Macroeconomic Policy under Floating Exchange Rate

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Introduction

A floating exchange rate is “an exchange rate regime whereby a currency’s value is allowed to fluctuate according to the performance of the foreign exchange markets”. This means that the exchange rate is flexible and can change from time to time in response to the dynamics of the foreign exchange markets.

The floating exchange rate has been adopted by several countries since it helps them to dampen the effects of shocks and predict the possibility of having a balance of payment crisis. Besides, it adjusts itself to the changes in the market.

Despite these benefits, the floating exchange rate has in several cases failed to ensure stability in the financial markets and to promote economic growth. Consequently, proposals have been formulated in response to its weaknesses. This paper analyzes such proposals in terms of their merits and demerits.

Limitations of the Floating Exchange Rate Regime

The floating exchange rate regime has failed to ensure stability in financial markets and stimulate economic growth due to the following reasons. First, a flexible exchange rate limits a country’s autonomy over its national macroeconomic policies.

This is attributed to the high international capital mobility associated with the world economy. According to the Mundell-Fleming model, a floating exchange rate limits the extent to which fiscal policies can be implemented in a country thus lowering economic growth.

Second, liberation of monetary policy at domestic level is often illusionary under a floating exchange rate. This is attributed to the open nature of financial markets and the fact that central banks are usually attached to monetarist targets.

Thus under floating exchange rate, “the monetary policy becomes exchange rate policy”. This means that the ability of an expansionary monetary policy to stimulate domestic demand is determined by the exchange rate depreciation and the resultant impact on trade balance.

It is also difficult to depend on monetary policy at international level when using floating exchange rate. In most cases, an expansionary monetary policy in one country leads to a deflationary shock in another country especially if the aggregate demand is strategically composed of export-import balances.

Third, the use of floating exchange rate leads to uncoordinated macroeconomic policies. “Shocks from foreign exchange markets are usually transmitted to domestic markets”. Consequently, each government develops its own defense mechanism in response to the shocks and this complicates the process of coordinating macroeconomic policies. Lack of coordination is likely to cause more volatility in the economy especially in the employment sector.

Fourth, the floating exchange rate regime is likely to worsen speculation and volatility associated with foreign exchange markets. Investors normally sell their stock of a given currency if they expect its value to depreciate in order to make profits.

Speculation normally results into high exchange rate fluctuations in the long run as investors respond to changing economic trends. High fluctuations in exchange rate is likely to cause great instability in the foreign exchange markets as investors lose their confidence in the market. Besides, investors who are not able to sell their stock of currencies may incur huge losses as the currencies depreciate.

Reform Proposals

Due the above limitations, several reforms have been proposed to help in ensuring stability in the foreign exchange markets. Even though the proposals are expected to address the weaknesses of the floating exchange rate regime, they are also associated with limitations and this can be explained as follows.

Target Zones

This is an exchange rate system whereby “wide margins are devised around adjustable sets of exchange rates and are meant to be consistent with a sustainable pattern of balance of payment”. Under this system, the authorities are under no obligation to formally make commitments to intervene so that the actual exchange rate is maintained within the zone.

However, they are allowed to intervene and suggest the optimal level of exchange rate. The target zone system differs from managed exchange rate since it targets a specific area and has a greater influence on monetary policy. The system is characterized by both ‘loud zones and quiet zones’.

Public announcement concerning the exchange rates are made in the loud zones. However, confidential information is only revealed in the quiet zones. This is meant to facilitate joint intervention and surveillance on exchange rate.

The Merits of Target Zone System

First, it promotes effective supervision of the activities of member countries. If a country breaches the rules of the zone either through inappropriate fiscal or monetary policies, it will be subjected to multi-lateral reviews by its peers.

Such a country will then be put under pressure by its peers to adjust its policies accordingly to enhance coordination. Second, even if the target zone is changed instead of the fiscal policies, the “domestic political costs accruing from regular adjustment of the exchange rate will impart its own discipline”.

Finally, the target zone system aims at providing an anchor for expectations on exchange rates in order to minimize volatility and misalignment. The anchor is attributed to estimated exchange rates as announced by the authorities and the expected course of the monetary policy among the member countries in future.

Demerits

First, for the target zone to be effective, it must be “wide enough to reflect the uncertainty concerning equilibrium central rate”. It should also be wide enough to cushion the member countries against transitory disturbances that can not change long-term rate.

Besides, it should provide better protection against speculative bets. Thus the target zone will not be able to achieve its objective if it is narrow. Second, the effectiveness of the target zone is determined by the frequency with which it is revised.

While frequent revision of the zone is good for stabilizing the economy, it might reduce the credibility of the zone. Finally, the zone will achieve its goals only if the authorities are committed to implementing polices that will help them realize their exchange rate forecasts. This means that the zone is likely to fail if the authorities are not committed or are not able to effectively implement the policies that will help in achieving equilibrium exchange rate.

Stronger Institutional Coordination of Economic Policies

International coordination refers to “a significant modification of national policies in recognition of international economic interdependence”. Coordination is necessitated by the fact that, economic policy measures taken by one country usually generate externalities for other countries.

