Destabilizing effects of exchange-rate escape clauses
This paper studies the merits of policy rules with escape clauses, analyzing as an example fixed exchange-rate systems that allow member countries the freedom to realign in periods of stress. Motivating this example is the debate within the European Monetary System over how quickly to move from the current regime of national currencies, linked by pegged but adjustable exchange rates, to a single European currency. The paper's main point is that while well-designed rules with escape clauses can raise society's welfare in principle, limited credibility makes it difficult for governments to implement such rules in practice. An EMS-type institution - which presumably imposes a political cost on policymakers who realign - may lead to an optimal escape-clause equilibrium, but may just as well lead to alternative equilibria far inferior to an irrevocably fixed exchange rate. Countries can suffer periods in which no realignment occurs, yet unemployment, real wages, and ex post real interest rates remain persistently and suboptimally high.
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