Lecture 6 Exchange rate regimes Flashcards
Dollarization
A foreign currency has been adopted as a country’s legal tender.
Currency board
A fixed exchange rate enshrined in law and backed by foreign currency reserves. Domestic currency 100% backed by CB’s holding of reserve currency.
Traditional central bank functions eliminated. CB can’t act as last lender.
Intended to provide safeguard against abandoning fixed exchange rate.
Monetary union
A group of countries that use a common currency and have a common central bank.
Fixed exchange rate
A currency whose value is maintained at a constant ratio to the value of another currency by the central bank
Crawling peg
A system for altering the exchange rate based on pre-determined rules, sometimes expressed as bands within which the currency is allowed to fluctuate.
Managed float
An exchange rate that is allowed to be determined by market forces unless the central bank intervenes at its discretion to alter its value.
Free float
An exchange rate determined by market forces without central bank intervention.
What are the pros of a fixed exchange rate?
1) provide a nominal “anchor” for monetary policy that may help reduce inflation. Increased investor confidence (price stability, reduced currency risk)
2) Monetary policy has to be subordinated to maintaining the fixed rate (no indy monetary policy)
3) Inflation subdued if peg credible
What are the cons of fixed exchange rates?
1) Defending may result in high interest rates and recession
2) Abandoning can be costly
3) No scope for attributing exchange rate movements to the market
4) Loss of independent monetary policy
What are the pros of floating?
1) Government can conduct independent monetary policy
2) More scope for gov to manage the exchange rate
3) Gov does not need to sterilize capital inflows (can be costly)
What are the cons of floating
1) can also come under speculative attacks like fixed
2) most EMs don’t use true floats (managed floats)
3) exchange rate volatility
What is full dollarization?
a country abandons its own currency and officially adopts a foreign currency — usually the U.S. dollar.
Pros of full dollarization
Risk of devaluation is eliminated
May allow risk premium on country’s sovereign debt to decrease
Cons of full dollarization
Lose seigniorage revenue
Risk premium for devaluation eliminated but sovereign risk exists.
What is a monitoring band
A crawling peg.
A credible central bank and low inflation may be a better way to make the currency consistent with fundamentals than a crawling peg.
