Exchange Rate Regimes: Middling Through

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. We find that the majority of countries are moving towards somewhat higher exchange and lower interest rate volatility. Features of foreign exchange (forex) markets could be partly motivating these choices. A model with noise trading, non-traded goods and price rigidities shows that bounds on the volatility of the exchange rate can lower noise trading in forex markets; decrease fundamental variance and improve real fundamentals in an emerging market economy (EME); and give more monetary policy autonomy. 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, pre-empt 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. In conclusion, the regime's applicability to an EME is explored.

Keywords: Exchange rate regimes, noise traders, non-traded goods, price rigidities

JEL Classification: F31, E44, E52