A Fixed Exchange Rate 11111111111

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A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell–Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. There are no major economic players that use a fixed exchange rate (except the countries using the euro and the Chinese yuan). The currencies of the countries that now use the euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China[citation needed], which did so in July 2005. [1] However, as of September 2010, the fixed-exchange rate of the Chinese yuan has already increased 1.5% in the last 3 months. [2] Contents

[hide] 1 Maintenance • 2 Criticisms • 3 Fixed exchange rate regime versus capital control • 4 Literature • 5 See also
• •

6 References

[edit] Maintenance Typically, a government wanting to maintain a fixed exchange rate does so by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves. Another, less used means of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This is difficult to enforce and often leads to a black market in foreign currency. Nonetheless, some countries are highly successful at using this method due to government monopolies over all money conversion. This was the method employed by the Chinese government to maintain a currency peg or tightly banded float against the US dollar. Throughout the 1990s, China was highly successful at maintaining a currency peg using a

government monopoly over all currency conversion between the yuan and other currencies.[3][4] [edit] Criticisms The main criticism of a fixed exchange rate is that flexible exchange rates serve to automatically adjust the balance of trade. [5] When a trade deficit occurs, there will be increased demand for the foreign (rather than domestic) currency which will push up the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and thus pushes down the trade deficit. Under fixed exchange rates, this automatic rebalancing does not occur. Governments also have to invest many resources in getting the foreign reserves to pile up in order to defend the pegged exchange rate. Moreover a government, when having a fixed rather than dynamic exchange rate, cannot use monetary or fiscal policies with a free hand. For instance, by using reflationary tools to set the economy rolling (by decreasing taxes and injecting more money in the market), the government risks running into a trade deficit. This might occur as the purchasing power of a common household increases along with inflation, thus making imports relatively cheaper. Additionally, the stubbornness of a government in defending a fixed exchange rate when in a trade deficit will force it to use deflationary measures (increased taxation and reduced availability of money) which can lead to unemployment. Finally, other countries with a fixed exchange rate can also retaliate in

response to a certain country using the currency of theirs in defending their exchange rate. [edit] Fixed exchange rate regime versus capital control The belief that the fixed exchange rate regime brings with it stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. A fixed exchange rate regime should be viewed as a tool in capital control. For instance, China has allowed free exchange for current account transactions since December 1, 1996. Of more than 40 categories of capital account, about 20 of them are convertible. These convertible accounts are mainly related to foreign direct investment. Because of capital control, even the renminbi is not under the managed floating exchange rate regime, but free to float, and so it is somewhat unnecessary for foreigners to purchase renminbi. [edit] Literature Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)


Fixed or Flexible?


Getting the Exchange Rate Right in the 1990s[6]

Monetary policy From Wikipedia, the free encyclopedia Jump to: navigation, search This article may contain too much repetition or redundant language. Please help improve it by merging similar text or removing repeated statements. (September 2009) Public Finance A series on Government

Policies[show] Fiscal policy[show] Monetary policy[show] Trade policy[show] Revenue and Spending[show] Optimum[show] v·d·e Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate

of interest for the purpose of promoting economic growth and stability.[1] The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.[2] Contents [hide]






1 Overview o 1.1 Theory 2 History of monetary policy o 2.1 Trends in central banking o 2.2 Developing countries 3 Types of monetary policy o 3.1 Inflation targeting o 3.2 Price level targeting o 3.3 Monetary aggregates o 3.4 Fixed exchange rate



• • •

3.5 Gold standard o 3.6 Policy of various nations 4 Monetary policy tools o 4.1 Monetary base o 4.2 Reserve requirements o 4.3 Discount window lending o 4.4 Interest rates o 4.5 Currency board o 4.6 Unconventional monetary policy at the zero bound 5 See also 6 External links
o

7 References

[edit] Overview Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the

interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). [edit] Theory Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a

monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages. To achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate highlevel inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail. Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation).

Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued[3] that to prevent some pathologies related to the time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations. Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.[4]

[edit] History of monetary policy Monetary policy is associated with interest rates and availabilility of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base.[5] For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. Paper money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation. With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.[6] The goal of monetary policy was to maintain the value of the coinage, print notes which

would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[7] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs. Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output.[8] Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[9] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[10] Even Milton Friedman

acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003.[11][12][13] Therefore, monetary decisions today take into account a wider range of factors, such as: short term interest rates; • long term interest rates; • velocity of money through the economy; • exchange rates; • credit quality; • bonds and equities (corporate ownership and debt); • government versus private sector spending/savings; • international capital flows of money on large scales; • financial derivatives such as options, swaps, futures contracts, etc.


