«Do Currency Regimes Matter in the 21st Century? An Overview Hiroshi Fujiki and Akira Otani This paper selectively reviews the recent literature on ...»
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002
Do Currency Regimes Matter
in the 21st Century?
Hiroshi Fujiki and Akira Otani
This paper selectively reviews the recent literature on currency
regimes in Europe, the Americas, and East Asia. We argue that,
given the global interdependence among today’s economies, currency
regimes should always be evaluated in relation to monetary policy,
fiscal policy, structural policies, and the working of financial markets. Thus, currency regimes do matter and are a relevant concern for policymakers.
Key words: Bipolar view; Euro; Dollarization; Regional currency area Hiroshi Fujiki: Manager and Senior Economist, Institute for Monetary and Economic
Studies, and Financial Markets Department, Bank of Japan (E-mail:
hiroshi.fujiki@ boj.or.jp) Akira Otani: Assistant Manager and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: firstname.lastname@example.org) The authors are grateful to two discussants, Stefan Gerlach and Reuven Glick, two honorary advisors, Allan H. Meltzer and Maurice Obstfeld, as well as conference participants Ismail Alowi, Jorge A. Braga de Macedo, Roger W. Ferguson, Jr., Han Ming Zhi, Malcolm D. Knight, Robert W. Rankin, Pierre van der Haegen, and Jürgen von Hagen for their helpful comments. The authors also thank Kyoji Fukao, Eiji Hirano, Kazuo Ishida, Masahiro Kawai, Makoto Saito, Akihisa Shibata, Etsuro Shioji, Masaaki Shirakawa, Miyako Suda, Kazuo Ueda, and staff at the Institute for Monetary and Economic Studies (IMES) for their useful comments on the earlier version of this paper.
The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank of Japan or IMES.
47 I. Introduction Aliber (2000) summarizes the major questions regarding world currency regimes as “to fix or not to fix” and “optimum currency areas or not.” The classical answer by modern industrial economies to both these questions since the late 19th century has been to fix currencies to gold. Keynes (1923) made the crucial distinction between “internal stability (a stable price level)” and “external stability (a stable exchange rate and equilibrium in the balance of payments).” He favored the former in the presence of nominal rigidity in domestic prices and thus argued in favor of a flexible exchange rate.1 Many economists at the time were skeptical about a free-floating exchange rate.
Most prominently, Nurkse (1944) regarded the experience of European currencies, such as that of the French franc from 1922 to 1926, as evidence that speculators are in general destabilizing under a floating exchange rate.2 At the launch of the Bretton Woods system in 1944, major economies chose an adjustable fixed exchange rate to the dollar backed by the gold reserve in the United States.
During the operation of the Bretton Woods system, two distinct views that became the foundations of the analysis of exchange rate regimes appeared. Friedman (1953) eloquently stated the possible merits of a floating exchange rate for the sake of absorbing external shocks.3 Mundell (1961) and McKinnon (1963) responded that, depending on the economic conditions, some economies would be better off if they retained a fixed exchange rate.4 Their contributions are well known as the theory of optimum currency areas.5 They also stressed that the economically desirable extent of common currency areas might not coincide with national borders.
After the collapse of the Bretton Woods system, many industrial economies chose to float, except for the notable exception of the European Monetary System (EMS).
Emerging market economies have gradually shifted from a fixed exchange rate system toward a floating exchange rate system, often after experiencing currency
1. Note that whether a country chooses a fixed or floating exchange rate, the real exchange rate has to adjust. Thus, the main choice is whether the cost of adjustment is lower if a country chooses to deflate (a choice with which Keynes disagrees) or depreciates.
2. He points out that the system of flexible exchanges in the 1930s uses gold as a vehicle for “hot money” transfer.
He concludes, “If there is anything that inter-war experience has clearly demonstrated, it is that paper currency exchanges cannot be left free to fluctuate from day to day under the influence of market supply and demand” (Nurkse [1944, p. 137]).
3. He says, “Changes in internal prices and incomes are undesirable because of rigidities in internal prices, especially wages, and the emergence of full employment—or independence of internal monetary policy—as a major goal of policy” (Friedman [1953, pp. 172–173]). He argues that the floating exchange rate would be stabilizing thanks to speculative transactions. Bordo and James (2001) point out that Gottfried Haberler made a strong intellectual case for floating exchange rates as a mechanism to insulate economies from the transmissions of booms and depressions in his book published in 1937.
4. For example, if factor mobility could be high enough to smooth out divergent shocks across regions, those regions could adjust for the relative wage discrepancies induced by adverse shocks without adjusting the nominal exchange rate. In a region whose external openness is high, the fluctuations in nominal exchange rate under a floating exchange rate arrangement would have an influence not only on the prices of tradable goods, but also on the wages and the prices of non-tradable goods. Thus, a floating exchange rate may not be helpful.
5. Recent studies such as Frankel and Rose (1998) demonstrate that optimal currency area criteria are endogenous, i.e., although these criteria may not be satisfied before the introduction of a common currency, these same criteria might be satisfied once the regions form a common currency area. The sources of endogeneity of country characteristics on its choice of currency regimes are not only economic conditions, but also cultural, historical, and political conditions. Glick (2002) also stresses that how quickly such endogenous changes in country characteristics occur is open to question.
48 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview crises. Against this background, Krugman (1979) proposes a model of a balance of payments crisis that focuses on inadequate government policy.
In the 1990s, many economies moved in the direction of free capital mobility.
