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Managed Floating: Understanding the New International Monetary Order A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Bofinger, Peter; Wollmershäuser, Timo Working Paper Managed floating: Understanding the new international monetary order W.E.P. - Würzburg Economic Papers, No. 30 Provided in Cooperation with: University of Würzburg, Chair for Monetary Policy and International Economics Suggested Citation: Bofinger, Peter; Wollmershäuser, Timo (2001) : Managed floating: Understanding the new international monetary order, W.E.P. - Würzburg Economic Papers, No. 30, University of Würzburg, Department of Economics, Würzburg This Version is available at: http://hdl.handle.net/10419/48479 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. 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Würzburg Economic Papers No. 30 Managed floating: Understanding the new international monetary order Peter Bofinger and Timo Wollmershäuser September 2001 (revised) Universität Würzburg Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen Sanderring 2, D-97070 Würzburg [email protected] [email protected] Tel.: +49/931/31-2945 ii Managed floating: Understanding the new international monetary order Peter Bofinger and Timo Wollmershäuser September 2001 Abstract Although there seems to be a broad consensus among economists that purely floating or completely fixed exchange rates (the so-called corner solutions) are the only viable alternatives of exchange rate management, many countries do not behave according to this paradigm and adopt a strategy within the broad spectrum of exchange rate regimes that is limited by the two corner solutions. These intermediate regimes are characterized by significant foreign exchange market interventions of central banks and a certain degree of exchange rate flexibility. We develop a new empirical methodology that identifies three different forms of floating on the basis of a central bank's intervention activity: pure floating (no interventions), independent floating (exchange rate smoothing), and managed floating (exchange rate targeting). Our cross- country study shows that exchange rate targeting is at least as important as exchange rate smoothing. Subsequently we present a monetary policy framework in which central banks use the exchange rate as an operating target of monetary policy. We explain the mechanics of interventions and sterilization and we explain why a central bank has an interest of controlling simultaneously the exchange rate and the short-term interest rate. We derive the monetary policy rules for our two operating targets from a simple open economy macro model in which the uncovered interest parity condition and the Monetary Conditions Index play a central role. JEL classification: E 52, F 31, F 33, F 41 Keywords: exchange rate regime, monetary policy, interventions, sterilization, floating, Monetary Conditions Index iii Contents 1 Introduction ...........................................................................................................................1 2 Defining and identifying three forms of floating ................................................................3 2.1 “Floating”: the predominant exchange rate regime in the New Millennium .................3 2.2 Three forms of floating.......................................................................................................4 2.3 Governments do not always tell the truth ..........................................................................6 2.4 A different approach for identifying three variants of floating........................................7 2.4.1 A new method for measuring different forms of floating..................................................... 7 2.4.2 Data description and proceeding......................................................................................... 10 2.4.3 Main results.......................................................................................................................... 12 3 What can we learn from the literature? ............................................................................14 3.1 The Mundell-Fleming legacy...........................................................................................15 3.2 Open economy inflation targeting ...................................................................................16 3.3 John Williamson’s proposals ...........................................................................................18 4 A theoretical framework for managed floating ................................................................18 4.1 The exchange rate as an operating target of monetary policy........................................19 4.1.1 The flow channel of interventions matters.......................................................................... 19 4.1.2 Sterilized interventions can be effective .............................................................................. 22 1.1.3 How can the costs of sterilization be avoided...................................................................... 27 1.1.4 Scope and limits of exchange rate targeting ....................................................................... 28 1.2 Internal and external equilibrium under exchange rate targeting.................................29 1.2.1 Internal equilibrium............................................................................................................. 29 1.2.1.1 Measuring the actual monetary policy stance: the concept of the actual MCI (MCIt)....................32 opt 1.2.1.2 Deriving the optimal monetary policy stance: the concept of the optimal MCI (MCIt ) ..............34 1.2.1.3 The internal equilibrium rule ..........................................................................................................35 1.2.2 External equilibrium............................................................................................................ 36 1.2.2.1 The private investor’s external equilibrium ....................................................................................37 1.2.2.2 The central bank’s external equilibrium .........................................................................................37 1.2.2.3 The overall external equilibrium and the central bank’s intervention response function................38 1.3 A monetary policy framework for small open economies ...............................................40 1.4 The advantages of managed floating in comparison with traditional exchange rate strategies....................................................................................................................................45 1.4.1 Absolutely fixed exchange rates .......................................................................................... 46 1.4.2 Crawling pegs....................................................................................................................... 48 iv 1.4.3 Purely floating exchange rates............................................................................................ 49 1.5 Overcoming the inconsistency triangle through managed floating ...............................51 1.6 Unresolved issues of managed floating ...........................................................................52 1.6.1 In search of a new anchor for private sector expectations................................................. 53 1.6.2 The control over the exchange rate is asymmetric ............................................................. 54 1.6.3 Managed floating and beggar-my-neighbor policies.......................................................... 55 2 Selected case studies ............................................................................................................56 2.1 Slovenia.............................................................................................................................56 2.2 Peru ...................................................................................................................................57 2.3 Poland ...............................................................................................................................58 2.4 Japan.................................................................................................................................60 3 Conclusion............................................................................................................................60
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