Volatile exchange rates and how to manage them are a contentious topic whenever economic policymakers gather in international meetings. This book examines the broad parameters of exchange rate policy in light of both high-powered theory and real-world experience. What are the costs and benefits of flexible versus fixed exchange rates? How much of a role should the exchange rate play in monetary policy? Why don't volatile exchange rates destabilize inflation and output? The principal finding of this book is that using monetary policy to fight exchange rate volatility, including through the adoption of a fixed exchange rate regime, leads to greater volatility of employment, output, and inflation. In other words, the "cure" for exchange rate volatility is worse than the disease. This finding is demonstrated in economic models, in historical case studies, and in statistical analysis of the data. The book devotes considerable attention to understanding the reasons why volatile exchange rates do not destabilize inflation and output. The book concludes that many countries would benefit from allowing greater flexibility of their exchange rates in order to target monetary policy at stabilization of their domestic economies. Few, if any, countries would benefit from a move in the opposite direction.

In recent years, analysts and policy makers alike have been evaluating the nexus between exchange rates and macroeconomic stability. Among the most important questions is why have some countries adopted rigid, including fixed, exchange-rate 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 infla- tion 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 choosing the regime it is assumed authorities compare the expected losses under each scenario. The model is subsequently extended extended to cover the somewhat more complicated case where the authoriities must choose between fixed-but-adjustable and flexible exchange-rate regimes. In this latter case, potential political costs of abandoningithe 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, 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.

Standard models of policy credibility, defined as the expectation that an announced policy will be carried out, emphasize the preferences of the policymaker, and the role of tough policies in signalling toughness and raising credibility. Whether a policy is carried out, however, will also reflect the state of the economy. We present a model in which a policymaker maintains a fixed parity in good times, but devalues if the unemployment rate gets too high. Our main conclusion is that if there is persistence in unemployment, observing a tough policy in a given period may lower rather than raise the credibility of a no-devaluation pledge in subsequent periods. We test this implication on data for the interest rate differential between France and Germany and find support for our hypothesis.

Praise for Handbook of Exchange Rates “This book is remarkable. I expect it to become the anchor reference for people working in the foreign exchange field.” —Richard K. Lyons, Dean and Professor of Finance, Haas School of Business, University of California Berkeley “It is quite easily the most wide ranging treaty of expertise on the forex market I have ever come across. I will be keeping a copy close to my fingertips.” —Jim O’Neill, Chairman, Goldman Sachs Asset Management How should we evaluate the forecasting power of models? What are appropriate loss functions for major market participants? Is the exchange rate the only means of adjustment? Handbook of Exchange Rates answers these questions and many more, equipping readers with the relevant concepts and policies for working in today’s international economic climate. Featuring contributions written by leading specialists from the global financial arena, this handbook provides a collection of original ideas on foreign exchange (FX) rates in four succinct sections: • Overview introduces the history of the FX market and exchange rate regimes, discussing key instruments in the trading environment as well as macro and micro approaches to FX determination. • Exchange Rate Models and Methods focuses on forecasting exchange rates, featuring methodological contributions on the statistical methods for evaluating forecast performance, parity relationships, fair value models, and flow–based models. • FX Markets and Products outlines active currency management, currency hedging, hedge accounting; high frequency and algorithmic trading in FX; and FX strategy-based products. • FX Markets and Policy explores the current policies in place in global markets and presents a framework for analyzing financial crises. Throughout the book, topics are explored in-depth alongside their founding principles. Each chapter uses real-world examples from the financial industry and concludes with a summary that outlines key points and concepts. Handbook of Exchange Rates is an essential reference for fund managers and investors as well as practitioners and researchers working in finance, banking, business, and econometrics. The book also serves as a valuable supplement for courses on economics, business, and international finance at the upper-undergraduate and graduate levels.

Traditionally the choice of exchange rate regime has been seen as a second-best policy choice, which can be directed toward mitigating the distortionary effects of price or information rigidities. In this paradigm the optimal degree of exchange rate flexibility is found to depend of the source and nature of shocks hitting an economy. More recent literature views the exchange rate as a widely and frequently seen manifestation of government policy with careful exchange-rate management emerging as a tool that can enhance shaky policy credibility.

''In summary, the book is valuable as a textbook both at the advanced undergraduate level and at the graduate level. It is also very useful for the economist who wants to be brought up-to-date on theoretical and empirical research on exchange rate behaviour.'' ""Journal of International Economics""

This paper examines whether decisions about the appropriate exchange rate regime in six Central American countries were based on longer-run economic fundamentals or on the confluence of historical and political circumstances. To uncover any actual relationship both across countries and across time, we estimate several probit and multinomial logit models of exchange rate regime choice with data spanning the period 1974-2001. We find that theoretical long-run determinants, such as trade openness, export share with the major trading partner, economic size, and per capita income, are adequate, but not robust, predictors of exchange rate regime choice. However, we were not able to establish a statistically significant association between the terms of trade fluctuations or capital account openness and a particular regime in any specification using our sample.