1

EXCHANGE RATE REGIMES AND

MONETARY POLICY IN SMALL OPEN ECONOMIES∗∗∗∗

Philip R. Lane

Economics Department and IIIS, Trinity College Dublin

and CEPR

This version: May 2002

Abstract

For an economy with open capital markets, it is well understood that monetary policy is constrained by the choice of exchange rate regime. This chapter provides an overview of the relationship between exchange rate regimes and monetary policy rules. For a small open economy, the restrictions imposed on monetary policy by different types of fixed exchange rate regime (including the currency board case) and the range of monetary policy rules under more flexible exchange rate arrangements are considered. The roles played by external shocks and internal policy consistency in determining performance are analysed. A review of the impact of nominal and structural rigidities and financial development on the relative desirability of alternative regimes and monetary policy rules are also given. Finally, the sustainability of alternative regimes is discussed: for instance, what are the requirements to operate a successful currency board arrangement?

∗ Prepared for The Choice of Exchange Rate Regime and Monetary Policy Rules in Accession to EU and in Entry to EMU (Bank of Estonia). I am grateful to an anonymous referee for useful comments. Email: plane@tcd.ie. Address: Economics Department, Trinity College Dublin, Dublin 2, Ireland. Telephone: 353-1-6082259. Fax: 353-1-6772503.

2

1. Introduction

The objective of this chapter is to provide an overview of the comparative properties of the

alternative monetary and exchange rate strategies that are available to small open economies.

Small economies can be defined by an inability to affect world prices in goods and asset

markets: in many ways, this is liberating in that the policies adopted by a small economy are not

constrained by their impact on the global macroeconomic equilibrium. For small economies that

are open to international trade in goods and assets, the exchange rate is a critically important

relative price and the choices of monetary policy and the exchange rate regime cannot be

separately analysed.

Since other chapters in this section present specific theoretical models in great

detail, our approach here is to take a wide-ranging approach in order to provide a general

perspective on the complex set of issues that underlie the optimal choice of exchange rate

regime and monetary policy strategy for a small open economy. We discuss the general

principles that should guide such decisions. In addition, in the later sections of the paper, we

emphasize the practical problems in implementing monetary commitments such as a promise to

maintain a fixed value of the exchange rate. In turn, this leads us to an analysis of the conditions

that are required in order to make such commitments sustainable.

This chapter is organized as follows. Section 2 highlights the role played by trade

openness in determining the effectiveness of monetary policy. In section 3, we analyze the

functions of monetary policy in terms of achieving price stability and counteracting

3

macroeconomic volatility. We also consider the impact of foreign-currency debt and financial

frictions on the transmission mechanism of monetary and exchange rate policies and the role of

policy shocks in driving business cycle fluctuations. Section 4 studies the properties of

temporary exchange rate pages and speculative attack episodes. We turn to the requirements for

sustaining a hard exchange rate peg (currency union, unilateral adoption of a foreign currency or

a currency board) in section 5. Finally, section 6 offers some concluding remarks.

2. Trade Openness and the Effectiveness of Monetary Policy

As a precursor to the subsequent analysis, we highlight in this section the limitations imposed

by trade openness for the effectiveness of monetary policy in improving welfare. To make this

point, consider a two-sector economy that produces traded and nontraded goods.1 For

simplicity, we assume that the output of the traded sector is a fixed endowment, with its

foreign-currency price determined on world markets and the law of one price holding.

However, nontraded goods are differentiated and produced under monopolistic competition.

Moreover, there is a nominal rigidity in the nontraded sector: prices are set one period in

advance.

Let preferences be given by

0(1 )log log logt t

Nt Tt Ntt t

M dV c c h yP

εβ α αε

∞

=

= − + + −

∑ (1)

1 See Obstfeld and Rogoff (1996) and Lane (1997) for more details on this model.

4

where α is the relative size of the traded sector and thereby represents an index of economic

openness. The parameter restrictions are 1 , 0, , 0, 1d hα β ε> > > ≥ and we assume the elasticity

of substitution between the differentiated varieties of the nontraded good is 1θ > . We assume

international asset trade is in an indexed bond that is denominated in units of the traded good.

Obstfeld and Rogoff (1996) and Lane (1997) fully describe the characteristics of this

model. We consider here the impact of a surprise permanent monetary expansion on welfare, in

order to gauge the role of economic openness in determining the effectiveness of monetary

policy. With the unit elasticity of substitution between traded and nontraded goods that is

embodied in the preferences in equation (1), the monetary shock does not induce any current

account imbalance and therefore has only short-run effects. The impact on nontraded output

and consumption (in percentage changes) is given by

! "N Nc y m= =! (2) where "m is the size of the monetary shock: under sticky prices, short-run nontraded activity

rises in proportion to the monetary shock.

We can use equation (1) to evaluate the net impact on welfare: on the positive side,

consumption has risen; on the negative side, there is an increase in work effort. If we assume

that real balances play a minor part in welfare ( 0h → ), there is a very simple expression for the

change in welfare

5

(1 ) 1; 0dVdV αθ α θ− ∂= = − <

∂ (3)

From equation (3), two factors affect the welfare gain from a monetary surprise. First, the more

competitive is the economy (i.e. the larger is θ ), the lower is the incentive to have an activist

monetary policy since the volume of free-market output is closer to the socially desirable level.

Second, a more open economy (i.e. the larger is α ) also gains less from a surprise monetary

expansion: since the price stickiness and the output distortion is in the nontraded sector, the net

impact on welfare is directly related to the relative size of the nontraded sector in the economy.

As a quantitative illustration, Table 1 shows the relative welfare improvement for

different degrees of trade openness. We observe that the gain is sharply decreasing in

openness: if relative size of the traded sector is 80 percent, the net increase is only 25 percent of

that obtained if the traded sector constituted only 20 percent of the economy.

