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.

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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: Abstract This paper examines the optimal appreciation path of an undervalued currency in the presence of speculative capital inflows that are endogenously affected by the appreciation path. A central bank decides its appreciation policy based on three costs: (i) misalignment costs associated with the gap between the actual and long-run equilibrium exchange rates, (ii) short-term adjustment costs due to resource reallocation, and (iii) capital losses due to speculative capital inflows. Our model finds (1) when speculators face no liquidity shocks, the central bank tends to appreciate the currency quickly to discourage speculative capital; (2) when speculators face liquidity shocks, the central bank optimally pre-commits to a slower appreciation path, and the appreciation takes the longest time when the probability of liquidity shocks takes intermediate values; (3) the central bank tends to appreciate the currency more quickly when it conducts discretionary policy. Ce mémoire examine le sentier optimal d'appréciation d'une monnaie sous-évaluée quand il y a des flux de capitaux spéculatifs qui sont affectés de manière endogène par la nature du sentier. Une banque centrale décide de sa politique d'appréciation à partir de la prise en compte de trois coûts : (i) les coûts de désalignement associés à l'écart entre les taux de change actuels et ceux qui correspondent à l'équilibre de long terme, (ii) les coûts d'ajustement attribuables à la réallocation des ressources, et (iii) les pertes de capital attribuables aux flux de capitaux spéculatifs. On découvre que (1) quand les spéculateurs ne font pas face à des chocs de liquidité, la banque centrale tend à apprécier la monnaie rapidement pour décourager le capital spéculatif; (2) quand les spéculateurs font face à des chocs de liquidité, la banque centrale se pré-engage optimalement à suivre un sentier d'appréciation plus lent, et l'appréciation prend le plus de temps quand la probabilité de chocs d'appréciation a des valeurs intermédiaires; (3) la banque centrale tend à faire s'apprécier la monnaie plus rapidement quand elle mène une politique discrétionnaire.
    Full-text · Article · Jan 2009 · Canadian Journal of Economics/Revue Canadienne d`Economique
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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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