ABSTRACT

The choice of exchange rate regime for small countries is a question which is attracting increasing attention. The interest in this topic has been reinforced by the unfortunate experiences of some emerging market countries in recent years in managing their exchange rates. Recent experience may seem to favour freely fl oating exchange rates or hard pegs, but economists have held different and changing views on the choice of exchange rate regimes. At the beginning of the 1960s,1 the literature stressed the effects of shocks on the domestic economy as the crucial criterion. According to this approach, the choice between fl exible or fi xed exchange rate regimes depends on the nature and sources of the shocks which affect the domestic economy. The main result of these studies was to indicate the superiority of the fl exible exchange rate regime if the economy faces primarily real shocks such as fl uctuations in national aggregate demand. However, when the economy faces nominal shocks, for example to money demand, a fi xed exchange rate is preferable. Edwards and Levy-Yeyati (2003) and Broda (2004) confi rm this point of view, which contrasts with the argument supported by the cycle school to the effect that there is no signifi cant difference between exchange rate regimes.2