wp/88/14 international monetary fund€¦ · ments and exchange rate arrangements 1. monetary and...

IMF WORKING PAPERThis is a working paper and the author would welcome anycomments on the present text. Citations should refer to anunpublished manuscript, mentioning the author and the dateof issuance by the International Monetary Fund. The viewsexpressed are those of the author and do not necessarilyrepresent those of the Fund.

WP/88/14 INTERNATIONAL MONETARY FUND

Research Department

Exchange Rate Arrangements and Monetary Policy

Prepared by Donald J. Mathieson \J

February 5, 1988

Abstract

This paper examines the relationship between monetary and exchangerate policies by considering the factors that have led the authoritiesin developed and developing countries in Asia to alter their use ofmonetary policy instruments and exchange rate arrangements since themid-1970s. There is first consideration of the extent to which real andmonetary shocks, country size, and the degree of goods and capitalmarket integration can explain the evolution of exchange rate arrange-ments. There is then an examination of the factors influencing thechoice of money and credit policy instruments. Finally, there is adiscussion of integrating monetary and exchange policies with extensivetrade and financial market reforms.

JEL Classification Number;1431

\J This paper was prepared for the San Francisco Federal ReserveConference on Pacific Basin Monetary Policy on September 21-22, 1987.The author would like to thank Joseph Bisignano, Jeffrey Frankel,Peter Isard, Jurg Niehans, Liliana Rojas-Suarez, and Nicholas Sargen forcomments on an earlier draft. The views presented in this paper arethose of the author and should not be taken as representing those of theInternational Monetary Fund.

©International Monetary Fund. Not for Redistribution

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Table of Contents

Summary

I. Introduction

II. The Evolution of Exchange Rate Arrange-ments and Principal Monetary PolicyInstruments in Selected Asian Countries

III. The Choice of Monetary Policy Instru-ments and Exchange Rate Arrangements

1. Monetary and exchange rate policieswith highly integrated markets

a. Real and monetary shocksb. Other considerations

2. Monetary and exchange rate policies withimperfect but increasing market integration

a. The choice of money and credit instruments(1) Integration of domestic

and external goods markets(2) Fiscal imbalances and the structure

of domestic financial markets(3) Integration wi th external

financial markets(4) Exchange rate policy

b. Monetary and exchange rate policies duringperiods of extensive structural change

III. Conclusions

Appendix

References

Table 1. Exchange Rate Arrangements, Monetary Instruments,and Financial Characteristics of SelectedAsian Countries

Pageiii

1

2

6

91 1

1 1

13

13

14

1416

18

21

23

34

3

6


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Summary

This paper examines the relationship between monetary and exchangerate policies by considering the factors that have led the authoritiesin developed and developing countries in Asia to alter their use ofmonetary policy instruments and exchange rate arrangements since themid-1970s.

For these countries, this period has encompassed increased flexi-bility in exchange rate arrangements, the substitution of monetary forcredit policy instruments, major reforms of domestic financial systems,and a growing integration of domestic and external financial markets.

The analysis first examines the extent to which real and monetaryshocks, country size, and the degree of goods-market and capital-marketintegration can explain the evolution of exchange rate arrangements.

It then considers the factors influencing the choice of money andcredit policy instruments in order to explain why some developing coun-tries have continued to rely on credit instruments, while many othercountries have increasingly relied on monetary instruments. Finally,there is an examination of issues involved in integrating monetary andexchange policies into programs designed to bring about extensive tradeand financial market reforms.


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I. Introiluotion

In recent years, many countries have relied on monetary policy asthe principal means not only for offsetting external and domesticcyclical shocks but also for containing secular inflation, especiallywhen fiscal policies have been constrained by large structural deficits.However, it has been long recognized that the ability of monetary policyto achieve such objectives in an open economy is influenced by suchfactors as country size, the degrees of integration between domestic andinternational goods and financial markets, and the country's exchangerate arrangements. Since the current international monetary systemencompasses countries of divergent economic sizes, with varying degreesof integration with international markets, and with sharply differentdegrees of exchange rate flexibility, it is difficult to make generalstatements about the effectiveness of monetary policy without specifyingthe particular economic and financial structures being considered.

There have traditionally been two alternative approaches to examin-ing the issue of the effectiveness of monetary policy under alternativeexchange rate arrangements: an examination of the effect on the economyof a change in a given monetary policy instrument, or consideration ofthe factors which lead a country to select a particular set of monetarypolicy instruments and exchange rate arrangements. The second of theseapproaches, the analysis of optimal monetary and exchange rate policies,is broader in the sense that it explicitly takes into account theauthorities' objectives. This paper adopts this latter approach andexamines the relationship between monetary and exchange rate policies byconsidering the factors that have led the authorities in developed anddeveloping countries in the Pacific Basin to alter their use of monetarypolicy instruments and exchange rate arrangements during the pastdecade.

The paper has three sections. Section I examines the monetarypolicy instruments and exchange rate arrangements that have been used inselected Asian countries during 1975-85. This has been a period ofsubstantial structural change for almost all of these countries, whichhas encompassed changes in exchange rate arrangements, the substitutionof monetary for credit policy instruments, major reforms of the domesticfinancial systems, a growing integration of domestic and external finan-cial markets (often accompanied by a relaxation of restrictions oncapital flows), and the need to adapt to large external and internalmacroeconomic shocks. Although these countries have generally adoptedmore flexible exchange rate arrangements and have moved from credit tomonetary policy instruments, a number of the developing countries havecontinued to peg their exchange rates and relied to an important degreeon credit policy instruments.

Section II focuses on the question of what changes in economicconditions would lead countries to substitute monetary for credit policyinstruments and introduce a greater degree of flexibility into theirexchange rate arrangements. Although the recent literature on thechoice of optimal exchange rate regimes and monetary policy instrumentsoffers some important answers to this question, the typical assumption


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of perfect substitutability between domestic and foreign securitiesrules out consideration of a number of factors that have been especiallyimportant in the selection of policy instruments when there is less thanperfect but increasing integration of domestic and international goodsand financial markets, or when there are extensive structural changes.These factors are illustrated by examining the conditions that wouldinfluence the authorities' decision to make use of either credit ceil-ings or limits on the expansion of monetary aggregates as their princi-pal monetary policy instruments under alternative exchange rate arrange-ments. In addition, the influence of on-going structural changes on theselection of policy instruments is discussed by considering the types ofmonetary and exchange rate policies that have been adopted by countriesundertaking extensive trade and financial liberalizations.

The final section summarizes the main conclusions concerning therelationship between monetary and exchange rate policies.

II. The Evolution of Exchange Rate Arrangements and PrincipalMonetary Policy Instruments in Selected Asian Countries

The extent of the changes in exchange rate arrangement and finan-cial market policies that have occurred in a number of Asian countriessince 1975 is summarized in Table 1. \J Since the specific experiencesof a number of these countries are addressed in other papers beingpresented at this conference, this information on changes in exchangerate arrangments, principal money and credit instruments, capital con-trols, and structural policies relating to the domestic financial systemis intended to provide only an overview of general developments.

Four key trends are evident. First, countries have increased thedegree of flexibility associated with their exchange rate arrangements.In these tables, exchange rate arrangements have been classified accord-ing to the categories employed in the IMF's Annual Report on ExchangeArrangments and Exchange Restrictions. Countries are grouped into thosepegged to the U.S. dollar, other currencies, the SDR, or compositeindicators; those which follow a policy of managed floating; those whichare independent floaters; and those which have adopted other flexiblearrangements. 2_/ These categories represent a spectrum of exchange ratearrangements ranging from those with little flexibility (e.g., theexchange rate peggers) to those allowing for considerable flexibility(the independent floaters). The divisions between these two extremesare necessarily somewhat arbitrary, but shifts in the distribution of

\J For more detailed information on individual countries, seeTables 2 through 12 in the Appendix.

2/ The Fund also identifies countries participating in cooperativearrangments such as those associated with the European Monetary system.