The lesson from this section is that the evaluation of alternative exchange rate regimes

and monetary regimes will differ for more open versus less open economies. In what follows,

we focus on the appropriate monetary and exchange rate arrangements for small open

economies: the same recommendations may not apply for larger economic entities such as the

US, Japan or the aggregate euro zone.

6

3. The Functions and Limitations of Monetary Policy

It is necessary to recognize the multi-functional nature of monetary and exchange rate policies

in determining the appropriate regime for a given country. In addition, it is also important to

appreciate the limitations to what can be feasibly achieved by even the best monetary strategy.

In this section, we first consider the primary goal of attaining price stability before turning to

counter-cyclical stabilization objectives. In the latter parts of the section, we also discuss the

implications of foreign-currency liabilities, policy shocks and external factors in influencing the

relative desirability of alternative regimes.

3.1 Price Stability

3.1.1. General Issues

The primary function of monetary policy is to provide medium-term price stability. It is well

known that medium- or high- average rates of inflation impose generate economic costs

(Fischer et al 2002). Significant levels of inflation requires that resources be diverted to

minimizing the role of domestic money in the economy; makes more difficult the setting of

prices and wages; reduces the signaling power of the market price mechanism; and increases

the dispersion of prices. Moreover, the real value of unindexed nominal assets is destroyed by

unanticipated high inflation, leading to a redistribution of income and an increase in the poverty

rate among those reliant on nominally-fixed income streams. The empirical evidence is that

inflation rates above a threshold value significantly reduces long-term economic growth

performance (Sarel 1996)

7

At an operational level, the European Central Bank employs a sensible definition of

price stability as �an increase in prices below 2 percent.� By targeting non-negative inflation,

the spectre of deflation is thereby minimized. Inflation of 1-2 percent is not viewed with

concern, since it is well known that measured CPI inflation is likely overstated due to the

substitution and quality biases inherent in the construction of such indices.

Since the central bank cannot perfectly control the price level, the medium-term

(say 2-3 years) is the appropriate horizon for evaluating the achievement of price stability. This

allows the central bank to discount purely transitory shocks such as seasonal fluctuations in

food or energy prices that exert no lasting influence on the price level. It also potentially allows

the central bank to employ monetary policy to avoid unnecessary volatility in output or other

welfare-relevant macroeconomic variables to the extent these goals are consistent with the

attainment of medium-term price stability.

For large economies (the US, Japan or the eurozone), the technical challenge in

delivering such price stability is relatively minor since the consumer price index is largely

driven by domestic price developments. For a small open economy, fluctuations in the

exchange rate can seriously impede the ability of the central bank to achieve this objective.

Short-term exchange rate volatility increases the �noise-to-signal� ratio in interpreting price

level movements. This is exacerbated by the fact that, all else equal, the pass-through of

exchange rate movements to consumer prices is likely to be inversely related to the size of the

economy. As such, the central bank must successfully decompose exchange rate movements

into the components that are perceived to be purely transitory (that can be ignored for the

8

purpose of achieving medium-term price stability) and those that are long lasting in nature (that

must induce a corresponding change in monetary policy to avoid inflation/deflation).

In contrast, if the small open economy and the anchor country share similar

medium-term economic prospects, a stable medium-term price level can be achieved more

directly by a fixed exchange rate that links price developments in the small open economy to

those in the anchor zone. Of course, this statement is based on the assumption that the central

bank of the anchor zone will indeed deliver low inflation, which is a reasonable prediction for

the European Central Bank (or indeed the US Federal Reserve).

3.1.2 Real Exchange Rate Adjustment and the Price Level The main obstacle to attaining medium-term price stability under a fixed exchange rate is if the

real exchange rate of the small open economy is projected to experience long-run trend

appreciation (or indeed depreciation) vis-à-vis the anchor zone. With a fixed nominal exchange

rate, real appreciation requires a positive inflation differential with respect to the anchor zone. To

see this, define the real exchange rate as

*SPRERP

= (4)

where S is the number of domestic currency units per unit of foreign currency, *P is the foreign

consumer price index and P is the domestic consumer price index. Let Π denote rates of

change. Then we have that the rate of real depreciation is given by

9

*RER S P PΠ = Π +Π −Π (5)

A fixed nominal exchange rate implies that 0SΠ = such that that the rate of real appreciation is

given by

( ) *RER P P−Π = Π −Π (6)

Trend real appreciation may occur if the small open country is expected to grow quickly relative

to the anchor zone: for instance, as part of a convergence process.

One popular explanation for this prediction is the �Balassa-Samuelson�

hypothesis (Balassa 1964, Samuelson 1964). Imagine that productivity growth is

concentrated in the tradables sector of the economy, with the nontradables sector lagging

behind. A rising value marginal product of labor in the tradables sector allows that sector to

increase production and wages. To retain workers, the nontradables sector must match this

wage growth. Without any corresponding increase in productivity, the increase in labor

costs generates a price increase in the nontradables sector. The relative price of

nontradables to tradables rises and the real exchange rate appreciates.

At a quantitative level, Halpern and Wyplosz (2001) estimate that the Balassa-

Samuelson effect could imply annual 3.5 percent real appreciation for the transition economies

vis-à-vis the eurozone, a sizeable effect. However, Estrada and Lopez-Salido (2001) make the

point that the evolution of relative markups also influences the rate of differential inflation

between the tradables and nontradables sectors: in this way, a fall in the relative markup of

10

nontraded goods may act to offset the Balassa-Samuelson effect. In this regard, pro-

competition policies in sheltered industries may be helpful.

We also note that other mechanisms also link real exchange rates to income levels.

An important channel is that an increase in incomes tends to be associated with a demand shift

towards personal services and entertainment products that tend to be nontraded: that is,

preferences are non-homothetic, with a rising share of expenditure being devoted to

nontradables as wealth increases. Accordingly, the nontradables share in the consumer price

index is an increasing function of income per capita and this re-weighting reinforces the trend

towards an appreciating real exchange rate.

