When Is It Optimal to Abandon a Fixed Exchange Rate? / Sergio Rebelo, Carlos A. Vegh.

Format:

Book

Author/Creator:

Rebelo, Sergio.

Contributor:

National Bureau of Economic Research.

Vegh, Carlos A.

Series:

Working Paper Series (National Bureau of Economic Research) no. w12793.

NBER working paper series no. w12793

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2006.

Summary:

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.

Notes:

Print version record

December 2006.