Front Matter Page
Research Department
Contents
I. Introduction
II. Stylized Facts
1. Shifts between exchange rate regimes
2. Variability of real and monetary shocks
3. Divergence of inflation rates and government expenditure
III. The Model
1. The basic framework
2. Time varying stochastic structure and fixed costs
IV. Policy Choices
1. The social criterion
2. Selection of the appropriate regime
V. Model Extension: Inflation, Government Expenditure and Regime Choice
VI. Conclusions
Table
1. Standard Deviations of Real and Monetary Shocks
Appendix I. Estimation of Real and Monetary Shocks
Appendix II. Database and Estimation
References
Charts
1. Changing Exchange Rate Regimes
2. Fixed Exchange Rate Regimes
3. G5 Countries: Standard Deviation of Inflation Rates
Figure 1
Summary
This paper studies issues relating to the evolution of exchange rate regimes. A simple model is developed that attempts to capture some aspects of recent changes in the economic environment. The analysis may be helpful in understanding why countries alter their exchange rate policy in a predictable manner, although sometimes with great reluctance and often with seeming delay.
Historically observed shifts in exchange rate regimes are discussed and attention is drawn to the major shift that took place in the 1970s toward flexible exchange rates. The paper presents an empirical investigation of some aspects of the changing economic environment underlying these regime shifts. In particular, the variation over time of real and monetary shocks and the divergence of inflation rates and government expenditures of the main industrial countries are studied. The decade of the 1970s is shown to exhibit relatively greater turbulence compared to the 1960s and 1980s. Furthermore, a sharp divergence in cross-country inflation rates occurred in the early 1970s. Both empirical regularities are captured in the theoretical analysis.
A theoretical model is constructed that helps explain two types of exchange rate regime changes. The first type is an initial switch that occurs in response to an unexpected event such as an upheaval in the relative variability of real and monetary shocks or a sudden large change in desired government spending. The second type is the predicted return to the prior regime. One interesting implication of the analysis is that a policymaker may switch temporarily from one regime to another while planning to return to the prior regime at some point in the future. Such a decision may be viewed as an optimal response to movements in the systematic component of real relative to monetary variances or of desired government spending that are expected to return to their steady-state level. In both examples, the switch may be delayed because of fixed costs incurred by policymakers in restructuring the existing exchange rate regime.