Choice Of Exchange Rate Regimes For Developing Countries

Introduction
1. An exchange rate, as a price of one country's money in terms of another's, is among the most important prices in an open economy. It influences the flow of goods, services, and capital in a country, and exerts strong pressure on the balance of payments, inflation and other macroeconomic variables. Therefore, the choice and management of an exchange rate regime is a critical aspect of economic management to safeguard competitiveness, macroeconomic stability, and growth1. 2. The choice of an appropriate exchange rate regime for developing countries has been at the center of the debate in international finance for a long time. What are the costs and benefits of various exchange rate regimes? What are the determinants of the choice of an exchange rate regime and how would country circumstances affect the choice? Does macroeconomic performance differ under alternative regimes? How would an exchange rate adjustment affect trade flows? The steady increase in magnitude and variability of international capital flows has intensified the debate in the past few years as each of the major currency crises in the 1990s has in some way involved a fixed exchange rate and sudden reversal of capital inflows. New questions include: Are pegged regimes inherently crisis-prone? Which regimes would be better suited to deal with increasingly global and unstable capital markets? While the debate continues, there are areas where some consensus is emerging, and there are valuable lessons from earlier experience for developing countries. This note provides a review of the main issues in selecting an appropriate regime, examines where the debate now stands, and summarizes the consensus reached and lessons learned from recent experience2. 3. A growing consensus seems to be emerging on the following: (a) Selection of an exchange rate regime that is most likely to suit a country's economic interest would depend on a variety of factors including: specific country circumstances (the size and openness of the country to trade and financial flows, structure of its production and exports, stage of its financial development, its inflationary history, and the nature and source of shocks it faces); policymakers' preferences for the trade offs among the main policy objectives; political conditions in the country; and the credibility of its policy makers and institutions. Therefore, there is no single ideal exchange rate regime that is appropriate for all countries . The actual choice from an array of regimes depends on the relative weight given to each of these factors. In addition, an exchange rate regime appropriate for a country would change over time with changing country circumstances.download