Summary of WP/92/100
“Optimal and Sustainable Exchange Rate Regimes: A Simple Game-Theoretic Approach” by Masahiro Kawai
This paper focuses on how to design optimal and sustainable exchange rate regimes in a world economy comprising two interdependent countries. For this purpose, it develops a simple game-theoretic, two-country model of the Barro-Gordon type, in the context of which noncooperative equilibria are compared under different assumptions of credibility and different exchange rate regimes. By means of a two-stage approach to the strategic choice of policy instruments, sustainable (Nash or self-enforcing) and optimal (in a Pareto sense) exchange rate regimes are identified. The paper concludes that international coordination requires each authority to agree not on the conduct of monetary policy but only on an exchange rate regime. Because the choice of such a regime is found to depend fundamentally on the credibility of monetary policy commitments by the two countries’ authorities, the paper also examines the decision-making process whereby an authority chooses whether or not to acquire credibility.
Some of the innovative results of the paper can be summarized as follows:
First, when both countries’ authorities are fully credible, flexible and managed exchange rate regimes yield identical welfare outcomes, and, therefore, coordination concerning the choice of exchange rate regimes is unnecessary. The fixed exchange rate regime can become optimal and sustainable only when real shocks to the economies are global or goods produced in both countries are perfect substitutes.
Second, when one authority is credible and the other is not, international coordination is required to prevent the credible authority’s exchange rate management from adversely affecting the noncredible authority. The credible authority must agree to control the money supply, while the noncredible authority may either control the money supply or manage the exchange rate. Thus, a flexible or managed exchange rate regime, with the anchor country pursuing a stable and low-inflationary policy, emerges as an optimal, sustainable regime.
Third, when neither authority is credible, only the flexible exchange rate regime is both optimal and sustainable. Insofar as exchange rate management by one authority has a beggar-my-neighbor effect on the other, the managed exchange rate regime is Pareto-inferior. No scope exists for fixed exchange rates as an optimal and sustainable regime.
Finally, the lower the cost of pursuing an anti - inflation monetary policy and the lower the subjective rate of time preference, the more incentive there is for each authority to establish and maintain its policy credibility.