When is it Optimal to Abandon a Fixed Exchange Rate?

Review of Economic Studies (Impact Factor: 2.81). 07/2008; 75(3):929-955. DOI: 10.1111/j.1467-937X.2008.00479.x
Source: RePEc


The influential Krugman-Flood-Garber (KFG) model of balance of payment crises assumes that a fixed exchange rate is abandoned if and only if international reserves reach a critical threshold value. From a positive standpoint, the KFG rule is at odds with many episodes in which the central bank has plenty of international reserves at the time of abandonment. We study the optimal exit policy and show that from a normative standpoint, the KFG rule is generally suboptimal. We consider a model in which the fixed exchange rate regime has become unsustainable due to an unexpected increase in government spending. We show that when there are no exit costs, it is optimal to abandon immediately. When there are exit costs, the optimal abandonment time is a decreasing function of the size of the fiscal shock. For large fiscal shocks, immediate abandonment is optimal. Our model is consistent with evidence suggesting that many countries exit fixed exchange rate regimes with still plenty of international reserves in the central bank's vault. Copyright © 2008 The Review of Economic Studies Limited.

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Available from: Carlos A. Vegh, Feb 02, 2015
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    • "However, a large increase may hasten the crisis. Rebelo and Végh (2008) find that the optimal time to abandon a fixed exchange rate after a negative fiscal shock will be sooner when the shock is larger. In their model, a late abandonment decreases exit costs, such as output losses. "
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    ABSTRACT: This paper examines the optimal appreciation path of an under-valued currency in the presence of speculative capital inflows that are endogenously affected by the appreciation path. A central bank decides the optimal appreciation path based on three factors: (i) Misalignment costs associated with the gap between the actual exchange rate and the fundamental exchange rate, (ii) short-term adjustment costs due to fast appreciation, and (iii) capital losses due to speculative capital inflows. We examine two cases in which speculators do and do not face liquidity shocks. We show that, in the case without liquidity shocks, the central bank should appreciate quickly to discourage speculative capital, and should appreciate more quickly in initial periods than in later periods. In the case with liquidity shocks, the central bank should pre-commit to a slow appreciation path to discourage speculative capital. The central bank should appreciate slowest when the probability of liquidity shocks takes middle values. If the central bank cannot commit and can only take a discretionary policy, appreciation should be faster.
    Canadian Journal of Economics/Revue Canadienne d`Economique 01/2009; 44(0905). DOI:10.1111/j.1540-5982.2010.01636.x · 0.61 Impact Factor
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    • "Similarly, Rebelo and Végh (2002) study the optimal time for abandoning a fixed exchange rate when a fiscal shock occurs that renders the peg unsustainable. Their approach differs from other papers considered here in that they use an optimising small-economy model, but the message is essentially the same : the sooner the peg is abandoned after the shock, the better. "
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    ABSTRACT: This study is aimed at the identification of the fa ctors that influence the conditions of exit from a fixed or intermediate exchange rate regime, to a more flexible arrangement. More specifically, we try to identify the economic varia bles that exercise a significant influence on the probability of an orderly exit. In order to do this, we employ a binary probit estimation procedure, applied to a large number of developed a nd emerging economies who have exited from fixed and intermediate exchange rate arrangements since 1980. We find that the significant variables are those representing the gr owth rate, the evolution of domestic credit, the interest rate, the duration of the initial exch ange rate regime and the incidence of exits over the years preceding and following the year dur ing which the exit episode under consideration takes place. These results point stro ngly towards possible contagion and duration-dependence effects, but also to a strong i nfluence of certain economic fundamentals.
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    ABSTRACT: This paper presents a monetary model of international reserves. By studying optimal ination policy together with reserve accumulation, the paper argues that a benevolent central bank accumulates reserves to smooth ination. This is the result of two traditional assumptions: (i) ination is distortionary and (ii) the government is running a primary de…cit that is …nanced by ination related revenues. Previous work on international reserves has implicitly assumed that taxation is lump-sum and focused on consumption smoothing. Moving away from this assumption, the model can match the observed growth of international reserves. JEL classi…cation: F31, F34, F41.
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