International_Economics_Tenth_Edition (1)

crises for their own profit. The world's best-known currency speculator, George Soros, made $2 billion in 1992 by speculating against European currencies. However, speculation can also result in substantial losses. George Soros retired in 2000 after suffering the effects of losing almost $2 billion as the result of unsuccessful speculations. However, currency speculation is not just an activity of big speculators,

Millions of ordinary people also speculate in the form of holding foreign currency in their wallets, under their mattresses, and the like. Millions of small speculators can move markets like the big speculators do. Simply put, currency crises are not simply caused by big currency speculators who arise out of nowhere. There must be an underlying reason for a currency crisis to occur.

460 Exchange-Rate Systems and Currency Crises

One source for a currency crisis is budget deficits financed by inflation. If the government cannot easily finance its budget deficits by raising taxes or borrowing, it may pressure the central bank to finance them by creating money. Creating money can increase the supply of money faster than demand is growing, thus causing inflation. Budget deficits financed by inflation seemed to capture the essentials of many currency crises up through the 1980s. By the 1990s, however, this explanation appeared to be lacking. During the currency crises in Europe in 1992-1993, budget deficits in most adversely affected countries were small and sustainable. Moreover, most East Asian countries affected by the currency crisis of 1997-1998 were running budget surpluses and realizing strong economic growth. Economists have thus looked for other explanations of currency crises.

Currency crisis may also be caused by weak financial systems. Weak banks can trigger speculative attacks if people think the central bank will rescue the banks even at the cost of spending much of its foreign reserves to do so. The explicit or implicit promise to rescue the banks is a form of moral hazard-a situation in which people do not pay the full cost of their own mistakes. As people become apprehensive about the future value of the local currency, they sell it to obtain more stable foreign currencies.

Some of the major currency crises of the last 20 years have occurred in countries that had recently deregulated their financial systems. Many governments formerly used financial regulations to channel investment into politically favored outlets. In return, they restricted competition among banks, life insurance companies, and the like. Profits from restricted competition subsidized unprofitable governmentdirected investments. Deregulation altered the picture by reducing government direction of investments and allowing more competition among institutions. However, governments failed to ensure that in the new environment of greater freedom to reap the rewards of success, financial institutions also bore greater responsibility for failure. Therefore, financial institutions made mistakes in the unfamiliar environment of deregulation, failed, and were rescued at public expense. This resulted

in public fears about the future value of local currency and the selling of local currency to obtain more stable foreign currencies.

A weak economy can trigger a currency crisis by creating doubt about the determination of the government and the central bank to continue with the current monetary policy if weakness continues. A weak economy is characterized by falling GDP growth per person, a rising unemployment rate, a falling stock market, and falling export growth. If the public expects the central bank to increase the money supply to stimulate the economy, it may become apprehensive about the future value of the local currency and beginning selling it on currency markets.

Political factors can also cause currency crises. Developing countries have historically been more prone to currency crises than developed countries because they tend to have a weaker rule of law, governments more prone to overthrow by force, central banks that are not politically independent, and other characteristics that create political uncertainty about monetary policy.

External factors can be another source for a currency crisis. For example, an increase in interest rates in major international currencies can trigger a currency crisis if a central bank resists increasing the interest rate it charges. Funds may flow out of the local currency into foreign currency, decreasing the central bank's reserves to unacceptably low levels and therefore putting pressure on the government to devalue its currency if the currency is pegged. Moreover, a big external shock that disrupts the economy, such as war or a spike in the price of imported oil, can likewise trigger a currency crisis. External shocks have been key features in many currency crises historically.

Finally, the choice of an exchange-rate system also affects whether and how currency crises occur. In recent years, fixing the value of the domestic currency to that of a large, low-inflation country has become popular. It helps to keeping inflation under control by linking the inflation rate for internationally traded goods to that found in the anchor country. For example, prior to 2002, the exchange rate for the Argentine peso was pegged at one peso per U.S. dollar. Thus, a bushel of corn sold on the world market at $4 had its price set at 4 pesos. If the public expects this exchange rate to be

unchangeable, the fixed rate has the extra advantage of anchoring inflation expectations for Argentina to the inflation rate in the United States, a relatively low-inflation country.

