The choice of an optimum currency peg for a small, open country

Abstract

This paper explores the choice of an optimal exchange rate system in a monetary context with rational expectations. It is related to the problem of the choice of an exchange rate regime (Heller (1978)) and some trade-oriented solutions (Black (1976), Branson and Katseli-Papaefstratiou (1978), Lipschitz (1979), Lipschitz and Sundararajan (1980)) but differs from these in that broad monetary considerations are stressed. It assumes that a country must choose to peg to one of two major currencies or to a basket of the two but cannot float independently for optimum currency reasons (Mundell (1961), McKinnon (1963)). In particular, the approach puts the accent on the notion of international competition between national monies (Tullock (1973), Klein (1975)) in a rational-expectations framework with national money demands and supplies causing changes in relative prices (Connolly and Taylor (1979), Dornbusch (1978)). The specific question asked is: To which, if any, of two reserve currencies, say the US dollar and the pound sterling, should a small open country peg in order to best insure domestic monetary stability (e.g. stable home prices)? Or, in general, is a basket peg composed of the two currencies preferable to a single currency peg?