Future Exchange Rate Policy: Rules or Discretion?
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Thai Baht appreciation is now the hottest issue in Thailand and the most interesting for many with various attempted measures proposed for the government and the Bank of Thailand (BOT).
It is my opinion, however, that these are somewhat ad-hoc short-term strategy proposals that should give way to a desirable long-term exchange rate policy process. Thus, my discussion paper will focus on whether rules or discretion will provide better, more desirable solutions in the long-term.
Economically speaking, a discretionary policy is considered as launched from a policymaker whose authority is free to act in accordance with his own judgment. By this definition, the authorization of the policymaker to contextually adapt the goals or means of a policy provision must make it a kind of discretionary policy. We may infer too, that the discretionary concept is aligned with the Keynesian macroeconomics theory, which encourages governments to intervene in economic activity.
By contrast, rules restrict the use of a policymaker own judgment as his or her authority is also overruled, thus committing the policymaker to accomplish certain assigned goals without reference to external factors. This concept is congruent with neoclassical macroeconomic theory, in which the market mechanism operates under rules of law.
In the past, many economists believed the use of discretion to be better than rules.Discretionary judgment allows the quick adjustment of policies where circumstances are uncertain, whereas rules are fixed to legislation.
In practice now, however, economists begin to prefer rules over discretion. Policymakers who use authority overbearingly are worse than those restricted by rules as private sector confidence is lost where there is no commitment to policy, though this is a necessary condition for reaching policy goals. This claim was proven in the Nobel prize-winning paper of Kydland and Prescott (1977), named ldquo;Rules rather than Discretion: The Inconsistency of Optimal Plans.rdquo;
In the context of exchange rate policy, discretionary policies include exchange rate intervention, both on the demand and supply side of foreign currencies, where the operation is based on policymaker judgments.
Under rules, the exchange rate stabilization policy is committed to assigned goals that the exchange rate ldquo;hostrdquo; must accomplish.
Having followed these rules for a somewhat extended period, in my opinion, almost every exchange rate solution proposal then becomes discretionary in nature, implementing the provisions under somebodyrsquo;s judgment without previous commitment. One lone proposal may be considered a rule, however, thus targeting a change in framework for the exchange rate in order to limit the fluctuation of the Thai Baht.
The inflation targeting approach of BOT provides the best example of policymaker commitment. The BOT must accomplish its assigned goal by implementing monetary instruments in order to keep the inflation rate lower than the target rate. When the BOT first embarked on an inflation targeting approach, Thailandrsquo;s low inflation rate after economic crisis testified to the success of rule implementation for policy stabilization in Thailand.
On the other hand, there is no organization committed to an exchange rate stabilization goal. Though the BOT is responsible for exchange rate stabilization, there is no commitment to this goal. Therefore, the private sector tends to treat Thai Baht speculation as easy to implement.
If rules are proposed as essential for exchange rate policy stabilization, there must be a government organization (perhaps BOT) assigned to commit to such exchange rate stabilization. Legislative back-up will also be necessary for this commitment to receive private sector confidence.
However, it would not be desirable to target rules in a fixed exchange rate system. The exchange rate should be partially flexible and free to change according to the market mechanism, though not be subject to excessive fluctuation. I would therefore propose that the instruments of change be sorted into groups of low, medium and high potency. A legal ruling must also cite which specific instruments of change are suited to exact levels of fluctuation. This would be able to lead private sector expectations in relation to future exchange rate trends. The making of good rules is, however, inevitable; with impossible rules likewise ruinous to the Thai economy, such as the rule of ten years ago proved to be in fixing the exchange rate at 25 baht per US dollar. Where rules lack and are biased, there are also harmful effects for the country.