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Exchange-Rate Policies For Developing Countries: What Have We Learned? What Do We Still Not Know?

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  • Andrés VELASCO

Abstract

The 1997–1998 Asian crisis, with its offshoots in Eastern Europe and Latin America, has reignited the debate about appropriate exchange-rate policies for developing countries. One widely shared conclusion from this episode is that adjustable or crawling pegs are extremely fragile in a world of volatile capital movements. The pressure resulting from massive capital flow reversals and weakened domestic financial systems was too strong even for countries that followed sound macroeconomic policies and had large stocks of reserves. As a consequence, the polar regimes of a "hard pegs" (such as a currency board), or a clean float, are enjoying new popularity. This paper argues that, while currency boards or even dollarization may be justified in some extreme cases, they are not appropriate for all developing countries. The recommendations formulated on the basis of the Mundell-McKinnon criteria for the optimum currency are considered still sensible today. Currency boards face serious implementation problems. One is the choice of the currency to peg to and at what rate; another is the need to ensure stability of the domestic financial system in the absence of a domestic lender of last resort. Floating appears to have wider applicability. As Friedman already argued in the early 1950s,if prices move slowly, it is both faster and less costly to move the nominal exchange rate in response to a shock that requires an adjustment in the real exchange rate. But for exchange-rate flexibility to be stabilizing, it has to be implemented by independent central banks whose commitment to low inflation is credible. Ongoing depreciations that follow from imprudent of opportunistic monetary behaviour will surely come to be expected by agents, and hence will have no real effect; occasional depreciations that respond exclusively to unforecastable shocks will, almost by definition, have real effects. But floating also faces questions of implementation. Given that no central bank completely abstains from intervention in currency markets, what principles should govern such intervention? The paper elaborates on a number of points in this regard on which recent experience is likely to be instructive, but on which more research is needed. Finally, any exchange-rate regime, and especially one of flexible rates, requires complementary policies to increase its chances of success. In this context, some have suggested the use of capital controls; less controversial is the need for prudential regulation of the financial system and for counter-cyclical fiscal policy.

Suggested Citation

  • Andrés VELASCO, 2000. "Exchange-Rate Policies For Developing Countries: What Have We Learned? What Do We Still Not Know?," G-24 Discussion Papers 5, United Nations Conference on Trade and Development.
  • Handle: RePEc:unc:g24pap:5
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    Cited by:

    1. Corrado, L. & Marcus Miller & Lei Zhang, 2002. "Exchange Rate Monitoring Bands: Theory and Policy," Cambridge Working Papers in Economics 0209, Faculty of Economics, University of Cambridge.
    2. Flávio Vilela Vieira & Márcio Holland, 2004. "Exchange Rate Dynamics In Brazil," Anais do XXXII Encontro Nacional de Economia [Proceedings of the 32th Brazilian Economics Meeting] 066, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
    3. Moron, Eduardo & Winkelried, Diego, 2005. "Monetary policy rules for financially vulnerable economies," Journal of Development Economics, Elsevier, vol. 76(1), pages 23-51, February.
    4. Barbara Fritz & Laurissa Mühlich, 2006. "Regional Monetary Integration among Developing Countries: New Opportunities for Macroeconomic Stability beyond the Theory of Optimum Currency Areas?," GIGA Working Paper Series 38, GIGA German Institute of Global and Area Studies.
    5. Luisa Corrado & Marcus H. Miller & Lei Zhang, 2003. "Exchange Monitoring Bands: Theory and Policy," CEIS Research Paper 8, Tor Vergata University, CEIS.
    6. Carrera, Jorge Eduardo, 2004. "Hard peg and monetary unions.Main lessons from the Argentine experience," MPRA Paper 7843, University Library of Munich, Germany, revised 2007.

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