However, it should be recognized that there are also economic forces that may

attenuate the positive correlation between growth in relative incomes and real appreciation. As

noted above, if growth is in part stimulated by market liberalization and competition-enhancing

reforms, output expansion may actually be associated with a declining relative price level. If

convergence also involves greater trade openness, the proportion of goods that are traded may

increase, ameliorating domestic cost pressures. Similarly, the logic of the Balassa-Samuelson

hypothesis implies that rapid relative productivity growth in the nontraded sector generates real

depreciation (Devereux 1999).

To illustrate the weak relation between output levels and real exchange rates, Figure

1 graphs the price level against GDP per capita for the group of high-income countries (i.e.

those countries with 1997 per capita production in excess of $20,000 in PPP terms). The plot

shows that there is no systematic relation between the relative output position and the real

exchange rate: the correlation is only 0.015. Honohan (2001) interprets a similar picture to

11

imply that the convergence process may either involve a �steep slope� (real appreciation) or a

�plateau� (a constant real exchange rate).

Another factor is that the convergence process may also involve an accumulation

of net external liabilities. The �transfer problem� phenomenon suggests that a negative net

foreign asset position exerts downward pressure on the real exchange rate. The argument is that

a long-run net outflow of investment income payments requires a sustained improvement in the

trade balance, which in turn involves real depreciation via a negative wealth effect and the

transfer of resources from the nontraded to the traded sector (Lane and Milesi-Ferretti 2000,

2002). That is

( ; ) 0RERRER f NFL XNFL∂= <∂

(7)

where NFL is the net foreign liability position and X is the set of other factors (including

relative income per capita) that influence the real exchange rate. Accordingly, if fast-growing

countries also accumulate net foreign liabilities, the net effect on the real exchange rate is

attenuated.

Overall, this suggests that a convergence process does not necessarily imply strong

real appreciation. However, even if trend real appreciation is anticipated to be high, a small

open economy may still achieve greater price stability under a fixed exchange rate than under a

float. This will be the case if the domestic institutional structure is such that an independent

monetary policy will fail to deliver low inflation.

12

3.1.3 Domestic Sources of High Inflation under a Float

One source of high inflation under a float is if the government must rely on seigniorage

revenues to finance public spending. A small tax base, unsustainable expenditure programs

and/or an excessive level of public debt are associated with a thirst for seigniorage. Unless the

central bank is fully insulated from political pressures, such a situation will generate high

domestic inflation under a float. Accordingly, the attainment of price stability under a floating

exchange rate regime requires the development of strong domestic fiscal and monetary

institutions. For an economy in transition, such institution building requires a significant

allocation of scarce economic, human and political resources. By way of contrast, a credibly

fixed exchange rate strictly limits the availability of seigniorage revenues by removing control

of the money supply from the domestic authorities.

A second generator of inflation under a float is the well known �inflation bias�

identified by Kydland and Prescott (1977) and Barro and Gordon (1983). Consider the reduced-

form output function

* ( ) 0ey y b b= + Π −Π > (8)

where (log) output y can exceed its natural-rate level *y if inflation is surprisingly high

( eΠ > Π ), where eΠ is the expected level of inflation. The natural-rate output level is that

generated in a flexible-price flexible-wage equilibrium. Let the loss function of the monetary

authority be represented by

13

2 2( )L y yλ= − +Π (9)

where the �desired� level of output exceeds the natural-rate level ( * , 0y y κ κ= + > ) and loss

function penalizes deviations of inflation from zero.2 The natural-rate level of output may be

suboptimally low if, for example, monopoly power in factor and product markets restricts the

level of competition.3

It is well known that the solution for the inflation rate under a discretionary regime

is

bλκΠ = (10)

Despite the zero target for inflation, equilibrium inflation is positive and increasing in the size

of the distortion κ . For a given level of distortion, the inflation bias is stronger the more elastic

is output with respect to surprise inflation (the larger is b ) and the greater the weight attached

to the output component in the monetary authority�s loss function (the larger is λ ).

This inflation bias model is a useful way to interpret the high inflations that

occurred in many countries after the switch to floating exchange rate regimes during the mid-

1970s. A subsequent literature has identified some options in eliminating the inflation bias

problem. One well-known approach is to appoint a �conservative� central banker who places a

2 The intuition underlying this two-equation reduced-form model is also found in a wide range of micro-founded dynamic general equilibrium models with nominal rigidities. See, for example, Neiss (1999). 3 Another potential source of the inflation bias may be a desire to inflate away domestic-currency nominal debt.

14

lower weight on output stabilisation than in the social welfare function (Rogoff 1985).

However, the central bank must have sufficient independence from political and social

pressures if it is to autonomously determine monetary policy and such independence must be

demonstrated over a considerable period of time and under a range of economic conditions

before it is fully credible.

A related option is to recognize that this �inflation game� is repeated over many

periods and it is therefore possible and productive for a central bank to develop a reputation for

not yielding to the temptation to run a surprise inflation. However, establishing such a

reputation is time-consuming and costly when there is imperfect information about the central

banker�s �type� and the state of the economy. As is pointed out by Atkeson and Kehoe (2000)

and Frankel et al (2000), a fixed exchange rate is an especially helpful commitment device in

this regard since it represents a verifiable and transparent target. In contrast, under a floating

regime, it may be hard for even a well-intentioned central bank to convince a sceptical public

that a realisation of high inflation in a particular period should be interpreted as bad luck, rather

than an attempt to fool agents into producing more output. This is especially the case for a

highly open economy, since the prevalence of external shocks means that the central bank

exerts only limited short-run control over price level fluctuations.

