Searching for an Appropriate Exchange Rate Regime

Abstract

This paper attempts to survey current debates on the choice of exchange rate regime in emerging market economies. The issue of choosing an appropriate exchange rate regime is being actively discussed since the recent Asian crisis. As a lesson from the recent crises, one widely shared conclusion is that soft peg exchange rate regimes are extremely vulnerable in a world of volatile capital movements. Consequently, new orthodoxy based on the impossible trinity hypothesis favours two corner solutions ― greater flexibility or credible institutional assurance, like a currency board system or dollarization. Nevertheless, questions whether such corner solutions are adequate for developing countries are rising of late. "Fear of floating" is still conspicuous in many developing countries having adopted nominally a free-floating exchange rate regime. Developing countries are sensitive to exchange rate fluctuations because the cost of exchange rate volatility is greater than the benefit when compared to developed countries. Monitoring bands is a compromise solution, but it still needs further enhancement of estimation techniques for fundamental equilibrium exchange rates in order to make those estimation results more workable in practice. Other alternatives include the creation of soft peg of the G-3 currencies. Despite counterarguments, the stability of G-3 currencies could prove to be beneficial to emerging market economies.