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Should small open economies in East Asia put all their eggs in one basket: the role of balance sheet effects

Author

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  • Slavi T. Slavov

    (Pomona College)

Abstract

Yen-dollar fluctuations increase macroeconomic instability in small economies in East Asia. I investigate the choice of an exchange rate regime for these countries so as to minimize the adverse effects of this volatility. I build a sticky-price dynamic model of a small economy whose trade is invoiced in dollar and yen. First, I show the conditions under which pegging to a tradeweighted basket of the two currencies is the optimal policy for the small economy. Then, I introduce net worth constraints and unhedged dollar borrowing which pull the optimal policy away toward putting a much greater weight on the dollar.

Suggested Citation

  • Slavi T. Slavov, 2005. "Should small open economies in East Asia put all their eggs in one basket: the role of balance sheet effects," International Finance 0501001, EconWPA.
  • Handle: RePEc:wpa:wuwpif:0501001
    Note: Type of Document - pdf; pages: 35
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    References listed on IDEAS

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    4. Michael B. Devereux & Philip R. Lane & Juanyi Xu, 2006. "Exchange Rates and Monetary Policy in Emerging Market Economies," Economic Journal, Royal Economic Society, vol. 116(511), pages 478-506, April.
    5. Carmen M. Reinhart & Vincent Raymond Reinhart, 2002. "What Hurts Emerging Markets Most? G3 Exchange Rate or Interest Rate Volatility?," NBER Chapters,in: Preventing Currency Crises in Emerging Markets, pages 133-170 National Bureau of Economic Research, Inc.
    6. Andrew Crockett & Chairman, 1999. "General discussion : exchange rates and financial fragility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 411-422.
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    12. Ito, Takatoshi & Ogawa, Eiji & Sasaki, Yuri Nagataki, 1998. "How Did the Dollar Peg Fail in Asia?," Journal of the Japanese and International Economies, Elsevier, vol. 12(4), pages 256-304, December.
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    14. Ronald McKinnon & Gunther Schnabl, 2002. "Synchronized Business Cycles in East Asia: Fluctuations in the Yen/Dollar Exchange Rate and China’s Stabilizing Role," Working Papers 02010, Stanford University, Department of Economics.
    15. Jeffrey A. Frankel & Shang-Jin Wei, 1994. "Yen Bloc or Dollar Bloc? Exchange Rate Policies of the East Asian Economies," NBER Chapters,in: Macroeconomic Linkage: Savings, Exchange Rates, and Capital Flows, NBER-EASE Volume 3, pages 295-333 National Bureau of Economic Research, Inc.
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    Cited by:

    1. Teo, Wing Leong, 2009. "Should East Asia's currencies be pegged to the yen? The role of invoice currency," Journal of the Japanese and International Economies, Elsevier, vol. 23(3), pages 283-308, September.
    2. Ronald McKinnon & Gunther Schnabl, 2004. "The East Asian Dollar Standard, Fear of Floating, and Original Sin," Review of Development Economics, Wiley Blackwell, vol. 8(3), pages 331-360, August.
    3. Constant A Lonkeng Ngouana, 2012. "Exchange Rate Volatility Under Peg; Do Trade Patterns Matter?," IMF Working Papers 12/73, International Monetary Fund.
    4. Zihui Ma & Leonard K. Cheng, 2014. "An Optimal Currency Basket to Minimize Output and Inflation Volatility: Theory and an Application to Hong Kong," Pacific Economic Review, Wiley Blackwell, vol. 19(1), pages 90-111, February.
    5. Kang Shi & Juanyi Xu, 2008. "The Optimal Currency Basket with Input Currency and Output Currency," Working Papers 172008, Hong Kong Institute for Monetary Research.
    6. Xu, Juanyi, 2011. "The optimal currency basket under vertical trade," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1323-1340.
    7. Slavov, Slavi T., 2008. "Measuring and modeling the effects of G-3 exchange rate fluctuations on small open economies: A natural experiment," Economic Systems, Elsevier, vol. 32(3), pages 253-273, September.

    More about this item

    Keywords

    East Asia; optimal basket pegs; balance sheet effects; exchange rate regimes;

    JEL classification:

    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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