When Is It Optimal to Abandon a Fixed Exchange Rate?

No 12793, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The influential Krugman-Flood-Garber (KFG) model of balance of payment crises assumes that a fixed exchange rate is abandoned if and only if international reserves reach a critical threshold value. From a positive standpoint, the KFG rule is at odds with many episodes in which the central bank has plenty of international reserves at the time of abandonment. We study the optimal exit policy and show that, from a normative standpoint, the KFG rule is generally suboptimal. We consider a model in which the fixed exchange rate regime has become unsustainable due to an unexpected increase in government spending. We show that, when there are no exit costs, it is optimal to abandon immediately. When there are exit costs, the optimal abandonment time is a decreasing function of the size of the fiscal shock. For large fiscal shocks, immediate abandonment is optimal. Our model is consistent with evidence suggesting that many countries exit fixed exchange rate regimes with still plenty of international reserves in the central bank's vault.

JEL-codes: F31 (search for similar items in EconPapers)
Date: 2006-12
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (17)

Published as Rebelo, Sergio and Carlos Vegh. "When is it Optimal to Abandon a Fixed Exchange Rate." Review of Economic Studies 75, 3 (2008): 929-955.

Downloads: (external link)
http://www.nber.org/papers/w12793.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:12793

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w12793

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().