We note that the inflation bias problem may be smaller for an open economy. As

was shown in section 2, Since output in an open economy is less responsive to a surprise

inflation by the home central bank, since it is relatively less reliant on the level of domestic

aggregate demand. Moreover, a monetary expansion that generates real depreciation makes

more expensive the consumption of imported goods, reducing the net gain to a surprise

15

inflation. On the other side, however, an economy that is small in world markets need not

suffer a terms of trade deterioration if it increases domestic production, thereby avoiding one of

the negative side effects of surprise monetary expansion for a larger economy (Romer 1993,

Lane 1997).

Addressing the inflation bias problem represents a significant challenge for a

central bank in a floating exchange rate system. For an economy in transition with young

institutions and no track record, it would take time and a significant investment of resources to

establish an independent monetary framework that credibly delivers price stability. For these

reasons, a hard currency peg is especially attractive in that an authoritative monetary strategy is

imported from the anchor zone. Of course, the capacity to sustain a hard peg must be in place

and we return to these requirements later in the chapter. Finally, we note that a hard peg is

easier to achieve for a small open economy, since its equilibrium discretionary inflation rate

under a float is lower than for a larger, more closed economy.

3.2 Business Cycles

The maintenance of medium-term price stability does not necessarily exclude a potential role

for monetary and exchange rate policy in smoothing business cycle fluctuations. Small open

economies are exposed to a range of external shocks, in addition to domestic disturbances. On

the real side, shocks to global demand conditions, the world interest rate and the international

relative price schedule represent important sources of volatility: for instance, Kose (2002)

estimates that 88 percent of output fluctuations in small open developing economies can be

16

attributed to world price shocks. On the monetary side, financial openness means that the

volatility of demand for domestic currency may be affected by conditions in international

capital and money markets and by substitutability between home and foreign monies in

supporting transactions in goods and asset markets.

Of course, monetary and exchange rate policy is only potentially useful in

dealing with sufficiently persistent shocks, given the time lags present in the monetary

transmission mechanism: policy cannot be employed to fine tune the economy in response to

purely transitory shocks. Policy effectiveness also depends on the existence of nominal

rigidities in prices and/or wages.

Calvo (1999) provides a very simple reduced-form model to demonstrate the

essential difference between fixed and floating exchange rate systems in absorbing cyclical

shocks. Consider the two-equation system

(11)(12)

y e um y v

α= += +

where , ,y e m represent deviations in domestic output, the nominal exchange rate and the

domestic money stock and ,u v are respectively real and nominal disturbances. The money

stock is held fixed ( 0m = ) under a float, whereas a fix entails 0e = by definition. Output

volatilities under the two regimes are given by

( ) ( ); ( ) ( ) (13)float fixVar y Var v Var y Var u= =

Equation (13) demonstrates the traditional wisdom that fixed exchange rates are stabilizing in

the face of monetary shocks but that exchange rate flexibility is desirable in responding to real

17

shocks. However, the latter result has come under attack in recent years and we turn to a

consideration of these recent criticisms in the following subsections.

3.3 Foreign-Currency Liabilities and Financial Frictions

The gains to exchange rate flexibility may be restricted if a country has significant net external

liabilities that are denominated in foreign currency. In this case, real exchange rate depreciation

increases the real domestic value of external liabilities. This negative wealth may serve to

further depress the level of domestic demand.

The situation is exacerbated if frictions in financial markets mean that investment

spending is constrained by the net worth of firms. If depreciation leads to a fall in the

creditworthiness of investors by raising the real burden of external obligations, a negative

financial accelerator channel may operate by which investment declines in line with the

deterioration in the quality of balance sheets.4 Indeed, the relevant state variable may be the

level of gross external liabilities, if the corporate sector tends to be major external debtor and

private households are the primary holders of external assets.

At a surface level, it may seem that these contractionary effects of exchange

rate depreciation may provide an argument in favor of refraining from exchange rate

adjustment in response to shocks. However, a number of authors have found that the presence

of such financial frictions in fact does not substantially alter the calculus regarding the relative

4 See Bernanke et al (1999) for a full treatment of the financial accelerator mechanism in a closed-economy setting.

18

merits of fixed versus floating exchange rate regimes (Cespedes et al 2001, Devereux and Lane

2001a, Gertler et al 2001). The explanation is that financial frictions act to amplify the business

cycle: accordingly, the gain to an aggressive monetary policy response (feasible only under a

floating system) is actually enhanced.

However, this finding is sensitive to the precise specification of the financial

constraints facing the economy. Devereux and Lane (2001b) show that if the purchase of

necessary imported intermediates is constrained by creditworthiness, the negative balance sheet

channel may actually dominate in this case since the financial friction in this case generates a

large fall in output. Under this scenario, exchange rate flexibility may be dominated by a fixed

exchange rate in responding to real shocks.

Moreover, Krugman (1999) and Aghion et al (2001) develop models in which

multiple equilibria exist. In such an environment, these authors show how foreign-currency

debt and financial frictions can generate crisis episodes in which the exchange rate collapses

and the level of output undergoes a severe recession. This serves to re-affirm that the

combination of foreign-currency debt and exchange rate depreciation is a dangerous mix.

A natural response is to argue that this channel can be shut down if the small

open economy concentrates on issuing debt in domestic currency. The microeconomic barriers

to developing domestic-currency debt markets are the subject of much current research (see, for

example, Eichengreen and Hausmann 1999). However, it is worth noting that the inefficiency

inherent in developing a separate domestic-currency debt market is greatest for small

economies, given the limited supply of debt instruments and the attendant illiquidity problems.

19

3.4 Policy Shocks

A second limitation in pursuing an independent monetary policy under flexible exchange rates

is the capacity for incurring serious policy errors that serve to amplify business cycle

fluctuations. At a technical level, conducting a successful stabilization policy requires the

collection of significant amounts of accurate information and a high level of analytical skill in

forming opinions about the sources and potential duration of cyclical shocks. In this regard, a

small economy will be unable to match the resources available to larger entities: for instance,

the Board of Governors of the US Federal Reserve System employs more than two hundred

professional economists.