A small but vocal group of people, primarily libertarians and Constitutionalists[14], advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others[who?] see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt. In fact, many economists[who?] disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in

monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 2008-2009. [edit] Trends in central banking The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when the exchange rate is floating.[15] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate. In the 1980s, many economists[who?] began to believe that making a nation's central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy

have long, fixed terms. Obviously, this is a somewhat limited independence. In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation. The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI). The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments,[16] but most economists fall into either the Keynesian or neoclassical camps on this issue. [edit] Developing countries Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government

debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation. Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks. [edit] Types of monetary policy In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Inflation Targeting Price Level Targeting Monetary Aggregates

Target Market Variable: Interest rate on overnight debt Interest rate on overnight debt The growth in money supply

Long Term Objective: A given rate of change in the CPI A specific CPI number A given rate of change in the CPI

Fixed The spot price of The spot price of the Exchange Rate the currency currency Gold Standard Mixed Policy The spot price of Low inflation as measured gold by the gold price Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is

also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index). [edit] Inflation targeting Main article: Inflation targeting Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards

achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[17] The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom. [edit] Price level targeting Price level targeting is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted pricelevel is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years. [edit] Monetary aggregates In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities. [edit] Fixed exchange rate This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation. Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.) Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This

ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency. Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy). These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors. See also: List of fixed currencies [edit] Gold standard Main article: Gold standard The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting.

The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base. Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971.[18] Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by increasing their money supply.[19] The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971. The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream

economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisis lengthening the amount of time a economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes. [edit] Policy of various nations Australia - Inflation targeting • Brazil - Inflation targeting • Canada - Inflation targeting • Chile - Inflation targeting • China - Monetary targeting and targets a currency basket • Czech Republic - Inflation targeting • Colombia - Inflation targeting • Hong Kong - Currency board (fixed to US dollar) • India - Multiple indicator approach • New Zealand - Inflation targeting • Norway - Inflation targeting • Singapore - Exchange rate targeting • South Africa - Inflation targeting [20] • Switzerland - Inflation targeting • Turkey - Inflation targeting [21] • United Kingdom - Inflation targeting, alongside secondary targets on 'output and employment'.


United States[22] - Mixed policy (and since the 1980s it is well described by the "Taylor rule," which maintains that the Fed funds rate responds to shocks in inflation and output)


Further information: Monetary policy of the USA [edit] Monetary policy tools [edit] Monetary base Monetary policy can be implemented by changing the size of the monetary base. Central banks use open market operations to change the monetary base. The central bank buys or sells reserve assets (usually financial instruments such as bonds) in exchange for money on deposit at the central bank. Those deposits are convertible to currency. Together such currency and deposits constitute the monetary base which is the general liabilities of the central bank in its own monetary unit. Usually other banks can use base money as a fractional reserve and expand the circulating money supply by a larger amount. [edit] Reserve requirements The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do

not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier. [edit] Discount window lending Discount window lending is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), thereby affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole. [edit] Interest rates Main article: Interest rates The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations

are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply. [edit] Currency board Main article: currency board A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are threefold: 1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation;

3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization). In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency. The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners. Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay

of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro). Currency boards have advantages for small, open economies that would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation. [edit] Unconventional monetary policy at the zero bound This section requires expansion. Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing, and signaling. In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an “extended period”, and the Bank of Canada made a “conditional commitment” to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010

Capital control From Wikipedia, the free encyclopedia Jump to: navigation, search Capital controls are measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate the flows into and out of the country's capital account. Types of capital control include exchange controls that prevent or limit the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or purchase of various financial assets, transaction taxes such as the proposed Tobin tax, minimum stay requirements, requirements for mandatory approval, or even limits on the amount of money a private citizen is allowed to remove from the country. There have been several shifts of opinion on whether capital controls are beneficial and in what circumstances they should be used. Capital controls were an integral part of the Bretton Woods system which emerged after World War II and lasted until the early 1970s. This period was the first time capital controls had been endorsed by mainstream economics. In the 1970s free market economists became increasingly successful in persuading their colleagues that capital controls were in the main harmful. The US, other western governments, and the international