In spite of the advantage of promoting relatively low inflation, a fixed exchange-rate system makes countries vulnerable to speculative attacks on their currencies. Recall that preservation of fixed exchange rates requires the government to purchase or sell domestic currency for foreign currency at the target rate of exchange. This forces the central bank to maintain a sufficient quantity of international reserves in order to fulfill the demand by the public to sell domestic currency for foreign currency at the fixed exchange rate. If the public thinks that the central bank's supply of international reserves has decreased to the level where the ability to fulfill the demand to sell domestic currency for foreign currency at a fixed exchange rate is doubted, then a devaluation of the domestic currency is anticipated. This anticipation can result in a speculative attack on the central bank's remaining holdings of international reserves. The attack consists of huge sales of domestic currency for foreign currency so that the decrease of international reserves is expedited, and devaluation results from the decline of reserves. In is no wonder that the most important recent currency crises have happened to countries having fixed exchange rates but demonstrating lack of political will to correct previous economic problems.

Next, we will examine two cases of currency crisis: the speculative attack on the Swedish krona and the speculative attacks on East Asian currencies.

Speculators Attack the Krona

In May 1991, Sweden applied to enter the Exchange Rate Mechanism of the European Union in a bid to stabilize its currency: To stabilize the krona-mark exchange rate, interest rates in Sweden and Germany had to be the same. Thus, the Swedish and German central banks couldn't independently use changes in short-term interest rates if they wanted to keep the exchange rates stable. If Sweden wanted to act independently, it had

'Gregory Hopper, "What Determines the Exchange Rate: Economic Factors or Market Sentiment?" Business Review, Federal Reserve Bank of Philadelphia, September/October 1997, p. 23.

to use fiscal policy (tax and government spending policies) to stimulate the country's growth rate.

However, a weak Swedish economy provoked speculators, who mounted an attack on the krona in September 1992. Speculators knew that the weak economy would tempt Sweden to abandon its fixed exchange rate and use monetary policy to cut shortterm interest rates, especially since the new Swedish government was adopting restrictive fiscal policy. Speculators believed that if the Swedish central bank cut the short-term interest rate, the krona wouldn't be as attractive to investors. Thus, the speculators thought that after interest rates were cut, the currency would depreciate with respect to other European currencies. But because speculators expected the depreciation to happen, they decided to sell the krona immediately and thus mount a speculative attack on the currency.

This attack put the Swedish central bank in an uncomfortable position. To combat the currency's depreciation, the central bank raised short-term interest rates temporarily to repel the speculative attack--exactly the policy it didn't want in the face of sluggish economic growth. In fact, the Swedish central bank raised the short-term interest rate to an astonishing 500 percent and held it there for four days. The speculators were deterred, but not for long.

The speculators understood that the Swedish central bank had to raise short-term interest rates temporarily to support the currency. But they were betting that the central bank wouldn't fight off the attack for long, especially in the face of disquiet in the country resulting from weak economic growth and the higher interest rates needed to fight the speculative attack. The high short-term interest rates had made the economic situation in Sweden even more precarious so, in November, the speculators attacked again, selling the krona in favor of other European currencies. This time the Swedish central bank did not aggressively raise interest rates, and the krona depreciated.

Speculators Attack

East Asian Currencies

After more than a decade of maintaining the Thai baht's peg to the U.S. dollar, Thai authorities

462 Exchange-Rate Systems and Currency Crises

abandoned the peg in July 1997. 5 By October, market forces had led the baht to depreciate by 60 percent against the dollar. The depreciation triggered a wave of speculation against other Southeast Asian currencies. Over the same period, the Indonesian rupiah, Malaysia ringgit, Philippine peso, and South Korean won abandoned links to the dollar and depreciated 47, 35, 34, and 16 percent, respectively. This episode reopened one of the oldest debates in economics: whether a currency should have a fixed or floating exchange rate. Consider the case of Thailand.

