Shocks and the Viability of a Fixed Exchange Rate Commitment

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Abstract

The incentive to renege on a commitment to a fixed exchange rate is shown to be state contingent. A fixed exchange rate policy is not viable under “unusual” circumstances, and the incentive to violate the commitment is larger in the case of contractionary shocks than in the case of expansionary shocks. The possibility that the exchange rate regime is changed in “unusual” circumstances has significant effects also under “normal” circumstances, implying systematic devaluation expectations, excessive real wages and (ex post) real rates of interest, lower output and loss of reserves, which in turn reduces the incentive to initiate a fixed exchange rate policy. Moreover, policyshifts may be contagious among countries.

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