1. Exchange Rate Arrangemu, Monetary Irvtrmenti, and Financialof Selected Aiiin Gxncrlei 17

Capital Controls V

tone? end Credit Policy^change Arrangenents 2/

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

19H5

Peggedto U.S.Collar

2

2

2

1

1

0

0

0

0

0

0

Peggedto Other

Currenciesor

Coofxult*

7

6

5

5

5

5

4

4

4

4

5

OtherFlexibleArrange-ment*

1

1

1

2

2

2

2

3

1

1

0

rtanagedFlexibility

2

3

3

3

3

4

6

5

7

6

4

IndependentFloaters

1

1

2

2

2

2

1

1

1

2

4

RequiredReserveRatio

12 (4)

12 (4)

12(4)

12 (3)

12 (3)

12 (2)

12 (0)

11 (0)

11 (0)

10(0)

9 (1)

liquidityRatio

6(2)

6 (2)

6 (2)

6 (2)

6(2)

6 (2)

6 (0)

6(0)

5(0)

5 (0)

5(1)

GeneralDiscountFacility

andDiscount

Rate

13(2)

13 (2)

13 (2)

13 (2)

13(2)

13 (3)

13(2)

13 (3)

13(3)

13 (3)

13 (2)

OpenmrfcstOpera-

tions 5/

3(1)

3(1)

3(1)

3 (2)

4 (2)

4 (2)

5(3)

6(4)

6(4)

9 (4)

9(5)

AnnouncedMonetaryAggregate*Target!or Pro-

Jectlons

0

1(0)

1(0)

2(0)

J(0)

2(0)

2(0)

3(0)

4(0)

2 (0)

1(0)

Instruments V

Cellingon

OverallCredit

""•".loo

10 (4)

10(4)

10(4)

10(4)

10(4)

9 (4)

9(4)

6 (2)

5(1)

5 (1)

5(1)

CreditAl Idea-tionRule*

10(2)

11 (2)

11 (2)

10(2)

10(2)

10(2)

10(3)

9 (2)

9 (1)

7 (1)

7 (1)

SectoralRerHsmisirFacilities

3 (0)

3 (0)

3(0)

3(0)

3(0)

3 (0)

3(0)

3(0)

3 (0)

3 (0)

3(0)

CellingInterest

Rsta

12(1)

12 (1)

12(1) 11 «/

12 (0) 2R V

12 (0) 2R 6/

12 (0) 41 6/

12 (0) 4* 6/

12 (0) tt A/

10 (0) * «/

9 (0) 4R 6/

9 (0) 4R 6/

RequiredSurrender

ofReport

Proceeds

11

11

11

10

10

10

IT Tl 10

9

7

7

7

Advancedlaport

Deposits

4

5

4

3

3

3

2

1

1

1

2

Limita-tion* orAdvanced

Approvaloa

Paymentsfor

Invisible*

9

9

9

8

8

8

8

8

8

A

6

Limitationson

ForeignCurrencyDeposit*

byResident*

11

11

11

10

10

10

10

10

9

8

*.

PriorApprovalRequired

forForeign

lending orBorrowing

byFinancial

Institution*

10

10

11

11

11

11

11

10

8

8

8

lax orSpecialPeaerveHooul re-sent onForeign

Borrowing

2

1

2

2

1

1

1

1

1

I

1

I/ Ihe dxntrles are Auatralla, &im, Fiji, Indonesia, Japan, Korea, feUyala, Nw Zealand, ch* PhlllpplJWs, Singapore. Sri Unu, Thailand, and Ifeatern Sanaa.T/ Njnber of oxntrlea with given eshange rat* arrsngerent.3/ The first nutxr represents the oxsitrlea reported eaoloying a given Instrunent; uhereas the umber In parentheses represents these oouttrles for which this 1* a principal Insnvxent.I/ tijater of oouitrlea utilizing a given capital control.T/ Inclining foreign exchange swap operaUons and repurch*** agreeaanta.?/ Thu nvmber before the letter R denote* the ouBber of axjncriea with Interest at* ceilings chat had freed son deposit or landing rates (typically on longer can deposits).T/ The nmfcer before the letter T denotes the rajafacr of coisitrle* relnposlng Interest rat* ceilings on previously freed rstes.

Tablecharacterlacica


countries along this spectrum do provide a view as to whether the flexi-bility in exchange rate arrangements has increased or decreased. \J

While there has been a general trend towards employing greaterflexibility in exchange rate arrangments (Table 1), it is important todistinguish between the experience of certain subgroups of countries(Tables 2 through 12 in the Appendix). The industrial countries haveemployed greater exchange rate flexibility since Australia and NewZealand moved from initially being classified as pegged to a compositeindicator to independent floaters. However, although the number ofdeveloping countries represented in Table 1 that were classified asemploying some form of exchange rate flexibility rose from three in 1975to five in 1985, five other developing countries pegged their exchangerates in some form throughout the period. This pattern of some develop-ing countries continuing to peg their exchange rates while many othercountries (especially industrial countries) introduced greater flexi-bility into their exchange rate arrangements is consistent with thechanges that have occurred in other regions of the world (see Goldstein(1984) and Crockett and Goldstein (1987)).

A second major change has been the movement away from implementingmonetary policy through credit market instruments toward the employmentof monetary instruments (Table 1). In this paper, monetary instrumentsare taken as those instruments which principally affect the price andnominal quantity of base money and credit policy instruments are thosewhich primarily affect the price and nominal quantity of credit to theprivate sector. By this criteria, ceilings on the expansion of commer-cial bank credit to the private sector, credit allocation rules, andceiling interest rates are clasified as credit instruments; whereas,open market operations and discount window policies are treated asmonetary instruments. Reserve and liquidity ratios fall between thesetwo polar cases in that they can affect both the demand for base moneyand the availability of credit to the private and public sectors. Inthe mid-1970s, most of the countries represented in Table 1 implementedtheir monetary policies through the use of credit instruments, includinglimitations on the expansion of total bank credit, rules for the alloca-tion of credit to particular sectors or borrowers, and ceiling interestrates on loans and deposits. By the mid-1980s, in contrast, monetarypolicy was most often implemented through open market operations,changes in the terms and conditions under which discount windows couldbe accessed, and the employment of intermediate targets or projections

1/ To some extent, however, examination of changes in the spectrum ofarrangements may either understate or overstate the degree of exchangeflexibility employed by countries. For example, although a countrycould formally peg its exchange rate to a particular currency, thiswould not rule out the possibility that it would undertake frequentadjustments of that rate. In contrast, a country that was independentlyfloating could still undertake extensive exchange market interventiondesigned to limit exchange rate movements.

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_ C —

for monetary aggregates. This change has been most evident in theindustrial countries and those developing countries which have under-taken the most extensive financial reforms. Nonetheless, credit instru-ments have remained the principal monetary policy tools in a number ofdeveloping countries, especially those with pegged exchange rates.

Third, the greater flexibility of exchange rate arrangments and theincreased use of monetary instruments has also been accompanied by somerelaxation of restrictions on capital flows. While many of the develop-ing countries represented in Table 1 still retain extensive controls onexternal financial transactions, the industrial countries and a numberof the developing countries have either eliminated many of these con-trols or, where the controls have remained on the "books," have limitedthe types of portfolio and financial flows that are subject to controls.Where these controls have been relaxed, domestic residents have rapidlydiversified their portfolios; and domestic financial conditions havebeen increasingly influenced by developments in international markets.The countries that have retained the most extensive controls overcapital flows have also tended to peg their exchange rates and to relyon credit instruments in the conduct of monetary policy. Nonetheless,even where capital controls do not inhibit the arbitrage of financialmarket conditions, the linkages between domestic and internationalmarkets still appear to be far from perfect, with large borrowers orlenders from the industrial countries having much greater access tointernational markets than small- and medium-sized entities fromdeveloping countries, and with short-term markets being much moreclosely linked than medium- or long-term markets.

A final characteristic of many of these Asian countries has beentheir willingness to undertake extensive liberalization of their domes-tic financial systems. The extent of these reforms has naturally dif-fered considerably across countries, but they have often involved remov-ing or relaxing ceilings on loan and deposit interest rates, increasingthe degree of competition through the entry of new domestic and foreignfinancial institutions, reductions in required reserve and liquidityratios, the payment of interest on bank reserves, and the elimination ofrules governing the allocation of credit or the provision of specialcredits at preferential rates. j_/ In some cases (e.g., Australia,Japan, and New Zealand), these reforms have been accompanied by signifi-cant relaxations of capital controls.

These structural changes in the Asian economies represented inTable 1 raise a number of questions relating to the effectiveness ofmonetary policy under alternative exchange rate arrangements. First,what domestic and international developments have led some countries toundertake such extensive changes in their exchange rate arrangements,

\J In some countries, these financial reforms were accompanied bychanges in commercial policy and trade reforms designed to open domesticgoods markets to external competition.


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their mix of money and credit market instruments, their use of capitalcontrols, and the structure of their domestic financial markets whileother countries have shown much more limited structural change. Second,how have these changes altered the effectiveness of monetary policy interms of its ability to help the authorities achieve their internal andexternal objectives? Finally, since real and financial structuralchanges seem likely to continue, how can monetary and exchange ratearrangements be designed not only to obtain the best performance out ofa given economic structure, but also to cope with the problems encoun-tered during periods of ongoing structural changes? In this paper,these issues will be considered from two traditional points of view:(1) that which focuses on a single country linked, to varying degrees,with exogenously determined conditions on international markets forgoods, factors, and financial assets; and (2) that which focuses on theinterdependent effects of countries' policies.

