The Choice of Exchange-rate Regime and Speculative Attacks

We develop a framework for studying the choice of exchange rate regime in an open economy where the local currency is vulnerable to speculative attacks. The framework makes it possible to study, for the first time, the strategic interaction between the ex ante choice of regime and the likelihhod of ex post currency attacks. The optimal regime is determined by a policymaker who trades off the loss from nominal exchange rate uncertainty, against the cost of maintaining a given regime. This cost in turn increases with the fraction of speculators who attack the local currency. Searching for the optimal regime within the class of exchange rate bands, we show that the optimal regime is either a peg (a zero-width band), a free float (an infinitewidth band), or a non degenerate band of finite width. Our framework generates several novel predictions and shows that when the endogeneity of the exchange rate regime is recognized explicitly, conventional wisdom may be reversed. For instance a Tobin tax, designed to reduce ∗We thank Barry Eichengreen, Ron McKinnon, Maury Obstfeld, Ady Pauzner, Assaf Razin, Roberto Rigobon, Alan Sutherland, Jaume Ventura and participants at the CEPR conferences on ’International Capital Flows’ held in London in November 2001 and on ’Controlling Global Capital: Financial Liberalization, Capital Controls and Macroeconomic Performance’ held in Barcelona in October 2002 for helpful discussions. Attila Korpos provided efficient library search. Previous versions of the paper were presented at U. C. Berkeley, CERGE-EI (Prague), Cornell University, Stanford University, Tel Aviv University, Tilburg University, The University of Canterbury, Université de Cergy-Pontoise. Itay Goldstein thanks Princeton University for its hospitality during the time this paper was written. †Eitan Berglas School of Economics, Tel Aviv University, Ramat Aviv, Tel Aviv, 69978, Israel, CentER, Tilburg University and CEPR. email: ‡The Fuqua School of Business, Duke University, Box 90120, Durham, NC 27708, USA. email: §Recanati Graduate School of Business Adminstration, Tel Aviv University, Ramat Aviv, Tel Aviv, 69978, Israel. email: