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This chapter looks at exchange rate management and other policy options for an open economy. It begins with an introductory discussion of overall macroeconomic management for open economies, including the issues of internal and external balance and inflation targeting. It then examines how countries can attempt to manage the exchange rate. Topics covered in this section include the benefits of maintaining an undervalued exchange rate in some developing countries, government interventions to smooth out exchange rate fluctuations, and the trade-off between stability and flexibility when choosing an exchange rate regime. The chapter concludes with an analysis of other policy options in open economies, including heterodox microeconomic interventions, public sector liability management, and debt restructuring.

This chapter discusses the basic analytical framework of “first-generation” models of currency crises and their extensions to deal with important features of balance-of-payments crises such as alternative post-collapse regimes, capital control and borrowing constraints, interest rate defence policies, the interaction between bank solvency and currency stability, uncertainty about government policies, real effects of crises. The key implication of this approach is that a fixed exchange rate regime cannot survive the long-run inconsistency between monetary, fiscal, and exchange rate policies. Unnecessary domestic money growth leads to a persistent loss of reserves and ultimately to a speculative attack against the home currency that forces the government to switch out of the peg once reserves approach a minimum level. It also predicts that the attack will take place at the point where the shadow exchange rate (i.e., the rate that would prevail if the government diverted into a floating rate) equals the fixed peg.

This chapter reviews recent developments in optimal currency area (OCA) theory. It argues that criticisms do not undermine the OCA approach, but rather add to the number of relevant considerations as well as influence the relative weights that should be given to traditional criteria. Thus, OCA criteria do not always provide clear signals about what exchange rate regime a country should adopt.

The negative effects on exports and FDI flows of an exchange rate misalignment are amplified when the misalignment is among countries that share a regional integration agreement. Such agreements strengthen the well-established relationship between real appreciation and currency crises. We conclude that coordination to achieve real-exchange-rate consistency within blocs is key to macro stability and, a fortiori, sustainable trade agreements.

The chapter first examines the limitations of conventional open-economy macro models, such as the Mundell–Fleming model, when they are applied to developing countries. It discusses the Swan–Salter model and the three-sector dependent-economy model that better capture the reality of the external sector in poor countries. It then discusses the impact of devaluation under conditions of closed and open capital accounts and shows the limitation of a devaluation unaccompanied by structural measures in little diversified poor economies and in economies with large dollar liabilities. In this regard, it examines the results of the empirical literature on the contractionary or expansionary effect of devaluation in developing countries. Finally, it reviews the pros and cons of alternative exchange rate regimes, the impossible trinity theorem, and measures to control exchange rate volatility through capital controls.

This chapter analyzes the concept of “fixer” and “floater” in classifying countries during the gold standard period. These terms, though archaic, have not ceased to be relevant, and are seen still to draw similar patterns in a small number of countries. The chapter mentions the research of Obstfeld and Rogoff, “The Mirage of Fixed Exchange Rates”, and cites the existence of a significant number of stable, meaningful exchange rate regimes that go against recent research. The chapter delves deeper into the history of fixed, floating and flipping exchange rate regimes in relation to the number of exchange rate spells and questions how these spells have survived, as well as how the reformation of pegs affect stability.

This chapter identifies the relationship between trade and exchange rate volatility. A model of bilateral trade is used to estimate structurally the effect on trade of exchange rate volatility and exchange rate regimes such as fixed exchange rates and currency boards. The model highlights the role of trade in determining bilateral real exchange rate volatilities, and the differences in the impact of real exchange rate volatility on trade in different types of goods. These features of the model constitute the main building blocks of our identification strategy. The disaggregated data is used to exploit identification structure and test the predictions of the model. In this model, the bilateral pattern of real exchange rate volatility can differ across countries, even though the underlying shocks to each country are identical. Trade costs and aggregate price indexes belong in the equation system, suggesting that land area may not be suitable as an instrument.

This chapter creates the foundation that will affect and be built upon by much of the book, creating a context for questioning and exploration. It introduces the standard view of exchange rate regimes as a means of determining what economic consequences these regime may have yielded. This exposition will be the basis through which the standard results from international macroeconomics will be discussed. The chapter talks of the policy trilemma, its limitations and constraints placed upon the government. How the loss of monetary policy affects the overall performance and stabilization of the economy is also explored in the chapter, and how it serves as advantageous for a fixed exchange rate. Furthermore, the chapter provides a brief history of the international monetary system from the time of the gold standard.

This chapter gives a brief overview of the important questions surrounding the exchange rate regimes in the modern era. These are questions about the exchange rate regime choices, their nature and consequences. The question of the implications of exchange rate regime choice was initiated and instigated by the exchange rate volatility being higher than what experts had anticipated. The chapter gives a concise introduction to each chapter in the book and how these chapters affect the surrounding topic and theme, and how they answer the questions raised. These topics are classic questions in the area of international finance, which have recently changed with the coming of the modern era. The overall objective of the research and studies conducted in the book is to help in creating a better understanding of the modern era as well as expand our knowledge of international finance.

