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Choosing the Correct Currency Anchor for a Small Economy

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  • Sibel Yelten
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    Abstract

    This paper uses the Sjaastad model to estimate the optimal currency area for the Nepalese rupee and concludes that, currently, Nepal may be reasonably well off with its peg to the Indian rupee. As its economy opens and its trade base and trading partners expand, it may want to reevaluate whether moving toward an exchange rate basket including the U.S. dollar may be a better policy choice. The regression results indicate that, currently, the prices of imported goods in Nepal are solely influenced by India, suggesting that with the peg to the Indian rupee, Nepal can isolate the import side of its economy completely from external shocks. On the export side, the regression results indicate that Nepalese export prices seem, to a large extent, to be influenced by U.S. prices. However, the export price index had to be constructed, and the construction methodology is likely to entail an overestimation of the impact of the U.S. dollar.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/142.

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    Length: 15
    Date of creation: 01 Aug 2004
    Date of revision:
    Handle: RePEc:imf:imfwpa:04/142

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    Related research

    Keywords: Exchange rates; Currency pegs; Economic models; exchange rate; export prices; import prices; currency basket; exchange rate rule; import price; export price; exchange rate regime; trading partners; real exchange rate; exchange rate fluctuations; real exchange rates; world prices; currency areas; exchange rate movements; exchange rate policies; currency exchange; imported goods; exchange rate policy; currency exchange rate; external shocks; real exchange rate movements; world market; basket of currencies; fixed exchange rate regime; trade flows; exchange rate peg; foreign exchange; open economies; balance of payments; optimum currency areas; flexible exchange rate regime; monetary unions; import side; flexible exchange rate; fixed exchange rate;

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    1. Takatoshi Ito & Eiji Ogawa & Yuri Nagataki Sasaki, 1999. "How Did the Dollar Peg Fail in Asia?," NBER Working Papers 6729, National Bureau of Economic Research, Inc.
    2. Graciela L. Kaminsky & Carmen M. Reinhart, 2001. "Financial Markets in Times of Stress," NBER Working Papers 8569, National Bureau of Economic Research, Inc.
    3. Larry A. Sjaastad, 1998. "Why PPP Real Exchange Rates Mislead," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 179-207, November.
    4. June Flanders, M. & Tishler, Asher, 1981. "The role of elasticity optimism in choosing an optimal currency basket with applications to Israel," Journal of International Economics, Elsevier, vol. 11(3), pages 395-406, August.
    5. Flanders, M June & Helpman, Elhanan, 1979. "An Optimal Exchange Rate Peg in a World of General Floating," Review of Economic Studies, Wiley Blackwell, vol. 46(3), pages 533-42, July.
    6. Wei, S.J. & Frankel, J.A., 1992. "Yen Bloc or Dollar Bloc: Exchange Rate Policies of the East Asian Economies," Papers 92-08, University of Birmingham - International Financial Group.
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