MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matterin the 21st Century?
An Overview
Hiroshi Fujiki and Akira Otani

This paper selectively reviews the recent literature on currency
regimes in Europe, the Americas, and East Asia. We argue that,given the global interdependence among today’s economies, currency
regimes should always be evaluated in relation to monetary policy,
fiscal policy, structural policies, and the working of financial
markets. Thus, currency regimes do matter and are a relevant
concern for policymakers.
Key words: Bipolar view; Euro; Dollarization; Regional currency
area

Hiroshi Fujiki: Manager and Senior Economist, Institute for Monetary and Economic
Studies, and Financial Markets Department, Bank of Japan (E-mail:hiroshi.fujiki@ boj.or.jp)
Akira Otani: Assistant Manager and Economist, Institute for Monetary and Economic
Studies, Bank of Japan (E-mail: akira.ootani@boj.or.jp)
The authors are grateful to two discussants, Stefan Gerlach and Reuven Glick, twohonorary advisors, Allan H. Meltzer and Maurice Obstfeld, as well as conference participants
Ismail Alowi, Jorge A. Braga de Macedo, Roger W. Ferguson, Jr., Han Ming Zhi,
Malcolm D. Knight, Robert W. Rankin, Pierre van der Haegen, and Jürgen von Hagenfor their helpful comments. The authors also thank Kyoji Fukao, Eiji Hirano, Kazuo
Ishida, Masahiro Kawai, Makoto Saito, Akihisa Shibata, Etsuro Shioji, Masaaki
Shirakawa, Miyako Suda, Kazuo Ueda, and staff at the Institute for Monetary andEconomic Studies (IMES) for their useful comments on the earlier version of this paper.
The views expressed in this paper are those of the authors and do not necessarily reflect
those of the Bank of Japan or IMES.

47

I. Introduction
Aliber (2000) summarizes the major questions regarding world currency regimes as“to fix or not to fix” and “optimum currency areas or not.” The classical answer bymodern industrial economies to both these questions since the late 19th century has
been to fix currencies to gold. Keynes (1923) made the crucial distinction between“internal stability (a stable price level)” and “external stability (a stable exchange rateand equilibrium in the balance of payments).” He favored the former in the presenceof nominal rigidity in domestic prices and thus argued in favor of a flexible exchange
rate.1 Many economists at the time were skeptical about a free-floating exchange rate.
Most prominently, Nurkse (1944) regarded the experience of European currencies,
such as that of the French franc from 1922 to 1926, as evidence that speculators arein general destabilizing under a floating exchange rate.2 At the launch of the Bretton
Woods system in 1944, major economies chose an adjustable fixed exchange rate to
the dollar backed by the gold reserve in the United States.
During the operation of the Bretton Woods system, two distinct views that
became the foundations of the analysis of exchange rate regimes appeared. Friedman(1953) eloquently stated the possible merits of a floating exchange rate for the sake ofabsorbing external shocks.3 Mundell (1961) and McKinnon (1963) responded that,
depending on the economic conditions, some economies would be better off if theyretained a fixed exchange rate.4 Their contributions are well known as the theory of
optimum currency areas.5 They also stressed that the economically desirable extent ofcommon currency areas might not coincide with national borders.
After the collapse of the Bretton Woods system, many industrial economies choseto float, except for the notable exception of the European Monetary System (EMS).
Emerging market economies have gradually shifted from a fixed exchange rate
system toward a floating exchange rate system, often after experiencing currency
1. Note that whether a country chooses a fixed or floating exchange rate, the real exchange rate has to adjust. Thus,
the main choice is whether the cost of adjustment is lower if a country chooses to deflate (a choice with which
Keynes disagrees) or depreciates.
2. He points out that the system of flexible exchanges in the 1930s uses gold as a vehicle for “hot money” transfer.
He concludes, “If there is anything that inter-war experience has clearly demonstrated, it is that paper currency
exchanges cannot be left free to fluctuate from day to day under the influence of market supply and demand”(Nurkse [1944, p. 137]).
3. He says, “Changes in internal prices and incomes are undesirable because of rigidities in internal prices, especiallywages, and the emergence of full employment—or independence of internal monetary policy—as a major goal ofpolicy” (Friedman [1953, pp. 172–173]). He argues that the floating exchange rate would be stabilizing thanks to
speculative transactions. Bordo and James (2001) point out that Gottfried Haberler made a strong intellectual casefor floating exchange rates as a mechanism to insulate economies from the transmissions of booms and depressions
in his book published in 1937.
4. For example, if factor mobility could be high enough to smooth out divergent shocks across regions, those regions
could adjust for the relative wage discrepancies induced by adverse shocks without adjusting the nominal exchange
rate. In a region whose external openness is high, the fluctuations in nominal exchange rate under a floatingexchange rate arrangement would have an influence not only on the prices of tradable goods, but also on the wages
and the prices of non-tradable goods. Thus, a floating exchange rate may not be helpful.
5. Recent studies such as Frankel and Rose (1998) demonstrate that optimal currency area criteria are endogenous,i.e., although these criteria may not be satisfied before the introduction of a common currency, these same criteria
might be satisfied once the regions form a common currency area. The sources of endogeneity of country
characteristics on its choice of currency regimes are not only economic conditions, but also cultural, historical,
and political conditions. Glick (2002) also stresses that how quickly such endogenous changes in country
characteristics occur is open to question.

48 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

crises. Against this background, Krugman (1979) proposes a model of a balance of
payments crisis that focuses on inadequate government policy.
In the 1990s, many economies moved in the direction of free capital mobility.
Many crises in the 1990s seem to be correlated with large capital inflows and outflows,
and economists have proposed new ways to analyze these new experiences. Motivatedby the EMS crisis in 1992, Obstfeld (1994) conjectured that the costs incurredby the authorities in maintaining the pegged exchange rate regime depended on
public expectations. In other words, the cost of resisting a currency attack depends on
endogenous variables. If governments determine the extent of their resistance througha cost-benefit analysis, however, self-fulfilling crises become likely in situations where
economic distress already places the government under pressure. If some exogenous
events change the public’s expectation regarding the future exchange rate regime,
it might lead to self-fulfilling crises among possible multiple equilibria. This could
happen even if the authorities have committed themselves to maintaining a fixedexchange rate regime, thus the authorities’ commitment is not time-consistent. Morrisand Shin (1998) proposed a way to pin down a unique equilibrium by adding a small
amount of noise in speculators’ signals regarding the fundamentals.
Observing currency crises in the emerging market economies, such as Mexico in
1994, East Asia in 1997, Russia in 1998, and Brazil in 1999, Summers (2000) statesthat the sources of those currency crises are serious banking and financial-sector
weakness, and short-term capital flows.6 Those episodes remind us of the argumentof the impossible trinity: economies cannot have capital mobility, an independent
monetary policy, and a fixed exchange rate simultaneously, which leads to the“bipolar view.” This view suggests that hard pegs and floating exchange rates are goodcandidates for currency regimes for emerging market economies under conditions offree capital mobility.7
This paper has two objectives. It first reviews some debates on the choice of
exchange rate regime with special attention to examples of hard pegs, the EMS, theeuro, and currency boards, to evaluate to what extent the bipolar view is useful.
Second, it explores the possibility of future regional currencies in Europe, theAmericas, and East Asia. The rest of this paper is organized as follows.
Section II reviews the definition of and trends in exchange rate regimes, andintroduces the bipolar view.8 Section III examines the experience of European
economies. It discusses lessons from the EMS crisis, issues for monetary policy after
the launch of the euro, and the possibility of expansion of the euro area. Section IV
6. This paper focuses on the theoretical literature. Thus, we do not discuss studies on contagion motivated by theepisodes of the Tequila crisis, the Asian flu, or the Russian virus. Recent examples include Kaminsky and Reinhart(2000, 2001).
7. Even under the surge of global capital flows during the 1990s, the “original sin hypothesis” (Eichengreen and
Hausmann [1999]) forces most emerging market economies to rely on short-term bank lending denominated indollars, rather than their own national currency. Other economists wonder if capital account liberalization during
the 1990s was helpful or not (see Rodrik [1998]). Thus, the term “free capital mobility” here is used for the sakeof a conceptual framework. Indeed, capital account liberalization remains one of the most controversial policy
issues (see Eichengreen [2001] for a recent review).
8. One may argue that the choice of exchange rate regime per se does not provide any useful lesson, because “nosingle currency regime is right for all countries or at all times” (Frankel [1999]). A lesson from his point of view isthat the issue of an exchange rate regime cannot be settled definitively, but must be continually kept in mind.

49first reviews the debate over unilateral dollarization in Latin America as a notable
example of a hard peg, then turns to the possibility of a common currency area in theAmericas. Section V reviews the twin-crisis models motivated by the East Asian crisis,
then discusses the possibility of an Asian common currency. Section VI summarizes
the observations made in this paper and topics for future study.
Note that illustrations for recent theoretical contributions in this paper show thatthe traditional Mundell-Fleming model may not be the sole theoretical reference
point for policymaking. However, space limitations did not allow us to discuss
any alternative theoretical building block in the main text. The appendix reviews
promising theoretical alternative literature following a consideration of the international transmission of monetary policy and exchange rate regimes under conditionsof uncertainty. An important policy implication obtained from those literatures isthat market structure and the parameters of the production function can affect thetransmission process of monetary policy.9 Consistent with this view, recent empiricalstudies point out the interaction between real factors and monetary regime. For
example, Rose (2000) uses five-year bilateral trade data from 1970 to 1995 for
186 countries. He regresses these data on real GDP, distance, dummy variables for
a common language, a common border, a common trade agreement, whether thecountry is a colony or not, as well as the volatility of nominal exchange rates andthe dummy variables for using the same currency. His results show that the effectsof currency union on bilateral trade are positive and statistically significant. Two
economies that share the same currency trade three times as much as they would withdifferent currencies. Glick and Rose (2001) estimate the same equation as Rose
(2000) using panel data methods, and find that two countries which share the same
currency trade twice as much as they would with different currencies. Rose andvan Wincoop (2001) find modest but still significant effects of a currency union on
the increase in the bilateral trade compared with the evidence reported by Rose
(2000). However, the inherent endogeneity problem in the choice of currency
regimes and economic performance still poses a difficult empirical problem in these
up-to-date studies.
In this paper, the terms “exchange rate regime” and “currency regime” aresometimes used interchangeably; however, currency regimes could refer to broader
issues that improve the working of exchange rate regimes. For example, the gold
standard is a currency regime that consists of a fixed exchange rate regime and a fiscal
policy that consists of a balanced-budget discipline. Similarly, a floating exchange
rate per se does not imply particular monetary rules, such as inflation targeting ormonetary targeting.

9. Cooper (1999) states that traditional analysis of exchange rate regime is not adequate due to the division of thereal factor and the monetary factor, and that the new approach summarized in the appendix breaks with part ofits tradition.

50 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

II. Exchange Rate Regimes: Definitions and Current Trends
Regarding the definition of exchange rate regimes, the International Monetary Fund(IMF) reports the exchange rate classification system among its members either in its
Exchange Rate Arrangements and Exchange Restrictions or in its International Financial
Statistics based on the member economies’ own assessments. The classifications of
exchange rate arrangements reported in those publications are summarized in Table 1.
There are eight categories: (1) exchange arrangements with no separate legal tender,(2) currency board arrangements, (3) other conventional fixed-peg arrangements,(4) pegged exchange rates within horizontal bands, (5) crawling pegs, (6) exchange
rates within crawling bands, (7) managed floating with no preannounced path for theexchange rate, and (8) independent floating.
Fischer (2001) classifies those arrangements into three groups: hard pegs (categories[1] and [2], 47 economies in Table 1), intermediate group (categories [3] through [6],59 economies), and float (categories [7] and [8], 80 economies). As of the endof March 2001, approximately one-third of the world’s economies, presumably
developing economies, belonged to the intermediate group, as can be seen in Table 1.
Summers (2000) observes that the sources of recent currency crises are not fiscal
deficit and current account crises, but serious banking and financial-sector weakness
and short-term capital flows. He points out that fixed exchange rates work poorly
under conditions of financial deregulation and free capital mobility. He states the
choice of appropriate exchange rate regime means “a move away from the middle
ground of pegged but adjustable exchange rates toward the two corner regimes of
either flexible exchange rates or a fixed exchange rate supported, if necessary, by acommitment to give up altogether an independent monetary policy” (Summers[2000, p. 8]). Is the bipolar view (also referred to as the “hollowing-out hypothesis”
by Eichengreen [1994]) the answer to the choice of exchange rate regime? In theremaining part of this section, we will discuss the pros and cons of this idea.
Fischer (2001) argues that in the last decade there has been a hollowing out of the
middle of the distribution of exchange rate regimes, with the share of both hard pegs
and floating gaining at the expense of soft pegs (Figure 1). He expects the bipolar
view will apply to the emerging market economies. The choice between hard peg
and floating depends on the characteristics of the economies, in particular on theirinflation history. Hard pegs make sense for economies with a long history ofmonetary instability or for an economy closely integrated in both capital and current
account transactions with another economy.10 Fischer’s view is clear-cut in theory, butwhat about empirical evidence for the bipolar view?
One may object to the bipolar view based on the classification published by the
IMF, especially before 1998, because those classifications might simply reflect legal(de jure) institutional frameworks in the reporting economies.11 Thus, de facto
10. Glick (2001) also shows that capital controls were more frequently employed by economies with intermediate
regimes than with either hard pegs or independently floating regimes in 1999. Those economies experiencing
greater integration with international capital markets tend to find it difficult to commit to intermediate regimes.
11. The classification system since January 1999 is based on the members’ actual regimes, which may differ fromtheir officially announced arrangements.

51

Table 1 Exchange Rate Arrangements
Exchange rate regime as of March 31, 2001
(1) Exchange arrangements with no separate legal tender:
The currency of another country circulates as the sole
legal tender or the member belongs to a monetary or
currency union in which the same legal tender is sharedby the members of the union.

Numberof countries

39

OECD members (euro area 12)
Latin America (8)Europe* (1)Oceania (4)Africa (14)8

Latin America (1)Europe* (4)East Asia (1)Southeast Asia (1)Africa (1)44Latin America (6)Europe* (5)East Asia (1)Southeast Asia (2)South Asia (4)Middle East (11)Oceania (5)Africa (10)6OECD member (Denmark)Latin America (1)Europe* (1)Southeast Asia (1)Africa (1)(5) Crawling pegs:
The currency is adjusted periodically in small amounts
at a fixed preannounced rate or in response to changes
in selective quantitative indicators.

4

Latin America (3)Africa (1)(6) Exchange rates within crawling bands:
The currency is maintained within certain fluctuation
margins around a central rate that is adjusted periodicallyat a fixed preannounced rate or in response to changes inselective quantitative indicators.

5OECD member (Hungary)
Latin America (3)Middle East (1)33OECD members (Czech Republic,
Norway, Slovak Republic)
Latin America (4)Europe* (11)South Asia (3)Southeast Asia (3)Africa (9)47OECD members (Australia, Canada,
Iceland, Japan, Korea, Mexico,
New Zealand, Poland, Sweden,
Switzerland, Turkey,
United Kingdom, United States)
Latin America (6)Europe* (5)East Asia (1)Southeast Asia (3)Middle East (2)Oceania (1)Africa (16)(2) Currency board arrangements:
A monetary regime based on an implicit legislative
commitment to exchange domestic currency for a
specified foreign currency at a fixed exchange rate,
combined with restrictions on the issuing authority toensure the fulfillment of its legal obligation.
(3) Other conventional fixed-peg arrangements:
The country pegs its currency (formally or de facto) at a
fixed rate to a major currency or a basket of currencies
where the exchange rate fluctuates within a narrowmargin of at most ±1 percent around a central rate.

