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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%u2019s lesser responsiveness to output shocks. In these circumstances, using a pegged exchange rate as an anti-inflation commitment device can create a %u201Ctrap%u201D 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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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11652.

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Date of creation: Oct 2005
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Publication status: published as Joshua Aizenman & Reuven Glick, 2008. "Pegged Exchange Rate Regimes-A Trap?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 817-835, 06.
Handle: RePEc:nbr:nberwo:11652

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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. Enrica Detragiache & Eisuke Okada & Ashoka Mody, 2005. "Exits From Heavily Managed Exchange Rate Regimes," IMF Working Papers 05/39, International Monetary Fund.
  3. Reinhart, Carmen & Rogoff, Kenneth, 2004. "The modern history of exchange rate arrangements: A reinterpretation," MPRA Paper 14070, University Library of Munich, Germany.
  4. 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.
  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. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  7. Nancy P. Marion & Robert P. Flood, 1998. "Perspectiveson the Recent Currency Crisis Literature," IMF Working Papers 98/130, 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. Ahmet Atil Asici, 2007. "Parametric and Non-parametric Approaches to Exits from Fixed Exchange Rate Regimes," IHEID Working Papers 14-2007, Economics Section, The Graduate Institute of International Studies.
  3. Aizenman, Joshua & Glick, Reuven, 2010. "Asset Class Diversification and Delegation of Responsibilities between Central Banks and Sovereign Wealth Funds," Santa Cruz Department of Economics, Working Paper Series qt5ps238ph, Department of Economics, UC Santa Cruz.
  4. Reuven Glick & Michael Hutchison, 2008. "Navigating the Trilemma: Capital Flows and Monetary Policy in China," Working Papers 252008, Hong Kong Institute for Monetary Research.
  5. Joshua Aizenman & Reuven Glick, 2008. "Sterilization, monetary policy, and global financial integration," Working Paper Series 2008-15, Federal Reserve Bank of San Francisco.
  6. 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.
  7. Eduardo Levy-Yeyati, 2011. "Exchange Rate Regimes," Business School Working Papers 2011-02, Universidad Torcuato Di Tella.
  8. Aizenman, Joshua & Glick, Reuven, 2008. "Sovereign Wealth Funds: Stylized Facts about their Determinants and Governance," Santa Cruz Department of Economics, Working Paper Series qt1fj4b203, Department of Economics, UC Santa Cruz.
  9. repec:got:cegedp:84 is not listed on IDEAS
  10. Frederic S. Mishkin, 2006. "Monetary Policy Strategy: How Did We Get Here?," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 53(4), pages 359-388, December.
  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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