Collaborative Research: The Political Economy of Exchange Rate Regimes: Managing the Middle in an Era of Global Capital

University Of Colorado At Boulder, Boulder CO

Investigators

Abstract

While many factors contributed to the rash of international currency crises over the past decade, many economists point to the use of pegged exchange rates as one of the most important. Such compromises between genuinely fixed and flexible exchange rates were one of the hallmarks of the post war international monetary system established at Bretton Woods, but as international capital mobility has grown pegged rates have become increasingly difficult for governments to defend. This has given rise to the "hollowing out" or "unstable middle" hypothesis -that exchange rate regimes will continually be driven towards "corner solutions" -arrangements comprised of either relatively free floats or hard fixed rates such as currency boards, currency unions, and dollarization. There are two versions of this hypothesis, however. One, accepted by most economists, is simply that countries will be driven away from dead center -the Bretton Woods type narrow band adjustable peg. The other, more controversial, version is that to avoid crises, countries must go all the way to one extreme or the other. Dissenters argue that smaller movements such as to crawling bands would be viable. Advocates can point to examples where such regimes have worked well while critics can point to others where they haven't. What is missing from the extant literature is a large-scale study of the relationships between different types of intermediate exchange rate regimes and currency crises. This is particularly important because there are good reasons to believe that many countries will try to avoid corner solutions. An important and under appreciated implication of the theory of optimum currency areas is that only a minority of countries are likely to be good candidates for firmly fixed or highly flexible exchange rates. For very large countries flexible rates tend to be preferable and for very small ones fixed rates are usually superior. There is a broad middle range of countries, however, where neither is likely to be optimal. This project will pay special attention to the role of politics and political institutions when it comes to managing middle exchange rate regimes. From this point of view macroeconomic policy more often than not reflects the desires of policymakers and not the equilibrium solution of economic models. In a world of increasing capital mobility, policymakers have to choose a mixture of exchange rate rigidity and monetary policy autonomy. Intermediate exchange rate regimes thus constitute a middle ground where policymakers can have some exchange rate flexibility and some monetary policy autonomy. However, if the two policies are not related to each other in a consistent manner then currency crises are likely to result. The economic literature correctly stresses how high capital mobility makes such management more difficult. We will develop a political economy analysis that shows how political considerations also add importantly to the difficulty of managing such intermediate exchange rate regimes. In this project we will examine the extent to which different types of exchange rate regimes are crisis prone and investigate how a number of economic, political, and institutional considerations interact with regime choice to increase or reduce the likelihood of crisis. We will undertake a large-N Statistical study of (i) the exchange rate regime types and their connection with currency crises, (ii) the degree to which regimes have to move away from to middle to decrease the likelihood of crisis, and (iii) the policies required to effectively "manage" the middle. We will pay considerable attention to the classification of various types of intermediate exchange rate regimes and will develop a new behavioral measure to compare with institutionally based classifications.