(4) Pegged exchange rates within horizontal bands:
The value of the currency is maintained within margins
of fluctuation around a formal or de facto fixed peg thatare wider than ±1 percent around a central rate.

(7) Managed floating with no preannounced path for theexchange rate:
The monetary authority influences the movements of theexchange rate through active intervention in the foreignexchange market without specifying, or precommitting
to, a preannounced path for the exchange rate.
(8) Independent floating:
The exchange rate is market determined, with any foreignexchange intervention aimed at moderating the rate ofchange and preventing undue fluctuations in theexchange rate rather than at establishing a level for it.

Note: Europe* includes the newly independent states (NIS) composed of the former Soviet Union countries.
Source: International Monetary Fund, International Financial Statistics, 2001, pp. 124–125.

52 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

Figure 1 Exchange Rate Regimes in 1991 and 1999

70

Number of countries as a percentage of total
62 percent
(98)

1991

1999

60
50

42 percent(77)
34 percent(63)40
24 percent
(45)

30
20

23 percent(36)

16 percent
(25)

10
0
Hard peg

Intermediate

Float

Note: Parentheses indicate the number of countries.
Source: Fischer (2001), figure 1.

exchange rate regimes based on the working of financial markets or macroeconomic
variables might be more appropriate. Studies based on a de facto exchange rate regime
give a mixed answer to the bipolar view. Levy-Yeyati and Sturzenegger (2000, 2001)
classify economies into four exchange rate regimes using cluster analysis basedon three macroeconomic variables.12 According to their analysis, the number of
economies classified as “intermediate group” still accounts for more than one-fourthof all economies. Masson (2001) also shows that the intermediate cases will continue
to constitute a sizable fraction of actual exchange rate regimes.13 On the other hand,Frankel et al. (2000) add an argument against intermediate regimes based on Chile’s
data and on the results of Monte Carlo simulation.
In our view, a weak point of the bipolar view is that there are few economies withhard pegs, especially large ones.14 Exceptions include the euro-area economies, the
CFA Franc zone economies, Ecuador, Panama, and Hong Kong, at the time thispaper was written. Thus, the next three sections first review a few debates on
the management of exchange rate regimes with special attention to examples of thehard pegs listed above to evaluate the bipolar view. Then those sections explore thepossibility of future regional currencies in each area.
12. They use monthly percentage changes in the nominal exchange rate, the standard deviation of monthly
percentage changes in the exchange rate, and the volatility of reserves. Shambaugh (2001) discusses the problemsof coding method by Levy-Yeyati and Sturzenegger (2000) and proposes a new approach of de facto two-way
coding system between pegs and non-pegs focusing on the volatility of exchange rates.
13. He computes a transition matrix across exchange rate regimes from the data published by Ghosh et al. (1997)
and Levy-Yeyati and Sturzenegger (2000) to obtain his conclusion.
14. Glick (2002) nicely states that “the hard peg pole is narrower than we thought.”

53III. The European Experience
It is well known that one of the economic backgrounds of the European Monetary
Union (EMU) was the theory of optimum currency areas. However, according toDellas and Tavlas (2001), the European Union (EU) economies do not satisfy
optimum currency area criteria sufficiently.15
So what lesson about exchange rate regimes in the 21st century can we learn fromthe European experience? Note that behind the bipolar view lie successive speculative
attacks against economies with pegged exchange rates since the EMS crisis in 1992–93.
Thus, in this section, we will review the lessons from the EMS that may apply to futureexchange rate regimes. We then move on to problems faced by policymakers in theeuro area following the euro’s establishment. Finally, we will discuss the possibility ofa future expansion of the euro area.
A. The Way toward the Euro: Past and Present
1. Lessons from the EMS
After the collapse of the Bretton Woods system, European economies moved todevelop their own arrangements for exchange rate stability. These started with the“snake in the tunnel” and moved on to a more structured EMS in 1979. The EMS
was de facto a system in which “capital controls were permitted to allow governments
to negotiate realignment while providing them a degree of policy autonomy”(Aldcroft and Oliver [1998]). It experienced 11 episodes of realignment between
1979 and 1987. However, over the years, a code of conduct had been built up as the
EMS developed from a mere exchange rate arrangement into a powerful convergence
instrument, such as the Basle-Nyborg Agreement, which strengthened intervention
in the foreign exchange market. It implied the acceptance of the deutschemark as
the anchor of the system (Braga de Macedo et al. [2001]). Differentials in rates ofinflation in the EMS economies converged remarkably during the late 1980s, which
could be explained by the “credibility hypothesis.” According to this, economies suchas those of France, Italy, or the United Kingdom could increase the credibility of
their national monetary policies and lower their national expected rates of inflation
by pegging their currencies to the deutschemark, which usually recorded a low rate of
inflation under a credible monetary policy.
These successful periods did not last long. By July 1990, most EMS member
economies had removed capital controls, which had been one of the most important
methods of successful monetary management under the EMS.16 The removal of
capital controls seemed to be one of the key factors behind the EMS crisis in

15. According to Dellas and Tavlas (2001), among the optimal currency area criteria, the EU economies satisfy only
the criteria of openness and trade integration. Note that EMU is just a factor of European integration, which
includes European economic integration and European political integration. Thus, the economic and political
integration in the EU economies could allow those economies to satisfy the optimum currency area criteria in
the future.
16. Wyplosz (2001a) mentions that the conflict between fixed exchange rates and the active use of monetary policy
was reconciled through internal financial repression such as quantitative limits on bank credit and ceilings oninterest rates in addition to capital controls.

54 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

1992–93, consistent with the bipolar view. Of course, free capital mobility does notalways mean that the peg is subject to attack, as can be seen in the experience of the
EMS after the crisis. The acceptance of a stability-oriented policy by member
economies that essentially meant mutual regional surveillance, together with central
parity within a large band, seemed to improve the credibility of the peg under the
single European capital market (Braga de Macedo et al. [2001]).
Moreover, free capital mobility is not the only problem in the EMS. Let us briefly
summarize two other internal problems that made it difficult for the EMS economies
to defend their band, following Dellas and Tavlas (2001).
First, suppose that a shock occurs in the central economy (Germany) and that thecurrency of the central economy appreciates against a currency outside the EMS (say,the dollar). Within the EMS, the currencies of the other member economies (such as
France or Italy) also must be made to appreciate against the dollar to defend the
EMS band, although they have been hit by no shock at all. Dellas and Tavlas (2001)
call such a process of transmitting shocks within the central economies to the othermember economies the “magnification effect.”17
Second, member economies with relatively high inflation and high nominalinterest rates experienced capital inflows and their nominal exchange rates become
overvalued against the currencies of low-inflation economies. Such overvaluationencourages more production of non-traded goods, and leads to current accountdeficits in relatively high-inflation economies. This episode demonstrates that thepegged system has a transition problem.18
Based on those arguments, Dellas and Tavlas (2001) conclude that the experienceof the EMS provides evidence that an exchange rate peg nominal anchor contains
internal dynamics which make such a regime especially fragile.
2. Issues relevant to a successful single monetary policy
The launch of the euro on January 1, 1999 and the circulation of euro-denominatedbanknotes and coins in January 2002 are two important events demonstrating that
the European economies have finally completed the formation of a single currency.
However, a number of “flaws” or “hazards” have been pointed out in the construction
or in the working of EMU. Among these problems, Bordo and Jonung (1999)
highlight three: (1) the absence of a central lender-of-last-resort (LLR) function andthe lack of supervisory authority of the EMU-wide financial system, (2) the absenceof central coordination of fiscal policy within EMU, and (3) weak democratic
control (accountability) of the European Central Bank (ECB). We will discuss these
problems in turn.

17. This process illustrates the overall appreciation of European currencies during German reunification. At thattime, the Bundesbank tightened monetary policy during the massive fiscal investment that occurred in the former
East Germany, and that policy mix led to the appreciation of the deutschemark. Other member economies
maintained exchange rate stability against the deutschemark by tightening their monetary policies at the cost of
accepting appreciation against the dollar and the yen.
18. This phenomenon is consistent with the many episodes of realignment in the early 1980s. At that time, rates ofinflation in the other EMS economies were higher than that in Germany. But the nominal exchange rates of
those other economies’ currencies did not depreciate much within the EMS. As a result, appreciated realexchange rates led to subsequent realignments.

55

a. Maintaining the financial stability of EMU
In EMU, it is not the ECB but national central banks (NCBs) that primarily have
LLR functions. Bank supervising authorities (NCBs or government agencies), rather
than the ECB, are primarily responsible for bank supervision.
The advent of the euro has stimulated the integration of financial markets ofmember economies. An integrated financial market might spread a large negative
shock in one member economy into area-wide financial instability. Obstfeld (1998)
pointed out two problems regarding the Maastricht Treaty’s blueprint for safeguarding
financial stability.
First, regarding the structure of euro zone prudential supervision, Obstfeld (1998)
wondered whether the division of regulatory responsibility among national regulators
might be a misguided application of the principle of subsidiarity, because the optimal
domain of regulation in an integrated financial market would not be smaller than themarket itself. For example, the national regulators may not fully internalize theadverse repercussions of a financial crisis, particularly when the bill for containment
arrives at the EMU or EU level. Another concern is that national regulators mightfavor national institutions or financial centers through lax application of the rules.
Second, regarding the lack of a statutory mandate for the ECB to act as an LLR,
Obstfeld (1998) argues that such an arrangement is only consistent with the special
features of the German financial system. Those include a relatively low degree of
securitization, the dominant position of large universal banks; the high levels ofreserves and collateralizable securities that German banks hold, and other features ofthe domestic payments system.19 However, the euro financial system does not sharethese structural features of the German system.20
Against this criticism, Padoa-Schioppa (1999) claims that many bank supervision
procedures have been harmonized within EMU, and that “there are neither legalcum-institutional, nor organizational, nor intellectual impediments” to operating
LLR when an EMU-wide crisis occurs. He concludes, “There is no expectation, atleast to my mind, that the division of responsibility . . . should be abandoned.”21
b. The central coordination of fiscal policy within EMU
Is a harmonized single fiscal policy necessary for a monetary union?22 In Europe, theDelors Report of the Committee for the Study of Economic and Monetary Union(1989) emphasizes the necessity of harmonized fiscal policy in EMU.
19. As for the reasoning of this argument, Folkerts-Landau and Garber (1992) state, “Financial systems witha limited extent of securitization have in practice a small number of large universal banks in the market forwholesale funds. Wholesale payments and securities transactions are cleared internally in these organizations.
The risk of nonsettlement is low due to the lack of significant exposure to non-bank financial institutions andan increased ability to work out unexpected problems quickly among the small number of players. Hence,
although the clearing banks ultimately clear on the books of the central bank, there is little need for the central
bank to provide intra-day credit or stand ready to act as lender-of-last-resort to the clearinghouse to ensure thepayments settlements.”
20. Parti and Schinasi (1999) also insist that the absence of the central LLR and supervising arrangement may
undermine the existence of EMU in the face of area-wide financial crises.
21. Buiter (2000a) also states that LLR actions should be left at the national level, subject to ECB oversight andcoordination, since the capital of the ECB is limited and it is not backed, either formally or informally, by the
deep pockets of a ministry of finance.
22. Optimum currency area criteria suggest the necessity of fiscal transfer within monetary union. If one region
suffers from high unemployment due to a region-specific negative shock, fiscal transfers from low-unemployment
regions to high-unemployment regions can smooth out the shock without adjusting nominal exchange rates.

56 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

Many economists have conducted empirical analyses regarding the necessity ofcentral fiscal policy to guard against asymmetric shocks. For the United States, vonHagen (1992) estimated that 47 cents of net federal transfers would be made in
response to a US$1 difference in the level or change in state income compared to
U.S. average income. However, for economies other than the United States, such as
Canada, many research findings have shown different estimates of the transfer in arange from more than 10 to more than 50 cents (see Kletzer and von Hagen [2000]
for a recent review). These studies indicate that fiscal transfer may be significant insome existing monetary unions, but it is difficult to answer the question of how
important it is in practice for the stabilization of the regional economies.
Another reason for the need of central coordination of fiscal policy within the
EMU could be the possibility of the dynamic inconsistency problem. One may well
wonder whether fiscal authorities would expect the EMU to accept discretionary
fiscal policies that are slightly inconsistent with the Maastricht Treaty, because asingle monetary policy cannot emphasize a particular economic situation of member
economies.23 Von Hagen et al. (2001) argue that the EU surveillance of publicfinance should focus on the content of consolidation efforts, as well as the ceiling on
the gross government debt to GDP ratio and general government deficit to GDP
ratio to achieve prudent fiscal policies in monetary union.
c. Democratic control (accountability) of the ECB
Some economists are concerned about issues relating to democratic control of the
ECB, such as its independence and accountability. First, concerning the independence
issue, Feldstein (1997) argues that pressure from governments on the ECB would bias
monetary policy.24 The decision-making body of the ECB, the Governing Council,
consists of six Executive Board Members, appointed by the European Council, and thecentral bank governors of the EMU member economies. Monetary policy is decided
by simple majority in the Governing Council. Therefore, the representatives on
the ECB Governing Council might reflect their national attitudes and face politicalpressure to represent what domestic governments perceive to be their national
interests.25 Second, concerning the accountability issues, Buiter (2000a) states that
the U.K. arrangements, with an operationally independent central bank pursuing apolitically mandated set of objectives, are superior to the current EMU arrangements
in a democratic economy. Regarding the procedural openness and transparency ofmonetary policy, he also suggests that the individual voting records of the members of
the Governing Council and its minutes should be in the public domain.
Hämäläinen (2001) opposes these criticisms. First, the Maastricht Treaty prohibits
the ECB and NCBs from taking instructions from any external bodies; therefore, the23. Von Hagen et al. (2001) show the empirical evidence that the pressure of the Maastricht Treaty might haveresulted in some short-lived and revenue-based consolidation efforts during the recession years of the early 1990s.
The policy implication of their evidence could be that the pressure from the Maastricht Treaty should not be
underestimated.
24. Feldstein (1997) suggests that the future average rate of inflation would rise and that the net economic effect of
EMU would be negative, based on the above argument.
25. The future expansion of EMU means an increase in membership of the Governing Council. If Feldstein (1997)
is right, in our interpretation, the future expansion of EMU members might also increase the risk that the ECB
will receive greater pressure from governments and that its monetary policy will be biased.

