POLI 445 Reading Notes Weeks 7-9
Larrain, velasco: Exchange rate policies in
emerging market economies
Drastic shift from predominance of pegged Ers to floating, in mid 1970s
about 70% of trade in developing countries conducted with fixed, by
1996 about 70% floating. Many forced to flaot in response to crisis,
Asian crisis 1990s, others looking for greater flexibility. How to float?
Four questions arise: can float and low inflation? Can be done, CBs
seem an important part, does floating provide as much insulation from
external shocks a thought? Some who floated in Asian crisis were more
greatly affected. Are ER stability and stability of financial system re-
lated? Sudden changes in ER can be nasty, floating may help avoid mis-
alignment. How should monetary policy be conducted under a float?
How often should intervention take place?
• Hard pegs:
◦ Credibility: gained by pegging to another hard currency, Ar-
gentina pegging to USD, contract style commitments with
limited escape clauses may be more credible but there may
be issues of credibility in developing countries, skeptical
publics may choose to be skeptical of gov manipulating con-
ditions to justify abandonment of peg. If devaluation seems
possible or likely because gov is allowed to devalue if things
get too nasty private sector may take pre-emptive measures
by demanding high wages and IR, causing high real costs
which may force gov into devaluation or be faced with costly
new equilibrium. Pegs are never irreversible, private sector
will always demand some premium for risk.
1
, ◦ Discipline: pegs will induce fiscal discipline because lax fis-
cal policies will deplete resources end the peg. Punishment
for poor unsustainable policy will deter politicians from do-
ing such and thus will keep the disciplined, bad policy today,
punishment tomorrow. Fiscal laxity however has costs under
flexible ER as well. Effects of unsustainable policy immedi-
ately felt in flexible in changes of IR or price level, put off
until no longer sustainable in fixed with falling reserves and
exploding debt. Flexible then would make unsound policy
more costly because immediately accountable.
◦ Prereqs for adoption: Criteria for an optimum currency area
must be satisfied, large countries worse candidates than
smaller, pegging to country subject to very asymmetric shock
problematic. Bluk of adopting country's trade should be con-
ducted with those who it intends to peg to. Must shared broad
inflation prefs with country peg-base country. Flexible labour
markets are essential, with fixed ER nominal wages and
prices must adjust to adverse shocks. Labour market de-regu-
lation advised of countries looking to peg. Strong, well capi-
talized and well regulated banks are also essential because
hard peg prevents local CB from being LLR to domestic
banks. Hard pegs most necessary to conts. That have weak
CBs and chaotic fiscal insts. Hard pegs require quality insts
and rule of law,
◦ Pegging to the right currency: problems can arise when the
pegged to currency shifts, appreciation causes the pegging
ER to also appreciate relative to an important trading partner
outside of peg base. One way to resolve is to peg to basket of
currencies, though implementing problematic and difficult,
weights used to calculate rate must change in response to
changes but who does and to what criteria? Can lead to arbi-
trary control which eliminates credibility of even CBs. If cur-
2
, rency baord is valued for simplicity, transparency and ob-
servability basket may undermine setup. Basket also means
greater fluctuations in bilateral terms than pegging just to that
currency.
◦ Considering dollarization: Panama has had success with its
dollarization, inflation has remained stable and low, also
lower IR than rest of Latin America and less sensitive to
shocks in world confidence than them. However GDP volatil-
ity has been higher than most developing countries, among
worst in Latin America. Panama looks to foreign capital to
resolve issues because lacking LLR for domestic banks. Ab-
sence of LLR and inflexibility in facing shocks greatest
drawbacks of dollarization.
◦ Strategic considerations: pegged rate may have issues if ma-
jor trading partners flexible rates, can adujest to shock by de-
preciating which resores competitiveness faster, almost all
emerging econs devalued during 97-98 shocks.
◦ Monetary Union: Eichengreen consideres 4 essential prereqs
for MU: and indep. CB insulated from political business cy-
cle, wage and price flexibility, a strong financial sector, and
significant barriers to exiting the union. Unon more credible
if other econ, pol and social agreements tied to union, greater
exit costs. Union eliminates transaction costs of currency ex-
change, greater attractiveness of foreign investment, and pos-
sibility of large econ area to capture seignoriage.
