A) With reference to ‘the impossible trinity’ argument, explain the ‘bipolar view of

exchange rate policy.

The Impossible Trinity is the choice of an exchange rate regime which cannot be
considered separately from the choice of policy stance towards capital flows. The
standard formulation of the Impossible Trinity says that it is impossible to achieve the
goals of exchange rate stability, capital market integration and monetary autonomy
simultaneously. According to the Impossible Trinity, the sharp increase of mobility of
capital flows due to financial globalization has reduced the natural and policy barriers to
capital flows. This has reduced the policy menu to a simple choice between fixed and
floating exchange rates. This excludes the option of choosing an intermediate regime. As
stated above, this ignores the option of choosing an intermediate regime. The bipolar
view specifically addresses this point. It states that that no intermediate regime is
sustainable in the presence of high capital mobility and is inevitable because capital
controls are not feasible. On this view, the policy choice does indeed reduce to fixed vs
floating rates since all intermediate regimes are unsustainable. The bipolar view predicts
that all countries will move to the “fixed” and “floating” corners of the spectrum of
exchange rate regimes.

From one point of view of the bipolar view is the fixed exchange rate. The term fixed
exchange rate is defined as one which is irrevocably fixed, i.e. a super-hard peg. In this
regime, the central bank commits itself irrevocably to defending a fixed exchange rate.
The strength of this regime is that it provides a firm anchor against inflation, provided of
course that the peg-currency is stable in value. The outstanding weakness of this regime
follows from the complete surrender of monetary sovereignty that it entails. Seignorage is
either fully lost (dollarisation) or highly circumscribed (currency board). So is the ability
to use monetary policy to adjust to asymmetric shocks, a safety-valve of major
importance when money wages and prices are sticky downwards (provided real wages
are flexible).

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The second stand point of the bipolar view is the floating exchanged rate. The term can
be defined as a regime in which the authorities do not have an exchange rate target,
formal or informal. The strength of this regime is that it facilitates real adjustment.
Exchange rate movements provide a natural cushion against real shocks. Floating
exchange rates however are prone to inflation unless supported by a firm domestic
nominal anchor. The exchange rates are also prone to fluctuations and are not suitable for
small developing countries where traded goods are a big part of output (motivating the
formation of the EMU).

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B) If fixed exchange rates are technically feasible, why have they been so difficult to
maintain in practice in countries such as the UK (1992), Mexico (1994) and
Thailand (1998)?

The technical feasibility of the fixed exchange rate regime is being overshine by its costs
and problems that accompanies it. Thus, making the fixed exchange rate regime hard to
maintain in practice. This is evident in the case of UK in 1992, Mexico in 1994 and
Thailand in 1998 which saw the government forced to retreat to a floating exchange rate
regime from the fixed exchange rate regimes.

One of the few problems that the fixed exchange rate regime possessed is that very few
central banks are willing to cling to an exchange rate target without regard to what is
happening in the rest of the economy. It is known theoretically that, to fend off a major
speculative attack to the exchange rate and the domestic economy, the monetary
authorities must be prepared to allow an increase in the domestic interest rates. Such
increases in the interest rates can give problems to the banking system. Therefore, in
order to have such strategies, a country needs to have a sound banking system. This is as,
over the long term, the unanticipated rise in the interest rates can have profoundly
negative effects on the investments, unemployment, government budget deficit and the
domestic distribution of income. The government will then pledge to not allow those side
effects to surface in defence to the exchange rate. This is however, not credible. The lack
of creditability of the government or the central bank will make the fixed exchange rate
vulnerable to speculative attacks. Due to the costliness of the unanticipated increase in
the interest rates, the central bank will eventually make the investors to believe that they
will not fold, so that the interest rates can go back to its normal level. If the approach is
not convincing enough, the authorities will eventually have to sacrifice the fixed
exchange rate regime to rescue the domestic economy.

Also, in order to defend the fixed exchange rate regime, the government or the central
bank will have to liquidate its assets. Say for example, running out of its foreign
exchange reserves in order to buy domestic currency on the foreign exchange market to

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ensure exchange rate stability. This will lead to a worsening of the countries’ fiscal
position and if it is not being sustained will lead to a liquidity crisis which in turn will
force the country to retreat to a floating exchange rate. This is as a liquidity crisis also
makes the economy vulnerable to speculative attacks.

Another problem of the fixed exchange rate regime is the impossible trinity dilemma. In a
fixed exchange rate regime one will not be able to have an independent monetary policy
and openness to capital flows all together. Say that a country faces a sudden and
permanent fall in the demand for its exports; the economy’s deterioration of its wellbeing
is further magnified with a fixed exchange rate. This is as, with no way for the relative
prices of exports and imports to adjust in the short run, domestic employment and output
must fall. A country with a fixed exchange rate regime and a mobile capital market will
not have the power to adjust its interest rate and stimulates its short run demand in order
to protect its economy as its domestic nominal interest rates are determined by the foreign
monetary policies. Thus, making the domestic country powerless in controlling their
money supply.

