Exchange Rate RegimesExchange rate regimes are divided into 7 categories according to IMF’s classification. These are as follows.- Exchange arrangements with no separate legal tender; EU,- Currency board arrangements- Other conventional fixed peg arrangements- Pegged exchange rates within horizontal bands- Crawling pegs- Exchange rates within crawling bands- Managed floating with no predetermined path for the exchange rate- Independently floatingBut broadly, we can divide exchange rate regimes into 3 more general categories. These are fixed exchange rate regimes, floating exchange rate regimes, and intermediate exchange rate regimes.Attribute of the ideal currencyThrough the currency regimes, every government wants to achieve 3 goals, like these. First, a stable exchange rate. Second, Full integration into the global financial market. Third, Monetary independence.But, no country can get all three goals. The government, which have full floating regime, can have both monetary independence and full financial integration, but exchange rate may not stable. The country, which takes fully fixed regimes, can achieve both exchange rate stability and financial integration, without monetary independence. The authority, which has full capital control, can achieve both monetary independence and exchange stability, but can not achieve full financial integration.This phenomenon is called as ‘the impossible trinity’“Bipolar View”Through the empirical data, especially in 1990s, the number of country with hard peg or floating rate regime increased, but the number of intermediate regimes decreased.Between 1991 and 1999, the number of countries with hard peg increase from 25 to 45, the number of countries with floating regimes from 36 to 77. During the same period, the number of countries with intermediate regimes decreased from 98 to 63. (Fisher, 2001)Clearer change was discovered among developed and emerging countries in the same time period of 1990s.This phenomenon of changing regimes to one of the end point of exchange rate regimes categories is referred to as ‘bipolar view’.Fisher stated the reason why this change happens is that ‘soft peg systems have not proved viable over any length period, especially for countries integrated or integrating into the international capital markets’ (Fisher, 2001)Considering the impossible trinity, countries with open economy to the global financial market have to choose one of the extreme regimes, full floating or hard peg.The bipolar tendency was dated back to the breakup of the Bretton Woods system in early 1970s.Major developed economies have opened capital market, so many emerging countries are trying to open their financial market to the world believing benefit of openness outweigh the cost of capital integration.So, capital control can maintain soft peg system for a short time. But in the long run, it will lose their effectiveness over time.There is argument that intervention in currency market will not work or at least it is not wise.Generally, small economies have reason for hard peg. Hard peg regime is good for inflation control and helpful for GDP growth.In the medium term, there is tendency for country to move from a hard peg currency to fully flexible exchange rate. However, in the long term, the trend could be move from floating to hard peg, depending success of euro area and dollarized economies.There was paper against bipolar view, arguing that for many emerging countries, the optimal regimes would be a combination of an intermediate exchange rate regime with focused capital control. (Joshi, 2003)Joshi questioned about two points. One is perfect capital mobility as assumption of the impossible trinity. The other is how about achieving partial monetary independence and partial exchange stability.Fixed exchange rate regimes with capital account convertibility.Fixed exchange rate regimes have one of the forms among monetary union, dollarization, and currency board.With fixed exchange rate regime, it provides a firm anchor against inflation with stable currency value. There is no risk of exchange volatility, which might encourage trade and investment. But effective exchange rate can be a problem, due to the volatility of pegged currency. It was the case in the mid-1900s in Argentina and East Asia.But this regime must lose monetary independence and seignorage. So, they can not react against asymmetric shocks.This regime is really considerable for small, open countries with a propensity to hyper-inflation.Only a few countries moved the fixed end of the exchange rate spectrum recently.Floating exchange rate regimes with capital account convertibility.In the floating exchange rate regimes, the exchange rate finds its level in the market.It provides cushion against real shocks. Monetary policy can be freely deployed to adjust to cyclical and other disturbances.But short deviation of exchange rate from fundamentally adequate level by currency traders can cost severely, especially in the economies without fully developed financial infrastructures.Usually, most developing economies don’t have enough financial infrastructures. So, there is