The Choice of Exchange-Rate Regime and Speculative Attacks

Abstract

We develop a framework for studying the choice of exchange rate regime in an open economy where the local currency is vulnerable to speculative attacks. The optimal regime is determined by a policymaker who trades off the loss from nominal exchange rate uncertainty, against the cost of maintaining a given regime. This cost is affected in turn by the likelihood of a speculative attack. Searching for the optimal regime within the class of exchange rate bands, we show that the optimal regime is either a peg (a zero-width band), a free float (an infinite-width band), or a non degenerate finite width band. The paper shows that lower costs of moving across currencies induce policymakers to set more flexible exchange rate systems. This lowers, ceteris paribus, the likelihood of financial crises. One implication is that a Tobin tax does not necessarily reduce the likelihood of currency crises. The paper also investigates the effects of country size, openess, variability in fundamentals and reputation on the choice of exchange rate regime. The role of abrupt changes in reputation in triggerering crises (even with unchanged fundamentals) as an alternative to ”sunspots” is discussed and illustrated.