Exchange Rate Policy and Endogenous Price Flexibility

This paper explores the relationship between exchange rate regimes and inflationary instability in small open economies, focusing on their role during periods of crisis and economic recovery. Small economies, due to their high degree of openness and limited monetary autonomy, are particularly vulnerable to external shocks and currency fluctuations. The choice of exchange rate regime—whether fixed, floating, or intermediate—plays a significant role in shaping inflationary trends and overall macroeconomic stability. Through an analysis of various regime types and their historical impact on developing countries, the paper highlights the importance of consistent and well-coordinated monetary and fiscal policies. Special attention is given to the challenges of maintaining price stability amid global uncertainty and the mechanisms through which exchange rate policy can either mitigate or amplify inflation. The findings emphasize that while no one-size-fits-all solution exists, flexible and credible exchange rate frameworks, combined with institutional resilience, are key to sustaining long-term economic recovery in small open economies.

Before 2005 July 21st, RMB exchange rate was pegged to US Dollar and adopted a fixed exchange rate. The correlation between RMB exchange rate and exchange rates of other East Asian economies was not significant. Empirical findings indicated that since Mainland China changed its exchange rate regime to a basket of currencies on July 22nd, 2005, in addition to the insignificant correlation between RMB exchange rate and exchange rates of Hong Kong, Malaysia, Thailand, and Indonesia duration the certain period, the correlation between exchange rate fluctuations of RMB and other East Asian economies is significantly related. This shows that the exchange rate regime of East Asian economies is mostly pegged to a basket of currencies. In order to avoid effects of exchange rate fluctuations from other countries on trade interests, exchange rate fluctuations of East Asian economies have a clear regional linkage. However, Mainland China’s exchange rate policy is gradually becoming more open, causing RMB exchange rate fluctuations to become an important reference for overall exchange rate structure in East Asia. RMB internationalization will continue in the future, cross-border trade with RMB settlement increasing, and RMB offshore market size will also expand. And currently Mainland China is leading East Asian economic and trade integration; hence RMB exchange rate fluctuations will have a significant impact on exchange rate fluctuations of other East Asian economies in the foreseeable future.

Exchange Rate Regimes: Is the Bipolar View Correct?

Financial Fragility and the Exchange Rate Regime

Too Sensational: On the Choice of Exchange Rate Regimes By W. Max Corden. Cambridge, MA: MIT Press. 2002. Pp. xiv, 274. $29.95.This volume is the 10th in the series of Ohlin lectures initiated in 1988 at the Stockholm School of Economics. This volume, like the others (the first of which was Bhagwati's 1988 lively Protectionism) is characterized by clear and imaginative thought with no equations. Corden describes his method as story telling informed by theory (p. xiii). The jacket of Bhagwati's book was a cartoon from Punch, which showed the British Prime Minister being led to free trade. My choice for the jacket of this book would have been something like The Economist's November 28, 1968, cover, which showed the heads of Charles DeGaulle, Richard Nixon, and Harold Wilson bobbing among the waves, with the caption It's much better to float. That is the message of the book for most countries: floating is better than a fixed-but-adjustable exchange rate regime, or a FBAR, to use Corden's abbreviation.Instead, the jacket of the book displays the quote from Oscar Wilde's The Importance of Being Earnest that introduced one of the chapters in an early edition of Samuelson's textbook. Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat sensational. Even these metallic problems have their melodramatic side. Since my introductory course in economics, I had wondered about what that quote meant. Now 42 years later, I discover that the rupee had been pegged to silver, the pound to gold, and when the price of silver plummeted in the 1870s, the rupee depreciated. Indian goods became more competitive, creating competitiveness problems for British industry, and the home charges, which India had to take to Britain, were denominated in sterling, creating fiscal problems for India. Corden notes that the more recent FBARs have also been too sensational (p. x). This is his way of saying it is important to keep exchange rates in line with fundamentals, or It's much better to float.Corden credits Ohlin with seeing clearly in 1931 the importance of adjusting the Swedish Kroner in order to stabilize the Swedish price level, yet another contribution in addition to his ideas on the factor price equalization theorem and the transfer problem, and his service as leader of Sweden's liberal party for 34 years. Corden quotes Keynes in 1923 as favoring price level stability as more important than exchange rate stability and believing that the most cogent rationale for a gold standard was the rather weak discipline argument, strapping down Ministers of Finance (p. 13).Corden reminds us of core ideas about exchange rate regimes. For example, there is Milton Friedman's point that there is a presumption that currency speculation will be stabilizing, for destabilizing speculation is unprofitable. He laments the jerkyness of FBARs. He suggests that either flexible nominal wages or inflexible real wages creates an overwhelming case for an absolutely fixed (exchange rate) regime. In the former case, exchange rate change is not needed to maintain competitiveness, and in the latter it is not useful. A peg to an individual currency is preferable to pegging to a currency basket in that the former saves transaction costs and is easier to monitor. What follows is a collection of Corden's insights that 1 found particularly interesting.Not many economists living in the real world would dispute that in the short run there is some degree of sluggishness downward of nominal wages in most, if not all, countries (p. 89). And based on overwhelming empirical evidence, Keynesian analysis and policies as presented here are still appropriate for short-to-medium-term situations (p. 90). Also, the Barro-Ricardo complication that forward-looking tax payers will offset fiscal actions is only partial at best, leaving Keynesian demandside prescriptions in tact. …

