Deck 19: Fixed Exchange Rates and Currency Unions

Question 1

What is a currency board system? What are the strengths and weaknesses of such a system?

Answer 1

A currency board system is an exchange-rate system where the value of the currency is irrevocably fixed to the value of another currency. In this sense, it is similar to the exchange control system. However there is a major difference. In this system, the central bank holds no domestic currency, only foreign currency. Before a country adopts a currency board system, it is prudent to examine the strengths and limitations of such a system. Essentially, a currency board helps to stabilize the exchange rate by ensuring that the money supply is fully backed by foreign exchange reserves. Like any exchange rate peg, a currency board makes a commitment to fix the value of the domestic currency relative to a foreign currency. With full backing, the currency board is able to make this commitment believable because it is able to redeem domestic currency for foreign currency at a fixed rate. However, the resulting stability carries a price. Most important is the fact that a country loses independent control of its monetary policy. In this case, the country is tying its economic fate to that of the foreign currency to which it is pegged. Without independence, the monetary authority also loses its ability to serve as a lender of last resort during a liquidity crisis. All monetary authorities seek credibility, whether through reputation, explicit inflation targets, or exchange rate pegs. Currency boards help to establish credibility by ensuring full currency backing. Another characteristic of a currency board is that it is prohibited from buying or holding domestic treasury or commercial securities. Since a currency board is constrained to issue currency only in exchange for the reserve currency, it is powerless to create domestic money by extending credit as conventional central banks can do. Strict limits on a currency board's power to issue money constrain its operations in two important respects: the board cannot finance (i.e., monetize) the government's budgetary deficits and it cannot regulate the nation's money supply by engaging in open market operations. It is these two constraints that attract the most determined opposition to the currency board idea and at the same time inspires its greatest admiration. Currency boards are one particular monetary arrangement among many for establishing and maintaining confidence in a national currency, but they may not be the best choice in all situations.

Question 2

List and explain the difficulties associated with exchange controls.

Answer 2

If one does not fully examine the implications of exchange controls, it initially seems to be a plausible method of fixing a country's exchange rate. However, as a practical matter, exchange controls tend to cause a number of economic difficulties. First, there is the simple annoyance of dealing with a government bureaucracy. The government must sell or buy all foreign exchange earned and requested by residents and firms within the country. As the government is the sole source of foreign exchange, this type of bureaucracy is unlikely to provide the same quality service as a free market. A more serious difficulty arises with respect to the difference between the nominal exchange rate and the real exchange rate. When a country fixes an exchange rate, the exchange rate is expressed in nominal terms. So long as the nominal exchange rate is close to its purchasing power parity value, then a nominal peg may be sustainable over time. If the real exchange rate depreciates while the nominal exchange rate is held constant, then the nominal exchange rate becomes overvalued and a shortage of foreign exchange will result. To balance the demand and supply of foreign exchange, the government can use one of three options. First, the government could allow the currency to depreciate. Second, the government could implement restrictive macroeconomic policies (contractionary fiscal and/or monetary policy) that would reduce the demand for foreign exchange. The third and most common option available to the government is to ration the available supply of foreign exchange. Since the quantity demanded is greater than the quantity supplied, the government must decide who will get foreign exchange and who will not.

Question 3

Explain how it is possible for the nominal exchange rate to remain fixed and the real exchange rate to depreciate in a country with exchange controls and a nontrivial amount of inflation.

Answer 3

When a country fixes an exchange rate, the exchange rate is expressed in nominal terms. So long as the nominal exchange rate is close to its purchasing power parity value, then a nominal peg may be sustainable over time. However, the real exchange rate may change even if the nominal exchange rate does not. A common problem in this regard is that a country's domestic inflation may not be equal to the foreign rate of inflation. Controlling the money supply in developing countries is difficult due to the lack of open market operations and changes in the government budget deficit can easily translate into large changes in the monetary base and the money supply. This may lead to an increase in the domestic price level relative to the foreign price level. In such a case, the country's real exchange rate is appreciating and the nominal exchange rate is becoming overvalued.

Question 4

Show how a central bank fixes the exchange rate in the face of a rising domestic interest rate.

Question 5

If aggregate demand is increasing rapidly, then the central bank may need to sell foreign exchange. Show why this statement is true.

Question 6

Show how intervention can automatically correct a balance of payments deficit with no further actions by the central bank.

Question 7

Suppose that a country has problems with inflation and a current account deficit. Describe why the policies needed to deal with internal and external balance are consistent or not.

Question 8

Explain why letting the exchange rate float is a convenient way for a country to deal with the potential problems of maintaining internal and external balance.

Question 9

Show the effect of an expansionary fiscal policy on the economy when exchange rates are fixed.

Question 10

Suppose that the U.S. and Canada were considering forming a currency union. Discuss the potential monetary efficiency gains and the economic stability losses for both countries.