III. The Choice of Monetary Policy Instrumentsand Exchange Rate Arrangements

Since countries select the policy instruments which best allow themto achieve their internal and external objectives, it is usually arguedin the literature on the optimal design of monetary and exchange ratepolicies that the set of most effective instruments depends on eachinstrument's time pattern of effects on domestic and external variables(which will reflect the economy's real and financial structure anddegree of openness), the disturbances or other factors which need to beoffset by policy measures, and the relative importance the authoritiesattach to their objectives. This implies that the changes in the use ofmonetary policy instruments and exchange rate arrangements evident inTable 1 and Tables 2 through 12 in the Appendix should be explained asresponses to shifts in the pattern of shocks affecting the economy,changes in the real and financial structures of the economy, and shiftsin the weights that authorities attach to the attainment of individualinternal and external goals. However, it has also been emphasized thatthe relative importance of each of these factors depends importantly onthe degree of integration between domestic and international goods andfinancial markets. It is, therefore, useful to divide the discussion ofthe most effective monetary and exchange rate policies into those poli-cies that should be adopted under perfect market integration and thosethat should be selected under less than perfect integration.

1. Monetary and exchange rate policieswith highly integrated markets

It has been argued that, when domestic and international financialmarkets are highly integrated (i.e., domestic and foreign securities areperfect substitutes), monetary and exchange rate policies are not inde-pendent. However, this conclusion reflects a particular view of thepotential monetary and exchange rate instruments available to the


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authorities. \_t The authorities' exchange rate arrangements are typi-cally described in terms of a foreign exchange market intervention rule,which specifies the scale of the authorities purchases or sales offoreign exchange (for domestic base money) to the departures of the

]_/ Much of the recent work has focused on extending the earlieranalyses by Fleming (1962) and Mundell (1962) to allow for a more com-plete portfolio specification, stochastic monetary and real distur-bances, traded and nontraded goods, rational expectations, the possi-bility of asymmetric information and wage-price rigidities, and theimplications of intertemporal budget constraints. See Marston (1985)and Branson and Henderson (1985) for comprehensive surveys of the de-velopment of this literature. The most recent models typically havefour basic components. There is first a set of relationships describingthe portfolio behavior and budget constraints facing the public andprivate sectors. For the private sector, this often consists of thespecification of the demand for money, the degree of substitutionbetween domestic and foreign securities, and any wealth and incomeconstraints. In much of this literature, domestic and foreign securi-ties are taken as perfect substitutes and uncovered interest rate parityis assumed to hold (i.e., the domestic interest rate equals the sum ofthe foreign interest rate plus the expected rate of depreciation of theexchange rate). The public sector is typically entered either verysimply via a money supply rule (or alternatively via an exchange marketintervention rule) or in a more complex manner via both a money supplyrule and an intertemporal budget constraint representing the limitationsimposed by international markets on the ability of the authorities tofinance their budget deficits through borrowing. A second set of rela-tionships describes both the linkages between external and domesticgoods prices and the determinants of domestic output. Some form ofpurchasing power parity relationship usually links (apart from stoch-astic shocks) domestic and foreign prices. Output is either specifiedas an exogenous (stochastic) variable or is determined via a stochasticproduction function that depends on the amount of labor employed. Asthe third basic component of these models, the supply of labor is thentaken as a function of the real wage, and wages are set to equate theexpected demand and supply of labor. Finally, there is a specificationof how expectations regarding prices and wages are formed. Whileearlier analyses used static wage-price expectations, more recent dis-cussions have focused on rational expectations although certain types ofcontract rigidities have been incorporated into even this framework.Examples of the use of these models for analyzing either the choice ofoptimal exchange rate arrangements or exchange rate dynamics areprovided by the articles by Aizenman (1985), Aoki (1985), Bhandari(1985a), Carlozzi and Taylor (1985), Driskill and McCafferty (1985),Flood and Hodrick (1985), Flood and Marion (1982), Frenkel and Mussa(1985), Gray (1976), Harkness (1985), Helpman (1984), Hodrick (1982),Marsten (1985b), Mussa (1985), Obstfeld. (1983), Obstfeld and Rogoff(1984), Obstfeld and Stockman (1985), Turnovsky U985a and 1985b), andWeber (1981).


exchange rate from a target level or to the movements in the exchangerate ("leaning against the wind"). \J Monetary policy is conductedthrough open market operations which alter the domestic component ofbase money. Thus, monetary and exchange rate policies are linkedthrough their effects on domestic base money. Moreover, since it isoften assumed that domestic and foreign assets are perfect substitutesand that interest rate parity conditions are satisfied, these two poli-cies are collapsed into one policy and "... monetary policy is exchangerate policy." 2J With perfect asset substitution across countries, openmarket purchases of either a domestic security or foreign exchange, bothset in motion portfolio and spending adjustments of a comparable nature.

In this situation, the exchange rate intervention rule (or equiva-lently the money supply rule) that best allows the authorities toachieve their objectives depends on the nature of the internal andexternal shocks affecting the economy, the economy's structural rigidi-ties, asymmetries in the information sets available to the authoritiesand the private sector, the country's size, and the degree of integra-tion of its goods and financial markets with those in the rest of theworld. The importance of these factors was indirectly illustrated byHelpman (1981) who showed that, in a frictionless world of perfectcertainty with purchasing power parity and interest rate parity beingattained, the consumption patterns associated with alternative exchangerate arrangements would be identical unless the arrangements involved apermanent transfer of resources from one country to another. _3_/ Whilesuch a world is unlikely to ever exist, the analysis implies that theappropriateness of a particular mix of exchange rate arrangements andmonetary policy will depend on the exact nature of the market failuresand frictions that exist.

1/ In addition to this "unsterilized" intervention, there have alsobeen discussions of "sterilized" intervention where the effects on thedomestic monetary aggregates are offset by open market operations. Suchsterilized intervention has generally been regarded as ineffective.

21 Daniel (1985) , p. 253.3/ Mussa (1983) has argued that such exchange rate system neutrality

requires that: (1) Ricardian equivalence must hold with regard to theevaluation of government securities as wealth; (2) a pegged rate mustnot be maintained through foreign exchange operations that involveassets that are not part of the efficient portfolio that would be main-tained by the private sector under a flexible exchange rate regime;(3) the redistribution of wealth that occurs because of unanticipatedchanges in nominal prices and the exchange rate in the presence of bondsmust be absent or have no effect on world demands; (4) money must playno role in the real economy; and (5) problems with imperfect informationmust be absent. These issues are also discussed in Aschauer and Green-wood (1983), Helpman (1979), and Stockman (1983). Aschauer andGreenwood argue, in particular, that Helpman's neutrality conclusions donot hold when output is taken as endogenous rather than exogenous.

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a. Real and monetary shocks

The nature of the real and monetary shocks affecting the economyhave been viewed as especially important determinants of optimalexchange rate arrangements. The exact nature of the policy recommenda-tions for dealing with these shocks, however, differ somewhat dependingon the extent of the feedback between the domestic and external econo-mies. One possibility is that the domestic economy is "small" and thatdomestic developments, therefore, have no impact on external prices orincomes. Alternatively, a two-country framework has been used in whichthe levels of income, prices, and interest rates are affected by thepolicies adopted in both countries. In the case of a small country, forexample, Frenkel and Aizenman (1982) showed that the higher the varianceof shocks to real output, the more desirable is a fixed exchange rate.With a fixed exchange rate, changes in the current account balance cancushion the effects of real shocks on domestic consumption. Countriesfaced with relatively large real shocks should hold large stocks ofinternational reserves to allow for large variability in the balance ofpayments. However, the importance of this consideration diminishes asthe economy's degree of integration with world capital markets increasessince the same cushioning can be achieved through international borrow-ing or lending. In contrast, a greater variability of monetaryshocks j_/ increases the desirability of exchange rate flexibility sinceexchange rate adjustments can offset these monetary shocks and preventthem from altering real output and consumption. When both types ofshocks are present, the optimal exchange rate regime involves a systemof managed floating with the degree of intervention being that whichallows the external economy to serve as the most efficient buffer forthe domestic economy.

If there are two economies of comparable size, the policy recommen-dations change somewhat since neither country will find it optimal toact as the sole buffer in the system. Moreover, a distinction must bemade between high and low degrees of financial and goods market integra-tion between the two countries. In a two-country context, the notionthat a floating exchange rate insulates a country from foreign shocks ismore likely to be true when capital mobility is low than when it ishigh. For example, with low capital mobility, an exogenous increase inforeign demand for money might raise the foreign interest rate sharplybut still generate few capital flows. Flexible exchange rates wouldthen only have to respond to offset the changes in trade flows inducedby the adjustments in aggregate demand in the foreign country. With ahigh degree of capital mobility, the increased capital flows wouldnecessitate a sharper exchange rate adjustment that would (at least inthe short run) affect prices and output to a greater degree than with

"\J In the Frenkel and Aizenman (1982) analysis, monetary shocksencompass not only shocks to the money demand or supply, but also shocksto foreign prices or purchasing power parity conditions.


