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This chapter extends the analysis of the previous chapter to an open economy by introducing exchange rate policy; analyzing the complex relationships between exchange rate, fiscal, and monetary policies; and examining the ways in which capital flows complicate traditional analyses. Despite the greater complexities associated with open economy macroeconomics, the policy conclusions for a closed economy remain remarkably unaffected. While Keynesians and heterodox economists believe that government should actively intervene, conservatives remain skeptical about the desirability of such interventions. The objective of this chapter is to shed some light on how economists can come to such diverse views on economic policy. The first section examines the macroeconomic effects of exchange rates on employment, trade, inflation, aggregate demand, growth, and balance sheets. The second section examines the complex interactions between fiscal, monetary, and exchange rate policies in open economies with either fixed or flexible exchange rate regimes. This section also examines the effects of interest rates and exchange rates on capital flows in both crisis and non-crisis situations.

This chapter discusses the basic analytical framework of “first-generation” models of currency crises and their extensions to deal with important features of balance-of-payments crises such as alternative post-collapse regimes, capital control and borrowing constraints, interest rate defence policies, the interaction between bank solvency and currency stability, uncertainty about government policies, real effects of crises. The key implication of this approach is that a fixed exchange rate regime cannot survive the long-run inconsistency between monetary, fiscal, and exchange rate policies. Unnecessary domestic money growth leads to a persistent loss of reserves and ultimately to a speculative attack against the home currency that forces the government to switch out of the peg once reserves approach a minimum level. It also predicts that the attack will take place at the point where the shadow exchange rate (i.e., the rate that would prevail if the government diverted into a floating rate) equals the fixed peg.

The major Asian sovereign wealth funds are the only funds in the world not based on commodity revenues. China and Singapore created their sovereign wealth funds from accumulated budgetary and trade surpluses. China and Singapore also manage their funds differently taking a more statist view of economic matters targeting specialized industries. Conversely, Chinese and Singaporean investment in both local and foreign firms are focused on controlling stakes in targeted industries. They have taken significant stakes in domestic companies urging them to expand internationally and protecting them from foreign take overs. China has targeted financial services, natural resource, and high technology industries which it views as vital to sustaining and increasing Chinese growth. This investment pattern, more than any other sovereign wealth fund, has caused concern by governments around the world not swayed by the declared benign intentions of the Chinese government. Singapore has taken a statist view to its sovereign wealth fund but designed to build up national flagship giving them preferred access to capital and even venture capital funding for high technology firms. While the intention of Chinese investment worries foreign critics, the inconsistency of declared Singaporean returns is most concerning. The divergence between the stated returns of Temasek, the primary Singaporean indexes, of which they are the primary owner, and other financial metrics such as Singaporean indexes or other sovereign wealth funds is worrying.

This chapter analyzes the concept of “fixer” and “floater” in classifying countries during the gold standard period. These terms, though archaic, have not ceased to be relevant, and are seen still to draw similar patterns in a small number of countries. The chapter mentions the research of Obstfeld and Rogoff, “The Mirage of Fixed Exchange Rates”, and cites the existence of a significant number of stable, meaningful exchange rate regimes that go against recent research. The chapter delves deeper into the history of fixed, floating and flipping exchange rate regimes in relation to the number of exchange rate spells and questions how these spells have survived, as well as how the reformation of pegs affect stability.

This chapter explores the optimal exchange rate and monetary policies in emerging countries. It specifically evaluates whether domestic monetary authorities should actively defend their currencies against speculative attacks. Highly variable nominal interest rates, or nominal rates that rise when adverse shocks hit, are not an indication of fear of floating. The shock and the associated monetary policy resulted to an increase in wage inflation. Social loss is larger under fixed rates than under the discretionary solution presented. Even if fixed exchange rates enjoy a credibility advantage, they do not yield higher welfare than does optimal floating under discretion. Under the three alternative discretionary flexible exchange rate regimes, it is noted that the welfare losses are lower than under fixed rate regimes. Moreover, balance sheet effects are very severe when the move to floating exchange rates is a result of a currency collapse.

This chapter examines the cyclical behaviour of financing activities by Islamic banks as well as the cyclicality behaviour of fixed-rate financing. More specifically, it investigates the impact of aggregate economic activity fluctuations on Islamic bank lending. Analysis of panel data for the period 1998–2008 for twenty-four Islamic banks shows that strong GDP growth accelerates financing growth, a trend that is also observed in conventional banks. Financing is positively correlated with bank reserves, capital and loan loss provision, but weakly related to money supply. The chapter suggests that financing may be less pro-cyclical if Islamic banks would rely more on profit and risk sharing.

