Choosing an Exchange Rate Regime

Citation:

Frankel, Jeffrey. 2012. “Choosing an Exchange Rate Regime.” The Handbook of Exchange Rates, 767-784. New York: John Wiley. Copy at http://www.tinyurl.com/kzf48dy
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Abstract:

The single most important aspect of an exchange rate regime is the degree of flexibility. The matter is of course more complicated than a simple choice between fixed exchange rate and floating. One can array exchange rate regimes along a continuum, from most flexible to least, and grouped in three major categories:

  1. Floating corner
    1. Free float
    2. Managed float
  2. Intermediate regimes
    1. Target zone or band
    2. Basket peg
    3. Crawling peg
    4. Adjustable peg
  3. Institutionally fixed corner
    1. Currency board
    2. Dollarization
    3. Monetary Union

    This chapter reviews the state of research concerning how a country should choose where to locate along this continuum of exchange rate regimes.

    The ‘‘corners hypothesis’’ - that countries are, or should be, moving away from the intermediate regimes, in favor of either the hard peg corner or the floating corner - was proposed by Eichengreen (1994) and rapidly became the new conventional wisdom with the emerging market crises of the late 1990s. But it never had a good theoretical foundation. The feeling that an intermediate degree of exchange rate flexibility is inconsistent with perfect capital mobility is a misinterpretation of the principle of the impossible trinity. To take a clear example, Krugman (1991) shows theoretically that a target zone is entirely compatible with uncovered interest parity. The corners hypothesis began to lose popularity after the failure of Argentina’s quasi currency board in 2001. Many countries continue to follow intermediate regimes and do not seem any the worse for it.

    Attempts to address the optimal degree of exchange rate flexibility within a single theoretical model are seldom very convincing. Too many factors are involved. Better instead to enumerate the arguments for and against exchange rate flexibility and then attempt to weigh them up. This chapter considers five advantages of fixed exchange rates, followed by five advantages for exchange rate flexibility. We then turn to analysis of how to weigh the pros and cons to choose a regime. The answer depends on characteristics of the individual country in question.

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Last updated on 10/02/2013