57

independence of the ECB is firmly safeguarded by the treaty. Second, if the minutesand voting record of the Governing Council were published, there would be a riskthat the individual members of the council might be subject to pressure from theirdomestic publics, which could discourage their necessary euro area-wide thinking.
B. Expansion of EMU in the Future
The discussion so far shows that the introduction of a common currency is nota panacea, and unsolved problems remain with regard to EMU. Thus, it is understandable that some EU economies had still not joined the euro at the time this paper
was written.
However, the euro area has its own frontier: with East European, Mediterranean,and African economies. Currently, many East European transition economies areapplying for EU accession, and trade and financial links, as well as political dialog,
between these economies and the EU have been deepening.26 Noyer (2000) expects
the future expansion of the euro area, stating, “The more a process of regional
integration moves beyond a free trade area toward a single market, or even an
economic union, the stronger the need for intra-area exchange rate stability, andeventually, irrevocably fixed exchange rates.” Are there any pitfalls during theaccession process?
To analyze this question, we should take care to distinguish EU membership from
EMU membership. EMU candidates must meet both the exchange rate criterion27
and the inflation rate criterion28 in addition to the fiscal deficit criterion. Buiter and
Grafe (2001) suppose that the productivity growth differential between the traded
and the non-traded sectors is larger in the accession economies than EMU member
economies. This means that the relative price of non-traded goods to traded goods ishigher in the accession economies and their overall inflation rate will be higher at agiven exchange rate—the Balassa-Samuelson effect. Then, the introduction of theeuro in accession economies would lead to a period of declining prices and large costsof adjustment to meet the Maastricht ceiling under sticky prices. Buiter and Grafe(2001) suggest that the inflation rate criterion should be specified more concretely interms of traded good prices to resolve this conflict. Noyer (2001) responded to such a
concern on the consistency of nominal and real convergence during the accession
26. Regarding the choice of exchange rate regimes in the accession economies, at the beginning of the 1990s,
conventional fixed pegs (intermediate based on Fischer [2001]) were the most common type among thoseeconomies. As of the year 2000, except for Hungary and Slovenia, accession economies employed either hardpegs (a currency board in Estonia, Lithuania, Bulgaria, and Latvia) or a float (the Czech Republic, Poland,
Romania, and the Slovak Republic). Thus, Begg et al. (2001) report that after the liberalization of short-term
capital flows in the accession economies, the bipolar view applies to these economies. See von Hagen and Zhou
(2002a) for an empirical explanation of the choice of rate regimes that seems to be consistent with the openness
criterion of the optimum currency area in transition economies. Von Hagen and Zhou (2002b) compare de facto
exchange rate regime classification based on methods by Levy-Yeyati and Sturzenegger (2000) and officialclassification by the IMF. Von Hagen and Zhou (2002c) show that the exchange rate regime choice affects
capital controls, while feedback effects from capital controls on the choice of exchange rate regime are absent. We
omit the discussion on two small economies negotiating entry into the EU (Cyprus and Malta) as well as Turkey.
27. The exchange rate criterion requires EMU candidates to stabilize their exchange rates within a ±15 percent bandfor two years before joining EMU without capital or exchange controls.
28. The inflation criterion requires that the inflation rate must not exceed the average of the three lowest-performing
economies by more than 1.5 percentage points.

58 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

process as follows. First, most empirical studies estimate the Balassa-Samuelson effectwithin a range of 1 to 2 percentage points. Second, the Maastricht inflation criterion,
which will not be revised to take into account any possible Balassa-Samuelson effect,
should not be seen as an immediate requirement for these countries, but rather as a
medium-term objective for central banks.

IV. The Experience of the Americas
In the Americas, following the large currency crises, such as those in Argentina (2002),
Brazil (1999), and Mexico (1994), large economies have moved toward floatingexchange rate regimes. Canada, which has sometimes been advised by economists tojoin the U.S. currency union, remains under a floating exchange rate regime.
However, several small economies are officially dollarized, such as Panama, andsome economies have opened the way to unilateral dollarization, such as Ecuador or
El Salvador.
In this section, following Edwards and Magendzo (2001), we define “dollarization”
as a policy proposal that emerging market nations should give up their national
currencies and adopt advanced nations’ currency as legal tender. We identify the
dollarization proposal as one of two poles.29 We will first discuss the pros and cons ofdollarization relative to clean floating in detail in the context of Latin American
economies. Note that the current choice of a floating exchange rate in many American
economies does not necessarily mean that there is no possibility of a regional currency
area in the Americas in the future. Thus, we will discuss this issue in the latter part ofthis section.30
A. The Pros and Cons of Unilateral Dollarization
1. The case for dollarization
Calvo (2000) points out compelling reasons for emerging market economies to avoid
exchange rate flexibility. Dollarization may be costly, but it may put emerging markets on the first stage of the track leading toward monetary and financial stability. He
observes that the heart of the problem may lie in imperfect information, inexperiencein handling sudden large capital inflows, and shaky political equilibrium, especiallyin Latin America.
Calvo (2000) summarizes Mundell’s condition regarding the choice of exchange
rate regime. Consider a simple model, y = αe + g + u and m = y + v. Here, y, e, g, and

29. Broader definition of dollarization would include the holdings by residents of a significant share of their assets
in the form of foreign currency-denominated assets and the use of foreign currency-denominated assets fortransaction (see Baliño et al. [1999]). It is well known that in high-inflation economies, citizens abandon thelocal currencies and choose to use the dollar as the medium of exchange, and this reduces the base for inflation
tax and introduces a parallel currency. Needless to say, the allocation of seigniorage between the United States
and a dollarized economy depends on the nature of the legal framework proposed in the dollarized economies.
30. This paper does not attempt to list desirable monetary policy strategies for all economies in the Americas.
Mishkin and Savastano (2001) regard hard pegs and constrained discretion based on inflation targeting as two
promising strategies. They conclude that the choice between the two depends on political and institutional
factors which constrain monetary policy.

59

m denote the logs of output, the nominal exchange rate, the shift parameter of an
external factor such as U.S. demand, and money supply. The first equation is an
open-economy IS curve, and the second equation is an LM curve. u and v show
random shocks, and α is a positive constant. The existence of a fixed exchange ratemeans e is constant and m is endogenous. The floating exchange rate means m isconstant and e is market determined. Hence, under the fixed exchange rate regime,var( y ) = var(u + g ), and var(e) = 0, while under the float, var(y ) = var(v ), and var(e) =(1/α 2)var(u + g + v ). If we worry about the var(y ), a fixed exchange rate is better ifvar(v) is larger than var(u), abstracting momentarily from g.
In practice, policymakers do not know the size of var(v ) and var(u). It would bebetter to have a discretionary exchange rate policy depending on the shock, but formost emerging market economies it would be impossible. More seriously, if mostbank lending is dollarized, an unexpected devaluation of the nominal exchange rate
could lead to debt deflation, hence it may make more sense to pay attention to var(e ),rather than var(y ). In addition, if the markets of emerging economies are subject
to asymmetric information in financial markets, it makes sense to offset var(v ) by
just pegging the nominal exchange rate.31 By means of dollarization, an economy’s
monetary policy obtains credibility, lowers the information cost, and moderates
relative price changes compared with floating.
Calvo (2000) also points out that dollarization provides a cushion for sharp
relative price changes in comparison with a flexible exchange rate. If prices and wages
are sticky, the nominal profit of firms will change slowly. Thus, firms would be more
willing to repay debt and might facilitate a more orderly recontracting of debt
under Keynesian-type recession. Calvo (2000) admits the cost of losing the LLR
function. However, adding international banking, as can be seen in Panama, would
be a solution.32 An alternative to dollarization is not a textbook-style free flexible
exchange rate system but a closely managed flexible rate system, because the lack ofcredibility of central banks would mean a managed float with a lot of intervention,or inflation targeting with less credibility.33 If this regime is a realistic alternative,
dollarization might make sense.
2. Is unilateral dollarization the solution?
Corbo (2001) discusses the advantages and disadvantages of dollarization in theAmericas. He points out that potential benefits of dollarization are low inflation, theelimination of currency risk and its associated risk premium, low transaction costs ofusing the currency, lower relative price volatility of tradable goods with dollarized
economies and thus a larger amount of foreign trade with those economies, and the

31. Calvo and Reinhart (2000) illustrate why large exchange rate swings are feared when access to international credit
may be lost.
32. Calvo (2000) evaluates Panama’s system as follows: “In Panama, banks are subject to minimal reserve
requirements and there is no institution in charge of LOLR operations. Seemingly, the de facto LOLR has beena large American bank . . . . . The country has suffered only minor tremors from Tequila and other recent
financial crises.”
33. Calvo and Reinhart (2002) find that economies that say they allow their exchange rate to float mostly do not
do so. Relative to committed floaters such as Japan, the United States, and Australia, observed exchange rate
volatility is small.

60 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

elimination of currency mismatch in foreign liabilities. He suggests the main cost isthat, in the presence of nominal rigidity in the labor market, real depreciation is hardto achieve, and thus a real negative shock, such as a terms of trade shock, would leadto serious unemployment.
Consider economies with poor records of monetary stability, in which currency
substitution is high, or economies in which a substantial part of trade in goods andcapital flows occurs with the United States. Corbo (2001) suggests that the benefit ofdollarization would outweigh the cost of dollarization in such economies, if labormarkets are flexible and the appropriate institutions support the financial system. He
suggests that many Central American economies satisfy this condition, while in large
economies, except for Argentina, their choices are not clear.
Edwards (2001a) admits that the argument made by Calvo and others in favor of
dollarization goes beyond the scope of the static theory of optimum currency areas.
However, he warns that their policy recommendations are based on very limited
empirical and historical evidence in very small economies. He examines a small
group of economies that live under a so-called dollarized monetary system,34 andfinds that those nations have (1) had significantly lower inflation, (2) grown ata significantly lower rate, and (3) had similar fiscal deficits and current accountbalances compared with non-dollarized economies. In the case of Panama, he points
out its success in achieving lower inflation, but behind these achievements it has
failed to maintain fiscal discipline and has been helped by the IMF programs quite
often. He also shows that external shocks in the form of terms of trade disturbancesand current account balance reversals have had larger negative effects on Panama thanon non-dollarized economies.
Edwards (2001b) stresses that the credibility of hard pegs is not automatic. At aminimum, an economy needs to address key structural issues such as fiscal solvency,
appropriate preparation for exercising the LLR function,35 a solid banking sector,
and a sufficiently high quantity of dollar reserves in the case of a currency board.
Based on the information available while this paper was written, the experience inArgentina suggests that even a currency board cannot work if the economy does
not follow a prudent fiscal policy. Another lesson is that an economy’s choice of
currency regime should take into account those of their key trading partners.36 The
combination of low inflation and market liberalization in the early 1990s did not
result in fast and sustained productivity growth that exceeded the rise in real wages,
which could have preserved Argentina’s competitiveness under the currency board(Feldstein [2002]).

34. These economies are the following very small economies: Andorra, Kiribati, Liberia, Liechtenstein, the MarshallIslands, Micronesia, Monaco, Nauru, Palau, Panama, San Marino, and Tuvalu.
35. For example, one may wonder if the private banks alone could adequately handle a sudden increase in demandfor dollars by citizens in a dollarized economy. Such a demand shock, if large enough, could be transmitted to the
U.S. financial market.
36. Given the devaluation of the peso, Hausmann (2002) recommends establishing an independent central bankwith a price stability mandate, to increase the jobs in agriculture, industry, and tourism, stimulate foreign
demand, lower tariffs, and reestablish financial stability. Sachs (2002) wonders if Argentina’s history of monetary
instability makes the benefit from devaluation questionable, and thus dollarization would still be preferable.

61

B. A Common Currency Area for the Americas in the Future
The recent movement toward a floating exchange rate may not be the end of the
discussion on the currency regime in the Americas. For example, Dornbusch (2001)
argues that Mexico would benefit from the immediate introduction of a currencyboard to deepen economic integration with the United States. Corbo (2001) statesthat the type of monetary arrangement which would be more appropriate for theSouthern Cone Common Market (MERCOSUR) as a whole is an open question.
However, in the long run, Corbo (2001) states that interest in moving towardcurrency areas in Latin America will increase, as the experience of the euro becomes
clear. In this case, as Salvatore (2001) suggests, the United States might have anegative interest in the expansion of the dollar area. Suppose many Latin American
economies succeed in reducing the rate of inflation to a level as low as that of theUnited States in the future. In such a situation, the U.S. government might benefit
from dollarization in the Americas because of the increases in seigniorage and tradeflows. At the same time, massive use of the dollar in the Americas, especially in large
economies, might make the monetary management task of the Federal Reserve Board(FRB) harder in terms of gearing its policy exclusively toward the U.S. economy.
And if this difficulty were to raise doubts regarding the credibility of the dollar, it
could well result in a sudden shift from the dollar to the euro, producing large-scalefinancial turmoil (Salvatore [2001]).37

V. The East Asian Experience
At the beginning of the 1990s, many East Asian economies experienced high-speed
economic growth. There were many economic discussions regarding the keys of
success in the East Asian economies, such as World Bank (1993). Krugman (1994)
was a notable critic of this success, although what he expected was a slowdown of
Asian growth based on lower estimates of total factor productivity growth in thisregion computed by Young (1995), rather than a meltdown of the financial system insome economies in this area.
Since the East Asian crisis, a large amount of literature has been published on
this topic (see, for example, Corsetti et al. [1999a] for an overview of economic
fundamentals and the debate regarding this experience). Economists started tocomplain about many features of the economic environment in this region, forexample, crony capitalism, weak banking sectors, inadequate sequencing of capital
account liberalization, the lack of a legal basis in these economies, and so on, as well
as about the de facto dollar peg employed in some economies. Since the bipolar viewin the Asian context is motivated by the twin crises, in this section we will review avariety of models of the twin crises and policy debates. We will then move on to theissue of an Asian currency area.
37. One may object to this view because U.S. monetary policy did not show so much external concern during thedollar-standard era. An important assumption here is that the euro becomes another important international
currency and the use of the dollar prevails throughout the Americas.

62 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

A. Twin Crises and Policy Debates: What’s New?
A variety of research papers have tried to explain the twin crises and subsequent
policy debates following the East Asian crisis.
Many economists have focused on moral hazard as the common source of theover-investment, excessive external borrowing, and current account deficits that led
to the twin crises (see, for example, Corsetti et al. [1999b], Krugman [1998], andSchneider and Tornell [2000]). Among the sources of moral hazard, some economists
complain that the involvement of the IMF in Mexico might have allowed foreign
investors in East Asian economies to expect that the Fund would help them. Such
concerns led to extensive discussions regarding the role of the IMF (see, for example,
Meltzer Commission [2000]).
Excessive investment based on bank lending requires a new way of thinking about
the policy response to a crisis. The IMF often suggests a temporary sharp tighteningof monetary policy to support the exchange rate, followed by gradual loosening once
confidence seems to have been restored. Does this cure make the disease worse?
Furman and Stiglitz (1998) argue that high interest rates in highly leveraged
economies can drive the exchange rate in an unintended direction. This is becausesuch an operation would put local banks in jeopardy and make the economic
situation worse.
Krugman (2000) gives an intuitive explanation why a low interest rate policy may
not help such a crisis-hit economy using a slightly modified Mundell-Fleming
framework (Figure 2). In the commodity market, a currency depreciation will
increase net exports and domestic output in the ordinary case. Suppose that the
Figure 2 Krugman (2000) ModelA

S

Exchange rate

Crisis equilibrium

Good equilibrium

S

A

OutputSource: Krugman (2000).