Although Thailand was widely regarded as one of Southeast Asia's outstanding performers throughout the 1980s and 1990s, it relied heavily on inflows of short-term foreign capital, attracted both by the stable baht and by Thai interest rates, which were much higher than comparable interest rates elsewhere. The capital inflow supported a broad-based economic boom that was especially visible in the real estate market.

By 1996, however, Thailand's economic boom fizzled. As a result, both local and foreign investors got nervous and began withdrawing funds from Thailand's financial system, which put downward pressure on the baht. However, the Thai government resisted the depreciation pressure by purchasing baht with dollars in the foreign-exchange market and also raising interest rates, which increased the attractiveness of the baht. But the purchases of the baht greatly depleted Thailand's reserves of hard currency. Moreover, raising interest rates adversely affected an already weak financial sector by dampening economic activity. These factors ultimately contributed to the abandonment of the baht's link to the dollar.

Although Thailand and other Southeast Asian countries abandoned fixed exchange rates in 1997, some economists questioned whether such a policy would be in their best interest in the long run. Their reasoning was that these economies were relatively small and wide open to international trade and investment flows. Moreover, inflation rates were modest by the standards of a developing country, and labor markets were relatively

'Ramon Mnrr nn. "Lessons from Thailand," Economic l etu:r. Federal

Reserve Bank of San Francisco, November 7 ] 997.

flexible. In other words, floating exchange rates were probably not the best long-run option. Indeed, these economists maintained that unless the Southeast Asian governments anchored their currencies to something, currencies might drift into a vicious cycle of depreciation and higher inflation. There was certainly a concern that central banks in the region lacked the credibility to enforce tough monetary policies without the external constraint of a fixed exchange rate. Simply put, neither fixed exchange rates nor floating exchange rates offer a magical solution. What really makes a difference to a country's prospects is the quality of the overall economic policies that are pursued.

I Capital Controls

Because capital flows have often been an important element in currency crises, controls on capital movements have been established to support fixed exchange rates and thus avoid speculative attacks on currencies. Capital controls, also known as exchange controls, are government-imposed barriers to foreign savers investing in domestic assets (for example, government securities, stock, or bank deposits) or to domestic savers investing in foreign assets. At one extreme, a government may seek to gain control over its payments position by directly circumventing market forces through the imposition of direct controls on international transactions. For example, a government that has a virtual monopoly over foreign-exchange dealings may require that all foreign-exchange earnings be turned over to authorized dealers. The government then allocates foreign exchange among domestic traders and investors at government-set prices.

The advantage of such a system is that the government can influence its payments position by regulating the amount of foreign exchange allocated to imports or capital outflows, limiting the extent of these transactions. Capital controls also permit the government to encourage or discourage certain transactions by offering different rates for foreign currency for different purposes. Furthermore, capital controls can give domestic monetary and fiscal policies greater freedom in their stabilization roles. By controlling the balance of payments through

capital controls, a government can pursue its domestic economic policieswithout fear of balance- of-payments repercussions.

Speculative attacks in Mexico and East Asia were fueled in part by large changes in capital outflows and capital inflows. As a result, some economists and politicians argued for restrictions on capital mobility in developing countries. For example, Malaysian Prime Minister Mahathir imposed limits on capital outflows in 1998 to help his economy regain financial stability.

Although restrictions on capital outflows may seem attractive, they suffer from several problems. Evidence suggests that capital outflows may further increase after the controls are implemented, because confidence in the government is weakened. Also, restrictions on capital outflows often result in evasion, as government officials get paid to ignore domestic residents who shift funds overseas. Finally, capital controls may provide government officials the false senseof securitythat they do not have to reform their financial systemsto ameliorate the crisis.