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C) To what extent is the ‘bipolar view’ supported by the data on

• de jure exchange rate regimes

The de jure exchange rate regimes can be defined as what a countries government
‘claims’ to do and in regard with the bipolar view, supports it and shows that countries
are generally moving towards either corner of the bipolar view of fixed exchange rate or
floating exchange rate. The de jure exchange rate regimes are important as a way of what
the central bank communicates to the public as this is likely to have bearing on the
outcome. By having a de jure fixed exchange rate and a de facto floating exchange rate,
the breach of commitment will likely have negative consequences. On the other hand,
having a de jure floating exchange rate and a de facto fixed exchange rate does not breach
its commitments.

• de facto exchange rate regimes

The de facto exchange rate regime can be defined as what a countries government
actually does in regard to its exchange rate system despite what it claims. This is usually
associated with a ‘fear of floating’ and is usually seen as intermediate exchange rate
regimes. The bipolar view is not really supported as country’s actual (de facto)
exchange rate regime often differs from its de jure, or officially
announced, policy, raising questions about whether the observed trend
away from intermediate regimes is a fallacy. The crux of the matter can be
briefly put: free capital movements can be hugely beneficial if they are well-behaved but
in the real world they can be perverse. There is therefore a case for government action to
counter this perversity. This view does not however support the bipolar view which
claims that the market would find its own way around them.

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D) Identify and briefly explain three plausible reasons for divergences between de
facto and de jure policies. Which of these reasons appears to be best supported by
the evidence?

The first reason for the divergences between de facto and de jure policies is that, de facto
exchange rate stability is just an incidental side effect of a monetary policy strategy in
which the exchange rate is only one of the many variables that the central bank monitors
and reacts to. This is as; whatever decision of the authorities of the country that is being
made in turn will have an effect on the pricing of its goods and services, economic
wellbeing of the country and also its exchange rate. The second reason to it is that, the
central bank thinks that the economy will occasionally be affected by idiosyncratic
shocks that will require significant exchange rate adjustments. This means that the central
bank does not want the exchange rate to be tied by a previous commitment that might
make the adjustments more difficult to be carried out. The third reason to why the
divergences between the de facto and de jure policies are that a country is afraid to being
a focus of attention to speculators if they were to announce parity for the exchange rate.
They fear that the currency would have a higher probability of being attacked by
speculators through buying and selling of the domestic currency in the international
financial market and making it unstable.

The best reason out of the three to the plausible reasons for divergences between de facto
and de jure policies is the third reason where a country is afraid to announce parity on
their exchange rate in fear to the behaviour of speculators. As according to the empirical
test that is found in the article written by Genberg and Swoboda(2005), this particular
hypothesis is consistent with the findings. The test used the Reinhart–Rogoff database to
extract the countries and months that fell into the de facto fixed exchanged rate
classification. They also used the IMF de jure classifications as reported in Ghosh,Gulde
and Wolf(2002) to divide the de facto fixers and de jure fixers and de jure floaters. With
the data collected the monthly percentage change in the market exchange rate is being
calculated. From the test, the following result is found and that the de facto fix and de
jure fix category contains a higher frequency of large exchange rate changes compared to

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the de facto fix and de jure float category. Therefore, there is consistency with the
hypothesis that the reason some de facto fixers do not want to announce a fixed exchange
rate is that they fear that doing so would lead to speculative attacks resulting in
occasionally large devaluations and revaluations of their domestic currency. Thus,
making the targeted exchange rate unstable and deteriorates the economic wellbeing of a
country.

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E) For what reasons might the monetary authorities of a country have both ‘a fear
of floating’ and a reluctance to publish a fixed exchange rate target?

In the modern era, many countries claim to be running a floating exchange rate.
However, many of these countries actively limit fluctuation in the external value of their
national monies. This behaviour has been dubbed “fear of floating”, several reasons exist
for it.

Firstly, there is the ‘original sin’ problem. Many emerging economies are unable to
borrow overseas in their domestic currency. This leads to an accumulation of foreign debt
liabilities that are unhedged. If there is a sharp depreciation in these nations’ exchange
rate, the domestic currency value of their external debt will be altered and thus their
economies net worth will also change.

Secondly, policymakers in emerging markets suffer from a chronic lack of credibility.

The economies may therefore experience large and frequent shocks to exchange rate
expectations or to interest rate risk premiums. To gain confidence and credibility, the
authorities who set the interest rate will therefore accord a much higher weight to the
stabilization of the exchange rate.

A third reason for a ‘hidden peg’ is that monetary policy is often pro-cyclical. As central
banks raise interest rates to restore confidence and stem capital outflows, benefits will
result for the monetary authorities. That is, the central bank will not be indifferent to
‘surprise inflation’ which generates additional revenue from money creation and erodes
the real value of nominal government debt.

