Endogenous Exchange Rate Regime Switches
46 Pages Posted: 27 Feb 2001 Last revised: 2 Apr 2010
Date Written: August 1989
In this paper we demonstrate that exchange rate regime switching is compatible with optimal government policies. Nominal exchange-rate regimes are formalized as equilibrium commitments on future seigniorage policies, and the collapse of an exchange-rate peg as an excusable default which allows the government to lump-sum tax private sector money holdings. We demonstrate that a regime in which the exchange-rate peg is allowed to collapse when government spending is unusually high is a trigger-strategy equilibrium. Such a regime can be superior to both fixed and flexible exchange rate because it combines some of the flexibility of the floating exchange rates with some of the benefits of precommitment afforded by fixed rates.
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