Although economists are generally dubious of controls on capital outflows, controls on capital inflows often receive more support. Supporters contend that if speculative capital cannot enter a country, then it cannot suddenly leave and create a crisis. They note that the financial crisis in East Asia in 1997-1998 illustrated how capital inflows can result in a lending boom, excessive risk taking by domestic banks, and ultimately financial collapse. However, restrictions on the inflow of capital are problematic because they can prevent funds that would be used to finance productive investment opportunities from entering a country. Also, limits on capital inflows are seldom effective because the private sector finds ways to evade them and move funds into the country.'

Should Foreign-Exchange

Transactions Be Taxed?

The 1997-1998 financial crises in East Asia, in which several nations were forced to abandon their fixed exchange-rate regimes, produced demands for more stability and government regu-

'Sebastian Edwards, "How Effective Are Capital Controls?" Journat of Economic Perspective, Winter 2000, Vol. 13, No.4, pp. 65-84.

lation in the foreign-exchange markets. Indeed, market volatility was blamed for much of the trouble sweeping the region.

Economists generally argue that the free market is the best device for determining how money should be invested. Global capital markets provide needy countries with funds to grow, while permitting foreign investors to diversify their portfolios. If capital is allowed to flow freely, they contend, markets will reward countries that pursue sound economic policies and will pressure the rest to do the same. Indeed, most countries welcome and even encourage capital inflows such as foreign direct investment in factories and businesses, which represent long-lasting commitments. But some have become skeptical of financial instruments such as stocks and bonds, bank deposits, and short-term debt securities, which can be pulled out of a country with a stroke of a computer key. That's what occurred in East Asia in 1997, in Mexico in 1994 and 1995, and in the United Kingdom and Italy in 1992 and 1993.

To prevent international financial crises, several notable economists have called for sand to be thrown in the wheels of international finance by imposing a tax on foreign-exchange transactions. The idea is that a tax would increase the cost of these transactions, which would discourage massive responses to minor changes in information about the economic situation and thus dampen volatility in exchange rates. Proponents argue that such a tax would give traders an incentive to look at long-term economic trends, not short-term hunches, when buying and selling foreign exchange and securities. Traders must pay a small tax, say, 0.1 percent for every transaction, so they won't buy or sell unless expected returns justify the additional expense. Fewer transactions suggest less volatility and more stable exchange rates.

Proponents of a tax may well contend that they are not trying to interfere with free markets, but only to prevent excess volatility. However, we do not know how much volatility is excessive or irrational. It's true that economists cannot explain all exchange-rate volatility in terms of changes in the economic fundamentals of nations, but it does not follow from this that we should seek to regulate such fluctuations. Indeed,

464Exchange-Rate Systems and Currency Crises

some of the volatility may be produced by uncertainty about government policies.

There are other drawbacks to the idea of taxing foreign-exchange transactions. Such a tax could impose a burden on countries that are quite rationally borrowing overseas. By raising the cost of capital for these countries, it would discourage investment and hinder their development. Also, a tax on foreign-exchange transactions would be difficult to implement. Foreign-exchange trading can be conducted almost anywhere in the world, and a universal agreement to impose such a tax seems extremely unlikely. Those countries that refused to implement the tax would become centers for foreign-exchange trading.

IIncreasing the Credibility

of Fixed Exchange Rates

As we have learned, when speculators feel that a central bank is unable to defend the exchange rate for a weakening currency, they will sell the local currency to obtain more stable foreign currencies. Are there ways to convince speculators that the exchange rate is unchangeable? Currency boards and dollarization are explicitly intended to maintain fixed exchange rates and thus prevent currency crises.

