The last three decades saw an extraordinary increase in cross-border capital flows and the elimination of barriers to free capital mobility. From a historical perspective, however, financial globalization is not a new phenomenon. A first wave of globalization started in the middle of the 19th century and came to an abrupt end with World War I. This era was characterized by a high level of integration reached again only in the 1990s. Obstfeld and Taylor (2004) characterize the development stages of global financial markets, connecting financial globalization in the 19th century with the present, by the exchange rate regimes and their consequences for capital flows. During the period from 1870 until 1914, most countries successively adopted the classical gold standard and both capital and labor markets were highly integrated. Policymakers followed a laissez-faire policy and few restrictions were imposed on financial markets. The following period, between 1914 to 1945, was shaped by the two World Wars and the Great Depression leading to a rise in nationalism. During this time, policymakers increasingly focused on domestic goals and pursued protectionist policies. Capital controls were put in place to pursue monetary policy under more flexible exchange rates. As a consequence, private capital flows ceased and national financial markets decoupled.
The Bretton Woods system characterized the period between 1945 and 1971 when currencies were linked through a system of fixed but adjustable exchange rates to the US-Dollar. However, significant capital controls were in place and allowed countries some policy autonomy. Financial markets started to reintegrate; the process, however, was slow and mainly driven by international trade flows. After the breakdown of the Bretton Woods system in 1971, the developed countries moved towards more flexible exchange rates, capital account restrictions were successively lifted and capital increasingly flowed across borders. However, Obstfeld and Taylor (2004) and others estimate that only in the 1990s did capital mobility regain the degree achieved in 1914.
The development phases of global financial markets are strongly influenced by the macroeconomic policy trilemma between free capital mobility, fixed exchange rates, and independent monetary policy (Obstfeld and Taylor, 1998). High capital mobility is only reconcilable with fixed exchange rates when monetary policy is subordinated to these goals and with the pursuit of domestic goals only when the exchange rate is allowed to adjust to market conditions. The simultaneous achievement of domestic policy goals and exchange rate stability is only feasible when capital controls are in place. This trilemma helps in understanding the ups and downs in financial integration.
After the breakdown of Bretton Woods and the financial liberalization in the 1970s, countries did not only experience increased real and nominal exchange rate volatility but also a variety of crises. Hence, financial integration poses significant challenges for policymaking. This thesis consists of three self-contained chapters studying financial globalization and the implications for monetary and exchange rate policy. Chapter 2 analyzes the empirical patterns underlying exchange rate regime announcements and deviations in de facto policies and highlights the role of financial integration. Chapter 3 focuses on the consequences of financial openness for monetary policy, more specifically, for inflation targeting. Financial globalization in the 19th century is the focus of chapter 4 which examines the role of Germany as a financial center.
The increasing capital mobility and the emerging market crises in the 1990s led to the bipolar view and the observation of fear of floating which are the starting points for the analysis in chapter 2. In accordance with the policy trilemma, the bipolar view states that countries should move towards the extreme corners of exchange rate flexibility by either joining a monetary union, unilaterally adopting the currency of another country, or operating a currency board, thereby, surrendering monetary independence, or by having a freely floating exchange rate (Fischer, 2001). Intermediate exchange rate regimes, more precisely soft pegs, are not considered viable as long as capital is internationally mobile. Figure 2.2 illustrates that for the two reference years of Fischer, 1991 and 1999, there was indeed a shift from announced (de jure) intermediate exchange rate regimes to fixed and flexible ones. A more continuous appraisal of regime choices, however, is much less clear-cut and the high share of de facto intermediate regimes throughout the 1990s further challenges the bipolar view. Furthermore, there is widespread agreement that it is not uncommon for countries to declare a different exchange rate regime than they actually follow (Calvo and Reinhart, 2002). However, the observation of fear of floating raises the question: If countries indeed have good reasons to manage their exchange rate actively, why would they not announce a regime consistent with optimal policies?
Starting from this observation, chapter 2 studies the apparent disconnect between what countries announce to be their exchange rate regime and what they de facto implement. Discrepancies between announcements and de facto policies are a quantitatively important phenomenon describing policies in roughly 40 per cent of all countries. Nevertheless, there is still a lack of understanding of actual patterns and underlying reasons. The aim of chapter 2 is to fill some of the gaps present in existing studies. Starting from the hypothesis that observed regime discrepancies are systematic, i.e., not the result of random policy errors, it provides evidence for the existence of systematic elements in observed regime discrepancies by linking them to specific country characteristics. The main empirical finding is that countries tend to communicate exchange rate regimes at the corners of the flexibility spectrum, i.e., either fixed or flexible regimes, but to operate intermediate regimes. Whether countries announce a fixed or flexible exchange rate depends on country characteristics, in particular related to trade structure, financial development, and financial openness. Also, countries at different stages of economic and financial development differ in the nature of regime discrepancies. Finally, the decreasing frequency of countries managing their exchange rate less than announced and the increasing occurrence of countries intervening more than announced align with broader economic trends and developments worldwide related to financial globalization and changes in monetary policy design.
