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Destabilizing Effects of Exchange-Rate Escape Clauses

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Obstfeld, Maurice

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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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 518.

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Date of creation: Mar 1991
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Handle: RePEc:cpr:ceprdp:518

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Keywords: Credibility Escape Clause European Monetary System Realignment

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. 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. [Downloadable!] (restricted)
  2. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August. [Downloadable!] (restricted)
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  3. Alesina, Alberto & Tabellini, Guido, 1988. "Credibility and politics," European Economic Review, Elsevier, vol. 32(2-3), pages 542-550, March. [Downloadable!] (restricted)
  4. Maurice Obstfeld, 1986. "Floating Exchange Rates: Experience and Prospects," NBER Reprints 0792, National Bureau of Economic Research, Inc.
  5. 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. [Downloadable!] (restricted)
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