Many crises in the 1990s seem to be correlated with large capital inflows and outflows, and economists have proposed new ways to analyze these new experiences. Motivated by the EMS crisis in 1992, Obstfeld (1994) conjectured that the costs incurred by the authorities in maintaining the pegged exchange rate regime depended on public expectations. In other words, the cost of resisting a currency attack depends on endogenous variables. If governments determine the extent of their resistance through a cost-benefit analysis, however, self-fulfilling crises become likely in situations where economic distress already places the government under pressure. If some exogenous events change the public’s expectation regarding the future exchange rate regime, it might lead to self-fulfilling crises among possible multiple equilibria. This could happen even if the authorities have committed themselves to maintaining a fixed exchange rate regime, thus the authorities’ commitment is not time-consistent. Morris and Shin (1998) proposed a way to pin down a unique equilibrium by adding a small amount of noise in speculators’ signals regarding the fundamentals.
Observing currency crises in the emerging market economies, such as Mexico in 1994, East Asia in 1997, Russia in 1998, and Brazil in 1999, Summers (2000) states that the sources of those currency crises are serious banking and financial-sector weakness, and short-term capital flows.6 Those episodes remind us of the argument of the impossible trinity: economies cannot have capital mobility, an independent monetary policy, and a fixed exchange rate simultaneously, which leads to the “bipolar view.” This view suggests that hard pegs and floating exchange rates are good candidates for currency regimes for emerging market economies under conditions of free capital mobility.7 This paper has two objectives. It first reviews some debates on the choice of exchange rate regime with special attention to examples of hard pegs, the EMS, the euro, and currency boards, to evaluate to what extent the bipolar view is useful.
Second, it explores the possibility of future regional currencies in Europe, the Americas, and East Asia. The rest of this paper is organized as follows.
Section II reviews the definition of and trends in exchange rate regimes, and introduces the bipolar view.8 Section III examines the experience of European economies. It discusses lessons from the EMS crisis, issues for monetary policy after the launch of the euro, and the possibility of expansion of the euro area. Section IV
6. This paper focuses on the theoretical literature. Thus, we do not discuss studies on contagion motivated by the episodes of the Tequila crisis, the Asian flu, or the Russian virus. Recent examples include Kaminsky and Reinhart (2000, 2001).
7. Even under the surge of global capital flows during the 1990s, the “original sin hypothesis” (Eichengreen and Hausmann ) forces most emerging market economies to rely on short-term bank lending denominated in dollars, rather than their own national currency. Other economists wonder if capital account liberalization during the 1990s was helpful or not (see Rodrik ). Thus, the term “free capital mobility” here is used for the sake of a conceptual framework. Indeed, capital account liberalization remains one of the most controversial policy issues (see Eichengreen  for a recent review).
8. One may argue that the choice of exchange rate regime per se does not provide any useful lesson, because “no single currency regime is right for all countries or at all times” (Frankel ). A lesson from his point of view is that the issue of an exchange rate regime cannot be settled definitively, but must be continually kept in mind.
49 first reviews the debate over unilateral dollarization in Latin America as a notable example of a hard peg, then turns to the possibility of a common currency area in the Americas. Section V reviews the twin-crisis models motivated by the East Asian crisis, then discusses the possibility of an Asian common currency. Section VI summarizes the observations made in this paper and topics for future study.
Note that illustrations for recent theoretical contributions in this paper show that the traditional Mundell-Fleming model may not be the sole theoretical reference point for policymaking. However, space limitations did not allow us to discuss any alternative theoretical building block in the main text. The appendix reviews promising theoretical alternative literature following a consideration of the international transmission of monetary policy and exchange rate regimes under conditions of uncertainty. An important policy implication obtained from those literatures is that market structure and the parameters of the production function can affect the transmission process of monetary policy.9 Consistent with this view, recent empirical studies point out the interaction between real factors and monetary regime. For example, Rose (2000) uses five-year bilateral trade data from 1970 to 1995 for 186 countries. He regresses these data on real GDP, distance, dummy variables for a common language, a common border, a common trade agreement, whether the country is a colony or not, as well as the volatility of nominal exchange rates and the dummy variables for using the same currency. His results show that the effects of currency union on bilateral trade are positive and statistically significant. Two economies that share the same currency trade three times as much as they would with different currencies. Glick and Rose (2001) estimate the same equation as Rose (2000) using panel data methods, and find that two countries which share the same currency trade twice as much as they would with different currencies. Rose and van Wincoop (2001) find modest but still significant effects of a currency union on the increase in the bilateral trade compared with the evidence reported by Rose (2000). However, the inherent endogeneity problem in the choice of currency regimes and economic performance still poses a difficult empirical problem in these up-to-date studies.
In this paper, the terms “exchange rate regime” and “currency regime” are sometimes used interchangeably; however, currency regimes could refer to broader issues that improve the working of exchange rate regimes. For example, the gold standard is a currency regime that consists of a fixed exchange rate regime and a fiscal policy that consists of a balanced-budget discipline. Similarly, a floating exchange rate per se does not imply particular monetary rules, such as inflation targeting or monetary targeting.
9. Cooper (1999) states that traditional analysis of exchange rate regime is not adequate due to the division of the real factor and the monetary factor, and that the new approach summarized in the appendix breaks with part of its tradition.
II. Exchange Rate Regimes: Definitions and Current Trends Regarding the definition of exchange rate regimes, the International Monetary Fund (IMF) reports the exchange rate classification system among its members either in its Exchange Rate Arrangements and Exchange Restrictions or in its International Financial Statistics based on the member economies’ own assessments. The classifications of exchange rate arrangements reported in those publications are summarized in Table 1.
There are eight categories: (1) exchange arrangements with no separate legal tender, (2) currency board arrangements, (3) other conventional fixed-peg arrangements, (4) pegged exchange rates within horizontal bands, (5) crawling pegs, (6) exchange rates within crawling bands, (7) managed floating with no preannounced path for the exchange rate, and (8) independent floating.