Currency Board

A currency board is a monetary authority that issues notes and coins convertible into a foreign anchor currency at a fixed exchange rate. The anchor currency is a currency chosen for its expected stability and international acceptability. For most currency boards, the U.S. dollar or British pound has been the anchor currency. Also, a few currency boards have used gold as the anchor. Usually, the fixed exchange rate is set by law, making changes to the exchange rate very costly for governments. Put simply, currency boards offer the strongest form of a fixed exchange rate that is possible short of full currency union.

The commitment to exchange domestic currency for foreign currency at a fixed exchange rate requires that the currency board have sufficient foreign exchange to honor this commitment. This means that its holdings of foreign exchange must

at least equal 100 percent of its notes and coins in circulation, as set by law. A currency board can operate in place of a central bank or as a parallel issuer alongside an existing central bank. Usually, a currency board takes over the role of a central bank in strengthening the currency of a developing country.

By design, a currency board has no discretionary powers. Its operations are completely passive and automatic. The sole function of a currency board is to exchange its notes and coins for the anchor at a fixed rate. Unlike a central bank, a currency board does not lend to the domestic government, to domestic companies, or to domestic banks. In a currencyboard system, the government can finance its spending only by taxing or borrowing, not by printing money and thereby creating inflation. This results from the stipulation that the backing of the domestic currency must be at least 100 percent.

A country that adopts a currency board thus puts its monetary policy on autopilot. It is as if the chairman of the board of governors of the Federal Reserve System were replaced by a personal computer. When the anchor currency flows in, the board issues more domestic currency and interest rates fall; when the anchor currency flows out, interest rates rise. The government sits back and watches, even if interest rates skyrocket and a recession ensues.

Many economists maintain that, especially in the developing world, central banks are incapable of retaining nonpolitical independence and thus instill less confidence than is necessary for the smooth functioning of a monetary system. They are answerable to the prerogatives of populism or dictatorship and are at the beck and call of political changes. The bottom line is that central banks should not be given the onerous responsibility of maintaining the value of currencies. This job should be left to an independent body whose sole mandate is to issue currency against a strict and inalterable set of guidelines that require a fixed amount of foreign exchange or gold to be deposited for each unit of domestic currency issued.

Currency boards can confer considerable credibility on fixed exchange-rate regimes. The most vital contribution a currency board can make to exchange-rate stability is by imposing discipline on

the process of money creation. This results in greater stability of domestic prices, which, in turn, stabilizes the value of the domestic currency. In short, the major benefits of the currency-board system are:

•making a nation's currency and exchange-rate regimes more rule-bound and predictable

•placing an upper bound on the nation's base money supply

•arresting any tendencies in an economy toward inflation

•forcing the government to restrict its borrowing to what foreign and domestic lenders are willing to lend it at market interest rates

•engendering confidence in the soundness of the nation's money, thus assuring citizens and foreign investors that the domestic currency can always be exchanged for some other strong currency

•creating confidence and promoting trade, investment, and economic growth

Proponents cite Hong Kong as a country that has benefited from a currency board. In the early 1980s, Hong Kong had a floating exchange rate. The immediate cause of Hong Kong's economic problems was uncertainty about its political future. In 1982, the United Kingdom and China began talks about the fate of Hong Kong after the U.K.'s lease on the territory expired in 1997. Fear that China would abandon Hong Kong's capitalist system sent Hong Kong's stock market down by 50 percent. Hong Kong's real estate market weakened also, and small banks with heavy exposure in real estate suffered runs. The result was a 16 percent depreciation in the Hong Kong dollar against the u.s. dollar. With this loss of confidence, many merchants refused to accept Hong Kong dollars and quoted prices in U.S. dollars instead. Panic buying of vegetable oil, rice, and other staples emptied merchants' shelves.

In 1983, the government of Hong Kong ended its economic crises by announcing that Hong Kong would adopt a currency-board system. It pegged its exchange rate at HK$7.8 = US$1. The currency reform immediately reversed the loss of confidence about Hong Kong's economy despite continuing troubles in the U.K.-China discussions.

A stable currency provided the basis for Hong Kong to continue its rapid economic growth.

