Exchange Rates
Regime choice

In late 1992, several Scandinavian and EMS member countries' inability to resist speculative attacks on their currencies led to the effective breakdown of the fixed exchange rate system that had emerged in Europe since the late 1970s. The choice of exchange rate regime can be discussed theoretically in terms of optimal currency areas or the microeconomic consequences and credibility of alternative regimes, but observed choices need have no economic rationale and may merely reflect intellectual fashions or political considerations. In Discussion Paper No. 744, Research Fellow Seppo Honkapohja and Pentti Pikkarainen relate countries' choice of exchange rate system empirically to their size, degree of economic development, openness of goods and financial markets, commodity and geographic diversification of foreign trade and terms-of-trade fluctuations. In their sample of 140 industrialized and developing countries, flexible arrangements in fact gained in popularity during the 10 years up to 1992.

Honkapohja and Pikkarainen compare the means and medians of the country characteristics under alternative regimes and estimate logit and probit models to explain their choice. They find some support for the view that small economies and those with low commodity diversifications of foreign trade restrict exchange rate fluctuations, but the level of development, openness of real and financial sectors, geographic diversification of exports and terms-of-trade fluctuations have little effect. They predict that Italy, Spain and the UK should adopt floating rates; Israel, New Zealand and Switzerland should adopt more rigid regimes; while Finland should seek limited flexibility (as in the EMS). In this light, the emerging monetary cooperation among EC member countries appears quite strange. These are quite large, rich and financially well integrated and have well-diversified trade, which suggests they should have floating rates; but their real sectors are very open and their terms-of-trade fluctuations very low, which have traditionally been associated with fixed rates.

Country Characteristics and the Choice of the Exchange Rate Regime: Are Mini-skirts Followed by Maxis?
Seppo Honkapohja and Pentti Pikkarainen

Discussion Paper No. 744, December 1992 (IM)