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Twin fallacies about exchange rate policy: A note

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  • Reinhart, Carmen
  • Reinhart, Vincent

Abstract

Two assertions about exchange rate regimes circulate with some frequency in policy circles. The first, which could be called the hypothesis of the excluded middle, holds that authorities must either choose perfectly floating exchange rates or a hard peg. The second, seemingly unrelated, notion attempts to explain why policy makers in some countries have little credibility. That mistrust, exemplified by the inability of emerging market economies to borrow at long maturities in their own currencies (original sin), transcends current fundamentals and traces back to the failure of prior policy makers. We argue that the theories of the excluded middle and original sin are twin and related fallacies that are contrary to theory and evidence. The sense that credibility problems stem from a simple and irrational source–failures of prior generations of policy makers–lends credence to alternative regimes that seem to allow the easy purchase of investor confidence–an exchange rate regime at one of the corners. Two decades of theory and empirical evidence cumulate to argue that this is too simple an answer. As to the theory, the literature on time inconsistency has amply demonstrated that the inability to precommit future policy decisions gives reason to doubt that the current regime will be maintained. That doubt stems, not from the record of prior failures, but from the inconsistency of incentives in the future.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 13763.

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Date of creation: Sep 2003
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Handle: RePEc:pra:mprapa:13763

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Keywords: exchange rate debt domestic currency original sin;

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  1. Carmen M. Reinhart & Vincent R. Reinhart, 2003. "Twin Fallacies About Exchange Rate Policy in Emerging Markets," NBER Working Papers 9670, National Bureau of Economic Research, Inc.
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