By maintaining a legal commitment to exchange domestic currency for a foreign currency at a fixed exchange rate, and a commitment to issue currency only if it is backed by foreign reserves, a currency board can be a good way of restoring confidence in a country gripped by economic chaos. Although a currency board cannot solve all of a country's economic problems, it may achieve more financial credibility than a domestic central bank can.

Although currency boards help discipline government spending, therefore reducing a major source of inflation in developing countries, there are concerns about currency boards. Perhaps the most common objection is that a currency board prevents a country from pursuing a discretionary monetary policy and thus reduces its economic independence. Also, it is sometimes said that a currency-board system is susceptible to financial panics because it lacks a lender of last resort. Another objection is that a currency-board system creates a colonial relationship with the anchor currency. Critics cite the experiences of British colonies, which operated under currency-board systems in the early 1900s.

It is possible for a nation's monetary system to be orderly and disciplined under either a currency board or a central banking system. But neither system by itself guarantees either order or discipline. The effectiveness of both systems depends on other factors, such as fiscal discipline and a sound banking system. In other words, it is a whole network of responsible and mutually supporting policies and institutions that make for sound money and stable exchange rates. No monetary regime, however well conceived, can bear the entire burden alone.

For Argentina, No Panacea

in a Currency Board

For much of the post-World II era, when the financial press focused on Argentina, it was to highlight bouts of very high inflation and failed stabilization efforts. Hyperinflation was rampant in the 1970s and 1980s, and prices increased by more than 1,000 percent in both 1989 and 1990.

466 Exchange-Rate Systems and Currency Crises

In 1991, to tame its tendency to finance public spending by printing pesos, Argentina introduced convertibility of its peso into dollars at a fixed one- to-one exchange rate. To control the issuance of money, the Argentines abandoned their central- bank-based monetary regime, which they felt lacked credibility, and established a currency board. Under this arrangement, currency could be issued only if the currency board had an equivalent amount of dollars.

The fixed exchange rate and the currency board were designed to ensure that Argentina would have a low inflation rate, one similar to that in the United States. At first, this program appeared to work: By 1995, prices were rising at less than 2 percent per year.

During the late 1990s, however, the Argentine economy was hit with four external shocks: (1) the appreciation of the dollar, which had the same negative effect on Argentine exportand importcompeting industries that it had on similar industries in the United States; (2) rising U.S. interest rates that spilled over into the Argentine economy, resulting in a decrease in spending on capital goods; (3) falling commodity prices on world markets, which significantly harmed Argentina's commodity-exporting industries; and (4) the depreciation of Brazil's real, which made Brazil's goods relatively cheaper in Argentina and Argentina's goods relatively more expensive in Brazil. These external shocks had a major deflationary effect on the Argentine economy, resulting in falling output and rising unemployment.

Argentina dealt with its problems by spending much more than it collected in taxes to bolster its economy. To finance its budget deficits, Argentina borrowed dollars on the international market. When further borrowing became impossible in 2001, Argentina defaulted, ended convertibility of pesos into dollars, and froze most deposits at banks. Violence and other protests erupted as Argentinians voiced their displeasure with politicians.

Some economists have questioned whether the establishment of a currency board was a mistake for Argentina. They note that although Argentina tied itself to the American currency area as if it were Utah or Massachusetts, it did not benefit from adjustment mechanisms that enable the American currency area to work smoothly in the face of neg-

ative external shocks. For example, when unemployment rose in Argentina, its people could not move to the United States were jobs were relatively plentiful. Also, Federal Reserve policy was geared to the conditions of the United States rather than to Argentina. Moreover, the U.S. Congress did not target American fiscal policy on problem areas in Argentina. As a result, the negative shocks to the Argentine economy were dealt with by wage and price deflation. It was a consequence of having fixed its currency rigidly to the dollar.