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low capital mobility. \J In particular, Obstfeld (1985, p. 405) hasargued that, under conditions of high capital mobility, 2f

The risk-sharing argument suggests that the two regions will prefera fixed exchange rate, together with appropriate internationalsettlement arrangements, when monetary shocks are dominant, andespecially when they are negatively correlated across regions, butwill prefer a floating rate when aggregate demand shocks are themain concern.

In terms of explaining the evolution of the exchange rate arrange-ments for the countries represented in Table 1 and Tables 2 through 12in the Appendix, these analyses suggest that one first needs to identifythe nature of the shocks that have dominated during the period 1975-85and the relative sizes and degrees of openness of the economiesinvolved. With regard to the nature of the shocks that have occurred,Obstfeld (1985) has argued that the divergent fiscal trends across themajor industrial countries, the extensive changes in oil and commodityprices, and the fact that exchange rates and stock market prices havenot moved together in the way one would expect if the shocks were mone-tary in origin 3/ all point to the fact that the past decade has beenone in which real shocks have dominated monetary shocks. 4_/ If realshocks have dominated in the period since the mid-1970s, then thechanges in exchange rate arrangements evident in Table 1 and Tables 2through 12 in the Appendix are consistent with the predictions of thetheoretical analysis. The dominance of real shocks would imply that a

_]_/ Saidi (1980) has argued, however, that these conclusions havearisen out of models that assume the existence of price rigiditiesand/or agents that neglect available information in forming expectationsthat are crucial to current decisions. In the context of a generalequilibrium model with rational expectations, he argued that a flexibleexchange rate does not insulate domestic employment and output fromforeign disturbances. The importance of the information sets of theauthorities and private sectors have also been discussed in Bhandari(1985a), Eaton (1985), Flood and Hodrick (1985 and 1986), Frenkel(1981), and Click and Wihlborg (1986).2! Hsief (1984) also examines this risk-sharing argument.3/ Obstfeld examined the relative importance of real and monetary

shocks by considering the correlation between changes in nominalexchange rates and in nominal stock prices. He argued that if domesticmonetary shocks are the dominant source of disturbance, the nominalprices of stocks and foreign exchange should be highly positivelycorrelated; whereas, if the shocks are real, the correlation should bemuch lower or even negative. In considering these correlations for theFederal Republic of Germany, Japan, and the United States for varioussubperiods between 1976 and 1985, he generally found low negativecorrelations.V This does not rule out the possibility that unanticipated monetary

policy changes were also important.


small country confronted with low capital mobility (due possibly to thepresence of capital controls) would choose a pegged exchange rate, andthe smaller developing countries with relatively restrictive capitalcontrols represented in Table 1 and Tables 2 through 12 in the Appendixhave tended to adopt pegged rates. In contrast, larger economies ordeveloping economies more closely integrated with international capitalmarkets have moved as expected toward greater exchange rate flexibility.However, since there is no information about the relative sizes of thereal and monetary shocks affecting each country, one cannot specify themost appropriate degree of exchange rate flexibility. Moreover, theoptimal degree of exchange rate flexibility would be expected to varyover time with changes in the authorities' perceptions regarding thenature and severity of these shocks.

b. Other considerations

In addition to real and monetary shocks, a number of other determi-nants of the most appropriate degree of exchange rate flexibility havebeen identified in the literature on optimum currency areas. Optimumcurrency area analyses have focused on the costs and benefits associatedwith expanding the area linked by fixed exchange rates. For example,Mundell (1961) first argued that a country should peg its exchange ratewith another country if the two countries shared a high degree of factormobility which would ensure real adjustment even without exchange rateadjustments. In contrast, McKinnon (1963) stated that the key factordetermining whether a country should fix its exchange rate was theopenness of the economy. In the short run, a relatively closed economycould use an exchange rate depreciation to switch expenditures fromtraded to nontraded goods, but a highly open economy would most likelyjust increase its price level. Subsequent analyses suggested that acountry should be included in an optimum currency area if, relative tothe existing members, it has a similar fiscal system, comparable size,limited geographic or commodity diversificaton of exports, a willingnessto share a common rate of inflation, and close trade and financialrelationship with the existing currency bloc. \J While it is generallyrecognzied that an optimum currency area would in most cases not corres-pond to the political boundaries of modern nation-states, these discus-sions do suggest that countries will tend to adopt greater exchange rateflexibility, the lower the degree of factor mobility between countries,the greater the divergence of fiscal systems, the more dispersed areinflation objectives, the less open are the individual economies, andthe less they are associated with existing currency blocs.

2. Monetary and exchange rate policies withimperfect but increasing market integration

While the analysis of monetary and exchange rate policy underconditions of perfect asset substitution helps to identify factors

1/ For a summary of these arguments see Tower and Willett (1976).

- 1 1 -


- 12 -

influencing the optimal combination of monetary and exchange ratepolicies, it provides little insight into the questions of why countriesuse different mixes of monetary and credit policy instruments and whatconsiderations would lead the authorities to alter this mix over time.With perfect asset substitution, for example, a ceiling on the expansionof domestic commercial bank credit would have no effects on domesticactivity if borrowers could immediately substitute foreign for domesticcredit. As already noted, the set of monetary and exchange rate instru-ments included in most analyses of exchange rate policy is much narrowerthan that the authorities typically use (Table 1 and Tables 2 through 12in the Appendix).

The changes in the mix of monetary policy instruments and exchangerate arrangements that have occurred in the past decade in part reflecta response to increasing but less than perfect degrees of integration ofgoods and assets markets. While international trade and financialtransactions have become increasingly important for all countries,empirical studies (e.g., Isard (1977)) have found that purchasing powerparity conditions can be violated for extended periods even among indus-trial countries. Moreover, Yuan (1986) recently argued that the overalldegree of financial market integration across Asian countries is stilllow for most countries, especially for medium- or long-term credits. ]_/Nonetheless, the gradual relaxation of capital controls has resulted inincreasingly close linked short-term financial markets, especiallyacross the major countries. 2/

With less than perfect integration of domestic and internationalmarkets, monetary and exchange rate policies no longer can be repre-sented by a single combined policy since many monetary and exchange ratepolicy instruments may have differential effects on the domestic economyand external transactions. 3/ This naturally makes the choice of themost effective instruments more complex, but some of relevant factorsinfluencing that choice can be illustrated by considering the conditionsunder which a country would use as its principal monetary policy instru-ment either a ceiling on the expansion of commercial bank credit orcontrols over the growth of domestic monetary aggregates. While manyother policy choices could be examined, this choice is most closely

]_/ Dooley, Frankel, and Mathieson (1987) found that the analysis ofsavings and investment patterns across both industrial and developingcountries suggest that, while some financial markets are closely inte-grated, this integration does not extend to the markets for physicalcapital.

2_/ The nature of these linkages, even in the presence of capitalcontrols, are discussed in Canto (1985) and De Macedo (1986).

_3/ The choice of policy instruments has been considered by Ann andJung ( 1 9 8 5 ) , Bryant ( 1 9 8 0 ) , Cot tare l l i , Gal l i , Reedtz and Pittaluga( 1 9 8 6 ) , Gardner (1983) , Mantel and Mart i rena-Mantel ( 1 9 8 2 ) , Rojas-Suarez( 1 9 8 7 a ) , and Wickham ( 1 9 8 5 ) .


- 13 -

related to the switch from credit to monetary instruments that is evi-dent in Table 1 and Tables 2 through 12 in the Appendix.

a. The choice of money and credit instruments

Whether the authorities' ability to achieve their domestic andexternal objectives will be enhanced by establishing and maintaining aceiling on a given monetary or credit aggregate will depend on a numberof characteristics of the domestic economy including the strength oflinkages between domestic and external goods and financial markets, thestructure of the domestic financial system, the state of the fiscalaccounts, and the country's exchange rate arrangements. _!_/

(1) Integration of domesticand external goods markets

The strength of the linkages between domestic and interna-tional markets for goods is a key factor influencing the use of ceilingsfor monetary or credit aggregates. If domestic and international tradedgoods markets are closely integrated, for example, movements in thedomestic prices of tradable goods would be tied to changes in theexchange rate and international prices. If international traded goodsprices are stable, domestic traded goods prices would then change onlyin response to an exchange rate movement. Stable domestic prices oftradable goods would also help stabilize the prices of nontraded goods.In this situation, inflation would generally be associated only with thechanges in prices produced by an exchange rate depreciation regardlessof the type of credit or monetary ceiling used. 2/

For most countries, however, the linkages between domestic andinternational goods markets are far less direct as a result of theexistence of trade barriers, transactions costs, and shipping charges.These weaker linkages provide scope for extended periods of domesticinflation and create the possibility of a conflict between the attain-ment of the authorities' external balance and inflation objectives.Domestic prices would respond not only to exchange rate adjustments butalso to such factors as increases in reserve money generated by theconversion of foreign exchange or issuance of domestic credit by thecentral bank. In this situation, a ceiling on domestic monetary growthcould be an important element in limiting inflation.

