IMF Working Papers

Optimal and Sustainable Exchange Rate Regimes: A Simple Game-Theoretic Approach

Author/Editor:

Masahiro Kawai

Publication Date:

November 1, 1992

Summary:

This paper examines the question of how to design an optimal and sustainable exchange rate regime in a world economy of two interdependent countries. It develops a Barro-Gordon type two-country model and compares noncooperative equilibria under different assumptions of monetary policy credibility and different exchange rate regimes. Using a two-stage game approach to the strategic choice of policy instruments, it identifies optimal (in a Pare to sense) and sustainable (self-enforcing) exchange rate regimes. The theoretical results indicate that the choice of such regimes depends fundamentally on the credibility of monetary policy commitments by the two countries’ authorities. The nature of shocks to the economies and the substitutability between goods produced in the two countries also play some role. International coordination on instrument choice is necessary to design optimal and sustainable exchange rate regimes.

Series:

Working Paper No. 1992/100

Subject:

Conventional peg Exchange rate arrangements Exchange rate flexibility Exchange rates Foreign exchange Monetary base Money

Notes:

Examines the question of how to design an optimal and sustainable exchange rate regime in a world economy of two interdependent countries. Also published in Staff Papers, Vol. 40, No. 2, June 1993.