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

IMF Working Papers, November 1, 1992

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

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Bibliographic details

• Authors: Masahiro Kawai
• Published: November 1, 1992
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451852325.001

Research Question and Framework

• Examines how to design an optimal and sustainable exchange rate regime in a world economy of two interdependent countries.
• Develops a Barro-Gordon type two-country model.
• Uses a two-stage game approach to the strategic choice of policy instruments.
• Compares noncooperative equilibria under different assumptions of monetary policy credibility and different exchange rate regimes.

Key Theoretical Findings

• Identifies regimes that are optimal (in a Pareto sense) and sustainable (self-enforcing).
• The choice of optimal and sustainable regimes depends fundamentally on the credibility of monetary policy commitments by the two countries’ authorities.
• The nature of shocks to the economies plays a role in regime selection.
• The substitutability between goods produced in the two countries also influences the choice of regime.
• International coordination on instrument choice is necessary to design optimal and sustainable exchange rate regimes.

Policy Implications and Recommendations

• Strengthen credibility of monetary policy commitments to broaden the set of sustainable and Pareto-optimal exchange rate regimes.
• Consider the cross-country nature of shocks and the degree of goods substitutability when selecting exchange rate arrangements.
• Pursue international coordination on instrument choice to achieve regimes that are both optimal and self-enforcing.