What determines the choice of an optimal exchange rate regime?

What determines the choice of an optimal exchange rate regime? Identify a set of conditions that would constitute a case against fixed exchange rate regimes. There are two broad types of exchange rate regimes. These are flexible and fixed. The regimes between them consist of a currency union, currency board, adjustable peg, crawling peg, basket peg, target zone and managed float. Economic theory suggests that the larger the economy the stronger the case for a flexible exchange rate regime. This is due to the fact that a large economy is likely to be more open to international currency movements.

A fixed exchange rate would be unsustainable in such an environment. A flexible exchange rate is also extremely useful when wages and thus prices are sticky downwards. Any external shocks can be dealt with by changing the exchange rate rather than the domestic price level. A fixed regime would not allow this with the only option being a deflationary policy to increase competitiveness. A government cannot use monetary policy when their currency has a constant value. If fiscal policy is the main tool used to establish economic stability rather than monetary strategy, a fixed exchange rate will be easier to introduce.

Similarly a fixed exchange rate is also more suited to economies where foreign trade makes up a large percentage of GDP. A fixed exchange rate might reduce currency speculation, preventing fluctuations in import and export levels. The choice of an optimal exchange rate is clearly dependent on the size of the economy in question and its dependence on foreign trade. Speculation is perhaps the biggest danger when a fixed parity is in use. An effective example would be the UK's difficulties in supporting the ERM in 1992.

Although it was a target zone set against the DM rather that a fixed currency regime, there was little confidence that the pound was at its correct value. George Soros, a large investor in pounds believed it was heavily overvalued and sold in vast quantities causing the majority of sterling holders to abandon it with him. The British Government was responsible for maintaining the ERM and spent 15 billion pounds of foreign currency to buy the domestic currency and maintain its value. They also set interest rates at an incredible 15% to try and prevent the capital outflow.

Unfortunately they were forced to abandon the ERM on the 12th September 1992, and its consequences effectively cost John Major the general election in 1997. Clearly the existence and power of speculation is one case against a fixed regime. A further argument against a rigid exchange rate would come in the case of the UK if and when it joins the single European currency. As a nation with low inflation in a geographical area where inflation has been higher on average over the last ten years, Britain may suffer a conflict in monetary policy.

While Europe may impose high interest rates to limit inflation, Britain might require the opposite to stimulate the domestic market. The argument is that asymmetric shocks might decrease demand in Britain without a corresponding effect on Europe. If Britain is tied to the Euro then it has no control over monetary policy. A less effective fiscal policy might have to be introduced instead, a reduction in prices is another alternative and at worst the population may have to emigrate to find employment. This leads on to the case that a fixed regime requires perfect wage flexibility and labour mobility if emigration is to occur.

If Britain were to join the single currency and suffer a demand shock, then its final option after exhausting fiscal measures would be to encourage emigration of labour to other nations. In this case if labour does not have the right language skills or the acceptance of lower wages, Britain cannot export its human capital. In a perfect economic world it would not be a problem if Britain suffered a demand shock in Europe. In reality the single currency prevents effective domestic monetary policy, whose alternatives are less reliable.

Taking the UK as the principal example it is necessary to look at the appropriateness of differing exchange rate regimes in terms of welfare. The Single Currency is a good regime to analyse as its supposed benefits and costs are obvious, even though it is difficult to measure them. The benefits of the single currency are reduced transaction costs, elimination of currency fluctuations and greater price transparency. All of these are factors which benefit countries trading primarily within the E. U. Therefore the OCA model argues that greater trade integration should mean greater benefits from being part of the currency area.

The costs of the currency area are excess unemployment or inflation from asymmetric demand shocks, which cannot be treated with monetary policy. Using the OCA model above it can be argued that the UK should rank the Single Currency as its optimal choice only if it is to the right of E, which we take to be the E. U. 15 member average, as it is very difficult to estimate the costs and benefits of the union as a percentage of GDP. Using the formula for trade intensity as M14 + X14 / 2Y for each nation in the E. U. where M14 and X14 are the imports from and exports to the other 14 nations in the E. U. , the average is ascertained to be 14.

35%. Therefore E= 14. 35. This assumes that all the nations involved will be either to the right or left of E and that those to the right are benefiting from the Union and those to the left are suffering from the single currency. From the graph below it is clear that Germany, Greece, Spain, France and Italy lie to the left of E. The currency area is not beneficial to them. If Britain were to join then she would also be to the left of E at 13. 05 % meaning that presently it would be costly to join the E. U. , as her trade intensity is not sufficient to outweigh the costs of the loss of monetary control.

Clearly the currency union could be ranked as a negative welfare model if the UK is taken as the principal example. If we observe the CPI of the UK over the last thirteen years it is clear that Britain has had stable inflation. In 2002 her debt to GDP ratio was 37%, which was a lot lower than Euro land which had ratios of 68%. Her inflation in 2002 was 2. 0% compared to Euro land's 2. 1% and her interest rate prevailed at 4. 9% against Euro land's 5. 1%. Clearly Britain looks set to join with the single currency as most of the indicators show that she is converging.

However Britain's past experiences of a fixed exchange rate have been unsuccessful to say the least. The return to gold in 1925 saw Britain deflate the economy for a decade to maintain the high fixed exchange rate. The dollar peg was also a problem with the emergence of stagflation in the seventies, which made the exchange rate untenable. Even the most recent experience, with the aforementioned ERM, concluded with Britain reverting to a managed float. Clearly the welfare obtained from sporadically fixing the UK exchange rate has not been a positive one.

Even with the signs indicating that Britain is ready for the Euro, perhaps history should convince that a free-floating economy creates the greatest welfare. Jeffrey Frankel is of the opinion that there is no set exchange rate system that can be prescribed to all countries for all time. He believes that trade pressures on smaller countries will cause them to fix their exchange rate, and the sheer size of international capital trading will ensure that larger economies are forced to submit to a floating exchange rate. Differing situations call for different measures.

He also argues that although recent evidence indicates that more nations are taking to the extremes of fixing and floating, there is still a need for mid-way regimes. Developing nations where large-scale capital flows are not an issue will not be concerned with using a managed floating exchange rate. Similarly it is often important for smaller nations to exit from fixed regimes when their currency becomes overvalued. Over time as a country begins to trade more with its neighbour the benefits of a currency union will rise and the need for them to keep their own exchange system will disappear.

Hence a transformation of an economy will require a new exchange rate regime. Frankel argues that although the world may not become one currency or a billion currencies, there is scope for blocs to emerge, constantly disbanding and reforming to suit the economic climate. Clearly a permanent exchange rate regime for all nations is a hard theory to support with so many disparate trade integrations, economy sizes and strengths and long-term goals. In reality it is never likely to occur.