Exchange Rate Choices Of Microstates

In this paper we first explain why most microstates (countries with less than 2 million inhabitants) have gained independence only in the last 30 years. Despite the higher costs and risks microstates face, their ability to better accommodate local preferences combined with a more integrated world economy probably explains why the benefits of independence have risen. We explain why microstates at independence have chosen either dollarization, currency board arrangements, or fixed exchange rates rather than more flexible forms of exchange rate systems. We then, using the Geweke-Hajvassiliou-Keane multivariate normal simulator, model empirically the determinants of each of the different fixed exchange rate regimes in microstates and analyze the policy implications.

An empirical study of exchange rate regimes based on data compiled from 150 member countries of the International Monetary Fund over the past thirty years. Few topics in international economics are as controversial as the choice of an exchange rate regime. Since the breakdown of the Bretton Woods system in the early 1970s, countries have adopted a wide variety of regimes, ranging from pure floats at one extreme to currency boards and dollarization at the other. While a vast theoretical literature explores the choice and consequences of exchange rate regimes, the abundance of possible effects makes it difficult to establish clear relationships between regimes and common macroeconomic policy targets such as inflation and growth. This book takes a systematic look at the evidence on macroeconomic performance under alternative exchange rate regimes, drawing on the experience of some 150 member countries of the International Monetary Fund over the past thirty years. Among other questions, it asks whether pegging the exchange rate leads to lower inflation, whether floating exchange rates are associated with faster output growth, and whether pegged regimes are particularly prone to currency and other crises. The book draws on history and theory to delineate the debate and on standard statistical methods to assess the empirical evidence, and includes a CD-ROM containing the data set used.

This paper analyzes the appropriate choice of an exchange rate regime in agricultural commodity-exporting economies. In an open economy model that incorporates key structural characteristics of agricultural commodity exporters including dual labor markets, the benefits of exchange rate flexibility are shown to depend on the extent of labor and product market development. With developed markets, flexible exchange rates are preferred as they allow for greater relative price fluctuations, which amplify the transmission mechanism of labor reallocation upon commodity price volatility. When labor and product markets are not welldeveloped, however, international relative price adjustments exacerbate currency and factor misalignments. A nominal exchange rate peg, by mitigating relative wage and price fluctuations, increases welfare relative to a float. Given the current low level of labor and product market development across most agricultural commodity exporters, the study provides a counterpoint to conventional arguments in favor of flexible exchange rates and a rationale as to why exchange rate targeting is appropriate in agricultural economies.

In this paper, I survey the issue of exchange rate regime choice from the perspective of both the industrial and emerging economies taking an historical perspective. I first survey the theoretical issues beginning with a taxonomy of regimes. I then examine the empirical evidence on the delineation of regimes and their macroeconomic performance. The penultimate section provides a brief history of monetary regimes in industrial and emerging economies. The conclusion considers the case for a managed float regime for today's emerging economies.

Traditionally the choice of exchange rate regime has been seen as a second-best policy choice, which can be directed toward mitigating the distortionary effects of price or information rigidities. In this paradigm the optimal degree of exchange rate flexibility is found to depend of the source and nature of shocks hitting an economy. More recent literature views the exchange rate as a widely and frequently seen manifestation of government policy with careful exchange-rate management emerging as a tool that can enhance shaky policy credibility.

This paper examines whether decisions about the appropriate exchange rate regime in six Central American countries were based on longer-run economic fundamentals or on the confluence of historical and political circumstances. To uncover any actual relationship both across countries and across time, we estimate several probit and multinomial logit models of exchange rate regime choice with data spanning the period 1974-2001. We find that theoretical long-run determinants, such as trade openness, export share with the major trading partner, economic size, and per capita income, are adequate, but not robust, predictors of exchange rate regime choice. However, we were not able to establish a statistically significant association between the terms of trade fluctuations or capital account openness and a particular regime in any specification using our sample.

We describe unique aspects of microstates-they are less diversified, suffer from lumpiness of investment, they are geographically at the periphery and prone to natural disasters, and have less access to capital markets-that may make the current account more vulnerable, penalizing exports and making imports dearer. After reviewing the "old" and "new" view on current account deficits, we attempt to identify policies to help reduce the current account. Probit regressions suggest that microstates are more likely to have large current account adjustments if (i) they are already running large current account deficits; (ii) they run budget surpluses; (iii) the terms of trade improve; (iv) they are less open; and (v) GDP growth declines. Monetary policy, financial development, per capita GDP, and the de jure exchange rate classification matter less. However, changes in the real effective exchange rate do not help drive reductions in the current account deficit in microstates. We explore reasons for this and provide policy implications.