In addition, there is significant uncertainty about the strength and lag structure of

the monetary transmission mechanism. A policy action taken in response to a current economic

slowdown may turn out only to take effect after recovery is already underway, resulting in a

procyclical policy stance. In this regard, it is noteworthy that the European System of Central

Banks has recently devoted large-scale resources to research on the monetary transmission

mechanism (the �Monetary Transmission Mechanism Network�) but has concluded that

significant uncertainties remain (Angeloni et al, 2001).

Other factors may also generate procyclical monetary policy under a float. In

particular, a monetary authority that is incompletely insulated from political interference may

be placed under pressure to maximize the popularity of the incumbent government (and support

its re-election campaign) by engineering appropriately timed temporary output expansions.

20

3.5 External Factors

A small open economy that pegs its exchange rate against some anchor economic zone

effectively adopts the monetary stance of the larger entity. For common economic shocks, this

implies that the pegger will enjoy the benefits of the stabilization policy pursued by the central

bank of the anchor zone. If the larger central bank is more competent in formulating and

executing monetary policy (perhaps simply due to the larger resources available to it), this will

represent a preferable outcome for the small open economy.

Clearly, selecting an anchor zone that shares similar economic shocks

minimizes the loss from sacrificing exchange rate flexibility. Typically, the choice is obvious: a

country�s dominant trading partner. In principle, a country could target an anchor that is

composed of a basket of the currencies of its trading partners. However, baskets face weight

selection problems and are less transparent than pegging to a single currency.

The stability of a currency peg is also affected by the exchange rate strategies of

a country�s neighbors. If some country A is part of a regional cluster of similar economies,

devaluation against the anchor zone by countries B and C will place pressure on the exchange

rate of country A via a competitiveness channel and by attracting the attention of speculators

(Corsetti et al 2000). In this way, the exchange rate strategies of neighbors can be viewed as

strategic complements: a peg by country A is more sustainable if countries B and C also peg to

the anchor zone.

21

Finally, we emphasize that throughout this section we have had in mind

permanently fixed exchange rates in describing stabilization performance. Clearly, temporary

pegs that end in collapse can endogenously induce cyclical movements in output. We turn to

this case in the next section.

4. Temporary Pegs and Speculative Attacks

The economics of fixed exchange rate regimes that are ultimately abandoned has been the

subject of a vast literature in the last two decade. These episodes are especially striking, since

standard textbooks typically contrast �floating versus fixed� exchange rates without taking into

account (voluntary or forced) regime switches. Put differently, regime sustainability and the

implications of sharp reversals are central in assessing the practical gains from alternative

policy options.

4.1 General Remarks

It is well known that fixed exchange rate regimes vary in the degree of �hardness� of the

commitment to maintain a fixed peg. Of course, the ultimate fix is to eliminate domestic

currency by joining a monetary union or adopting some foreign currency. A currency board is

next in terms of the degree of commitment, since the issue of domestic currency must be

backed by sufficient quantities of foreign reserves. We turn to such hard pegs in the next

section.

22

Weaker varieties of exchange rate pegs rather place more reliance on the

institutional credibility of the domestic central bank and government to fulfil its commitments.

A weak or temporary exchange rate commitment may be preferred as part of a dynamic

strategy in some circumstances. For instance, a transitional peg may be helpful in moving from

a high- to low-inflation regime: that is, an exchange-rate-based stabilization program. Once

disinflation is complete, the country may choose to voluntarily exit the peg and move to a more

flexible system. In other cases, a country may value the desirable properties of a pegged

exchange rate but still wish to retain the option to re-align the exchange rate in the event of a

large macroeconomic shock.

Of course, if capital is internationally mobile, the inherent problem with a weak

fixed exchange rate commitment is that it exposes the country to the risk of a speculative attack

and a currency crisis. Attack episodes are typically associated with very high interest rates (to

the extent the country attempts to defend the regime) and an associated contraction in economic

activity, thereby generating severe costs.

4.2 First Generation Attacks

Speculative attacks may occur for a variety of reasons. A �first generation� attack is one that

accelerates the collapse of a fixed regime that is bound to eventually collapse anyway

(Krugman 1979). The inevitability of the collapse can be attributed to monetary behavior that is

fundamentally inconsistent with maintaining the peg: the central bank expanding domestic

credit when there is no alteration in demand for real balances. For fixed money demand, growth

23

in domestic credit implies a corresponding decline in the level of foreign exchange reserves: if

this policy is sustained, the levels of reserves continuously fall and the fixed exchange rate

must collapse in finite time. Since the regime collapse can be anticipated, arbitrage principles

dictate that agents sell the domestic currency in advance and this decline in money demand

brings forward the date of the devaluation.

This kind of temporary peg is well understood: excessive domestic credit

expansion is intrinsically inconsistent with sustaining a fixed exchange rate commitment. As

such, a country that is heavily reliant on seigniorage revenues must in the end switch to a

floating exchange rate. Why might such a country ever adopt a fixed exchange rate, given its

finite duration? A benign view is that the fixed exchange rate may be a political gamble to

induce a domestic fiscal reform that eliminates the excessive dependence on seigniorage. A

more cynical interpretation is that a temporary peg may be politically attractive: in the short-

run, inflation is stabilized without any sacrifice in terms of fiscal restraint. If the probability of

re-election is an inverse function of the current inflation rate, a well-timed pegging episode

may be strategically useful.5

The latter view is consistent with the empirical evidence that the collapse of pegs

frequently occurs just after the holding of elections. Tornell and Velasco (2000) go further and

argue that the peg may actually encourage fiscal imprudence since the inflationary costs of

excessive seigniorage are only incurred after the collapse has occurred.

5 The electorate may not directly observe reserves behavior or the underlying fiscal fundamentals and so may be uncertain about the durability of the peg. In this case, they assign some weight to the scenario that the government has indeed successfully conquered inflation.

