Abstract:
The appropriate exchange rate regime, in the context of integration of currency markets with financial markets and of large international capital flows, continues to be a policy dilemma. The revealed preference for most governments is for some kind of intermediate regime, suggesting a need to study these regimes more carefully. We find that the majority of countries are moving towards somewhat higher exchange and lower interest rate volatility. Features of forex markets could be partly motivating these choices. In a model with noise trading, non-traded goods, and price rigidities we show that bounds on the volatility of the exchange rate can lower noise trading in forex markets; decrease fundamental variance and improve real fundamentals in a developing economy; and give more monetary policy autonomy to smooth interest rates. Central banks prefer secret interventions where they have an information advantage or fear destabilizing speculation. But in our model, short-term pre-announced interventions can control exchange rate volatility, preempt deviations in prices and real exchange rates, and allow markets to help central banks achieve their targets. The long-term crawl need not be announced. We conclude with some discussion of the regime's applicability.