This chapter examines the effect of exchange rate regimes on international trade through an overview of the research conducted on the effects of exchange rate volatility on trade. Research done by Rose as well as Klein and Shambaugh are taken into account as well to present evidence of the economically meaningful influence of fixed exchange rates and exchange rate regimes on trade. Further literature is discussed and investigated to give a broader scope of the subject. The chapter also demonstrates the value of gravity models as a successful empirical framework in international economics. In conclusion, the chapter tries to show the demerits of pegging and how it promotes an expansion of bilateral trade with the base country.

The traditional view is that fixed exchange rate regimes are best for the globalization of financial markets. This view is based on the stellar performance of the classical gold standard. Yet today we are in another era of globalization as pervasive as the earlier one, and the dominant regime is floating. This paradox suggests at first glance that globalization, rather than being determined by the exchange rate regime, occurs independent of the exchange rate regime. However, although this may be the case for advanced countries, it is not for emergers, whose regime choice is in large measure driven by international financial integration. This chapter focuses on the different historical regime experiences of the core and the periphery. Section 9.2 sets the stage by considering the evidence on global financial integration from 1880 to 1997, using the well-known Feldstein–Horioka approach. Section 9.3 lays out the financial maturity hypothesis and presents narrative evidence for the pre-1914 period of the different experiences of the core and peripheral countries in adhering to the gold standard. Section 9.4 presents some empirical evidence on the link between financial depth and the exchange rate regime for core (advanced) and peripheral (emerging) countries from 1880–1913 and today. Section 9.5 summarizes the findings and suggests some lessons from history. A commentary is also included at the end of the chapter.

The Managing Director of the IMF deemed the crisis faced by the Mexican peso in December 1994 as the ‘first major crisis of the 21st century’. Analyzing the Mexican peso crisis reveals that it was brought about by several different factors that include the large scale of deficits in the current account, how these deficits were funded by short-term capital inflows, how the Mexican authorities asserted a relatively fixed nominal exchange rate that was seemingly overvalued to reduce inflation, and the outwardly relaxed monetary policy imposed during 1994. The causes also include how the government allowed the transformation of a huge part of this debt into dollar-dominated paper, how devaluation was mismanaged, and, lastly, how criminal and political events have emerged during this period. This chapter takes on a chronological approach in analyzing this crisis and concentrates on issues of devaluation and imperfections within the capital market.

This chapter creates the foundation that will affect and be built upon by much of the book, creating a context for questioning and exploration. It introduces the standard view of exchange rate regimes as a means of determining what economic consequences these regime may have yielded. This exposition will be the basis through which the standard results from international macroeconomics will be discussed. The chapter talks of the policy trilemma, its limitations and constraints placed upon the government. How the loss of monetary policy affects the overall performance and stabilization of the economy is also explored in the chapter, and how it serves as advantageous for a fixed exchange rate. Furthermore, the chapter provides a brief history of the international monetary system from the time of the gold standard.

The GCC countries maintain a policy of open capital accounts and a pegged (or nearly-pegged) exchange rate, thereby reducing their freedom to run an independent monetary policy. This chapter shows, however, that the pass-through of policy rates to retail rates is on the low side, reflecting the shallowness of money markets and the manner in which GCC central banks operate. In addition to policy rates, the GCC monetary authorities use reserve requirements, loan-to-deposit ratios, and other macroprudential tools to affect liquidity and credit. A panel vector auto regression model suggests that U.S. monetary policy has a strong and statistically significant impact on broad money, non-oil activity, and inflation in the GCC region. Unanticipated shocks to broad money also affect prices but do not stimulate growth. Continued efforts to develop the domestic financial markets will increase interest rate pass-through and strengthen monetary policy transmission.

This chapter presents theoretical arguments to explain why countries may or may not opt for a currency board arrangement. The adoption of a currency board arrangement can be seen as being based on two distinct decisions: first, the choice of a fixed over a floating exchange rate regime; and, second, within the spectrum of pegged exchange rate regimes, the selection of a hard peg over a traditional “softer” peg. The chapter reviews the relative merits of fixed versus floating exchange rates before turning to the trade-off between the credibility gain provided by a hard peg and the easier escape in the face of shocks allowed by softer pegs.