The separation of communication and implementation of exchange rate policy may provide policymakers with an additional tool to tackle challenges from financial globalization. In an era of high financial integration and capital mobility, countries may not be restrained to choose between pursuing an independent monetary policy and stable exchange rates while refraining from capital controls. For numerous countries the optimal policy may be neither of the two extremes but a combination. However, as intermediate exchange rate regimes are difficult to communicate, see, e.g., Frankel, Fajnzylber, Schmukler and Serven (2001), countries may find it optimal to use exchange rate regime announcements and a diverging implementation as a second best policy.
The empirical patterns point at the role of monetary policy within the macroeconomic policy trilemma. Especially emerging market economies that adopted inflation targeting and, hence, announce flexible exchange rates, manage their exchange rate more than announced. This is not surprising as the exchange rate is one, if not the most important price in an open economy. As small open economies steadily move away from fixed exchange rates towards a more independent monetary policy, open economy aspects become increasingly important in analyzing monetary policy. The literature frequently resorts to two simple concepts in international economics, purchasing power parity and uncovered interest rate parity, to describe the relation between prices, interest rates, and exchange rates between countries. Although the empirical relevance of these two concepts is subject to an ongoing debate, they are frequently used in theoretical models. Chapter 3 examines the implications of these concepts on the implementation of monetary policy. Monetary policy is analyzed in an open economy version of the standard New Keynesian framework described by Clarida, Galí and Gertler (1999). More specifically, flexible inflation targeting as characterized by Svensson (2007) is the monetary policy under scrutiny. A central bank operating under flexible inflation targeting is not only concerned about stabilizing the inflation rate around the target but additionally about stabilizing the real economy.
Purchasing power parity is based on the idea that international goods arbitrage keeps the relative purchasing power of two currencies constant over time. Uncovered interest rate parity is derived from arbitrage in international financial markets according to which the nominal exchange rate adjusts to interest rate differentials. Chapter 3 contributes to the literature by analyzing in a unified framework how these two concepts and possible alternatives used in the literature affect monetary policy. More specifically, the implications for the interest rate reaction function describing monetary policy responses to shocks under flexible inflation targeting are examined. Thereby, useful insights into the consequences of using the simple concepts of purchasing power parity and uncovered interest rate parity in monetary policy analysis are provided.
The main insight is that the interest rate reaction function is affected when purchasing power parity and uncovered interest rate parity are relaxed. As long as purchasing power parity holds, monetary policy reacts only to cost-push shocks and excess-demand shocks. If, however, purchasing power parity does not hold, monetary policy also fully offsets the effects of foreign shocks. Furthermore, not the direction but the strength of the interest rate response to cost-push shocks and excess-demand shocks is affected. Whether the relation between interest rates and exchange rates is described by uncovered interest rate parity or in the more generic way proposed by Ball (1999) does affect both to which type of shocks monetary policy responds and how strong the response is.
Contents
1 Introduction
2 When countries do not do what they say: Systematic discrepancies between exchange rate regime announcements and de facto policies
2.1 Introduction
2.2 Data
- 2.2.1 Exchange rate regimes and discrepancies
2.2.2 Explanatory variables
2.3 Time trends and joint factors
2.4 Descriptive statistical analysis
- 2.4.1 Consistent regime combinations
2.4.2 Intervening less than announced (ILA)
2.4.3 Intervening more than announced (IMA)
2.5 Econometric analysis
- 2.5.1 Methodological considerations
2.5.2 Baseline results
2.5.3 Robustness checks - sensitivity analysis
2.5.4 Interpretation of the empirical evidence
2.6 Conclusions and outlook
2.A Appendix
- 2.A.1 Data issues
2.A.2 Graphs and tables
3 Inflation targeting in small open economies
3.1 Introduction
3.2 Literature review and stylized facts
3.3 Theoretical model
3.4 Implementing flexible inflation targeting
- 3.4.1 Basic model
3.4.2 Relaxing purchasing power parity
3.4.3 Relaxing purchasing power parity and uncovered interest rate parity
3.5 Comparison of the results
3.6 Conclusion
3.A Derivation of the interest rate reaction function .
4 Financial globalization in the 19th century: Germany as a financial center
4.1 Introduction
4.2 Capital markets, main players, and regulations in stock exchanges
- 4.2.1 Development of the German stock exchanges
4.2.2 Main players
4.2.3 Regulation of the stock exchanges
4.2.4 The process of issuance
4.3 International issuances
- 4.3.1 Data sources
4.3.2 Aggregate issuances
4.3.3 Individual foreign securities
4.4 The role of external shocks
- 4.4.1 The model
4.4.2 Estimation
4.4.3 Robustness checks
4.5 Conclusion
4.A Appendix: Figures and tables
Bibliography
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