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The Mechanics of a Successful Exchange Rate

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The Mechanics of a Successful Exchange Rate FEDERAL RESERVE BANK OF ST.LOUIS that would have hinted at problems for Thailand The Mechanics of a prior to July 1997. The next section discusses alternative exchange Successful Exchange rate regimes to put the unilateral peg in context. The third section presents an empirical model of mone- Rate Peg: Lessons for tary policy to describe the mechanics with which Austria pegged its exchange rate. The fourth section Emerging Markets applies the same model to describe Thailand’s monetary policy and the contrast with Austria. Michael J. Dueker and Andreas M. Fischer ALTERNATIVE EXCHANGE RATE xchange rate pegs collapsed in many coun- REGIMES tries in the 1990s, leading to dreary assess- As a prelude to an analysis of the mechanics Ements of the merits of pegged exchange rate of a unilateral exchange rate peg, it is useful to regimes. Whether one points to the failure of describe the spectrum of alternative exchange rate Mexico’s peg in December 1994 or to the sharp regimes. In addition to unilateral exchange rate devaluations in East Asia in 1997-98, in Russia in pegs, there are five other exchange rate regimes: a August 1998, and in Brazil in January 1999, the floating rate (including managed floats), multilateral collapse of unilateral exchange rate pegs often exchange rate pegs, currency boards, dollarization, preceded acute financial and macroeconomic and currency union. We describe here where the crises. Despite recent failures, however, exchange unilateral peg lies along the spectrum. Since the rate pegs remain a prevalent policy choice. Calvo end of the Bretton Woods system of fixed exchange and Reinhart (2000) argue that the exchange rate rates in 1973, floating exchange rates have displayed volatility that accompanies a floating exchange rate a very high degree of variability without a corre- regime is particularly onerous to emerging markets, sponding increase in the variability of exchange rate and thus can be a worse policy choice than a peg fundamentals (Flood and Rose, 1999). Moreover, that reduces the variability of the exchange rate, Hausmann, Panniza, and Stein (1999) have shown even if it does not attain the complete confidence that emerging markets in Latin America that have of investors. Given the continued prevalence of attempted to allow their exchange rates to float have pegs, it is worth seeking additional understanding experienced greater interest rate volatility than of what makes a peg successful or not. fixed-rate regimes. For this reason, Calvo and For this reason, we find it useful to study what Reinhart (2000) argue that floating exchange rates was arguably the most successful unilateral can have destabilizing effects on emerging markets. exchange rate peg: Austria’s peg to the Deutsche For the next four regimes—all variants of fixed mark prior to Austria’s entry into the European exchange rates—we start with the type of fixed rate Monetary System in 1995. An estimated model of that is closest to a float and move along the spec- Austrian monetary policy mechanics helps identify trum from there. In the first three regimes, a home salient features that made the Austrian peg credible country unilaterally fixes its currency to an “anchor” to the public. We then apply the same model to currency. The unilateral nature of the regime implies monetary policy in Thailand: among the East Asian that the anchor country is not obligated to assist countries that eventually devalued, Thailand had the home country if its currency comes under maintained the tightest peg to the U.S. dollar prior speculative attack. In a pegged regime, it is incum- to July 1997. The conventional wisdom is that the bent on the pegging country to set a monetary currency crisis in Thailand came without warning policy that always appears to currency traders to and caught financial markets by surprise (Corsetti, be consistent with the preannounced conversion Pesenti, and Roubini, 1999, and Halcomb and rate. The best way to uphold this commitment is to Marshall, 2000). We investigate whether there were run a monetary policy that is similar to that in the any contrasts between the Austrian and Thai pegs anchor country in terms of inflation rates and credit expansion. A pegging regime is more resistant to Michael J. Dueker is a research officer at the Federal Reserve Bank of speculative attack if banks and other institutions St. Louis. Andreas M. Fischer is an economic adviser at the Swiss National Bank, Zurich, Switzerland. Mrinalini Lhila provided hold an amount of foreign-exchange reserves that research assistance. is at least as great as the quantity of short-term debt © 2001, THE FEDERAL RESERVE BANK OF ST.LOUIS SEPTEMBER/OCTOBER 2001 47 R EVIEW that is denominated in foreign currencies. Taiwan, A MODEL OF MONETARY POLICY for example, was largely immune to the Asian crisis MECHANICS FOR A UNILATERAL