The fixed exchange rate system had been abandoned back in 1971, raising questions at that time about the role of the International Monetary Fund. However, the abandonment of the fixed exchange rate system did not mark an end to crises; rather, they seemed to become both more frequent and of greater depth. When the Bretton Woods institutions were founded, there was a less well-developed theory of collective action that outlined the circumstances under which public, as opposed to private, action was desirable. There was, in particular, a less well-developed theory of market failure, of the circumstances under which markets by themselves did not yield efficient outcomes. This chapter explores the role of the Bretton Woods institutions from the perspective of global public goods and externalities. The discussion begins by focusing on the IMF, simply because there was, in its establishment, a clear vision of a global market failure that it was supposed to address.

This chapter examines and provides a distinction between the behaviors of fixed exchange rate regimes and floating exchange rate regimes. First it separates the indisputable and disputable floats through the work of Calvo and Reinhart. Next, the chapter explores and measures volatility between float observations and peg observations using the Klein-Shambaugh classification system to classify each one. Pegging is thus seen to have persistent outcomes and changes in volatility. Pegs are concluded to be fragile, yet are good predictors of low volatility. Typical floating observations, on the other hand, are seen to have more volatility even when placed under certain controls. It is suggested, therefore, that pegs can be expected to have real effect on economic outcomes.

During the recent precipitate slide of the Hong Kong dollar against the US currency, the Hong Kong government had intervened to support the local currency on the foreign exchange market. This chapter discusses the steps the authorities had taken that had undermined their ability to hold the exchange rate steady at some specified nominal rate against the US$. It begins by examining how a normal central bank and banking system operates and how intervention in the foreign exchange market can be made effective. It then examines how Hong Kong's automatic adjustment mechanism under a fixed exchange rate operated in effect like any orthodox central bank would have done and how errors of policy caused Hong Kong's banking system to come off the rails in 1972–74. It also describes how the system now differs from orthodox banking systems around the world. Finally, it explains why operations in the foreign exchange market by the government or Exchange Fund under present institutional arrangements neither tighten the money market nor reduce monetary growth.

This chapter studies how Norges Bank came to play a central, technical role in maintaining and defending a stable krone exchange rate during the years 1946–86. This role was reflected in how the bank advised on the basis of a loyal position to the fixed krone exchange rate regime and to binding international exchange rate cooperation. In 1978, Norway backed out of the European fixed exchange rate cooperation, and during 1976–86, the krone was devalued ten times. Even though Norges Bank officially came to contribute to both recommending and carrying out this policy, the policy defied the strong ideals and viewpoints of the organization. The exchange rate policy, and the problems it led to in relation to the central bank, caused the government, in the first half of the 1980s, to push Norges Bank completely aside when it came to the shaping of Norwegian exchange rate policy. Nevertheless, much of the policy was still shaped inside the walls of the institution.

The nation’s persistent budget deficits and rising national debt have driven policymakers to make tax expenditures a logical focus of future efforts at deficit-reducing tax reform. In this chapter, Daniel Baneman, Joseph Rosenberg, Eric Toder, and Roberton Williams examine how revenues might be raised by reforming individual tax expenditures. They first review how tax expenditures have changed over the past 25 years and provide estimates of the distribution of tax savings resulting from tax expenditures today. The authors then examine three comprehensive approaches for reducing the impact of tax expenditures: (1) the replacement of six major tax expenditures with a combined 15 percent credit, (2) a cap on the total of seven major tax expenditures to 4 percent of AGI, and (3) a “haircut” that reduces the value of a set of tax expenditures by 35 percent. Among many results, they estimate that taxpayers who are affected by these changes experience a reduction in after-tax-income on average of just below 2 percent, and that the AGI limit raises significantly more revenue than the other two options.

This chapter describes why the gold standard and the euro are extreme forms of fixed exchange rates, and how these policies had their most potent effects in the worst peaceful economic periods in modern times. While the world is lucky to have avoided another catastrophe like the Great Depression in 2008–09, mainly by policy makers’ aggressive use of monetary and fiscal stimuli, the world economy is still experiencing many difficulties. As in the Great Depression, this second round of problems stems from the prevalence of fixed exchange rates. Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad.

This chapter details how, in 1993, Norges Bank argued in favour of supplementing the fixed exchange rate target, and in 1997 in favour of replacing it with an inflation target, with a view to maintaining inflation at a low and stable level. The introduction of an inflation target provided Norges Bank with greater scope for the exercise of independent judgement. Controversial increases in the policy rate in 2000 and 2002 demonstrated that Norges Bank was willing to use its increased independence. Moreover, amendments to the Norges Bank Act in 2003 weakened the scope of action available to the government and parliament to influence the bank’s decisions, and the Executive Board largely became a council of economic experts. In addition, Norway’s slightly inefficient central bank organization underwent major changes, with extensive outsourcing of non-core tasks, as defined by the new guidelines.