Dollarization

Instead of using a currency board to maintain fixed exchange rates, why not "dollarize" an economy? Dollarization occurs when residents of, say,Ecuador, use the U.S. dollar alongside or instead of the sucre. Partial dollarization occurs when Ecuadoreans hold dollar-denominated bank deposits or Federal Reserve notes to protect against high inflation in the peso. Partial dollarization has existed for years in many Latin American and Caribbean countries, where the United States is a major trading partner and a major source of foreign investment.

Full dollarization means the elimination of the Ecuadorean sucre and its complete replacement with the U.S. dollar. The monetary base of Ecuador, which initially consisted entirely of sucre-denominated currency, would be converted into U.S. federal Reserve notes. To replace its currency, Ecuador would sell foreign reserves (mostly U.S. Treasury securities) to buy dollars and exchange all outstanding sucre notes for dollar notes. The U.S. dollar would be the sole legal tender and sole unit of account in Ecuador. Full dollarization has occurred in the U.S. Virgin Islands, the Marshall Islands, Puerto Rico, Guam, Ecuador, and other Latin American countries.

Full dollarization is rare today because of the symbolism countries attach to a national currency and the political impact of a perceived loss of sovereignty associated with the adoption of another country's unit of account and currency. When it does occur, it is principally implemented by small countries or territories that are closely associated politically, geographically, and/or through extensive economic and trade ties with the country whose currency is adopted.

Why Dollarize?

Why would a small country want to dollarize its economy? Benefits to the dollarizing country include the credibility and policy discipline that is derived from the implicit irrevocability of dollarization, Behind this lies the promise of lower interest and inflation rates, greater financial stability, and increased economic activity. Countries with a history of high inflation and financial instability often find the potential offered by dollarization to be quite attractive. Dollarization is considered to be one way of avoiding the capital outflows that often precede or accompany an embattled currency situation.

A major benefit of dollarization is the decrease in transaction costs as a result of a common currency. The elimination of currency risk and hedging allows for more trade and more investment within the unified currency zone to occur. Another benefit is in the area of inflation. The choice of another currency necessarily means that the rate of inflation in the dollarized economy will be tied to that of the issuing country. To the extent that a more accepted, stable, recognized currency is chosen, lower inflation now and in the future can be expected to result from dollarization. Finally, greater openness results from a system where exchange controls are unnecessary and balance of payments crises are minimized. Dollarization will not assure an absence of balance of payments difficulties, but it does ensure that such crises will be handled in a way that forces a government to deal with events in an open manner, rather than by printing money and contributing to inflation.

Effects of Dollarization

A convenient way to think about any country that plans to adopt the dollar as its official currency is to treat it as one would treat any of the 50 states in the United States. Thus, in discussions about monetary policy in the United States, it is assumed that the Federal Reserve conducts monetary policy with reference to national economic conditions rather than the economic conditions in an individual state or region, even though economic conditions are not uniform throughout the country. The reason for this is that monetary policy works

through interest rates on credit markets that are national in scope. Thus, monetary policy cannot be tailored to deal with business conditions in an individual state or region that is different from the national economy. When Ecuador dollarized its economy, it essentially accepted the monetary policy of the Federal Reserve.

With dollarization in Ecuador, U.S. monetary policy would presumably be carried out as it is now. If Ecuadorean business cycles do not coincide with those in the United States, Ecuador could not count on the Federal Reserve to come to its rescue, just as any state in the United States cannot count on the Federal Reserve to come to its rescue if its business conditions are out of sync with the national pattern. This may be a major downside for the Ecuadoreans. Despite this, Ecuador might still be better off without the supposed safety valve of an independent monetary policy.

Another limitation facing the Ecuadoreans is that the Federal Reserve is not their lender of last resort as it is for Americans. That is, if the U.S. financial system should come under stress, the Federal Reserve could use its various monetary powers to aid these institutions and contain possible failures. Without the consent of the U.S. Congress, the Federal Reserve could not perform this function for Ecuador or for any other country that decided to adopt the dollar officially as its currency.

