Trilemma of the exchange rate regime

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The trilemma of the exchange rate regime describes one of the trade- offs to which a state is exposed in its exchange rate policy decisions. The Impossible Trinity model was developed by John Marcus Fleming in 1962 and Robert Alexander Mundell in 1963 independently of one another. The model can be summarized in simplified form as a triangle, whereby the corner points of the triangle represent the three exchange rate policy goals of exchange rate stability, monetary policy autonomy and free movement of capital. In the trilemma, a maximum of two goals can be achieved at the same time. Achieving all three goals at the same time is considered impossible.

"Trilemma of the exchange rate regime" (based on Krugman, Internationale Wirtschaft, 2009)

Mundell-Fleming model

The Mundell-Fleming model is an extension of the IS-LM model . The IS-LM model relates to the goods and money market and applies to closed economies. In addition to the money and goods market, the Mundell-Fleming model also considers the foreign exchange market (international capital movements) and applies to open economies. Since only two goals can be achieved, according to the trilemma of the target triangle, this means for open economies:

  1. The decision in favor of free capital movements and monetary policy autonomy leads to a flexible exchange rate regime (e.g. USA, EU)
  2. The decision in favor of fixed exchange rates and preservation of monetary policy autonomy leads to restrictions on the movement of capital (e.g. China)
  3. The decision in favor of fixed exchange rates with free movement of capital leads to a waiver of monetary policy autonomy (e.g. Hong Kong)

Exchange rate stability

Exchange rate stability is understood to mean supporting or fixing an exchange rate. In order to stabilize the exchange rate, the central bank or the government intervenes in the exchange rate through interest rate policy measures and interventions in the foreign exchange market, the effect on the national money supply being greatest with interventions by the central bank. The choice of the exchange rate regime depends on the development of a country. Some of today's industrialized countries have a controlled fluctuating exchange rate, which is a mixed system between fixed and flexible exchange rates. Other countries, especially developing countries, are pegged to another currency (mostly dollars) with their currency.

To stabilize the exchange rate, a country can unilaterally peg its currency to another currency or to a basket of other currencies (Vis-à-Vis a single currency or Vis-à-Vis a basket). If the exchange rate deviates by more than one percent, the central bank has to intervene. The country will then no longer pursue its own monetary policy, but will make the same monetary policy decisions as the central bank of the anchor currency country. This means that advantages of the stable currency can also be used for your own currency. In the case of fixed exchange rates, the central bank is obliged to intervene in the foreign exchange market in order to stabilize the exchange rate. However, this has a direct impact on the money supply. A trade-off between exchange rate stability and price level stability can arise here. With fixed exchange rates, in contrast to flexible exchange rates, an independent and thus effective monetary policy of the central bank is not possible. This will be explained using an example, assuming free capital movements (no restrictions on capital movements): The central bank increases the domestic money supply. This leads to a decrease in the domestic interest rate. If the domestic interest rate is lower than abroad, investors will want to invest their capital abroad. The capital then flows out of Germany (capital export). The excess demand for foreign capital investments (foreign exchange) would result in a devaluation of the domestic currency. The central bank now has to intervene in the foreign exchange market to counter the devaluation pressure and keep the exchange rate stable. Therefore, she is now buying domestic currency in exchange for selling foreign currency. The devaluation pressure is counteracted, but by buying domestic currency it pulls in a certain amount of money again. The central bank can thus neutralize the increase in the money supply through open market operations. The imbalance on the foreign exchange market remains, however, because the central bank now holds less foreign currency (currency reserves). The foreign exchange losses correspond to the increase in the domestic money supply. If the central bank wants to prevent capital from flowing out, this would have to be done through restrictions on capital movements.

There are a number of possible exchange rate regimes .

Hard pegs:

  • Formal dollarization, currency board, monetary union

Floating regimes:

  • Free Exchange Rates, Administered Exchange Rates

Soft pegs:

  • Conventional fixed pegs, crawling pegs (moving parity), crawling bands (moving bands), tightly managed floats

Hard pegs regimes (fixed exchange rates)

Formal dollarization

We speak of official dollarization when a country uses another currency (US dollar) and this is also legal tender. In formal dollarization, the domestic currency is replaced by the US dollar. In many developing countries dollarization actually took place, but only a few countries also formally changed their currency to dollars. These include Panama (1904), Ecuador (2000) and El Salvador (2001). With the adoption of the US dollar as a means of payment, the countries also adopt the monetary policy of the US Federal Reserve (US Fed).

