Fixed exchange rate, pegs to hard currencies that can be adjusted, are fragile, the more so the more mobile are capital funds across currencies and national markets. Once market participants doubt, for whatever reason, the ability of a developing or emerging economy's central bank to meet its commitment to redeem it currency in hard currency at the promised rate, they will race to claim the country's external reserves. Vulnerability to crises becomes greater as financial markets become less regulated and more internationally open. To escape currency crises, a country may lock its money to that of a reserve-currency country, as by a "currency board." This may, if an only if reserves are ample and all other economic objectives are subordinated, maintain the peg and hold down inflation. But it sacrifices monetary autonomy and seignorage, leading in effect and perhaps literally to substitution of the reserve currency for the local currency as unit of account and means of payment. When crises hit, the IMF and other lenders give highest priority to restoration of credibility and confidence in the currency under attack. They require the victim country to take drastic restrictive monetary and fiscal measures, whether or not irresponsibility in these policies brought on the crisis. Since these measures damage the economy, businesses, and banks, they may not restore confidence. Lenders of last resort are essential and should concentrate above all on replenishing liquidity. The adjustable-peg system has outlived its usefulness. For most countries it is better to let exchange rates float in markets, like those of the big three currencies, dollar, yen, and deutsche mark (or euro). Even so, unimpeded inflows and outflows of liquid funds result in unwelcome exchange rate movements. Protection against them, by taxes or special reserve requirements, are desirable, and need not curtail useful capital flows. Banks and businesses need to be prevented from incurring net short term debt positions in hard currency. Equity and direct fixed capital are the desirable vehicles for developmental capital movements.
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Length: 15 pages Date of creation: Jul 1998 Date of revision: Publication status: Published, Annual World Bank Conference of Development Economics, 1999, pp. 63-75 Handle: RePEc:cwl:cwldpp:1188
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