According to the de facto classification in IMF (2003) the share of countries with pegged exchange rates decreased from about 80 to about 60 percent between 1990 and 1998. What explains exits from a fixed to a flexible exchange rate regime? The literature explains this in two ways:
- (i) Economic fundamentals or speculators drive the authorities towards a point of no return where the only option is to let the currency float.
(ii) Parity is at an unacceptable level to the decision makers and this triggers an optimizing decision to exit from the fixed exchange rate regime.
The first explanation involves what is called "first generation" and "second generation" models of currency crises. In the "first generation" model by Krugman (1979) it is fundamentals themselves that bring about the breakdown of the fixed exchange rate regime. The breakdown is inevitable since an exogenous government deficit is financed by borrowing from the central bank. Since the nominal exchange rate is fixed and purchasing power parity holds, the depreciation pressure on domestic currency is offset by the central bank buying domestic currency with international reserves. With limited reserves, there will come a time when speculators realize that the fixed exchange rate regime cannot be sustained and the currency inevitably depreciates. This model of currency crises appeared to be appropriate for the Latin-American countries experiencing sharp currency depreciations following a fixed exchange rate regime in the 1970’s and 1980’s.
For the countries involved in the ERM-crisis in the early 1990’s there seemed to be less of a problem of poor fundamentals and more of a problem of inconsistencies in policy making that lead to more or less "self-fulfilling" currency crises. Obstfeld (1986), stresses the importance of expectations in the collapse of a fixed exchange rate regime and investigates the possibility of multiple equilibria. This model has been called "second generation" as it stresses the importance of the expectations channel for depreciations and fixed exchange rate regime collapses.
However, there is a considerable similarity in that both the Krugman and the Obstfeld models treat the occurrence of the exchange rate regime collapse as more or less inevitable and something that the policy maker only passively observes without taking a stand on what is preferable and on what actions that would be necessary to defend the fixed exchange rate regime. But as Obstfeld and Rogoff (1995) argue a country is always able to resist a speculative attack if it is truly committed. It can do so by buying back the entire monetary base and driving up interest rates. Therefore, the policy maker always has the option not to exit the fixed exchange rate regime; it is only a matter of the willingness of the policy maker to bear the costs of staying.
The second explanation of fixed regime exits instead emphasizes the optimizing decision of the policy maker. Edwards (1996), Bensaid and Jeanne (1997), Ozkan and Sutherland (1998), Bénassy-Quéré and Coeuré (2002) and Rebelo and Vegh (2006) present stylized models within this category. These studies all have in common that they view the choice of exchange rate regime as an optimizing decision involving economic and political elements. Bensaid and Jeanne (1997) and Ozkan and Sutherland (1998) consider an optimizing policy maker who may voluntarily choose to exit from a fixed exchange rate regime. In these models it is concerns about macroeconomic stability that may make the policy maker exit from the fixed exchange rate regime. Obstfeld (1996) and others argue that this type of model appears to offer a more accurate portrayal of the ERM-crisis and aspects of other crises such as the one in Mexico 1994-95. Although it is an oversimplification that countries which exit from a fixed exchange rate regime do so only for stabilization purposes, stabilization motives will most certainly be important.
For example, high unemployment could be costly for the incumbent government and trigger the decision to exit from the fixed exchange rate regime to get a temporarily higher output level under a flexible exchange rate regime. In Rebelo and Vegh (2006), it is shown that the mechanical rule of the Krugman-type of model, to leave the fixed exchange rate regime when international reserves are depleted, is at odds with many historical episodes. Instead, it as argued that a country will choose to leave a fixed exchange rate regime because of large expected increases in governement spending.
Download
PDF Ebook Macroeconomic imbalances and exchange rate regime shifts
