Question

The mobility of international capital flows is causing emerging market nations to choose between a

free-floating currency exchange regime and a currency board (or taken to the limit, dollarization).

Describe how each of the regimeswould work and identify at least two likely economic results for each regime.

Answer 1

A free floating exchange rate, sometimes referred to as clean or pure float, is a flexible exchange rate system solely determined by market forces of demand and supply of foreign and domestic currency, and where government intervention is totally inexistent. Clean floats are a result of  free market economics.

Free floating exchange rate is, theoretically, the best way to go. It allows countries to retain their monetary independence, which basically means they can focus on the internal aspects of their economy, an control inflation and unemployment without worrying about external aspects. However, we must take into consideration external shocks, such as oil price rises or capital flights, which can make it impossible to maintain a purely clean floating exchange rate system.

Advantages:

Independence: Freely floating exchange rates allow the governments and central banks of a nation to have a great degree of independence. As they do not have their currencies pegged to the dollar as a result it has a far greater degree of independence.

Low Requirement of Reserves: A freely floating exchange system does not require the central bank to hold massive reserves. This is because the Central Bank does not have to conduct active trading operations in order to maintain the value of the currency.

Currency board : The management of the exchange rate and money supply are given to a monetary authority that makes decisions about the valuation of a nation's currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of which is held in reserves. Often, this monetary authority has express instructions to back all units of domestic currency in circulation with foreign currency. In this way, a currency board operates not unlike the gold standard. Unlike a central bank, however, a currency board is not the lender of last resort, nor is it what some call 'the government's bank.

(1) Domestic currency expands only when foreign exchange reserves rise. Thus, there is no way that the monetary authority can use money financing to support government spending.

(2) A currency board system is a solution to the problem of lack of transparency and commitment. A currency board involves a strong commitment to the fixed exchange rate regime and can be effective in bringing down inflation quickly and in decreasing the likelihood of a successful speculative attack against the currency.