63

adverse balance-sheet effects, for example, an increase in the domestic value of debt
denominated in foreign currency due to depreciation, were to be sufficiently strong
in the crisis. Then, the negative wealth effect due to the balance-sheet problem would
generate a commodity market equilibrium condition S-shaped curve (the SS curvein the figure) against the nominal exchange rate. The asset market equilibrium
condition would be the downward-sloping AA curve in the figure. Given thedomestic GDP, if the monetary authority leans against the exchange rate movement,
we can suppose AA is downward sloping. Thus, there are two locally stable equilibria.
Suppose a lower interest rate policy and a depreciation of nominal exchange rate
were made. If this were done at around the good equilibrium in Figure 2, then thestandard remedy would work. However, consider a situation where self-fulfilling
capital flight or a political crisis occurs. Then, the economy might jump toward
the crisis equilibrium, rather than the good equilibrium in the figure. Facing therisk of moving toward the crisis equilibrium, the central bank would be reluctant
to loosen monetary policy because such a decision would only ensure that thecrisis equilibrium materializes. Alternatively, if the central bank tightened, at least
temporally, to persuade the market that the currency was strong, a sufficiently severe
short-run shock would produce lasting effects, as in the Indonesian experience. Thus,
the traditional policy response in a recession would reach a dead-end.
Another group of economists considers the role of liquidity during a banking crisis
and its relationship with exchange rate regimes (see, for example, Chang and Velasco[2000, 2001]). Caballero and Krishnamurthy (2001) make an important distinction
between domestic liquidity constraint and international liquidity constraint. The
standard Mundell-Fleming model approximates an external shock either as a rise in the
country premium or international interest rates based on interest parity condition.
In other words, it assumes that unlimited funds are available from abroad at a highbut fixed price. Thus, distressed firms with good collateral would be helped byforeign funds at constant but high interest rates. Reductions in the domestic liquidity
constraint due to a lower interest rate policy would also be helpful for these distressedfirms. However, Caballero and Krishnamurthy (2001) argue that if the internationalliquidity constraint and domestic liquidity constraint are simultaneously binding, adomestic low interest rate policy would mainly affect the domestic relative price of thelimited amount of international liquidity within this crisis-hit economy. Thus, a lowinterest rate policy during the crisis might bring about a sharp overshoot in theexchange rate depreciation without substantial gain in terms of real activity.
B. A Common Currency Area in Asia in the Future
In East Asia, based on the IMF classification as of March 31, 2001, we see hard-peg
economies (Hong Kong), conventional fixed exchange rate economies (Malaysia),
managed floating with preannounced exchange rate target economies (Singapore),and independent float economies (Korea, Indonesia, the Philippines, and Thailand).
Before the East Asian crisis, most of these were de facto dollar-peg economies.
Currently, exchange arrangements in the East Asian economies are diversifying.
However, it still makes sense to pose the following question: what is a desirable
exchange rate regime for the Asian economies, including a common currency area?

64 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

Japanese government officials have expressed views in support of the yen’s
internationalization, as well as of basket pegs for Asian economies as a first step.38 In
our view, academic opinion regarding a future Asian regional currency is mixed.
However, many Japanese economists are sympathetic to arguments in favor of theinternationalization of the yen. We will examine several opinions below.
Kawai and Akiyama (2000) observe that the role of the dollar as the dominantanchor currency in East Asia was reduced during the crisis period, but that its
prominence has been restored. They suggest that Asian economies are likely tomaintain more flexible exchange rate arrangements, at least officially, but would
prefer exchange rate stability without fixed-rate commitments. They expect to choose
a balanced currency basket system in which the yen and the euro play a more
important role. Moreover, given the strong degree of intra-regional trade andinvestment interdependence, East Asian economies have incentives to avoid harmful,large exchange rate fluctuations within this region, hence it would be useful for thoseeconomies to choose similar currency baskets.
McKinnon (2001) objects to the proposal of Kawai and Akiyama (2000) and suggests that the simplest conceptual framework is to fix the yen to the dollar,rather than worrying about the empirical difficulty inherent in the measurement ofa currency basket.39 Glick (2001) also points out that the virtues of simplicity,transparency, and observability are lost if the weights used in the basket are notpublic information and need to be adjusted over time in a timely manner. He argues
that for most emerging market economies in East Asia, floating is a plausible choice,although it might accompany discretionary use of intervention.
Ogawa (2001) reports that the exchange rate of some East Asian economies against
the dollar has stabilized, while the exchange rate against the yen has fluctuated since
the crisis. His evidence suggests that some East Asian economies have returned to ade facto dollar peg.40
Why is the basket peg not a widespread exchange rate regime in East Asian
economies so far? Bénassy-Quéré (1999) points out that the mismatch between
the country distribution of trade (high weight of the dollar) and the currency
distribution of their external debt (high weight of the yen) could be the reason that
Asian economies prefer a low weight for the yen.
38. See for example, the Council on Foreign Exchange and Other Transactions at the Japanese Ministry of Finance(1999), which pointed out the need for internationalization of the yen for the 21st century on April 20, 1999.
(Official statements on this matter by the Japanese Ministry of Finance can be downloaded from http://www.
mof.go.jp.) Japanese Vice Minister of Finance for International Affairs Haruhiko Kuroda stated, “It would be
difficult for the yen on its own to play a role similar to that of the euro and the dollar; however, the region could
start with a basket composed of the yen, the euro, and the dollar before imagining a common currency for Asia”(Kuroda [2000]).
39. Note that a high level of economic integration is possible without a common currency or currency pegs
(for example, Canada, the United States, Switzerland, and Germany). If this is the case, then floating currencies
with some leaning against the wind would be of considerable appeal for ASEAN economies as an intermediatetransition stage. For example, Williamson (2000) regards East Asian economies as “reluctant floaters,” andrecommends that they introduce publicly announced monitoring bands as a viable intermediate regime. The
authorities would not be asked to defend a particular rate, and they would announce the rate consistent withlong-term fundamentals to enhance the transparency and credibility of the exchange rate regime.
40. Consistent with his finding, the Study Group for the Promotion of the Internationalization of the Yen (2001)
concluded that the internationalization of the yen was not so advanced, and thus it should be an item on thelong-term agenda for Japan.

65In our view, the lessons from the EMS suggest that arrangements promoting astable exchange rate in Asia should accompany a blueprint for the regional safety
net of financial stability and a guideline on mutual surveillance on the fiscal andstructural policies for all member economies including Japan, together with peerpressure created by such an initiative.41 In this context, the Chiang Mai Initiative,
which consists of bilateral swap agreements among the ASEAN economies, Japan,
Korea, and China, could be an important first step, and there is no prior reason
why regional integration in Asia should take more or less time compared with
the European experience.42 Similarly, the initiatives toward a regional free tradearea among these economies are also important conditions for deepening regional
integration. In particular, the rapid growth in trade with China,43 if continued, would
increase the benefit of using a common currency in Asia, although one cannot be
sure as to which currency will play a pivotal role.44
One may interpret the current Asian arrangement as a commitment to multilateral
integration with the minimum set of regional agreements reflecting the Asian politicalenvironment. For example, Mundell (2000) points out that an Asian common
currency without the involvement of Japan and China is unrealistic. However, given
the differences in the political regimes of the two economies, he expects that it isunrealistic to consider a common central bank that issues a single Asian currency.
Based on such reasoning, he suggests that the Japanese government should not create
an Asian currency zone based on the yen for the sake of achieving exchange ratestability in Asia, and that a better alternative is for Japan to stabilize the yen-dollar
exchange rate and the yen-euro exchange rate.
If one believes that the stability of the current account is the major and mostpressing concern for the Asian economies, a currency basket proposal without a deep
commitment would be a good starting point.45 However, as Wyplosz (2001b) states,
even if such a practical but piecemeal approach achieved exchange rate stability, it
might be subject to a currency attack without a well-designed commitment device tomake the peg sufficiently credible.

41. For example, such a guideline could require changes in the current Japanese financial regulatory policies.
42. As of March 28, 2002, Japan has swap agreements with China, Korea, Thailand, Malaysia, and the Philippines.
43. For an impressive example, according to Japanese balance of payments statistics, Japanese imports from China
exceeded those from the United States in August 2001. However, Young (2000) estimates that China’s per capita
output growth rate from 1978 to 1998 was 6.1 percent, rather than the officially reported 7.8 percent, becauseof underestimation of the official deflator. He estimates total factor productivity growth in the non-agricultural
sector as only 1.4 percent rather than 3.0 percent, using official data.
44. However, regarding the possible future role of China, Cohen (2000) suggests that even though the yuan’stransactional network may eventually become large, the currency’s prospects suffer from the backwardness ofChina’s financial markets and lingering uncertainty over domestic political stability—to say nothing of the factthat use of the yuan continues to be inhibited by cumbersome exchange and capital controls.
45. Ogawa and Ito (2000) propose an optimal exchange rate regime that minimizes the fluctuation of trade balancesin emerging market economies using a two-country model. Without coordination, a Nash equilibrium withhigher dollar weight would be chosen. They suggest that a common currency unit in Asia will resolve such
coordination failure, because two economies would be better off moving to the basket peg.

66 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

VI. Tentative Conclusion and Challenges for Central Banks
A. Tentative Conclusions
The main observations in this paper are summarized as follows.
First, regarding the bipolar view, the logic behind it is clear. It is true that many
currency and banking crises in the 1990s were related to massive capital inflows andoutflows. However, in particular in East Asia, many economies do not allow a free
float even after the Asian crisis. A clean float without capital controls might be too
costly for these economies, perhaps reflecting the lack of deep and liquid financial
markets, which makes the economies vulnerable to speculative attacks. Moreover, so
far only a few large economies have successfully committed themselves to hard pegs
except for the euro-area economies.46
Second, the experience of the EMS and the recent history of the currency board
in Argentina show that even a strong fixed exchange rate regime may be subject topressure from financial markets. Such pressure may stem from rapid capital inflows
and outflows that induce dynamic inconsistency on the part of policymakers in
defending the peg in the case of the EMS, or to political and institutional factors that
do not support an exchange rate peg. The experience of Argentina suggests that evena currency board cannot work if the economy does not follow a prudent fiscal policy.
In addition, policymakers should address structural issues, such as inflexible labormarkets, which make adjustment under hard pegs too costly, or dependence on dollar
borrowing, which might make policymakers reluctant to revise apparently overvalued
parity. These risks could undermine the achievement of price stability either througha political or currency crisis.
Third, the currency crises in the 1990s suggest that economists should prepare
analytical tools that go beyond the Mundell-Fleming model, in terms of analysis offinancial market imperfections, and general treatment of asset prices. A currency
crisis model may in the future be part of an asset pricing model. Indeed, Figure 2
does not look like the traditional model of a currency crisis that focuses on thebalance of payments. Krugman (2001) argues, “A fourth-generation crisis model may
not be a currency crisis model at all; it may be a more general financial crisis modelin which other asset prices play the starring role.”
Fourth, the criticism made by Frankel and Rose (1998) and the European
experience suggest that the static version of optimum currency area criteria shouldbe evaluated carefully to make inferences regarding the pros and cons of acommon currency.

46. One may argue that the relevant question for these economies is “how to float.” In this context, temporary
capital controls to discourage excessive short-term capital inflows while posing little barrier to capital outflows,which were employed in Latin American economies such as Chile, Brazil, and Colombia in the 1990s, may be
worth mentioning. However, Ariyoshi et al. (2000) conclude that capital controls cannot substitute for soundmacroeconomic policies. Edwards (2001b) concludes that Chile’s experience was successful in changing thematurity profile of capital inflow, and of the country’s debt. However, the effect would be short term and notvery important quantitatively. Reinhart and Smith (2001) calibrate the potential effectiveness and welfare
implication of temporary capital inflow controls. They find that reducing foreign debt by 5 percent of GDP
requires 88.9 percent of an inflow tax under their reasonable parametric setup. They also find that the economic
benefit of taxing capital inflows is quite small.

67

Fifth, the prospects for regional currencies are very unclear. In particular, currently
it is very difficult to predict the development of an Asian currency area.
In sum, we argue that, given the global interdependence among economies thatexists today, currency regimes should be always evaluated in terms of their relationshipto monetary policy, fiscal policy, structural policies, and the working of financial
markets. Thus, a currency regime does matter, and is a relevant concern for policymakers. However, it should be noted that the currency regime is only one element of
national economic policymaking, and thus a broader perspective is always needed.
B. Challenges for Central BanksThis paper has not been able to discuss many important issues because of space
limitations. Let us touch on some of these issues for the sake of further discussions.
First, we did not discuss the debate regarding the appropriate policy response to
be made by emerging market economies and international organs. Althougheconomists disagree about the role of the IMF and the appropriate response to bemade by emerging market economies, the bottom line of the debate seems to beclear. Policymakers need detailed knowledge about the structures of their economies
to analyze currency crises and the resolution of such crises, and central banks are no
exception. The knowledge required is broad indeed. For example, Mishkin (2001)
lists 12 issues for crisis prevention. These include prudential supervision, accounting
and disclosure requirements, legal and judicial systems, market-based disciplines, theentry of foreign banks, capital controls, reduction of the role of state-owned financial
institutions, restrictions on foreign currency-denominated debt, elimination of“too-big-to-fail” in the corporate sector, the sequencing of financial liberalization,monetary policy and price stability, and exchange rate regimes and foreign exchange
reserves. Thus, the exchange rate regime is just one factor among many.
Second, this paper did not make explicit any consideration of the relationshipbetween exchange rate stability and domestic price stability among the three major
currencies. Standard macroeconomic econometric models (such as Taylor [1993])
suggest that the international spillover effect of domestic monetary policy is small.
Therefore, an optimal domestic monetary policy framework would achieve both
domestic stability and international stability. Obstfeld and Rogoff (2001) showedthat when monetary policy is governed by a rule-based policy, the gains from international policy coordination are not necessarily very large within the framework of
the “new open-economy macroeconomics” discussed in the appendix. Thus, Rogoff(2001) suggests that at least three or four currencies are preferable in the foreseeable
future. Meltzer (1996) suggests the United States, Germany, and Japan should
follow an adaptive monetary rule to achieve zero expected inflation. Very small
economies should eliminate the monetary operations of their central banks byestablishing a currency board or a permanently fixed exchange rate. Those economies
should permit their citizens to use foreign currency in a low-inflation economy asa medium of exchange to enforce commitment. This proposal shows that the bestpolicy for a small economy to follow depends on the policies followed by the major
currencies. Under this proposal, all small economies gain by pegging to the currencyof large economies or the basket. They import low inflation and gain from a fixed

68 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

exchange rate. Moreover, large economies gain too, since they have stable prices athome and for imports from the small economies. But they also buffer real shocks byfloating their currencies, facilitating adjustment to real shocks. Are those proposals
robust in the world of currency competition among a few currencies? Could currency
substitution be a destabilizing factor in such an era?
Third, although this paper implicitly assumes that the major currencies will be
the dollar, euro, and yen, should we take this limitation for granted in the long run?
For example, Buiter (2000b) expects that “within a decade or two, the advanced
industrial countries will have 2.5 currencies among them: the Euro, the US$, andsomething around the Yen or the Yuan.” Those opinions pose another importantquestion: how many central banks will survive in the long run? Alesina and Barro(2002) examine the optimal number of currencies that would balance the gains from
more international trade due to the existence of a single currency and the cost oflosing an independent monetary policy. Regions joining the same currency area will
experience reduced trading costs. Hence, without the cost of integration, regions are
better off having a single currency. However, the political costs of integration rise as
the size of the economy increases, hence single currency equilibrium does not occur.
Their model shows that as the number of economies increases, the average size of theeconomy decreases, and the volume of international transaction expands. Hence,an increasing number of economies will find it profitable to relinquish independent
currencies, possibly even faster than the number of economies. Although it is unclear
whether the prediction is correct, central banks should be ready to answer these
theoretical questions within a decade or so.