Advantages:

  • Exclusion of currency risk
  • Elimination of the exchange rate risk premium
  • Lower domestic interest rates
  • Lower debt servicing costs for government and businesses
  • Eliminate the currency imbalance
  • Reduce dependence on foreign funding
  • Availability of long-term domestic funding for investments increases
  • Partial decline in monetary inflation
  • Credibility in the irrevocability of the decision

Disadvantage:

  • Country risk remains
  • The decline in domestic interest rates does not decrease to the US level
  • Loss of Monetary Profits - Seignorage
  • No independent monetary policy (can have negative consequences in the event of an exogenous shock)
  • The central bank loses its role as the “ lender of last resort ” and can no longer supply liquidity in the event of a crisis

Currency boards

The currency board is an independent financial institution and defends a statutory exchange rate. The entire money supply is covered exclusively by currency reserves. This circumstance is intended to protect against speculation and is therefore recommended for implementation in developing countries on a case-by-case basis, especially for overcoming financial crises. The currency board has its origins in earlier European colonial areas. The first was introduced by a British crown colony in Hong Kong. In addition to Hong Kong, Lithuania, Estonia and Bosnia have also installed the currency board and pegged their currencies to the euro. The prerequisite for a functioning currency board is that both countries develop approximately equally economically.

Advantages:

  • No risk of devaluation
  • Possible decline in inflation
  • Better access to the international capital market and better conditions
  • Greater attractiveness for direct investment
  • High currency reserves protect against speculative attacks

Disadvantage:

  • Renouncing autonomous monetary policy
  • Monetary policy cannot counteract exogenous disturbances
  • Greater flexibility in national goods and factor markets is necessary
  • Currency risk cannot be completely eliminated

Monetary union

A monetary union is a single currency area. It can be created either with fixed exchange rates or by introducing a common currency with a central bank. An example of a currency union with fixed exchange rates was the Scandinavian Coin Union of Denmark, Norway and Sweden in the period from 1872 to 1924. The European Union (EU) is an example of a common currency with a central bank . The euro was introduced as the common currency in 11 countries on January 1, 1999. For the creation of the monetary union, the acceding countries should have the same macroeconomic development. The common direction of financial policy is a major problem.

Advantages:

  • price stabilizing effect
  • Growth effects in foreign trade
  • No to lower transaction costs
  • No more exchange rate risks
  • higher protection against the risk of currency crises

Disadvantage:

  • Waiver of monetary policy autonomy
  • common focus on stability-oriented goals, such as Price level stability or full employment can prove difficult
  • Countries should develop in the same way economically (is considered a condition for entry and a success factor)
  • after joining, the incentive to act in line with stability disappears
  • Monetary union without economic union inefficient and not optimal

Floating Regimes (flexible exchange rates)

With the completely flexible (free) exchange rate, the rate is formed exclusively by supply and demand on the foreign exchange market and state intervention is dispensed with. They are also called floating exchange rates. Since the collapse of the Bretton Woods monetary system, there has been a flexible exchange rate between the US dollar, Japanese yen and the euro.

Administered exchange rates are flexible exchange rates that are only flexible to a limited extent due to certain bandwidths. Once a certain intervention point has been reached, the central bank intervenes to keep the exchange rate within the range. This is also called "controlled floating". Examples of countries with administered exchange rates are Canada, Japan, and many developing countries.

International monetary systems

The gold standard was used between 1717 and 1933 and was historically the most important basis for the formation of fixed exchange rates. The value ratio of gold to currency determined each country for itself. Queen Victoria of England fixed around 1/4 ounce of gold for one British pound. William McKinley , US President from 1897 to 1901, specified 1/20 ounce of gold for one US dollar . The exchange rate of the British pound was therefore 5 to 1 (US $ 5 to £ 1). With the gold standard, the currencies are determined by the gold content. David Hume demonstrated in 1752 that gold starts an automatic adjustment mechanism and restores the balance in the balance of payments. Maintaining the mechanism does not require tariffs or other government intervention.

After the Second World War, institutional institutions helped rebuild the world economy. The most important are the International Monetary Fund ( IMF ), the World Bank and the Bretton Woods System . The IMF is still regarded as the "central bank of the central banks". Its tasks are to monitor the international monetary system and the financial and economic policies of its members. The IMF also supports developing and emerging countries in economic matters and helps restore a country's macroeconomic stability by granting loans against conditions.

The World Bank is provided with capital by lending countries. The five largest shareholders are France, Germany, Japan, the United Kingdom and the United States. The World Bank grants low-interest loans and thereby supports the development of countries in areas such as education, health, infrastructure and public administration, agriculture and environmental and resource management.