Besides, such externalities must be taken into consideration in order to achieve economic stability at the international level. Thus coordination offers a framework for internalizing the externalities. The success of the coordination process is assessed by several indicators which include the following.

It can be assed based on growth in domestic demand, changes in GNP and the level of inflation. Other indicators used to assess the coordination process include monetary conditions as well as balance of trade.

The coordination process should be implemented as “a regular, ongoing process” for it to be effective in achieving its objectives. This is attributed to the following reasons. First, the possibility of multi-period bargaining increases the chances of completing policy bargaining.

This means that the countries involved in the coordination process have ample time to bargain on the consequences or the expected benefits of the policies to be implemented if the coordination is done on a continuous basis.

Besides, it gives them an opportunity to adjust their policies accordingly in response to emerging challenges. This would not be possible if the coordination exercise is done through periodic episodes. Second, it enables countries to take advantage of the recurring bargaining strengths and considerations on reputation during coordination.

As countries coordinate their policies over time, they tend to realize their strengths and weaknesses. Thus they are able to take advantage of their strengths to enhance stability while reducing their weaknesses.

Besides, the countries with a reputation of cooperation during the coordination exercise can be rewarded through special considerations. Finally, implementing coordination as an ongoing process enables the participants to have more freedom to maneuver on policies than when negations are done only during crisis situations.

Merits of Coordination

Coordination of economic policies is associated with the following benefits. First, misalignment and excessive volatility is usually caused by inappropriate policies and inefficiencies in the market. Consistent coordination over time helps to deal with the above mentioned causes of volatility and misalignment and this has been achieved as follows.

First, coordination specifies the commitments expected of each and every participant. Second, coordination ensures better cooperation in implementing intervention policies in exchange markets. Besides, it enables the participants to have a fair view on the actual exchange rate patterns.

Second, a wide-ranging multi-issue coordination method is likely to enhance the chances of concluding bargains that are beneficial to all parties. The coordination process leads to the generation of favorable spillover effects which benefits all the countries involved in the coordination and negotiation process.

Demerits of Economic Policy Coordination

Despite its benefits, achieving effective economic coordination has proved to be difficult. The difficulties in achieving economic coordination are attributed to the following factors. First, international policy bargains characterized by objectives that are common among participating countries can be frustrated in the event that the policy instruments are considered as objectives in themselves.

For example, in 1980s President Reagan of US was committed to increasing expenditure on defense while reducing taxes. Under such circumstances, it would have been very difficult to realize “target zones for exchange rates”.

Second, the implementation of the coordination process is likely to be derailed as countries disagree on the impacts of policy changes on the goals of the policies. Agreeing on jointly developed policies has always been difficult since participants in the coordination process interpret the functioning of the global economy in different ways. There has never been a universal view of how the global economy functions.

Finally, most countries usually compromise on their growth and inflation targets due to their domestic financial or economic crisis. Consequently, their ability to compromise further on demand measures during coordination remains limited. T

he global inflation rate is likely to increase if deliberate attempts are made to stabilize a given pattern of exchange rate. It is for this reason that the US Treasury Secretary and UK Chancellor made proposals in 1987 for the introduction of “commodity-price-basket indicator as an early warning signal of emerging aggregate price developments”.

Taxes

Critics of the floating exchange rate system have proposed the introduction of “internationally uniform tax on all spot conversions of one currency into another”. The tax that is expected to correspond to the size of transactions is meant to prevent “shot –term financial round-trip excursions into another currency”.

Each government will be responsible for implementing the tax under its jurisdictional area. The tax revenue can be deposited in international financial institutions such as World Bank or IME. All financial instruments purchased in foreign currencies will be subject to taxation.

Merits

First, the international tax will help in reducing fluctuations in exchange rates. It aims at limiting the margins over which the exchange rates can fluctuate. Second, the international tax system will enable governments to have more autonomy to pursue their domestic macroeconomic polices.

Demerit

The main problem associated with the international tax system is the difficulties related to its administration and enforcement. Due to inefficiencies or lack of political commitment, some governments might fail to implement the tax system thus leading to its failure. Besides, dishonest traders can take advantage of the weaknesses of the tax laws to evade taxes.

Conclusion

Floating exchange rate refers to an exchange rate regime whereby the appreciation or depreciation of a given currency is determined by the dynamics of the exchange market. Even though it helps countries that use it to dampen the effects of shocks, it has been criticized due its limitations as discussed above.

Consequently, various reform proposals have been developed to stabilize the foreign exchange market. The proposals include introduction of an international tax system, stronger coordination of economic policies and adopting target zone systems.

Works Cited

Blanchard, Oliver. Macroeconomics. Pearson Prentice Hall: New York, 2008.

Frenkel, Jacob and Morris Golstern. Excgange Rate Volatility and Misalignment: Evaluating some Proposals for Reform. New York: International Monetary Fund, 2004.

Tobin, James. “A proposal for monetary reform.” Eastern Economic Journal, 29(4) (2003): 519-526.

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