Choice and Reform of the Exchange Rate System

The appropriateness of the exchange rate system, which includes the exchange rate arrangement and exchange rate policies, must be carefully considered in any financial reform program. This is mainly because the exchange rate is a key price that affects the cost of imported goods and the profitability of export industries. It also influences the rate of inflation, output, and employment. The choice of exchange rate arrangement — that is, whether the exchange rate is pegged, floating, or something in between — is also an important feature in the financial reform for these countries. This choice influences the extent to which an economy is affected by external economic disturbances or shocks and defines the scope for independent domestic monetary policy. It is therefore not surprising that Eastern European countries have introduced new exchange systems as part of their financial reform programs; that participation in the exchange rate mechanism of the European Monetary System has expanded, with member countries recognizing the advantages of exchange rate stability; and that many African and Latin American countries have been questioning inflation-linked devaluation, which appeared to lead to higher rates of inflation in the absence of sound domestic economic policies.