\J A general discussion of the role of money and credit, especiallyin developing countries is presented in Rojas-Suarez (198?a and b).

2/ There is still the issue of whether a fixed exchange rate couldremain fixed if there was excessive domestic credit expansion by thecentral bank. This possibility implies that the choice among monetaryand credit instruments may have to be based on the authorities otherobj ecti ves .


(2) Fiscal imbalances and the structureof domestic financial markets

A country's fiscal position and the structure of its domesticfinancial markets often interact to strongly influence whether a givenmonetary or credit aggregate will be effective and controllable. Inparticular, the absence of control over the fiscal accounts may meanthat neither a monetary nor a credit ceiling would be effective. Withregard to the former type of ceiling, a large fiscal deficit financed bythe provision of central bank credit to the government would clearlymake it difficult to maintain a reasonable rate of expansion for anymonetary aggregate. Moreover, the maintenance of a ceiling on credit ofthe banking system could involve an extensive redistribution of creditwithin the economy since any increase in central bank credit to thegovernment (which would also increase reserve money) would have to bematched by a reduction of credit to private borrowers by either thecentral bank or commercial banks. While an increase in central bankcredit to the government matched by a reduction in commercial bankcredit to the private sector is neutral in terms of satisfying theoverall credit ceiling on the financial system, such a shift may stillstrongly affect the level and distribution of economic activity. Incountries where credit is rationed more by administrative procedure thanby market interest rates, firms that are excluded from their traditionalsources of credit (e.g., central bank's special lending programs) mayhave considerable difficulty in finding new sources of funds. Thiswould be especially true for firms that are already in serious financialdifficulties. Thus, if an overall credit ceiling is maintained whenthere is a large government budget deficit, there could be a majorredistribution of credit between the private and public sectors whichcould lead to a sharp crowding out of private spending and thereby afall in real output and investment.

Another threat to the effectiveness of a ceiling on domestic creditof the banking system arises when an extensive system of unregulatedfinancial intermediaries exists or develops. In this case, any increasein reserve money (from whatever source) would allow increased lending bythe unregulated nonbank financial institutions even if credit from thebanking system remained at the ceiling level. The existence of such analternative source of credit naturally weakens the relationship betweena ceiling on credit of the banking system and the levels of spending andreal output.

(3) Integration with external financial markets

The strength of the linkages between domestic and interna-tional markets for financial instruments is also a key factor influenc-ing the use of ceilings for monetary and credit aggregates. Access tointernational financial markets affects the economy's structure in atleast two important ways: (1) it gives.residents an opportunity toacquire net credit (and goods and services) from abroad; and (2) reservemoney can expand as a result of the conversion of foreign exchange

- 14 -


- 15 -

acquired through current account imbalances or external borrowing.Depending on their size and sustainability, capital flows can weaken theeffectiveness of credit ceilings both by providing a source of creditfrom outside the banking system and also by creating an incentive forthe development of unregulated domestic sources of credit.

It has been suggested that the problems created by capital flowscould be mitigated by a ceiling placed on the expansion of reservemoney. Such a ceiling on reserve money would require the central bankto sterilize the impact of the capital inflows on reserve money byreducing the domestic credit of the central bank. While sterilizationis always possible in a technical sense, the sustainability of such apolicy depends on the cost of reducing central bank domestic credit andon the scope and persistence of the inflows. The domestic cost ofsterilization is, in part, related to the fact that the firms obtainingcredits from the external sector may be quite different from thoseeconomic units which obtain the central bank credits. In an economywhere credit is rationed and interest rates are constrained, it hasalready been noted that it may be quite difficult for firms or entei—prises that obtain credits from the central bank to obtain credits fromany other foreign or domestic source. Thus, the sterilization ofcapital inflows may involve a sharp redistribution of credit within theprivate sector, and this could create serious financing difficulties forcertain sectors of the economy. ]_/

The feasibility of sterilizing capital inflows is also determinedby the nature of the capital flows. In some situations, the capitalinflow may represent a once-and-for-all movement of capital betweendomestic and international markets. For example, there could be areflow of funds to the domestic market following a currency realignment.In cases where it was judged necessary to offset any price level effectof this inflow, either the credit ceilings could be adjusted in advanceby the anticipated size of this inflow or a ceiling on reserve moneycould ensure that automatic sterilization takes place.

There is a far more serious problem when the capital flows repre-sent the continuing arbitrage of financial market conditions betweendomestic and international markets. In economies with severe creditrationing, there are large incentives to obtain credit from interna-tional sources. In this case, sterilization of the capital inflow maynot only involve a sharp redistribution of credit within the privatesector (from those that obtain credits from the central bank to thosewith access to international financial markets) but also would noteliminate the original incentives for further capital flows. Thus, inthe presence of distortions or other conditions that give rise to con-

1_/ It is also important to note that in economies where credit isrationed primarily by interest rates, such sterilization would be muchless likely to have these sectoral effects since credit could flow fromone sector to another in response to changes in relative interest rates.


- 16 -

tinuing capital inflow, a ceiling on reserve money could lead to contin-uing increases in the central bank's foreign exchange reserves and anongoing redistribution of credit within the private sector. Alterna-tively, the absence of such a ceiling on reserve money could result in arapid increase in reserve money and thereby in inflationary pressure. \J

(4) Exchange rate policy

In general, a country's exchange rate arrangements will morestrongly influence the use of a ceiling on a monetary aggregate ratherthan a credit aggregate. With a commitment to hold the exchange ratefixed, or to adjust it only gradually (e.g., to reflect inflation dif-ferentials), the authorities may find it difficult to control the growthof domestic monetary aggregates over any extended period. Even when theauthorities limit the issuance of reserve money from domestic sources,portfolio and spending adjustments in the private sector would lead toexternal payments imbalances that could expand reserve money as theauthorities intervene in the foreign exchange markets to maintain theirexchange rate policy. In contrast, a flexible exchange rate would allowthe authorities to control the growth of reserve money which would makea ceiling on a monetary aggregate a potentially effective instrument.

To an important degree, the effectiveness of ceilings on domesticcredit depends more on the extent to which unregulated domestic andforeign sources of credit are available than on the nature of the coun-try's exchange rate arrangements. If sources of credit other thanthrough the domestic banking system are limited, then a ceiling ondomestic credit of the banking system can be quite effective in affect-ing domestic spending and activity regardless of the exchange ratestructure. As noted earlier, however, capital flows can create diffi-culties under a domestic credit ceiling, which may, therefore, requiresome degree of exchange rate flexibility. For example, if the exchangerate has been substantially depreciated in an effort to secure favorabletrade balance, then substantial capital inflows could be generated byyield differentials which reflect, in part, the expectation that furtherlarge exchange rate depreciations are unlikely. If such flows occur,there could be substantial inflationary pressure in the economy. Tolimit this inflation, a greater degree of exchange rate flexibility maybe required since a fixed exchange rate, relatively unrestricted capitalflows, and the establishment of effective ceilings on credit or reservemoney may at times be incompatible.

\J The potential inflationary effect of a continuing capital inflowwould also depend on how the borrowed funds are used. For example,foreign borrowing that is used to purchase foreign capital goods thatare employed in the domestic economy could yield a flow of resourcesmore than sufficient to service any external obligations. Moreover, tothe extent that this greater investment led to higher growth, it couldbe deflationary (with a flexible exchange rate and given money supply).


- 17 -

The combined influence of the above characteristics of an economyon the selection of a particular monetary or credit aggregate can beillustrated by comparing the conditions under which a ceiling on domes-tic credit would generally be preferred with the situation under which aceiling on a monetary aggregate would be most appropriate. A ceiling onthe domestic credit of the banking system would allow the authorities tohave the greatest influence on domestic spending and activity and there-by the country's external balance when most domestic financial institu-tions are part of the banking system, when domestic tradable goodsprices are closely tied to world prices, and when linkages betweendomestic and international financial markets are relatively weak. Withno alternative sources of domestic or foreign credit, control over thenominal level of domestic credit could be maintained with most types ofexchange rate arrangements. Moreover, with a fixed exchange rate, aceiling on domestic credit would generally be more readily attained thana ceiling on a monetary aggregate. The effectiveness of a credit ceil-ing would also be enhanced by the existence of relatively close tiesbetween domestic and international markets for goods. With such ties,there would be little possibility of extended periods of domestic infla-tion in the absence of continuing exchange rate or external price move-ments.