financial institutions (the IMF and WB ) began to take an increasingly critical view of capital controls and persuaded many countries to abandon them. After the Asian Financial Crisis of 1997–98, there was a shift back towards the view that capital controls can be appropriate and even essential in times of financial crisis, at least among economists and within the administrations of developing countries.[1] By the time of the 2008–09 crisis, even the IMF had endorsed the use capital controls as a response. In late 2009 several countries imposed capital controls even though their economies had recovered or were little affected by the global crisis; the reason given was to limit capital inflows which threatened to over-heat their economies. By February 2010 the IMF had almost entirely reversed the position it had adopted in the 80s and 90s, saying that capital controls can be useful as a regular policy tool even when there is no crisis to react to, though it still cautions against their overuse. The use of capital controls since the crises has increased markedly and proposals from the IMF and G20 have been made for international coordination that will increase their effectiveness. The UN, World Bank and Asian Development Bank all now consider that capital controls are an acceptable way for states to regulate potentially harmful capital flows, though concerns remain about their effectiveness among both senior government officials and analysts working in the financial markets. Contents [hide]


1 History



• • •

1.1 Pre WW1 o 1.2 WW1 to WWII: 1914 - 1945 o 1.3 The Bretton Woods Era: 1945–1971 o 1.4 Transition period and Washington consensus: 1971 - 2009 o 1.5 Post Washington Consensus: 2009 and later o 1.6 The impossible trinity trilemma 2 Free movement of capital and payments o 2.1 Arguments in favour of free capital movement o 2.2 Arguments in favour of capital controls 3 See also 4 External links
o

5 Notes and references

[edit] History [edit] Pre WW1 Prior to the 19th century there was generally little need for capital controls due to low levels of international trade and financial integration. In the first age of globalisation which is generally dated from 1870–1914, capital controls remained largely absent.[2] [edit] WW1 to WWII: 1914 - 1945 Highly restrictive capital controls were introduced with the outbreak of World War I. In the 1920s they were generally relaxed, only to be strengthened again in the wake of the 1929 Great Crash. This was more an ad hoc response to potentially damaging flows rather than based on a change in normative

economic theory. Economic historian Barry Eichengreen has implied that the use of capital controls peaked during World War II, but the more general view is that the most wide ranging implementation occurred after Bretton Woods.[2] [3] [4] [5] An example of capital control in the inter war period was the flight tax introduced in 1931 by Chancellor Brüning. The tax was needed to limit the removal of capital from the country by wealthy residents. At the time Germany was suffering economic hardship due to the Great Depression and the harsh war reparations imposed after World War I. Following the ascension of the Nazis to power in 1933, the tax began to raise sizeable revenue from Jews who emigrated to escape state sponsored anti Semitism.[6] [7] [8] [edit] The Bretton Woods Era: 1945–1971

A widespread system of capital controls were decided upon at the international 1944 conference at Bretton Woods At the end of World War II, international capital was "caged" by the imposition of strong and wide ranging capital controls as part of the newly created Bretton Woods system- it was perceived that this would help protect the interests of ordinary people and the wider economy. These measures were popular as at this time the western public's view of international bankers was generally very low, blaming them for the Great Depression.

[9] [10]

Keynes, one of the principal architects of the Bretton Woods system, envisaged capital controls as a permanent feature of the international monetary system,[11] though he had agreed current account convertibility should be adopted once international conditions had stabilised sufficiently This essentially meant that currencies were to be freely convertible for the purposes of international trade in goods and services, but not for capital account transactions. Most industrial economies relaxed their controls around 1958 to allow this to happen.[12] The other leading architect of Bretton Woods, the American Harry Dexter White and his boss Henry Morgenthau were somewhat less radical than Keynes, but still agreed on the need for permanent capital controls. In his closing address to the Bretton Woods conference, Morgenthau spoke of how the measures adopted would drive "...the usurious money lenders from the temple of international finance".[9] Following the Keynesian Revolution, the first two decades after World War II saw little argument against capital controls from economists, though an exception was Milton Friedman. However, from the late 1950s the effectiveness of capital controls began to break down, in part due to innovations such as the Eurodollar market. According to Dani Rodrik it is unclear to what extent this was due to an unwillingness on the part of governments to respond effectively, as compared with an inability to do so.[11] Eric Helliner has argued that heavy lobbying from Wall St bankers was a factor in persuading US authorities not to exempt the Eurodollar market from capital controls. From the late 1960s the prevailing opinion among economists began to switch to the view that capital controls are on the whole more harmful than beneficial.[13][14]

