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The Determinants of the Choice between Fixed and Flexible Exchange-Rate Regimes

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  • Sebastian Edwards

Abstract

In recent years, analysts and policy makers alike have been evaluating the nexus between exchange rates and macroeconomic stability. Among the most important questions is why have some countries adopted rigid, including fixed, exchange-rate paper addresses this question from a political economy perspective both theoretically and empirically. The model assumes that the monetary authority minimizes a quadratic loss function that captures the trade-off between infla- tion and unemployment. This framework is initially applied to the case where monetary authorities must choose between a (permanently) fixed and a flexible exchange-rate regime. In choosing the regime it is assumed authorities compare the expected losses under each scenario. The model is subsequently extended extended to cover the somewhat more complicated case where the authoriities must choose between fixed-but-adjustable and flexible exchange-rate regimes. In this latter case, potential political costs of abandoningithe pegged rate are taken into account. In the empirical section, an unbalanced panel data set of 63 countries from 1980-1992 is used to estimate a series of probit models, with a binary exchange-rate regime index as the dependent variable. Among the most important explanatory variables were measures of countries' historical degree of political instability, measures of the probability of abandoning pegged rates, and variables related to the relative importance of real (unemployment) targets in the preferences of monetary authorities. The regression results support the political economy approach developed in the theoretical discussion.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5756.

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Date of creation: Sep 1996
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Publication status: published as Ito, Takatoshi and Anne O. Krueger (eds.) Changes in Exchange Rates in Rapidly Developing Countries: Theory, Practice, and Policy Issues, National Bureau of Economic Research East Asia Seminar on Economics. University of Chicago Press, 1999.
Handle: RePEc:nbr:nberwo:5756

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  1. Devarajan, Shantayanan & Rodrik, Dani, 1991. "Do the benefits of fixed exchange rates outweigh their costs? The Franc Zone in Africa," Policy Research Working Paper Series 777, The World Bank.
  2. Robert P. Flood & Peter Isard, 1988. "Monetary Policy Strategies," NBER Working Papers 2770, National Bureau of Economic Research, Inc.
  3. Robert J. Barro, 1989. "Economic Growth in a Cross Section of Countries," NBER Working Papers 3120, National Bureau of Economic Research, Inc.
  4. Edwards, Sebastian, 1994. "The Political Economy of Inflation and Stabilization in Developing Countries," Economic Development and Cultural Change, University of Chicago Press, vol. 42(2), pages 235-66, January.
  5. Bruno, M., 1991. "High Inflation and the Nominal Anchors of an Open Economy," Princeton Studies in International Economics 183, International Economics Section, Departement of Economics Princeton University,.
  6. Alberto Alesina & Vittorio Grilli & Gian Maria Milesi-Ferrett, 1993. "The Political Economy of Capital Controls," NBER Working Papers 4353, National Bureau of Economic Research, Inc.
  7. Peter Montiel & Bijan B. Aghevli & Mohsin S. Khan, 1991. "Exchange Rate Policy in Developing Countries," IMF Occasional Papers 78, International Monetary Fund.
  8. Jeffrey A. Frankel, 1993. "Monetary regime choices for a semi-open country," Pacific Basin Working Paper Series 93-02, Federal Reserve Bank of San Francisco.
  9. Robert P. Flood & Peter Isard, 1989. "Monetary Policy Strategies," IMF Staff Papers, Palgrave Macmillan, vol. 36(3), pages 612-632, September.
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