In contrast, a ceiling on a monetary aggregate would be most usefulwhen the economy has a flexible exchange rate, domestic goods prices arenot closely tied to world prices, there are stong linkages between thedomestic and international financial markets, and there are a variety ofunregulated domestic financial intermediaries than can provide creditthat is not subject to the ceiling on credit from the banking system.Since credit ceilings are typically defined with regard to the lendingof the banking system, the existence of significant credits either fromabroad or from nonbank financial intermediaries could seriously under-mine any relationship between the ceiling on banking system credit andeconomic activity or the current account balance. In addition, with aflexible exchange rate, control over the growth of domestic monetaryaggregates would be feasible since the authorities would not be requiredto undertake exchange market intervention. Such monetary control wouldbe especially important for limiting inflation if domestic goods priceswere not very strongly linked to international tradable goods prices.

These considerations provide some explanation for the changingpattern of the use of monetary and credit policy instruments by thecountries that is evident in Table 1 and Tables 2 through 12 in theAppendix. For example, those countries which have continued to usecredit instruments typically have had the most extensive controls onboth their domestic financial systems and foreign financial transactionsand have some form of pegged exchange rate. Since the access of domes-tic residents of these countries to external financial markets islimited, credit instruments retain their effectiveness unless unorga-nized financial markets of significant size emerge. However, whendomestic financial regulations have been liberalized and capital con-trols relaxed, countries have shifted toward greater degrees of exchange


rate flexibility and the use of monetary instruments. In such a situa-tion, ceilings on credit from the organized financial sector can bereadily evaded; whereas monetary instruments impose more effectiveconstraints, especially under flexible exchange rates.

b. Monetary and exchange rate policiesduring periods of extensive structural change

Although the importance of real and monetary shocks in the deter-mination of optimal monetary and exchange rate policies has been recog-nized, it has often been implicitly assumed that the underlying real andfinancial structure of the economy is unchanged when the choice ofpolicy instruments is made. I/ However, the period since 1975 haswitnessed extensive and ongoing structural change.

The need to formulate monetary and exchange rate policies in theface of often unanticipated and rapid structural change has created avariety of problems. In particular, the effectiveness of traditionalinstruments has often been eroded, thereby creating the need to developand employ new policy instruments. Moreover, even where a given instru-ment remains effective, the nature of its impact can vary over time asstructural changes alter the channels through which the instrumentaffects spending and portfolio decisions. The authorities, therefore,have faced not only the traditional problem of identifying how to usetheir existing set of instruments to achieve the best performance of agiven economic structure, but also how to use or modify the types ofinstruments that they employ over time.

While the optimal intertemporal pattern of monetary and exchangerate policies has recently been examined in a number of studies (e.g.,see Eaton (1985), Frenkel and Razin (1986), and Helpman and Razin(1987)), the desire to arrive at closed-form solutions for the complextheoretical models needed to analyze the issues involved has necessarilylimited the types of policies examined. Moreover, the problem of uncer-tainty regarding likely structural changes has not been addressed.However, many of the issues have been considered in a somewhat lessformal framework dealing with the design of monetary and exchange ratepolicies during periods of extensive trade, fiscal and financial reforms(e.g., see Khan (1987), McKinnon (1986), Mussa (1987), and Lai (1987)).These analyses have often dealt with an inflationary and partiallyindexed economy that has an uncontrolled fiscal deficit and extensivedistortions in goods, factor, and financial markets. It is generallyargued that the optimal mix of exchange rate arrangements and monetary(or credit) policies that should accompany the structural reforms will

1/ An exception to this has been the discussion (e.g., see Gray(1976) and Frenkel and Aizenman (1982)) of the optimal degree of wageindexation under alternative exchange rate regimes.

- 18 -


- 19 -

vary over time depending on the in i t i a l condi t ions f ac ing the economy,the pace of the structural reforms, and the speed wi th which domesticand external marke ts integrate. 1/

While the long-run objective of the reform program is to removepolicy induced dis tort ions in order to achieve greater e f f i c i e n c y , thediscussions of the sequencing of reform measures and s tabi l izat ionpolicies have been most concerned wi th ensuring that the adjus tment tothe long-run equ i l ib r ium is stable. The policy recommendations haveoften reflected the view that complete and instantaneous l iberalizationof goods, f i n a n c i a l , and factor markets in an environment of high infla-tion and general uncertainty about l ike ly macroeconomic developmentsdoes not work well . If prices in all markets were fu l ly f l ex ib le andexpectations cer tain, then there would be no sequencing problem—thepolicy distortions could be removed immediate ly and prices would quicklyadjust to establish a new e q u i l i b r i u m . 2J However , since asset marketsadjust more rapidly than goods or factor markets , it has been arguedthat the immedia te removal of capital controls and interest rateceilings could lead to capital inflows that result in a real apprecia-tion of the exchange rate which would work against the reallocation ofresources from the nontraded to traded goods sectors that the tradereform would be at tempting to achieve. As a result , a more carefulsequence of reforms is needed.

While there is far from a consensus about the most appropriatesequencing of policies, it is f requent ly recommended that the fiscalaccounts should be brought under control at the beginning of the reformperiod. The rationale for f i r s t undertaking the f iscal reform is thatthe other reforms are un l ike ly to be successful if a large fiscalimbalance is generating rapid monetary growth and high in f la t ion . It isalso argued that trade reforms (the removal of quotas and lowering oft a r i f f s ) should be announced early in the reform period and should bephased in a preannounced manner . The objective in adopt ing this gradu-alist program is to provide factors of production wi th time to movebetween sectors and also to indica te to investors the types of relativeprices (at least for traded goods) that are l ike ly to prevail in thefu tu re . 3/

_1_/ In a sense, however, even these analyses do not deal f u l l y withthe problems created by unant ic ipa ted structural changes: since theyfocus on policy-induced structural changes that are typicallypreannounced.

2J Even w i t h f l ex ib le prices, there could be a once-and-for-allcapital in f low and a new e q u i l i b r i u m real exchange rate.3/ There is also the question of whether the trade reforms are

perceived to be permanent or temporary. A temporary trade reform may beworse than no reform at all.


- 20 -

Monetary and exchange rate policies have been viewed as pursuingthree often contradictory objectives: (1) removing financial systemdistortions; (2) implementing a "forward looking" monetary policydesigned to stabilize prices; and (3) establishing external paymentsbalance and thereafter avoiding an excessive real appreciation of theexchange rate. While it is generally agreed that positive real interestrates should be established at an early stage, there has not been aconsensus about how best to achieve this objective. Some have arguedthat this can best be accomplished by immediately removing interest rateceilings, reducing required reserve ratios, eliminating portfolio selec-tion restrictions, and allowing for more entry into the financialsystem; but others have favored a more gradual elimination of thesedistortions especially in a highly inflationary environment where pastentry into the banking system was severely restricted. _]_/ Moreover,while some have favored establishing a floating exchange rate (e.g., Lai(1987)), McKinnon (1986) has argued for a more managed exchange ratepolicy encompassing a "passive" crawling peg policy (adjusting theexchange rate to reflect inflation differences) that should be usedduring the initial stages of the reform program when inflation is stillhigh and an "active" crawling peg that should be used when the budgetdeficit has been brought under control and inflation has slowed. Theactive crawl would be designed to provide an unambiguous signal aroundwhich private expectations about inflation could coalesce. However, tobe successful, this active crawling peg policy would have to besupported by appropriate labor and financial market policies to preventa real appreciation of the exchange rate. 2/

To support this managed exchange rate policy, it has been arguedthat the removal of capital controls should be delayed until the end ofthe reform period. Without such controls, high domestic real interestrates coupled with an improved prospect for the economy's future perfor-mance could induce a large capital inflow which would tend to appreciatethe real exchange rate. The resulting changes in relative goods priceswould induce inappropriate investments and distort the reallocation ofresources across sectors, thereby helping to destabilize the reformprocess. However, Lai (198?) has argued that capital controls should beremoved relatively early in the reform period (and the exchange rate

I/ There is also the issue of whether the full institutionalstructure needed for the operation of competitive markets is likely toexist at the beginning of the reform and how they can be developed. Theimplications of this issue for the reform process have been discussed byDooley and Mathieson (1987).2/ The use of real exchange rate policies is also subject to a

potential inflationary bias. See Adams and Gros (1986) for a discussionof this possibility.


- 21 -

floated) because it is unlikely that such immiserizing investment wouldtake place when expectations are rational and announcements arecredible. ]_/

Three conclusions seem warranted regarding the roles of monetaryand exchange rate policies during a period of structural reforms.First, there are a number of reasons why some differentiation existsbetween the effectiveness of exchange market intervention, provision ofcredit to the government, changes in interest rate ceilings, and modifi-cation of credit controls. These reasons include the fact that assetsare imperfect substitutes; markets adjust at different speeds; wages,prices, and interest rates do not immediately adjust to their long-runequilibrium values (and may actually overshoot); and the expectationsare uncertain (as opposed to irrational). Second, the optimal mix ofstabilization policies adopted will vary over the reform program. Forexample, the exchange rate arrangements best suited for the turbulentperiod at the beginning of the reform would be expected to be quitedifferent from that at the end of the reform period. Third, the optimalset of policy instruments would change over the course of the reformperiod as such instruments as credit controls and interest rate ceilingwould be replaced by more market oriented instruments (e.g., open marketoperation in government securities). This change would be a response tothe fact that adjustment in the economy would increasingly rely onchanges in the relative prices of goods, factors, and assets rather thancredit rationing or quantitative restrictions.