The Bretton Woods system, based on the gold foreign exchange standard, was developed to replace the gold standard. Some economists (particularly John Maynard Keynes ) thought the gold standard was too inflexible and believed it would worsen and lengthen business cycles . An exchange rate has been set for every currency, including US dollars and gold. In the 1970s the system was changed so that the exchange rates could be changed within a certain range. But this could no longer prevent the collapse of the system. US President Richard Nixon announced on August 15, 1971, without prior consultation with other governments, the abolition of dollar convertibility into gold (for details see Nixon shock ); this was the "beginning of the end" of the Bretton Woods system. There are two reasons for its end:

  1. The US dollar was the national currency and international means of payment. The politics of the USA thus influenced the inflation rates of all other countries. The high current account deficit in the USA (caused by the Vietnam War ) led, among other things, to global inflation. The countries were no longer willing to finance the US current account deficits with their current account surpluses.
  2. The exchange rates were adjusted hesitantly. The credibility of the system was lost and led to destabilizing speculation.

There is hardly any commitment to a fixed exchange rate today. Some countries are officially or unofficially pegged to another currency or to a basket, but this is weakened by fixed ranges within which the currency can fluctuate.

Free movement of capital

The free movement of capital is understood to mean the cross-border movement of capital. Between the two world wars, protectionism determined international trade. With protectionism, countries restrict foreign trade in order to stimulate domestic demand for domestic goods and to dampen or even prevent the demand for foreign goods. Foreign trade can be influenced in the following ways:

  • Influencing the price of goods (e.g. tariffs, subsidies)
  • Direct volume regulations (e.g. import quotas or quotas, total import bans, foreign exchange control)
  • Other non-tariff trade barriers (measures that complicate the technical or legal processing of commercial transactions)

The protectionist measures led to a reduction of the world trade volume by 67% between 1929 and 1933. The reason for this was the tariff decree "Smoot-Hawley" by the USA, which provoked protectionist counter-reactions from the other countries. After the Second World War, the International Monetary Fund, the World Bank and the General Agreement on Tariffs and Trade ( GATT ) were established to help the world economy rebuild. GATT was incorporated into the establishment of the World Trade Organization (WTO - World Trade Organization ) on January 1, 1995. The aim of the WTO is the liberalization of world trade. The WTO is also an arbitration body for trade disputes.

Liberalization also refers to the abolition of capital controls . They represent situation-dependent measures that are intended to stabilize one's own currency and the financial markets, safeguard monetary policy autonomy and prevent capital outflows. Capital controls can limit the exchangeability of currencies (convertibility) and prevent capital inflow from abroad or capital outflow abroad.

In theory, the benefits of liberalized financial flows are:

  • Efficient resource allocation
  • Improving opportunities for risk diversification
  • Development of the financial sector (growth effect)

Empirical studies show that the liberalization of financial flows through the abolition of capital controls depends crucially on a country's economic policy objectives. The influence on the central bank also seems to play a role. In the case of independent central banks, the openness of the financial markets appears to be generally greater.

The liberalization of the industrialized countries is promoted by the “Code of Liberalization of Capital Movement” and is published every two years by the OECD. It contains binding rules, the implementation of which is monitored by means of country reviews and reports. In developing countries, the liberalization of financial flows turns out to be difficult, as instability and sometimes crises have occurred in some countries in the past. The growth effect also seems to depend on a country's level of development.

Currency crises

Due to the large increase in the free movement of capital, there have been dangerous crises in the past, especially in the emerging countries. The signs were mostly:

  • Systematic overvaluation of the currency
  • Relatively low currency reserves (foreign currency)
  • Large current account deficits, often with large increases in borrowing abroad
  • Higher inflation rates compared to industrialized countries

The currency crises and their causes can be divided into three generations. First generation currency crises mostly arose in countries with fixed exchange rate systems, because the exchange rate was not adjusted or adjusted too late despite the deterioration in macroeconomic conditions. The reasons for second generation currency crises were speculative attacks on currencies and a lack of confidence in the credibility of politics. The third generation currency crises are the most recent and quickly spread to other countries. They mostly arose due to microeconomic deficits, such as excessive debt and weaknesses in the financial system. Possible causes are the increasing use of electronic media, the high willingness to take risks and a changed behavior of the fund managers.