This chapter presents an empirical analysis of the effect of exchange rate regimes on long-run economic growth, demonstrating that empirics rather than theory can best judge growth. The chapter aims to show that exchange rate regimes per se affect long-run economic growth, and that this is influenced by other variables as well. The chapter presents both theories and an empirical analysis in order to draw conclusion on the relationship between growth and regimes. The conclusion arrived at by the analysis states that real variables such as savings rate, population growth and initial income are what long-run economic growth is dependent on. Drawing on the same conclusion that Ghosh, Gulde, and Wolf came upon, the chapter makes an argument that exchange rate regimes are not necessarily vital for growth.

This chapter charts monetary and exchange rate policy aspects of countries’ descent into, and exit from, economic fragility and draws out some key normative policy lessons for fragile countries and their external partners. Choices around exchange rate regime and the conduct of monetary policy in fragile states will rarely be fundamental drivers of deep structural fragility, even though they may present as proximate causes. Nor are they likely to be decisive in driving the recovery from extreme fragility. However, monetary and exchange rate policy choices can and do play an important role in affecting movements into fragility as well as shaping potential exit paths. Moreover, choices in these domains affect the likely distribution of rents, including those generated by policy distortions themselves. In doing so, they alter the balance of power and can decisively shift the points of influence for policy, including by outside agents.

This chapter examines whether lower inflation under currency boards compared to other regimes is associated with the currency board regime itself or the result of other determinants of inflation or possible simultaneity bias. The evidence suggests that the relationship between currency boards and good inflation performance is robust and causal. Controlling for other determinants of inflation, currency boards are associated with 8–20 percentage points per year lower inflation than simple pegs or floating regimes, reflecting both tighter monetary discipline and greater confidence in the currency.

This chapter examines the effect of exchange rate regimes on international trade through an overview of the research conducted on the effects of exchange rate volatility on trade. Research done by Rose as well as Klein and Shambaugh are taken into account as well to present evidence of the economically meaningful influence of fixed exchange rates and exchange rate regimes on trade. Further literature is discussed and investigated to give a broader scope of the subject. The chapter also demonstrates the value of gravity models as a successful empirical framework in international economics. In conclusion, the chapter tries to show the demerits of pegging and how it promotes an expansion of bilateral trade with the base country.

This chapter summarizes in conclusion for the whole book on the subject of exchange rate regimes and how it has impacted economies in the last thirty-five years. Exchange rate regimes do have an effect on how exchange rates behave, and it is shown that the choices countries make with regard to exchange rate regimes do matter and affect outcomes. Economic theory and monetary autonomy are a limited means of setting interest rates. Pegging countries, therefore, should instead follow the interest rate policy of their base country. Exchange rate regimes are indeed important and require consideration as variables in economic growth, however they are not expected to greatly determine the long-run potential growth of an economy.

The authors study a wide range of hybrid inflation-targeting (IT) and managed exchange rate regimes, analysing their implications for inflation, output and the exchange rate in the presence of various domestic and external shocks. To this end, the chapter presents an open economy New Keynesian model featuring sterilized interventions in the foreign exchange (FX) market as an additional central bank instrument operating alongside the Taylor rule, and affecting the economy through portfolio balance sheet effects in the financial sector. The chapter shows that there can be advantages to combining IT with some degree of exchange rate management via FX interventions. Unlike ‘pure’ IT or exchange rate management via interest rates, FX interventions can help insulate the economy against certain shocks, especially shocks to international financial conditions. However, managing the exchange rate through FX interventions may also hinder necessary exchange rate adjustments, e.g., in the presence of terms of trade shocks.

A currency union has been suggested for East Asia. The chapter analyzes the feasibility of various types of unions, such as a dollar bloc, euro bloc, yen bloc, and basket currency and assess the welfare effects for East Asian economies. Judging from optimum currency area (OCA) criteria, including the symmetry of output and price shocks across countries, commitment to price stability, and trade and financial integration, East Asia does not have highly favorable economic conditions for a currency union, particularly when compared to the euro area. The low political proximity between Japan and other East Asian economies impedes Japan’s leadership in the creation of an East Asian currency union. For most countries in East Asia, a currency union involving a broad group of economies would result in a net welfare gain due to trade creation. However, if the increased volatility due to the loss of monetary policy independence generates a significantly negative effect on growth, the larger East Asian economies such as the People’s Republic of China (PRC), Indonesia, and Japan may suffer a net welfare loss. A substantial welfare gain from joining an East Asian currency union would occur if a currency union lowers the probability and size of disasters such as wars and financial crises in East Asia.

The theme of this book is that a meaningful strategy for managing risk, exploiting opportunities, and assessing performance requires that the interdependence among macroeconomic variables is recognized. The effects of exchange rates, interest rates, and inflation rates cannot be estimated and managed one variable at a time. The variables influence the firm through a variety of channels not captured by conventional accounting systems. Strategies based on a comprehensive approach for managing exchange rate and “related” macroeconomic exposures are called for. The forward-looking aspects of strategy include measurement and management of these exposures. The backward-looking aspects refer to analysis of sources of firms' performance with the objective of decomposing performance into changes in competitiveness and changes caused by macroeconomic events.