Nominal and Real Effects of Exchange Rate Regimes

Looking forward, the selection of the post-crisis exchange rate regime is one of the key policy challenges. Two separate lines of argument have been put forth. The first and so far the more dominant school of thought regards a return to announced pegs as an open invitation for future speculative attacks with significant adverse effects. This standpoint thus advocates more flexible managed floats with an active but discretionary use of intervention and other monetary policy tools to restrict exchange rate movements within (possibly unannounced) bands. The alternative school leans in the opposite direction, viewing the classical announced peg as insufficiently credible and proposing instead the adoption of a currency board as a means of re-establishing credibility. Meanwhile, in the background of the exchange rate regime debate, a related discussion focuses on the desirability of short-term capital flows and the cost-benefit analysis of imposing capital controls.

This essay presents an integrated review of the theory and empirics of alternative exchange rate arrangements and puts forward a proposed regime in view of the current situation in the region.

Nominal and Real Effects of Exchange Rate Regimes

The relative merits of alternative exchange rate regimes have been discussed for centuries, with varying conclusions. While the size of the literature defies any attempt at comprehensive summary, a few key channels of influence have attracted most attention.

In assessing the empirical validity of these arguments, valuable insights can be culled from the historical evidence on the comparative economic performance - in terms of the gross domestic product (GDP), export growth, and inflation - across exchange rate regimes.

Matching the real world to the theoretical concepts raises some problems, however. For instance, the conceptual distinction between "fixed" and "flexible" exchange rates does not neatly map into the rich variety of real-world exchange rate regimes, and compressing the assortment into this dichotomy risks oversimplifying matters.There may be important performance differences within the group of "flexible" regimes which span all the way from pure floats with no government intervention and full capital account convertibility to heavily managed floats with extensive restriction on capital movements. Similarly, it is often argued that currency boards have greater credibility but less monetary flexibility than simple pegs, suggesting important differences within the group of "fixed" regimes as well. To allow for these differences, the empirical results insert a separate category of "intermediate regimes" between the pure floats and the pure pegs.25