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 man aging their exchange rates. Recent experience may seem to favour freely floating 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 flexible or fixed 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 flexible exchange rate regime if the economy faces primarily real shocks such as fluctuations in national aggregate demand. However, when the economy faces nominal shocks, for example to money demand, a fixed exchange rate is preferable. Edwards and Levy-Yeyati (2003) and Broda (2004) confirm this point of view, which contrasts with the argument supported by the cycle school to the effect that there is no significant difference between exchange rate regimes. 2
Furthermore, the contribution of Barro and Gordon (1983a, 1983b) allowed the issue of exchange rate regime choice to be related in a new perspective to the credibility of the policymaker. Barro and Gordon (1983a, 1983b) tackle the case of a central bank which uses discretionary monetary policy to generate surprise inflation in order to reduce unemployment. They show that with rational expectations the result would be higher inflation but the same unemployment because people adjust their inflationary expectations in a way that eliminates any consistent pattern of surprises. The only way to protect against this time-inconsistency is to institute a commitment mechanism which ties the hands of the monetary authorities. In this configuration, a fixed exchange rate regime could provide a clear nominal anchor and help to establish a stabilisation programme (Guillaume and Stasavage, 2000).