69

APPENDIX: NEW OPEN-ECONOMY MACROECONOMICS AND
EXCHANGE RATE REGIMES
Obstfeld and Rogoff (1995) presented the dynamic general equilibrium model (O-Rmodel), which incorporated price rigidities—a traditional feature of Keynesian
economics—and imperfect competition. The model features at least two advantages
that suggest it as a “superior alternative to the Mundell-Fleming model” (Lane [2001]).
First, the classic IS-LM approach may not be useful for the sake of future policy
recommendations, since it relies on reduced-form macroeconomic models whoseparameters can vary under alternative policy regimes. However, “new open-economy
macroeconomics” allows a researcher to form a detailed analysis of the effect ofinternal and external shocks on the choice of labor, leisure, and consumption made bya representative agent and the profits of representative firms under the assumption of
optimization behavior. Second, new open-economy macroeconomics summarizes such
effects on the maximum level of utility for a representative agent; thus, a researcher
does not need to use ad hoc welfare criteria to evaluate the effectiveness of economic
policies and exchange rate regimes. In this appendix, we will review some new
open-economy macroeconomics models that incorporate uncertainty and the choiceof exchange rate regime.
A. Models with Uncertainty in the Spirit of the O-R Model
Many researchers have recently tried to build stochastic versions of new open-economy
macroeconomics models with monetary policy shocks or productivity shocks.
For example, Obstfeld and Rogoff (1998) add uncertainty concerning changes inmoney supply to their original O-R model. They show that the variability of money
supply influences not only the variance of consumption and production but also
the expected level of those two variables. The reasons are as follows. Suppose firms
risk-averse to changes in profit levels face uncertainty in foreign money supply. They
charge higher export prices than they would do without uncertainty, because they
add a risk premium to compensate for uncertain changes in foreign monetary policy.
Higher export prices decrease the expected level of production. They also improve
the terms of trade and change the expected level of consumption. Note that thetraditional Mundell-Fleming approach focuses only on changes in the variance ofmacroeconomic variables across policy regimes. However, the O-R approach suggeststhat the evaluation of the choice of exchange rate regimes and alternative monetary
policy rules would be better compared by means of the maximum attainable utility
that reflects both the levels and variances of relevant macroeconomic variables underalternative policy regimes.
B. Choice of Exchange Rate Regime Based on the O-R Model
Recent studies examine the optimal exchange rate regime taking into account threedifferent macroeconomic environments. First, alternative price-setting behaviors offirms (producer’s currency pricing [PCP] or local currency pricing [LCP]). Second,different types of uncertainty (such as monetary shock or productivity shock). Third,
whether an economy should accommodate external shocks or not (that is, whether it
is insulated from the foreign shock or else imports a foreign discipline in the presence

70 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

of domestic monetary shock). We will review three recent theoretical contributions tothe choice of exchange rate regime, based on new open-economy macroeconomics
in turn.
1. Devereux and Engel (1998)
Devereux and Engel compared fixed versus floating exchange rate regimes based on
their usefulness in insulating an economy from foreign monetary shock.47 They
showed that the optimal exchange rate regime depends on whether prices are set in
the producer’s currency or the local (buyer’s) currency.
First, under symmetric LCP, variability in the exchange rate does not influenceimport prices in the home economy, thus the economy is completely insulated against
external shocks. Therefore, the ranking in the variance of the relevant macroeconomic
variables satisfies the following inequality:
Floating exchange rate regime under LCP < floating exchange rate regime
under PCP < fixed exchange rate regime.48
The latter part of inequality in this result is consistent with Friedman (1953), who
assumed PCP and concluded that a floating exchange rate regime was superior to a
fixed exchange rate regime.
Second, let us see the effects on the expected levels of key macroeconomic
variables. Since firms add a risk premium to local currency-denominated export
prices taking into account exchange rate volatility under PCP, the expected level ofconsumption will decrease. However, under LCP, firms do not change their local
currency-denominated export prices to compensate for changes in the exchange
rate, thus an external monetary shock does not influence the expected level ofconsumption at home. After estimating changes in overall welfare, they conclude
that a floating exchange rate regime is desirable under LCP, since it can insulate theeconomy completely from an external monetary shock. However, they also show thata floating exchange rate regime is not always desirable under PCP, because it cannot
completely prevent an external shock from affecting the home economy.
2. Engel (2001)
Engel investigates the welfare effects of fixed and floating exchange rate regimes
under PCP and LCP when a domestic monetary shock is not negligible, and on thisbasis he proposes an optimal exchange rate regime between the United States and
Mexico.49 He assumes that the monetary policy in each country is independent of theother and that the money supply in each country follows a random-walk process.
According to his analysis, if foreign firms set export prices in local (home)currency (LCP), a fixed exchange rate regime is superior to a floating exchange rate
regime, provided that the variance of the domestic money supply is larger than that

47. Devereux and Engel (1998) assume foreign monetary shock not as the change in the average of foreign money
supply but the rise in its variance.
48. When the fixed exchange rate regime is adopted, choice of currency is irrelevant.
49. He also analyzes the asymmetric case where a domestic firm’s price-setting behavior is LCP and a foreign firm’s
behavior is PCP.

71

of the foreign money supply. In other words, the credibility of domestic monetary
policy is lower than that of the foreign economy. Intuitively, the home economy
can eliminate domestic monetary shock through the import of a credible foreign
monetary policy.
Consider the case where foreign firms set export prices in the home currency(PCP). Engel shows that a floating exchange rate regime could be desirable even if
the variance of the domestic money supply is to some extent larger than that of
the foreign money supply. This may be puzzling, because fixed exchange rates
eliminate idiosyncratic risk. The answer to this puzzle is that, for a certain value ofthe variances of home and foreign money supply, floating exchange rates can reduce
aggregate risk at the risk of increasing idiosyncratic risk. Intuitively, under a floatingexchange rate regime, real money supply (or real consumption in his specification) is
less volatile than the nominal money supply if there is any pass-through of theexchange rate price to prices. More specifically, he proves that under a floatingexchange rate regime, the variance of consumption is var(c) = n 2σm2 + (1 – n )2σm*2,
where σm2 is the variance of the home money supply, σm*2 is that of the foreign money
supply, and n is the relative country size. On the other hand, under a fixed exchange
rate regime, var(c ) =σm*2. Therefore, even if σm2 is larger than σm*2, the variance ofconsumption under a floating exchange rate regime could be smaller than under afixed exchange rate regime, depending on the value of σm2, σm*2, and n.
3. Obstfeld and Rogoff (2000)
Obstfeld and Rogoff construct a stochastic model with productivity shock andexamine the optimal exchange rate regime under the assumption that firms set theirexport prices in producers’ currency (PCP).
First, they investigate “constrained-efficient” monetary policy rules, in the senseof maximizing an average of home and foreign expected utilities subject to the
optimal wage-setting behavior of workers and optimal price-setting behavior ofmonopolistically competing firms. Then they show that, under their parameterization,
if policymakers can absorb the productivity shock, by suitably adjusting home andforeign monetary policy rules, this behavior replicates an efficient resource allocation
under flexible price-setting, and those rules are optimal from the viewpoint of an
economy’s individual perspectives.50 This policy rule is procyclical with regard to
productivity shock. For example, a positive productivity shock under conditions offlexible prices increases the wage level, labor supply, and production. Under thepredetermined wage, “constrained-efficient” monetary policy requires an increase inmoney supply in responding to a positive productivity shock, thus the response isinherently procyclical. Since the nominal exchange rate is determined by both
domestic and foreign money supply, “constrained-efficient” monetary policy allows
the exchange rate to fluctuate in response to cross-country differences in productivity
shocks under a floating exchange rate regime.
Second, Obstfeld and Rogoff calculate the expected utility for three alternative
monetary regimes—a fixed exchange rate regime, a floating exchange rate regime,
50. The monetary policy rules discussed here cannot offset the monopoly distortions; they merely bring the economy
to flexible price equilibrium with the monopoly distortions.

72 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

and world monetarism51—to compare the performance of mitigating the effects ofuncertainty in productivity. They conclude that a floating exchange rate regime canrealize the highest welfare, since exchange rate moves respond to differences in
productivity shocks between the home economy and a foreign economy under the
optimal monetary policy.
4. Summary
We may well consider that the choice of optimal exchange rate regime with productivity shock and foreign monetary shock is relevant to the choice of exchange rate
regime between developed economies if we assume that monetary disturbances indeveloped economies are negligible enough to ignore. On the other hand, we may also
regard models with home monetary shock as approximating an optimal exchange rate
regime between developed economies and emerging economies under the assumptionthat domestic monetary shocks in developing economies are large.
Based on those assumptions, we summarize tentative conclusions obtained fromthese recent studies in the Appendix Table 1. This shows, first, that the welfare-based
approach is a promising way to consider the choice of optimal exchange rate regime.
The welfare-based approach requires us to examine not only changes in varianceof macroeconomic variables but also changes in their expected level. The latter
effect is ignored in the traditional Mundell-Fleming approach. Second, regardless offirms’ price-setting behavior, when domestic central banks do not have sufficientcredibility, a fixed exchange rate regime would be desirable as a way to eliminate home
idiosyncratic shocks.52 However, if the credibility of the home central bank is not solow, there might be some cases where a floating exchange rate regime would be better.
Third, the choice of optimal exchange rate regime between advanced economies
depends on firms’ price-setting behavior and the nature of the shocks (monetaryshock or productivity shock). To the best of our knowledge, little research using the
Appendix Table 1 Optimal Exchange Rate Regime Based on
New Open-Economy Macroeconomics

Monetary shock
Foreign monetary shock(exchange rate regime
between developed
economies)
Home monetary shock(exchange rate regime
between developed
economies andemerging economies)
Productivity shock

Producer’s currency pricing(PCP)

Local currency pricing(LCP)

Trade-off between varianceand expected level

Floating

Floating—
fixed regime might be better
when home shock is farlarger than foreign shock

Fixed

Floating—

51. This regime considers a case where both home and foreign economies fix not only the exchange rate but also an
exchange rate weighted average of world money supply.
52. Shioji (2001) builds a three-country model of Japan, the United States, and East Asian economies, extending
Corsetti et al. (2000), and examines the choice of optimal exchange rate regime in East Asia. He shows thatswitching from a fixed exchange rate regime to a floating regime or basket regime, which makes it possible toallow a depreciation of the domestic currency, is theoretically beneficial when the yen depreciates as a result of
an increase in money supply or a negative productivity shock in Japan. However, he also concludes that thetheoretical model which induces the above result is not supported empirically.

73

framework of new open-economy macroeconomics shows that a fixed exchange rate
regime is desirable. Much research demonstrates that a floating regime is better.
C. Reservations
We conclude this appendix by pointing out some reservations about these recent
intensive analyses.
First, recent researches focusing on firms’ price-setting behavior can be divided into
the symmetric PCP approach and the symmetric LCP approach, in the sense that there
is a globally unique price-setting strategy. Therefore, under PCP, purchasing power
parity (PPP) holds both in the short run and in the long run, and the exchange ratepass-through is always 100 percent. On the other hand, under LCP, the exchange ratepass-through is zero and the depreciation of the home currency leads to an improvementin terms of trade in the home economy (Obstfeld and Rogoff [2000]). However,
empirical studies (such as Marston [1990] or Knetter [1993]) indicate that exchange ratepass-through lies in the range of zero to 100 percent, and that a depreciation of the homecurrency causes a deterioration in domestic terms of trade. To resolve this problem, amixed PCP/LCP approach holds promise. This approach assumes that some firms set
their export prices in producers’ currency and that others set theirs in local currency inan open economy, and that the ratio of PCP/LCP is asymmetric. For example, the ECUInstitute (1995), cited in Obstfeld and Rogoff (2000), shows that the percentagesof exports and imports which are denominated in the home currency in developed
economies are relatively low, except in the United States.53 Such evidence may justify
the usefulness of a mixed PCP/LCP approach (see Otani [2002] for an example).54
Second, to the best of our knowledge, studies based on the O-R model assume
that the choice of currency in which prices are set is exogenous. However, theexporter’s choice of currency may well be endogenous. Devereux and Engel (2001)
analyze this point using the framework of new open-economy macroeconomics.
They show that exporters generally set prices in the currency of the economy withthe most credible monetary policy. Thus, the interaction between price-setting
behavior and monetary policy might be a promising topic for future research.
Finally, the O-R model has its own limitations. Many central banks consider
that the omission of political and strategic factors would in practice complicate thechoice of currency regime and the credibility of monetary policy rules. And somemight argue that the assumption of perfect capital markets55 and the omission of theaccumulation of physical capital56 are appropriate for only a few economies.
53. As for the United States, 92 percent of exports and 80 percent of imports are denominated in dollars. For Japan,
the percentage of exports and imports, respectively, denominated in the home currency are 40 percent and 17
percent. For Germany, the respective totals are 77 percent and 56 percent (Obstfeld and Rogoff [2000, p. 123]).
54. Otani (2002) explicitly incorporates asymmetric price-setting behavior into Betts and Devereux (2000) andshows that the international transmission effect of monetary policy is not symmetric, depending on the differenceof price-setting behavior between the home economy and the foreign economy.
55. For example, Devereux (2001) assumes that economies cannot access international financial markets andconcludes that a fixed exchange rate regime is superior to a floating exchange rate regime based on the maximum
attainable welfare level. However, in practice, emerging market economies can access international financial
markets subject to the “original sin hypothesis” (Eichengreen and Hausmann [1999]). Therefore, research on the
optimal currency regime under incomplete international financial markets would be desirable.
56. Recently, a number of researchers have tried to incorporate capital accumulation into “new open-economy
macroeconomics.” For example, see Kollmann (2001) and Chari et al. (2000).

