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## **V. THE OBJECTIVES OF EXCHANGE RATE POLICY IN EAST ASIA**

Exchange rate policy may be assigned several specific objectives, such as maintenance of balance in payments equilibrium, stability of real output, prices and other macroeconomic variables, promotion of international trade and investment, reduction of exchange risk, uncertainty, and transactions costs, and crisis prevention. Of these objectives, it appears that the crisis prevention role of exchange rate policy has been almost exclusively emphasized in some of the recent literature, given the increasingly yet imperfectly globalizing environment for emerging market economies. Such an emphasis, though important, may not serve the best interests of these countries in the long run, if it is focused on exclusively. For one thing, even if crisis prevention is a worthy goal, the policymakers should balance the benefit of crisis prevention against the costs of potentially foregoing the achievement of other goals, such as trade and FDI promotion and economic growth. For another, given the fact that the two corner-solution approach to exchange rate policy may not prevent crisis, by and of itself in the absence of other credible macroeconomic policy and prudential measures, it may not be wise to assign that task to the exchange rate alone. We believe that the dynamic East Asian economies can and should continue to pursue growth-oriented policies in a stable macroeconomic environment by promoting trade, FDI, other forms of capital inflows, investment, and growth, without exposing themselves to the recurrence of a crisis.

# I. **Macroeconomic Stabilization**

For most practical purposes, exchange rate policy for small open economies may broadly be considered to have a microeconomic or allocative role (e.g., maintaining international price competitiveness or facilitating relative price adjustment) and a macroeconomic role (including that of anchoring domestic prices). At times, the microeconomic role and the macroeconomic role can be conflicting, with one requiring exchange rate flexibility, while the other requiring exchange rate stability. The structural VAR analysis presented in the previous section clearly indicates that real output and price inflation in all major East Asian countries are sensitive to fluctuations in real effective exchange rates. Thus, from the standpoint of minimizing domestic output and price fluctuations, it is important that the East Asian economies pay sufficient attention to maintaining stability of real effective exchange rates. For this purpose, a peg to a single currency (be it the US dollar, the yen or the euro) may not be a good option, because it would inherently destabilize real effective exchange rates.

Maintaining stable macroeconomic environments is one of the key components of sound economic management. Given that the emerging market economies are subject to numerous types of shocks, such as sudden changes in terms of trade, foreign demand, and global interest rates, exchange rate flexibility may be useful as a buffer against these shocks originating abroad. In small open economies, however, exchange rate instability due to free floating can be a source of additional shocks to prices and other macroeconomic variables, thus making macroeconomic policy management difficult. Thus the potential benefits of floating as a shock absorber must be weighed against the potential costs of greater difficulties in macroeconomic management associated with exchange rate instability.