Twin fallacies about exchange rate policy: A note

Carmen Reinhart and Vincent Reinhart

MPRA Paper from University Library of Munich, Germany

Abstract: Two assertions about exchange rate regimes circulate with some frequency in policy circles. The first, which could be called the hypothesis of the excluded middle, holds that authorities must either choose perfectly floating exchange rates or a hard peg. The second, seemingly unrelated, notion attempts to explain why policy makers in some countries have little credibility. That mistrust, exemplified by the inability of emerging market economies to borrow at long maturities in their own currencies (original sin), transcends current fundamentals and traces back to the failure of prior policy makers. We argue that the theories of the excluded middle and original sin are twin and related fallacies that are contrary to theory and evidence. The sense that credibility problems stem from a simple and irrational source–failures of prior generations of policy makers–lends credence to alternative regimes that seem to allow the easy purchase of investor confidence–an exchange rate regime at one of the corners. Two decades of theory and empirical evidence cumulate to argue that this is too simple an answer. As to the theory, the literature on time inconsistency has amply demonstrated that the inability to precommit future policy decisions gives reason to doubt that the current regime will be maintained. That doubt stems, not from the record of prior failures, but from the inconsistency of incentives in the future.

Keywords: exchange; rate; debt; domestic; currency; original; sin (search for similar items in EconPapers)
JEL-codes: E4 F31 F32 (search for similar items in EconPapers)
Date: 2003-09
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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https://mpra.ub.uni-muenchen.de/13763/1/MPRA_paper_13763.pdf original version (application/pdf)

Related works:
Working Paper: Twin Fallacies About Exchange Rate Policy in Emerging Markets (2003)
Working Paper: Twin fallacies about exchange rate policy in emerging markets (2003)
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Working Paper: What Hurts Most? G-3 Exchange Rate or Interest Rate Volatility (2001)
Working Paper: What hurts most?: G-3 exchange rate or interest rate volatility (2001)
Working Paper: What does a G-3 target zone mean for emerging-market economies? (2000)
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