While many of the capital controls in this era were directed at international financiers and banks, some were directed at individual citizens. For example in the 1960s British families were at one point restricted from taking more than £50 with them out of the country for their foreign holidays.[15] In their book This Time Is Different economists Carmen Reinhart and Kenneth Rogoff suggest that the use of capital controls in this period, even more than its rapid economic growth, was responsible for the very low level of banking crises that occurred in the Bretton Woods era.[16] [edit] Transition period and Washington consensus: 1971 2009 By the late 1970s, as part of the displacement of Keynesianism in favour of free market orientated policies and theories, countries began abolishing their capital controls, starting between 1973 - 1974 with the U.S., Canada, Germany and Switzerland and followed by Great Britain in 1979.[17] Most other advanced and emerging economies followed, chiefly in the 1980s and early 1990s.[2] During the period spanning from approximately 1980 - 2009, known as the Washington Consensus, the normative opinion was that Capital controls were to be avoided except perhaps in a crises. It was widely held that the absence of controls allowed capital to freely flow to where it is needed most, helping not only investors to enjoy good returns, but also helping ordinary people to benefit from economic growth. During the 1980s many emerging economies decided or were coerced into following the advanced economies by abandoning their capital controls, though over 50 retained them at least partially.[2] [18] The then orthodox view that capital

controls are a bad thing was challenged to some extent following the 1997 Asian Financial Crisis. Asian nations that had retained their capital controls such as India and China could credit them for allowing them to escape the crisis relatively unscathed.[16][19] Malaysia's prime minister Mahathir bin Mohamad imposed capital controls as an emergency measure in September 1998, both strict exchange controls and limits on outflows from portfolio investments - these were found to be effective in containing the damage from the crisis. [2] [20] [21] In the early nineties even some pro-globalization economists like Jagdish Bhagwati [22] and some writers in publications like The Economist[20] [23] spoke out in favour of a limited role for capital controls. But while many developing world economies lost faith in the free market consensus, it remained strong among western nations.[2] [edit] Post Washington Consensus: 2009 and later By 2009, the global financial crisis had caused a resurgence in Keynesian thought which reversed the previously prevailing orthodoxy.[24] During the 2008–2009 Icelandic financial crisis, the IMF proposed that capital controls should be imposed by Iceland, calling them "an essential feature of the monetary policy framework, given the scale of potential capital outflows."[25] In the latter half of 2009, as the crisis eased and financial activity picked up, several emerging economies adopted limited capital controls to protect against potential negative effects of capital inflows. This included Brazil imposing a tax on the purchase of financial assets by foreigners and Taiwan restricting overseas investors from buying Time deposits. [26]

Pro capital control statements by various prominent economists, together with a February 2010 report by the IMF have been hailed as an "end of an era" and said to represent a reversal of the IMF's long held position that capital controls should be used in crises only. [27] [28] [29] However the IMF warn that capital controls are not always appropriate and shouldn't be used as an alternative to the more challenging policy changes needed to address the root cause of economic problems.[30] In June 2010 The Financial Times published several articles on the growing trend towards using capital controls. They noted influential voices from the ADB and World Bank had joined the IMF in advising there is a role for capital controls. The FT reported on the recent tightening of controls in Indonesia, South Korea, Taiwan, Brazil and Russia. In Indonesia recently implemented controls include a one-month minimum holding period for certain securities. In South Korea limits have been placed on currency forward positions. In Taiwan the access that foreigner investors have to certain bank deposits has been restricted. The FT cautioned that imposing controls has a downside including the creation of possible future problems in attracting funds. [31] [32] [33] By September 2010, emerging economies had experienced huge capital inflows resulting from carry trades made attractive to market participants by the expansionary monetary policies several large economies had undertook over the previous two years as a response to the crisis. This has led to countries such as Brazil, Mexico, Peru, Colombia, Korea, Taiwan, South Africa, Russia and Poland further reviewing the possibility of increasing their capital controls as a response. [34] [35] In October, with