The article summarizes the patterns of development of exchange rate policy in Ukraine as the transition from administrative to economic methods of regulating the foreign exchange market in the process of increasing the degree of its liberalization. It is shown that the evolution of the exchange rate regime is described by the following chain: fixed, currency corridor, flexible, adjustable-floating, floating. The change in the objects of monetary targeting took place in the following sequence: credit channel, monetary aggregates, exchange rate, inflation. The main task of the NBU's exchange rate policy is to ensure price stability, and an additional one is the impact on the hryvnia exchange rate. It is determined that currently the main instrument of the NBU's monetary policy is the interest rate, and foreign exchange interventions are ancillary to the inflation targeting and floating exchange rate, which acts as a compensator for negative foreign exchange shocks and supports the competitiveness of producers. It is shown that within the current exchange rate regime in Ukraine foreign exchange interventions are carried out on the principles of reducing the role, scale and frequency as the currency market is liberalized, non-interference in its fundamental trends, priority of foreign exchange demand by foreign exchange market participants. and transparency of the criteria for the participation of entities in auctions and bidding. It is argued that the purpose of foreign exchange interventions is: replenishment of official foreign exchange reserves, smoothing the shortcomings of the foreign exchange market in case of its limited ability to self-regulate, loss of benchmarks for pricing, high exchange rate volatility, which negatively affects the currency security of the state and businesses. It is established that between foreign exchange interventions and the interest rate there is a transmission mechanism to strengthen the main instrument in regulating the foreign exchange and monetary markets on the principles of effectiveness of its consequences for the economy in case of adequate perception of NBU signals.

Sustainability of macroeconomic policies in selected MENA countries: Post financial and debt crises

The Pacific island countries have opted for exchange rate regimes with varying degrees of flexibility. Whereas several microstates have adopted an external currency as their legal tender, others have decided to use a basket currency, and yet others have chosen a managed float. The choice of exchange rate regime can have far reaching economic consequences. In the paper, we study the basket currency arrangements by Fiji, Samoa, the Solomon Islands, and Tonga. We first build a new four‐country exchange rate model that illustrates how monetary authorities should best determine the weights of the basket currencies given certain macroeconomic objective functions. In this model, we explicitly include tourism flows. In the second part of the paper, we estimate the de facto weights of foreign currencies in the currency basket of the four countries. We show how the composition has changed amid the global financial crisis. Finally, we demonstrate that the current weights are not optimal compared with the predictions of our model.

