When Is It Optimal to Abandon a Fixed Exchange Rate?
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.
We thank L. Goldberg, P. O. Gourinchas, M. Klein, A. Razin, and seminar participants at the NBER, Federal Reserve Bank of New York, Maryland, Princeton, and University of Pennsylvania for their comments. We are particularly grateful to R. Flood, F. Zilibotti, and two anonymous referees for their suggestions. Financial support from the National Science Foundation and UCLA Academic Senate is gratefully acknowledged. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
Rebelo, Sergio and Carlos Vegh. "When is it Optimal to Abandon a Fixed Exchange Rate." Review of Economic Studies 75, 3 (2008): 929-955.