How Much to Commit to an Exchange Rate Rule? Balancing Credibility and Flexibility

Abstract

There are different ways in which policy-makers back their commitment to a fixed exchange rate. A regime where countries can devalue unilaterally represents a weaker commitment than one where a devaluation needs to be agreed upon with other parties (e.g. the European monetary system). Full dollarization, understood here as full replacement of the domestic currency by the U.S. dollar, is an extreme commitment to a fixed exchange rate. Indeed, it is a special case of a fixed exchange rate.

The central message of this paper is that the cost of reneging is a key reason holding policymakers back from making strong commitments on their exchange rate policy. The stronger the commitment to an exchange rate rule, the more costly it is to deviate from it. The paper develops a Barro-Gordon type model in which the policymaker has to decide the degree of commitment under uncertainty.

It is shown that, even for policy makers that have a strong preference for maintaining the fixed exchange rate, there are circumstances under which they will choose to devalue. This will happen when the economy is hit by an adverse shock and the costs of adhering to the fixed exchange rate are larger than those associated with devaluing.

The model provides useful insights to understand why many high inflation economies have not adopted full dollarization as a way to stabilize prices. Our emphasis on the cost of reneging stands in contrast with most existing works, which single out the desire to rely on seigniorage as the main motive for stopping short of full dollarization. Strong commitments will only be made once there is a good chance that the policy maker will not renege, and by then they might not be necessary. We illustrate the main points of the paper with examples from Latin American countries.