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«Do Currency Regimes Matter in the 21st Century? An Overview Hiroshi Fujiki and Akira Otani This paper selectively reviews the recent literature on ...»

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presumably are given exogenously, the way in which firms set prices is likely to depend on economic factors. As the authors emphasize, this feature of the economy is therefore likely to be endogenous. In turn, this suggests that any conclusions that hinge strongly on the nature of the price-setting process should be taken with a grain of salt.

Turning to the question of what main conclusion we can draw from this literature for the choice of the exchange rate regime, the authors emphasize that a positive, but finite, degree of exchange rate flexibility is often preferable to perfect exchange rate flexibility or fixity. Thus, central banks should avoid corner solutions and instead go for the middle ground. “Float, but pay attention to the exchange rate” is the message.

From this perspective it is a striking fact that many economies, particularly in Asia, have expressed a clear preference for fixing the nominal exchange rate.

Moreover, it is noteworthy that the literature on the economic effects of currency unions, the ultimate fixed exchange rate regime, suggests that irrevocably fixing the exchange rate is associated with greater trade and increased economic growth.58 There thus seems to be a tension between what theory suggests is a desirable policy framework and what regime countries choose in practice. This naturally leads to the question why this is so.

At a fundamental level, there are two main sets of explanations. The first is that policymakers may for some reason have adopted the “wrong” policy framework.

The second is that the current state of theory disregards some aspect(s) of the economy that policymakers attach great weight to in selecting an appropriate exchange rate system. While doubtless there are cases of policymakers selecting an incorrect exchange rate regime, to my mind it seems more plausible that the literature on the new open-economy macroeconomics, which is developing rapidly, has still not captured all the mechanisms that may make economies prefer fixed exchange rate regimes. This is the view the authors take, and they point to imperfections in capital markets and to the absence of physical capital as potential missing factors. I find their arguments persuasive. My own view is that capital market imperfections are likely to be the more important explanation.

In particular, most economists think that floating exchange rates tend to be excessively volatile, and that the market itself generates this volatility. As argued by Jeanne and Rose (2002), the impact of such “noise traders” on the economy can be removed by fixing the exchange rate. It is easy to see that endogenous exchange rate volatility may be a particular concern for policymakers in economies in which the foreign exchange market is thin and where small economic disturbances can lead to large exchange rate movements and associated economic dislocation.

It is also worthwhile noting that a fixed exchange rate regime may be particularly attractive to policymakers in economies with limited capital markets, since it is difficult for firms in these countries to borrow in domestic currency. If the borrowing is in foreign currency, exchange rate movements can have a large impact on firms’ net worth and therefore, through the familiar credit channel, on the level of economic activity. In this case, a fixed exchange rate may reduce economic fluctuations. However,

58. See Rose (2000) or Frankel and Rose (2002).

81 it should be remembered that such regimes entail a fixed exchange rate typically only for a limited period of time, as speculative forces all too frequently overwhelm soft pegs if capital mobility is high. Since the combination of depreciation and large foreign currency-denominated borrowing can have an extraordinarily negative effect on economic activity, it is important that a fixed exchange rate in this case be very hard indeed.

In sum, I share the authors’ view that the new open-economy macroeconomics constitutes a very fruitful area for research. Moreover, future extensions of the theory will ultimately conclude that fixing the exchange rate may be a good option if there is endogenous exchange rate volatility, which is particularly likely if foreign exchange markets are thin and if incomplete capital markets cause firms to borrow in foreign currency. Finally, as is suggested by recent theoretical research, a fixed exchange rate is a desirable exchange rate arrangement in economies that are so open that exchange rate changes have little impact on relative prices.


Frankel, Jeffrey, and Andrew K. Rose, “An Estimate of the Effect of Common Currencies on Trade and Income,” Quarterly Journal of Economics, 117, 2002, pp. 437–466.

Jeanne, Olivier, and Andrew K. Rose, “Noise Trading and Exchange Rate Regimes,” Quarterly Journal of Economics, 117, 2002, pp. 537–569.

Lane, Philip, “The New Open Economy Macroeconomics: A Survey,” Journal of International Economics, 54 (2), 2001, pp. 235–266.

Obstfeld, Maurice, and Kenneth Rogoff, “Exchange Rate Dynamics Redux,” Journal of Political Economy, 103, 1995, pp. 624–660.

Rose, Andrew K., “One Money, One Market: Estimating the Effect of Common Currencies on Trade,” Economic Policy, 30, 2000, pp. 7–45.



Federal Reserve Bank of San Francisco The goal of a conference overview paper is to highlight the major issues and summarize the relevant literature. The paper by Hiroshi Fujiki and Akira Otani achieves this goal very well, with a wide-ranging and well-balanced coverage of the issues on future currency arrangements.

I will focus my comments on the paper in three areas. First, I will provide a brief overview of the authors’ overview. Second, I will offer some specific comments on the bipolar debate, where I think the authors could have gone into more depth. Lastly, since the authors by and large avoided taking strong positions on any of the issues, I will give my views on prospects for regional currency arrangements, particularly in Asia. Before proceeding, let me inoculate myself by saying that I will be expressing my personal views, not those of the Federal Reserve Bank of San Francisco or of the Federal Reserve System.

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I. Overview The paper begins with a review of facts underlying the “bipolar view” of currency arrangements, also known as the “hollowing out” or “corner solutions” hypothesis.

