ABSTRACT
Exchange rate policy is an important pillar of macroeconomic policy for any country, but this is especially true for small, open economies. The value and volatility of any currency affects flows of both trade and investment. A stable exchange rate promotes trade and investment, but it sometimes invites excessive capital inflows. A flexible exchange rate is important so that authorities and markets can make adjustments in response to domestic and external shocks. However, excessive flexibility can itself become a shock to the economy. Indeed, the market sometimes overshoots, and exchange rates may sustain misalignment. A fixed exchange rate regime with capital mobility may limit the degree of freedom in monetary policy, while a free-floating regime with capital mobility may expose exporters and importers to the whims of large investment funds abroad.
