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Fear of Floating Needn't Imply Fixed Rates: Feasible Options for Intermediate Exchange Rate Regimes

Thomas D. Willett
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Thomas D. Willett: Claremont McKenna College and Claremont Graduate University

Claremont Colleges Working Papers from Claremont Colleges

Abstract: The criteria of the theory of optimum currency areas suggest that many (most?) countries are not good candidates for either of the poles of genuinely fixed exchange rates or freely floating exchange rates. Thus many countries should have an interest in intermediate exchange rate regimes. However, in a world of substantial capital mobility most forms of intermediate exchange rate regimes have proven to be highly crisis prone. The paper argues that the unholy trinity analysis doesn't imply that intermediate exchange rate regimes are inherently unstable, but rather that exchange rate and monetary policies need to be jointly determined. The difficulties of maintaining such consistency are as much political as economic since temporarily pegged or managed rates create a time inconsistency problem. Therefore policy officials need some institutional insulation from short sighted political pressures. A problem with most intermediate regimes is that they have focused on particular forms of limited exchange rate flexibility per se, rather than the weight that should be given to the exchange rate in setting monetary policy. It is argued that OCA theory provides the framework for determining the appropriate weights and limits on the amount of sterilized intervention to maintain the consistency between exchange rate and monetary policies necessary to avoid currency crises. The paper also considers a number of the issues involved in integrating their approach with the literature on open economy aspects of inflation targeting.

Keywords: political economy; capital mobility; exchange rates; discipline (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fin, nep-ifn and nep-rmg
Date: 2002-05
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