PEG of 1997-98 due to its large holdings of foreign exchange reserves. Many other emerging markets, In practice, nearly all central banks implement however, intend to be net borrowers in foreign cur- monetary policy by setting a short-term interest rencies, and they attract foreign lending by estab- rate as a policy instrument. A central bank trying lishing a peg and promising a stable exchange rate. to maintain an exchange rate peg will focus on the The best way to keep this promise is to run a mon- interest rate differential between the short-term etary policy that closely mimics that of the anchor rate in its domestic currency and the prevailing country. short-term rate in the anchor currency. If the home A currency board differs from a unilateral peg currency comes under selling pressure, an increase in that the home country no longer sets its own in the interest rate differential can attract buyers monetary policy. Instead, the size of the monetary by convincing them that higher domestic interest base is determined by monetary policy in the anchor rates will keep domestic inflation in check, prevent country and capital flows. The currency board a devaluation, and result in excess returns to the arrangement leaves no room for policies that are domestic currency relative to the anchor currency. inconsistent with the fixed exchange rate because In the long run, the pegging central bank must the only policy is a commitment to adjust the mone- keep domestic inflation rates close to inflation in tary base in tandem with flows of foreign exchange the anchor currency. By harmonizing the inflation reserves in and out of the central bank. As a conse- rates, the central bank prevents the real exchange quence, the home country’s central bank can no rate from appreciating to unsustainable levels at longer act as a lender of last resort to the domestic the pegged nominal exchange rate. Speculators often banking sector; thus, speculative attacks can take bet that central banks that have allowed substantial place against banks instead of the currency. appreciation of the real exchange rate through rel- Dollarization represents the unilateral decision atively high domestic inflation will choose to break to enact two formal changes.1 The first change is the peg and devalue, rather than let the domestic that all local currency in circulation plus vault cash economy stagnate for a prolonged period with a in banks is redeemed for U.S. dollars at some high, uncompetitive real exchange rate. announced conversion rate and is then destroyed. We preface our presentation of a model of The second change involves transforming all con- monetary policy mechanics by noting that monetary tracts denominated in local currency into contracts policy decisions do not strictly obey a particular in U.S. dollars at the conversion rate. Dollarization, formula or equation. Nevertheless, central banks do which has recently taken place in Ecuador, has not have to implement in a literal fashion a model received increasing attention in academic and policy of monetary policy for the model to be useful. In circles. fact, central banks often monitor such models them- Exchange rates can also be fixed through multi- selves because these models provide useful informa- lateral arrangements, although these require more tion about the rate of inflation that is likely to result coordination and negotiation than unilateral pegs. from recent policy decisions. Two multilateral systems are multilateral pegs and In our empirical model of monetary policy currency unions. In a multilateral peg, the distinc- mechanics, we assume that a pegging central bank tion between the anchor currency and the pegging adjusts the policy instrument, i (the interest rate currency becomes blurred because the participating differential), according to a forecast of the relation- countries are obligated to take monetary policy ship between the policy instrument and domestic π measures to defend the exchange rate peg. The price inflation, : prime example of a multilateral peg is the European (1) ∆Εii=+[] ∆ππ− , Monetary System prior to the adoption of a single t tt−1 tt0 t currency in January 1999. A currency union, in π where 0t is the desired inflation rate, which is pre- contrast, consists of an agreement to merge several sumably close to the rate of inflation expected in currencies to fix the exchange rates and unify their the anchor currency. Note that this use of a forecast monetary policymaking permanently. The European Monetary Union, undertaken in 1999, is the most 1 The term dollarization pertains to adopting the U.S. dollar; however, prominent currency union. another major currency could be adopted as well. 48 SEPTEMBER/OCTOBER 2001 FEDERAL RESERVE BANK OF ST.LOUIS to choose the policy instrument setting is analogous (4)ee=+−δδ−−()1 e . to setting a money-supply instrument, m in logs, ˜˜tt11 t according to a velocity forecast: Gradual rebasing of the target occurs for values of δ less than one.
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