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Destabilizing Effects of Exchange-Rate Escape Clauses

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  • Obstfeld, Maurice

Abstract

This paper studies the merits of policy rules with escape clauses, analysing as an example fixed exchange rate systems that allow member countries the freedom to realign in periods of stress. Motivating this example is the debate within the European Monetary System over how quickly to move from the current regime of national currencies, linked by pegged but adjustable exchange rates, to a single European currency. The paper's main point is that while well-designed rules with escape clauses can raise society's welfare in principle, limited credibility makes it difficult for governments to implement such rules in practice. An EMS-type institution which presumably imposes a political cost on policy-makers who realign may lead to an optimal escape-clause equilibrium, but may just as well lead to alternative equilibria far inferior to an irrevocably fixed exchange rate. Countries can suffer periods in which no realignment occurs, yet unemployment, real wages, and ex post real interest rates remain persistently and sub-optimally high.

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Bibliographic Info

Paper provided by Department of Economics, Institute for Business and Economic Research, UC Berkeley in its series Department of Economics, Working Paper Series with number qt15n3p5dt.

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Date of creation: 01 Dec 1996
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Handle: RePEc:cdl:econwp:qt15n3p5dt

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Keywords: realignment; escape clause; credibility; speculative attack; European Monetary System; Social and Behavioral Sciences; Arts and Humanities;

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References

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  1. Walsh, Carl E, 1995. "Is New Zealand's Reserve Bank Act of 1989 an Optimal Central Bank Contract?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1179-91, November.
  2. de Kock, Gabriel & Grilli, Vittorio, 1993. "Fiscal Policies and the Choice of Exchange Rate Regime," Economic Journal, Royal Economic Society, vol. 103(417), pages 347-58, March.
  3. Robert J. Barro & David B. Gordon, 1983. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  4. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  5. Maurice Obstfeld, 1985. "Floating Exchange Rates: Experience and Prospects," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(2), pages 369-464.
  6. Stanley Fischer, 1995. "The Unending Search for Monetary Salvation," NBER Chapters, in: NBER Macroeconomics Annual 1995, Volume 10, pages 275-298 National Bureau of Economic Research, Inc.
  7. Maurice Obstfeld, 1986. "Rational and Self-Fulfilling Balance-of-Payments Crises," NBER Working Papers 1486, National Bureau of Economic Research, Inc.
  8. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  9. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 53-84, December.
  10. Alesina, Alberto & Tabellini, Guido, 1988. "Credibility and politics," European Economic Review, Elsevier, vol. 32(2-3), pages 542-550, March.
  11. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
  12. Robert P. Flood & Peter Isard, 1989. "Monetary Policy Strategies," IMF Staff Papers, Palgrave Macmillan, vol. 36(3), pages 612-632, September.
  13. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  14. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  15. Susanne Lohmann, 1990. "Monetary Policy Strategies: A Correction: Comment on Flood and Isard," IMF Staff Papers, Palgrave Macmillan, vol. 37(2), pages 440-445, June.
  16. Horn, Henrik & Persson, Torsten, 1988. "Exchange rate policy, wage formation and credibility," European Economic Review, Elsevier, vol. 32(8), pages 1621-1636, October.
  17. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476.
  18. Lewis, Karen K., 1989. "On occasional monetary policy coordinations that fix the exchange rate," Journal of International Economics, Elsevier, vol. 26(1-2), pages 139-155, February.
  19. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
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