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This chapter presents theoretical arguments to explain why countries may or may not opt for a currency board arrangement. The adoption of a currency board arrangement can be seen as being based on two distinct decisions: first, the choice of a fixed over a floating exchange rate regime; and, second, within the spectrum of pegged exchange rate regimes, the selection of a hard peg over a traditional “softer” peg. The chapter reviews the relative merits of fixed versus floating exchange rates before turning to the trade-off between the credibility gain provided by a hard peg and the easier escape in the face of shocks allowed by softer pegs.

This chapter considers the possible connection between the exchange rate regime and inflation performance. A basic framework is conceptualized, using a heuristic approach and a model of inflation based on money demand and money supply. Empirical studies are then discussed and surveyed in the chapter to further discover whether or not these regimes affect inflation. In this analysis, the European Monetary System is one establishment that is studied, as are the works of Levy-Yeyati and Sturzenegger and many others. The conclusion derived from the analysis of data and evidence suggests that exchange rate regimes play an important role in influencing inflation, and results show that tempering inflation can be achieved through pegged exchange rates in order to help discipline policy.

This chapter performs tests that answer the question regarding the theory of the policy trilemma and if predictions of this theory are often borne out in practice. The chapter also looks at the modern era experiences of certain countries for discussion on whether exchange rate pegs limit monetary autonomy. The literature on the trilemma is given a brief overview, such as the work of Bordo and MacDonald is explored, particularly how it suggests that gold standard countries were flexible in their monetary policy. Empirical evidence is then analyzed and tested and shows that the policy trilemma affects economic outcomes as well, and not simply monetary policy. In conclusion, the policy trilemma theory is an appealing theoretical framework and carries vital implications on the monetary autonomy of a country.

This chapter compares the behavior of failed and successful defenses of pegged exchange rates. It shows that the costs of unsuccessful defense against an attack on a currency system are large, about one year of economic growth or three percent of gross national product. The analysis also reveals that the difference in output losses between successful and unsuccessful defense is only significant for just one year. This finding can help account for a number of observations about the behavior of open economies and their policy makers.