a good reason for developing countries to ‘fear floating’.A floating exchange rate can be inflationary. And the pre-conditions of successful inflation targeting are not easy to meet.This regime is not suitable for small and opened economies, in which the proportion of trade in GDP is high. Fluctuation of exchange rate might have a serious effect on prices and transactions.Intermediate exchange rate regimes with capital account convertibilityThese regimes try to achieve a balance between fixed and freely floating exchange regimes.The most important short fall of these regimes is vulnerability to currency and banking crisis. Speculators can use exchange rate target of the government. It can be a threat even when its fundamental is healthy.These currency crises include Mexico (1994), Thailand, Korea, Malaysia, Indonesia (1997/98), Brazil (1999), Russia (1999), Argentina (2001), Turkey (2001).Intermediate exchange rate regimes with capital control.Emerging countries are small in relation to capital flow, and they have inadequate supervisory structures to deal with perversity of capital movement.Short term, foreign-exchange denominated, unhedged bank loan is especially risky point among others in developing country’s financial structure.So, capital control focusing on especially risky point might effectively works, if it prevent from large and sudden movement of speculative hot money.These kinds of successful story go with Singapore, Chile, China, India and Malaysia. In case of India, the authority was liberal for foreign direct investment and portfolio equity investment but restrictive for debt-creating inflows, especially short term debt.Considering exchange rate in the market, we can start from both fundamental aspect and financial aspect. First one is ‘Purchasing power parity theory’ and the second is ‘Interest rate parity theory.“Purchasing Power Parity”Generally speaking, purchasing power parity theory means ‘market exchange rates are determined by currencies’ purchasing power parity. In other words, the exchange rate between two countries must reflect the ratio of the price levels.The Law of one priceThis considers one identical good or service to compare the purchasing power. The law of one price states:‘Abstracting from complicating factors such as transportation costs, taxes, and tariffs, any good that is traded on world markets will sell for the same price in every country engaged in trade, when prices are expressed in an common currency’ (Pakko, M and Pollard, P., 2003)Absolute Purchasing Power ParityThis considers a basket of goods and services of each country to be compared for purchasing power parity. Absolute PPP has its base on the law of one price.The equation below shows the absolute PPP.(): Price level measured in foreign currency: Exchange rate of foreign currency to home currency: Price level measured in home currencyEmpirical data stated that there is significant and sometimes even prolonged deviation from PPP.Recent study showed that the deviation is, in fact, temporary.The best example is ‘Big Mac Index’ which is published by ‘The Economist’ magazine.Uniform composition made the Big Mac index attractive as a purchasing power parity indicator.There are also newly coming Starbucks index and iPod index.Relative Purchasing Power ParityNormally purchasing power parity (PPP) refers to absolute PPP. Relative PPP is different from PPP.Relative purchasing power parity states that changes in price levels will be related to changes in exchanges rates.()The equation states that the percentage change in exchange rate is equal to the difference in their inflation rates.In short term, deviation dose exist in relative PPP, as is absolute PPP. So, next question may be the reason why the volatility exists.The reason why PPP does not hold empirically is the frictions in trade between comparable countries, such as transportation costs, trade restrictions, taxes .There are other reasons of deviation related to non-trade goods. These are productivity, government expenditure, current account deficitsPricing to market can be another reason of deviation.Purchasing Power Parity PuzzleConsequently based on many studies , purchasing power parity is proved as acceptable in the long term, but with a high degree of volatility in the short term.Long term convergence of exchange rate into purchasing power parity and short term high volatility looks contradictory at first sight. So, it is called ‘The Purchasing Power Parity Puzzle’.I already mentioned the reason of deviation from PPP. Studies related to ’the Puzzle’, there are some modifications in PPP.First, rich countries are relatively more productive in the traded goods sector. (The Balassa-Samuelson Hypothesis). Because, rich countries have high productivity and high capital-labor ratio .Second, Cumulated current account deficits are associated with long-run real exchange rate deviation .Third, a rise in government spending leads to an increase in the real exchange rate.Rogoff stated that PPP deviations tend to damp out, but only at the slow rate of roughly 15 percent per annum. (Rogoff, K., 1996 )“Interest Rate Parity”In financial aspect, another explanation of exchange rate change is related to interest rate parity theory.Uncovered Interest Rate ParityThe idea of uncovered interest rate parity is as follows.In equilibrium, a country’s exchange rate depends upon the ratio of the country’s interest rate to foreign interest rates and upon the expected future exchange rate.It can be expressed as equation like this.