Summary

In practice, the preffered exchange rate regime, particularly for developing and emerging market economies, has evolved considerably over the past couple of decades. Pegging the exchange rate to a strong anchor currency was popular in the early 1990s. But, the 1990 also saw a spate of capital account leading to collapsing currencies and underscoring the fragility of such fixed exchange rate regimes.

In practice, central banks were willing to follow such a policy of benign neglect because they cannot be indiferrent to the value of their currency. When the value of the currency declines, authorities worry about both imported inflation and the balance sheet effects of an exchange rate depreciation on borrowers that have borrowed in foreign currency and suddenly find that debt more expensive to service. On the other hand, when a currency’s value rises, there is a loss of export competitiveness.

The current study finds important trade-offs in the choice of exchange rate regimes. Regimes that are more rigid help countries anchor inflation expectations, sustain output growth, and foster deeper economic integration. But they also constain the use of macroeconomic policies, increase vulnerability to crisis, and impede external adjustment. This trade-off is illustrated by the recent experience. Many countries with less flexible regimes enjoyed strong growth in the years leading up to the present crisis, they also built up large external imbalances, increasing their vulnerability to abrupt and disruptive adjustment and limiting their potential for countercyclical macroeconomic policies.