Dynamic Effect of a Change in the Exchange Rate System: From a Fixed Regime to a Basket-Peg or a Floating Regime

Abstract

This paper theoretically evaluates the dynamic effects of a shift in an exchange rate system from a fixed regime to a basket peg, or to a floating regime, and obtains transition paths for the shift based on a dynamic stochastic general equilibrium model of a small open economy. We apply quantitative analysis using data from the People’s Republic of China and Thailand and find that a small open country would be better off shifting to a basket peg or to a floating regime than maintaining a dollar-peg regime with capital controls over the long run. Furthermore, due to the welfare losses associated with volatility in nominal interest rates, the longer the transition period, the larger the benefits of shifting suddenly to a basket-peg regime from a dollar-peg regime than proceeding gradually. Regarding sudden shifts to desired regimes, the welfare gains are higher under a shift to a basket peg if the exchange rate fluctuates significantly. Finally, shifting to a managed-floating regime is less attractive than moving to a basket peg, as the interventions necessary to maintain the exchange rate for certain periods result in higher losses and the authority lacks monetary policy autonomy.