply growth has implications on GDP growth,
unemployment, etc.

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Central Banks

Foreign Exchange Interventions

• Non-sterilized
– Money supply can change
– Supply more of its currency, it will weaken the currency, and vice
versa.
• Sterilized
– Keep money supply constant
– Conducting an offsetting open market transaction.

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 Exhibit 5.7 Sterilized and Non-Sterilized Foreign Exchange
Intervention

Fed buys ForEx from Bank, which is an asset.

Sterilization part

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Central Banks

• How do Central Banks peg a currency?

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The Balance Sheet of a Currency Board

Its liabilities are fully backed by foreign assets.

Fiscal discipline: It cannot lend to the government and hence cannot monetize
fiscal deficits

Hong Kong (since 1983), Argentina (1991 to 2001), and Estonia (1992 to 2010)

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Limited-Flexibility Systems:
Target Zones and Crawling Pegs
• Target zones
– move within some ranges

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Exhibit 5.13 A Tight Target Zone
Crawling Pegs
• Mexican central bank wanted to fix the Mexican peso’s
value relative to the dollar in the past.
• What happens if Mexico experiences higher inflation
than the U.S.?
– Loses exports as the prices of Mexican goods increase relative
the prices of U.S. goods.
• Mexican central bank will start to devalue its currency.
• Ended up the currency crisis in Dec 1994.

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History of FX Regime Classification

• IMF used to classify exchange rate regimes according to

official government statements (de jure classification)
• Many supposedly fixed rates often adjusted
• Some supposedly flexible rates heavily managed.

Distinction between
• What countries declare as their official de jure regime
• Their actual de facto exchange rate practices

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History of FX Regime Classification

• De facto classifications:
– Actual practices or actions
– Reinhart and Rogoff (2004): Based on exchange rate variability
incorporating parallel FX market.
• De jure classifications
– Declared or legally mandated policies
– IMF in the past: moved to de facto classifications from 2009
• Why are there differences between the two
classifications?
– Existence of parallel markets
– Actual practices may differ from their official policies. 22
What are Parallel FX Markets?

• Unified rate system

– One official exchange rate
– No significant “black” or parallel market
• Multiple exchange rate or dual systems
– In addition to an official exchange rate
– One or more of the rates is market-determined in parallel
markets.
– Parallel markets may or may not be legal.

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Importance of Parallel FX Markets

• Half the time for official pegs, parallel rates were used as
a form of ”back door” floating.
• Parallel FX markets the norm in Europe in the 40’s and
50’s
• Parallel FX market common in less developed countries

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Importance of Parallel FX Markets

Source: Reinhart and Rogoff (2004) 25

Importance of Parallel FX Markets

• Note also that pegs accounted for over 90% of all

exchange rate regimes in the early 1970s.
• But over half of these pegs had parallel markets.

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Why do parallel markets exist?

• The private market response to the incorrectly valued

exchange rate.
– Ex. Venezuelan government devalued its currency to VEF
4.3/USD in January 2011, but in the parallel market, it was VEF
9.25/USD!

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Why do parallel markets exist?

• For instance, when monetary policy is too loose to

maintain peg,
• parallel rate (market-determined rate) will start
depreciating
• Eventually, an inevitable devaluation of an official rate
would follow.
• Parallel FX market better barometer of monetary policy

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Source: Reinhart and Rogoff (2004) 29
Preview of empirical observations and main
conclusions
• Still, regimes with limited flexibility remain in the majority.
• The U.S. dollar remains as the world’s dominant anchor
currency by a very large margin.
– The global role of the euro has stalled.
• Large accumulation of reserves since 2002.
– Exchange rate controls in an environment with reduced
exchange rate restrictions (or capital controls)

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Anchor Currency Classification

• Freely floating: No anchor

• Relatively fixed (target zones): Based on FX volatility
• Managed float:
– Calculate one-year moving average of monthly absolute change
in exchange rate with respect to all candidate anchors (USD,
EUR, JPY, GBP, AUD, CNY)

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Source: Ilzetzki, Reinhart and Rogoff (2017) 32
Source: Ilzetzki, Reinhart and Rogoff (2017)

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Evolution of Anchor Currencies

• Large shift towards USD as anchor

• Emergence of DEM/EUR as anchor
• Several waves:
– Dismantling of the GBP zone
– Breakdown of Bretton Woods leads to emergence of DEM/EUR
– Collapse of the Soviet Union

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Source: Ilzetzki, Reinhart and Rogoff (2017)
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