When is it Optimal to Abandon a Fixed Exchange Rate?

46 Pages Posted: 24 Dec 2006 Last revised: 22 May 2007

See all articles by Sergio T. Rebelo

Sergio T. Rebelo

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2006

Abstract

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.

Suggested Citation

Tavares Rebelo, Sergio and Vegh, Carlos A., When is it Optimal to Abandon a Fixed Exchange Rate? (December 2006). NBER Working Paper No. w12793. Available at SSRN: https://ssrn.com/abstract=953358

Sergio Tavares Rebelo (Contact Author)

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Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

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