It makes three empirical observations based on Fischer (2001): first, the frequency of regimes at the poles—hard pegs and floating exchange rate regimes—has risen over time, at the expense of soft pegs and other intermediate regimes in the middle. Second, a lot of countries still maintain intermediate regimes—30 to 40 percent, depending on how such regimes are classified. Third, the distribution of regimes at the poles is not symmetric: more countries have moved toward greater exchange rate flexibility than toward hard pegs, the adoption of the euro in Europe notwithstanding. The authors then ask why there are relatively few hard peggers, and in the bulk of the paper they discuss the pros and cons for the emergence of more hard peggers in Europe, the Americas, and Asia. Specifically, will peripheral and transition countries in Europe adopt the euro? Will more Latin American countries dollarize? Will countries in East Asia adopt some common exchange rate arrangement that ends with a form of currency union?

II. Questions in the Bipolar Debate Let me turn now to some questions related to the bipolar debate that the authors did not fully address, but warrant further discussion. First, how viable is the middle ground of intermediate currency regimes? Second, if intermediate regimes are becoming increasingly unviable, how wide are the poles? Third, what kinds of criteria should be considered in determining regime choice?

How viable is the middle? It is well understood that intermediate regimes are potentially more viable for countries that do not have to worry much about large, sudden shifts in private capital flows. It is worth emphasizing the obvious point that one way to preserve the viability of an intermediate regime is to maintain balance of payments (BOP) controls, which a great many countries still do.

Figure 1 illustrates this point nicely. It updates Glick (2001) using International Monetary Fund (IMF) regime classifications to year-end 2001 (and reclassifies Argentina and Uruguay as managed floaters), disaggregates the floating regime category into managed floats and independent floats, and also disaggregates the intermediate regime category into single currency pegs, basket pegs, and bands and crawling pegs. Hard pegs consist of both currency boards and dollarized regimes.

The figure shows the percentage of countries in each regime category that employ significant BOP controls, where I use as the measure of controls surrender requirements for export proceeds at the end of 2000. (In the case of countries with pegged regimes, they are classified according to whether surrender requirements apply to trade with the anchor currency country.) As is well known, measuring the breadth and intensity of controls is problematic. Export proceed surrender requirements are narrow enough in their focus to overcome some of these limitations by providing a minimum condition for the existence of widespread controls on external transactions: countries

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80 67 60 60 44 36 40 28 20 13

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that employ surrender requirements are likely to impose controls on capital flows as well. Of course, this measure does not catch countries without surrender requirements that still limit capital movements.

Observe that for countries with intermediate regimes the percentage with controls is relatively high: 67 percent of countries with single currency pegs and 60 percent with basket pegs employ controls. (With a more comprehensive measure of controls, the figures would likely be even higher.) In contrast, for countries at the extreme poles, the percentage with controls is much lower: only 13 percent of countries with hard pegs and 28 percent of countries labeled as independent floaters imposed controls. For countries with band/crawls and managed floats, somewhat more impose controls—36 percent for the former and 44 percent for the latter—but not as much as in the case of those with single and basket pegs. (Excluding industrial countries, the percentage with controls is 17 percent for hard peggers, 38 percent for band/crawl regimes, and 37 percent for independent floaters; the figures for countries with single peg, basket peg, and managed float regimes are unaffected, as they do not include any industrial countries.) This picture is consistent with the view that countries with intermediate regimes generally must resort to capital controls. Without controls, the logic of the bipolar view implies they will be forced eventually to move to one pole or the other. I think it is pretty clear that intermediate regimes in countries with open capital markets generally fail, sooner or later. Mexico, Thailand, Indonesia, Korea, Russia, Brazil, and Turkey all followed some form of intermediate regime, at least de facto, before crashing. In other cases where countries operated crawling band arrangements, like Chile, Colombia, and most recently Uruguay, the intervention bands were successively widened before being abandoned altogether. So the message is that countries with intermediate regimes that loosen or remove their controls need to have an exit strategy.

84 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Comment How wide are the poles? Recent experience suggests that the hard peg pole is narrow, while the flexible rate pole is relatively wide. Specifically, the experience of Argentina demonstrated that hard pegs in the form of currency boards may not always survive. This suggests that the hard peg pole is narrower than we thought, i.e., the range of viable hard pegs is limited. In contrast, the number of countries with flexible-style arrangements, but that still intervene in some manner because of “fear of floating” concerns, demonstrates that the flexible rate pole may be relatively wide;

i.e., the viable range of flexible rate arrangements is broad and can include both so-called managed and independent floaters. In other words, the nature of a viable flexible regime is “flexible.” What makes a flexible regime more viable than traditional intermediate regimes is that policymakers do not make explicit or implicit commitments to keep the exchange rate within some target range for an extended period of time. As long as policymakers are not perceived as trying to defend a particular rate, the exchange rate avoids becoming a lightning rod for speculators, and the regime is less susceptible to the one-way bets that have often characterized the demise of soft peg or soft band regimes once the rate nears the edge of the band. As a result, policymakers in a more flexible regime, even those that intervene sometimes, have more room than in an intermediate regime to deal with large and sudden shifts in capital flows.

A basket band crawling (BBC) regime is more adjustable than an adjustable peg, but it is still not generally flexible enough to handle large and abrupt shifts in private capital flows.

Of course, the absence of an exchange rate target requires an alternative nominal anchor, such as an inflation target, in its place. Inflation targeting is still compatible with some concern for behavior of the exchange rate.

What criteria are relevant for determining which currency regime works best for a particular country? One obvious place to start is how the currency regime affects economic performance, specifically inflation and economic growth. Here is an area in which the scope of the paper could be expanded. Though it does discuss how the currency regime matters for the conduct of monetary policy and for vulnerability to crises, the paper does not say much about how the currency regime matters for economic performance. Indeed, there is a substantial empirical literature that attempts to assess the implications of the currency regime for inflation and economic growth, though the results tend to be ambiguous.

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