Abstract

The exchange rate performs a dual role in small open economies. Its movements can achieve and maintain international competitiveness and so ensure a viable balance of payments. At the same time, a stable exchange rate can anchor domestic prices. A debate has emerged, however, in both policymaking and academic circles on the relative weight that should be assigned to each of these objectives in formulating exchange rate policy.

The exchange rate performs a dual role in small open economies. Its movements can achieve and maintain international competitiveness and so ensure a viable balance of payments. At the same time, a stable exchange rate can anchor domestic prices. A debate has emerged, however, in both policymaking and academic circles on the relative weight that should be assigned to each of these objectives in formulating exchange rate policy.

This paper addresses analytical aspects of exchange rate policy and emphasizes particularly the relationships among exchange rate flexibility, financial discipline, and international competitiveness. It should be recognized at the outset that economic research has not reached a consensus on some of these relationships. Furthermore, the nature of these relationships depends crucially on the circumstances in which countries find themselves. Therefore, rather than formulating a position purporting to be of universal applicability, the paper develops separate analytical frameworks within which specific issues in the formulation of exchange rate policy can be assessed. As the discussion focuses on the analytical aspects of these issues, it makes no judgment on the appropriateness of the exchange rate policy adopted in specific cases. Furthermore, although much of the analysis has general applicability and is thus equally relevant to industrial countries, it focuses here on developing countries.

The paper draws on recent theoretical developments to summarize what economic theory has to say about the choice of exchange rate regimes for developing countries, the relationship between real exchange rate rules and macroeconomic stability, and the relationship between flexible nominal exchange rates and financial discipline. This analysis is intended to synthesize the implications of these findings for the formulation of exchange rate policy in developing countries. It specifies the factors that should be considered in deciding between a flexible or a fixed exchange rate arrangement, the implications of real exchange rate rules for macroeconomic stability, and the conditions under which a fixed exchange rate arrangement would enhance financial discipline.

Section II describes the evolution of exchange rate arrangements in developing countries. Section III reviews the literature on optimal exchange rate regimes, which has been developed mainly from the perspective of short-run stabilization of output in industrial countries. The subsequent sections focus on exchange rate issues that are of greater concern to developing countries. Section IV examines how the exchange rate brings about external adjustment, and, in particular, what real exchange rate rules imply for macroeconomic stability. Section V analyzes the relationship between exchange rate flexibility and financial discipline. Section VI summarizes the main findings and the basic lessons that emerge from the analysis.

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