IV. Conclusions

One common element in the experiences of almost all countriesduring the past decade has been the need to adjust their exchange ratearrangements and monetary policy instruments in order to respond moreeffectively to extensive external and domestic disturbances. In thePacific Basin, these changes have encompassed the employment of greaterexchange rate flexibility and a switch from credit to monetary instru-ments; and they have been accompanied by a growing but still incompleteintegration of domestic and external financial markets and often sub-stantial liberalizations of domestic financial systems. However, the

1/ The issue in all reforms is how to make the announcements ofpolicies credible in a situation where past reforms may have beenreversed and the "staying power" of the current reform is unclear. Evenif private sector participants have a complete understanding of theeffects of the reforms (e.g., in the rational expectations sense they"know" the model), they may still be uncertain about whether the reformswill be sustained. In these circumstances, investors may significantlyshorten the maturity of their investments, attempt to make investmentsor loans that they feel they can get out of quickly if things go wrong,and delay long-term investments that would be appropriate if the reformshould be successful.


- 22 -

formulation of monetary and exchange rate policies was complicated bythe need to undertake extensive structural changes in the real andfinancial sectors to improve economic efficiency and adapt to a changinginternational environment. Many of the adjustments in monetary andexchange rate policies have been consistent with the types of policiesthat recent theoretical analyses recommended when a country is con-fronted with a period in which real shocks have dominated monetaryshocks.


Table 2. Australia: Exchange Rate Arrangements, Monetary Instruments,and Financial Characteristics of Selected Asian Countries I /

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

1981

1985

Exchange RateArrangements

Pegged to compositeindicator

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Independentlyfloating

Independentlyfloating

Monetary and CreditPolicy Instruments

During 1975-80, authorities initiallyfocused on use of a required reserve ratio(Statutory Reserve Deposits), a liquidityratio, controls on lending of financialinstitutions, and ceilings on Interestrates. First public reference of possibleoutcomes for growth of broadly definedmoney (M3) was in 3/76. Open market opera-tions and direct sales of government secur-ities to nonbanks increasingly used tolimit monetary expansion.

Major reforms in the period 1980-85.In December 1980, most ceilings on depositrates removed and those relating to loanrates relaxed. Quantitative bank lendingguidance terminated at end-June 1982.Exchange controls liberalized, and therewas a (December 1983) removal of portfoliorestrictions on banks (e.g., minimum matur-ity of deposits) and other nonbank finan-cial institutions. Reserve requirementlittle changed after 1981. Main Instrumentwas open market operations.

Capital ControlsPrior

Approval TaxLimitations Limita- Required or

or tlons for SpecialAdvanced on Foreign ReserveApproval Foreign Lending or Require-

Requlred on Currency Borrowing nentSurrender Advanced Payments Deposits by onof Export Import for by Financial ForeignProceeds Deposits Invisibles Residents Institution Borrowing

X -- X X X

X ~ X X X —

X " X X X ~

x — x x x

X — X X X

x — x x x —

X — X X X

X — X X X

—

—

--

\l A x ( — ) denoted the presence (absence) of a particular capital control. A blank indicates an absence of information.


Table 3- Burza: Characteristics of Selected Asian Countries, 1975-85 I /

Exchange RateYear

1975

1976

Arrangements

Pegged

Pegged

to

to

SDR

SDR

Capital ControlsPrior

Approval TaxLimitations Limita- Required or

or tlons for SpecialAdvanced on Foreign ReserveApproval Foreign Lending or Requlre-

Required on Currency Borrowing mentSurrender Advanced Payments Deposits by on

Monetary and Credit of Export Import for by Financial ForeignPolicy Instruments Proceeds Deposits Invisibles Residents Institution Borrowing

The bankingpally concerned

system has been prlncl- x — x x xwith supplying the flnan-

clal resources needed to fulfi l l the x — x x xauthorities overall national economic plan.

1977

1978

Pegged

Pegged

to

to

SDR

SDR

The volume and allocation of credit, x — x x xInterest rates.determined so as

and foreign borrowing areto be consistent with the x — x x x

plan's objectives. The banking system has1979

1980

1981

1982

1983

198K

1985

"

Pegged

Pegged

Pegged

Pegged

Pegged

Pegged

Pegged

A x (--)

to

to

to

to

to

to

to

SDR

SDR

SDR

SDR

SDR

SDR

SDR

denoted the

been the primarycredit, and the

presence (absence) of

, often the sole, source of x — x x xbanks are state owned.

X " X X X

x -- x x x

x — x x x

X ~ X X X

x — x x x —

X " X X X —

a particular capital control. A blank indicates an absence of Information.


Table «. Fi j i : Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

1981

1985

1/2/1'


Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite


Throughout this period, there havebeen both cash reserve and governmentsecurity ratios. The allocation of credithas been affected by portfolio allocationrules for banks. In June 1981, ceiling onlarge deposit rates removed, and othersteps taken during 1982-85 to gradualderegulation interest rates. Open marketoperations have not been used actively.

A x ( — ) denotes the presence (absence) of a particular capital control. AGenerally free but large amounts subject to approval.Net foreign liabilities of banks subject to a 5 percent reserve requirement

RequiredSurrender Advancedof Export ImportProceeds Deposits

X

X

X

X

X

X

X

X

X

X

X

PriorApproval Tax

Limitations Llmlta- Required oror tions for Special

Advanced on Foreign ReserveApproval Foreign Lending or Require-

on Currency Borrowing mentPayments Deposits by on

for by Financial ForeignInvisibles Residents Institution Borrowing

2f

21

2J

2/

2/

2/

2/

Zl

2/

21

Zf

blank Indicates an absence of

•

x x 3/

X X

x x

x x

x x

x x

x x

x x

x x

x x

x x

information.>T3T)tnaaHHx©International Monetary Fund. Not for Redistribution

Table 5. Japan: Characteristics of Selected Asian Countries, 1975-85 ]_/

Capital Controls

Year

1975

1976

1977

1978

197.9

1980

1981.

1982.

1983

198U

1985

I/

t/5/6/

RequiredSurrender Advanced

Exchange Rate Monetary and Credit of Export ImportArrangements Policy Instruments Proceeds Deposits

Independently floating Throughout most of this period, broadmoney (M2) has been used as a monetary

Independently floating policy Indicator. To Influence M2, thecentral bank has relied on a complex mecha-

Independently floating nisn of short-term money market operationsto meet short-run changes in demand for

Independently floating reserve money and bond market operations toprovide for trend growth in the demand.

Independently floating These operations were supported throughdiscount policy, reserve ratios, and

7/ Independently floating (during the period until 1980) window guid-ance policy. While most interest rates

Independently floating were controlled in 1975, there has been agradual removal of such celling rates. As

Independently floating the proportion of f inancial instrumentscarrying market determined Interest rate

Independently floating has Increased, there has been increasingemphasis on control of monetary aggregates

Independently floating as opposed to bank credit .

Independently f loat ing

Limitationsor

AdvancedApproval

onPayments

forInvisibles

Zf

2/

5/

—

—

—

—

—

—

—

--

Limita-tionson

ForeignCurrencyDeposits

byResidents

3/

3/

I/

I'

I!

I!

I!%/

3/

1'-


forForeign

Lending orBorrowing

byFinancial

Institution

x J/

x I/

x £/

x V

' .§/

6/

e/

6/

6V

6/

6/

Taxor

SpecialReserveRequire-

menton

ForeignBorrowing

._

—x

X

—

—--

—

—

—

—

A x ( — ) denoted the presence (absence) of a particular capital control. A blank indicates an absence of information.Certain l imitat ions on large payments.Foreign currency deposit overseas subject to prior approval if not carried out by authorized bank.Foreign exchange banks subject to controls over their overall net position In foreign currencies.Payments subject to verif icat ion but without l i m i t a t i o n .Generally free but certain transactions require prior notice and wai t ing period.

TJ Since the Foreign Exchange and Foreign Trade Control Law became effect ive in December 1980, capital transactions are In general permitted unlessspecifically prohibited.

1/

3/


Table 6. Korea: Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Limitationsor

AdvancedApproval

Required onSurrender Advanced Payments

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

198K

1985

I/2/3/u/5/S/

Exchange Rate Monetary and CreditArrangements Policy Instruments

Pegged to U.S. dollar From 1975 to 1982, authorities reliedon reserve ratios, ceilings on Interest

Pegged to U.S. dollar rates, limits on volume of bank credits,and rules governing allocation of credit.

