Front Matter

Front Matter

International Monetary Fund
Published Date:
September 1990
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    Choosing an Exchange Rate Regime: The Challenge for Smaller Industrial Countries

    Edited by Victor Argy and Paul De Grauwe, With a Summary by J.J. Polak

    International Monetary Fund

    Katholieke Universiteit Leuven Macquarie University

    © 1990 International Monetary Fund

    Library of Congress Cataloging-in-Publications Data

    Choosing an exchange rate regime : the challenge for smaller industrial countries / edited by Paul de Grauwe and Victor Argy.

    • p. cm.

    Includes bibliographical references.

    ISBN 1-55775-133-1

    1. Foreign exchange. 2. Foreign exchange administration.

    I. Grauwe, Paul de. II. Argy, Victor.

    HG3851.C47 1990




    Price: US$19.50

    The cover and interior of this book were designed by the IMF Graphics Section.

    Address orders to:

    External Relations Department, Publication Services

    International Monetary Fund, Washington, D.C. 20431

    Telephone: (202) 623-7430


    The Editors would like to thank the authors for their contributions and for cooperating actively in preparing the papers in the required format.

    The success of the conference also owes a great deal to the skillful management of Catherine O’Neill and the intellectual guidance of Jacques J. Polak. Our thanks also go to Peter Ludlow for allowing us to convene at the Centre for European Policy Studies. Finally, for publication of the proceedings, we wish to thank David M. Cheney for all of his editorial work.


    Victor Argy and Paul De Grauwe

    Although much has been written on the European Monetary System (EMS), there remains considerable scope for a new and more general reevaluation of the considerations that enter into the choice of exchange rate regime for a smaller industrial country and for some up-to-date review of smaller country experiences. Our principal objective in organizing this conference was to undertake such a reevaluation. We believe the seminar papers and the associated discussants’ comments met this objective excellently. Some papers dealt with analytical issues, while country reviews were undertaken by leading experts on these countries. We believe this volume should serve as an up-to-date review of, and as a basis and inspiration for, continuing work on exchange rate regimes. We recognize that the conference, comprehensive as it was, left many issues unresolved.

    Jacques J. Polak’s summary of the individual papers and discussion of the seminar is excellent. Therefore, in this short introduction we focus on a few general questions prompted by the seminar about the choice of exchange rate regime.

    One question touched on but not attacked head-on is whether there are certain “characteristics” in a country that predispose it to adopt a fixed or a flexible rate regime. This is, of course, a relatively old question, first raised by Mundell in the context of currency unification (Mundell, 1961), and subsequently developed in detail in what became a substantial literature. In due course this literature was summarized in Corden (1972), Ishiyama (1975), and Tower and Willett (1976). The literature also provoked some empirical work, which attempted to determine if there were in fact links between country traits and the exchange rate regime actually adopted across a wide spectrum of countries. The best known of these studies were those by Heller (1978) and Holden et al. (1979).

    From today’s perspective, can much be said on this general question?

    Some of the early literature on optimum currency areas sought to identify some key characteristics thought to be decisive in choosing a fixed or flexible rate regime. Among the characteristics given the most attention were factor mobility, openness, capital mobility, diversification of the external sector, geographic concentration of trade, degree of economic development, and degree of divergence in the inflation rate. Subsequent literature raised serious doubts about the theoretical relationship between the country characteristics and the assumed case for a fixed or a flexible rate regime (see again Ishiyama, 1975; and Tower and Willett, 1976). Each of these proves to be very complex, and theoretical ambiguities abound. Two illustrations suffice.

    Openness was thought to be a characteristic favoring fixed rates. Put simply, the more open an economy to trade, the smaller is likely to be the degree of money illusion; thus an exchange rate change will be less effective in securing an improvement in the real exchange rate. At the same time, in an open economy with fixed rates the use of demand management will be less effective and the leakages larger. Moreover, the more open the economy, the greater the potential cost of exchange rate volatility on trade. One might therefore expect very open economies to opt for less exchange rate flexibility. On the other hand, openness may increase a country’s exposure to external shocks under fixed rates.