reference to increased concern about capital flows and widespread talk of an imminent Currency war, financier George Soros has suggested that capital controls are going to become much more widely used over the next few years.[36] But several analysts have questioned whether controls will be effective for most countries, with Chile's finance minister saying his country had no plans to use them.[37] In February 2011, over 250 economists headed by Joseph Stiglitz wrote to the Obama administration asking them to remove clauses from various bilateral trade agreements that allow the use of capital controls to be penalised. There was strong counter lobbying by business and so far the US administration has not acted on the call, although some figures such as Treasury secretary Tim Geithner have spoken out in support of capital controls at least in certain circumstances.[14][38] Econometric analyses by the IMF and academic economists found that in general countries which deployed capital controls weathered the 2008 crisis better than comparable countries which did not.[14][39] In April 2011 the IMF published its first ever set of guidelines for the use of capital controls.[40][41] [edit] The impossible trinity trilemma The history of capital controls is sometimes discussed in relation to the Impossible trinity – the finding that its impossible for a nation's economic policy to simultaneously deliver more than two of the following three desirable macroeconomic goals: 1) A fixed exchange rate, 2 ) an independent monetary policy, 3) free movement for capital (absence of capital controls). [5] In the first age of globalization, governments largely chose to pursue a

stable exchange rate while allowing freedom of movement for capital- the sacrifice was that their monetary policy was largely dictated by international conditions, not by the needs of the domestic economy. In the Bretton woods period governments were free to have both generally stable exchange rates and independent monetary policies at the price of capital controls. The impossible trinity concept was especially influential during this era, as a justification for capital controls. In the Washington consensus period, advanced economies generally chose to allow freedom of capital and to continue maintaining an independent monetary policy while accepting a floating or semi floating exchange rate.[2][14] [edit] Free movement of capital and payments

Finnance workers such as those in the International Finance Centre may find ways to profitably exploit any loop holes in capital controls, often only weeks or days after they are implemented. Full freedom of movement for capital and payments has so far only been approached between individual pairings of states which have free trade agreements and relative freedom from capital controls, such as Canada and the U.S., or the complete

freedom within regions such as the European Union, with its "Four Freedoms" and the Eurozone. During the first age of globalization that was brought to an end by World War I, there were very few restrictions on the movement of capital, but all major economies except for Great Britain and the Netherlands heavily restricted payments for goods by the use of current account controls such as tariffs and duties.[2] [edit] Arguments in favour of free capital movement Pro free market economists claim the following advantages for free movement of capital: It enhances the general economic welfare by allowing savings to be channelled to their most productive use.[20] • By encouraging foreign direct investment it helps developing economies to benefit from foreign expertise.[20] • Allows states to raise funds from external markets to help them mitigate a temporary recession.[20] • Enables both savers and borrowers to secure the best available market rate.[5] • When controls include taxes, funds raised are sometimes siphoned off by corrupt government officials for their personal use.[5] • Hawala-type traders across Asia have always been able to evade currency movement controls • Computer and satellite communication technologies have made Electronic funds transfer a convenience for increasing numbers of bank customers.


[edit] Arguments in favour of capital controls Pro capital control economists have made the following points. Capital controls may represent an optimal Macroprudential policy that reduces the risk of financial crises and prevents the associated externalities.[1][42] • Global economic growth was on average considerably higher in the Bretton Woods periods where capital controls were widely in use. Using Regression analysis, economists such as Dani Rodrik have found no positive correlation between growth and free capital movement.[20] • Capital controls limiting a nation's residents from owning foreign assets can ensure that domestic credit is available more cheaply than would otherwise be the case. This sort of capital control is still in effect in both India and China. In India the controls encourage residents to provide cheap funds directly to the government, while in China it means that Chinese businesses have an inexpensive source of loans.[16] • Economic crises have been considerably more frequent since the Bretton Woods capital controls were relaxed. Even economic historians who class capital controls as repressive have concluded capital controls, more than the period's high growth, were responsible for the infrequency of crisis.[16] Studies have found that large uncontrolled capital inflows have frequently damaged a nation's economic development by causing its currency to appreciate, by contributing to inflation, and by causing unsustainable economic booms which often precede financial crises - caused when the inflows sharply reverse and both domestic and foreign capital flee the country. The risk of crisis is especially high in


developing economies where the inbound flows become loans denominated in foreign currency, so that the repayments become considerably more expensive as the developing country's currency depreciates. This is known as original Sin (economics).[2][43][44]

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