24

4.3 Second Generation Attacks

However, many recent crisis episodes do not conform to this scenario. Rather, �second

generation� speculative attack models focus on cases in which maintenance of the peg is

technically feasible but the government ultimately opts to devalue.6 A government in a country

that is experiencing a recession, high unemployment or weakness in the banking sector may

feel politically unable to defend a pegged exchange rate by increasing interest rates on a

sustained basis. Accordingly, weak macroeconomic fundamentals may encourage an attack by

speculators since they realize that the government will be disinclined to robustly defend the

currency (Obstfeld 1994).

Of particular frustration for emerging market small open economies is that

vulnerability to speculative attack may be exacerbated by various international

interdependencies. Most directly, devaluation by trade rivals may damage international

competitiveness, thereby weakening the desirability of maintaining a peg. Countries are also

linked via international financial markets: devaluation by one country may prompt a negative

re-rating of an entire asset class (e.g. the �emerging markets� category). This may induce a

generalized capital outflow and raise the cost of accessing external capital markets, again

weakening domestic macroeconomic fundamentals in the process.

A noteworthy feature of second-generation attacks is that post-devaluation

performance appears to differ widely between advanced and emerging market economies. On

6 As pointed out by Jeanne (2000), there is a tendency to highlight the role played by self-fulfilling expectations (multiple equilibria) in second-generation models. However, multiple equilibria are not a necessary feature of these models and, indeed, are also possible in some first-generation models.

25

the one side, the enforced exit of Great Britain from the EMS in 1992 is now commonly viewed

as a positive development since the move to a floating exchange rate allowed a monetary

expansion that helped the UK to recover from recession. On the other, severe recessions were

experienced by Mexico after its 1994 devaluation and by some Asian economies after the 1997-

1998 crisis. One differential factor is that the institutional reputation of advanced economies

tends to be quite robust: agents knew that the switch to a float did not presage an era of high

inflation and that the central banks in such countries can be trusted to deliver low inflation over

the medium-term. In contrast, there was much less confidence in the future monetary strategies

of the emerging market economies that went into crisis during the 1990s: accordingly, risk

premia remained high even after devaluation.

A second important difference is that emerging market economies tend to have

much larger foreign-currency external liabilities and experience more severe financial frictions.

For the reasons outlined in the previous section, these factors mean that the contractionary

impulse of a given devaluation is much stronger for these countries.7 This is compounded if a

country attempts engages in a failed defence of a peg, since there is a further negative wealth

effect through the loss of reserves in that case.

This section has illustrated the potential volatility of temporarily fixed exchange

rates. The collapse of a regime can undo many of the gains from a period of prolonged

exchange rate stability and, at least for emerging market economies, tends to be associated with

a severe economic contraction. For these reasons, it is important to understand the economic,

7 The role of financial frictions has led some researchers to label these crises as �third-generation� speculative attack episodes.

26

institutional and political factors that can minimize the probability of an exchange rate attack.

We turn to this topic in the next section.

5. Sustaining a Fixed Exchange Rate Regime A country that is truly committed to sustaining a fixed exchange rate regime can improve its

chances by adopting a �hard� version of a currency peg. As was noted above, the options here

are (a) to join a currency union; (b) to unilaterally adopt a foreign currency (i.e. �dollarization�

or �euroization�); or (c) establish a currency board.

There are several elements required in order to maintain a hard peg. First, policy

consistency requires that the government maintain fiscal probity: sustainable levels of public

debt and moderate fiscal deficits. Otherwise, a lax fiscal stance engenders fears that the

government may ultimately turn to seigniorage revenues or attempt to inflate away domestic-

currency debt, implying an exit from the currency peg (Sargent and Wallace 1981, Tornell and

Velasco 2000, Corsetti and Mackowiak 2001).

Second, a sound banking system facilitates the sustainability of a fixed exchange

rate regime. Empirically, banking crises and currency crises are often correlated events

(Kaminsky and Reinhart 2000, Domac and Martinez Peria 2001). The provision of liquidity to

troubled banks and the fiscal costs of recapitalising a failed banking sector may ultimately

require a shift to a floating exchange rate (Chang and Velasco 2000). As such, it is imperative

to ensure that banks are well regulated and alternative sources of funds are available in the

event of liquidity or solvency problems. Again, a government with a low level of public debt

27

and access to capital markets is better able to deal with a banking crisis without resort to the

printing press. A substantial role for foreign-owned institutions in the domestic banking sector

is also desirable, since this improves monitoring and the parent firms are also a source of

reserves and confidence in the event of trouble.

Third, a high level of external debt potentially poses a threat to a hard peg. Debt

markets are exposed to the risk of speculative activity: if a country is expected to repudiate its

external debt, interest rates rise to compensate for the default risk. In turn, this raises the cost of

servicing the debt, making repudiation more likely (Calvo 1988).8 In turn, this may involve the

abandonment of the peg, if the government prefers indirect methods of repudiation to outright

default (e.g. conversion of foreign-currency debt into domestic currency, with the government

printing money to formally pay the domestic-currency debt in nominal terms). Clearly, in

addition to maintaining fiscal prudence as discussed above, a stable political environment in

which all major parties are fully committed to servicing external debt is helpful in avoiding

speculative attacks in the debt markets.

In addition to the risk of speculative risk premia, high levels of external debt also

potentially threaten the viability of a currency peg through the operation of the �transfer

problem� discussed in section 2 above. That is, significant outflows of investment income may

require a real depreciation to generate the associated trade surpluses. In turn, real depreciation

implies deflation under a peg, which has damaging economic consequences.

Note that the transfer problem really applies to all forms of external liabilities

(i.e. FDI and portfolio equity in addition to debt). However, non-debt-creating liabilities have

8 The external debt need not be sovereign. Imagine country risk applied to private debt: the government will also be sensitive to repayment difficulties in the corporate and/or household sector.