Real exchange rates, devaluation and adjustment: Exchange rate policy in developing countries: Sebastian Edwards, (MIT Press, Cambridge, MA, 1989) pp. xi + 371, $32.50

Economic theory has stressed the vulnerability to currency crises of intermediate exchange regimes. ERM II constitutes a fixed but adjustable pegged exchange rate arrangement and can therefore be categorized as an intermediate regime, in contrast to polar regimes such as currency boards and freely floating exchange rates. Our regression results for eight new EU Member States reveal the role of economic fundamentals in explaining exchange market pressure in these countries and confirm the bipolar view on exchange rate regimes. We conclude that the new EU members should not enter ERM II before their fundamentals are strong enough to compensate for the vulnerability of the exchange rate regime. Otherwise the condition for entering EMU, i.e. preceding participation in ERM II without devaluation or serious tensions on the exchange market, could be jeopardized.

Since the 1990s, some developing and transition countries have adopted hard peg exchange rate regimes. Hard peg exchange rate regimes consist of dollarization, currency boards, and currency unions. A currency board is an exchange rate regime under which the exchange rate is fixed and the monetary base is fully backed by foreign exchange reserves. Dollarization is an exchange rate regime under which a country unilaterally lets another country's currency circulate in place of a national currency. Under both regimes, monetary policy autonomy is largely restricted.

Part 1 Balance-of-payments accounting and the foreign-exchange market: concepts of the balance of payments the accounting balance of payments balance-of-payments equilibrium more on the concept of equilibrium the foreign-exchange market the demand for dollars the supply of dollars capital movements and speculation the forward rate of exchange types of exchange-rate regime fixed versus flexible exchange rates exchange rate reform. Part 2 The capital account of the balance of payments: the components of the capital account official reserves special drawing rights the balancing item the capital account and the net external wealth of the U.K. Part 3 Exchange rate determination: theories of exchange rate determination purchasing power parity current balance model the importance of theories of expectations formation the Mundell-Fleming model exchange rate overshooting models the portfolio model of exchange rate determination speculatice bubble models of exchange rate determination exchange rate determination - what have we learnt? exchange rate systems and policies fixed versus flexible exchange rates types of exchange rate regime controls on capital movements exchange rate policy in the 1990s. Part 4 The balance of payments and the national economy: the integration of the balance of payments into the nationnal accounts the conflict between balance-of-payments equilibrium and other objectives of economic policy income equilibrium in an open economy and the foreign-trade mulitplier the foreign-trade multiplier relating imports to expenditure the 'new' foreign-trade multiplier with foreign repercussions balance-of-payments adjustment the classical price-specie flow mechanism the elasticity approach the absorption approach the monetary approach. Part 5 The elasticity approach to the balance of payments: the Marshall-Lerner condition derived devaluation and the response of firms lags and the J-curve effect devaluation and inflation payments imbalance in the World economy devaluation and the terms of trade the difficulties of measuring price elasticities. Part 6 The absorption approach to the balance of payments: the direct effect of devaluation on income the direct effect of devaluation on absorption the interaction between changes in income and changes in absorption strengths and dangers of the absorption approach the monetary aspects of balance-of-payments deficits domestic credit expansion. Part 7 The monetary approach to the balance of payments. Part 8 Simultaneous internal and external balance: internal and external balance under flexible exchange rates with no capital movements internal and external balance under fixed exchange rate woth capital movementsl internal and external balance in an IS-LM curve framework the use of monetary and fiscal policy under alternative exchange-rate regimes the assignment of policies in the United Kingdom. (part contents).

An authoritative analysis that employs economic theory, cross-country empirical comparison, and case studies to analyze the effect of currency boards on inflation, output growth and macroeconomic performance. Currency boards, more so than other exchange rate regimes, have come in and out of fashion. Defined by a fixed exchange rate with full convertibility, central bank liabilities backed with foreign exchange reserves, and a high cost of exiting the regime, currency boards were common in colonial times—until most were cast off as countries gained independence after World War II. In the 1990s, currency boards enjoyed a revival as the cornerstone of various macroeconomic stabilization programs—including many in central and eastern European transition economies—only to fall into disfavor again with the collapse of the Argentine regime in 2002. The authors of Currency Boards in Retrospect and Prospect take a balanced look at the effects of currency board regimes on inflation, output growth, and macroeconomic performance more generally. Drawing on historical experience, economic theory, cross-country empirical analysis, and case studies of currency boards in Argentina, Estonia, Lithuania, Bulgaria, and Bosnia and Herzegovina, the authors conclude that currency boards deliver significant reductions in inflation compared to other regimes and do not seem to result in slower growth or a markedly higher vulnerability to crisis.