74 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview
References

Aldcroft, Derek H., and Michael J. Oliver, Exchange Rate Regimes in the Twentieth Century, Edward
Elgar Publishing, Inc., 1998.
Alesina, Alberto, and Robert J. Barro, “Currency Unions,” Quarterly Journal of Economics, 117, 2002,
pp. 409–436.
Aliber, Robert Z., “Introduction,” in Robert Z. Aliber, ed. International Finance, Volume 1, The
International Library of Critical Writings in Economics, An Elgar Reference Collection, 2000.
Ariyoshi, Akira, Karl Habermeier, Bernard Laurens, Inci tker-Robe, Jorge I. Canales-Kriljenko, andAndrei Kirilenko, “Capital Controls: Country Experiences with Their Use and Liberalization,”
IMF Occasional Paper 190, International Monetary Fund, 2000.
Baliño, Tomás J. T., Adam Bennett, and Eduard Borensztein, “Monetary Policy in Dollarized
Economies,” IMF Occasional Paper 171, International Monetary Fund, 1999.
Begg, David, Barry Eichengreen, László Halpern, Jürgen von Hagen, and Charles Wyplosz, “Sustainable
Regimes of Capital Movements in Accession Countries,” Centre for Economic Policy Research,
2001.
Bénassy-Quéré, Agnès, “Optimal Pegs for East Asian Currencies,” Journal of the Japanese andInternational Economies, 13, 1999, pp. 44–60.
Betts, Caroline, and Michael B. Devereux, “Exchange Rate Dynamics in a Model of Pricing-toMarket,” Journal of International Economics, 50, 2000, pp. 215–244.
Bordo, Michael D., and Lars Jonung, “The Future of EMU: What Does the History of Monetary Unions
Tell Us?” NBER Working Paper No. 7365, National Bureau of Economic Research, 1999.
———, and Harold James, “The Adam Klug Memorial Lecture: Haberler versus Nurkse: The Case for
Floating Exchange Rates as an Alternative to Bretton Woods?” NBER Working Paper No.
8545, National Bureau of Economic Research, 2001.
Braga de Macedo, Jorge A., Daniel Cohen, and Helmut Reisen, eds. Don’t Fix, Don’t Float, OECD
Development Centre Studies, Organisation for Economic Co-operation and Development,
2001.
Buiter, Willem H., “Optimal Currency Areas: Why Does the Exchange Rate Regime Matter?” CEPR
Discussion Paper No. 2366, Centre for Economic Policy Research, 2000a.
———, “Exchange Rate Regimes for Accession Countries,” speech given at the European Bank for
Reconstruction and Development Annual General Meeting in Riga, Latvia, May 21, 2000b.
———, and Clemens Grafe, “Central Banking and the Choice of Currency Regime in Accession
Countries,” SUERF Studies, No. 11, Société Universitaire Européenne de Recherches
Financières, 2001.
Caballero, Ricardo J., and Arvind Krishnamurthy, “A ‘Vertical’ Analysis of Crises and Intervention: Fearof Floating and Ex-Ante Problem,” NBER Working Paper No. 8428, National Bureau of
Economic Research, 2001.
Calvo, Guillermo A., “Capital Markets and the Exchange Rate: With Special Reference to the
Dollarization Debate in Latin America,” mimeo, 2000.
———, and Carmen M. Reinhart, “Fixing for Your Life,” NBER Working Paper No. 8006, National
Bureau of Economic Research, 2000.
———, and ———, “Fear of Floating,” Quarterly Journal of Economics, 117, 2002, pp. 379–408.
Chang, Roberto, and Andres Velasco, “Financial Fragility and the Exchange Rate Regime,” Journal of
Economic Theory, 92, 2000, pp. 1–34.
———, and ———, “A Model of Financial Crisis in Emerging Markets,” Quarterly Journal of
Economics, 116, 2001, pp. 489–517.
Chari, V. V., Patrick, J. Kohoe, and Ellen R. McGrattan, “Can Sticky Price Models Generate Volatileand Persistent Real Exchange Rates?” Staff Report 277, Federal Reserve Bank of Minneapolis,
2000.
Cohen, Benjamin J., “Life at the Top: International Currencies in the 21st Century,” Cuadernos deEconomia, 37 (110), 2000, pp. 9–34.
Committee for the Study of Economic and Monetary Union, Delors Report, European Union, 1989.

75

Cooper, Richard N., “Exchange Rate Choices,” mimeo, 1999.
Corbo, Vittorio, “Is It Time for a Common Currency for the Americas?” Journal of Policy Modeling, 23,2001, pp. 241–248.
Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini, “What Caused the Asian Currency and
Financial Crisis?” Japan and the World Economy, 11, 1999a, pp. 305–373.
———, ———, and ———, “Paper Tigers? A Model of the Asian Crisis,” European Economic Review,
43, 1999b, pp. 1211–1236.
———, ———, ———, and Cedric Tille, “Competitive Devaluations: Toward a Welfare-BasedApproach,” Journal of International Economics, 51, 2000, pp. 217–241.
Council on Foreign Exchange and Other Transactions, “Internationalization of the Yen for the 21stCentury,” April 1999.
Dellas, Harris, and George S. Tavlas, “Lessons of the Euro for Dollarization: Analytical and Political
Economy Perspectives,” Journal of Policy Modeling, 23, 2001, pp. 333–345.
Devereux, Michael B., “International Risk-Sharing and the Exchange Rate: Re-Evaluating the Case for
Flexible Exchange Rates,” CEPR Discussion Paper No. 2900, Centre for Economic Policy
Research, 2001.
———, and Charles Engel, “Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal
Choice of Exchange-Rate Regime,” NBER Working Paper No. 6867, National Bureau of
Economic Research, 1998.
———, and ———, “Endogenous Currency of Price Setting in a Dynamic Open Economy Model,”NBER Working Paper No. 8559, National Bureau of Economic Research, 2001.
Dornbusch, Rudiger, “Fewer Monies, Better Monies,” American Economic Review, 91 (2), 2001,
pp. 238–242.
ECU Institute, “International Currency Competition and the Future Role of the Single European
Currency,” London: Kluwer Law International, 1995.
Edwards, Sebastian, “Dollarization Myths and Realities,” Journal of Policy Modeling, 23, 2001a,
pp. 249–265.
———, “Exchange Rate Regimes, Capital Flows and Crisis Prevention,” NBER Working Paper No.
8529, National Bureau of Economic Research, 2001b.
———, and I. Igal Magendzo, “Dollarization, Inflation and Growth,” NBER Working Paper No.
8671, National Bureau of Economic Research, 2001.
Eichengreen, Barry, International Monetary Arrangements for the 21st Century, Washington, D.C.:
Brookings Institution, 1994.
———, “Capital Account Liberalization: What Do Cross-Country Studies Tell Us?” World Bank
Economic Review, 15 (3), 2001, pp. 341–365.
———, and Ricardo Hausmann, “Exchange Rates and Financial Fragility,” in New Challenges for
Monetary Policy, a symposium sponsored by the Federal Reserve Bank of Kansas City, 1999.
Engel, Charles, “Optimal Exchange Rate Policy: The Influence of Price Setting and Asset Markets,”
Journal of Money, Credit and Banking, 22 (2), 2001, pp. 518–541.
Feldstein, Martin, “The Political Economy of the European Economic and Monetary Union: Political
Sources of an Economic Liability,” Journal of Economic Perspectives, 11, 1997, pp. 23–42.
———, “Lessons from Argentina,” mimeo, 2002 (http://www.nber.org/~confer/2002/argentina02/
feldstein.pdf).
Fischer, Stanley, “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic
Perspectives, 15 (2), 2001, pp. 3–24.
Folkerts-Landau, David, and Peter M. Garber, “The ECB: A Bank or a Monetary Policy Rule?”in Matthew B. Canzonerik, Vittorio Grilli, and Paul R. Masson, eds. Establishing a Central
Bank: Issues in Europe and Lessons from the US , Cambridge: Cambridge University Press, 1992,
pp. 86–110.
Frankel, Jeffrey A., “No Single Currency Regime Is Right for All Countries or at All Times,” Princeton
Essays in International Finance, No. 215, International Finance Section, Department of
Economics, Princeton University, 1999.

76 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview———, and Andrew K. Rose, “The Endogeneity of the Optimum Currency Area Criteria,” The
Economic Journal, 108, 1998, pp. 1009–1025.
———, Sergio Schmukler, and Luis Servén, “Verifiability and the Vanishing Intermediate Exchange
Rate Regime,” NBER Working Paper No. 7901, National Bureau of Economic Research, 2000.
Friedman, Milton, “The Case for Flexible Exchange Rates,” in Essays in Positive Economics, Chicago andLondon: University of Chicago Press, 1953, pp. 157–203.
Furman, Jason, and Joseph Stiglitz, “Economic Crises: Evidence and Insights from East Asia,” Brookings
Paper on Economic Activity, No. 2, 1998, pp. 1–114.
Ghosh, Atish R., Anne-Marie Gulde, Jonathan D. Ostry, and Holger C. Wolf, “Does the Nominal
Exchange Rate Regime Matter?” NBER Working Paper No. 5874, National Bureau of
Economic Research, 1997.
Glick, Reuven, “Fixed versus Flexible Exchange Rates: Is It Still Possible to Manage in the Middle?”
in Gordon de Brouwe, ed. Financial Markets and Policies in East Asia, Routledge Press, 2001,
pp. 220–234.
———, “Comment on ‘Do Currency Regimes Matter in the 21st Century? An Overview,’” Monetaryand Economic Studies, 20 (S-1), Institute for Monetary and Economic Studies, Bank of Japan,
2002, pp. 82–88 (this issue).
———, and Andrew K. Rose, “Does a Currency Union Affect Trade? The Time Series Evidence,”
NBER Working Paper No. 8396, National Bureau of Economic Research, 2001.
Hämäläinen, Sirrka, “The ECB’s Monetary Policy—Accountability, Transparency, and Communication,”
speech given at the Conference on Old Age, New Economy and Central Banking in Helsinki,
Finland, September 14, 2001.
Hausmann, Ricardo, “Argentina’s Route to Salvation,” Financial Times, January 4, 2002.
International Financial Institution Advisory Commission (Meltzer Commission Final Report), Allan H.
Meltzer, Chairman, 2000, Washington, D.C. (Meltzer Commission [2000]).
Kaminsky, Graciela L., and Carmen M. Reinhart, “On Crises, Contagion, and Confusion,” Journal ofInternational Economics, 51, 2000, pp. 145–168.
———, and ———, “Financial Markets in Times of Stress,” mimeo, 2001.
Kawai, Masahiro, and Shigeru Akiyama, “Implications of the Currency Crisis for Exchange Rate
Arrangements in Emerging East Asia,” World Bank Working Paper No. 2502, World Bank,
2000.
Keynes, John Maynard, A Tract on Monetary Reform, Macmillan and Co., 1923.
Kletzer, Kenneth M., and Jürgen von Hagen, “Monetary Union and Fiscal Federalism,” ZEI Working
Paper B01-2000, Center for European Integration Studies, 2000.
Knetter, Michael, “International Comparisons of Pricing-to-Market Behavior,” American Economic
Review, 83, 1993, pp. 473–786.
Kollmann, Robert, “The Exchange Rate in a Dynamic-Optimizing Business Cycle Model with Nominal
Rigidities: A Quantitative Investigation,” Journal of International Economics, 55 (2), 2001,
pp. 243–262.
Krugman, Paul, “A Model of Balance-of-Payment Crisis,” Journal of Money, Credit and Banking, 11 (3),1979, pp. 311–325.
———, “The Myth of Asia’s Miracle,” Foreign Affairs, November/December, 1994, pp. 62–93.
———, “What Happened to Asia?” unpublished manuscript, 1998.
———, “Crisis: The Price of Globalization?” in Global Economic Integration: Opportunities andChallenges, a symposium sponsored by the Federal Reserve Bank of Kansas City, 2000,
pp. 75–106.
———, “Crisis: The Next Generations?” paper prepared for a conference at Tel Aviv University on
March 25–26, 2001.
Kuroda, Haruhiko, “The Future International Financial Architecture and Regional Capital Market
Development,” speech given at the Round-Table on Capital Market Reform in Asia in Tokyoon April 11, 2000 (http://www.mof.go.jp/english/if/if015/htm).
Lane, Philip, “The New Open Economy Macroeconomics: A Survey,” Journal of International
Economics, 54 (2), 2001, pp. 235–266.

77

Levy-Yeyati, Eduardo, and Federico Sturzenegger, “Classifying Exchange Rate Regimes: Deeds vs.
Words,” mimeo, 2000.
———, and ———, “To Float or to Trail: Evidence on the Impact of Exchange Rate Regimes,”
mimeo, 2001.
Marston, Richard C., “Pricing to Market in Japanese Manufacturing,” Journal of International
Economics, 29, 1990, pp. 217–236.
Masson, Paul R., “Exchange Rate Regime Transition,” Journal of Development Economics, 64, 2001,
pp. 571–586.
McKinnon, Ronald I., “Optimum Currency Areas,” American Economic Review, 53 (4), 1963,
pp. 717–725.
———, “After the Crisis, the East Asian Dollar Standard Resurrected: An Interpretation of HighFrequency Exchange-Rate Pegging,” in Joseph Stiglitz and Shahid Yusuf, eds. Rethinking theEast Asian Miracle, World Bank and Oxford University Press, 2001.
Meltzer, Allan H., “On Making Monetary Policy More Effective Domestically and Internationally,”
Monetary and Economic Studies, 14 (1), Institute for Monetary and Economic Studies, Bank ofJapan, 1996, pp. 1–27.
Mishkin, Frederic S., “Financial Policies and the Prevention of Financial Crisis in Emerging Market
Countries,” NBER Working Paper No. 8087, National Bureau of Economic Research, 2001.
———, and Miguel A. Savastano, “Monetary Policy Strategies for Latin America,” Journal of
Development Economics, 66, 2001, pp. 415–444.
Morris, Stephen, and Hyun Song Shin, “Unique Equilibrium in a Model of Self-Fulfilling Currency
Attacks,” American Economic Review, 88 (3), 1998, pp. 587–597.
Mundell, Robert A., “A Theory of Optimum Currency Areas,” American Economic Review, 51 (4),1961, pp. 509–517.
———, “Interview with Mundell: Thinking about International Economy,” Diamond Harvard
Business, December–January, 2000, pp. 11–19 (in Japanese).
Noyer, Christian, “The International Impact of Euro,” speech on the occasion of a visit to the UnitedStates, 2000 (http://www.ecb.int/key/00/sp000113.htm).
———, “‘Challenges Ahead’: The Accession Process,” speech given at the Foreign and Commonwealth
Office, London, November 12, 2001.
Nurkse, Ragnar, “Exchange Fluctuations,” in International Currency Experience: Lessons of the Inter-War
Period, League of Nations, Princeton University Press, 1944, pp. 113–142.
Obstfeld, Maurice, “The Logic of Currency Crises,” Cahiers Economiques et Monétaires, 43, Banque deFrance, 1994, pp. 189–213.
———, “EMU: Ready, or Not?” Princeton Essays in International Finance, No. 209, International
Finance Section, Department of Economics, Princeton University, 1998.
———, and Kenneth Rogoff, “Exchange Rate Dynamics Redux,” Journal of Political Economy, 103,
1995, pp. 624–660.
———, and ———, “Risk and Exchange Rates,” NBER Working Paper No. 6694, National Bureau
of Economic Research, 1998.
———, and ———, “New Directions for Stochastic Open Economy Models,” Journal of International
Economics, 50, 2000, pp. 117–153.
———, and ———, “Global Implications of Self-Oriented National Monetary Rules,” mimeo, 2001.
Ogawa, Eiji, “The US Dollar in the International Monetary System after the Asian Crisis,” mimeo,
2001.
———, and Takatoshi Ito, “On the Desirability of a Regional Basket Currency Arrangement,” NBER
Working Paper No. 8002, National Bureau of Economic Research, 2000.
Otani, Akira, “Pricing-to-Market (PTM) and the International Monetary Policy Transmission: The‘New Open-Economy Macroeconomics’ Approach,” Monetary and Economic Studies, 20 (3),Institute for Monetary and Economic Studies, Bank of Japan, 2002, pp. 1–34.
Padoa-Schioppa, Tommaso, “EMU and Banking Supervision,” lecture given at the London School of
Economics, 1999.