Mexico crisis of 1994/1995

The oil price shocks in 1973/74 and 1979/80 led to high current account deficits in non-oil exporting countries. Argentina, Brazil and Mexico in particular all borrowed heavily. Most of the loans came from foreign commercial banks. Poland became insolvent in 1980 and Mexico in 1982. The Latin American debt crisis endangered the international financial system. The Bank for International Settlements (BIS) and the IMF were able to reduce the risk to the international banking system through stabilization programs, short-term bridging loans and debt rescheduling negotiations. By 1987, the debtor countries were able to reduce 1/6 of their current account deficit, but only with a weakening of the economy, which led to a loss in standard of living. The eighties are therefore also called the “lost decade” in Latin America. A number of reforms were initiated in Mexico in 1989:

  • 1989 Deregulation of the economy, privatization, tariff reductions
  • 1994 Joined NAFTA (North American Free Trade Agreement) when it was founded
  • 1991 Introduction of a broad exchange rate band and pursuit of an exchange rate-oriented stabilization strategy

In 1993 the peso was almost stable against the US dollar. In addition to the reforms, this led to an upturn among investors, which triggered a credit and equity boom. Although the inflation rate remained in the single digits, there was no significant economic growth. In particular, the savings rate in the private sector fell. An uproar and the assassination of the ruling party's presidential candidate early in 1994 cast doubt on the political stability of Mexico. Capital flight, devaluation of the peso and rise in interest rates for financial assets were the result. As a result, maturing national debt was replaced by "Tesobonos" (securities indexed in US dollars). In October 1994 currency reserves fell rapidly. As a result of the neutralization policy, the domestic money supply increased and was even expanded. In December 1994 the range of the peso was expanded. The exchange rate was released two days later, resulting in the peso's extensive devaluation against the dollar over the next two years. The main causes of the Mexico crisis were:

  • the overvaluation of the peso
  • the weaknesses in the implementation of privatization and deregulation
  • the shared responsibility of international investors

The IMF provided Mexico with a loan of US $ 17.8 billion. This enabled Mexico to serve the Tesobonos and avert the payment crisis. The consequences were a very high real devaluation and a very severe economic crisis. In 1996 Mexico found itself in economic growth again.

literature

  • Wesley W. Widmaier: The Social Construction of the "Impossible Trinity": The Intersubjective Bases of Monetary Cooperation . In: International Studies Quarterly , Volume 48 No. 2, June 2004, pp. 433-453.
  • Robert Mundell : Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates . In: The Canadian Journal of Economics and Political Science / Revue canadienne d'Economique et de Science politique , Volume 29 No. 4, November 1963, pp. 475-485.
  • Marcus Fleming : Domestic financial policies under fixed and floating exchange rates . IMF Staff Papers 9, 1962, pp. 369-379.