A third shortcoming arising from the adoption of the dollar as the official currency is that Ecuador could no longer get any seigniorage from its monetary system. This cost for Ecuador stems from the loss of the foreign reserves (mainly U.S. Treasury securities) that Ecuador would have to sell in exchange for dollars. These reserves bear interest and, therefore, are a source of income for Ecuador. This income is called seigniorage. But once Ecuador's reserves are replaced by dollar bills, this source of income disappears.

With dollarization, Ecuador would enjoy the same freedom that the 50 states in the United States enjoy as to how to spend its tax dollars. Ecuador state expenditures for education, police protection, social insurance, and the like would not be affected by its use of the U.S. dollar. Also, Ecuador could establish its own tariffs, subsidies, and other trade policies. Therefore, Ecuador's

sovereignty would not be compromised in these areas. There would, however, be an overall constraint on Ecuador fiscal policy: Ecuador would not have recourse to printing more pesos to finance budget deficits and would thus have to exercise caution in its spending policies.

Official dollarization of Ecuador's economy also has implications for the United States. First, when Ecuadoreans acquire dollars they surrender goods and services to Americans. Thus, for each dollar sent abroad, Americans enjoy a one-time increase in the amount of goods and services they are able to consume. Second, by opting to hold

dollars rather than the interest-bearing debt of the United States, the United States, in effect, gets an interest-free loan from Ecuador. The interest that does not have to be paid is a measure of seigniorage that accrues on an annual basis to the United States. On the other hand, use of U.S. currency abroad might hinder the formulation and execution of monetary policy by the Federal Reserve. Also, by making Ecuador more dependent on U.S. monetary policy, dollarization could result in more pressure on the Federal Reserve to conduct policy according to the interests of Ecuador rather than those of the United States.

1.Most nations maintain neither completely fixed nor floating exchange rates. Contemporary exchange-rate systems generally embody some features of each of these standards.

2.Small, developing nations often anchor their currencies to a single currency or a currency basket. Anchoring to a single currency is generally used by small nations whose trade and financial relationships are mainly with a single trading partner. Small nations with more than one major trading partner often anchor their currencies to a basket of currencies.

3.The special drawing right (SDR) is a currency basket composed of five currencies of IMF members. The basket-valuation technique attempts to make the SDR's value more stable than the foreign-currency value of any single currency in the basket. Developing nations often choose to anchor their exchange rates to the SDR.

4.Under a fixed exchange-rate system, a government defines the official exchange rate for its currency. It then establishes an exchangestabilization fund, which buys and sells foreign currencies to prevent the market exchange rate from moving above or below the official rate. Nations may officially devalue/revalue their currencies to restore trade equilibrium.

S.With floating exchange rates, market forces of supply and demand determine currency values. Among the major arguments for floating

rates are (a) simplicity, (b) continuous adjustment, (c) independent domestic policies, and

(d) reduced need for international reserves. Arguments against floating rates stress (a) disorderly exchange markets, (b) reckless financial policies on the part of governments, and

(c)conduciveness to price inflation.

6.With the breakdown of the Bretton Woods system of fixed exchange rates, major industrial nations adopted a system of managed floating exchange rates. Under this system, centralbank intervention in the foreign-exchange market is intended to prevent disorderly market conditions in the short run. In the long run, exchange rates are permitted to float in accordance with changing supply and demand.

7.To offset a depreciation in the home currency's exchange value, a central bank can (a) use its international reserves to purchase quantities of that currency on the foreign-exchange market;

(b)initiate a contractionary monetary policy, which leads to higher domestic interest rates, increased investment inflows, and increased demand for the home currency. To offset an appreciation in the home currency's exchange value, a central bank can sell additional quantities of its currency on the foreignexchange market or initiate an expansionary monetary policy.

8.Under a crawling-peg exchange-rate system, a nation makes frequent devaluations (or