78 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Do Currency Regimes Matter in the 21st Century? An Overview

Parti, Alessandro, and Garry J. Schinasi, “Financial Stability in European Economic and Monetary
Union,” IMF Working Paper, International Monetary Fund, 1999.
Reinhart, Carmen M., and Todd R. Smith, “Temporary Controls on Capital Inflows,” NBER Working
Paper No. 8422, National Bureau of Economic Research, 2001.
Rodrik, Dani, “Who Needs Capital-Account Convertibility?” Princeton Essays in International Finance,
No. 207, International Finance Section, Department of Economics, Princeton University, 1998.
Rogoff, Kenneth, “On Why Not a Global Currency?” American Economic Review, 91 (2), 2001,
pp. 243–247.
Rose, Andrew K., “One Money, One Market: Estimating the Effect of Common Currencies on Trade,”
Economic Policy, 30, 2000, pp. 7–45.
———, and Eric Van Wincoop, “National Money as a Barrier to International Trade: The Real Casefor Currency Union,” American Economic Review, 91 (2), 2001, pp. 386–390.
Sachs, Jeffrey, “Duhalde’s Wrong Turn,” Financial Times, January 10, 2002.
Salvatore, Dominick, “Which Countries in the Americas Should Dollarize?” Journal of Policy Modeling,23, 2001, pp. 347–355.
Schneider, Martin, and Aaron Tornell, “Balance Sheet Effects, Bailout Guarantees and Financial
Crisis,” NBER Working Paper No. 8060, National Bureau of Economic Research, 2000.
Shambaugh, Jay C., “The Effects of Fixed Exchange Rates on Monetary Policy,” University ofCalifornia, Berkeley, Job Market Paper, 2001.
Shioji, Etsuro, “Welfare Implications of the 1995–1998 Yen Depreciation on Asia,” paper prepared for
the EMEAP Deputies’ Meeting held in March 2001.
Study Group for the Promotion of the Internationalization of the Yen, Report, June 27, 2001
(http://www.mof.go.jp/english/if/if043a.htm).
Summers, Lawrence, “International Financial Crises: Causes, Prevention and Cures,” American
Economic Review, Papers and Proceedings, 90, 2000, p. 1–16.
Taylor, John B., Macroeconomic Policy in a World Economy, New York: Norton, 1993.
von Hagen, Jürgen, “Fiscal Arrangements in a Monetary Union—Some Evidence from the US,” in Don
Fair and Christian de Boissieux, eds. Fiscal Policy, Taxes, and the Financial System in an
Increasingly Integrated Europe, Kluwer Academic Publishers, 1992.
———, Andrew Hughes Hallett, and Rolf Strauch, “Budgetary Consolidation in Europe: Quality,
Economic Conditions and Persistence,” paper presented at the 14th Annual NBER-CEPRTCER Conference, 2001.
———, and Jizhong Zhou, “The Choice of Exchange Rate Regimes: An Empirical Analysis forTransition Economies,” ZEI Working Paper B03-2002, Center for European Integration
Studies, 2002a.
———, and ———, “De Facto and Official Exchange Rate Regimes in Transition Economies,” ZEIWorking Paper B13-2002, Center for European Integration Studies, 2002b.
———, and ———, “The Determination of Capital Controls in Transition Economies: Which RoleDo Exchange Rate Regimes Play?” mimeo, 2002c.
Williamson, John, Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option,
Institute for International Economics, 2000.
World Bank, The East Asian Miracle, Oxford University Press, 1993.
Wyplosz, Charles, “Exchange Rate Regimes: Some Lessons from Post-War Europe,” CEPR Working
Paper No. 2773, Centre for Economic Policy Research, 2001a.
———, “A Monetary Union in Asia? Some European Lessons,” paper presented at the conference
organized by the Reserve Bank of Australia on July 24, 2001b.
Young, Alwyn, “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian
Growth Experience.” Quarterly Journal of Economics, 110, 1995, pp. 641–680.
———, “Gold into Base Metals: Productivity Growth in the People’s Republic of China during
the Reform Period,” NBER Working Paper No. 7856, National Bureau of Economic
Research, 2000.

79

Comment
STEFAN GERLACH57
Hong Kong Monetary Authority andHong Kong Institute for Monetary Research
I am delighted to have this opportunity to comment on the paper by Hiroshi Fujiki
and Akira Otani. It is always a difficult task to write an overview paper, particularly
so on a broad and highly controversial topic such as the choice of exchange rate
regime. However, it is a task the authors handle very well. They cover a wide rangeof topics—from what lesson we can draw from the process of European monetaryunification, the issues that arise in the context of the widely expected enlargement of
the European Monetary Union (EMU), the costs and benefits of dollarization, to theprospects for currency unification in Asia and in the Americas, and so on—and do soin a balanced way. Overall, there is little I take issue with.
As with any broad and careful paper, this is not one that it is easy to comment on.
However, the authors would like to draw our attention to an underlying issue
concerning the choice of theoretical framework in which to analyze the choice of
exchange rate regime. While historically that analysis has been conducted within theframework of the Mundell-Fleming model, the paper suggests that this is not agood starting point. Rather, as they make clear in their appendix, their preference is
to start from the recent literature on the “new open-economy macroeconomics,”
which was initiated by Obstfeld and Rogoff (1995) and which is nicely summarized
by Lane (2001). In my discussion, I will therefore focus on what that literature has
to say about the central issue policymakers face, that is, whether and under whatcircumstances they should adopt a fixed or a floating exchange rate regime.
Before doing so, it is useful to briefly outline the most important features of the
new literature. Its defining characteristic is the incorporation of Keynesian featuresin a dynamic general equilibrium model of the open economy. Two aspects ofthe models are particularly important. First, there is imperfect competition in goods
markets and prices are sticky. This implies that there is a serious price-setting decision
to be modeled. Moreover, with prices above marginal costs, firms would like toexpand production at the current level of prices. Thus, output is in this sensedemand determined. Finally, activity is below the level that would arise if goods
markets were competitive. This implies that monetary policy could potentiallyraise welfare by expanding output. Second, firms maximize profits and consumers
maximize utility. That is important because it provides a natural metric, the level ofutility, which can be used to compare and rank exchange rate regimes.
It deserves to be noted that, as is the case with all economic theory, the conclusions
we draw depend on the assumptions made. One particularly important assumption
concerns the nature of the price-setting process. In contrast to utility functions that
57. I am grateful to Mick Devereux for useful discussion regarding the literature on the new open-economy
macroeconomics. The views expressed here are solely my own and not necessarily those of the HKMA andthe HKIMR.

80 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Comment

presumably are given exogenously, the way in which firms set prices is likely todepend on economic factors. As the authors emphasize, this feature of the economy
is therefore likely to be endogenous. In turn, this suggests that any conclusions
that hinge strongly on the nature of the price-setting process should be taken with agrain of salt.
Turning to the question of what main conclusion we can draw from this literature
for the choice of the exchange rate regime, the authors emphasize that a positive, but
finite, degree of exchange rate flexibility is often preferable to perfect exchange rate
flexibility or fixity. Thus, central banks should avoid corner solutions and instead gofor the middle ground. “Float, but pay attention to the exchange rate” is the message.
From this perspective it is a striking fact that many economies, particularly
in Asia, have expressed a clear preference for fixing the nominal exchange rate.
Moreover, it is noteworthy that the literature on the economic effects of currency
unions, the ultimate fixed exchange rate regime, suggests that irrevocably fixing
the exchange rate is associated with greater trade and increased economic growth.58
There thus seems to be a tension between what theory suggests is a desirable policy
framework and what regime countries choose in practice. This naturally leads to thequestion why this is so.
At a fundamental level, there are two main sets of explanations. The first isthat policymakers may for some reason have adopted the “wrong” policy framework.
The second is that the current state of theory disregards some aspect(s) of theeconomy that policymakers attach great weight to in selecting an appropriate
exchange rate system. While doubtless there are cases of policymakers selecting an
incorrect exchange rate regime, to my mind it seems more plausible that the literatureon the new open-economy macroeconomics, which is developing rapidly, has still not
captured all the mechanisms that may make economies prefer fixed exchange rate
regimes. This is the view the authors take, and they point to imperfections in capital
markets and to the absence of physical capital as potential missing factors. I find theirarguments persuasive. My own view is that capital market imperfections are likely tobe the more important explanation.
In particular, most economists think that floating exchange rates tend to be
excessively volatile, and that the market itself generates this volatility. As argued by
Jeanne and Rose (2002), the impact of such “noise traders” on the economy can beremoved by fixing the exchange rate. It is easy to see that endogenous exchange rate
volatility may be a particular concern for policymakers in economies in which theforeign exchange market is thin and where small economic disturbances can lead tolarge exchange rate movements and associated economic dislocation.
It is also worthwhile noting that a fixed exchange rate regime may be particularly
attractive to policymakers in economies with limited capital markets, since it isdifficult for firms in these countries to borrow in domestic currency. If the borrowing
is in foreign currency, exchange rate movements can have a large impact on firms’ net
worth and therefore, through the familiar credit channel, on the level of economic
activity. In this case, a fixed exchange rate may reduce economic fluctuations. However,
58. See Rose (2000) or Frankel and Rose (2002).

81

it should be remembered that such regimes entail a fixed exchange rate typically
only for a limited period of time, as speculative forces all too frequently overwhelm
soft pegs if capital mobility is high. Since the combination of depreciation and large
foreign currency-denominated borrowing can have an extraordinarily negative effecton economic activity, it is important that a fixed exchange rate in this case be very
hard indeed.
In sum, I share the authors’ view that the new open-economy macroeconomics
constitutes a very fruitful area for research. Moreover, future extensions of the theory
will ultimately conclude that fixing the exchange rate may be a good option if there is
endogenous exchange rate volatility, which is particularly likely if foreign exchange
markets are thin and if incomplete capital markets cause firms to borrow in foreign
currency. Finally, as is suggested by recent theoretical research, a fixed exchange rate isa desirable exchange rate arrangement in economies that are so open that exchange
rate changes have little impact on relative prices.

ReferencesFrankel, Jeffrey, and Andrew K. Rose, “An Estimate of the Effect of Common Currencies on Trade andIncome,” Quarterly Journal of Economics, 117, 2002, pp. 437–466.
Jeanne, Olivier, and Andrew K. Rose, “Noise Trading and Exchange Rate Regimes,” Quarterly Journalof Economics, 117, 2002, pp. 537–569.
Lane, Philip, “The New Open Economy Macroeconomics: A Survey,” Journal of International
Economics, 54 (2), 2001, pp. 235–266.
Obstfeld, Maurice, and Kenneth Rogoff, “Exchange Rate Dynamics Redux,” Journal of Political
Economy, 103, 1995, pp. 624–660.
Rose, Andrew K., “One Money, One Market: Estimating the Effect of Common Currencies on Trade,”
Economic Policy, 30, 2000, pp. 7–45.

Comment
REUVEN GLICK
Federal Reserve Bank of San Francisco
The goal of a conference overview paper is to highlight the major issues and summarize the relevant literature. The paper by Hiroshi Fujiki and Akira Otani achieves thisgoal very well, with a wide-ranging and well-balanced coverage of the issues on future
currency arrangements.
I will focus my comments on the paper in three areas. First, I will provide a brief
overview of the authors’ overview. Second, I will offer some specific comments on the
bipolar debate, where I think the authors could have gone into more depth. Lastly,since the authors by and large avoided taking strong positions on any of the issues,
I will give my views on prospects for regional currency arrangements, particularly in
Asia. Before proceeding, let me inoculate myself by saying that I will be expressing
my personal views, not those of the Federal Reserve Bank of San Francisco or of theFederal Reserve System.

82 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Comment

I. Overview
The paper begins with a review of facts underlying the “bipolar view” of currency
arrangements, also known as the “hollowing out” or “corner solutions” hypothesis.
It makes three empirical observations based on Fischer (2001): first, the frequency of
regimes at the poles—hard pegs and floating exchange rate regimes—has risen overtime, at the expense of soft pegs and other intermediate regimes in the middle. Second,a lot of countries still maintain intermediate regimes—30 to 40 percent, depending on
how such regimes are classified. Third, the distribution of regimes at the poles is not
symmetric: more countries have moved toward greater exchange rate flexibility than
toward hard pegs, the adoption of the euro in Europe notwithstanding. The authors
then ask why there are relatively few hard peggers, and in the bulk of the paper they
discuss the pros and cons for the emergence of more hard peggers in Europe, theAmericas, and Asia. Specifically, will peripheral and transition countries in Europe
adopt the euro? Will more Latin American countries dollarize? Will countries in
East Asia adopt some common exchange rate arrangement that ends with a form of
currency union?

II. Questions in the Bipolar Debate
Let me turn now to some questions related to the bipolar debate that the authors did
not fully address, but warrant further discussion. First, how viable is the middle groundof intermediate currency regimes? Second, if intermediate regimes are becoming
increasingly unviable, how wide are the poles? Third, what kinds of criteria should beconsidered in determining regime choice?
How viable is the middle? It is well understood that intermediate regimes arepotentially more viable for countries that do not have to worry much about large,
sudden shifts in private capital flows. It is worth emphasizing the obvious point that
one way to preserve the viability of an intermediate regime is to maintain balance of
payments (BOP) controls, which a great many countries still do.
Figure 1 illustrates this point nicely. It updates Glick (2001) using International
Monetary Fund (IMF) regime classifications to year-end 2001 (and reclassifies
Argentina and Uruguay as managed floaters), disaggregates the floating regime
category into managed floats and independent floats, and also disaggregates theintermediate regime category into single currency pegs, basket pegs, and bands andcrawling pegs. Hard pegs consist of both currency boards and dollarized regimes.
The figure shows the percentage of countries in each regime category that employ
significant BOP controls, where I use as the measure of controls surrender requirements for export proceeds at the end of 2000. (In the case of countries with pegged
regimes, they are classified according to whether surrender requirements apply to tradewith the anchor currency country.) As is well known, measuring the breadth andintensity of controls is problematic. Export proceed surrender requirements are narrow
enough in their focus to overcome some of these limitations by providing a minimum
condition for the existence of widespread controls on external transactions: countries

83Figure 1 Percentage of Countries in Regime with BOP Controls
Percent
100

80
67
60
60
44
36

40

28
20

13

0
Hard
peg

Singlepeg

Basketpeg

Band orcrawling peg

Managedfloat

Independent
float

that employ surrender requirements are likely to impose controls on capital flows as
well. Of course, this measure does not catch countries without surrender requirementsthat still limit capital movements.
Observe that for countries with intermediate regimes the percentage with controls
is relatively high: 67 percent of countries with single currency pegs and 60 percent
with basket pegs employ controls. (With a more comprehensive measure of controls,
the figures would likely be even higher.) In contrast, for countries at the extreme
poles, the percentage with controls is much lower: only 13 percent of countries
with hard pegs and 28 percent of countries labeled as independent floaters imposed
controls. For countries with band/crawls and managed floats, somewhat more impose
controls—36 percent for the former and 44 percent for the latter—but not as muchas in the case of those with single and basket pegs. (Excluding industrial countries,
the percentage with controls is 17 percent for hard peggers, 38 percent forband/crawl regimes, and 37 percent for independent floaters; the figures for countries
with single peg, basket peg, and managed float regimes are unaffected, as they do notinclude any industrial countries.)
This picture is consistent with the view that countries with intermediate regimes
generally must resort to capital controls. Without controls, the logic of the bipolar
view implies they will be forced eventually to move to one pole or the other. I think
it is pretty clear that intermediate regimes in countries with open capital markets
generally fail, sooner or later. Mexico, Thailand, Indonesia, Korea, Russia, Brazil,
and Turkey all followed some form of intermediate regime, at least de facto, before
crashing. In other cases where countries operated crawling band arrangements,
like Chile, Colombia, and most recently Uruguay, the intervention bands weresuccessively widened before being abandoned altogether. So the message is thatcountries with intermediate regimes that loosen or remove their controls need to havean exit strategy.

