Nber Wo~g Paper Series the Determinants of the Choice between Fixed and Flexible Exchange-rate Regimes

In recent years, analysts and policy makers alike have been evaluating the nexus between exchange rates and macroeconomic stability. Among the most important questions asked is why have some countries adopted rigid, including fixed, exchange-rate regimes, while others have opted for more flexible systems? This paper addresses this question from a political economy perspective, both theoretically and empirically. The model assumes that the monetary authority minimizes a quadratic loss function that captures the trade-off between inflation and unemployment. This framework is initially applied to the case where monetary authorities must choose between a (permanently) fixed and a flexible exchange-rate regime. In selecting the regime, the authorities are assumed to compare the expected losses under each scenario. The model is subsequently extended to cover the somewhat more complicated case where the authorities must choose between fixed-but-adjustable and flexible exchange-rate regimes. In this latter case, potential political costs of abandoning the pegged rate are taken into account. In the empirical section, an unbalanced panel data set of 63 countries from 1980-1992 is used to estimate a series of probit models, with a binary exchange-rate regime index as the dependent variable, Among the most important explanatory variables were measures of countries’ historical degree of political instability, various measures of the probability of abandoning pegged rates, and variables related to the relative importance of real (unemployment) targets in the preferences of monetary authorities. The regression results support the political economy approach developed in the theoretical discussion. Sebastian Edwards Anderson Graduate School of Management University of California, Los Angeles Los Angeles, CA 90095 and NBER [email protected]. edu