Institutional restraints on monetary policy typically make special provision for exceptional circumstances. In times of economic crisis, a gold standard may be suspended, a monetary growth target breached or an exchange rate realigned despite a previous international agreement fixing its level. While institutional discipline is on the whole a good thing, such escape clauses grant policy-makers discretion to act to improve social welfare in the face of unusually severe shocks. This issue is one of great practical importance to the debate within the European Monetary System over how quickly to move from the current regime of pegged but adjustable exchange rates to a single European currency.

In Discussion Paper No. 518, Research Fellow Maurice Obstfeld derives a simple model of a fixed exchange rate system of the EMS type that allows member countries the freedom to realign in periods of stress. In Obstfeld's model, a national policy-maker with an incentive to raise employment above its natural rate through a `surprise' currency depreciation has an informational advantage over the private sector, so such interventions can play a stabilizing role. The policy-maker's freedom to stabilize gives an inflationary bias to the economy, however; so an optimal fixed exchange rate with realignment clauses efficiently trades off higher mean inflation against more effective stabilization.
Obstfeld finds, however, that this `optimal escape-clause' policy rule is unfortunately not time consistent. If society imposes a fixed personal cost of realigning on policy-makers, this may induce them to implement the socially optimal escape- clause rule; but even imposing the `correct' cost may lead to alternative equilibria that produce welfare levels far below that associated with an irrevocably fixed exchange rate. Pervasive uncertainty about the structure of the economy naturally compounds this problem, so more sophisticated incentive schemes are unlikely to produce socially preferable equilibria. Member countries of an EMS-type institution which may impose a political cost on policy-makers who realign can suffer periods during which there is no realignment, but unemployment, real wages, and ex post real interest rates remain persistently and sub-optimally high.

Destabilizing Effects of Exchange-Rate Escape Clauses
Maurice Obstfeld

Discussion Paper No. 518, March 1991 (IM)