84 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Comment

How wide are the poles? Recent experience suggests that the hard peg pole isnarrow, while the flexible rate pole is relatively wide. Specifically, the experience ofArgentina demonstrated that hard pegs in the form of currency boards may notalways survive. This suggests that the hard peg pole is narrower than we thought, i.e.,
the range of viable hard pegs is limited. In contrast, the number of countries withflexible-style arrangements, but that still intervene in some manner because of “fearof floating” concerns, demonstrates that the flexible rate pole may be relatively wide;i.e., the viable range of flexible rate arrangements is broad and can include both
so-called managed and independent floaters. In other words, the nature of a viable
flexible regime is “flexible.”
What makes a flexible regime more viable than traditional intermediate regimes
is that policymakers do not make explicit or implicit commitments to keep theexchange rate within some target range for an extended period of time. As long as
policymakers are not perceived as trying to defend a particular rate, the exchange rate
avoids becoming a lightning rod for speculators, and the regime is less susceptible
to the one-way bets that have often characterized the demise of soft peg or softband regimes once the rate nears the edge of the band. As a result, policymakers ina more flexible regime, even those that intervene sometimes, have more room thanin an intermediate regime to deal with large and sudden shifts in capital flows.
A basket band crawling (BBC) regime is more adjustable than an adjustable peg, but
it is still not generally flexible enough to handle large and abrupt shifts in private
capital flows.
Of course, the absence of an exchange rate target requires an alternative nominal
anchor, such as an inflation target, in its place. Inflation targeting is still compatible
with some concern for behavior of the exchange rate.
What criteria are relevant for determining which currency regime works best fora particular country? One obvious place to start is how the currency regime affects
economic performance, specifically inflation and economic growth. Here is an area inwhich the scope of the paper could be expanded. Though it does discuss how thecurrency regime matters for the conduct of monetary policy and for vulnerability
to crises, the paper does not say much about how the currency regime mattersfor economic performance. Indeed, there is a substantial empirical literature that
attempts to assess the implications of the currency regime for inflation and economic
growth, though the results tend to be ambiguous.
Some discussion of this literature in the paper might have been useful. Somestudies find no differences in growth rates across regimes. Others find that countries
with pegged rates are more likely to have lower growth. However, the paper on
the program here by Edwards and Magendzo (2002) finds that countries withindependent currency unions, such as the those in the CFA Franc zone and theEastern Caribbean Currency Union (ECCU), experienced higher growth.
To resolve such differences in results, it is essential to address a number ofmethodological issues. What is the appropriate methodology to classify countries by
their exchange rate regime? There are a number of different approaches to regime
classification. Some classify countries according to de jure self-descriptions given to
the IMF. Others look at de facto behavior as evidenced by observed variations in85exchange rates. Others take into account movements of other related variables, suchas international reserves, interest rates, and parallel rates. None of these approaches
is without problems, however. In particular, even if a country’s de facto preferences
differ from its officially announced designation, this difference may not be revealed
unless the shocks it faces are sufficiently large.
Other methodological issues include: how should one handle possible simultaneity
problems—i.e., the possibility that the choice of regime, such as a currency union,
may depend endogenously on the expected economic performance. How should one
handle the contamination effects of regime collapses on performance comparisons?
In other words, when a pegged regime collapses and a country adopts a floating rate
regime, one would like to avoid inappropriately attributing the economic performance
effects of the pegged regime in the period after the collapse to the floating regime. How
useful are the results for larger countries, since much of the test power in some studies
typically comes from small countries in the sample? These issues all need to beaddressed when making cross-regime comparisons.
What other criteria are relevant in making regime choices? The optimum currency
area (OCA) literature provides a long list of well-known criteria for evaluating therelative desirability of fixed versus flexible exchange rate regimes. It is generally
accepted that a country is more likely to benefit, on net, from establishing a hardpeg with an anchor country if it trades a lot with the anchor, the economic shocks
they face are highly correlated, there is a high degree of labor mobility among them,
there exists a federal fiscal mechanism to transfer funds to regions that suffer adverse
shocks, and if the exchange rate is needed as a nominal anchor.
Here I would like to make two points: first, as the authors recognize, somecountry characteristics may be endogenous to the exchange rate regime. For example,
the act of fixing to a particular currency may promote greater trade with the anchor
country and a greater correlation of shocks over time. This implies that a country
that does not initially satisfy OCA criteria when adopting a hard peg may come todo so over time. That is, a country may grow into being a good candidate for a hardpeg ex post.
But how quickly such endogenous changes in country characteristics occur isopen to question. Much of the evidence of endogeneity between regimes andeconomic integration is based on cross-section evidence, not time-series evidence.
Consequently, we do not know how long it may take for a currency union to
generate large trade effects. It may be quick: trade between West and East Germany
grew fourfold within five years of reunification. It may be slow: 10 years afterArgentina’s adoption of a currency board with the United States its bilateral tradewith that nation was little changed; indeed, the proportion of Argentina’s trade with
the United States—less than 15 percent—was little different from New Zealand’s.
Second, the decision to enter into a hard peg is ultimately as much political as it is
economic. Clearly, political factors sped up the economic integration of East andWest Germany. Clearly, politics played a key role in the formation of the European
Monetary Union (EMU). Many would argue that EMU was feasible only as part of alarger political goal of integrating Germany with the rest of Europe. Moreover, thehard pegs of the CFA, ECCU, and Pacific Island countries—which account for

86 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Comment

almost two-thirds of the current hard pegs among developing countries—are essentially artifacts of colonial or trustee political relationships. So, if we are looking for
criteria to guide us about which countries are the best candidates for hard pegs andcurrency unions, the role of political factors should not be underestimated.

III. Outlook for Regional Currency Arrangements
Let me conclude with my own views of where things are headed. As I said earlier,in my opinion intermediate regimes are not viable in the long run without capital
controls. Without capital controls, few developing countries have the prerequisitesof strong banking systems, flexible economies, and political stability to sustain anintermediate regime successfully even in the short run.
So, as countries open their capital accounts, most will choose—voluntarily insome cases, involuntarily in others—to move to harder pegs or greater exchange rate
flexibility. But I have my doubts about how many hard pegs will emerge outsideof Europe. In Europe, harder pegs will be attractive for some Central European
countries, as much for political reasons as for economic reasons, particularly if they
have a voice in the formulation of monetary policy once they join Europe’s monetary
union. In the Americas, harder pegs may be attractive for small economies that tradeheavily with the United States, following the example of Ecuador and El Salvador,
but I do not see hard pegs in the future of the larger countries.
As for Asia, I also do not see hard pegs as desirable for most countries in theregion. A lot of people, including some at this conference, still urge some form ofintermediate regime in Asia, involving a common peg to a basket of the dollar,yen, and euro. But I think such a regime would be neither in the interests ofmost countries in the region, nor would it be easy to implement. Differences in tradepatterns across the region complicate agreement on the composition of the basket.
Such a basket, even with a band, would face speculative pressures. There is nonatural focal country for the convergence of policies, at least not until Japan escapesfrom its current economic stagnation. Moreover, there does not yet appear to be
the strong political will for deeper economic integration as was the case in Europe.
Consequently, a more flexible rate regime is likely to perform better for mostcountries in the region.
That is not to say there are no reasons to have less formal kinds of coordinationof exchange rate policies among countries in the region, particularly to deal withcontagion episodes. In this regard, I recognize that progress in Asia has been madethrough, for example, the Chiang Mai currency swaps agreement. But the funds
potentially available under these arrangements are still small relative to the liquidity ofinternational financial markets. Hence, they represent only one step on what is likely
to be a long path if the goal of greater cooperation in the region is to be achieved.

87References

Edwards, Sebastian, and I. Igal Magendzo, “Independent Currency Unions, Growth, and Inflation,”
Monetary and Economic Studies, 20 (S-1), Institute for Monetary and Economic Studies, Bankof Japan, 2002, pp. 215–232 (this issue).
Fischer, Stanley, “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic
Perspectives, 15 (2), 2001, pp. 3–24.
Glick, Reuven, “Fixed versus Flexible Exchange Rates: Is It Still Possible to Manage in the Middle?”
in Gordon de Brouwe, ed. Financial Markets and Policies in East Asia, Routledge Press, 2001,
pp. 220–234.

General Discussion
Responding to the comments of the discussants, Hiroshi Fujiki addressed the questionof the relation between the choice of exchange rate regimes and capital mobility, andagreed that Reuven Glick’s position was consistent with the experiences of the
1992–93 European Monetary System (EMS) crisis. Fujiki also stated that endogenous
factors needed to be taken into consideration in the empirical studies on the choiceof appropriate exchange rate regimes, and that this would be a subject for future
study. Regarding the choice of exchange rate regimes from the perspective of economic
welfare criteria, Akira Otani reiterated the promising aspects of the new openeconomy macroeconomics and agreed with Stefan Gerlach’s comment that it would
be necessary to expand this approach in the direction of incorporating imperfectionsin international financial markets.
Following this discussion, a wide range of general comments were made by otherparticipants concerning such matters as specific regional currency areas and desirable
exchange rate regimes.
Regarding the European experience, Fujiki and Otani, and Glick took theposition that the elimination of capital controls contributed to the EMS crisis.
Jorge A. Braga de Macedo (OECD Development Centre) and Pierre van derHaegen (European Central Bank) expressed doubts that the removal of capital
controls constituted a fundamental cause of the currency crisis, for the following
reasons. (1) The crisis was triggered by a major shock generated by German
reunification; and (2) after the crisis, in compliance with the convergence criteria
and requirements of the Maastricht Treaty, the countries concerned adopted policies
that were consistent with stabilizing the exchange rate of the deutschemark.
Subsequently, exchange rates among member countries were extremely stable underconditions of free capital movement.59 Glick responded to these comments as
59. Braga de Macedo stated that, in compliance with the Maastricht Treaty, member countries adopted policies
consistent with future monetary union under the provisions of the “Exchange Rate Mechanism (ERM) code of
conduct,” and that this contributed to exchange rate stability. For details, see Jorge A. Braga de Macedo, Daniel
Cohen, and Helmut Reisen, Don’t Fix, Don’t Float: The Exchange Rate in Emerging Markets, Transition Economies
and Developing Countries, Development Centre Studies, Paris: Organisation for Economic Co-operation andDevelopment, 2001. This publication states that the “ERM code of conduct” meant that, in the event of interest
rate changes and in crisis management, the fiscal and monetary authorities of the member countries would workin close coordination under the leadership of the Bundesbank, using the deutschemark as the anchor currency
for the EMS.

88 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

General Discussion

follows. While agreeing that a negative shock affecting the anchor country provided
the immediate cause for the EMS crisis, Glick argued that the elimination of capital
controls prompted the markets to test the appropriateness of the policy mix adopted
by the policy authorities.
Regarding the Asian region, Ismail Alowi (Central Bank of Malaysia) motionedthat the global experience showed that when fixed exchange rate regime collapsed,
it was not due to the regime itself, but to weaknesses in the economy such as large
fiscal and current account deficits and the fragility of the financial and banking
systems, concluding that pursuit of an appropriate and consistent policy mix was
essential under any exchange rate regime. Han Ming Zhi (The People’s Bank of
China) commented that while the Chiang Mai Initiative was a worthy first step,
various problems remained to be addressed in the Asian region, including the development and improvement of financial markets. Responding to this statement, Bragade Macedo commented that, in light of the experience of the European Monetary
Union (EMU), the Asian countries would need to develop close cooperation andpeer pressure in order to advance toward a regional currency area.
Commenting on the impact of hypothetical widespread dollarization in theAmericas on the anchor country, Roger W. Ferguson, Jr. (Board of Governors of theFederal Reserve System) noted that explicit institutional requirements for dollarization
should be considered.
Responding to the comments of Gerlach on the new open-economy macroeconomics, Maurice Obstfeld noted that future research in this area should bedirected toward developing models which incorporate incomplete capital markets.
While agreeing with Glick concerning the endogeneity of optimal currency-area
criteria and economic performance, Obstfeld went a step further to note thatassessments based on welfare criteria are indispensable when attempting to determine
whether it is more desirable for business cycles for a set of countries to be synchronized under a common currency, or for them not to be synchronized by instead
adopting floating exchange rate regimes. He emphasized that the new open-economy
macroeconomics was useful in comparing maximum attainable utilities of different
types of exchange rate regimes.
Regarding large exchange rate fluctuations, Allan H. Meltzer commented that transitory and permanent fluctuations should be treated separately, because only permanent
fluctuations have a major impact on terms of trade and resource allocation. Malcolm D.
Knight (Bank of Canada) stated that inflation targeting was effective in restraining
excessive exchange rate volatility, because fluctuations resulting from an unanticipatedshift in monetary policy would be constrained. Responding to these views, Glickexplained that emerging economies were fearful of large exchange rate fluctuations
because of the “original sin” of being unable to borrow in their own currencies.60
60. The “original-sin hypothesis” describes a situation faced by most emerging market economies, in which theycannot borrow funds from abroad in their own currency but remain dependent on dollar-denominatedshort-term bank loans, as occurred even during the period of rapid and global capital movement liberalization of
the 1990s. For the original presentation of this hypothesis, see Barry Eichengreen and Ricardo Hausmann,“Exchange Rates and Financial Fragility,” New Challenges for Monetary Policy, a symposium sponsored by theFederal Reserve Bank of Kansas City, 1999, pp. 329–368.

89Hence, he asserted, when adopting floating exchange rates, in addition to adopting
inflation targeting, it is necessary to take steps to resolve “currency mismatches.”61
Knight commented that the choice of exchange rate regimes cannot be made inisolation and must be consistent with other macroeconomic policies. Robert W.
Rankin (Reserve Bank of Australia) commented that when examining the relation
between desirable exchange rate regimes and the depth of market liquidity, as well as
the degree of sophistication of domestic financial markets, it is necessary to pay due
attention to the fact that both are endogenously determined.
The chairperson of the session, Miyako Suda (Bank of Japan), closed the session
with the following observations. As a result of growing global interdependence andrecent developments in economic theory, a far more complex series of factors must be
considered in evaluating exchange rate regimes. It was hoped that this matter would
be discussed further in the following sessions.

61. This argument is patterned after Morris Goldstein’s “managed floating plus” position, which calls for the combination of inflation targeting and aggressive measures to reduce currency mismatches (Morris Goldstein,
Managed Floating Plus, Washington, D.C.: Institute for International Economics, 2002). Goldstein proposes avariety of measures to limit currency mismatches; these include periodic announcements of the ratio of short-term
foreign debt to foreign reserves, the development of deeper capital markets that allow better hedging mechanisms,
and a prohibition against government borrowing in foreign currencies.

90 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002