The promotion order between exchange rate marketization and capital account openness is one of the hotspots and debates in the field of international finance. Some scholars support the reform order of internal first, external next”, while others believe that they should be promoted in a coordinated manner. In view of the above two points, some scholars try to use econometric methods such as the Granger causality test and VAR model to determine the promotion order, but these methods are often limited to the selection of samples and depend on the data to a large degree, and different samples may draw different conclusions. Due to the lack of a reference system, the promotion order between exchange rate marketization and capital account openness is not determined. What is the basis or determination? The economic development level, total factor productivity or financial stability? If there is no basis, it is difficult to make a clear judgment on the promotion strategy. If the reference system is abandoned, the investigation only based on the data does not have practical significance. In view of this, this paper refers to the study of Rodriguez（2017）, constructs the influence equation of the exchange rate regime on total factor productivity（with capital account openness as the conversion variable）and the influence equation of capital account openness on total factor productivity（with the exchange rate system as the conversion variable）, respectively. Moreover, total factor productivity is selected as the reference system, and a non-linear modeling technology PSTR model is adopted to investigate the promotion strategy. It is revealed that the exchange rate regime has a significant non-linear effect on total factor productivity, the influence coefficient changes from negative to positive with the increase of capital account openness, which indicates that capital account openness can weaken the negative impact of exchange rate fluctuations on total factor productivity. The influence coefficient of capital account openness on total factor productivity is negative, and it shows obvious stage characteristics with the change of the exchange rate regime. When the exchange rate regime is flexible enough, its negative impact decreases significantly, which indicates that a more flexible exchange rate regime is conducive to absorbing the negative impact of capital account openness. Therefore, with total factor productivity as a reference system, there is a mutual adjustment mechanism between exchange rate marketization and capital account openness. Capital account openness is the premise of exchange rate marketization, and exchange rate marketization is also the prerequisite of capital account openness. They should be promoted in a coordinated way. Compared with the existing results, the possible contributions of this paper are as follows: First, the exchange rate regime and capital account openness are taken as the key explanatory variable and adjustment variable respectively, which enriches the literature with respect to the promotion order of exchange rate marketization and capital account openness, and overcomes the shortcomings of the existing literature that only employ one of them as the key explanatory variable and adjustment variable, making the research more comprehensive and detailed. Second, compared with most existing literature that directly adopt the interactive terms（only the first-order non-linear relations can be identified）, this paper utilizes a non-linear method—the PSTR model, which can identify higher-order non-linear relations and solve the problem of missing implicit non-linear relations. Third, compared with most existing literature focusing on economic growth or financial crisis, this paper conducts the analysis from the perspective of total factor productivity to re-judge the promotion order. The study can provide theoretical support and a decision-making basis for how to promote exchange rate marketization and capital account openness in the constitutive reform and transition from quantitative growth to qualitative development of China’s economic development.

Exchange rates have been central to the course of economic development in Latin America from the heyday of import substitution to the rapid expansion of foreign debt in the 1970s, and from the debt crisis and its troubled aftermath to renewed growth and borrowing in the 1990s. Why do governments choose the currency policies they do, and how do economic and political factors affect these policies? Although currency policy is made by governments operating in a political environment, there has been little study of the political economy of exchange rate policy. This work seeks to fill this void by examining the range of potential determinants of currency choices by Latin American governments. While purely economic factors - especially economic structure, trade patterns and exogenous economic conditions - are of course important to these choices, the book focuses on the political and political economy considerations that have typically been underrepresented in the literature. These include the effects of interest groups, electoral competition, and the timing of elections on exchange rate decisions. Since exchange regimes are adopted for reasons as diverse as inflation control, reduced volatility and improved competitiveness, the book also features a cross-country analysis of national exchange rate policies, as well as case studies of Argentina, Brazil, Chile, Colombia and Peru.