28

superior risk-sharing properties and are not as exposed to the speculative attack problem

discussed above. Accordingly, it is desirable to ensure that capital imports are not excessively

biased towards debt flows.9

Finally, a hard peg is clearly more sustainable, the more closely the small open

economy and the anchor zone resemble an optimum currency area. The greater are the gains

and the smaller are the costs to a hard peg, the larger are trade volumes, the more diversified

the export base and the more flexible are prices and wages. Moreover, Devereux and Lane

(2001b) emphasize that a peg is easier to maintain, the more external debt is financed in the

currency of the anchor zone. Clearly, many of these criteria are to some extent endogenous to

the exchange rate regime. The hope is that fixing the exchange rate will itself raise trade

volumes, induce greater flexibility in prices and wages and encourage the integration of

financial markets. These trends can be reinforced by active government policies and

institutional reform in support of such structural adjustment.

Comparing across alternative forms of hard peg, the currency union is most

attractive. Membership allows the small open economy to contribute to the formation of the

monetary policy for the currency union and share in the seigniorage revenues earned by the

common central bank. Regarding the former, the small open economy may itself be too small

in size to matter for aggregate economic variables in the currency union. However, if it is

similar in economic structure to some other members of the union, this grouping may have

sufficient weight to be factored into monetary policy decisions.

9 The �double play� in the Hong Kong equity and currency markets in 1998 demonstrates that these markets are not fully insulated from speculative attack.

29

At the least, membership of a currency union may improve the political

acceptability of the monetary stance, since the small open economy is formally involved in the

decision-making process. Finally, this option provides the strongest commitment to a fixed

exchange rate, since the country would experience intense pressure from other members of the

union if it ever contemplated leaving the union.

In contrast, unilateral adoption of a foreign currency (i.e. �dollarization� or

�euroization�) offers relatively fewer benefits. Although the elimination of domestic currency is

a strong signal, it is more reversible in the unilateral case relative to joining a currency union.

Moreover, a unilateral approach may be expensive in terms of the loss of seigniorage revenue.

Although it is conceivable that the anchor zone could agree to compensate the pegger for the

transfer of seigniorage, this tends not to happen in practice since the anchor zone may not wish

to formally endorse unilateral decisions to adopt its currency. Finally, a unilateral pegger must

passively adopt the monetary stance of the anchor zone. This loss of voice may especially

engender political controversy if the small open economy experiences economic conditions

that are asymmetric to the anchor zone (Lane 2000).

A currency board is the third option in establishing a hard peg and shares the

property of signaling a much stronger commitment than weaker pegged exchange rate systems.

Since the domestic currency remains in existence, this is a less irreversible peg than in the

other hard peg cases. However, if the conditions for membership of a currency union are not

yet established, a currency board may be more politically acceptable to the anchor zone than

the unilateral elimination of the domestic currency. Furthermore, as a transitional stage, a

currency board retains the flexibility to permit a choice concerning the irrevocable conversion

30

rate upon entry into a currency union. A further advantage is that, compared with unilateral

adoption of a foreign currency, a currency board provides more seigniorage revenues.

Finally, it is important to re-emphasize that a hard peg should be entertained only

if the country fulfills the preconditions discussed above and is truly committed to maintaining

the regime. As Dornbusch and Giavazzi (1998) emphasize, a hard peg is a �poison pill�: it

should deter speculative attack but the price is that a successful attack entails larger economic

costs. The recent exit of Argentina from its currency board system dramatically underlines this

important caveat.

6. Conclusions

This chapter has provided an overview of the alternative monetary and exchange rate strategies

open to a small open economy. Both floating and fixed exchange rate regimes offer significant

benefits but intermediate quasi-fixed systems are highly vulnerable to speculative attacks. A

country that wishes to peg its exchange rate must accept that sustainability requires significant

discipline in the conduct of fiscal policy, banking supervision and the accumulation of external

debt. In addition, it is desirable to promote structural adjustment, in the direction of promoting

flexibility in price and wage formation.

31

References

Aghion, P., A. Banerjee and P. Bacchetta, 2001, Currency crises and monetary policy in an

economy with credit constraints, European Economic Review 45, 1121-1150.

Angeloni, I., A. Kashyap, B. Mojon and D. Terlizzese, 2001, Monetary transmission in the euro

area, mimeo, European Central Bank.

Atkeson, A. and P. Kehoe, 2000, Exchange-rate-based versus money-based systems: The

advantage of transparency, mimeo, UCLA.

Balassa, B., 1964, The purchasing power parity doctrine: A reappraisal, Journal of Political

Economy 72, 584-596.

Barro, R.J. and D. Gordon, 1983, A positive theory of inflation in a natural-rate model, Journal

of Political Economy 91, 589-610.

Bernanke, B., M. Gertler and S. Gilchrist, 1999, The financial accelerator in a quantitative

business cycle framework, in: J. Taylor and M. Woodford, eds, Handbook of macroeconomics

(North-Holland: Amsterdam), 1341-1393.

Calvo, G., 1988, Servicing the public debt: The role of expectations, American Economic

Review 78, 647-661.

32

Calvo, G., 1999, Fixed versus flexible exchange rates: Preliminaries of a turn-of-millennium

rematch, mimeo, University of Maryland.

Cespedes, L., R. Chang and A. Velasco, 2000, Balance sheets and exchange rate policy, NBER

Working Paper No. 7840.

Chang, R. and A. Velasco, 2000, Exchange rate policy for developing countries, American

Economic Review 90, 71-75.

Corsetti, G. and B. Mackowiak, 2001, Fiscal imbalances and the dynamics of currency crises,

mimeo, Yale University.

Corsetti, G., P. Pesenti, N. Roubini and C. Tille, 2000, Competitive devaluations: toward a

welfare-based approach, Journal of International Economics 51, 217-241.

Devereux, M.B., 1999, Real exchange rates and growth: a model of East Asia, Review of

International Economics 7, 509-521.