Individual evidence

  1. ↑ Samuelson, Paul Anthony et al. a .: Economics. The international standard work of macro and microeconomics, 3rd, updated edition, Landsberg am Lech, 2007, p. 860
  2. ↑ a b c d Heiduk, Günter S .: Foreign trade. Theory, empiricism and politics of the interdependent world economy, Heidelberg 2005, pp. 259 and 298
  3. ^ Rübel, Gerhard: Fundamentals of monetary foreign trade, Munich 2002, p. 131
  4. ↑ Deutsche Bundesbank: "Money and Monetary Policy", International Currency Relations, August 2009 p. 170 ( Memento of the original from September 23, 2010 in the Internet Archive ) Info: The archive link was inserted automatically and has not yet been checked. Please check the original and archive link according to the instructions and then remove this notice. (PDF) @1@ 2Template: Webachiv / IABot / www.bundesbank.de
  5. ↑ Jayant Menon, "Dealing with Dollarization: What Options for the Transitional Economies of Southeast Asia?", ADB Institute Discussion Paper No. 63, March 2007 pp. 1–2 (PDF; 138 kB)
  6. ↑ a b Deutsche Bank Research: "Dollarization - Sensible Policy or Highly Risky Strategy for Emerging Markets?", February 8, 2001, pp. 12–13 (PDF; 66 kB)
  7. ^ Paul R .; Obstfeld, Maurice: International Economy. Theory and Politics of Foreign Trade, 2009, p. 852
  8. ↑ Jayant Menon, "Dealing with Dollarization: What Options for the Transitional Economies of Southeast Asia?", ADB Institute Discussion Paper No. 63, March 2007 p. 3 (PDF; 138 kB)
  9. ^ Rübel, Gerhard: Fundamentals of monetary foreign trade, Munich 2002, p. 133
  10. ↑ a b Rübel, Gerhard: Fundamentals of monetary foreign trade, Munich 2002, pp. 132-134
  11. ^ Paul R .; Obstfeld, Maurice: International Economy. Theory and Politics of Foreign Trade, 2009, p. 845
  12. ↑ Deutsche Bank Research: "Dollarization - Sensible Policy or Highly Risky Strategy for Emerging Markets?", February 8, 2001, p. 12 (PDF; 66 kB)
  13. ↑ European Journalism Center (EJC): "Dossier: The Economic and Monetary Union and the Euro" ( Memento of the original dated May 16, 2010 in the Internet Archive ) Info: The archive link was automatically inserted and not yet checked. Please check the original and archive link according to the instructions and then remove this notice. (accessed December 6, 2010) @1@ 2Template: Webachiv / IABot / www.eu4journalists.eu
  14. ↑ a b c Cologne Institute for Economic Research: "European Monetary Union - The advantages outweigh" ( Memento of the original from July 13, 2011 in the Internet Archive ) Info: The archive link was automatically inserted and not yet checked. Please check the original and archive link according to the instructions and then remove this notice. (accessed December 6, 2010) @1@ 2Template: Webachiv / IABot / www.iwkoeln.de
  15. ↑ Hamburg Yearbook for Economic and Social Policy: 38th year, Renate Ohr: Integration in a non-optimal currency area, 1993, pp. 37–38
  16. ↑ Samuelson, Paul Anthony et al. a .: Economics. The international standard work of macro and microeconomics, 3rd, updated edition, Landsberg am Lech, 2007, p. 859
  17. ↑ a b Samuelson, Paul Anthony u. a .: Economics. The international standard work of macro and microeconomics, 3rd, updated edition, Landsberg am Lech, 2007, p. 860
  18. ^ Paul Anthony Samuelson et al. a .: Economics. The international standard work of macro and microeconomics, 3rd, updated edition (based on the first edition from 1948), mi-Fachverlag 2007, pp. 552–853
  19. ↑ a b c Samuelson, Paul Anthony u. a .: Economics. The international standard work of macro and microeconomics, 3rd, updated edition, Landsberg am Lech, 2007, pp. 855–856
  20. ^ Homepage of the International Monetary Fund: "About the IMF - Overview" (accessed on December 2, 2010)
  21. ^ Homepage of the World Bank: "Organization" (accessed on December 2, 2010)
  22. ^ Homepage of the World Bank: "About us" (accessed on December 2, 2010)
  23. ^ Jürgen Pätzold: "Bretton Woods System" (accessed on December 2, 2010)
  24. ↑ Dieckheuer, Gustav: International Economic Relations, 5th edition, 2010, p. 16
  25. ↑ US Department of Government State: "Smoot-Hawley Tariff" ( Memento of the original from March 12, 2009 in the Internet Archive ) Info: The archive link was inserted automatically and has not yet been checked. Please check the original and archive link according to the instructions and then remove this notice. (accessed on December 2, 2010) @1@ 2Template: Webachiv / IABot / future.state.gov
  26. ^ Heiduk, Günter S .: Foreign trade. Theory, empiricism and politics of the interdependent world economy, Heidelberg 2005, p. 277
  27. ^ Heiduk, Günter S .: Foreign trade. Theory, empiricism and politics of the interdependent world economy, Heidelberg 2005, p. 293
  28. ^ Heiduk, Günter S .: Foreign trade. Theory, empiricism and politics of the interdependent world economy, Heidelberg 2005, pp. 296–298
  29. ↑ a b Rübel, Gerhard: Fundamentals of monetary foreign trade, Munich 2002, p. 298
  30. ↑ Jarchow, Hans-Joachim ; Rühmann, Peter: Monetäre Außenwirtschaft, 5th ed., 2000, pp. 251-252
  31. ↑ Jarchow, Hans-Joachim; Rühmann, Peter: Monetäre Außenwirtschaft, 5th edition, 2000, pp. 255–256
  32. ↑ Jarchow, Hans-Joachim; Rühmann, Peter: Monetäre Außenwirtschaft, 5th edition, 2000, p. 257
  33. ↑ Jarchow, Hans-Joachim; Rühmann, Peter: Monetäre Außenwirtschaft, 5th ed., 2000, pp. 260–261
  34. ↑ Jarchow, Hans-Joachim; Rühmann, Peter: Monetäre Außenwirtschaft, 5th ed., 2000, pp. 261–262
  35. ↑ Jarchow, Hans-Joachim; Rühmann, Peter: Monetäre Außenwirtschaft, 5th edition, 2000, pp. 262–263
  36. ↑ International Monetary Fund: "IMF Approves US $ 17.8 Billion Stand-By Credit for Mexico", Press Release No. 95/10 (February 1, 1995, accessed December 3, 2010)
  37. ↑ Jarchow, Hans-Joachim; Rühmann, Peter: Monetäre Außenwirtschaft, 5th edition, 2000, p. 264