Pegged to U.S. dollar Interest rate ceilings were nonethelessused flexibly. As part of a financial

Pegged to U.S. dollar reform in 1982, direct credit controls onlending by individual banks were replaced

Pegged to U.S. dollar by indirect control through use of reserverequirements, open market operations, and

Managed floating the rediscount mechanism. Preferentialinterest rates were eliminated, but credit

Managed f loat ing allocation rules were retained. Regularreserve requirements have been supplemented

Managed floating by monetary s tabi l izat ion accounts (effec-tively a marginal reserve requirement).

Managed f loating

Managed floating

Managed floating

A x ( — ) denoted the presence (absence) of a particular capital control. AOr deposited In foreign exchange accounts In domestic banks.

of Export Import forProceeds Deposits Invisibles

x 21 x

x 2_t x

x 21

X 21

x 2J

x 21

x 21

x 21

x 2J

x £/

x 21

blank indicates an absence

x

x

X

X

X

X

X

X

X

X

X

Limita-tionson


byResidents

V

l>

V

3/

H/

K /

£/

ix

II /

I/

ix

PriorApproval TaxRequired or

for SpecialForeign Reserve

Lending or Require-Borrowing ment

by onFinancial Foreign

Institution Borrowing

x

x

X

X

X

X

x

X

X

lx

6/

of Information.

Certain residents may hold foreign currency deposits at foreign exchange banks.All residents may hold foreign currency deposits at foreign exchange banks.Borrowing above certain minimum amounts require approval.Subject to ceilings on conversion of foreign borrowing. All outward bound capital requires approval.


Table 7. Malaysia: Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

1981

1985

I /21y

at a5/6/


Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite


During 1975 and 1976, the authoritiesInstruments Included reserve and liquidityratios, controls on Interest rates, andcredit allocation rules. Since October1978, interest rates have been graduallyliberalized. During the 1980s, open marketoperations, foreign exchange swap opera-tions I/ and the recycling of governmentdeposiTs became Important instruments, butthe authorities continue to use reserve andl iquidi ty requirements and credit alloca-tion rules as Instruments.

A x ( — ) denoted the presence (absence) of a particular capital controlL i m i t e d exchange control governing report ing and payments structure.Few restrictions.Swap of fore ign exchange between central bank and f inancial Inst i tut ion

more favorable exchange rate for the financial inst i tut ion at the end ofIf above certain l imits.

RequiredSurrender Advancedof Export ImportProceeds Deposits

21

21

21

2J

2J

2J

21

21

21

I

21

Limitationsor

AdvancedApproval

onPayments

forInvisibles

y

y

y

yyy

yyyyIJ

PriorApproval

Limlta- Requiredtlons foron Foreign

Foreign Lending orCurrency BorrowingDeposits by

by FinancialResidents Institution

X

5/

5/

5/

5/

6/

6/

6/

6/

Taxor

SpecialReserveRequi re -

menton

ForeignBorrowing

—

—--

--

—

—

—

—

—

——

A blank Indicates an absence of information.

at current exchange rateone to three months.

accompanied by

Banks could borrow f r ee ly , but there was a l i m i t on their net foreign currency position. Nonbanks could borrow

agreement to unwind the

freely from abroad sums

transaction

which wereless than M$100,000, but they also faced a l imi t on their net foreign currency position.

4/


Table 8. New Zealand: Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

198U

1985


Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Managed f loat ing

Managed floating

Managed floating

Managed f loat ing

Independently floating


During the period up to 1981, theauthorities' instruments Included reserveratios, government security ratios, rulesgoverning the allocation of expansion ofcredit and (at t imes) controls on theexpansion of credit. While Interest ratecontrols were relaxed during 1977-80, theywere relnstituted during 1981-82. Monetarygrowth was also l imited through marketfinancing of the government defici t . In1981, all rat io requirements were abol-ished, open market operations were usedmore act ively , discount policy was tight-ened, guidelines on credit to privatesector were abolished, Interest rate ceil-ings were removed, and capital controlswere liberalized.

Limita t ionsor

AdvancedApproval

Required onSurrender Advanced Paymentsof Export Import forProceeds Deposits Invisibles

x ~ 21

X x 21

x x 21

x — 21

x — 21

x — 21

x — 21

X — 21

2J

—

--

Limita-tionson


byResidents

x

x

X

X

X

X

X

X

X

—

—



Lending or Requlre-Borrowlng ment



x

x

X

x

x

x

X

X

X

v -- --

l / A x (--) denotes the presence (absence) of a particular capital control. A blank indicates an absence of Information.~2/ Certain payments required reserve bank approval.3/ Limitations on borrowing by corporate ent i t les .


Table 9. Singapore: Characteristics of Selected Asian Countries, 1975-85 \l

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

198H

1985


Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite

Pegged to composite


Since a government budget surplus(especially for the retirement fund) hasacted to reduce base money growth, redis-count operations have been the main domes-tic source of monetary growth. Balance ofpayments flows nave also been a majorsource of monetary growth. While therewere reserve and liquidity ratios, theytended to be changed infrequently.

Limitationsor

AdvancedApproval


21 — V

2f — 3/

2/ -- If

—--

—

—~

—

—

—

PriorApproval Tax

Limita- Required ortions for Specialon Foreign Reserve

Foreign Lending or Require-Currency Borrowing raentDeposits by on

by Financial ForeignResidents Institution Borrowing

X

X

2/

—

—„

—_.

-.

_.

._

_!_/ A x ( — ) denoted the presence (absence) of a particular capital control. A blank indicates an absence of information.2/ Above certain minimum amounts.3_/ Above certain maximum amounts.


Table 10. Sri Lanka: Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

1981

1985

1 /21


Pegged to sterling

Pegged to a composite

Independently f loat ing




Managed floating

Managed floating

Managed f loat ing

Managed f loat ing

Managed f loat ing


Instruments have included interestrate ceilings, limits on access of indivi-dual banks to Central Bank credit andcredit allocation rules. By 1978, princi-pal instruments were the Bank rate, theamount the Central Bank would finance atthat rate, and the penalty rate for furtherdiscounts. In June 1981, the Central Bankbegan auctions of Central Bank securities.

A x (--) denotes the presence (absence) of a particular capital control.Certain payments require exchange control permission.

Limitationsor

AdvancedApproval


X — X

x — x

x — 21

x — 21

x — 21

x — 21

x — |/

x — 2J

x — 21

x — 2J

x — Zf

Limi ta-tionson


byResidents

x

X

X

X

X

X

x

X

X

X

X



Lending or Require-Borrowing ment



x

x

X

X

X

X

X

X

X

X

X

A blank indicates an absence of information.


Table 11. Thailand: Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

198K

1985

1/2/1'


Other flexiblearrangement










Pegged to composite

A x C — ) denoted theSome limitation (e.g.


Instruments have included ceilingInterest rates, reserve and liquidityratios, rediscount facilities, credit allo-cation rules, and occasional ceilings oncredit expansion by banks. In 1979, arepurchase market for government securitieswas created. By 1985, unwanted fluctua-tions in reserve money were principallyoffset by operations in the government bondmarket.

presence (absence) of a particular capital control., on travel).

Limitationsor

AdvancedApproval


x — U

x — 2t

x — 2f

x ~ 21

x ~ 2f

x — Zl

x — 2/

x -- 2/

x — 2/

x — 2_/

x — 2/

Limita-tionson


byResidents

x

x

X

X

X

X

X

X

X

X

X


forForeign

Lending orBorrowing

byFinancial

Institution

x

x

X

X

X

X

x

X

x

V

I!

Taxor


menton

ForeignBorrowing

_ —

—

—

—

—

—

—

—

—

—

—

A blank indicates an absence of Information.

A limit existed on financial institutions net foreign currency position.


Table 12. Western Samoa: Characteristics of Selected Asian Countries, 1975-85 I/

Capital Controls

Year

1975

1976

1977

1978

1979

1980

1981

1982

1983

1981

T985


Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

Managed floating

RequiredSurrender

Monetary and Credit of ExportPolicy Instruments Proceeds

Instruments have Included interest xrate ceilings, required reserve ratios.credit allocation rules, and controls over xvolume of bank lending.

X

X

X

X

X

X

X

X

X

AdvancedImport

Deposits

y2/

2/

Zf

2/

2/

2f

—

—

2f

Limitationsor

AdvancedApproval

onPayments

forInvisibles

X

X

X

X

X

X

X

X

X

X

X

Limita-tionson


byResidents

X

X

X

X

X

X

X

X

X

X

X


forForeign

Lending orBorrowing

byFinancial

Institution

X

X

X

X

X

X

X

X

X

X

X

Taxor


menton

ForeignBorrow! ng

_.

~

—

—--

—

—~

--

—

~

1/ A x ( — ) denoted the presence (absence) of a particular capital control. A blank Indicates an absence of information.~ZI For motor vehicles.0


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