Exogenous shocks and exchange rate management in developing countries: a theoretical analysis

Within the context of developing economies, this article examines the choice of an appropriate exchange rate policy. Rapid globalisation has on one hand benefited the less developed countries (LDCs), but on the other hand made them more vulnerable to exogenous shocks. While relying on imported technologies and intermediate inputs, many LDCs are competing in international market by exporting better quality and cost efficient products. Exchange rate has a direct impact on cost of production. This article utilises a small open economy model that involves direct supply-side effects of exchange rate and expectations of key economic variables such as output, prices and exchange rate. The article considers four possible exchange rate policies: fixed exchange rate, perfectly flexible exchange rate, leaning against the wind and leaning with the wind. Contrary to the conventional wisdom, the article finds that in the event of a shock, leaning against the wind is likely to be the most appropriate exchange rate policy. Moreover, in the event of rigid wages, a fixed exchange rate policy is advisable.