( ): The current exchange rate of the home country’s currency in terms of the foreign country’s at time t: The interest rate of home country at time t for a period of length k: The interest rate of foreign country at time t for a period of length k: The expected future exchange rate after a length of kThis equation is true when it is equilibrium, but equilibrium is assumption in economics, we can barely see the equilibrium in real economy as we are seeing now in 2009 world economic crisis.The problematic variable in this equation is expected future exchange rate. How can we find the expected rate? Always in economics, we assume rational expectations. But, there always are irrational expectations. In other words, market imperfection makes deviation.According to the test of real data on uncovered interest parity , a change of exchange rate is less than what we can get from the equation of uncovered interest parity. Some times we can even find negative value of expected future exchange rate.We can call this a case of anomalies. Some scholars tried to explain this with time-varying risk premium or expected errors.International Fisher EffectEconomist Irving Fisher theorized the Fisher effect, which is stated that nominal interest rate in each country equal to the required real rate of return plus compensation for expected inflation.General equation is as follows.(): Nominal interest rate: Real required rate of return: expected inflationFisher gave us a good guidance for exchange rate. This is known as international Fisher effect that is the relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rate in different national capital market.The equation is as follows()Or (): Spot exchange rate (foreign currency / home currency): Future exchange rate: Nominal interest rate in home country: Nominal interest rate of foreign countryThis theory is supported empirically only with considerable short-run deviationsCovered Interest Rate ParityInterest rate parity theory states:The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.The theory’s equation is like this.()Or (): Interest rate in home country: Interest rate in foreign country: Spot exchange rate: Forward exchange rateRelated to this theory, we can suppose 2 ways of investing. One is investing in home country to get an interest profit. The other is investing in foreign country after converting home currency into foreign currency on spot exchange rate. The profit of second investing way after converting back to home currency from foreign currency should be the same as the profit of first investing, if the market is in equilibrium.Covered Interest ArbitrageConsidering interest rate parity, we can get a fixed profit by using forward sell exchange contract.If there were any kind of imbalance in the interest rate parity, it gave us arbitrage chance to get a risk free profit.The decision where to invest is depend on which one is large or small between the difference of interest rates and the difference of exchange rate premium or discount .Forward sell fixes profit simultaneously with finishing investment process. So, it’s covered.Uncovered Interest ArbitraryIf investor uses interest rate parity without selling forward exchange contract, then the investment position is opened to the risk of volatility of exchange rate in the future.In this case, investor took an advantage of market imbalance, but final profit or loss didn’t fixed. We call this uncovered interest arbitrage.Finally commenting, PPP and IRP are not mutually exclusive but reconcilable with each other in explaining the global financial market.ReferencesEiteman, David K., Arthur I. Stonehill and Michael H. Moffett (2007) Multinational Business, Finance 11th edition, Boston MA: Pearson/ Addison Wesley.Fisher, S (2001) ‘Exchange Rate Regimes: Is the Bipolar View Correct?’, Journal of Economic Perspectives 15.Froot, K and Thaler, R (1990) Anomalies: Foreign Exchange’, the Journal of Economic Perspective, Vol.4, No.3 (summer, 1990)Joshi, V (2003) ‘Financial Globalisation, Exchange Rates and Capital Controls in Developing Countries’, Working Papers in Trade and Development no.19, Economics, RSPAS, Australian National University.Pakko, M and Pollard, P (2003) ‘Burgernomics: A Big Mac Guide to Purchasing Power Parity’, The Federal Reserve Bank of St Louis Review, November/December, Vol.85, No.6.Rogoff, K (1996) ‘The Purchasing Power Parity Puzzle’, Journal of Economic Literature, XXXIV, (June).Vachris, M and Thomas, J (1999) ‘International price comparisons based on purchasing power parity’, Monthly Labor Review, October, Washington DC: US Department of Labor, Bureau of Labor Statistics.- This is Assignment 1 for Finance in the Global Market at CeFiMS | SOAS | University of London