Loss of trade may result for nations with flexible exchange rates. There is a current
conception that access to global financial markets for developing countries is conditioned
on currency stability. Correspondingly, a steep drop in the nominal exchange rate will
often cause a reversal of capital flows into the country, resulting in a current account
surplus, an output contraction and a collapse in credit ratings.

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There are also political reasons behind “fear of floating”. Policymakers are very
interested in the movements of both nominal and real exchange rates. Understandably,
politicians will endeavour to keep the exchange rate stable overall given the impact that
can arise with a wildly fluctuating exchange rate.

A “fear of fixing” refers to monetary authorities avoiding an announced fixed exchange

rate target. An announced target may produce unwanted implications for countries that
maintain a pegged exchange rate. For example, speculators may test the actual
commitment that a central bank has to the target rate, in order to profit. In modern
economic times, the scale of international integration is such that at some point, the
announced target rate will be unsustainable.

Another reason is that central banks realise that the economy is open to experience
serious shocks. If a Government is committed to a fixed exchange target, there will be
political repercussions if it won’t adjust interest rates when the exchange rate becomes
overvalued and real income of the domestic economy begins to fall.

Where domestic banks are subject to moral hazard, the choice of exchange-rate regime
may have important implications for the macroeconomic stability of the economy. Central
banks which hold Government guarantees with a targeted exchange rate have an
incentive to increase foreign borrowing and incur foreign-exchange risks. In the absence
of capital controls, this increases the likelihood of over borrowing and leaves the
economy both more vulnerable to speculative attack and more exposed to the real
economic consequences of such an attack. Therefore, the monetary authorities would be
even more wary of publishing a fixed rate.

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F) “A currency crisis can be defines as a speculative attack on a country’s currency
that can result in a forced devaluation and possible debt default” (Chiodo and
Owyang). Briefly identify the main factors which contributed to the Russian crisis of
1998. To what extent do economic models of financial crises contribute to our
understanding of these factors?

In August 1998, the Russian economy experienced a default on its national currency. A
currency crisis is defined as a speculative attack on country 1’s currency as investors seek
to protect their portfolio by buying other nations’ currency with the currency of country
1.

There are three generational forms of economic models that present specific factors that
will trigger a currency crisis. The factors are:
(i) An exchange rate peg and a central bank willing to defend it with foreign
exchange reserves.
(ii) Rising fiscal deficits beyond the reach of Government.
(iii) Central bank control of the interest rate in an imperfect credit market.
(iv) Expectations of a devaluation and/or rising inflation.

Russia’s high government debt and falling national output left it vulnerable to a
speculative attack in 1998. Interest payments on foreign debt were a large percentage of
the federal budget. Additionally the global prices of oil and non-ferrous metals, Russia’s
main export earners, began to drop. Taxation revenues were also corroded by lower
output and through corruption at the regional collection points. Thus, the current account
deficit continued to spiral, contributing much to the coming speculative attack. Under
Krugman’s first generation model, Russia’s only choice under an exchange rate peg was
to exhaust its foreign reserves to finance the deficit, resulting in currency default.

The crisis became unavoidable as investors’ confidence was lowered when monetary
authorities increased the yield on Government bonds to 150 %. From the increased

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lending rates, potential investors had genuine fears in the Russian government devaluing
the currency rate and defaulting on bond repayments. Additionally, the increase did not
result in higher levels of lending capital as hoped.

The third generation model, which postulates that where lending is sensitive to interest
rates, an increase in the nominal rate can be detrimental by lowering domestic
productivity and greatly reducing investment. The model suggests that the correct
procedure is to lower interest rates in order to invigorate investment and output in the
domestic economy.
.
The analysis of contagious crisis in the second generation model matches events that
unfolded in Russia following the Asian economic meltdown in 1997. Many economic
agents were worried that the Russian economy would also collapse like its near
neighbours in the Asian East. The anxiety over a Russian devaluation intensified as the
Russian political signals by Prime Minister Kiriyenko indicated an imminent devaluation.

Chiodo and Owyang write: “Each of these components acted to push the Russian
economy from a stable equilibrium to one vulnerable to a speculative attack.”1

The Central Bank of Russia (CBR) defended the Russian ruble during a speculative
attack in 1997, losing $6 billion in foreign exchange. However, the same monetary policy
wasn’t successful in 1998 when Russia’s financial reserves were exhausted, leading to an
unavoidable devaluation on August 17, 1998. This outcome is contained in the first
generation model on currency crises, which states that a pegged exchange can be
vulnerable under sustained speculative attack.

The Russian default of 1998 was characterised by specific aspects that can be explained if
we are to incorporate all three generation models of currency crisis.

1
Chiodo, Abbigail J and Owyang, Michael T, “A Case Study of a Currency Crisis: The Russian Default of
1998”, The Federal Reserve Bank of St. Louis Review, November/December 2002 pp 7-17

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In any case, there is no one prescription to cure a currency crisis, but the Russian
experience provides an opportunity to re-examine monetary responses in the face of a
financial collapse.

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