• Fixed rates seem to have lower inflation but also as developing
countires and emerging econs moved to floating they also experi-
enced lower inflaiton. Skepticism about flexibility of floating rates,
some studues have shown little effect, uses of ER to devalue sys-
3
Larrain, velasco: Exchange rate policies in
emerging market economies
Drastic shift from predominance of pegged Ers to floating, in mid 1970s
about 70% of trade in developing countries conducted with fixed, by
1996 about 70% floating. Many forced to flaot in response to crisis,
Asian crisis 1990s, others looking for greater flexibility. How to float?
Four questions arise: can float and low inflation? Can be done, CBs
seem an important part, does floating provide as much insulation from
external shocks a thought? Some who floated in Asian crisis were more
greatly affected. Are ER stability and stability of financial system re-
lated? Sudden changes in ER can be nasty, floating may help avoid mis-
alignment. How should monetary policy be conducted under a float?
How often should intervention take place?
• Hard pegs:
◦ Credibility: gained by pegging to another hard currency, Ar-
gentina pegging to USD, contract style commitments with
limited escape clauses may be more credible but there may
be issues of credibility in developing countries, skeptical
publics may choose to be skeptical of gov manipulating con-
ditions to justify abandonment of peg. If devaluation seems
possible or likely because gov is allowed to devalue if things
get too nasty private sector may take pre-emptive measures
by demanding high wages and IR, causing high real costs
which may force gov into devaluation or be faced with costly
new equilibrium. Pegs are never irreversible, private sector
will always demand some premium for risk.
1
, ◦ Discipline: pegs will induce fiscal discipline because lax fis-
cal policies will deplete resources end the peg. Punishment
for poor unsustainable policy will deter politicians from do-
ing such and thus will keep the disciplined, bad policy today,
punishment tomorrow. Fiscal laxity however has costs under
flexible ER as well. Effects of unsustainable policy immedi-
ately felt in flexible in changes of IR or price level, put off
until no longer sustainable in fixed with falling reserves and
exploding debt. Flexible then would make unsound policy
more costly because immediately accountable.
◦ Prereqs for adoption: Criteria for an optimum currency area
must be satisfied, large countries worse candidates than
smaller, pegging to country subject to very asymmetric shock
problematic. Bluk of adopting country's trade should be con-
ducted with those who it intends to peg to. Must shared broad
inflation prefs with country peg-base country. Flexible labour
markets are essential, with fixed ER nominal wages and
prices must adjust to adverse shocks. Labour market de-regu-
lation advised of countries looking to peg. Strong, well capi-
talized and well regulated banks are also essential because
hard peg prevents local CB from being LLR to domestic
banks. Hard pegs most necessary to conts. That have weak
CBs and chaotic fiscal insts. Hard pegs require quality insts
and rule of law,
◦ Pegging to the right currency: problems can arise when the
pegged to currency shifts, appreciation causes the pegging
ER to also appreciate relative to an important trading partner
outside of peg base. One way to resolve is to peg to basket of
currencies, though implementing problematic and difficult,
weights used to calculate rate must change in response to
changes but who does and to what criteria? Can lead to arbi-
trary control which eliminates credibility of even CBs. If cur-
2
, rency baord is valued for simplicity, transparency and ob-
servability basket may undermine setup. Basket also means
greater fluctuations in bilateral terms than pegging just to that
currency.
◦ Considering dollarization: Panama has had success with its
dollarization, inflation has remained stable and low, also
lower IR than rest of Latin America and less sensitive to
shocks in world confidence than them. However GDP volatil-
ity has been higher than most developing countries, among
worst in Latin America. Panama looks to foreign capital to
resolve issues because lacking LLR for domestic banks. Ab-
sence of LLR and inflexibility in facing shocks greatest
drawbacks of dollarization.
◦ Strategic considerations: pegged rate may have issues if ma-
jor trading partners flexible rates, can adujest to shock by de-
preciating which resores competitiveness faster, almost all
emerging econs devalued during 97-98 shocks.
◦ Monetary Union: Eichengreen consideres 4 essential prereqs
for MU: and indep. CB insulated from political business cy-
cle, wage and price flexibility, a strong financial sector, and
significant barriers to exiting the union. Unon more credible
if other econ, pol and social agreements tied to union, greater
exit costs. Union eliminates transaction costs of currency ex-
change, greater attractiveness of foreign investment, and pos-
sibility of large econ area to capture seignoriage.
• Fixed rates seem to have lower inflation but also as developing
countires and emerging econs moved to floating they also experi-
enced lower inflaiton. Skepticism about flexibility of floating rates,
some studues have shown little effect, uses of ER to devalue sys-
3