    Despite these ambiguities, openness has been widely perceived by authorities as a strong element favoring exchange rate stability. For example, a study by the Organization for Economic Cooperation and Development (OECD) of exchange rate practices in member countries (OECD, 1985) notes, in reference to the Netherlands, that:

    The Netherlands has a very open economy, with exports and imports of goods and services each amounting to more than 50 per cent of national income. The immediate influence of the exchange rate on prices has led the authorities to attach a high priority to maintaining a stable exchange rate.

    Referring to Belgium, the study states that:

    Since Belgium has a very open economy, the stability of the Belgian franc’s exchange rate against the currencies of its main trading partners has always been one of the monetary authorities’ main preoccupations.

    It is also worth noting in passing that there is some loose empirical relationship between openness and exchange rate flexibility. The most open economies (Belgium, the Netherlands, and Ireland) are also those that have chosen to peg, while the least open (the United Kingdom, New Zealand, Canada, and Australia) have adopted more flexible rates.

    Or, another illustration, divergence in inflation was perceived as an argument for flexible rates, but it is readily seen that this could also be turned into an argument for pegging. A high-inflation country may choose to peg as a means of importing inflation discipline (for example, Ireland, on joining the EMS).

    In a study of the EMS in 1986 (Ungerer et al., 1986), the International Monetary Fund identified country characteristics in the United Kingdom that were widely perceived to render it unsuitable to join the EMS. It stated:

    First, there is the “petrocurrency effect” attributable to the United Kingdom’s role as a large net exporter of oil. Second, the pound and the deutsche mark have often behaved differently at times of large swings in the external value of the dollar. Since the pound is an important trading currency, and exchange controls have been abolished, the volume of intervention necessary to defend the pound in case of a sustained attack could be much larger than that necessary for most other EG currencies. A large volume of intervention could, in turn, jeopardise domestic monetary objectives.

    The more modern literature has tended to focus on three broad characteristics: (i) the nature of disturbances; (ii) reputational considerations; and (iii) real wage flexibility.

    Since countries are exposed to different mixes of disturbances both at home and abroad, and since some disturbances favor exchange rate stability while others favor exchange rate flexibility, we have here a possible basis for discriminating between countries. This is one theme, for example, in Victor Argy’s paper and also in that by Adrian Blundell-Wignall and Robert G. Gregory. But even at this level there are difficulties. First, there are often theoretical ambiguities, depending on the model used. Second, it is difficult to determine empirically the weight attaching to particular disturbances in individual countries. Third, a measure of expected future, not past, disturbances is needed. (For example, if the monetary environment has been unstable in the past—potentially favoring fixed rates—will it remain so in the future?) Fourth, since the importance of different disturbances changes over time, it might be inefficient to change the regime in accordance with changes in these weights (see Flood et al., 1989).

    Even the reputational literature (reviewed in Argy) does not offer clear answers. For example, the literature suggests that if a strong trading partner has a good inflation record and the country in question a relatively poor reputation—other things being equal—that country should peg. But the smaller country might equally well choose to make its central bank more independent, assigning it the task of securing price stability as New Zealand and Switzerland, for example, have done (see The Economist, 1990; and Buckle and Stemp, 1989).

    Finally, countries with institutions favoring real wage flexibility might be considered better candidates for fixed rate regimes since wage-price adjustment might act as a substitute for exchange rate flexibility. (For empirical evidence on real wage flexibility, see Andersen, 1989.) This remains an important consideration. But it may also be that adopting fixed rates might be a means of manipulating labor market institutions and achieving real wage flexibility. At the other extreme, countries with real wage rigidity might run into adjustment problems whatever regime they adopt.

    To summarize then, it would seem that the country-characteristics approach to the choice of exchange rate regime is elusive and must be handled with great care. The reality is that countries that have changed regime in the last decade or so (Australia, New Zealand, and Ireland), or contemplate doing so (the United Kingdom), tend to do so on the basis of a cost-benefit analysis that looks carefully and comprehensively at all of the broad considerations that bear on the choice. (On Australia, see Australian Financial System Inquiry Final Report, 1981, and Reserve Bank of Australia, 1984; on Ireland, see Murray, 1979; and on New Zealand, see Reserve Bank of New Zealand, 1986.) The papers published in this volume also illustrate this point. They testify to the fact that the authorities of many countries take an eclectic view toward the considerations that determine the choice of an exchange rate regime. This also makes it possible that authorities change their perceptions about what is optimal, and that they decide to alter their exchange rate policies.

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