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Pegged exchange rate regimes -- a trap?

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  • Joshua Aizenman
  • Reuven Glick

Abstract

This paper studies the empirical and theoretical association between the duration of a pegged exchange rate and the cost experienced upon exiting the regime. We confirm empirically that exits from pegged exchange rate regimes during the past two decades have often been accompanied by crises, the cost of which increases with the duration of the peg before the crisis. We explain these observations in a framework in which the exchange rate peg is used as a commitment mechanism to achieve inflation stability, but multiple equilibria are possible. We show that there are ex ante large gains from choosing a more conservative not only in order to mitigate the inflation bias from the well-known time inconsistency problem, but also to steer the economy away from the high inflation equilibria. These gains, however, come at a cost in the form of the monetary authority's lesser responsiveness to output shocks. In these circumstances, using a pegged exchange rate as an anti-inflation commitment device can create a "trap" whereby the regime initially confers gains in anti-inflation credibility, but ultimately results in an exit occasioned by a big enough adverse real shock that creates large welfare losses to the economy. We also show that the more conservative is the regime in place and the larger is the cost of regime change, the longer will be the average spell of the fixed exchange rate regime, and the greater the output contraction at the time of a regime change.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2006-07.

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Date of creation: 2005
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Handle: RePEc:fip:fedfwp:2006-07

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Keywords: Foreign exchange rates ; Monetary policy;

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References

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  1. Eichengreen, Barry, 1999. "Kicking the Habit: Moving from Pegged Rates to Greater Exchange Rate Flexibility," Economic Journal, Royal Economic Society, vol. 109(454), pages C1-14, March.
  2. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  3. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 1-48, February.
  4. Nancy P. Marion & Robert P. Flood, 1998. "Perspectiveson the Recent Currency Crisis Literature," IMF Working Papers 98/130, International Monetary Fund.
  5. Barry J. Eichengreen & Inci Ötker & A. Javier Hamann & Esteban Jadresic & R. B. Johnston & Hugh Bredenkamp & Paul R. Masson, 1998. "Exit Strategies," IMF Occasional Papers 168, International Monetary Fund.
  6. Cukierman, Alex & Liviatan, Nissan, 1991. "Optimal accommodation by strong policymakers under incomplete information," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 99-127, February.
  7. Enrica Detragiache & Eisuke Okada & Ashoka Mody, 2005. "Exits From Heavily Managed Exchange Rate Regimes," IMF Working Papers 05/39, International Monetary Fund.
  8. 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.
  9. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
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Cited by:
  1. Aizenman, Joshua & Chinn, Menzie David & Ito, Hiro, 2009. "Assessing the Emerging Global Financial Architecture: Measuring the Trilemma's Configurations over Time," Santa Cruz Department of Economics, Working Paper Series qt840728sc, Department of Economics, UC Santa Cruz.
  2. El-Shagi, Makram, 2009. "The impact of fixed exchange rates on fiscal discipline," Center for European, Governance and Economic Development Research Discussion Papers 84, University of Goettingen, Department of Economics.
  3. Joshua Aizenman & Reuven Glick, 2010. "Asset class diversification and delegation of responsibilities between central banks and sovereign wealth funds," Working Paper Series 2010-20, Federal Reserve Bank of San Francisco.
  4. Reuven Glick & Michael Hutchison, 2008. "Navigating the trilemma: capital flows and monetary policy in China," Working Paper Series 2008-32, Federal Reserve Bank of San Francisco.
  5. Ahmet Atil Asici, 2010. "Parametric and non-parametric approaches to exits from fixed exchange rate regimes," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 15(4), pages 381-406.
  6. Eduardo Levy-Yeyati, 2011. "Exchange Rate Regimes," Business School Working Papers 2011-02, Universidad Torcuato Di Tella.
  7. Joshua Aizenman & Reuven Glick, 2008. "Sovereign wealth funds: stylized facts about their determinants and governance," Working Paper Series 2008-33, Federal Reserve Bank of San Francisco.
  8. Joshua Aizenman & Reuven Glick, 2009. "Sterilization, Monetary Policy, and Global Financial Integration," Review of International Economics, Wiley Blackwell, vol. 17(4), pages 777-801, 09.
  9. Frederic S. Mishkin, 2006. "Monetary Policy Strategy: How Did We Get Here?," NBER Working Papers 12515, National Bureau of Economic Research, Inc.
  10. Tamgac, Unay, 2013. "Duration of fixed exchange rate regimes in emerging economies," Journal of International Money and Finance, Elsevier, vol. 37(C), pages 439-467.
  11. Frederic S. Mishkin, 2007. "Comment on "Monetary Rules in Emerging Economies with Financial Market Imperfections"," NBER Chapters, in: International Dimensions of Monetary Policy, pages 311-317 National Bureau of Economic Research, Inc.

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