Journal Article

When is it Optimal to Abandon a Fixed Exchange Rate?

Sergio Rebelo and Carlos A. Végh

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 75, issue 3, pages 929-955
Published in print July 2008 | ISSN: 0034-6527
Published online July 2008 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2008.00479.x
When is it Optimal to Abandon a Fixed Exchange Rate?

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  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • International Finance

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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.

Keywords: E62; F31; F33

Journal Article.  11497 words.  Illustrated.

Subjects: Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook ; International Finance

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