Devereux, M.B. and P.R. Lane, 2001a, Exchange rates and monetary policy in emerging

market economies, CEPR Discussion Paper No. 2874.

33

Devereux, M.B. and P.R. Lane, 2001b, Understanding bilateral exchange rate volatility,

mimeo, Trinity College Dublin.

Domac, I. and M. Soledad Martinez Peria, 2001, Banking crises and exchange rate regimes: Is

there a link?, mimeo, The World Bank.

Dornbusch, R. and F. Giavazzi, 1998, Hard currencies and sound credit: a financial agenda for

Central Europe, mimeo, MIT and Universita Bocconi.

Eichengreen, B. and R. Hausmann, 1999, Exchange rates and financial fragility, NBER

Working Paper No. 7418.

Estrada, A. and J.D. Lopez-Salido, 2001, Understanding Spanish dual inflation, mimeo, Bank

of Spain.

Fischer, S., R. Satay and C. Vegh, 2002, Modern hyper- and high inflatrions, NBER Working

Paper No. 8930.

Frankel, J., S. Schmukler and L. Serven, 2001, Verifiability and the vanishing intermediate

exchange rate regime, Brookings Trade Forum, 59-123.

34

Gertler, M., S. Gilchrist and F. Natalucci, 2001, External constraints on monetary policy and

the financial accelerator, mimeo, New York University.

Ghosh, A.R., A. Gulde and H. Wolf, 2000, Currency boards: more than a quick fix?, Economic

Policy 15, 271-321.

Halpern, L. and C. Wyplosz, 2001, Economic transformation and real exchange rates in the

2000s: the Balassa-Samuelson connection, mimeo, Graduate Institute of International Studies.

Honohan, P., 2000, Ireland in EMU: straitjacket or skateboard?, Irish Banking Review, Winter,

15-32.

Honohan, P. and P.R. Lane, 1999, Pegging to the dollar and the euro, International Finance 2,

379-410.

Honohan, P. and P.R. Lane, 2001, Will the euro stimulate more monetary unions in Africa?, in:

C. Wyplosz, ed., EMU and its impact on Europe and developing countries, Oxford University

Press: New York, 315-338.

Jeanne, O., 2000, Currency crises: A perspective on recent theoretical developments, Special

Papers in International Economics No. 20, Princeton University.

35

Kaminsky, G. and C. Reinhart, 1999, The twin crises: The causes of banking and balance-of-

payments problems, American Economic Review 89, 473-500.

Kose, M.A, 2002, Explaining business cycles in small open economies: �How much do world

prices matter,� Journal of International Economics 56, 299-328.

Krugman, P., 1979, A model of balance of payments crises, Journal of Money, Credit and

Banking 11, 311-325.

Krugman, P., 1999, Balance sheets, the transfer problem and financial crises, International Tax

and Public Finance 6, 459-472.

Kydland, F. and E. Prescott, 1977, Rules rather than discretion: The inconsistency of optimal

plans, Journal of Political Economy 85, 473-492.

Lane, P.R., 1997, Inflation in open economies, Journal of International Economics 42 , 327-

346.

Lane, P.R., 1999, What determines the nominal exchange rate? Some cross-sectional evidence,

Canadian Journal of Economics 32, 118-138.

36

Lane, P.R., 2000, Asymmetric shocks and monetary policy in a currency union, Scandinavian

Journal of Economics, 102, 585-604.

Lane, P.R. and G.M. Milesi-Ferretti, 2000, The transfer problem revisited: net foreign assets

and long-run real exchange rates, CEPR Discussion Paper No. 2511.

Lane, P.R. and G.M. Milesi-Ferretti, 2002a, External wealth, the trade balance and the real

exchange rate, European Economic Review, June, forthcoming.

Lane, P.R. and G.M. Milesi-Ferretti, 2002b, Long-term capital movements, NBER

Macroeconomics Annual 16, forthcoming.

Neiss, K.S., 1999, Discretionary inflation in a general equilibrium model, Journal ofMoney,

Credit and Banking 31, Part 1, 357-74.

Obstfeld, M., 1994, The logic of currency crises, Cahiers Economiques et Monetaires 43, 189-

213.

Obstfeld, M. and K. Rogoff, 1996, Foundations of international macroeconomics, Princeton

University Press (Princeton, New Jersey).

37

Rogoff, K., 1985, The optimal degree of commitment to an intermediate monetary target,

Quarterly Journal of Economics 100, 1169-1189.

Rogoff, K., 1999, The risk of unilateral exchange rate pegs, in: A. Meltzer, ed. The

implications of globalization of world financial markets, Bank of Korea: Seoul, 153-170.

Romer, D., 1993, Inflation and openness: Theory and evidence, Quarterly Journal of

Economics 108, 870-903.

Sargent, T.J. and N. Wallace, 1981, Some unpleasant monetarist arithmetic, Federal Reserve

Bank of Minneapolis Quarterly Review 9, 15-31.

Samuelson, P.A., 1964, Theoretical notes on trade problems, Review of Economics and

Statistics 46, 145-154.

Sarel, M., 1996, Nonlinear effects of inflation on growth, International Monetary Fund Staff

Papers 43, 199-215.

Tornell, A. and A. Velasco, 2000, Fixed versus flexible exchange rates: Which provides more

fiscal discipline?, Journal of Monetary Economics 45, 399-436.

38

Table 1. Monetary Expansion and Openness: Relative Welfare Gain

Openness Gain

0.8α = 0.25

0.6α = 0.5

0.4α = 0.75

0.2α = 1.0

Note: We normalize welfare gain for 0.2α = to unity.

39

Figure 1. Price Levels and GDP Per Capita for Industrial Countries

15000 20000 25000 30000 35000 4000050

75

100

125

150

GDP Per Capita

Pric

e Le

vel

Note: Data for 1997 from Penn World Tables version 6.0