The CFA Zone countries in Africa have maintained a fixed parity with the French franc since independence, but the predominance of a few agricultural products and natural resources in their exports has caused them to suffer frequent shocks to their terms of trade. Flexible exchange rates might have alleviated the output costs of these external shocks, but fixed exchange rates have enabled them to maintain lower inflation than their neighbours. In Discussion Paper No. 561, Shantayanan Devarajan and Research Fellow Dani Rodrik develop a framework to assess how small open economies that are subject to sharp swings in their terms of trade should choose their exchange rate regime, which they apply to the CFA Zone countries.

Proponents of the `real targets' school view the exchange rate as an indispensable policy instrument for attaining equilibrium in the `real' economy, which the authorities must manage flexibly in response to external or domestic price shocks with the requisite combination of expenditure-switching and expenditure-changing policies to regain macroeconomic equilibrium. The `nominal anchor' approach rejects the efficacy of nominal exchange rate adjustments, and a recent strand of theorizing spawned by rational expectations has stressed the policy regime's importance in shaping private sector setting of wages and prices.

Devarajan and Rodrik set up a formal model in which the government seeks to achieve both nominal (inflation) and real (growth) targets. The private sector sets prices (or wages) before the government sets the exchange rate, revealing an exogenous terms-of-trade shock. Since the government can manipulate the exchange rate after wages and prices have been set, the economy displays an inflationary bias. This calls for a fixed exchange rate, to remove discretion, but the setting of domestic wages and prices before the terms-of-trade shock makes output too volatile. The preferred regime will depend on the variance of the terms-of-trade shock, the openness of the economy and the relative weights the government places on controlling inflation and maintaining output.

Devarajan and Rodrik apply their framework to the CFA Zone countries to assess what membership of the Zone reveals about their ex ante valuation of the output-inflation trade-off and compare the range of these revealed trade-offs with `reasonable' trade-offs. They find an inflation differential between CFA and non-CFA African countries of around 14 percentage points. None the less, their highly stylized calculations suggest that fixed exchange rates have been, on the whole, a bad bargain for these Zone countries. For most of them, the benefits of low inflation appear not to have offset the costs of reduced output; while under `reasonable' trade-offs, they would have done better to use exchange rate flexibility to adjust to external shocks.

Do the Benefits of Fixed Exchange Rates Outweigh Their Cost? The Franc Zone in Africa
Shantayanan Devarajan and Dani Rodrik

Discussion Paper No. 561, July 1991 (IM/IT)