Fixed Exchange Rate Regimes in Mediterranean Countries and the Experience of Cyprus
Mediterranean countries following a fixed exchange rate regime have been confronted with some challenges that test the efficacy of the regimes in place. These challenges mostly arise from the combination of inflationary pressures and the need for further capital account liberalisation amid conditions of ample liquidity in the banking system and rapid money and credit growth. In light of these developments, some of these exchange rate targeting Mediterranean countries are assessing the framework in place or even contemplating change to a more flexible arrangement, which would allow them greater freedom to pursue domestic objectives. Theoretical and empirical considerations do not point to the superiority of a particular exchange rate regime, but provide broad guidance on the factors and conditions that are predisposed to a fixed exchange rate regime and its sustainability in a liberalised environment. The case of Cyprus confirms the view that, under certain conditions, it is possible to maintain a credible fixed exchange rate regime while advancing capital account liberalisation and still achieve the primary objective of monetary policy. Adherence to a simple monetary rule, such as an exchange rate target, can confer credibility on a central bank and deliver price stability. Another important lesson drawn from the Cyprus case is that this strategy requires an independent central bank and needs to be supplemented by additional measures. Monetary aggregates, in particular credit, should be closely monitored and controlled, if necessary. The current account also warrants close monitoring, both as an indicator of inflationary pressures and as a warning signal helping to avoid unsustainable external imbalances. Finally, capital account liberalisation requires that the authorities have in advance a well-prepared and comprehensive plan, including, first and foremost, reforms in the conduct of monetary policy and banking supervision.
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- Paul De Grauwe & Gunther Schnabl, 2008. "Exchange Rate Stability, Inflation, and Growth in (South) Eastern and Central Europe," Review of Development Economics, Wiley Blackwell, vol. 12(3), pages 530-549, 08.
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